Chapter 13, Problem 1EYK

a)

To determine

Prepare a 5-year trend analysis, using 2007 as a base year, of (1) net sales, (2) net income, (3) total assets and comment on the findings.

Explanation of Solution

Trend Analysis: Trend analysis is type of horizontal analysis used to calculate the changes in economic cycle of a business for several years in terms of changes in percentage using one of the years as base year.

$\text{Trend percentage }=\frac{\text{Amount for the particular year }}{\text{Amount for the year 1 }\left(\text{2007}\right)}\times 100$

Prepare a 5-year trend analysis, using 2007 as a base year, of (1) net sales, (2) net income, (3) total assets:

Net Sales, Net Income, and Total Assets
Trend Analysis
(Amount in thousands of dollars)
Particulars	Year 1 (2007)	Year 2 (2008)	Year 3 (2009)	Year 4 (2010)	Year 5 (2011)
Net sales	$1,356,039	$1,317,835	$1,244,023	$1,483,524	$1,693,985
Trend percentages	100%	97.2%	91.7%	109.4%	124.9%
Net income	$144,452	$95,047	$67,021	$77,037	$103,479
Trend percentages	100%	65.8%	46.4%	53.3%	71.6%
Total assets	$1,166,481	$1,148,236	$1,212,883	$1,294,754	$1,382,542
Trend percentages	100%	98.4%	104.0%	111.0%	118.5%

Table (1)

Comments:

• Net sales of the company decreases from 2007 to 2008 and 2009. Again, it increases in 2010 and 2011.
• Net income of the company decreases in all years compare to the year 2007.
• Total assets of the company decreases from 2007 to 2008. Again, it increases in 2009, 2010, and 2011.

b)

To determine

Calculate 1) gross profit percentage, 2) return on sales, and 3) return on assets for 2010 and 2011 and comment on profitability of the Company CS.

Explanation of Solution

1) Calculate gross profit percentage for 2010 and 2011:

Gross Profit Percentage: Gross profit is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the net sales revenue, and the cost of goods sold. It can be calculated by dividing gross profit and net sales.

$\text{Gross Profit percentage}=\frac{\text{Gross}\text{Profit}}{\text{Net Sales Revenue}}\times 100$

$\text{Gross profit = net sales – cost of goods sold}$

Calculate gross profit percentage for 2010.

Net sales = $1,483,524

Gross profit on sales = $629,404

$\begin{array}{c}\text{Gross profit percentage }=\frac{\text{Gross profit}}{\text{Net sales}}\times 100\\ =\frac{\$629,404}{\$1,483,524}\times 100\\ =42.43\%\end{array}$

Calculate gross profit percentage for 2011.

Net sales = $1,693,985

Gross profit on sales = $735,308

$\begin{array}{c}\text{Gross profit percentage }=\frac{\text{Gross profit}}{\text{Net sales}}\times 100\\ =\frac{\$735,308}{\$1,693,985}\times 100\\ =43.41\%\end{array}$

Gross profit percentage for 2010 and 2011 are 42.43% and 43.41% respectively.

2) Calculate return on sales ratio for 2010 and 2011.

Return on sales ratio: The ratio which evaluates the amount of net income earned for every dollar of net sales is referred to as return on sales ratio. Higher ratio indicates highly profitable company.

$\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}$

Compute the return on sales ratio for 2010.

Net sales = $1,483,524

Net income = $77,037

$\begin{array}{c}\text{Return on sales ratio }=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$77,037}{\$1,483,524}\\ =\text{0}\text{.0519 or 5}\text{.19\%}\end{array}$

Compute the return on sales ratio for 2011.

Net sales = $1,693,985

Net income = $103,479

$\begin{array}{c}\text{Return on sales ratio }=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$103,479}{\$1,693,985}\\ =\text{0}\text{.061 or 6}\text{.1\%}\end{array}$

Return on sales ratio for 2010 and 2011are 5.19% and 6.1% respectively.

3) Calculate the return on assets for 2010 and 2011.

Return on assets:

Return on assets is the financial ratio which determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings with relative to its total assets.

$\text{Return on Assets }\left(\text{ROA}\right)=\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Assets}}$

Compute return on assets for 2010.

Average total assets = $1,253,818.5 (Refer working note)

Net income = $77,037

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net}\text{income}}{\text{Average total assets}}\\ =\frac{\$77,037}{\$1,253,818.5}\times 100\\ =6.14\%\end{array}$

Compute return on assets for 2011.

Average total assets = $1,338,648 (Refer working note)

Net income = $103,479

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net}\text{income}}{\text{Average total assets}}\\ =\frac{\$103,479}{\$1,338,648}\times 100\\ =7.73\%\end{array}$

Return on assets for 2010 and 2011 are 6.14% and 7.73% respectively.

Working note:

Calculate average total assets for 2010:

$\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Opening balance of total assets}\\ +\text{Closing balance of total assets}\end{array}\right)}{2}\\ =\frac{\$1,212,883+\$1,294,754}{2}\\ =\$1,253,818.5\end{array}$

Calculate average total assets for 2011:

$\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Opening balance of total assets}\\ +\text{Closing balance of total assets}\end{array}\right)}{2}\\ =\frac{\$1,294,754+\$1,382,542}{2}\\ =\$1,338,648\end{array}$

Comment on profitability:

• Profitability of Company CS is measured by gross profit percentage, return on sales ratio, and return on assets ratio.
• The all three ratio has increased from 2010 to 2011.
• This shows that the company’s profitability has increased.

c)

To determine

Calculate 1) current ratio, 2) quick ratio, and 3) operating cash flow to current liabilities ratio for 2010 and 2011 and comment on liquidity of the Company CS.

Explanation of Solution

1) Calculate current ratio for 2010 and 2011:

Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. The ideal current ratio is 2:1. The following formula is used to calculate current ratio.

$\text{Current ratio}\text{=}\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$

Compute current ratio for 2010.

Current assets = $990,880

Current liabilities = $251,626

$\begin{array}{c}\text{ Current ratio }=\frac{\text{Current asset}}{\text{ Current liabilities}}\\ =\frac{\$990,880}{\$251,626}\\ =3.94\end{array}$

Compute current ratio for 2011.

Current assets = $1,049,526

Current liabilities = $267,002

$\begin{array}{c}\text{ Current ratio }=\frac{\text{Current asset}}{\text{ Current liabilities}}\\ =\frac{\$1,049,526}{\$267,002}\\ =3.93\text{times}\end{array}$

Current ratio for 2010 and 2011 are 3.94 times and 3.93 times respectively.

2) Calculate the quick ratio for 2010 and 2011:

Quick Ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

$\text{Quick Ratio}\text{=}\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$

Compute Quick ratio for 2010:

$\begin{array}{c}\text{Quick ratio}=\frac{\left(\begin{array}{l}\text{Cash and cash equivalents }+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\$234,257+\$68,812+\$300,181}{\$251,626}\\ =2.4\text{times}\end{array}$

Compute Quick ratio for 2011:

$\begin{array}{c}\text{Quick ratio}=\frac{\left(\begin{array}{l}\text{Cash and cash equivalents }+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\$241,034+\$2,878+\$351,538}{\$267,002}\\ =2.23\text{times}\end{array}$

Quick ratio for 2010 and 2011 are 2.4 times and 2.3 times respectively.

3) Calculate operating cash flows to current liabilities ratio for 2010 and 2011.

Operating cash flows to current liabilities ratio: It indicates the ratio of the amount of cash flows from operating activities to settle the current liabilities.

$\text{Operating cash flows to current liabilities }=\frac{\text{Cash flows from operating activities}}{\text{Average current liabilities}}$

Compute operating cash flows to current liabilities ratio for 2010:

$\begin{array}{c}\text{Operating cash flows to current liabilities }=\frac{\text{Cash flows from operating activities}}{\text{Average current liabilities}}\\ =\frac{\$23,517}{\left(\frac{\$179,287+\$251,626}{2}\right)}\\ =0.11\text{times}\end{array}$

Compute operating cash flows to current liabilities ratio for 2011:

$\begin{array}{c}\text{Operating cash flows to current liabilities }=\frac{\text{Cash flows from operating activities}}{\text{Average current liabilities}}\\ =\frac{\$63,796}{\left(\frac{\$251,626+\$267,002}{2}\right)}\\ =0.25\text{times}\end{array}$

Operating cash flows to current liabilities ratio for 2010 and 2011 are 0.11 times and 0.25 times respectively.

Comments:

• Liquidity of Company CS is measured by current ratio, quick ratio, and operating cash flows to current liabilities ratio.
• The current ratio of company for both the year is more than 2:1. This indicates that the company has good ability in meeting its short-term liabilities.
• The quick ratio of company for both the year is more than 1:1. This indicates that Company has more liquid assets that the standard requirement to settle the current liabilities.
• The Operating cash flows to current liabilities ratio of 2011 is more than 2010. It indicates that the company has more cash in 2011 than 2010 to settle the current liabilities.

d)

To determine

Determine debt to equity ratio for 2011 and 2010 and comment on the solvency of Company CS.

Explanation of Solution

Debt-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity.

$\text{Debt-equity ratio}\text{=}\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$

Compute debt to equity ratio for Company C S for the year 2010 and 2011.

For 2010:

Total stockholders’ equity = $1,001,974

Total liabilities = $292,780

$\begin{array}{c}\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}\\ =\frac{\$292,780}{\$1,001,974}\\ =0.29\end{array}$

For 2011:

Total stockholders’ equity = $1,074,545

Total liabilities = $307,997

$\begin{array}{c}\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}\\ =\frac{\$307,997}{\$1,074,545}\\ =0.286\end{array}$

Comments:

• Solvency of Company C S is measured by debt-to-equity ratio.
• Debt-to-equity ratio of Company C S is almost equal in both the years 2010 and 2011.
• This shows that the company has same potential to pay for the creditors in both the years.