Chapter Three
Managing Financial Health and Performance
This chapter contains 62 multiple choice questions, 19 short problems and 9 longer problems.
Multiple Choice
1. For a corporation, net worth is called ________.
(a) net income (b) assets
(c) stockholder’s equity (d) retained earnings
Answer: (c)
2. On a company’s published balance sheet, the value of assets, liabilities and net worth, are measured
at ________.
(a) expected market value (b) current book value (c) current market value
(d) historical acquisition costs
Answer: (d)
3. Any U.S. or non-U.S. company that wishes to list its shares on a U.S. exchange must regularly report
its activities by filing financial statements with the ________.
(a) SEC (b) NYSE (c) GAAP (d) AMEX
Answer: (a)
4. Noncurrent assets typically consist of ________.
(a) accounts payable
(b) receivables and inventories (c) cash and marketable securities (d) property, plant, and equipment
Answer: (d)
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5. The difference between a firm’s current assets and its current liabilities is called ________.
(a) net worth
(b) net working capital (c) net income
(d) stockholder’s equity
Answer: (b)
6. ________ is the difference between revenues and cost of goods sold.
(a) Operating income (b) Gross margin (c) Taxable income
(d) Change in retained earnings
Answer: (b)
7. ________ is the difference between gross margin and GS&A expenses.
(a) Operating income (b) Gross margin (c) Taxable income (d) Net income
Answer: (a)
8. Although it differs from the income statement, the statement of cash flows is a useful supplement to
the income statement because:
(a) it focuses attention on what is happening to the firm’s cash position over time
(b) it avoids the judgments about revenue and expense recognition that go into the income
statement
(c) it is influenced by accrual accounting decisions (d) (a) and (b)
Answer: (d)
9. On the statement of cash flows, the purchase of new plant and equipment represents a ________.
(a) cash flow from operating activity (b) cash flow from investing activity (c) cash flow from financing activity (d) total cash flow from (a) + (b) +(c )
Answer: (b)
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10. On the balance sheet, the value of assets, liabilities, and net worth are measured in accordance with
________.
(a) generally accepted economic principles (b) generally accepted accounting principles (c) market value accreditation
(d) generally adopted and accredited principles
Answer: (b)
11. ________ is the official accounting value of assets and shareholder’s equity.
(a) Market value
(b) Historical market value (c) Book value
(d) Economic value added
Answer: (c)
12. Building up a good reputation for quality and reliability, and building up a knowledge base as the
result of past research and development, are both examples of ________ that add to the firm’s ________.
(a) intangible assets, book value (b) tangible assets, market value (c) tangible assets, book value (d) intangible assets, market value
Answer: (d)
13. The value of goodwill is the difference between the ________ of the acquisition and its ________.
(a) market price, book value (b) amortized value, market price
(c) historical acquisition cost, book value (d) market price, after tax value
Answer: (a)
14. At the beginning of 19X7 Success Galore has a market price of $250 per share and at the end of the
year $225.50. Cash dividends for the year are $7.50 per share. Compute the total shareholder returns.
(a) 6.8% (b) –6.8% (c) 12.8% (d) –12.8%
Answer: (b)
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15. Success Galore had a market price of $178 per share at the beginning of 19X7 and at the end of the
year the price per share was $205.50. Cash dividends for the year were $7 per share. Calculate the total shareholder returns.
(a) 19.38% (b) –19.38% (c) 16.79% (d) –16.79%
Answer: (a)
16. In 19X7, Kanga Inc. had a net income of $40.2 million, assets of $600 million, and shareholders’
equity of $405 million. Calculate the return on equity.
(a) 4% (b) 6.7% (c) 9.93% (d) 20.62%
Answer: (c)
17. Asset turnover ratios ________.
(a) assess the firm’s profitability
(b) assess the firm’s ability to use its assets productively in generating revenue (c) highlight the capital structure of the firm
(d) measure the ability of the firm to meet its short-term obligations
Answer: (b)
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Use the information below for BGB Manufacturing to answer Questions 18-22.
Exhibit for BGB Manufacturing 1997-1999 Balance Sheet (All figures in 1997 1998 1999 $ millions) Cash & marketable securities 1.0 2.0 5.0 Accounts receivable, net 2.0 3.0 4.0 Inventories 3.0 4.7 8.0 Total current assets 6.0 9.7 17.0 Property Plant & Equipment, 14.0 13.0 12.0 net Total assets 20.0 22.7 29.0 Accounts payable 2.0 1.5 1.0 Other short term liabilities 2.0 2.5 3.0 Total current liabilities 4.0 4.0 4.0 Long term debt (bonds) 10.0 10.0 10.0 Total liabilities 14.0 14.0 14.0 Stockholder’s equity 6.0 8.7 15.0 Total liabilities & equity 20.0 22.7 29.0 Income Statement (All 1997 1998 1999 figures in $ millions) Revenues, net 10.0 15.0 25.0 Cost of Sales 5.0 7.0 10.0 Selling, Gen & Admin 1.0 1.5 2.0 Expenses EBIT 4.0 6.5 13.0 Total Interest 1.5 2.0 2.5 EBT 2.5 4.5 10.5 Taxes (@40%) 1.0 1.8 4.2 EAT 1.5 2.7 6.3 18. Calculate the current ratio for BGB Manufacturing for 1998.
(a) 1.5 times (b) 2.43 times (c) 3.19 times (d) 4.25 times
Answer: (b)
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19. Calculate the quick ratio for BGB Manufacturing for 1997.
(a) 0.25 times (b) 0.5 times (c) 0.75 times (d) 1.5 times
Answer: (c)
20. From the perspective of a bank loan officer from 1997 to the present, which of the following
statements best summarizes the information revealed by the current ratio and quick ratio for BGB Manufacturing?
(a) The ability of the firm to meet its long-term obligations has deteriorated. (b) The ability of the firm to meet its short-term obligations has improved. (c) The ability of the firm to meet its short-term obligations has deteriorated. (d) The ability of the firm to meet its long-term obligations has improved.
Answer: (b)
21. Calculate the debt ratio for BGB Manufacturing for 1999.
(a) 0.14% (b) 0.24% (c) 0.48% (d) 0.82%
Answer: (c)
22. Calculate the times interest earned (TIE) ratio for BGB Manufacturing for 1998.
(a) 2.25 times (b) 2.7 times (c) 3.25 times (d) 5.2 times
Answer: (c)
23. If a firm’s total asset turnover ratio is 3.0:
(a) its average total assets are one-sixth of its annual sales (b) its average total assets are three times its annual sales (c) its annual sales are three times its average total assets (d) its annual sales are one-third of its total assets
Answer: (c)
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24. A firm has a P/E of 9 and a market to book ratio of 2.5. If EPS are $3.50, what is the book value per
share?
(a) $8.75 (b) $12.60 (c) $31.50 (d) $78.75
Answer: (b)
25. A firm has EBIT of $3 million, sales of $15 million, and average total assets of $30 million. Calculate
its ROA.
(a) 6.67% (b) 10% (c) 20% (d) 50%
Answer: (b)
26. If the average inventory for a firm is $17 million and inventory turnover is 0.9 times, what is its cost
of goods sold?
(a) $15.3 million (b) $18.89 million (c) $153 million (d) $188.9 million
Answer: (a)
27. If the average total assets for the Heartland Corporation are $660 million and EAT are $100 million,
calculate its ROA. Assume a tax rate of 40% and interest of $3 million.
(a) 15.15% (b) 15.6% (c) 25.15% (d) 25.71%
Answer: (d)
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28. The beginning of year receivables for a firm are $40 million. If the receivables turnover for the firm is
4.2 times and its sales are $220 million, calculate the firm’s end of year receivables.
(a) $24.76 million (b) $52.38 million (c) $64.76 million (d) $168 million
Answer: (c)
29. In developing a financial plan, the first step is to:
(a) distribute rewards and punishments to relevant parties (b) develop the firm’s strategic plan
(c) establish specific performance targets for the firm and its suppliers (d) adjust targets based on the previous year’s data
Answer: (b)
30. The planning horizon is an important component of the financial planning process. Generally, the
longer the horizon:
(a) the less detailed the financial plan (b) the more detailed the financial plan
(c) the more performance targets the financial plan will include (d) the less a financial plan is needed
Answer: (a)
31. The “blueprints,” or the tangible outcomes of the financial planning process, are in the form of:
(a) executive stock options (b) auditor’s recommendations
(c) projected financial statements and budgets (d) tactical plans and budgets
Answer: (c)
32. Based on a consideration of the planning horizon, which of the following projects is most likely to
consist of the most detailed financial plans?
(a) a five-year financial plan (b) a one-year financial plan (c) a six-month financial plan (d) a one-month financial plan
Answer: (d)
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33. Forecasting sales for the next year and assuming that most of the items on the income statement and
balance sheet will maintain the same ratio to sales as in the previous year is called the _______________ method.
(a) forecast ratio (b) percent-of-sales (c) planning horizon (d) financial predictor
Answer: (b)
34. Using the percent-of-sales method, which of the following variables are typically assumed to increase
proportionately with sales?
(a) costs (b) EBIT (c) assets (d) all of the above
Answer: (d)
35. Rupert’s Glassworks Ltd. has an inventory period of 50 days, a receivables period of 55 days, and a
payables period of 40 days. Compute its cash cycle time.
(a) 35 days (b) 45 days (c) 65 days (d) 105 days
Answer: (c)
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Questions 36 through 45 refer to the following information:
Income Statement data and Balance Sheet data is provided for the firm Neural Way Inc. for 19x7 and 19x8.
Financial Statements for Neural Way Inc.19x7Income StatementSales$1,500,000Cost of Goods Sold$967,500Gross Margin$532,500Operating ExpensesAdvertising Expense$50,400Rent Expense$72,000Salesperson Commission Expense$48,000Utilities Expense$15,000EBIT$347,100Interest Expense$102,000Taxable Income$245,100Taxes (@35%)$85,785Net Income$159,315Dividends (40% payout)$63,726Change in Shareholders Equity$95,589Balance SheetAssetsCash and Equivalents$310,000Receivables$205,000Inventories$720,000Property, Plant and Equipment$1,956,000Total Assets$3,191,000LiabilitiesPayables$310,000Short Term Debt (10% interest)$510,000Long Term Debt (7% interest)$800,000Shareholders equityCommon Stock$1,150,000Retained earnings$421,000Total Liabilities and Equity$3,191,000
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19x8$1,980,000$1,277,100$702,900$66,528$95,040$63,360$19,800$458,172$107,000$351,172$122,910$228,262$91,305$136,957$409,266$270,666$950,400$2,571,306$4,201,638$409,266$1,088,535$995,880$1,150,000$557,957$4,201,638
36. From the financial data provided, which of the following items has maintained a fixed ratio to sales?
(a) interest expense (b) net income (c) rent expense (d) taxes
Answer: (c)
37. What is the ratio between sales and dividend payments in 19x8?
(a) 3.22% (b) 4.25% (c) 4.61% (d) 6.09%
Answer: (c)
38. Calculate the rate of sales growth from 19x7 to 19x8.
(a) 48% (b) 32% (c) 24.24% (d) 31.25%
Answer: (b)
39. What is the firm’s return on equity for 19x8?
(a) 10.14% (b) 13.36% (c) 19.85% (d) 40.91%
Answer: (b)
40. What is the firm’s external financing funding requirement determined to be for 19x8?
(a) $774,415 (b) $873,681 (c) $911,372 (d) $972,947
Answer: (a)
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41. If it is assumed that sales will grow by 17% for 19x9, then sales for 19x9 are forecast to be ________.
(a) $1,755,000 (b) $2,316,600 (c) $2,613,600 (d) $11,647,059
Answer: (b)
42. If sales growth is forecast to be 17% for 19x9, what is the forecast gross margin for 19x9?
(a) $393, 822 (b) $822,393 (c) $873,300 (d) $927,828
Answer: (b)
43. How much additional funding will the firm need for 19x9?
(a) $709,544 (b) $639,979 (c) $618,863 (d) $549,288
Answer: (d)
44. In 19x7, taxable income is what proportion of sales?
(a) 5.72% (b) 6.11% (c) 16.34% (d) 17.74%
Answer: (c)
45. In 19x8, common stock is what proportion of sales?
(a) 28.18% (b) 58.08% (c) 76.67% (d) 86.26%
Answer: (b)
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46. Which is the correct formula for calculating a firm’s sustainable growth rate?
(a) sustainable growth rate = earnings retention rate x ROE (b) sustainable growth rate = earnings retention rate x ROI
(c) sustainable growth rate = (1 – dividend payout) x ROE x ROI (d) sustainable growth rate = share repurchase rate x ROI
Answer: (a)
47. Lucinda Inc. has the following fixed ratios:
Asset Turnover = 0.6 Times per Year Debt/Equity Ratio = 1.5
Dividend Payout Ratio = 0.53 ROE = 25% per Year
What is the sustainable growth rate for this firm?
(a) 10% (b) 11.75% (c) 15% (d) 39.75%
Answer: (b)
48. Onegin Corporation has the following fixed ratios:
Asset Turnover = 0.4 Times per Year Debt/Equity Ratio = 1.4
Dividend Payout Ratio = 0.49 ROE = 27% per Year
What is the sustainable growth rate for this firm?
(a) 13.77% (b) 14% (c) 16.2% (d) 18.25%
Answer: (a)
49. If a firm’s working capital need is permanent rather than seasonal, the firm ________.
(a) will usually seek short-term financing for it (b) will not seek financing at all
(c) will revise its strategic plan immediately (d) will usually seek long-term financing for it
Answer: (d)
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50. Which of the following is not part of a firm’s working capital?
(a) inventories
(b) accounts payable (c) plant and equipment (d) cash
Answer: (c)
51. Working capital is defined to be ________.
(a) the difference between current assets and current liabilities
(b) the difference between accounts receivable and accounts payable (c) the difference between current assets and shareholders’ equity (d) the difference between total assets and total liabilities
Answer: (a)
52. The cash cycle time begins with ________and ends with ________.
(a) payment of cash to suppliers, liquidation of inventory
(b) receipt of cash from customers, payment of cash to suppliers (c) payment of cash to suppliers, receipt of cash from customers (d) selling of purchase on credit, receipt of cash from customers
Answer: (c)
53. Which of the following is the correct representation of the cash cycle time?
(a) Cash cycle time = inventory period – payables period
(b) Cash cycle time = inventory period – receivables period – payables period (c) Cash cycle time = receivables period – payables period
(d) Cash cycle time = inventory period + receivables period – payables period
Answer: (d)
54. A firm’s required investment in working capital is ________ to the cash cycle length of time.
(a) inversely proportional (b) directly related (c) indirectly related (d) not related at all
Answer: (b)
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Use the following data to answer Questions 55 - 59
Prepare a multi-step income statement for Kangarucci Inc. (a retailer) for the year ending December 31, 1997. Use the information below:
Interest Expense 18,799 Beginning Inventory 422,550 Depreciation 14,861 General and Administrative Expenses 19,745 Advertising 14,090 Interest Income 5,087 Ending Inventory 456,988 Gross Sales 543,777 Taxes 10,006 Lease Payments 61,444 Purchase of Materials 199,766 Returns and Allowances 9,888 R&D Expenditures 12,867 Repairs and Maintenance 7,542
55. The cost of goods sold is ________.
(a) $34,438 (b) $165,328 (c) $199,766 (d) 234,204
Answer: (b)
56. The operating expenses for the period are ________.
(a) $95,279 (b) $110,140 (c) $115,688 (d) $130,549
Answer: (d)
57. The gross margin for the period is ________.
(a) $353,700 (b) $368,561 (c) $378,449 (d) $543,777
Answer: (b)
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58. The operating income for the period is ________.
(a) $238,012 (b) $247,900 (c) $273,282 (d) $283,170
Answer: (a)
59. The net income is ________.
(a) $214,294 (b) $209,207 (c) $204,120 (d) $189,259
Answer: (a)
60. In the construction of a statement of cash flows, which of the following is considered a financing
activity?
(a) increase in accounts payable (b) repayment of long-term debt (c) reduction of accounts receivable (d) purchase of gross fixed assets
Answer: (b)
61. Assume you are given the following information for Flanders Company:
Current Ratio: 2.5x Quick Ratio: 2.0x
Current Liabilities: $200,000
Current assets comprise cash, account receivables and inventory.
Compute Inventory.
(a) $500,000 (b) $400,000 (c) $100,000 (d) $80,000
Answer: (c)
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62. Assume you are given the following information for Flanders Company:
Return on Assets (ROA): 11% Return on Equity (ROE): 20% Total Asset Turnover: 1.5x
Calculate the ROS for Flanders Company.
(a) 7.33% (b) 13.33% (c) 13.64% (d) 16.5%
Answer: (a)
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Short Problems
1. Explain why the market price of a company’s stock does not necessarily equal its book value.
Answer:
• The book value does not include all of a firm’s assets and liabilities.
• The assets and liabilities included on a firm’s official balance sheet are (for the most part)
valued at original acquisition cost less depreciation, rather than at current market values.
2. Explain why it may be possible for two firms to have the same ROA.
Answer: ROA = ROS x ATO
For example, a supermarket (low profit margin, high asset turnover) and a jewelry store (high profit margin, low asset turnover) – could have the same ROA.
3. As a financial document, what purpose does the statement of cash flows serve? What is a benefit of
the statement of cash flows?
Answer: The statement of cash flows gives a summary of cash flows from operating, investing, and financing activities for a period of time. The statement of cash flows focuses attention on what is happening to the firm’s cash position over time and it also avoids judgements about revenue and expense recognition that go into the income statement. A benefit of the statement of cash flows is that it is not influenced by accrual accounting decisions.
4. What are the three types of benchmarks?
Answer:
• Financial ratios of other companies for the same period of time. • Financial ratios of the company itself in previous time periods.
• Information extracted from financial markets such as asset prices or interest rates.
5. You invest in a stock that costs $215.50. It pays a cash dividend during the year of $12.20 and you
expect its price to be $229 at year’s end. What is the total shareholder return?
Answer:
Total Shareholder returns = Ending Price of a Share – Beginning Price of Share + Cash Dividend Beginning Price of Share = $229 - $215.50 + $12.20 $215.50 = 11.93%
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6. In 19X7, Slater Inc. had a net income of $30.3 million, assets of $560 million, and shareholders
equity of $400 million. Calculate its return on equity.
Answer: Return on equity = Net Income Shareholders’ Equity = $30.3 $400 = 7.58%
7. Grad Inc. has EBIT of $13 million, sales of $25 million, and average total assets of $50 million.
Calculate its ROA.
Answer: Return on assets = EBIT x Sales Sales Assets = 13 x 25 25 50
= 26%
8. If Profit Inc. has interest expenses of $16,000 per year, sales of $1,000,000, a tax rate of 40%, and a
net profit margin of 7%, what is Success Inc.’s times interest earned ratio?
Answer: EAT = Sales x Net Profit Margin = $1,000,000 x 0.07 = $70,000 EBT = EAT/(1-T) = $70,000/0.6 = $116,667 EBIT = EBT + I = $116,667 + $16,000 = $132,667 T.I.E = EBIT/ Interest Expense = $132,667/ $16,000 = 8.29 times
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9. A firm has a P/E of 9 and a market to book ratio of 2.5. If EPS are $4.50, what is the book value per share?
Answer: Price = P/E x EPS = 9 x $4.50 = $40.50 Book Value = Price/ Market to Book = $40.50/2.5 = $16.20 10. The beginning of year receivables for a firm are $40 million. If the receivables turnover for the
firm is 5.2 times and its sales are $225 million, calculate the end of year receivables.
Answer: Receivables turnover = Sales Avg. Receivables 5.2 = 225 (40 + E)/2 E = $46.54 million
11. To determine how fast a firm can grow if it is constrained in the amount of external financing
available to it, explain what assumptions must be made regarding the financing constraint.
Answer: One assumes the financing constraint takes the following form: • The firm will not issue any new equity shares so that the growth in equity capital occurs only
through the retention of earnings.
• The firm will not increase its ratio of debt to equity, so that external debt financing will grow at
the same rate as equity grows through retained earnings.
Under these circumstances, the firm cannot grow any faster than the growth rate in owner’s equity, which is called the firm’s sustainable growth rate.
12. You work at FaxMeSoon Corporation and are analyzing the results of 19x8 and are preparing pro
forma statements for 19x9. The company anticipates an increase in total assets of $60 million, an increase in retained earnings of $30 million, and an increase in accounts payable of $45 million. Assume that other than the payables, the firm’s liabilities include short term and long term debt, and that common stock and retained earnings make up the company’s equity.
a. Calculate the amount of external funding required in 19 x 9. b. Comment on the situation obtained in part a.
Answer: a. Amount = change in assets – increase in retained earnings – increase in payables
= $60 million - $30 million - $45 million = - $15 million
b. The company can take some of the retained earnings and pay it out as dividend, or it
could use it to reduce any of the payables, short-term debt, or long-term debt.
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13. Darcy Wentworth Industries has the following balance sheet for December 31, 19x8.
Assets ($000) Liabilities and Equity ($000)
Cash $10,000 Accounts Payable $30,000 Accounts Receivable $70,000 Notes Payable $9,000 Inventories $110,000 Other Current Liabilities $32,000 Net Plant & Equipment $210,000 Long Term Debt $12,000
Total Assets $400,000 Preferred Stock $89,000
Common Stock $30,000 Retained Earnings $80,000 Total Liabilities & Equity $282,000 Calculate the net working capital at the end of 19x8. Answer: Net Working Capital = Current Assets – Current Liabilities = ($10,000 + $70,000 + $110,000) – ($30,000 + $9,000 + $32,000) = $119,000
14. McCullers Corporation has the following balance sheet for December 19x8.
Assets ($000) Liabilities & Equity ($000) Cash $25,000 Accounts Payable $36,000 Marketable Securities $9,000 Notes Payable $15,000 Accounts Receivable $70,000 Other Current Liabilities $48,000 Inventories $125,000 Long Term Debt $200,000 Net Plant & Equipment $252,000 Preferred Stock $40,000 Common Stock $47,000 Total Assets $481,000 Retained Earnings $95,000 Total Liabilities & Equity $481,000 Calculate the net working capital at the end of 19x8 for McCullers Corporation. Answer: Net Working Capital = Current Assets – Current Liabilities = ($25,000 + $9,000 + $70,000 + $125,000) – ($36,000 + $15,000 + $48,000) = $130,000
15. WNJ Inc. has an inventory period of 65 days, a receivables period of 70 days, and a payables period
of 50 days. Compute the cash cycle time.
Answer: Cash cycle time = Inventory period + Receivables period – Payables period
= 65 + 70 – 50 = 85 days
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16. The Wright Way Inc. has an inventory period of 61 days, a receivables period of 67 days and a
payables period of 45 days. Compute the cash cycle time.
Answer: Cash cycle time = Inventory period + Receivables period – Payables period
= 61 + 67 - 45 = 83 days
17. The Wright Way Inc. has the following fixed ratios:
Asset Turnover = 0.55 Times per Year Debt/Equity Ratio = 1.4
Dividend Payout Ratio = 0.56 ROE = 24% per Year
What is the sustainable growth rate for Chekhov Way Inc.?
Answer: Sustainable growth rate = Earnings retention rate x ROE = (1 – 0.56) x 0.24 = 10.56%
18. Gogol Power Inc. has the following fixed ratios:
Asset Turnover = 0.6 times per year Debt/Equity = 1.6
Dividend Payout Ratio = 0.66 ROE = 26% per Year
What is the sustainable growth rate for Gogol Power Inc.?
Answer: Sustainable growth rate = Earnings retention rate x ROE = (1 – 0.66) x 0.26 = 8.84%
19. What is the main principle behind the efficient management of a firm’s working capital?
Answer: It is to minimize the amount of the firm’s investment in nonearning assets such as receivables and inventories and maximize the use of “free” credit such as prepayments by customers, accrued wages and accounts payable.
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Longer Problems
1. Discuss the limitations of financial ratio analysis.
Answer:
• There is no absolute standard by which to judge whether the ratios are too high or too low.
• It is difficult to define a set of comparable firms to serve as a benchmark for judging a
company’s performance, because even within the same industry firms can be quite different. • Ratios are comprised of accounting numbers, often calculated in arbitrary ways.
2. Discuss the main features of the balance sheet, income statement and statement of cash flows.
Answer: The basic accounting statements reviewed are the income statement, the balance sheet, and the statement of cash flows. The income statement reports the results of operations over the period and is based on the model of revenues minus costs (including depreciation and taxes) equals net income or earnings. The balance sheet shows the assets (both current and long-term or fixed assets) on the one hand, and the claims against them (i.e., the liabilities and equity) on the other. The statement of cash flows gives a summary of cash flows from operating, investing, and financing activities for the period.
3. You are a quantitative analyst at a multinational firm. As part of a consulting investigation of a
firm’s performance, you are required to explain different types of financial ratios. How would you describe the five basic sets of financial ratios?
Answer: First are profitability ratios. Profitability can be measured with respect to sales (return on sales) assets (return on assets), or its equity base (return on equity). Income here is taken as earnings before interest and taxes (EBIT) in the case of return on sales and return on assets, but as net income in the case of return on equity. Asset turnover ratios assess the firm’s ability to use its assets productively in generating revenue. Asset turnover is a broad measure, whereas receivable turnover and inventory turnover are specific measures for these particular asset categories. Financial leverage ratios highlight the capital structure of the firm, and the extent to which it is burdened with debt. The debt ratio measures the capital structure, and the times interest earned measure indicates the ability of the firm to cover its interest payments. Liquidity ratios measure the ability of the firm to meet its short-term obligations, or to pay its bills and remain solvent. The main ratios for measuring liquidity are the current ratio and the more stringent quick ratio or acid test, which considers only the most liquid of current assets: cash and marketable securities. Finally, market value ratios measure the relation between the accounting representation of the firm and the market value of the firm. The two most common ratios are price to earnings (P/E) and market to book (M/B).
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4. You have the following information taken from the 1997 financial statements of CompuInc. and
DigiCorp. All figures are in $ millions except per share amounts).
CompuInc. DigiCorp
Net Income 163.7 249.0 Dividend Payout Ratio 42% 25% EBIT 325.3 410.9 Interest Expense 58.7 6.8 Average Assets 2,600.5 3,637.8 Sales 3,500.9 4,790.2 Average Shareholders Equity 1,120.4 2,567.6 Market Price of Common Stock: Beginning of Year $20 $38 : End of Year $15 $42 Shares of Common Stock Outstanding 200 million 100 million
Compare and contrast the financial performance of the two companies using the financial ratios discussed in Chapter Three.
Answer: A suggested solution is as follows: Company Sh. Return ROE ROA ROS ATO I/LiabilitieDebt/Equits y CompuInc-23.28% 14.6% 12.5% 9.29% 1.35 3.97% 1.32 . DigiCorp 12.16% 9.70% 11.30% 8.58% 1.32 0.64% 0.42 DigiCorp offered a higher rate of return, 12.16% vs. –23.28% for CompuInc., despite the fact that CompuInc. has a higher ROE, ROA, ROS and ATO.
Average liabilities for CompuInc. were $1,480.1 million and for DigiCorp $1,070.2 million. Average interest rate on total liabilities was 3.97% for CompuInc. and 0.64% for DigiCorp. CompuInc. has a higher debt/equity ratio.
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5. Provide details of the steps involved in the financial planning process. In addition, provide a detailed
explanation of how the financial planning process fits in with a company where you either currently work or have worked in the past.
Answer:
1. Managers forecast the key external factors that determine the demand for the firm’s products and its production costs. These factors include the level of economic activity in the markets in
which the firm sells its products, inflation, exchange rates, interest rates, and the output and prices charged by the firm’s competitors.
2. Based on these external factors and their own tentative decisions regarding investment outlays, production levels, research and marketing expenditures, and dividend payments, managers forecast the firm’s revenues, expenses, and cash flows, and estimate the implied need for external financing. They check that the firm’s likely future financial results are consistent with their strategic plan for creating value for shareholders and that financing is available to implement the plan. If there are any inconsistencies, then managers revise their decisions until they come up with a workable plan, which becomes a blueprint for the firm’s operating decisions during the year. It is good practice to make contingency plans in case some of the forecasts turn out to be wrong. 3. Based on the plan, senior managers establish specific performance targets for themselves and their subordinates.
4. Actual performance is measured at regular intervals (either monthly or quarterly), compared to the targets set in the plan, and corrective actions are taken as needed. Management may adjust targets during the year to take into account large deviations from forecast values. 5. At the end of each year, rewards (e.g., bonuses or raises) are distributed and the
planning cycle starts again.
Answers regarding personal work experiences will vary.
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6. Consider the following data for Le Bon Meow Inc. for 19x7 and 19x8:
Financial Statements 19x7 19x8
Income Statement Sales $1,531,429 $2,052,115 Cost of Goods Sold $987,443 $1,323,174 Gross Margin $543,986 $728,941 Operating Expenses Advertising Expense $50,600 $67,720 Rent Expense $73,560 $98,502 Salesperson Commission Expense $48,790 $65,463 Utilities Expense $16,577 $22,163 EBIT $354,459 $475,093 Interest Expense $102,000 $106,000 Taxable Income $252,459 $369,093 Taxes (@35%) $88,361 $129,183 Net Income $164,098 $239,910 Dividends (45% payout) $73,844.26 $107,959.70 Change in Shareholders Equity $90,254 $131,951
Balance Sheet 19x7 19x8 Assets Cash and Equivalents $315,800 $423,146 Receivables $208,990 $280,114 Inventories $730,000 $978,243 Property, Plant and Equipment $1,967,778 $2,636,763 Total Assets $3,222,568 $4,318,266
Liabilities Payables $315,800 $423,146 Short Term Debt (10% interest) $500,000 $670,016 Long Term Debt (7% interest) $800,000 $1,486,386 Shareholders equity Common Stock $1,150,000 $1,150,000 Retained earnings $456,768 $588,719 Total Liabilities and Equity $3,222,568 $4,318,266 (a) From the above data, which of the following items have varied in constant proportion to sales
between 19x7 and 19x8?
(b) What are the ratios between dividend payout rate and sales for 19x7 and 19x8? (c) Calculate the percent by which sales grew from 19x7 to 19x8. (d) What is the firm’s return on equity for 19x8? (e) What is the firm’s external financing funding requirement determined to be for 19x8? (f) For 19x9, what are the forecast sales if the rate of growth in sales is expected to be 18%? (g) For 19x9, what is the forecast gross margin?
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Answer: Financial Statements
19x7 19x8 % of % of Sales Sales
Income Statement Sales $1,531,429 $2,052,115 100.00% 100.00% Cost of Goods Sold $987,443 $1,323,174 64.48% 64.48% Gross Margin $543,986 $728,941 35.52% 35.52% Operating Expenses Advertising Expense $50,600 $67,720 3.30% 3.30% Rent Expense $73,560 $98,502 4.80% 4.80% Salesperson Commission Expense $48,790 $65,463 3.19% 3.19% Utilities Expense $16,577 $22,163 1.08% 1.08% EBIT $354,459 $475,093 23.15% 23.15% Interest Expense $102,000 $106,000 6.66% 5.17% Taxable Income $252,459 $369,093 16.49% 17.99% Taxes (@35%) $88,361 $129,183 5.77% 6.30% Net Income $164,098 $239,910 10.72% 11.69% Dividends (45% payout) $73,844.26 $107,959.70 4.82% 5.26% Change in Shareholders Equity $90,254 $131,951 5.89% 6.43%
Balance Sheet 19x7 19x8 %of % of
19x7 19x8 Sales Sales
Assets Cash and Equivalents $315,800 $423,146 20.62% 20.62% Receivables $208,990 $280,114 13.65% 13.65% Inventories $730,000 $978,243 47.67% 47.67% Property, Plant and Equipment $1,967,778 $2,636,763 128.49% 128.49% Total Assets $3,222,568 $4,318,266 210.43% 210.43%
Liabilities Payables $315,800 $423,146 20.62% 20.62% Short Term Debt (10% interest) $500,000 $670,016 32.65% 32.65% Long Term Debt (7% interest) $800,000 $1,486,386 52.24% 72.43% Shareholders equity Common Stock $1,150,000 $1,150,000 75.09% 56.04% Retained earnings $456,768 $588,719 29.83% 28.69% Total Liabilities and Equity $3,222,568 $4,318,266 210.43% 210.43% (a) Sales, Cost of Goods Sold, Gross Margin, Advertising Expense, Rent Expense, Salesperson
Commission Expense, Utilities Expense, EBIT, Cash and Equivalents, Receivables, Inventories, Plant, Property and Equipment, Total Assets, Payables, and Total Liabilities and Equity all vary in constant proportion to sales between 19x7 and 19x8. (b) 4.82% in 19x7 and 5.26% in 19x8. (c) 34% (d) 13.80% (e) $856,401
(f) $2,052,115 x 1.18 = $2,421,495.70 (g) $2,421,495 x 0.3552 = $860,115.27
19x7 19x8
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7.
Consider the balance sheet for Crabby Tabby Corporation. Based on the data below, calculate the additional financing required for 19x8.
Balance Sheet Assets Cash and Equivalents Receivables Inventories Property, Plant and Equipment Total Assets Liabilities Payables Short Term Debt (10% interest) Long Term Debt (7% interest) Shareholders equity Common Stock Retained earnings Total Liabilities and Equity 19x7 19x8 $ 310,000 $ 409,266 $ 205,000 $ 270,666 $ 720,000 $ 950,400 $1,956,000 $2,581,722 $3,191,000 $4,212,054 $ 310,000 $ 409,266 $ 510,000 $1,089,000 $ 800,000 $ 995,880 $1,150,000 $1,150,000 $ 421,000 $ 567,908 $3,191,000 $4,212,054
Answer: Additional financing = Change in Assets – Increase in Retained Earnings – Increase in Payables = ($4,212,054 - $3,191,000) – ($567,908 - $421,000) – ($409,266 - $310,000) = $774,880
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8. Prepare a multi-step income statement for Kangarucci Inc. (a retailer) for the year ending December 31, 1997. Use the information below:
(in dollars, $)
Interest expense 18,799 Beginning Inventory 422,550 Depreciation 14,861 General and Administrative Expenses 19,745 Advertising 14,090 Interest Income 5,087 Ending Inventory 456,988 Gross sales 543,777 Taxes 10,006 Returns and Allowances 9,888 Lease Payments 61,444 Purchase of Materials 199,766 R & D Expenditures 12,867 Repairs and Maintenance 7,542
Answer: First compute net sales, operating expenses and cost of goods sold. Net sales = Gross sales – Returns and Allowances = $543,777 - $9,888 = $533,889 C.O.G.S. = Beginning Inventory + Materials Purchased – Ending Inventory = $422,550 + $199,766 - $456,988 = $165,328
Operating Expenses = Depreciation Expense + Gen. and Admin. Expense + Advertising + Lease Payments + R&D Expenses + Repairs & Maintenance = $14,861 + $19,745 + $14,090 + $61,444 + $12,867 + $7,542 = $130,549
Income Statement:
Net sales $533,889 - C.O.G.S. $165,328 Gross margin $368,561 - Operating expense $130,549 Operating margin $238,012 + Interest income $ 5,087 - Interest expense $ 18,799 Profit before taxes $224,300 - Taxes $ 10, 006 Net Income $214,294
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9. Based on the following data, prepare a balance sheet for Kangarucci Inc for the year ending
December 31, 1997
Cash Common Stock (@$0.20 par) Buildings & Equipment Inventories Long-Term Bank Loan Marketable Securities Wage and Tax Accruals Long-Term Investments Other Current Liabilities Accumulated Depreciation Land Notes Payable Leasehold Improvements Other Current Assets Retained Earnings Current Portion of L.T. Debt Net Accounts Receivable Additional Paid-In Capital Accounts Payable
Answer: Balance Sheet for Kangarucci Inc
Cash $15,664 $55,913 Marketable securities 8,624 35,827 Net Accounts Receivable 83,347 13,035 Inventories 106,062 Other Current Assets 17,215 Total Current Assets 230,912 120,549 Buildings & Equipment 231,473 Leasehold Improvements 71,434 Less: Accumulated Depreciation 90,541 268,279 Net Fixed Assets 212,366 Land 51,238 Long-Term Investments 16,731 Total Assets 511,247 78,760 511,247
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15,664 66,000 231,473 106,062 147,730 8,624 13,035 16,731 11,286 90,541 51,238 35,827 71,434 17,215 98,208 4,488 83,347 78,760 55,913 Accounts Payable
Notes Payable Wage & Tax Accruals Current Portion of L.T. Debt 4,488 Other Current Liabilities 11,286 Total Current Liabilities Long-Term Bank Loan 147,730 Total Liabilities Common Stock (@$0.20 par) 66,000 Additional Paid-In Capital Retained Earnings 98,208 Total Liabilities & S.E.
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