Chapter 24, Problem 1MP

1.

To determine

Prepare horizontal analysis of the comparative income statement and balance sheet.

Explanation of Solution

Ratio analysis: The analysis of a company using the financial ratios and comparing its trends and measure its performance within the company and the companies of the industry is known as ratio analysis. The main categories of ratio analyses are liquidity ratios, profitability ratios, activity ratios, and leverage ratios.

Horizontal analysis: The comparison of an item of a financial statement of one year against the same item of the same financial statement of another year, to determine the relation between the two items, is referred to as horizontal analysis. The horizontal analysis percentage is calculated by using the given formula:

$\text{Horizontal analysis percentage =}\frac{\text{Current year}-\text{Previous year}}{\text{Base year}}\times 100$

Prepare horizontal analysis of the comparative income statement of Company NPC.

Company CPC
Comparative Income Statement
For the Year Ended December 31, 20-2 and 20-1
Particulars	20-2 (A)	20-1 (B)	Increase (Decrease)
			Amount (C)	Percentage (C÷B)×100
Net sales	$466,451	$291,613	$174,838	60.0
Cost of goods sold	$285,889	$188,626	$97,263	51.6
Gross Profit	$180,562	$102,987	$77,575	75.3
operating expenses	$125,650	$78,200	$47,450	60.7
Operating income	$54,912	$24,787	$30,125	121.5
Interest expenses	$1,200	$500	$700	140.0
Income before income taxes	$53,712	$24,287	$29,425	121.2
Income tax expense	$18,250	$7,285	$10,965	150.5
Net income	$35,462	$17,002	$18,460	108.6

Table (1)

Prepare horizontal analysis of the comparative balance sheet of Company NPC.

Company NPC
Comparative Balance Sheet
For the Year Ended December 31, 20-2 and 20-1
Particulars	20-2 (A)	20-1 (B)	Increase (Decrease)
			Amount (C)	Percentage (C÷B)×100
Assets
Current assets:
Cash	$8,600	$7,500	$1,100	14.7
Government notes	$3,000	$2,000	$1,000	50.0
Receivables (net)	$10,500	$8,600	$1,900	22.1
Merchandise inventory	$53,600	$33,200	$20,400	61.4
Supplies and prepayments	$4,500	$3,200	$1,300	40.6
Total current assets	$80,200	$54,500	$25,700	47.2
Property, plant and equipment:
Land	$40,000	$40,000	$0	0.0
Building	$200,000	$150,000	$50,000	33.3
Delivery equipment	$13,000	$15,000	($2,000)	-13.3
Office equipment (net)	$5,400	$6,000	($600)	-10.0
Patents	$5,000	$6,000	($1,000)	-16.7
Factory equipment (net)	$200,000	$52,930	$147,070	277.9
Total property, plant and equipment	$263,400	$217,000	$46,400	21.4
Total Assets	$343,600	$271,500	$72,100	26.6
Liabilities
Current liabilities:
Notes payable	$5,000	$3,000	$2,000	66.7
Accounts payable	$28,700	$22,300	$6,400	28.7
Accrued interest payable	$500	$1,700	($1,200)	-70.6
Accrued and withheld payment taxes	$4,200	$5,600	($1,400)	-25.0
Total current liabilities	$38,400	$32,600	$5,800	17.8
Long-term liabilities:
Bonds payable	$50,000	$20,000	$30,000	150.0
Total liabilities	$88,400	$52,600	$35,800	68.1
Stockholders' Equity
Common stock	$115,000	$100,000	$15,000	15.0
Paid in capital in excess of par	$65,000	$60,000	$5,000	8.3
Retained earnings	$75,200	$58,900	$16,300	27.7
Total stockholders' equity	$255,200	$218,900	$36,300	16.6
Total liabilities and stockholders' equity	$343,600	$271,500	$72,100	26.6

Table (2)

2.

To determine

Prepare vertical analysis of the comparative income statement and balance sheet of Company NPC.

Explanation of Solution

Vertical Analysis: Vertical analysis is prepared to analyze the relationship among various financial statements with a particular base amount. This analysis is otherwise called as common-size statement.

Formula:

$\text{Vertical analysis percentage =}\frac{\text{Financial statement item}}{\text{Base item}}\times 100$

Prepare vertical analysis of the comparative income statement of Company NPC.

Company NPC
Comparative Income Statement
For Years Ended December 31, 20-2 and 20-1
Particulars	20-2		20-1
	Amount	percent	Amount	Percent
Net sales	$466,451	100%	$291,613	100%
Cost of goods sold	285,889	61.30%	188,626	64.70%
Gross profit	$180,562	38.70%	$102,987	35.30%
Operating expenses	125,650	26.90%	78,200	26.80%
Operating income	$54,912	11.80%	$24,787	8.50%
Other expenses	1,200	0.30%	500	0.20%
Income before income taxes	$53,712	11.50%	$24,287	8.30%
Income tax expense	18,250	3.90%	7,285	2.50%
Net income	$35,462	7.60%	$17,002	5.80%

Table (3)

Prepare vertical analysis of the comparative balance sheet of Company NPC.

Company NPC
Comparative Balance Sheet
December 31, 20-2 and 20-1
	20-2		20-1
	Amount	Percent	Amount	Percent
Assets
Current assets:
Cash	$8,600	2.50%	$7,500	2.80%
Government notes	3,000	0.90%	2,000	0.70%
Accounts receivable (net)	10,500	3.10%	8,600	3.20%
Merchandise inventory	53,600	15.60%	33,200	1.20%
Supplies and prepayments	4,500	1.30%	3,200	1.20%
Total current assets	$80,200	23.30%	$54,500	20.10%
Property, plant, and equipment:
Land	$40,000	11.60%	$40,000	14.70%
Building (net)	200,000	58.20%	150,000	55.20%
Delivery equipment (net)	13,000	3.80%	15,000	5.50%
Office equipment (net)	5,400	1.60%	6,000	2.20%
Patents	5,000	1.50%	6,000	2.20%
Total property, plant, and equipment	$263,400	76.70%	$217,000	79.90%
Total assets	$343,600	100%	$271,500	100%
Liabilities
Current liabilities:
Notes payable	$5,000	1.50%	$3,000	1.10%
Accounts payable	28,700	8.40%	22,300	8.20%
Accrued and withheld payroll  taxes	4,200	1.20%	5,600	2.10%
Accrued interest payable	500	0.10%	1,700	0.60%
Total current liabilities	$38,400	11.20%	$32,600	12%
Long-term liabilities:
Bonds payable	50,000	14.60%	20,000	7.40%
Total liabilities	$88,400	25.70%	$52,600	19.40%
Stockholders’ Equity
Common stock ($5 par)	$115,000	33.50%	$100,000	36.80%
Paid-in capital in excess of par	65,000	18.90%	60,000	22.10%
Retained earnings	75,200	21.90%	58,900	21.70%
Total stockholders’ equity	$255,200	74.30%	$218,900	80.60%
Total liabilities and stockholders' equity	$343,600	100%	$271,500	100%

Table (4)

3.

To determine

Compute the following liquidity measures for 20-2.

1. (a) Working capital
2. (b) Current ratio
3. (c) Quick or acid –test ratio

Explanation of Solution

Liquidity measures:

Liquidity measures denote a company’s capacity to meet its current liabilities. These measures focus on balance sheet amounts initially and on the ability of the company to generate funds to liquidate its current obligations.

(a)

Calculate working capital on December 31, 20-2.

$\begin{array}{c}\text{Working capital}\text{=}\text{Current assets }-\text{Current liabilites}\\ \text{=}\text{\$80,200 }-\text{\$38,400}\\ \text{=}\text{\$41,800}\end{array}$

(b)

Calculate current ratio on December 31, 20-2.

$\begin{array}{c}\text{Current ratio =}\frac{\text{Current assets}}{\text{Current liabilites}}\\ =\frac{\$80,200}{\$38,400}\\ =2.09:1\end{array}$

(c)

Calculate quick or acid test ratio on December 31, 20-2.

$\begin{array}{c}\text{Quick ratio =}\frac{\text{Quick assets}}{\text{Current liabilites}}\\ =\frac{\left(\$8,600+\$3,000+\$10,500\right)}{\$38,400}\\ =0.58\text{to1}\end{array}$

4.

To determine

Activity measures:

Activity measures initially focus on how efficiently the assets are used. For example, the speed of the receivables collected and inventories sold, as well as the usage of the assets to generate revenue.

Calculate the following activity measures for 20-2.

1. (a) Accounts receivable and average number of days to collect.
2. (b) Merchandise inventory turnover and average number of days to sell inventory.
3. (c) Asset turnover

Explanation of Solution

(a)

Calculate accounts receivable turnover.

$\begin{array}{c}\text{Accounts receivable turnover = }\frac{\text{Net sales}}{\text{Average accounts receivable}}\\ =\frac{\$120,000}{\left(\frac{\$8,600+\$10,500}{2}\right)}\\ =\frac{\$120,000}{\$9,550}\\ =12.57\text{times}\end{array}$

Calculate average collection period.

$\begin{array}{c}\text{Average collection period =}\frac{365}{\text{Accounts receivable turnover}}\\ =\frac{365}{12.57\text{times}}\\ =29.04\text{times}\end{array}$

(b)

Calculate merchandise inventory turnover.

$\begin{array}{c}\text{Merchandise inventory turnover =}\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$285,889}{\left(\frac{\$33,200+\$53,600}{2}\right)}\\ =\frac{\$285,889}{\$43,400}\\ =6.59\text{times}\end{array}$

Calculate average days to sell inventory.

$\begin{array}{c}\text{Average days to sell inventory =}\frac{365}{\text{Merchandise inventory turnover}}\\ =\frac{365}{6.59\text{times}}\\ =55.39\text{days}\end{array}$

(c)

Calculate asset turnover.

$\begin{array}{c}\text{Asset turnover = }\frac{\text{Net sales}}{\text{Average assets}}\\ =\frac{\$466,451}{\left(\frac{\$271,500+\$343,600}{2}\right)}\\ =\frac{\$466,451}{\$307,550}\\ =1.52\text{times}\end{array}$

5.

To determine

Compute the following profitability measures for 20-2.

1. (a) Profit margin ratio
2. (b) Return on assets
3. (c) Return on common stockholders’ equity
4. (d) Earnings per share of common stock

Explanation of Solution

Profitability measures:

Profitability measures show the ability of the company to earn income by operating proficiently (satisfactory return on investments). These ratios focus upon company’s’ profit margin and “the relationship between key income statement and balance sheet amounts”. Profit margin, return-on-assets, return on common stockholders’ equity, earnings per share of common stock are the profitability ratios.

(a)

Calculate profit margin ratio.

$\begin{array}{c}\text{Profit margin ratio =}\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$35,462}{\$466,451}\\ =7.60\%\end{array}$

(b)

Calculate return on assets for 20-2.

$\begin{array}{c}\text{Return on assets}\text{=}\frac{\text{Net income}}{\text{Average assets}}\\ =\frac{\text{\$35,462}}{\left(\frac{\$271,500+\$343,600}{2}\right)}\\ =\frac{\$35,462}{\$307,550}\\ =11.53\%\end{array}$

(c)

Calculate return on common stockholders’ equity for 20-2.

$\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{ stockholders' equity}\end{array})\text{ =}\frac{\text{Net income}}{\text{Average common stockholders' equtiy}}\\ =\frac{\$35,462}{\left(\frac{\$218,900+\$255,200}{2}\right)}\\ =\frac{\$35,462}{\$237,050}\\ =14.96\%\end{array}$

(d)

Calculate earnings per share of common stock.

$\begin{array}{c}\text{Earnings per share of common stock =}\frac{\text{Net income}}{\text{Average common shares outstanding}}\\ =\frac{\$35,462}{\left(\frac{20,000\text{ shares + 23,000}\text{shares}}{2}\right)}\\ =\frac{\$35,462}{21,500\text{shares}}\\ =\$1.65\text{per share}\end{array}$

Calculate beginning common shares outstanding.

$\begin{array}{c}\text{Begining common shares outstanding =}\frac{\text{Common stock during the period 20-1}}{\text{Book value per common stock}}\\ =\frac{\$100,000}{\$5}\\ =20,000\text{shares}\end{array}$

Calculate ending common shares outstanding.

$\begin{array}{c}\text{Ending common shares outstanding =}\frac{\text{Common stock during the period 20-2}}{\text{Book value per common stock}}\\ =\frac{\$115,000}{\$5}\\ =23,000\text{shares}\end{array}$

6.

To determine

Leverage measures:

Leverage measures overlook the mixture of debt and equity which is required for analyzing the ability of the Company to meet its debt obligations as they become due. Debt to equity ratio: Assets-to-equity ratio, Times interest earned ratio are the leverage measures.

Compute the following leverage ratios.

1. (a) Debt-to-equity ratio
2. (b) Times interest earned ratio.

Explanation of Solution

(a)

Calculate debt-to-equity ratio.

$\begin{array}{c}\text{Debt-to-equity ratio =}\frac{\text{Total liabilites}}{\text{Total stockholders' equity}}\\ =\frac{\$88,400}{\$255,200}\\ =0.35\text{to 1}\end{array}$

(b)

Calculate times interest earned ratio.

$\begin{array}{c}\text{Times interest earned ratio =}\frac{\text{Income before interest and taxes}}{\text{Interest expense}}\\ =\frac{\left(\$35,462+\$18,250+\$1,200\right)}{\$1,200}\\ =45.76\text{times}\end{array}$

7.

To determine

Calculate the following market measures for 20-2.

1. (a) Price earnings ratio
2. (b) Book value per share of common stock.

Explanation of Solution

(a)

Calculate price earnings ratio.

$\begin{array}{c}\text{Price earnings ratio =}\frac{\text{Market price of common stock}}{\text{Earnings per share of common stock}}\\ =\frac{\$23\text{per share}}{\$1.65\text{per share}}\\ =13.94\end{array}$

(b)

Calculate book value per share of common stock.

$\begin{array}{c}\begin{array}{l}\text{Book value per share}\\ \text{ of common stock}\end{array})\text{ =}\frac{\text{Common stockholders' equity as on 31st December 20-2}}{\text{Number of common shares outstanding as on 31st December 20-2}}\\ =\frac{\$255,200}{23,000\text{shares}}\\ =\$11.10\text{per share}\end{array}$