Chapter 18

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924 CHAPTER 18 » Financial Statement Analysis Horizontal Analysis . chnique for comparing a serieg d trend analysis, is @ t¢ Horizontal analysis, also calle i, financial statement data over 2 pe}:e y type of comparison casicr- first, t dara T annual report are prcsenled in czmp«.s o a summary of selected fnancial data is p ten years or more. ose of hori ; ercentage. For e Lexpp h may be expressed as either an amount or p ; 8 Xample, en place. This change may percentages for Canadian Tire are as follows: operating revenue figures and ) ATTECEEERAE (D (AT ER L 31 { 2005 2004 2003 2002 2001 : 59445 $5,374.7 i / $7,774.6 $7,153.6 $6,552.8 $5,94 A o base priodamourt e i 1219% 1106% 100.0% % change for period 8.7% 9.2% 10.2% 10.6% - — | Two features in annual reports make ;g ata in each of the financial statements found in the data for one or more previous years. Secong. 4 in the annual report for a series of five ¢ f tal analysis is to determine the increase or decrease that has t,). zonta ————— Helpful hint Percentage of If we assume that 2001 is the base year, we can express operating revenue as a percent- base period amount = Analy- age of the base-year amount. This is done by dividing the amount for the specific year we sis period amount + Base . | . det ine that ti ] eriod amount are analyzing by the base-year amount. For example, we can determine that operating rev enue in 2005 is 144.7 percent of the operating revenue in 2001 by dividing $7,774.6 million by $5,374.7 million. In other words, operating revenue in 2005 is 44.7 percent greater than sales five years earlier, in 2001. From this horizontal analysis, shown in the second row of the above table, we can easily see Canadian Tire's revenue trend. Revenue has increased each year since 2001. Ipful hint Percentage We can also use horizontal analysis to measure the percentage change for any one specific snge for period = Dollar it oF chers since asgs period. This is done by dividing the dollar amount of the change between the specific year od - Base period amount under analysis and the base year by the base-year amount. For example, if we set the previous year, 2004 in this case, as our base year, we can determine that operating revenue increased by $621 million ($7,774.6 million — $7,153.6 million) between 2004 and 2005. This increase can then be expressed as a percentage, 8.7 percent, by dividing the amount of the change be- tween the two years, $621 million, by the amount in the base year, $7,153.6 million. That is, in ?005, operating revenue increased by 8.7 percent compared to 2004. The percentage change In operating revenues for each period is presented in the last row of the above table. Balance Sheet To further illustrate horizontal anal : ysis, we will use the financial statements of Hometown Tires and I\'10re Inc. P'iomcfown Tires and More is a small, local retail store that directly competes with Canadian Tire. Its two-year condensed balan ce sheet, whi and percentage changes, is presented in lllustration 18-]. cet, which shows dollar T 2000000 s o 0.0% e ——— T i i { Note that, in a horizontal analys; i e that, ysis, while the amount column of the in i additive (e.g., the change in to o e e i tal liabilities totals to a net decrease : i of $50,800), the ent- age column is not additive (6.4 percent is not a total) i thin persat The horizontal analysis of Hometown Tires and More’s comparative balance shect shows that several changes have occurred between 2004 and 2005. In the current assets section, accounts receivable increased by $22,500, or 45 p ercent, while available-for-sale securities decreased by $15,000, or 42.9 percent. Note that there were no changes in market value for the available-for-sale securities, so all of this decrease relates to sales of short-term invest- ments. It looks like Hometown Tires and More may be financing its increase in reccivables by selling its investments. We will look at the income statement in the next section to deter- mine whether sales increased by the same proportion as receivables. If not, this may indicate that the receivables are slow-moving. Inventory increased by the largest dollar amount, $47,500, but not the largest percentage, 14.6 percent. Inventory may have changed because of increased sales—we will investigate this further when we analyze the income statement. Prepaid expenses also increased by 50 percent in 2005. One has to be careful in interpreting percentage changes like this. Because it is a proportionately large change ($10,000) on a smz?ll amount ($20,00(')),'tbe percentage change is not as meaningful as it first appears. Despite these changes, it is interesting to note that total assets are unchanged from 2004 to 2005. . bl Current liabilities increased by 7.7 percent. The increase in current .h.a'bllmcs nfiay e' ue to the increase in inventory. Changes in cx;‘rrenltl assets and c;::}:\n:vli‘l?b(;lctzsa:esufn );"?;O\czsl: the same direction—that is, normally bot v~{i increase or ! e liabiiities , both have risen, although current assets have increased more t an cur ‘ T _— Long-term iiabilitiei decreased by $75,000, or 158 szcgn‘é"tigg(i's:?r:?fi;:‘i :cmsc dby More appears to be using some of its profits to repay its dC t. Re Horizontal Analysis « 925 ) Hustration 18-1 « ‘ Horizontal analys:s ¢f talance | sheet Assets 2003 , Increase (Decreace ‘! —nerease (Decrease Current assets = __2004 M Percentage “g Cas i Available-for-sale secyrit; S 30 s ! ities 000 S 53 5 | Accounts receivable 20.000 ;:% S‘Em\‘ (‘:"E\ ‘ lnvcnsory 72500 SO000 Do 20 H:.‘) ) i Prepaid expenses 372,500 323,000 3:;00 43.0‘2 i Total current assets — 30,000 20.000 l(\.(\oo ‘{;’g: \ Property, plant, and equipment 343,000 483,000 m |3'4: i Intangible assets 40(_’-000 450,000 (S()‘O()O) (l;. \;\ i Total assets “5& 65000 (10000) (1547 | Liabilities and Shareholders' Equity 20050 2L000000 i 0.0% ]\ Current liabilities . \ Long-term liabilities $ 337700 s 313500 $ 242 79% | » 00 LY Ae ‘ Total liabilities —300000 475000 (750000 (1587 || Shareholders’ equity —137.700 788,500 (50.800) (6.4%) { Share capital | Retained earnings 122000 90,000 0 0.0% ‘ Total shareholders’ equity ’Jls\;gg(()) LZPOO 50.800 41.8% ‘t Total liabiliti T —=02,000 211,500 50,800 24.0% iabilities and shareholders equity $1.000.000 51000000 H ‘| § '

:dnean g 926 CHAPTER 18 llustration 18-2 » ot. This suggests that Home- hulaaces e rather than by adding to its ning income, > Financial Statement Analysis o ! ity secti the 418 percent in the sharcholders”equity .s.t.cll.(n;)o (he town ‘Tires and More is linancing its business by Jong-term debt. Income Statement s Tires and Morc’s condensed S is al unulysis Of Homet strati 18-2 presents hOl‘IlOnl.l ]”ll.\“’ iion 18 P - f ' ' Honizontal analysis of ncomo statement income statement for the ye w B OMETOWNALRESIANDM LI [ncomesiatemeny Year Ended.Decem ber3li Increase (Decrease) 2005 2004 Amount Pereentage e WY — —_— - ] $2,095,000 $1,960,000 $1 ;Z.ggg) (28;(’2) Sales \ N ‘ ' \l:lt: returns and allowances 1 ‘)32;‘8:;8 1 :;;;888 —1('&,0_06 870 o) s S 230, 11.4% p e s sold L1000 1240000 WL it L il 616,000 597,000 2.0 3% ()‘;-:c:.u[:ng expenses 433'.000 7;2888 2,,000 .1.3% Income from operations 159.000 ; -r reventes and expenses 162% ()II'::\-:-::l\x:c.l'::;‘;‘\'vnlw] 9,000 11,000 82&8) E]? 1(;;,; lnu'r.v\l epense 36.000 4().508 4.500 3.5% Income belore income tax 123888 L;Z:go (zjsoo) il ,\l":l‘,il:::()‘r:l:‘mm‘nsc S 87‘()00 < 75,000 S 7,000 9.3% [ e —— Horizontal analysis of the income statement shows the following changes: Net sales in- creased by 8.7 percent, while the cost of goods sold increased by' 11.4 pcrcen]tl.f " Sales do not appear to have increased at the same rate as reccivables. Recall from Illustra- tion 18-1 that receivables increased by 45 percent. Here we learn that net salc.s increased.by only 8.7 percent. Later in the chapter, we will look at the receivables turnover ratio to dctc.armlr.xc whether receivables are being collected more slowly or not. However, we must be cautious in over-interpreting this increase. This type of business relies a lot on cash sales, not credit sales. Therefore, a relatively small change in reccivables can produce a large percentage change. Recall also that in Hlustration 18-1 we observed that inventory increased by 14.6 percent. The cost of goods sold reported on the income statement also appears to have increast, by 11.4 percent, even though net sales only increased by 8.7 percent. We will look at the inven- tory turnover ratio Jater in the chapter to determine if these increases are reasonable. To continue with our horizontal analysis of the income statement, we note that gross profit increased by 3.2 percent. Operating expenses outpaced this percentage increase at 3.9 percent. Normally, management tries to control operating expenses wherever possible, so we would hope to sce operating expenses change at the same rate, or a lower rate, than gross profit. Other revenues and expenses declined. Overall, gross profit and net income both increased, so Hometown Tires and More's profit trend looks good. A horizontal analysis of changes from period to period is pretty straightforward and is quite useful. But complications can occur in making the calculations. If an item has no value in a base year and a value in the next year, no percentage change can be calculated. Or, if an item has a small value in a base year and a large value in the next year, the percentage change . n he analysis of the c ANEES against 3 by, comparisons of these ch ¢ amouny. PRevieW It 1. What are the differences bery : veen 2. What are the three differen; tools tl:;r[a;:iemupsar:iy. ed ¢ 3. How is a percentage of 4 b i 1 ase-period 5 riod calculated? P FIOME e imercompany' O compare fing leulated? Hoy an.(l lf\duslry COmparisong? ncial information: isa : percentage change for o pe- Selected, condensed information (i ended June 30 follows: 2008 2007 2006 3 o . 200 Ce;vcnuesf $5,035 $6,294 $9,468 S8 ; Gross prof 936 1077 a1y a0l Net income 251 110 .546 Izgg Calculate th : - (a) Calculate the percentage of the base-year amount for each year assuming that 2005 is the |, : ; is the base year. (b) Calculate the percenta and 2007 and 2008. Action Plan ge change between the following years: 2005 and 2006; 2006 and 2007. ® Set the base-year (2005) dollar et Ll amounts at 100. Express cach later year's amount ® Find the percentage of the base ividi -year amount by divid e doll: anslysls by the Bace gt s y dividing the dollar amount for the year under ® Find the percentage change between two periods by dividing the dollur amount of the change between the prior year and the curcent year by the prior-year amount. asa percentage Solution (a) Percentage of the base-year amount 2008 2007 2006 2005 Revenues 58.2% 72.8% 109.5% 1007% Gross profit 49.3% 56.7% 112.9% 100 Net income 58.6% 25.7% 127.6% 100% (b) Percentage change for each year 2008 2007 2006 Revenues (200)% (335)0% 95% Gross pr()fi[ (131)% (498)% 12.9% 128.2% (80.0)% 27.6% Net income Related exercise material: BE18-1, BE18-2, and E18-1. < ‘_)Ng (@ 927

> Financial Statement Analysis _‘-‘}— . 18 v 928 CHAPTER : lysis — Property, plany. . ‘ertical Analys ) o livati ) ’ » 4nd equipme Ver T common size analysis, s 3 technique for evaluating fifnar;)ma] f centages otf loljll assets— 45 Pzrc::i and intangipe assets bogh, Vertical Analysis <4 929 o sis, also called com : & t as a percentage ol a base cquipment and 6.5 | in 200 ssets deer . Vertical n;a,bts}l;t expresses ecach item in a financial statcmfi’}‘lan onepycal’, vertical analy. creasc is likely dye S)Ci’r:‘-‘m N 2004 ¢, 354 040 Percent in 2003 f:r‘m‘d 2 relutive - slalt‘m(‘"\f\ ':‘"’ h] izontal analysis compares data across more y Long-term liabiliy; C(;cascd aCcumu]atcscmm‘ n 2005 for intang-l};;op““)'- plant, and G "hile horiz ) i es ccr(-'aS(.‘df - amnni?.][j ible assets. ThlS d‘- sis compares data within the s yoc sscts are 54.5 percent of total assets (to. increased from 12.1 Percent 1o, 175 M 475 perceny 1 :n. ’ sis Using vertical a nalysis, we might say thlatcurr;’nlta O on the income statement, we might 2004 ang 2005. These results r ‘PFTCcnt of tora] Iiabil(i)(i 0 P:;c(}:\; while retained _— ) : 1) on the balance sheet. Ur, . More is financing it . ceinforce es and shyre S tal assets being the base amoun ;2 9 percent of net sales (net sales being the base amount). ( B 1s growth by Fetaining (‘arc Calier obsenvation that Hdcrs o35ty between say that operating expenscs are 22.9p ! nings. ray adduti Income Statement itional deb, Balance Sheet ) , - A vertical analysis of Hy, ; ertical analysis of Hometown Tires and More’s COmPal’au,‘e.b.Cllance 18-4. The base amount d Mores in Hlustration 18-3 shows a ver ¢ items is total assets. The base amount for the liability and s on the ome statement is shown in Mustration shect. The base amunt [or the ;IJSI?CI)‘II’I ios and shareholders' equity, which equals total assets. income statement, ) ' - i i sharcholders’ equity items is total Labiti . —— ARG 5 InCome ‘E‘ggﬂmm | Wustration 18-4 « {llustration 18-3 > X[ OWBaRESe 0 c , 1 D Cembar) ! Vertical analys:s of income \Vertcal analysis of balance Deeabecs | | statement sheet n 2003 ; _ : Amount Perc 2004 { 2005 2004 Sales o e Sicentage Amount Peree { Amount Percentage _ Amount Percentage iales rlclums and allowances shng;'m 104 9% m %SE | Net sales —23.000 49 . % i . - i Gross profit 87000 69.27 = L ‘ CU([“": e $ 50,000 0% 3 52'000 9:9% \ Opcragn ‘ex enses m 08 l.%«!(_\.()()n?__ fe 3% ‘:':‘;.';:\':L:mm 2 s N 20,000 20% 35.000 3.5% o8 Bepensgs) 157.000 gy 597.000 250 i Hiades lelpful hint Available-for-sale securities 23500 726 50.000 5.0% Income from operations m —=2.9% __$40.000 e ] stsaes = Each item on ba'ance sheet Accounts receivable 322500 37.3% 325.000 3259 Other revenues and expenses ’ 9% 157,000 85% , Tctal assets Inventory , s 20'000 2.0% Investment revenue 9 _ | Prcp.xid expenses —.—35.)£0_() _i'-(-): 485'000 48.5% Interest cxpense 3610)2(()) 0",'"' 11.000 06% i Total current assets 545,000 5 S: o5 0 250 Income before income tax 132000 =153 —30.500 22% ‘ Property, plant, and equipment 400,000 40.0% , : Income tax expense ' 66% 127,500 69 | 1t 55000 5.5% 65.000 6.5% e 0000 257 52,500 297 ’ Intangible assets — 2 00% $1.000.000 100.0% et income S_R2000 3% ool 297 Total assets $1.000,000 100.07 $1.000,000 100.0% P 3 ) S__75.000 3107 ] [P —————————— — 1 iabilities and Shareholders” Equity Wi hat th oo g | ; o € ¢an see that the co ; . Liabilties 7700 338% S 313,500 31.4% f st of goods sold as a percentage of net sales increased by 1.7 per- Current habilties $ 3377 — 4 cent (from 67.5 percent to 69.2 percent). Operati i : Long-term liabiliies 400,000 _40.0% 475000 _47.5% | sales by 1.1 percent (from 24 - perating expenses declined as a percentage of net Total liabilities 737,700 73.8% 788,500 78.9% did y h P b mf.n percent to 229 percent). As a result, income from operations Sharcholders' equity id not change substantially between 2004 and 2005: it declined by 0.6 percent (from 8.5 \l ‘ . . Share capital 90,000 9.0% 90,000 9.0% percent to 7.9 percent). Net income remained relatively unchanged as a percentage of net Rv‘lrdin?d}cm:nlfis o 213:38 ;Z;:‘f ;f: Zgg ;? }Z’ sales from 2004 to 2005: it increased by 0.1 percent. Although we saw Hometown Tires and otal shareholders’ equity 2.3 2% , 70 More’s net income increase by 9.3 percent in Hlustration 18-2, i ility i Total liabilities and sharcholders’ equity $1.000.000 100.0% 1,000,000 100.0% . ; y72P ustration 18-2, its profitability is unchanged in comparison to net sales. A vertical analysis can also be performed on the statement of retained earnings, cash flow statement, and statement of comprehensive income. However, this is rarely done, be- cause each statement already gives details that show changes between two periods. Vertical analysis shows the size of each item in the balance sheet compared to a base amount. It can also show the percentage change in the individual asset, liability, and shareholders’ equity items. For example, we can see that current assets increased from 48.5 percent of total assets in 2004 to 545 percent of total assets in 2005. We can also see that the biggest change was in . _— £ 3 -~ 1sons inventory, which increased from 32.5 percent of total assets in 2004 to 37.3 percent in 2005. Intercompany Compar This is contrary to what we first observed in Hllustration 18-1, where it appecared that prepaid Another benefit of vertical analysis is that it makes it possible to compare companics of differ- . . % o] itor is dian Tire. Usin expenses had the greatest percentage increase. In Hlustration 18-3, prepaid expenses increased ent sizes. For example, Hometown Tires and ieres mam mmlfi:g;:; ocf::}?;‘ small local n.-ufi only by one percentage point of total assets, from 2 percent in 2004 to 3 percent in 2005. You vertical analysis, the condensed balance sheet (or the income state will recall our carlier words of caution about inte ingfully ared with the balance rpreting such a large percentage change as company Hometown Tires and More can be more meaningfully compa | ' i i ian Tire, as shown in llustration 18-5. \ shat was presented for prepaid expenses in Illustration 18-1. shect (or income statement) o the giant eialer Cpadian

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930 CHAPTER 18 »> Hustration 18-5 » Intercompany balance sheet comparison—vertical analysts Analysis Financial Statement - gAY N Deceme ) thoteends) 1 lrnl'lclurvvln T Ti h e e A :)ll::l: dnl(’lcrc:-nln ¢ Amount M‘EB m J Amount AL 50.0% e — 5% $2,981,000 . 545 54. ; : e 76 i St A i M:'::.::i\"nl)lc< and other assets . 422;: #2500 s Long-term receivables 8¢ - 0 : . P::qfuny. plant, and equipmen l 030 s om0 i Intangible assels —_— —_— Total assets . SLO00 RS Liabilitics and Sharcholders Equity 33.8% $1,821,000 30.6% e . 40. 623,500 27.29 Liabilitics . 238 s 121 e Current liabilitics 100 Lsz0 B Long-term liabilities s . Total linbilin'.vs - o o Sharcholders’ equity 9(’) 205 om0 e Share capital 2)675 172% L2 ke stained carnings : 0 e RL,;“:I.:T:lmn:hnldcrs cquity o 22 262 2ol : o) abilitics and sharcholders” equity 3 $ e | Total liabilitics ar - 3 | . han the total assets of the rly 6,000 times grcater't ‘ €2 a: : ires and I\/?ori. Vertical analysis climinates this difference in aller Hometown Tires Tires and More has fewer dollars of property, plant, I—lome(tj(.)wn’nre ($400,000 compared to $2,743.9 mll.hon), using adian plant, and equipment for each company is relatively e e — Canadian Tirc's total assets arc ne much sm size. For example, although ! and equipment comparc'd to fan o percentages, the proportion of property, ared to 46.1 percent). . sx'mila’r}(-m I;Cflcr;:cizxfiq';‘?gcsoand I\/}I)ore has fewer dollars of debt compared to Canadian Although Ho illi i higher debt percentage than does i 3,444.5 million), it has a cr itage th e ($738’0'00 Compﬂf‘?dc;f’t iompared to 57.8 percent). This is r]O[ surprising given that S vt he same access to equity financing as does Ca- 4 ‘ have t A 'n Tires and More doces not . g ith limited shar HZ{"‘"?{‘_}; THomctown Tires and More is a privately owned hefiress, il ¢ nadian Tire. distribution. Accordingly, Hometown Tires and More has a lower equity base than Cana- jan Tire (26.2 percent compared to 42.2 percent). . dhm/\?)r':nf c61n spcce from this limited example, there are many things that can be learned by i anies of vastl looking at vertically analyzed financial statements even when comparing comp y different sizes. - XTI ACTNION C Blsiness (hsiin ] ies report financial information using percentages. Eor gxample, Groupe m§2¥ré$;n ga\r};ieaufit Inc., based in Montreal, reported the following ina recfent pé%sg release announcing its fourth quarter results: Net income rose 75 percent to $11.4 mllllon rom 'r- million. Revenue grew 12.7 percent to $175.3 million from $155.6 mull;gn. Growth was driven pnmaa ily by an 80.9-percent increase in revenue generated by the company's water treatment group, as result of acquisitions. Source: “Laperrigre Sees Profit Jump 75% in Quarter,” The Globe and Mail, May 30, 20086, B5. Are the percentage changes for Laperriére based on horizontal or vertical analysis? »Review It »Do it Ratio Analysis < 931 1. What is veric 2. How is vertical anglye:e 1. 3. What base amouny i):ls dl”cmm fre om used g, o, analyzed balance sheers lncor;aICUIale € Stare al analygje: ¢ per, menes Currcnt assetg Propeny . 2 . Tolal.a'sl:e‘::L = Cquipmeny 5;22000 3180000 Soal00 430 060 Calculate the percentage sizeq of each cype 290,000 2600 010 Action Plan fom foreach Y 5. using vertic analysis, ® The base amouny j | S total asser ¢ Find the relative pel 5 a balance sheet, reentage by dividin, . 2 2 the spec - Solution *Pecific asset amoun by the base amount for h > or cach year, 2008 3007 Current assets oount - p . . —reentage Amount Peren: = 5334,000 2365 m Peree nl:y. 756,000 o , 30.07% 76.4¢ T « 420~0()() o 290,000 Tongs 600,000 170' — Related exerci ial: =0 oo elated exercise materiq]. BE18-3, BEI8—4 ——iin . BE18-s, E18-2, EI8-3 and El18-4. Ratio Analysis Ratio analysis expresses the tios are generally classified int Property, plant, 5 nd equipment Total assets relationships bety o three types: veen selected financi] statement items, Ra- study obijective 3 7 obiect iSeqtitviandiise ratios) SOEWEL AT T l@m§-rlmfigLfr$Mr over a long period 3. Profitability ratios. These . : measure the operating success of 3 company for a specific period of time. In earlier chapters, we presented liquidity, solvency, and profitability ratios for evaluating the financial condition of a company. In this section, we give a summary list of these ratios. Chapter and page numbers of the earlier discussions are included so you can review any individual ratio. In addition, in the appendix to this chapter there is an example of a comprchensive financial analysis using these ratios. This analysis uses three bases for comparisons: (1) in- tracompany, comparing two years of data for Canadian Tire, (2) intercompany, comparing Canadian Tire to Hometown Tires and More, and (3) industry, comparing both companies to industry averages for the retail industry.

932 CHAPTER 18 Summary of liquidity ratios Illustration 18-6 » Financial Statement Analysis Liquidity Ratios Liquidity ratios measurc the short-term : as tions and to mect unexpected nccdls for ¢ ak y interested in assessing 4 pay its maturing obliga- such as bankers and ability of a company to 8-6 lists the liquidity h. Short-term creditors, iquidity. llustration 1 supplicrs, are particularl ratios we have scen in this (extbook. o ' - o o r_. - ]-,7 S Purpose _Discussion _ ' i “ormul: T - . Ch.4,p. - ;' R.n"_’ int assets — Current Jiabilities Measures s.horl term debt- Ch. 4, p. 182 ’ ! Working capital Current as paying hility. . l] i Current asscts Measures short-term debt- Ch. 4, p. 182 ‘ i Gurrent o Current liabilitics paying ability. N i Cost of goods sold Measures liquidity of Ch. 6, p. 304 | Inventory turnover ost of goods : e | crage inventor | Averag y " i . Days in year Measures number of days Ch. 6, p. 305 | 'l Di})’S 5:'-'110.\ " Inventory turnover inventory is on hand. | reiBlos Net credit sales Measures liquidity of Ch. 8, p. 427 | sceivables ver S St ! Receivables turne Average gross receivables reccivables. | Measures number of days Ch.8,p. 427 | Days in year Receivables turnover reccivables are outstanding. i !, Collection period | ! .world limitations because adding equal simple current rati i r & ggifififsaigrgmh thg numerator and denqmjnator causes this ratio to decrgl?.se‘ . Assume, for example, that a company has $2 million pf current assets and .$1 million of current liabilities. Its current ratio is 2:1. If it purchases $1 million of inventory on account, it will hana $3 million f current liabilities. Its current ratio now decreases to‘1‘.5.1 . | have $1.5 million of current of current assets and $2 million 0 t rent ratio NOW )f. instead, the company pays $500,000 of its current liabilities, it wil ' : ( iabilities. Its current ratio now increases to 3:1. Any comparisons assets and $500,000 of current | V > G ny. over time should therefore be done with care: this ratio can change quickly and is easily influenced by management. o can have real ratio? ; What could management do to influence a company'’s current Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and sharcholders are interested in a company’s long-term solvency, par- ticularly its ability to pay interest as it comes due and to repay the face value of debt at maturity. Illustration 18-7 lists the solvency ratios we have seen in this textbook. Ratio Analysis <« 933 Ratio Debt to total assets m a Toiain, % tal Purpoce Discuscinn Interest coverage Otal ageey \ Net in, B Measur, Come €S pereenty + Intereg eXpense C\rtdnm,. 42¢ of total aseers provided by Cho15,p. 750 + 1 \ . S15.p. T8 W s ahility 1 megy [ Free cash flow Cash i Interegy €Xpense ERIT) nterest payments. Ch.15.p. 750 | Provided (used) by ¥ OPerating acyjy - itie: investing actiy pice Measures it cash vy, 5 that manugemeny “l::k from operating actnines Ch, 17, o expendityres, use after paying ¢ apital Ulustration 18-7 A Summary of solvency ratios Profitability Ratios l"rofitability raltios measure the gporar: time. A company’s income, or lack of?cra““g success of 5 its liquidity position, and it growth 'é, affects evaluating profitability, Profitabilit i. tr)lh ing effectiveness. Tlustration 18~8)iisst: t;]e: ! col 1ts ability 1o Dh':‘::‘"j {)Or 2 ppecific period of creditors gn ) | ebt and equity f i nd inves quity financing, used as the Ullimaxzr(s are therefore interested in Profitability ragion e o *) MAN3REMENTs operar. Aiustration 18:3 ¥ - y 0s we have seen in the textbook Summary of profitability = . ratas Ratio ) Gross profit margin Gf:()rmula P - o T::Prloi — ur 0se Discussion Profit margin o sales i ¢S margin between selling Ch. 5, p. 244 Net income ‘;‘ © 2nd cost of goods sold. Net sales iMeasures net income generated by Asset turnover Net sales each dollar of sales. y Ch.s,p.245 Average total ass, Measures how effici assets iciently assets Ch, 9, p. 4 Return on assets A are used to generate sales. . Average total Measures overall profitabili Return on equity Niz L assets, i igpek % B, e income Measure: ili sures profitability of Ch. 13, p. 684 N Average shareholders’ equity shareholders' investment INet income — Preferred divide — — nds M ot Weighted average number of common shares enir::n:nr:;;‘:}f:: srimedon Ch B 728 Market pri : Tyni}%fi& Measures relationship between Ch. 14 p- 730 gs per share market price per share and o N carnings per share, nghfinv idends Measures percentage of income Ch. 14, p. 730 et income distributed as cash dividends. Earnings per share Price-earnings ratio Payout ratio It is important to remember that the ratios shown in Illustrations 18-6, 18-7, and 18-8 are only examples of commonly used ratios. You will find more examples as you learn more about financial analysis. As analysis tools, ratios can give clues to underlying conditions that may not be visible from the individual financial statement components of a particular ratio. However, a single ratio by itself is not very meaningful. Accordingly, ratios must be interpreted alongside the information gained from a detailed review of the financial information, including horizontal as described earlier in the chapter. and vertical analyses, and non-financial information,

936 CHAPTER 18 P> Pt Statemetit Analyst ident of corporate relations at anshCorp . A e, senior vice-preside ] disclosure. Betty-Ann Heggie, se oss can have and only by disclos; stated, “Reputation is the most valuable assct any bl;:m“:o ‘win ‘pcoplc"; trasi ind in\zl}l: ;:n.lin.‘l.\' transparent corporate information can we hope ' ¢ : : e with investors. course of evenls; enhance our value with inve . = srmm—— YAC OONTINGINIAGTION > ‘ five steps in analyzing a company: (1) reaq o Al and Mark Rosen re«lzt';mmegtli ;ge: ngeor\::;nigncludi"g all the notes and the managemen, A nnual financi ! : i ful a i con\panyré%trz’;‘;r'tesrg ?;)d :;latcf\ for t00-good-to-be-trué s'tyfi('ontséésgn?%icsizgstr egogr:c;"’(g?lvou d|scus‘5")°”,"( h for sy;)ec'ihc accounting games and poor financial sta e g bonuse's on sl 00k (t:‘:ts:o(( ex\;é’u‘t:ive compensation schemes that base management per Ppery accounting figures. Soue Al Rosen and Mark Rosen, The Rosens warn analysts to \_Natch for accounting games. Can you give an exam “Dig Deeper.” Canadian Business, January 17, 2008, 27. "too-good-to-be-true" situations and ple of what they might be referring to? Earning Power and Irregular Items ‘carning power,” or the norma| : Users of financial statements are interested in the concept (Tf ¢ e level of income. In order to determine earning power, nct income must be adjusted tor any irregular, or non-typical, items. Why? If we compare th.c performance o.f'onc <:‘(;mbpany with- out irregular items to another company with irregular ltcn?s, compnrablh'ty will be z')ffcctcd. Conscquently, financial statement items are normally adjusted Fc?r the impact of irregular items before analyzing them horizontally, vertically, or through ratios. . For example, suppose that Li Corporation reports that this year's net l.ncomc is $500,000, but a once-in-a-lifetime gain of $400,000 is included in that amount. Using the $500,000 to perform horizontal, vertical, and ratio analyses would be misleading, because the company’s carning power s really only $100,000, not $500,000 as reported. To help determine carning power, irregular items are reported scparately on the financial statements and net of income tax. You will recall that we learned about one type of irregular item in Chapter 14—a change in accounting principle. Changes in accounting principle are re- ported on the statement of retained carnings. In the next section, we will learn about another type of irregular item, which is reported on the income statement—discontinued operations. There is a third type of irregular item known as extraordinary items, that are sometimes found on U.S. corporate income statements. However, they are rarely found on Canadian corporate income statements as the criteria for recognizing extraordinary items are different in the U.S. and Canada. Financial Reporting in Canada notes that no public company has reported an extraordinary item in Canada since 2001. Consequently, we do not cover ex- traordinary items in this text but rather leave them for an intermediate accounting course. Discontinued Operations Discontinued operations refer to the disposal of an identifiable reporting or operating segment of the business. An identifiable business segment is a part of a company that can be clearly distinguished, for financial reporting and operating purposes, from the rest of the company. A segment can be a separate subsidiary company, an operating division within the company, or even a group of assets, as long as it is a separate business that can be clearly distinguished from the company as a wholc. Most large corporations have multij M : vle business segments or divisions. For example, Cana- dian Tire has lour business segments t hat it reports financial and operating information about: | { AL Canadian Tire Retaj} Financial Services, When an identifiyhy) afi the income SlﬂlCan a (or loss) reported in the d (loss) from these Operatig prcst‘"‘cd net of applic tions is.clcnrly separated frop, | To .,ll.uslmte, assume thay y,,. Fpme tax for g o o v $1.7 million ?gm e ity OP::!ancr ' oo income tax of $800,000, ff ,p, & 2Lions i st Ot : e . : n from chemical operatj 000 loss on disposal of the chemicy) savings). lllustration 18.9 shows Canadigy, - an Fare Pc"ﬂl!:u L e buc m, Marks Work y My Sineg ) " Weark, San ty . . Posed Isc”nlinu(.d nng “Cm c“ll(‘ 3{‘ lh(‘ dlsm , NS and th,. i able inc‘lmet gai (loss) < 937 n 2008, 7y . and sel|s ; ons is $140,000 (S200 (;()I:)s]unprnfi“‘hlc chemic 00 legs ) division is how thig in al div ision. The loss e ) o nLnt.n SVINgs). The l'ormuti(,n " in J“?&"@?@M{E Pt Jle State s \@gmufiiilfi“!u-@!= antleray A% gd‘kl! "‘_.’E:‘( 1 Wustration 18-9 <4 Revenucs Expenses Income before income tax Income tax expense | ¢scentrued comratiors $2.500 (00 i { } 1,700 ey t . - T Income from continuing Operations doomo Discontinued operations —20000 Loss from operations of chemical divig; wm income tax say ings o, net of $60 000 :( Loss on di : ; I s on in;pos.:l of chemical division, net of $30.000 1n S1H0.000 1 X savings . Come A Net income “0.000 210 100 1 —N.000 2 e — S_330 00wy —— BEFORE YOU GOON. .. PReview It 1. What are some of the limitations of financial analysis® 2. What factors can reduce the quality of earnings® 3. What is “earning power"? 4. What impact do irregular items have on the analysis of financial information® 5. Did The Forzani Group report any irregular items in fiscal 20062 The answer to this question is at the end of the chapter. | Statament presentanon of

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| 938 CHAPTER 18 > Financial Statement Analysis »Dolt In its 2008 income¢ : Juss on discontinued operatt the discontinued operations ot 2 income statement, beginning Wi ted income before income tax of $400,000; a pre-tay 000; and a pre-tax gain on the disposal of the asscts from 0;1; ;:)fosgg Thc: company has & 25-percent income Lax rate. Prepare an th income before income tax. statement, QU Ltd. repor! Action Plan nd income from atypical (djs. o Allocate income tax betw: continued) items. e Note that two disclosur results of operations of t een income from continuing operations a ued operations: separately disclose (1) the .quired for discontin . . i ivision, and (2) the disposal of the operation. he discontinued d Solution Qu LTD. ) Income Statement (partial) Year Ended December 31, 2008 $400,000 Income before income tax 100,000 Income tax expense ) 190,000 Income from continuing operations Discontinued operations - ) Loss from operations, net of $18,750° lnclome tax savings Szg..’égg 1750 sai isposi _net of $7,500% income tax expense 22, 33,750 Gain on disposal of assets, net o . Net income 1$400,000 x 257 = $100,000 2675,000 x 25% = $18.750 $$30.000 x 25% = $7,500 Related exercise material: BE18-12, BE18-13, BEI8-14, E18-12, and E18-13. Ty ACCEIE0R 1600 C COIPAENENEINE MOUGTRANEDN CF GANIO ADANAD In previous chapters, we calculated many ratios that are used to evaluate the liquidity, sol- vency, and profitability of a company. In this appendix, we do a comprehensive review of those ratios and discuss some important relationships among them. In this review, we use the following comparisons: ' 1. Intracompany comparisons covering two years (2004 and 2005) for Hometown Tires and More 2. Intercompany comparisons for the year ecnded December 31, 2005, for Canadian Tire, Hometown Tires and More's main competitor 3. Industry average comparisons for 2005 for the retail department store industry. For some of the ratios that we use, industry comparisons are not available. These are indi- cated by “n/a.” ; Yhou wiH. recall thaF Hometown Tires and More's balance sheet was presented earlier in the chapter in Hllustration 18-1 and its income statement in lllustration 18-2. We will use the information in these two financial stat i iti cments, in addition to the followin te Hometown Tires and More's ratios: e, fo caleul Cash pron i, . ed by Cash provide “Perat) A : d N ac - i . Dividends (u*d”’)'im“::l:h :P{ 200y Ereits X * 939 o a 362 — mber of comme, shar‘h-m-x 3200 120 i), es & 31),r‘n 30 0, 3 You can use these day —_— 0 30,000 v derstand where the numbers . ame 1, T I R ' - 010 mlle st ons Q ) - YOu un- e not shown for Liquidity RatiOs or lllhcr Liquidity ratios measure the ab;;, any to Pavi : % ¥ it Curres ties t.hat are reported on the income o iPS between o Fent liabiliies, Consequen prowded by operating activities Atement for ), FTent assets ang currcn? 1} r:‘y 1abily- SR TR T i » Ieporte ance she ng lqu‘ndlty. [flqu’d‘ty ratios incluSe \y:):-n the cagh ¢t and relae collection period, inventory turnoyer rdxng Capital, the , an days sales i Working Capital Working capital is the differe ; nce betwe and 2005 working capital f €N current asset, p gures for Hometown Tires '.usxdn '{(: C‘"‘c":l -biles. The 2004 ore, and data for com 3 parison, are shown in Illustration 18A-1. Wustration 18A-1 < Working capital | $545,000 - $337,700 = $207 300 54%0&1% A -$313,500 = $171,500 $160.0 million ——————— ¢ and increasing working capital: $207.300 in Industry Average n/a Hometown Tires and More has a positivi 2005 and $171,500 in 2004. It i ) - 1L 1s not ve i : i much larger Canadian Tire. In additionrynrc??r?(rl‘:]ntgm e filniamoum i : : 3 ; stry average is available for working capit and l\/:orkdmf%1 capital amounts are not comparable within the industry. B o is di Cu'lt to compare absolute dollar amounts. As we learned in Chapter 4, the cur- n ratlo—.whlch expresses current assets and current liabilitics as a ratio rather than as an amount—is a more uscful indicator of liquidity. In addition, two companies with the same amount of working capital may have very different current ratios. Current Ratio The current ratio is a widely used measure of a company’s liquidity and short-term debt-pay- ing ability. The ratio is calculated by dividing current assets by current liabilities. The 2005 and 2004 current ratios for Hometown Tires and More, and data for comparison, are shown in Illustration 18A-2 on the following page-

Financial Statement Analysis 940 CHAPTER 18 > filustration 18A-2 > Current 13t : Current assets Current 13110 = 5 rgnt liabilities Hometown Tires and More e T T ey — - T 2004 2005 — e $485,000 _ 1501 $545.000 _ 4 6.4 $313,500 ~ $337,700 I Canadian Tire Industry Average ————1‘6:1 ! 2.1 What does the ratio actually mean? The 2005 ratio of 1.6:1 means that f:{r every d0|la.r of current liabilities, Hometown Tires and More has $1.60 of current ea.ssgts.h ometown Tireg and More's current ratio has increased slightly in 2005. Its 20(?5 ratio is the samcfz as Cana. dian Tire's current ratio of 1.6:1 and quite a bit lower than the 1ndustr)_'davera§e of 2.1:1. The current ratio is only one measure of liquidity. It does not consider ‘:; atl the curreng asscts are composed of. For example, a satisfactory (':urrent ratlo‘ bdloes not disc ose.the fact that a portion of the current assets may be tied up m'uncol]ectl e .al;:co}:mts rzcellvab]e or in slow-moving inventory. A dollar of cash is more avexlable to pay bills than a dollar of ap overdue account receivable or a dollar of slow-moving inventory that has not yet been sold. Receivables Turnover Liquidity may be measured by how quickly certain assets can be ct-)m-ferted to cash. How liquid, for example, are the receivables? The receivables t.urnover ratio is used to asssass the liquidity of the receivables. It measures the number of times, on average, t'hi'it receivables are collected during the period. The receivables turnover is calculated by dividing net credit sales (net sales less cash sales) by the average gross receivables. Assuming that all sales are credit sales, that there is no allowance .for doubtful accounts, and that the balance of accounts receivable at the beginning of 2004 is $45,000, the receiv- ables turnover figures for Hometown Tires and More, and data for comparison, are shown in Hlustration 18A-3. [Hlustration 18A-3 > Receivables turnover Net credit sales Average gross receivables Receivables turnover = Hometown Tires and More ielpful hint Whenever an i 2005 2004 nd-of-period (e.g., balance $1.997.000 $1.837,000 1e_et) figurg is compared to a {$72.500 + $50,000/ =2 = 32.6 times [$50,000 + $45,000) = 2 xriod (e.g., income state- ] ent or cash flow statement) ure, the end-of-period Industry Average ure must be averaged so 66.1 1t it is for approximately > same period of time. mparisons of end-of-pe- 1 figures to end-of-period ires, or period figures to od figures, do not require ‘aging. = 38.7 times Canadian Tire 15.2 times S S Hometown Tires and More's receivables turn over (i.e., are collected) 32.6 times a year. In general, the faster the turnover, the more reliable the current ratio is for assessing liquidity. Hometown Tires and More’s receivables turnover declined from 38.7 times in 2004 to 32.6 times in 2005. It is still much higher than Canadian Tire's receivables turnover of 15.2 times a year, but slower than the industry average of 66.1 times a year in 2005. Why is Hometown T; R s Tes ap p s Canadian Tire?> Hometoywy, Ircdsh re’s g, I i - Most of jt an s 1y, receivables its sales are More Jj1® Urnoye, A ' m its franchise stores. for cagp, C €ly hag few 0 Much, high PPendix 184 < o4 from its 1 Nadign . Credit g 0" than thyy of It is important to be carefy] iy, f¢. on the oy, and thepef, dit sales, when in fa Hulin iNterprey: ther hyp, ore few credl b ! ct, lhlS is not a Cllng lhis fati - has mcci\ﬂb‘cs disclose their credit and cash salog TCasonap, ", tio. W —— comparisons can still be made, Since.lH ever, i MPtion, Cotfpge thay o sales were llCd to Canadian Tire . e “Npany, § 0 not g¢ . PP — Ndustry ave::m"‘l’llon\a“ s':]:-:mmp““?- and I];a(lr:l:l\ Collection Period Be. Were crediy o oy Sdles‘“as A popular variation of the receivab| in days. This is done by dividin hes turnover —_ turnover, as shown in mumatiog ‘l ; Number of davsoit:m itintg 5 collecy » n 18A-4 : A vyear (363 ON period ¢ J 3 . > dd\s) b\ ate Collection Period = €Ceivablgg Wngver Wustration 18A-4 <4 . ———— Hometown Tites ang More Collection periog i 2005 T ' 365 days _ . I 326 = Mdays 365:1% f 35 days 387 =9days 24 daYS i tion period of 24 days is still a reasonable one. So, despite earlier concerns, receivables both companies, and the industry. Because o expected. Management appears to be in good shape for f the large proportion of cash sales, this is to be Inventory Turnover Inventory turnover measures the average number of times that the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. The inventory turnover is calculated by dividing the cost of goods sold by the average inventory. Assuming that the inventory balance for Hometown Tires and More at the beginning of 2004 was $300,000, its inventory turnover figures, and data for comparison, are shown in Mlustration 18A-5 on the following page.

t Analysis > al Statemen 444 CHAFTER ® However, as mentioned in the chapter, . . it is privatc]y gwned: ! . S i to the equity markets sl;’\ce :re relevant calculation is whether or not n d this ]eve] anci m o relies on debt financing. i : ithout also looki I | assets ratio should never be mterprctcdl witho ! bO(:kl;ng atthe of debt. The debt to mtjx ﬂsosmpany may have a low debt to tota as;cttshr(zicll:)t t(l),t te l”"able ' ' . .m ; m 1 o e COVfrdge rtmmy ents Alternatively, a co pany may have a hig al assets to cover its interest pa . its i ments. ratio but easily be able to cover its intcrest pay Financi and More does not have access Hometown Tires Ao ha ned. Conscqucnt]y, it is not surprising that j; Interest Coverage i io gives an in e interest coverage ratio g h alculated dication of the company’s ability to make its intergst pay- by dividing income beforg interest expense and income Note that the interest coverage ratio uses.lr}]lcomedbeffore lntgrest S und income tax expensc. This is often abbreviatcfj as }‘;BIT, whic stands for carnings st d tax. EBIT represents the amount that is available to cover interest. bcro';‘i‘en.tze(;f);t;:d 28064 ratios for Hometown Tires and More, and data for comparison, are shown in [lustration 18A-8. INlustration 18A-8 > Interest coverage Alternative terminology = The interest coverage ratiois ments as they come due. Itisc also called the times interest tax expense by interest expense. Net income + Interest expense + Income tax expense Interest expense Interest coverage = Hometown Tires and More | o 202:2 500 | $82,000 + $36,000 + $50.000 _ , 5 ioc $75.000 + ::g,ggg +$52.500 _ ;4 5 iimes ! $36,000 ' f Industry Average Canadi.an Tire 13.6 times 7.3 times — ] Despite Hometown Tires and More's high debt to total assets ratio, it is able to cover its interest payments. Its income before interest and taxes was 4.7 times the amount needed for interest expense in 2005. Hometown Tires and More's interest coverage improved slightly in 2005, although it is still below that of Canadian Tire at 7.3 times and that of the industry at 13.6 times. Free Cash Flow One indication of a company’s solvency, as well as of its ability to expand operations, repay debt, or pay dividends is the amount of excess cash it generates after paying to maintain its current productive capacity. This amount is referred to as free cash flow. Hometown Tires and More's free cash flow figures for 2005 and 2004, and data for comparison, are shown in Illustration 18A-9. free cash flow = RS < 945 - e Wustration 18A-9 ¢ $86,200 + $15, = - | 000 = 5101,200 ) % n/a 2dan Ty that the $15,000 of W | Note . tivities i Of cash Provided p, - “on operating ac 1v.1 €8 1n 2005, com ared ¢ . ln"cs‘i“g activjy \,\ from cash provided by OPerating actiyiy; © the $29), 00 o d";: ' added 1 ¢y Hometown Tires and More has * ities in 2004 ed by inyegrp . Provided by 5 : Bt ent, repay debt, and pay it (; 25 free” cashto inveg ; CUvities dedueteg . e,rty plant, and equip ividends_ HQ'TICtownc—rs»t 0 additign) roperty, o] pl'Op f) ’ ment and ) ; ires - v.p £ ‘ sale securities. This sale of inye 'Nangibles in 5 s and More ¢iq and equip. Stments proyi 5, but it dig g o 2¢Quire addition] 10 the $86,200 proyig 00 of addigigny o ;f its available.-foy. 4 Tovided by s Sh tor my, e € Teported . Y Operati e nagement to $180.3 million more on investing aClivitie: t;:e tiv Ng activities, is no industry average available fo; free cash ;l]n it ge meaningful comparison of absolyte dollar 5 ow, use at its discretion in addition In contrast, Canadian Tir nera mounts for pyq . COMpan; Solvency Conclusion Panies of In an intracompany comparison, 4| Despite this improvement inside th of Hometown Tires ap, e Hometown Tires and More's solyen d More's ratios COMpany, in intercompa ¢+ MPrOved in 2005, o, ”lpany andi d : . . CY was sj nifi N ustry compar the industry with the exception of jig free cgsh [i:lntly lower than thay of Canadian‘zl‘i::(;r:,s(i W, I[ iS i"l ortant isti i . : p : to dlstlngu]sll between Hometo\vn Ilr [ ; ) i €s and Nifife and Canfidian il’e erent t ) as a small, privately held company, yPpes of companies, Hometown Tires and M s relies mai , ate enough income to cover its interest ;3;::2}3’5 olrm debt for its financing and has 1o R i ; - In contrast T ; company, relies more on equity for its financing needs » Canadian Tire, a large public Profitability Ratios Profitability ratios measure the income o period of time. Income, or the lack of it, affects the company's ability to obtain debt and equity financing. It also affects the company’s liquidity position and its ability to grow. Con- sequently, both creditors and investors are interested in evaluating profitability. Profit'ability is often used as the real test of management’s operating effectiveness. Profitability ratios include the gross profit margin, profit margin, asset turnover, return on assets, return on equity, earnings per share, price-earnings, and payout ratios. operating success of a company for a specific Gross Profit Margin The gross profit margin is determined by dividing gross profit (net sales less cost of goods sold) by net sales. This ratio indicates a company’s ability to keep a selling price that is blgh enough above its cost of goods sold. Gross profit margins should be watched closely over time.

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Financial Statement Analysis R Hometown Tires and More's gross profi]tomargm g comparison, are shown in Iustration 18A-10. 946 CHAPTER 18 » for 2005 and 2004, and data for Gross profit lllustration 18A-10 » ) o Gross profit margin = “Ngt sales Gross profit margin ires and More Hometown T're_ A IR 2004 | 2005 T$597.000_ _ 37 55, | i $616.000 _ 3 g% $1,837,000 ! $1,997,000 Canadian Tire 20% profit margin for 2005 means that 30.8 cents of each erating expenses and generate a profit. Hc?metown Tires and More's gross profit margin declined slightly,' fr(?m 3.2.’5% 11}11 200(‘:1 to 308%'1‘1n 3005, T e town Tiros d More’s gross profit margin is higher than Canadian Tire's ang ¥1omet0\vn Tl‘xres 2;”23 50. This could be the result of several factors. It may be e the industry i.lveragcdol\‘lor;a sc;”s higher quality merchandise than do Canadxan'Tlre and Hometown Tlres 81?1 addition, prices may be higher in general not only be'cause of increased ::):)};fsr CI)ZTZIC::([))I:c'aus; the co;npany offers a higher level of personal service. Homectown Tires and More's gross dollar of its sales that year went to cover 0p Profit Margin Profit margin is a measure of the pe'rcentag come. It is calculated by dividing net income margin figures, and data for comparison, are fllustration 18A-11 Profit margin ¢ of each dollar of sales that results in net in- by net sales. Hometown Tires and More’s profit shown in Illustration 18A-11. Alternative terminology Profit margin is also called the return on sales. ) . Net income Profit margin = ——’Ne! sales Hometown Tires and More R S TR $75 ogg - ' $82.000 _ 000 _ 4100 $1.997,000 = 41% $1,837,000 l ,} Industry Average Canadian Tire [ 5.4% 42% Hometown Tires and More's profit margin is unchanged from 2004 to 2005, at 4.1% of net sales. It is a bit lower than that of Canadian Tire and the industry. This is not what we would expect given that we found Hometown Tires and More's gross profit margin, analyzed above, to be higher than that of Canadian Tire and the industry. This suggests that Home- town Tires and More is not able to control its operating expenses as well as Canadian Tire and the industry do. Asset Turnover Asset turnover FROANIIes how effig;,, detefm‘"ed by dividing net sales by, , - 4 Comp, Append; llars of sales produced by each 4 AVeray, 16 " i 184 < do Olla al Ssep 004 were $1,090,000, Tofag 1s. $ o g of 2 o data Tor U 2005 and 300 ¢ Suming . Sulting o 4 Sales, |y ,a aris ! More on, are Shown in lalize: lluno\'l‘f r:;l[i‘za‘" et T showg the tratloh |8.~\.]2_ or b lllustution 18A12 ¢ 2005 ' Ao it $1,997,000 e —— {$1,000,000 + $1,000,000) 2 = 2.0 times “ S1ey { L] » Ind $1.000000 5 g7 l ndustry Average 20 0LETF = 181me | 2.4 times - | . 220 an Ty —— Thimer In 2005, Hometown Tires ang More ge T | . . P i nNerate TTTe—— ] in assets. Th}isdralino lr?prmed from 2004, 4, en} ‘d 82 of sales o each dollyr iy ollar h S ass A it had ipve sales for eac of assets. Although irs 260 €U tutnover o5 | 81 ad invested it is higher than Canadian Tire’s a5 Return on Assets An overall measure of profitabilit income by average total assets. H and 2004, and data for comparis yisreturn op assets ometown Tires apd on, are shown in ||| This ratio i caleula More's return on ggse ustration 18413 ed by dividing net ts figures for 2003 Return on assets = Netincome llustration 18A-13 « Average total assets Return on assets Hometown Tires and More 1 l | | | | | | | | | | | 2005 $82,000 2004 (81,000,000 + $1,000,000) < 2 = 82% S 81,000,000 + $1,090,000 =7 = 1 2% Industry Average Canadian Tire ' | 12.3% ‘ | j 5.9% - _____._- Hometown Tires and More's return on assets improved from 2004 to 2005. Its 2005 return of 8.2% is lower than the industry average. However, it is high in comparison to Canadian Tire’s return of 5.9%. Although the percentage is high, it must be analyzed in perspective. Hometown Tires and More's income improved, and it was strong to begin with. However, it is being compared to a relatively small asset base, so small dollar increases result in large percentage increases. The return on assets can be further analyzed by looking at the profit margin and asset turnover ratios in combination, as shown in [llustration 18A-14 on the following page.

assels Alternative terminolo Return on equity is also known as retum on invest- ment. lllustration 18A-15 » 948 CHAPTER 18 IHlustration 18A-14 Composition of return on » Financial Statement Analysis o ’;" sita Profit Margin i Asset Turnover sl - t | X Net sales - S = | Net income ! 20— 2 Net 'tn‘;:{?;gsets | “Net sales Jl Average total assets verage to | _ . 8.2% = 4.1% 2.0 times 2005 .2% . 0% _ 4.1% x 1.8 times 2004 2% r the asset turnover, the calculation for the ye,, Hometown Tires and More’s unrounded e t f 1.76 instcad of the rounded amount of 1.8, we can prove the aboYc calculation, ”"’;VC" y h i brcl:';kdown of the return on assets, we learn that Hometovyn Tires and More'g rcturnr ?)I: ;ss]::ts increased because of the improved as.set turn;)vcczjr..T};zrl‘t ::1 [—:z:l,:;(:v:n Tites and More's assets gencrated more efficient sales, V\{hxc: res:;i ex(rj] p eturn on assets. The profitability of each dollar of sales remained unchanged. With a rounded figure of 1.8 times used fo 2004 docs not work out precisely. If we use Return on Equity | | | For shareholders, a popular measure of profitability is the return on equg)ll) ral;o. This ratig shows how many dollars of net income were earned for each dollar mv;edste by the sharehold- ers. It is calculated by dividing net income by average Fotal shareho eris e]qmi]y. A.lthough we calculate this ratio using total shareholders’ equity, it can also be calculated using only the common shareholders’ equity if there is more than one clas§ of shares. }n such cases, net income is reduced by any preferred dividends to determine the income ave?llable for common shareholders. The denominator is the average common s}.1ar<.?holders equity. | Assuming that total shareholders’ equity at the beginning of 2004 was $166,500, the return on equity figures for Hometown Tires and More for 2005 and 2004, and data for comparison, are shown in Illustration 18A-15. gy Return on equity S Net income Retun onequity = Average shareholders’ equity Hometown Tires and More 2005 $82,000 f ($262,300 + $211,500) = 2 2004 $75,000 ($211,500 + $166,500) + 2 =39.7% =34.6% _Canadian Tire 13.9% Industry Average 23.9% Although it declined in 2005, Hometown Tires and More’s return on equity is unusually high at 34.6%. The return on equity figures for Canadian Tire and the industry are much lower at 13.9% and 23.9%, respectively. Note that Hometown Tires and More’s 2005 return on equity (34.6%) is much higher than its return on assets (8.2%). The reason is that Hometown Tires and More has made effective use of leveraging, or trading on the equity. Trading on the equity means that the company can earn a higher rate of interest by using borrowed money in its operations than it has to pay on the borrowed money. This enables Hometown Tires and More to use money supplicd by creditors to increase the return to the shareholders. Recall that Hometown Tires and More has substantially more debt than Canadian Tire, so it is not surprising that its return on equity is higher than Canadian Tire’s. A comparison of the rate of rgq money indicates the Profitabifip, equity is 3 IWOWay street, fo ' % ’ Tate o f . ercent on it, youre trading ¢, | : € i vy heqtm,_ Noke ;’:'mcye“ Pad Appendix 157 ” More €arns MOre on its boreq,, F UMY a1 g g 7 Mgy 2o Ttha g Porroncq 949 5 tath,. Yars return to sharcholders is higp, th l:]lds than a:lt}k Tthan asmmr: ! and e::rg\ m\l\h . . . O ha only are benefiting from positive lcveraging: feturn as;r& i the f,, ,"_**mr.m.,m':;r:s " tradip S which ; Ntereqy garnings Per Share (gpg, BON the ey ™ates g o ‘ksi dlhe nders i 5 0 8 ey calculated by dividing the ne inc?)ml preferred dividends) by the weigh g Shareholders usually think | sell. Reducing net income 10 net inc : Ome € availah), 15 a\erage of N termg of th Ol ¢q € n m m Per share b 0T of shy, measure is widely used and Teported. B, Bives 3 ratio, MOSt COMpanies are requireq Hometown Tires and More has in this number over the past three As mentioned previously, Hometq, a limited ownership market. The 2005 and 2004, and data for ¢q ause of th 0 pres;gnl it di n 30000 cqp. dlrcctl). i Wn Tires and €arnings per ) blicl = Mparison, are icly and have Earnings per share = Net ine Qi 2-Pre er'e::l(:vder'ds We o} Ge ny| er af cq Q h{e(! avera, 2 numb rof mm. ns'\a.es Wustration 18A-16 € Earnings per share | 2005 f $82,000 - $0 2004 30,000 -S273 5000 - 55 30000 =8250 lndustrx Average nfa Canad an Tire \ $4.04 —_— | ' Hometown Tires and More’s earnings per share increased by $0.23 per share in 2005 This represents a 9-percent increase over the 2004 earnings per s‘hare figure of $250 Com‘- parisons to the industry average or Canadian Tire are not meaningful, because of the large dlff'eren(.:es in the number of shares issued by companies. The only meaningful EPS com- parison is an intracompany one. Price-Earnings (PE) Ratio The price-earnings (PE) ratio is an often-quoted measure of the ratio of the market price of each common share to the earnings per share. The price-earnings ratio reflects insestors assessments of a company's future earnings. It is calculated by dividing the market price per share by earnings per share. The price-carnings ratios for Hometown Ti_res and More for 2005 and 2004, and data for comparison, are shown in lllustration 18A-17.

| 4 952 CHAPTER 18 Instructions Discuss the signifi cant changes between 200 Financial Statement Analysis 5 and 2008 for the company. Action Plan o Exclude the impact of injeg- ular items in your analysis. « Look at the percentage comparisons both veruc_ally (within the year) and hori- zontally (across the years). current lia abilities have gencrally be 2007, Mukhin’s noncurrent asse percentages of liabil termine the reasons In terms of profita clined, except in 2006. Excep position. While these sho norm over the last four years rat tinued operations have not sign! Solution to Demonstration Current assets increased in 200 bilities are a higher percentag en increasing, ts have a current liabilities have been increa help finance increasing purchases 0 Mukhin’s liquidity and solvency ities. We would h for this decline. bility, Mukhin appears t for this same year, opemtions) also appears to b}(: Ol:l th:c is i sting to note the 1Mp i, Wi he uld be excluded from our compara d nrecurring item 0 . e ot four her than the exceptton. However, ficantly impacted Mu lem ] P';Obd in 2007, and remained stable in 2008. Mukhin’s ined 1 L al assets than are its current assets. Current lj- e of lotdf - 2007. Except for during that same year, except for Ieasing as a percentage of total assets. Non- lso been incr likely increased its long-term liabilities to 6, dec sing. The company ent assets. . ] Fnoncurr[0 be declining over recent years, with mcreasmg appear to perform further analyses (e.g., ratio analysis) to de- ave to be controlling its expenses, which have de- its profitability (income from continuing increase. t that discontinued operations have on Mukhin’s financial tive analysis, one might question d operations appear to be the except for in 2005, the discon- khin's profitability. r not since discontinue Summary of Study Objectives I. Explain and apply horizontal analysis. Horizontal analysis is a technique for evaluating a series of data over a period of time. The increase or decrease that has taken place is determined, and is expressed as either an amount or a pcr- centage. 2. Explain and apply vertical analysis. Vertical analysis is a technique for expressing each item ina financial statement as a percentage of a relevant total (base amount). 3. Identify and use ratios to analyze a company’s liquid- ity, profitability, and solvency. The formula and purpose of each ratio are presented in Illustrations 18-6 (liquidity), 18-7 =y (solvency), and 18-8 (profitability). Glossary 4. Recognize and illustrate the limitatiorfs of fina‘ncial statement analysis. The usefulness of .analytlcal tools is li.m- ited by price-level changes, the use of estimates, t_he application of alternative accounting principles, leCl’.SlfiCHtlon of compa- nies, the quality of earnings, and irregul?r items. . One example of an irregular item is discontinued operations, which is a disposal of an identifiable busi_ness segment. Discon- tinued operations are presented on the income St’fitem(?nt; net of tax, below “Income from continuing operations to highlight the fact that they are unusual. Discontinued operations The disposal of an identifiable Identifiable business segment A division or part of a segment of a business. (p. 936) Earning power Net income adjusted for irregular, or atyp- ical, items. (p. 936) Horizontal analysis A technique for evaluating a series of financial statement data over a period of time to determine the increase (decrease) that has taken place. This increase .company that can be clearly distinguished, for financial re- porting and operating purposes, from the rest of the com- pany. (p. 936) Liquidity ratios Measures of the short-term ability of a company to pay its maturing obligations and to meet unex- pected needs for cash. (p. 932) . (decrease) is expressed as either an amount or a percentage. Profitability ratios Measures of the operating success of (p. 924) a company for a specific period of time. (p. 933) Ratio analysis A m:hnique for evalyae; res . at ments that expresses the 'ela"""Ship . mgfi“ancm qancial statement data. (p. g3 Stween g0 SLte L Self. % CCted !rtlca] e Stu . . £ golvency ratios Measures of . fi- meny dmam.l‘)si‘ As .d) Questions < 953 i a long period of tj COMpany's 1 is Within o o S Wique for evgly s yive Vet fme. (p. 93 ¥$ abiliry 1o gy CPressed o, © PeTiod, 2luating financial state- r- Answers are at the end of the chapter 1. In horizontal analysis, each centage of the: (a) net sales amount. (b) shareholders’ equity amoun, (c) total assets amount. (d) base-year amount. item s oy o1 K S CXpresg, (5 ed as per- _ Rankin Inlet Corporation repo % 330,000, and $360,000 i“p‘h?izf:sszl 2008, respectively. If 2006 is the bage percentage of the base-period Aibung rz?ﬂzfé\\'hm is the (a) 77% © 120% 08> (b) 108% (d) 130% In a vertical analysis, the base amq expense is generally: (a) net sales. (b) amortization expense in a (c) total assets. (d) total property, plant, and equipment, 4. The following schedule shows what type of analysis? g0 AP es of $300,00 502K 3. unt for amortization Previous year. 502, 31K Amount_ Percentage $200,000 25% 600,000 759 $800,000 100% p (a) Horizontal analysis (c) Vertical analysis (b) Differential analysis (d) Ratio analysis Current assets Long-lived assets Total assets 031K 5. Which of the following is not a liquidity ratio? (a) Current ratio (b) Asset turnover (c) Inventory turnover “(d) Receivables turnover (SO3 AN o . Which of the following situations would be the most likely indicator that Wang Corporation might have a sol- vency problem? (a) | NCreasip, Tatiog 2 debt 1o tot 006, 2007, and 7. . item 4 ’ €Nlage of the ™ 103 financial statement S¢ amount, (p. 928, al i N assets and interest coverage ncmasing debt 1g (c) gl COVerage ratiog eCreasin, fatiog ) Dccreasing debt 1o 1o est Coverage rating Which of the Profitabiliys (@) Aninge ) Increas tal 3 assets and dccrc.\sing inter- g debr 10 total assets and interest coverage al assel i i | assets and ncreasing inter- f()“m i ¢ 5 . VING situations is 4 ikely indicator of 1503 AN ¢asing price-¢ ; NG return o (© "l)““"gin tatios €) Decreas; ) A dEcres:lx:& ;elum on equity and Payout ratios ’ 8r0ss pro i ; . it margin profit margin and increasing prof- 8. \\'}.\ich of the followin a limitation of financi (a) Use of estimates (b) A high quality of earnings () Diversification arnings ratio M assets, asset turnover, and prof- 8 is generally not considered to be S04k al analysis? {d) Use of alternative accounting principles 9. The income statement j should be adjusted f i of which of the followin ctorming s ot analysis) g before performing a financial (a) Changes in accounting principles (b) Discontinued operations (¢) Inflation (d) Unrealized gains and losses on available-for-sale se- curities 10. In reporting discontinued operations, a special section (S0 4) in the income statement should show: (a) gains and losses on disposal of the discontinued seg- ment. {b) gains and losses from operations of the discontinued segment. (c) neither (a) nor (b). % (d) both (a) and (b). iy

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b T . O B TR S o 2L .w.;.;."i.’:.u-.tu P b rR R o/, - 954 CHAPTER 18 Questions > Financial Statement Analysis 12. Wong Ltd. reported debt to tota.l assets of 37% and ap, interest coverage ratio of 3 times in the current year. The industry average is 39% for debt to ,lotal assets and 2.5 times for interest cOVErage. Is Wong's solvency better of worse than that of the industry? providcd by operating activities wag double the amount of the prior year, but its free cash flow was one-half the amount. Discuss whether or not the decline in free cash flow indicates a decline in the i ascs sonc L@ What are the differences among the following h"‘lsn of comparison: (1} intracompany: (2) intercompany, l;lus- (3) industry averages? (b) Explain whether these lhru?l ! ¢s of comparison should be used individually or together: jod amount souk 2. Explain how the percentage of a ?msc-pcrlcl)d ;r:ld " and the percentage change for a period are calculd horizontal analysis. 13. Laser Corp-s cash < is alfected if an ac- ntal analysi : value in the in a base ycar and a cgative value in the base year an onc 3. Explain how a horizol count (a) has no value next year, or (b) hasan a positive value in the next year. company’s solvency. 14. Saputo Inc.'s return on assets is 12%. During the same year, it reported a return on equity of 19%. Has Saputo made effective use of leverage? Explain. 15. If you were an investor interested in buying the shares of a company with growth potential, would you look for a company that had high or low price-earnings and pay- out ratios? If you were interested in buying the shares of a company with income potential, would your answer change? Explain why. 16. In an effort to increase its profitability, Medicine Hat Inc. revised its sales strategy by reducing the selling price of its merchandise. The result was that sales and net income both increased but the gross profit margin and profit margin decreased. Discuss whether the presi- dent of Medicine Hat Inc. should be concerned about the decline in these ratios. 17. Identify and briefly explain the limitations of financial nalysis are two meth- Explain the differ- (son2c 4 Horizontal analysis and vertical a ods of financial statement analysis. ence between these two methods. (so1,21¢ 5. Tim Hortons Inc. reported $242,651 thousand of sales for its first quarter ended April 2, 2006. It became a publicly traded company at the beginning of 2006, a.fter separating from Wendy's International. Can a meaning- ful horizontal and vertical analysis be prepared, compar- ing the first quarter ended April 2, 2006, with the first quarter of the prior year? Explain. usually assigned a 100% value in a verti- (s02K 6. What items are . cal analysis of (a) the balance sheet and (b) the income statement? = Can vertical analysis be used to compare two companies of different sizes and using different currencies, such as InBev, the world's largest brewer, headquartered in Bel- gium, and Molson Coors Brewing Company, the fifth largest brewer, headquartered in the U.S.? Explain. (so2c analysis. 18. Give an example of how management might deliberately try to increase income by changing an accounting esti- mate. How would this affect the quality of the earnings reported? y3)¢ 9. Which ratio(s) should be used to help answer each of the . : ’ following questions? 19. 'Explax.n h.ow the choice of one .of the following account- (a) How efficient is a company at using its asscts o pro- ing principles over the other increases or decreases a duce sales? (b) How near to sale is the inventory on hand? (¢) How many dollars of net income were carned for cach dollar invested by the shareholders? (d) How able is a company to pay interest charges as they came due? (¢) How able is the company to repay a short-term loan? 031K 8. What do the following classes of ratios measure: (a) liquid- ity ratios, (b) profitability ratios, and (c) solvency ratios? company’s net income: (a) Use of FIFO instead of average cost for the inventory cost flow assumption during a period of continuing inflation (rising prices) (b) Use of a three-year estimated useful life to calculate amortization for machinery instead of a five-year life (c) Use of straight-line amortization instead of declin- ing-balance amortization 20. In 2007, Lai Inc. reported a profit margin of 5% before discontinued operations and a profit margin of 8% after discontinued operations. In 2008, the company had no discontinued operations and reported a profit margin of 8%. Has Lai's profit margin improved, weakened, or re- mained constant? Explain. AN 10. Does a high current ratio always indicate that a company has a strong liquidity position® Describe two situations in which a high current ratio might be hiding liquidity problems. N 1. Aubut Corporation, a retail store, has a receivables turn- over of 4.5 times. The industry average is 6.5 times. Does Aubut have a collection problem with its receivables? {S03) 5y (SO 4)¢c (SO 4)¢ (SO 4) AP | (S0 4)C | { i | | | i | 1 t { \ { i | | 4 | i { e e Jain the concept of earnip, )621' 5is, what is the fEla“Unship %é’l‘;w“. In finane, o the treatment of irregular itemes cen thig mnclal anal. o \ i : pt \ 3 Ptang ‘01'1&( are - Brlul’ E“\chiSc te Tey n S ol com, o Rt el OPCrations® Wi - < 955 ) e frg, . nued Operation. Why is it import A & Ny, 10ns g Jnt (SO H Brief ExerClses s 'l'-ninns:s S(par‘“"‘!' from in- “c Uit S BEIS’I Use l;le fo‘lOWing data (in lhgusa d b gsat December 31 to prepare a horizongy a:aIS) from the com o Vsis: oo ¥sis: Parative balance sh 4 Cash 2008 CCUof Federer Lud Yo Accounts recej =28 a0 Prepare hor W elv; 200 20Mal analys, |7 Inventory vable S 24 fi 1S0 1) Ap nalysis: L Prepaid 268 ¥ o b Paid expenses 199 257 L roperty, plant, ang 4 % ; , i 2 1 : Intangible assets “4uipment 3 7.12 0 . Total assets ';3) 3246 L = 3 1 Horizontal analysi SR : BE18-2 orizontal analysis percentages from Tilg = 2 tlden Lyg 'S inco i -3 INcome st Sales 2008 s alezmenl follow: i Cost of goods sold 96% E 2006 d:fe:‘;'\‘:““‘a‘ analysis 1o (0] i 102% ¢ 100% @ change in net perating expenses L0 970 \ :’ ncome. Income tax expense 1% 93¢, 00% (S0 1) AP _ %% g\ Did Tilden's net income increase, decrease, or remain ; T 00% ’ unchan ed ov E18—3 Use the following d Bed over the three-year pers & . B g data from the ¢ petiod? Explain, : : mparativy 3] to prepare horizontal and vertical analyses: pareive belanceshetof i b : -as at December Py epare horizontal and vertical analyses, 2008 Cash S\ 2007 1S01. 21 AP 1I\ccounts receivable 2?)%%00 3 rsm nventory 000 400,000 Property, plant, and equipment 3712?),000 600,000 Total assets w SN0 2,800,000 BN BEIS—4 Use the fo]lowing data (in thousands) from the comparative income for the year ended May 31 to prepare a vertical analysis: statement of J Tl Inc. - Prepare vertical analysss. (502) AP 2008 2007 Net sales SI914 52,073 Cost of goods sold 1,612 1,674 Gross profit T3 3% Operating expenses 218 210 Income before income tax g4 189 Income tax expense 30 68 $ 121 BEI8—5 Vertical analysis percentages for Waubons Corp.s sales, cost of goods expenses follow: Net income sold, and operating Use vertical analysis 10 determine change in net income. (SO 2) AP

956 CHAPTER 18 > (so3)C Evaluate liquidity. (SO 3) AP Calculate and evaluate recervables ratios. (SO 3) AN Calculate and evaluate inventory ratios. (SO 3) AN Calculate solvency ratios. (SO 3) AP Interpret changes in ratios. i ial Stz alysis Financial Statement Analy oos oo oo % 100% 100% 100% o 64% Cf)sctqufgoods sold g?Zz g?Zz 28; Operating expenscs 37: : o [ncome tax €xpense age of sales increas or remain unchanged over the l)](' LY/ s netin ; sreen e, decrease, 7. . i t A d id V dUbOn. net income as a pc¢ three-year period? Explain. 1 of the following independen r deterioration: ¢ situations, indicate whether this change would he BE18-6 For cacl viewed as an improvement 0 (a) A decrease in the receivables '[ur.nover (b) An increase in the days sales in inventory (¢) A decrease in debt to total asscts (d) A decrease in interest coverage (e) An increase in the gross profit margin () A decrease in assct turnover (g) An increase in return on cquity (h) An increase in the payout ratio o of 1.5:1 in the current fiscal year, which is higher than 4 receivables turnover of 8 times, which is less than lagy turnover of 6 times, which is less than last year’s g or deteriorating? Explain. reported a current rati [ 1.3:1. It also reported nd an inventory h's liquidity improvin BEI8-7 Holysh Inc. last year's current ratio o bles turnover of 9 times, a over of 7 times. Is Holys taken from Maple Leaf Foods Inc.’s financial statements: year’s receiva inventory turn BE18-8 The following data are MAPLE LEAF FOODS INC. December 31 (in thousands) 2005 2004 2003 Accounts receivable S 247,014 S 292,462 $ 242,306 6,462,581 6,364,983 5,041,896 Sales' credit terms of n/30. 1 Assume that all sales arc on account, with 004 (a) the receivables turnover, and (b) the collection period. What Calculate for cach of 2005 and 2 ble can be drawn from these data? conclusion about the management of accounts receiva BEI8-9 The following data are taken from Shumway Ltd.'s financial statements: o008 __2007 __2006 _ Sales $6,420,000 $6,240,000 $5,430,000 Cost of goods sold 4,540,000 4,550,000 3,950,000 Inventory 1,020,000 960,000 840,000 Calculate for cach of 2008 and 2007 (a) the inventory turnover, and (b) the days sales in inventory. Based on these ratios, what conclusion can be drawn about the management of the inventory? BE18-10 Shoppers Drug Mart Corporation reported the following selected financial data (in thousands) for the year ended December 31, 2005: Interest expense $ 48,649 Income tax expense 186,102 Net income 364,494 Total assets 4,375,383 Total liabilities 1:872'374 Cash provided by operating activities 450,575 Cash used by investing activities 274:182 Calculate the following: (a) debt to total assets, (b) interest coverage, and (c) free cash flow. Staples, Inc, reporteq 18-11 = BE 0781 million for the year end 6. : ed Comy 51, eginning of the year ang U Ji uary 5 of U, q,. ) beg S 5 8 " he d (b - $7.67 200, 34 <A csct turnover and (b) profig my 2761 gy, - R mlly, v @3 argin, iop i gl sy m o, - Ex ; Irite the € eng oo Vg - Mt CrCises B513—12 Write the numberg of the foj of the '\ml Ly thue of g o < g5y .15 10 show where each of the o l“‘\'ing~ Caly Vil dTuate prarag Jetter ) items g the mc(,me\ IS foll s 1503 ap ity ratos . Gross p.rofit section Steong lig ::'“lnl.m da Mang 2 Operating CXPENSCES section ( ould ep.\ ‘l(“‘lv.n\ beg 3. Other revenues section S )lh . ‘ e thy e A loss on the sale of tra; & Nl Ontinged - Cton R 17Ome Statamany (@) — ading seey i O repy Pty ey s Sales revenue Tilics d i SO Ve — . o (c) A change in accounting Princip| < Satemen ) — Salaries expense ple © Cost of goods sold () [nvestment revenue s from ; (g) Alos from operations of a discony; (h) — Amortization expense hued whojeg) b ks (i) Accumulated amortization Usingsg () — A gain on the sale of assets of , dise S ()nlinqu wholesale b sale busines N continui.ng operations, $500,000; loss fr moy and gain on disposal of assets of discony; oM operation of 1 for the —_— tax rate. Calculate (a) the income tax expe or savings on discontinued operations, ang (©) Jecttaa ncome N BE18-14 Osborn Corporation discontinyed axexpense The operating loss from these operations wag S these operations was $160,000 before income ¢ jncome tax was $950,000. The tax rate is 250 abusiness S segment of it s operat; 300,000 before income Deration ax. Oshorn's NS in Mexico in 20 Sper 2008, tax. The loss on the disposal of ; ions hefore € statement for Oshorn, smrlint ar ended December 31, 2008. ¢ Exercises nued o : ot discony N year. Petations tnued operg, Lome - Caleulate income tax on ub : B Canhnumg and d N i 1SContn Y incom, OPeratons, 8 (SO 4) AP Prepare discontinued operations section. (S0 4) AP E18-1 Financial information follows for Dressaire Inc. as aD -asat Dece mber 31: 2008 2007 5 Current assets S12 = 5120,000 $ 80,000 Noncurrent assets 400,000 350,000 SI3(())(())(())(())(()) Clagrent ligbilities 90,000 70,000 100000 Noncurrent liabilities 145000 95000 100,000 Shareholders' equity 285000 265000 200,000 Instructions (E) Calculate the percentage change since the base year, using 2006 as the base year. (b) Calculate the percentage changes between each year. Prepare horizontal analysis. {SO 1) AP y—

Lo B WLk e ASH TS . G e Sl v s b e e Vo8 h Vol e el ik i 958 CHAPTER 18 Prepare vertical analysis. (SO 2) AP Instructions Prepare a vert Prepare honzontal a_nd vertical analyses of income statement. (SO 1, 2) AP > Financial Statement Analysis E18—2 Opcrating dat E18—3 Here are the compara a for Flectwood Corporation follow: 2008 Sal $800,000 ales Cf)sl of gt;iods sold ;88 ggg Gross profit ; Operating expenses fgg 888 Income before income tax 25,000 Income tax expense 2 ,OOO Net income ical analysis for each year. 2007 $600,000 390,000 210,000 156,000 54,000 13,500 $ 40,500 tive income statements of Olympic Corporation: OLYMPIC CORPORATION Income Statement Year Ended December 31 2008 2007 Net sales $600,000 $550,000 Cost of goods sold 460,000 400,000 Gross profit 140,000 150,000 Operating expenses 55,000 50,000 Income before income tax 85,000 100,000 Income tax 34,000 40,000 Net income $ 51,000 $_60,000 Instructions (b) Prepare a vert Prepare horizontal and vertical analyses of balance sheet and comment. (a) Prepare a horizontal analysis. ical analysis for cach year. Ei18—4 The condensed comparative balance sheet of Mountain Equipment Co-operative, an outdoor equipment supplier, is presented here: (S0 1,2) AP MOUNTAIN EQUIPMENT CO-OPERATIVE Balance Sheet December 31 (in thousands) 2005 2004 Assets Current assets $ 69,237 $58,150 Property, plant, and equipment 37,587 39,225 Deferred store opening costs 296 Total assets $106,824 $97.671 Liabilities and Members' Equity Current liabilities $ 21,271 $18,873 Long-term liabilitics 641 4,113 Total liabilitics 21,912 22,986 Members' equity 84912 74,685 Total liabilities and members’ equity $97.671 Iustructions (a) Prepare a horizontal analysis. (b) Prepare a vertical analysis for each year. (c) Identify any significant changes from 2004 to 2005. g18-5 The following i alist Asset turnover ° Collection period Current ratig Days sales in inventg, Debt to total assets Earnings per shyre Free cash flow Gross profit margin —_— —_— —_— [nstructions if h of i . Classify each of the ratios a5 fiquidiy (. E18—6 Nordstar, Inc. op data for a recent year are as fq|) erates hyrd,, T owWs: Bal Cash and cash equivalent Accounts receivable Inventory Prepaid expenses Total current assets Total current liabilities - For the year ended December 31, 2005 sold was $2,600 million. Instructions are st Exercises ¥ Wenoy g 1503¢ 0 ). soly, ‘NORDSTAH bquiai aNce Sheet (narr: a _Et:emherg'lma“ in milliong) 2003 s 2005 2004 S0 gy 676 S56 628 386 R 52 » et credig o sales were $3.894 million and the cost of goods (a) Calculate the liquidity ratios for 2005. (b) Using the data in the chapter, com Corporation, Limited, and (2) the E18-7 The following selected ratios years: Current ratio Receivables turnover Inventory turnover Instructions are Nordstar's liquidi i;; dusxl or;l‘s’xars liquidity to the liquidity of (1) Canadian Tire Ty averages for the retail-department store industry are avaj lable for Pampered Pets Inc. for the most recent three 2008 2007 2006 2.6:1 1.4:] T 6.7 times 7.4 times 8.2 times 7.5 times 8.7 times 9.9 times < 959 Classtyranes ate and evaluate 1y ratios (SO AN Evaluate liquidity. (SO 3) AN (a) Has the company's f:ollz.?ction of its receivables improved or weakened over the last three years? (b) Is the company selling its inventory faster or slower than in past years> (c) Overall, has the company's liquidity improved or weakened over the last three years? Explain. E18-8 The following selected ratios are available for Ice-T Inc. for the three most recent years: 2008 2007 2006 Debt to total assets 50% 45% 40% 2.0 times 1.5 times 1.0times Interest coverage Evaluate solvency. (SO 3) AN

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R R s o e L B ST S Soduid add s > 960 CHAPTER 18 > Financial Statement Analysis Instructions (a) Has the debt to asscls im[?mvr:d'(f (b) Has the interest co\'cmgu‘lmpruuf (¢) Overall, has the companys solvene Canada reported the sGrvEars? r weakened over the last three yearss , | or weakened over the Jast three years: y improved or weakened over the last three years? following investor-related informagi, n H H o O- rial Oil and Petr Evaluate profitability. E18-9 Impe conat recently Imperial Oil Petro-Canada Earnings per share $2.54 ?83; Payout ratio 12.0%' 12.4 D e Price-carnings ratio 13.4 times 9.67 Profit margin 9.4% 6% Instructions (a) Based on the above information, which company is more profitable? i : investors favour? b) Which company do investor ' . B | ((c) Would investors purchase shares in these companies mainly for growth or for dividend income? EI18—10 Seclected comparative financial data (in thousands, except for share price) of Canada’s #i Colorlalorates. Indigo Books & Music Inc., are presented here for two years ended March 31: (S0 3 AP hookseller. 2006 2005 Revenue $849,616 $787,527 Interest expense 3917 5,809 Income tax expense — 360 EIZ Net income 25,337 11,702 Total assets 391,103 393,085 Total liabilities 275.4-_¥7 304,217 Total shareholders’ equity 115,656 88,868 Cash provided by operating activities 62,10() 38,453 Cash used by investing activities 17,407 13,758 Market price per share $14.10 $6.00 Weighted average number of common shares 24,134 24,067 Instructions Calculate the following ratios for 2006 and indicate whether each one is a measure of liquidity, profitability, or solvency: (a) Asset turnover (f) Price-earnings ratio (b) Debt to total assets (g) Profit margin (¢) Earnings per share (h) Return on assets (d) Free cash flow (i) Return on equity () Interest coverage Analyze ratios. EI8—11 The following sclected ratios are available for a recent year for Suncor Energy Inc. and (SO 3) AN Husky Energy Inc.: Suncor Husky Industrv Average Liquidity Current ratio 1.0:1 0.6:1 1.4:] Receivables turnover — 11.3 times 15.7 times 7.3 times Solvency Debt to total assets 60.1% 52.4% 32.0% Interest coverage 13.4 times 19.2 times 27.5 times P w&.,...*-&.,_y_ - Pro!:uahilitx % fih&- B Profit Margin | Return on assets 125 ““‘k\ . —udy % Exercives < 5 Price-carnings ratio 9.3 196 ave 61 269 time, B9 ustructions T ;i:: ) \Which company is more Wi s oy (b Which company is more sgl\»e,,.“_hgplain. -X ™ rofihic vt : n. Stors favayrs | (c) \Which company is more ( \Which company do inye . this ¢q, 18—12 Davis Ltd. has inc NSisteny femhef 31, 2008. It also has l?‘:’?olflr:m CONtining h youy findin 40,000 from the disc(,mimmnce Oi_\\m’ items (b gain from the operation of the s mQan fable counting principle that resulted i, the income tax rate on all items i 30 SELEFE fcrs Expla ain, A ended De. Ul o 1A net gun of Nerease s n the ‘ e a ¢ AN C i vears IMOrization \“:l " ‘\l:. | s assume thyg (a) Prepare a partial income stater, : ent, beg; (b) Indicate the statement presenta beg‘nnln i g with "] t ¥ n . 1on of any items ney inilt) de hf’"l COMiNUing greryric . » g18—13 Petrie Ltd. reported the following uded in (4. Perations, informati, n for the ye Yearended Ay 3 Slay 3L 2008 Cost of goads sold Gain on disposal of { iscontj InfEesss s Mtinued electronics division > 400000 Investment revenye fps ; 50 II:gSs: 22 soale T)F. available-for-sgle securities 20%?)% £oss on perations of dlscominucd electronice 4 10,000 S l;cra[]ng expenses onies division 40.000 ales . 300,000 1,000,000 Additional information: The company’s income tax ry : X rate is 257 Instructions c Prepare the income statement. Prepare discontinueg : OPerations section Posal, and (3, o GGu, ISewae Prepare income statement. (SO 4) AP

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966 CHAPTER 18 > e Ao Xt I PPN Sl e B _A‘b,.us«-—,;}-».-\c s AnalyTe ratos (S0 3) AN Analyze ratios. (SO 3) AN o anci atement Analysis ) A SE | g Financial Stat ) companics operating in the beverage industry follow. Industry tios for two i P1§-6A Selected included. . available, have also been i s where ; Refresh Corp. Jlavour Inc. Industry Ratio : il y = Asset turnover 1.0 times ;? 1“8“'5 8:_[!”5"“‘5 dat x doki Ol Current ratio (_)6"] 0 Loy ol Debt to total assets )(J.cs S s Earnings per share ?22” o sd v fit margin 3.8% o - 1(.1:2:-5‘:";)0]‘1-@5 15.3 times 7.9 times ;; tllm()s [nventory turnover 5.8 times 9.9 times 3.7 21m;seq Price cul"nings 50.3 times 24.3 times 8...1.‘" S ) % w4/ Profit margin 12.3? ”-2'.0 ’ o :imcs Receivables turnover 11.4 times 9.8 times 7.27 Return on asscts 11.2‘,‘2 393‘;2 2,6 ‘;% Return on equity 25.7% .8% A Instructions . . | omers credit terms of net 30 days. Indicate which ratio(s) should inies offer their cust 1l the accounts receivable are managed. Comment on how successful anaging its accounts receivable. ging its inventory (a) Both comp: be used to assess how we cach company appears to be at m (b) How well docs each company appear to be mana should be used to asscss inventory management. (¢) Which company. Refresh or Flavour, is more solvent? determine this and defend your choice. (d) To your surprise, you notice that Refresh’s gross profit marg and the industry average. Identify two possible reasons for this. (¢) What is mostly respansible for Refresh’s higher return on asse turnover? Explain. (f) What is the market price (g) Which company do investors appear to belic dividends® Indicate the ratio(s) that you used to re > Indicate the ratio(s) that Identify the ratio(s) that should be used to in is much higher than both Flavour’s ts: its profit margin or its asset per share of cach company’s common shares? ve has greater prospccts for growing its income and ach this conclusion and explain your reasoning, P18=7A The following ratios are available for toolmakers The Black & Decker Corporation and Snap-on Incorporated for a recent year: Black & Decker ~ _Snap-on _Industry Liquidity Current ratio 1.5:1 2.0:1 1.8:1 Receivables turnover 5.6 times 4.6 times 5.7 times Inventory turnover 3.7 times 4.0 times 4.6 times Solvency Debt to total assets 73.8% 52.0% 47.9% Interest coverage 8.8 times 8.6 times 7.2 times Profitability Gross profit margin 35.6% 45.6% 30.7% Profit margin 7.8% 4.1% 4.1% Asset turnover 1.2 times 1.1 times 1.2 times Return on assets 9.1% 4.6% 4.8% Return on equity 32.7% 9.5% 18.5% g::;:::j:::)rigs ratio }4.1 Ptjmes 24.9 times 18.1 times \ 8.8% 60.8% 25.8% ..“’""M : sy, <9 - \ = = [nsiructions (a) Which company is s ([)) Which company is m, (¢) Which company is mg, (d) Which company dg ip re I'(]Uid‘ : 2 !'-.\ Lui e Solvengs ‘Plain, Problems: Set A Te p“’fi\u},]@xg;“n" i < 967 Vestors ;mm'] Plain, Explain. el Your Mswer ¢ p18—8A The following Fatios ang SN With your g and m, : ndings i \ easyr, 2510 (a) 1o (e Recensy 53¢ availah)e for Hube ables ube tur 1 Cory r noy Porat Oht margin cr l()l 0n arnin, ‘mes Determine impact of ebt S per shyre 107 UANSACLONS O 1ati0s o 101014l yggerg 2 (SO 3) AN . € Cash flow 0% Instructions 50 =3.000 (a) Indicate whether each of the ahq, i% i aboy ; the f"""“_""gmdependem trame 0 Would incregee 4 1. Hubei issues common ghar-au;nns-, + eerease. or remyin 4 b shares, * nchanged by ged by each of 2. Hubei collects an account rece; 3, Hubei_ issues a mortgage no':c?l?'able_ 4. Hubei sells equipment ot 4 ]e payable. 5. Hubei's share price increas s (b) Would your answers to any nfs(e}? § ings per share were a loss ‘per shz om $10 ahove ¢ re? per share g 12 hange if the pmfitp“ share. margin were i BN Were negative and the earn- P18-9A Nexen Inc. reported the ollowing g except for per share amounts): Hlowing selected inform ation for the . @ last four years (in millions, Calculate and evatuate N 5 profitability ratios with Net sales 2005 2004 2003 discontinued Opfiratlnons Average shareholders” equity S399 Son o . soxaae fiverpge totalatsets B4l a8 suw ' - 1832 5 Income from continui A 13486 10050 7 1362 ntinuing operations 191 6,048 Discontinued operations Net income - 1;2) _23 7 o o N — — / 3 v Earm.ngs per share from continuing operations HEE 3578 S309 Earnings per share 269 $276 %205 S145 443308 233 ‘ ’ s 1.67 Inistructions a) Calculate Nexen’ i (a) ca dl (fe\(ens. profit. margin, asset turnover, return on assets, and i 5 Ee Te and after discontinued operations for 2003, 2004, and 200; e valuate Nexen' ility ov i e : ) ot elzxe'ns. profitability over the last three years before and after discontinued operati c ich analysis is more relevant to investors® Explain wopetons = e ledger Of ZunCh CO\‘pOl ation at December 4 o 3 3 2008, contains (he fO“l)\\lllg sum €epare ncome statement 4 €3arnings, with wregular tems. $1,700,000 Net sales Cost of goods sold 1,100,000 L Operating expenses 260,000 Other revenues 20,000 Other expenses 8,000 Retained earnings, January | 940,000 Dividends 25,000 Your analysis reveals the following additional information that is not included in the above data:

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PRRSESEE Rt 968 CHAPTER 18 > a =3 § Sy Pooyd gy DROMURT ST S shgt oy d T bdan Moo FoR i .4.;‘.‘.‘{»#‘4; i o Prepare hornizontal analysis and comment. (SO 1) AP Analysis division was discontinued during the year. The gain from op. vis i Financial Statement ¢ was $20,000. The division was sold at a loss of cation Devices The Communi ! o e n hefore income LN crations for the divisio b $70,000 before income ,w-‘-l J its amortization method from double declmlng-‘bu]ancc o . . ye; urich changed 185 € i ; sars’ net income was an increase 2. During the year, Z Jative effect of the change on prior y¢ irs’ net i 1 d‘d.' gt & ol straight-line. I'he cumulati e i the ledgn T d ax. Amortiz: $60,000 before tax. £ the currentyear. 3. The income tax rate is 25%. 4. There were 100,000 common shares. \tion under the new method is €0 Instructions - (a) Prepare an income statement, including carnings per me ‘ained carnings. () Prepare a statement of retained carning _I_’Loblems: Set B N al information is available for Big Rock Brewery In- corganixcd as an income trust in 2003, — p18—1B The following condensed financi . come Trust. The company, previously a corporation, ¥ B1G ROCK BREWERY INCOME TRUST Income Statement Year Ended December 31 2005 2004 2003 (12 months) (12 months) _(9 months) Revenues $40,563,180 $38,789,564 $28,503,840 Cost of sales 15.255.008 13.696.549 10,298,575 it Pr‘om 25,308,172 25,093,015 18,205,265 Operating expenscs _17.561.260 7-_5_61'260 17.397.249 12,757,866 Income before income taxes 7,746,912 7,695,766 5,447,399 Income tax expense 1_,1____27-036 __928.858 __ 891,543 Net income 5 6619876 $ 6,766,908 4,555,856 BIG ROCK BREWERY INCOME TRUST Balance Sheet December 31 2005 2004 2003 Assets Current assets $12,770,157 $ 9,947,060 $10,006,747 Noncurrent assets 29,016,020 30,981,408 30,804,429 Total asscts 341,786,177 $40,928.468 40,811,176 Liabilitics and Unitholders’ Equity Current liabilities $ 3,895,903 $ 4,014,186 $ 4,958,338 Noncurrent liabilities 8,060,167 7,394,131 9,166,319 Tolul h‘;lb'iliti@ 11,956,070 11,408,317 14,124,657 va}l‘lholdlcrs. cquity . 29.830.107 29,520,151 26,686,519 otal liabilitics and unitholders’ equity $41,786,177 $40.928,468 $40,811,176 il I RSSO O \ s | | | | ! | | Instructions (a) Prepare a horiz, Zontal ; . (b) What components indgia;)i::s.k Dek's by the change in the co = 3 e Mpany" NCe shee, (c) Is it meaningful 1o C(’m[:)ary s}f‘"““finl heet ang g ¢ the re 2003 covers only a 9-month per: oo Period by, 2004 4, d.a a Problems: Set B Y responsible for PI8-2B C i nd 2005 e Yeur periods e omparative Income 14 5 coner | " using 3 h"’“")m.xl:' P;"f’d- year ended December ;| €ment datg fo, Ch, “month periode F—"I‘;\‘l e ' 200 ; - ] * Jin. 8: ¢ and Chy,n L. twa - ol Net sales Ch o fol Pl?pavo o o Dty - calculate profitat ity ras g(:(_: of goods sold m E}‘% and comm:n‘ Aty rates, g :af.mfi' 1,080,450 9339033 S0 2,3) AN Income Fopebees TS oo om o . 502275 =21.032 I Peration =:275 7 e Incn:e before income 1oy 6.800 ~2.2§2 o € tax expense 239370 % et income 103.800 e Additional information: 02,670 Lfi\.fi —Sgohen Total assets S% —2007_ ’C!‘% Total shareholders’ equity ‘;Z)zg‘)o $812,410 52.9& 2007 26 ' 73 5.27 Instructions > s 2 o 2478 149998 (a) Prepare a vertical analys; | ysis of the incom, (b) Calz?tulate.thefgross profit margin profi:;‘:lc'mem for each company equity rat ies. 'Bin, " quity ratios for both companies, BIN, asset turnover, retyrn on assets, and retur B non (c) Comment on how profitable each company i is. P18-3B Th i i € comparative financial statements of Johnson Cables Ltd ables Ltd. follow: JOHNSON CABLES LTD. Income Statement Year Ended December AN Net sales 2008 0 Cost of goods sold Sl.9li§,500 e Gross profit l'g(:ﬂoo 600 Operating expenses 502’(())(())((]) et Income from operations 407‘000 47?‘000 Interest expense 28, 000 22;‘500 Income before income tax 379'000 256’05(())(()) Income tax expense 113,700 77,000 Net income $ 265300 $ 179,500 < 969 Calculate ratios. (SO 3) AP

' 970 CHAPTER 18 > Financial Statement Analysis JOHNSON CABLES LTD. Balance Shgl:( December 2008 _ 2007 Asscts T C t asscts $ 60,100 v Coh jo7s00 102.800 Accounts reccivable 143,000 ] Inventory 310,900 282,500 Total current asscts 54,000 50,000 Held-to-maturity securitics 625,300 520,300 Property, plant, and equipment $990,200 §852,800 Total asscts Liabilitics and Sharcholders’ Equit Current liabilitics $165,000 $145,400 Accounts payable 43,500 42,000 Income tax payable 208,500 187,400 Total current liabilities 86,000 200.000 Bonds payable 394500 387,400 Total liabilitics —_— —_— Sharcholders’ equity ) . 300,000 Common shares (56,000 jssued in 2008; 60,000 in 2007) .2‘?(5),388 125,400 Retained eurnin'i;]s —69’5‘:/'% m Total shareho ors’ equity ) e .q—_'_ Total liabilities and sharcholders’ equity $990,200 $852,800 l Additional information: 5 1. All sales were on account. . ‘ 3 2. The allowance for doubtful accounts was $5,400 in 2008 and $5,100 in 2007. 3. On July 1, 2008, 4,000 shares were reacquired and cancelled. 4 4. In 2008, $15,000 of dividends were paid to the common shareholders. 5 5. Cash provided by operating activities was $313,900. 6. 6. Cash used by investing activities was $161,000. 7 8 Iustructions 5 Caleulate all possible liquidity, solvency, and profitability ratios for 2008. 10. Calculate and evaluate ratios ~ P18—4B Financial information for Click and Clack Ltd. follows: for two years. (SO 3} AN CLICK AND CLACK LTD. Income Statement Year Ended December 31 2008 2007 Sales $900,000 $840,000 Cost of goods sold 620,000 575,000 Gross profit 280,000 265,000 Operating expenses 164,000 160,000 Income before income tax 116,000 105,000 Interest expense 30,000 20,000 Income before income tax 86,000 85.000 Income tax expense 30,000 30.000 Net income 56.000 55.000 $56000 $ 55000 . The allowance to ad; ; just avs and nil in 2007. a L The allowance for doubtful ¢ . Accounts receivable at th ounts was $5,000 e b ; n 2008 . accounts of $3,000. cginn and $4,000 in 2007, Click AND ¢ B[;"a“te ‘s':E:‘LTDA Assets ecember 3y Cash . 2 }Rvdllable-for-sule securig A ccounts receivabe Hes Inventories > ll";ep;icé expenses ;zooo n . . ‘ TOt, IUIldlngs, and equi 120000 al assets Hineng "(())(00)0 <) Liabilities and L%‘ .. ' 000 Notes payable techobdes E“um' m Accounts payable ggc:;.led liabilities g 5 nds payable, due 2015 oon ommon shares, 20,000 i o0 ietamedl earnings Foued iy ccumulated other ¢q Py . e m Ie ive i ‘ Total liabilities and shz::;;"‘;'c‘;‘lncomc ‘6-}200 cquity T Additional information: oun Instructions Income Statement Sales Cost of sales Gross profit Operating expenses Loss from operations Other expense Loss before income tax Income tax recovery Net loss were $630,000. ginning of 2007 w account. s S Domtar o S|t o~ |[— INfit= o v wio 2 53 " o0 00 — T 2648 00 e-[()l -Sdl(} securi (o ue wa a u ‘\ t l € Was S ( ‘ Tities to mar va I,()()() dt.bll in 2008 ing of 2007 — . were $88,000, net of an allowance § \ ntories at the beginning of 2007 v, e for doubtful . Total assets at the beginning of 2007 ere $115,000. Total shareholders’ equity at the be . Of the sales amount, 75% was on . In each of 2007 and 2008, $8 : , $8,000 of divid Cash provided by operating activities v::; ends were paij nds were paid to the common shareholders Cash used by investing activities was $12 0588.090 in 2008 and $60,000 in 2007, 000 in 2008 and $50,000 in 2007. (a) Calculate all possible liquidi quidity, sol ility rati (b) Discuss the changes in liqui?iit;), e il o o 2008 a2 rofitabili i caleulated in (a) profitability, and solvency by referring to the relevant ratios Cascades $3,460 2,890 570 634 (64) (74) (138) (41) $ 07 < I 18_58 Cascades lnc' alld Do“!tal lllc- are Ca“adla“ pdpel plOdUClS CO”IPGH\CS. Se‘fic[ed Calculate and evaluate ratios ( p ) d 8 lillathlal data n llll“lOnS) OE tllese two Close comy itor: pe“tors are resented hele Eol 2005 beiole DOH“ il¢ i mergEd Wlth VVeyerhﬂeuser Companyl | (SO 3) AN

Bt RS = 1t et e Y PR S S B i Financial Statement Analysis Average total sharcholders’ equity Instructions (a) For cach company, after cach ratio, where available. 1. Current ratio (1.5:1) 2. Receivables turnover (7.9 times) 3. Collection period (46 days) 4. Inventory turnover (5.7 times) 5. Days sales in inventory (64 days) 6. Debt to total assets (88.0%) (b) Compare the liquidity, solvency, industry. (c) Both Domtar and Cascades expericnccd losses for try. Because of these losses, are the company's pro calculate the 9. Assct tur and profitability of Analyze ratios. (SO 3) AN able, have also been included. ratios, where avail following ratios. Industry P18—6B Sclected ratios for two companies operating in the offic Cascades 972 CHAPTER 18 > Somtar Balance Sheet §1.157 §1.125 Current asscls 4035 1921 s ssels — e Pt oy s ) 703 $ 595 Current liabilitics $2 e | e Noncurrent liabilitics 225 it Total liabilitics -1'609 i Sharcholders’ cquity . . . }!Ij(::.'l}ulitlbililius and sharcholders” equity $5,192 $3,046 Average accounts receivable $ 268 $ ;ig Average inventorics 5 2;6 <338 «crage total assets ! : Average total asse g S averages are given in parentheses 7. Gross profit margin (24.7%) 8. Profit margin (-1.3%) nover (0.9 times) 10. Return on assets (-1.0%) 11. Return on cquity (-19.6%) the two companies to each other and their their most recent fiscal year, as did the indus- fitability ratios still meaningful? ¢ supply industry follow. Industry _ Raio _Paperclip. _Stapler Industry Average Assct turnover 3 times 2 times 3 times Current ratio 2:1 3:1 2:1 Debt to total assets 50% 33% 50% Earnings per share $3.50 $0.40 n/a Gross profit margin 23% 40% 27% Interest coverage 4 times 8 times 7 times Inventory turnover 7 times 3 times 5 times Payout ratio 8% 22% 10% Price-earnings ratio 29 times 45 times 38 times Profit margin 5% 4% 4% Receivables turnover 11.8 times 9.1 times 10.2 times Return on equity 25% 13% 16% Instructions . ) . ) (a) lapjrcllp offers its customers credit terms of net 30 days. Indicate the ratio(s) that should be used to assess Paperclip's accounts receivable management. Comment on how well Paperclip appears to be managing its accounts receivable. (b) tI)—im\' \\(-Jcll does Paperclip appear to be managing its inventory? Indicate the ratio(s) that should used to assess the company’s inventory management. How well is Paperclip managing its inventory compared to Stapler and the industry average? (¢) Which company, Paperclip o r ,'la determine thj than the ::n;::::;;l explain h,. s,:l':;. IS More soh (d) To your SUrprise, you not; ICance ;,fpdp:; &'lc Ul the p.- the lnduslry av(:rage ]dL:lcc lhat Pa ps fesuly I l:.:::““h-]ls be <« 973 daperclip' - 1ae (C) ! ﬂp(.l'CllpS Pﬂy()u[ rat : 4 ‘lp more or lcxs S:):l(‘: io j reason for this. s lower in (F) What is the market (g) Which company do dividends? Indicate p18—7B The followin . rati ration of Saskatchewg 05 are availy, an Inc. (Potagp, le for ag ¢ use S Rregf 'S conclygg as iCultu Corp) ang ’\grirzl chemicylg compeiy 1! ter pre ) Spects e for &rowing its nd exply ncome and n YOur reasaning 0 ne. for fiey] 2005'.5 Potash Corpo- Anavyze ravos Liquidiny Potutc Curre ; B Agri nt ratio —Lfhum Ind (S0 AN Receivables turnover 1.0, —Odustry Inventory turnover §'6 times 3-2:1. 181 Solvency 3.1 times 79 times s Deb 4.6 times 3 times ebt to total assets 4.8 times Interest coverage ?82"5 356 Profitability B times 10‘-2/‘1im¢s 570% Gross profit margin 10.2 times Profit margin 3;2'3% 3187 Asset turnover 057'6'?" 86';6 2847 gelurn on assets 1'0 :mes 1.2 times 72% eturn on equity 2 ()/'; 10.4% L0 times Ea.rnmgs per share 35'00" 26.6% -i‘fir'é gncc-earn_ings ratio 18.6 e $2.14 ni.i “ ayout ratio 12'07'"‘“ 12.0 times 7: i P . RV 39% <13 times nstructions 26.5% (a) Which company is more liquid? Explain (b) thch company is more solvent? Explai.ra (Z) wh{ch company is more profitable? Explain (d) Which company do investors favour? Is y0ul: answ swer consi i L istent with your findings in (a) to (o) P18—8B The following ratios are available for Yam; Corporati 10n: Current ratio Inventory turnover Debt to total assets Asset turnover Profit margin Instructions Determine impact of transactions on ratos. 1.5:1 (SO 3} AN 10 times 40% 2 times 10% a i i (a) Inleate whether each of the above ratios would increase, decrease, or remain unchanged as a result of each of the following independent transactions: 1. Yami pays an account payable. 2. Yami collects an account receivable. 3. Yami purchases a held-to-maturity investment. 4. Yami sells merchandise for cash at a profit. S. Yami buys equipment for cash. (b) Would your answers to any of the above change if the cur rent ratio were 0.5:1 instead of 15:12

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; i Analysis . Financial Statement i following selected information for the last four years (in U.S. 974 CHAPTER 18 > p18—9B Alcan Inc. reported th gz‘z:gf’t'fifsnrg‘?‘;‘: ":"’?“: millions, except for per share amounts): discontinued operations. 2005 2004 2003 _M cor o Sales and operating revenues 5?8:332 $?g:g:g $1 3:?;2 $1 g;;g? Avemgs s B R 1000 s 24854 17656 Income from continuing operations 51(22) ?j:g ig) $;4é—i) Il\)}is[cjt;r;t(ir;::d operations @ o8 503 Sl $0.40 $0.64 $0.79 $1.29 Earnings per share from continuing operations 033 0.69 0.30 155 Earnings per share Instructions ' and return on equity ratios (a) Calculate Alcan’s profit margin, before and after discontinued opera (b) Evaluate Alcan's profitability over the last three years (c) Which analysis is more relevant to investors? Explain. asset turnover, return on assets, tions for 2005, 2004, and 2003. before and after discontinued operations. Prepare income statement pP18—10B The ledger of Hyperchip Corporation at November 30, 2008, contains the following and statement of retained summary data: earnings, with irre ular items. (so 4’3"’ ? Net sales $1,500,000 Cost of goods sold 800,000 Operating expenses 240,000 Other revenues 40,000 Other expenses 30,000 Retained earnings, December 1, 2007 1,225,000 Dividends 30,000 | information that is not included in the above data: Your analysis reveals the following additiona oss from operations for this divi- 1. The ceramics division was discontinued during the year. The | s sold at a loss of $70,000 before sion before income tax was $150,000. The ceramics division wa income tax. 2. During the year, Hyperchip changed its amortization balance. The cumulative effect of the change on pri $30,000 before income tax. Amortization under the new method i ledger for the current year. 3. The income tax rate is 30%. 4. There were 235,000 common shares. method from straight-line to declining- or years’ net income was a decrease of s correctly included in the Instructions (a) Prepare an income statement, including earnings per share. (b) Prepare a statement of retained earnings. Continuing Cookie Chronicle (Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 17.) Thg balance sheet and income statement of Cookie & Coffee Creations Ltd. for its first year of op- erations, the year ended October 31, 2009, follows: Assets Assets Current assets Cash Accounts receivable Inventory Prepaid expenses Property, plant, and equipme Furniture and fixtures " Accumulated amortization f —turmj Computer equipment lure ang fixtures $12,500 Accumulated amortization—cq, .23 [liitchen lequipmem MPputer €quipmen, $ 4200 ccumulated amortizatig 1600 - ) Total assets Kitchen €Quipmen m Current liabilities - Accounts payable Income tax payable Dividends payable Salaries payable Interest payable Note payable—current portj ort Long-term liabilities portion Note payable—lon; g-term porti Total liabilities portion Shareholders’ equity Contributed capital Ereferred shares, 2,500 shares issued Comnjllc;n shares,' 23,180 shares issued $12,500 ontri uted capital—reacquisition of sh 23,180 Retained earnings shares 250 L Total liabilities and shareholders' equity COOKIE & COFFEE CREATIONS LTD Income Statement ' Year Ended October 31, 2009 Sales Cost of goods sold Gross profit Operating expenses Amortization expense $ 9,850 Salaries and wages expense 92500 Other operating expenses 35:987 Income from operations Other expenses Interest expense Income before income tax Income tax expense L Net income 300 ¢ 30411 4.500 BT $35.930 $462,500 231,250 231250 138,337 92913 413 92,500 18,500 S 74,000

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4 X b ey el bl f yha F ke e g LR ot Cidpesid ab damm bt 976 CHAPTER 18 > Financial Statement Analysis N itional $20,000 to buy more kitchen he terms of the Joan provide for equal mber 1 of each year, plus interest of Additional information: Natalie and Curtis ar¢ oan would be re Iment payments of $ thinking about borrowing an ad'cli‘ wipment. The | paid over 3 four-year period. :c?mil-'mnu:ll insta 2,500 on May | and Nove 55 on the outstanding balance. tions: . fstruc s where appropriate rather than average ) Calculate the following ra balances: 1. Current ratio 2. Receivables turnover 3. Inventory turnover 4. Debt to total assets 5. Interest coverage (b) Comment on your findings from part (a). (c) Based on your analysis in parts (a) and (b), do you t Creations Ltd. $20,000 to buy the additional equipm ‘ (d) What alternatives could Cookie & Coffee Creations consider inst: tios, using ending balance (a 6. Gross profit margin 7. Profit margin 8. Asset turnover 9. Return on asscts 10. Return on equity hink a bank would lend Cookie & Coffee ent? Explain your reasoning. ead of bank financing? BREAPENIDG 700 PEEOPEGTIVE . ~ Financial Reporting and Analysis Financial Reporting Problem BYP18-1 Refer to the consolidated financial statements and notes of The Forzani Group Ltd. in Appendix A. Instructions (a) Prepare a horizontal analysis for 2006 and 2005. (b) Prepare a vertical analysis for 2006 and 2005. (¢) Comment on the significance of any trends you observe from your calculations in (a) and (b). Interpreting Financial Statements BYPI8—2 Selected financial ratios for the Canadian National Railway Company (CN) and the Canadian Pacific Railway Limited (CP) are presented here for a recent year: CN CP Industry Liquidity Current ratio 0.6:1 0.8:1 1.6:1 Receivables turnover 10.2 times 9.2 times 26.6 times Inventory turnover 52.1 times n/a 59.5 times Solvency Debt to total assets 35.5% 40.5% 36.7% Interest coverage 8.8 times 4.8 times 26:4 times Free cash flow $1,630 million $181.5 million n/a M C e turnovi 213, Critj Return on ast:n 0»3’:‘ \ Indu“ Titical Thinking < Return on equi(s 8 Svl"‘“ :)2-4',2 T 2 5 - % ; - l;:;lce-eam'ings filio 1887 6.::2"‘“ ";'5 yout ratio :4: times 1307 7:6:'"11‘3 [nstructions - ?«3 times l.;'z’; ‘e Ay (a) Comment on the relative |; i na imes (b) Comment on the relative uidity of 1he |, solvenc VO Compan: (c) Comment on the relative profiat, of the 1y, . Panies. ility of the twn"lpa"it‘s. OMpanieg Critical Thinkin m— Collaborative Learnj ning Activity ‘ Note to ms;{mctor: Additional instructions ang Instructor Resource Si an Ite. Material for thig 8roup acy ] ] ivity can b BYPIS '3 In this group aCliVi[y_ you will n be found on the ‘ companies. apply your knowledge f & dl . ——— nancial analysis 1o two public o ?r:);:(::s([);t:sszerill divide the class into groups and d arge companies. Y, and distribyte Our group will selected inancial and ratio infor the information for one co 1. Is the company able tor::; ?1); z::;l[answemg 2. Will the company survive over | o 3. How profitable is the com - 4. Based on the answers to t T groups, with each ki ane h taking g period of time> (b) When the smaller groups are finished, each should explain xplai Communication Activity BYP18-4 You ar ea i ot paepatton yo?;vgrrst:er:\betl.' of tfht‘il boar(;l of directors and audit committee of Shifty Inc . st meeting of the audit committee and want to revi imations o financial statements with management and the auditors. prevenhelmtaionsf Instructions w # : . o . rite a list of questions that you should raise at the audit committee meeting in order to satisfy any concerns you may have about the limitations of financial statements. BYP18—5 Sabra Surkis, president of Surkis Industries, wants to issue a press release to improve her company's image and share price, which has been gradually falling. As controller, you have been asked to provide a list of financial ratios along with some other operating statistics from Surkis In- dustries’ first quarter operations.

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> Financial Statement Analysis the ratios 2 (inancial and op¢ news release, d, Carol Dunn, the public relations director rating data contained in the press rclcasc'wriucn by nd edited by Carol. In the the president hlgl‘ﬂlghts the sales increase of 1 the positive change in the current ratio ffom 1.5:1 last year to 3:] roduction was up 507 over the prior years first quarter. sitive of improved ratios, and none of the negative or hat the debt to total asscts ratio has increased up 89%. There was also no indication f the estimated lives of Surkis’ ma- 978 CHAPTER 18 “Two days after you provide nd data requeste of Surkis, asks you to review the the president a 257 over last year's first quartet anc this year. She also emphasizes that p that the release contains only Pt re is no mention t { inventorics arc 1d have been a loss i You note weakened ratios. For instancc, the from 35% to 55%. Nor was it mentioned tha that the reported income for the quarter wou chinery not been increased by 30%. Instructions (a) Who are the st (b) Is there anything (¢) Should you as controller re akeholders in this situation? uncthical in president Surkis' actions? main silent? Docs Carol have any responsibility? AUOWERS VO COHRPTEE OOEBTIONS Answers to Accounting in Action Insight Questions Business Insight, p. 930 Q: Are the percentage changes for Laperritre based on horizontal or vertical analysis? A: The growth percentages reported in the press release are an example of horizontal analysis which calculates percentage changes across ycars. Vertical analysis reports percentages within the same year. Business Insight, p. 932 Q: What could management do to influence a company’s current ratio? A: Management can affect the current ratio by speeding up of withholding payments on ac- counts payable just before the balance sheet date. Management can change the cash balance by increasing or decreasing long-term assets or long-term debt, or by issuing or repurchasing common shares. Ethics Insight, p. 936 Q: The Rosens warn analysts to watch for “too-good-to-be-true” (?un you give an example of what they might be referring to? Al "ICI'C are many examples that could be mentioned here. Examples of “too0-good-to-be-true” situ- ations could include inexplicable changes in trends and percentages from period to period. If the rC;IS?{I for the chungipg r.csulls does not seem intuitive or even obvious, it could be a sién that qt].e.summzl? vﬂCCOUnl‘lng is occurring. Examples of accounting games could include overstated mu;lifi.s;;fi ;:,:)Ld \lvrllc-(:,owns (Tf goodwill and long-lived assets, or delayed expenditures. gl inh,::f;.:i;i llhiscu;a'rf’e ’qluc.stlons about the quality of earnings. If analysts cannot B s gk n"‘,,-lcu(ling_y analyzing to be accurate and complete, then the results of the situations and accounting games. >— - Answer to Forzani Re.; evgmv 'l ,ani did not re . . Forz port any ch-‘lngc Quesho" 5 nC Answers to Self-Sty dy Que sti 1.d 2.¢ 3.a 4.¢ 5.4 o Ong b7 b b 10, Remember to go back to the chapter to check Sin e untip, »p. 93> 2pn & v Ple og s n Answe St ¢ (h.lplcr Duesii ns ved s CTati . i) 300 L > d Navigator Box at the peginning of the off your completed work.

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Chapter 18

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