Chapter 14, Problem 4CP

Part I a.

To determine

Identify the number of years that are covered in each of the primary comparative financial statements. State whether all of the statements were audited and state the name of the auditors. State the auditors’ conclusions concerning these statements.

Explanation of Solution

• The years covered in the primary comparative financial statements of Incorporation HD consist of the following:
• Comparative balance sheets are presented for two years: 2012 (Year ending January 31, 2013) and 2011 (Year ending February 1, 2012). 
• Three years of comparative statements of earnings are presented for the years: 2012 (Year ending January 31, 2013) and 2011 (Year ending February 1, 2012), and 2010 (Year ending February 2, 2011). 
• Three years of statements of cash flows are presented for the years: 2012 (Year ending January 31, 2013) and 2011 (Year ending February 1, 2012), and 2010 (Year ending February 2, 2011).
• All the financial statements of Incorporation HD are audited by the independent auditors – LLP KPMG.
• The auditors issued an unqualified audit report, concluding that the financial statements are prepared in accordance with generally accepted accounting principles and the financial position, results of operation and cash flows for each year are presented fairly.

Part I b.

To determine

Identify the part in which details about changes in the amount of retained earnings can be found in the annual report.

Explanation of Solution

Statement of changes in stockholders’ equity: The statement which reports the changes in stock, paid-in capital, retained earnings, and treasury stock, during the year is referred to as statement of stockholders’ equity.

Incorporation HD reports the Consolidated Statement of Stockholders' Equity that includes the statement of retained earnings. The 4^th column of numbers of left shows the changes in retained earnings for the three year period.

The descriptive captions to the left, combined with the numbers in the retained earnings column, make up the information that would otherwise have constituted a separate statement of retained earnings.

Part I c.

To determine

Identify whether the company’s annual net cash flows have been positive or negative from (1) operating activities, (2) investing activities, and (3) financing activities over the three years and identify whether the company’s cash balance increased or decreased during each of these three years

Explanation of Solution

Statement of cash flows: Statement of cash flows reports all the cash transactions which are responsible for inflow and outflow of cash and result of these transactions is reported as ending balance of cash at the end of reported period. Statement of cash flows includes the changes in cash balance due to operating, investing, and financing activities.

Cash flows from operating activities: These refer to the cash received or cash paid in day-to-day operating activities of a company.

Cash flows from financing activities: This section of cash flows statement provides information about the cash inflow and outflow as a result of issuance and financing of debt, issue of new stock and payment of dividends.

Cash flows from investing activities: This section of cash flows statement provides information concerning about the purchase and sale of capital assets by the company.

The statement of cash flows of Incorporation HD over the three years reveals the following:

Particulars	Amount
1) Cash flows from operating activities	The cash flows from operating activities have been positive for all three years: $6,975 million, $6,651 million, and $4,585 million in 2012, 2011, and 2010, respectively.
2) Cash flows from investing activities	The cash flows from investing activities were negative all three years ($1,432 million) in 2012, ($1,129 million) in 2011, and ($1,012 million) in 2010 respectively.
3) Cash flows from financing activities	The cash flows from financing activities were negative for each of the three years ($5,034 million) in 2012, ($4,048 million) in 2011, and ($4,451 million in 2010)

Table (1)

The cash balance of Incorporation HD increased $509 million in 2012 and $1,474 million in 2011 and decreased $878 million in 2010, respectively.

Part II a.

To determine

Compute the following for the fiscal years ending February 3, 2013, and January 29, 2012.

1. Current ratio.

2. Quick ratio.

3. Amount of working capital.

4 Percentage change in working capital from the prior year.

5. Percentage change in cash and cash equivalents from the prior year.

Explanation of Solution

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. Current ratio is calculated by using the formula:

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

Quick ratio: The financial ratio which evaluates the ability of a company to pay off the instant debt obligations is referred to as quick ratio. Quick assets are cash, marketable securities, and accounts receivables. This ratio assesses the short-term liquidity of a company. Quick ratio is calculated by using the formula:

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

Working capital: The measure which evaluates the ability of a company to pay off the short-term debt obligations, by computing the excess of current assets over current liabilities is referred to as working capital. Working capital is calculated by using the formula:

$\text{Working capital}=\text{Current Assets}-\text{Current Liabilities}$

Percentage change: In percentage change the amount of each item of the current period’s financial statement is compared with the previous period’s financial statement. The amount of each item increased or decreased in the current financial statement, and its respective percentage can be computed by taking the previous period statement as the base. Percentage change is calculated by using the formula:

$\text{Percentage change}=\frac{\text{Current year}-\text{Previous year}}{\text{Base year }}\times 100$

The ratios of Incorporation HD are computed as follows:

Incorporation HD
Particulars	February 3, 2013 (in million $)		January 29, 2012 (in million $)
1. Current ratio
Cash and Cash Equivalents	2,494		1,987
Receivables, net	1,395		1,245
Merchandise Inventories	10,710		10,325
Other Current Assets	773		963
Current assets (A)	$15,372		$14,520
Accounts Payable	5,376		4,856
Accrued Salaries and Related Expenses	1,414		1,372
Sales Taxes Payable	472		391
Deferred Revenue	1,270		1,147
Income Taxes Payable	22		23
Current Installments of Long-Term Debt	1,321		30
Other Accrued Expenses	1,587		1,557
Current liabilities (B)	$11,462		$9,376
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	1.34:1		1.55:1
2. Quick ratio
Cash and Cash Equivalents		2,494	1,987
Receivables, net		1,395	1,245
Quick assets (A)		$3,889	$3,232
Current liabilities (B)		$11,462	$9,376
Quick ratio $\left(\text{A}\right)÷\left(\text{B}\right)$		0.34:1	0.34:1
3. Working capital
Current assets (A)		15,372	14,520
Current liabilities (B)		11,462	9,376
Working capital $\left(\text{A}\right)-\left(\text{B}\right)$		$3,910	$5,144
4. Percentage change in working capital from the prior year.
Working capital at the end of the year(A)		15,372	11,462
Working capital at the beginning of the year(B)		14,520	9,376
Dollar change (C) $\left(\text{A}\right)-\left(\text{B}\right)$		$3,910	$5,144
Percentage change $\left[\text{(C)}÷\text{Amount of prior year}\right]\times 100$		(24%)	53.2%
5. Percentage change incash and cash equivalents from the prior year.
Cash at the end of the year		2,494	1,987
Cash at the beginning of the year		1,987	545
Dollar change (C) $\left(\text{A}\right)-\left(\text{B}\right)$		507	1,442
Percentage change $\left[\text{(C)}÷\text{Amount of prior year}\right]\times 100$		25.5%	264.6%

Table (2)

Part II b.

To determine

Explain whether the company’s liquidity have increased or decreased during the most recent fiscal year on the basis of your analysis in part a.

Explanation of Solution

From table (1), the schedule of changes in the company’s liquidity is as follows:

Ratios	February 3, 2013	January 29, 2012	Changes
Current ratio	1.34	1.55	Decreased
Quick ratio	0.34	0.34	No changes
Working capital	$3,910	$5,144	Decreased
Percentage change in working capital	(24%)	53.2%	Decreased
Percentage change in cash	25.5%	264.6%	Decreased

Table (3)

Overall, the liquidity position of Incorporation HD has not improved during the year.

Part II c.

To determine

Identify other major considerations that should be analyzed before taking decisions, apart from the ability of Incorporation HD to pay for its purchases.

Explanation of Solution

The Consolidated Statements of Stockholders' Equity of Incorporation HD reveals that the company has an aggressive policy of purchasing the treasury stock. Cash of $4,000 million, $3,501 million, and $2,608 million were used in 2012, 2011, and 2010 respectively for the purpose of purchasing the treasury stock. Over the years the company has consistently paid dividends of $1,743 million in 2012, $1,632 million in 2011, and $1,569 million in 2010 to the stockholders. The payment of dividend and the purchase of treasury stock have significantly affected the company's liquidity.

Part II d.

To determine

Write a memorandum explaining the reasons for assigning the possible credit rating to Incorporation HD.

Explanation of Solution

Memo

From

   XYZ

To

   XY,

   Chief Financial Officer,

   Incorporation HD

December 5, 2012

Sub: Analysis of the liquidity measure.

As per Table (1), the current ratio and quick ratio of Incorporation HD are below the thumb of rules, but the company appears to be in a strong financial situation. So, Incorporation HD is assigned “A outstanding” credit rating. The capital expenditures, payment of dividend and the repurchase of common stock have caused the liquidity measures to be low.

I surely believe that the analyses are sufficient for explanation. Please revert back for any further clarifications.

Regards,

XYZ

Part III a.

To determine

Compute the following for the fiscal years ending February 3, 2013, and January 29, 2012

1. Percentage change in net sales (relative to the prior year).

2. Percentage change in net earnings.

3. Gross profit rate.

4. Net income as a percentage of sales.

5. Return on average total assets.

6. Return on average total equity.

Explanation of Solution

Percentage change: In percentage change the amount of each item of the current period’s financial statement is compared with the previous period’s financial statement. The amount of each item increased or decreased in the current financial statement, and its respective percentage can be computed by taking the previous period statement as the base. Percentage change is calculated by using the formula:

$\text{Percentage change}=\frac{\text{Current year}-\text{Previous year}}{\text{Base year }}\times 100$

Gross Profit rate: The financial ratio which estimates the portion of gross profit retained from net sales revenue in terms of percentage is known as gross margin or gross profit margin. Gross profit is the difference between net sales revenue and cost of goods sold.

Formula to calculate the gross profit rate:

$\text{Gross profit rate = }\frac{\text{Net sales – Cost of goods sold }}{\text{Net sales}}$

Net income as a percentage of net sales: The percentage of net profit generated by every dollar of net sales is referred to as net income as a percentage of net sales. This ratio is also known as net profit margin or net margin. The formula to calculate the net income as a percentage of net sales is as follows:

$\text{Net income as a percentage = }\frac{\text{Net income }}{\text{Net sales}}$

Return on average total assets: This financial ratio evaluates the efficiency of management in utilizing the assets to generate operating income. This tool is used to measure the profitability of a company. The formula to calculate the return on equity is as follows

$\text{Return on assets = }\frac{\text{Operating income }}{\text{Average total assets}}\times 100$

Return on average total equity: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\text{Average total stockholders' equity}}\times 100$

The ratios of Incorporation HD are computed as follows:

Incorporation HD
Particulars	February 2, 2013 (in millions $)					January 29, 2012 (in millions $)
1. Percentage change in net sales.
Net sales in current year (A)	74,754					70,395
Net sales in previous year(B)	70,395					67,997
Dollar change (C) $\left(\text{A}\right)-\left(\text{B}\right)$	4,359					2,398
Percentage change $\left[\text{(C)}÷\text{Amount of prior year}\right]\times 100$	6.2%					3.5%
2. Percentage change in net earnings.
Net earnings in current year (A)	4,535					3,883
Net earnings in previous year(B)	3,883					3,338
Dollar change (C) $\left(\text{A}\right)-\left(\text{B}\right)$	652					545
Percentage change $\left[\text{(C)}÷\text{Amount of prior year}\right]\times 100$	16.8%					16.3%
3. Gross profit rate
Net sales (A)		74,754				70,395
Cost of products sold(B)		48,912				46,133
Gross profit (C)$\left(\text{A}\right)-\left(\text{B}\right)$		25,842				24,262
Gross profit rate $\left[\left(\left(\text{C}\right)÷\left(\text{A}\right)\right)\times 100\right]$		34.6%				34.5%
4. Net income as a percentage of net sales
Net earnings in current year (A)			4,535			3,883
Net sales (B)			74,754			70,395
Net income as a percentage of net sales$\left[\left(\left(\text{A}\right)÷\left(\text{B}\right)\right)\times 100\right]$			6.1%			5.5%
5. Return on average total assets
Total assets, Beginning (A)				40,518		40,125
Total assets, Ending (B)				41,084		40,518
Average total assets (C) $\left[\left(\left(\text{A}\right)+\left(\text{B}\right)\right)÷2\right]$				40,801		40,322
Operating income(D)				7,766		6,661
Return on average total asset$\left[\left(\left(\text{D}\right)÷\left(\text{C}\right)\right)\times 100\right]$				19.0%		16.5%
6.  Return on average total equity
Total stockholders’ equity, Beginning (A)					$17,898	$18,889
Total  stockholders’ equity, Ending (B)					$17,777	$17,898
Average total equity (C) $\left[\left(\left(\text{A}\right)+\left(\text{B}\right)\right)÷2\right]$					$17,838	$18,394
Net earnings (D)					$4,535	$3,883
Return on equity$\left[\left(\left(\text{D}\right)÷\left(\text{C}\right)\right)\times 100\right]$					25.4%	21.1%

Table (4)

Part III b.

To determine

Explain the conclusion(s) concerning trends in the profitability of Incorporation HD during the period.

Explanation of Solution

From table (4), the schedule of changes in the company’s liquidity is as follows:

Ratios	February 2, 2013	January 29, 2012	Changes
1. Percentage change in net sales (relative to the prior year).	6.2%	3.5%	Increased
2. Percentage change in net earnings.	16.8%	16.3%	Increased
3. Gross profit rate.	34.6%	34.5%	Increased
4. Net income as a percentage of sales	6.1%	5.5%	Increased
5. Return on average total assets.	19.0%	16.5%	Increased
6. Return on average total equity.	25.4%	21.1%	Increased

Table (5)

Overall, the profitability position of Incorporation HD has increased in 2013 as compared with the year 2012. The return on equity and net income as a percentage of net sales has increased significantly in 2013. The return on assets and the gross profit rate has slightly increased in 2013.