# chap014 by nuhman10

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```									                                        Chapter 14

Applying What You Have Learned to Analyze the Gap

Content Analysis of Exercises and Problems
Perform.        Difficulty                                                  Time Range
Number Obj. No.         Level     Content                                           (minutes)_

Calculating Specific Statement of Cash Flow
AE14-1        56           M                                                          20 – 25
Effects
Calculating Specific Statement of Cash Flow
AE14-2        56           M                                                          25 – 30
Effects
AP14-1        56           M       Preparing a Statement of Cash Flows                40 – 50
AP14-2        56           M       Preparing a Statement of Cash Flows                40 – 50
AP14-3        56           M       Preparing a Statement of Cash Flows                30 – 40

Note to Instructor: There is no definitive answer to this problem. Student answers will vary, but
they should consider at least some of the following in their response:

   A review of the nature of a company’s industry, sales, suppliers, business risk
factors, and potential capital expenditures, as contained in its Form 10-K.
   Conduct a comprehensive ratio analysis, calculating, interpreting, and discussing
liquidity, turnover, financial leverage, profitability, and valuation ratios. Some
ratios considered should include:
o Liquidity ratios:
 Working capital ratio
 Current ratio
 Acid test ratio
o Turnover ratios:
 Asset turnover ratio
 Inventory turnover ratio
 Average holding period
 Accounts receivable turnover ratio
 Average collection period
 Accounts payable turnover ratio
 Average payment period
 Length of operating cycle
o Leverage ratios:
 Debt to assets ratio
 Debt to equity ratio
 Times interest earned ratio

459
Solution to Making Business Decisions – Continued
o Profitability ratios:
 Return on equity ratio
 Return on assets ratio
 Gross margin ratio
 Profit margin ratio
 Du Pont Formula
o Valuation ratios:
 Earnings per share
 Price-earnings ratio
 Book value per share
 Dividend yield
   Make a comparison of financial statement ratios to industry averages and other
companies in the same industry.
   Conduct a review of the MD&A and the notes to the financial statements in the
company’s annual report.
   Employ horizontal and vertical analysis to support other ratios or to uncover
relationships and trends.
   Review primary and peripheral activities and evaluate their impact.
   Analyze the statement of cash flows.
   Consider the impact of recent world events, general economic conditions and
industry circumstances as compared to the results obtained through other
analyses.

Note to Instructor: There is no definitive answer to this problem. Student answers will vary.
Students are encouraged to consider the following:

1. With the information provided, students can do the following ratio analysis of the

12/31/2004                12/31/2003
Working                 Working Capital     \$20,859.50                \$27,391.12
=                      =             = .501                    = .641
Capital ratio            Current Assets      \$41,625.66                \$42,709.58

12/31/2004               12/31/2003
Current                 Current Assets       \$41,625.66               \$42,709.58
=                           =             = 2.00                   = 2.79
ratio                 Current Liabilities   \$20,766.16               \$15,318.46

460
Solution to Making Business Decisions – Continued

Current Assets - (Inventories + OCA)
Acid test ratio =
Current Liabilities

\$41,625.66 – (\$4,848.00 + \$22,800.00 + \$4,022.22)
12/31/2004                                                                              = .479
\$20,766.16

\$42,709.58 – (\$4,848.00 + \$19,800.00 + \$13,189.00)
12/31/2003                                                               = .318
\$15,318.46

Students may recognize that Peter is only interested in the auto repair portion of the
business, so they should omit the resale sales, sublet sales, auto sales and the related
cost of goods sold for the autos from their ratio calculations.

Asset turnover:                     12/31/2004                             12/31/2003
Net Sales Revenue            \$231,125.12                             \$194,605.33
=          1.395                        =        .923
Total Assets              \$165,645.82*                            \$210,826.08*
* End of the year total assets are used instead of average assets because 1/1/2003 numbers are
unavailable.

Inventory turnover:                       12/31/2004                           12/31/2003
Cost of Goods Sold               \$89,625.46                            \$72,812.44
= 18.487                             = 15.019
Merchandise Inventory               \$4,848.00                             \$4,848.00
* End of the year merchandise inventory amounts for parts and supplies are used instead of average
because 1/1/2003 numbers are unavailable and the inventory for autos is not applicable to the repair

Average holding period:                          12/31/2004                        12/31/2003
365 days                              365                               365
=        19.74                  = 24.30
Inventory Turnover                        18.487                            15.019

The calculations for accounts receivable turnover and average collection period do not
apply to this company, as it has no accounts receivable other than the amounts due
from stockholders. The calculations for accounts payable and average payment period
also do not apply to this company, as it has no accounts payable.

12/31/2004           12/31/2003
Average Holding Period                    19.74                24.30
+ Average Collection Period                + 0.0                + 0.0
- Average Payment Period                   – 0.0                – 0.0
Length of Operating Cycle                 19.74 days           24.30 days

461
Solution to Making Business Decisions – Continued
Debt to assets ratio:                     12/31/2004                         12/31/2003
Total Liabilities              \$84,236.69                          \$131,744.07
=         .509                     =           .625
Total Assets                \$165,645.82                          \$210,826.08

Debt to equity ratio:                      12/31/2004                          12/31/2003
Total Liabilities              \$84,236.69                           \$131,744.07
=         1.035                    = 1.666
Total Stockholders’ Equity           \$81,409.13                            \$79,082.01

As indicated above, students may recognize that Peter is only interested in the auto
repair portion of the business, so they should omit the resale sales, sublet sales, auto
sales and the related cost of goods sold for the autos from their ratio calculations.
Another item for students to consider is that this is a corporation, so the owner’s salary
is included as an expense on the income statement. The net income used below is net
income after omitting resale sales, sublet sales, auto sales, the related cost of goods
sold for the autos, and officer’s salaries. Additional items, such as payroll taxes related
to the officer’s salaries could also be considered, but have not been in this example.

Times interest earned:
Net Income + Interest Expense + Income Tax Expense
Interest Expense

\$18,143.23 + \$10,849.86 + \$0
12/31/2004                                                  =      2.672
\$10,849.86

\$736.59 + \$12,611.48 + \$0
12/31/2003                                                  =      1.058
\$12,611.48

Return on equity*:                        12/31/2004                         12/31/2003
Net Income                  \$18,143.23                           \$736.59
=         .223                     =           .009
Total Stockholders’ Equity          \$81,409.13                          \$79,082.01

*Since this company has no preferred stock, the simpler ROE formula, as introduced in Chapter 3, can be
utilized in this calculation.

Return on assets:                         12/31/2004                         12/31/2003
Net Income                    \$18,143.23                          \$736.59
=         .110                     =           .003
Total Assets*                 \$165,645.82                         \$210,826.08
* End of the year total assets are used instead of average assets because 1/1/2003 numbers are
unavailable.

462
Solution to Making Business Decisions – Continued
The gross margin used in the ratio below is calculated by using the net sales revenue
and cost of goods sold numbers determined earlier in this problem.

Gross margin:                               12/31/2004                         12/31/2003
Gross margin                   \$141,499.66                        \$121,792.89
=           .612                   =       .626
Sales revenue                  \$231,125.12                        \$194,605.33

Profit margin:                              12/31/2004                         12/31/2003
Net income                   \$18,143.23                          \$736.59
=           .078                   =       .004
Sales revenue                \$231,125.12                        \$194,605.33

Du Pont Formula:
Return on Assets          =      Asset Turnover   x   Profit Margin Ratio
12/31/2004                       .110                =          1.395        x           .078

12/31/2003                         .004*             =           .923        x          .004
* Difference from earlier calculation is due to rounding.

The earnings per share, price-earnings ratio, book value per share, and dividend yield
cannot be determined from the information provided.

Additional analyses students can prepare include horizontal and vertical analysis on the
income statement, balance sheet, and/or statement of cash flows and an examination of
primary and peripheral activities.

2. Additional items that would be useful to have would include notes to the financial
statements (if available), details about the physical plant, industry information,
competitor information, and information regarding the general economy.

3. Questions for Fritz Bruckner may include:
 Who are your current customers?
 Is any portion of sales due to warranty work?
 What caused the sizeable increase in sales revenues this year?
 Who are the suppliers?
 Does Fritz have contracts with suppliers?
 How old is the physical plant?
 What types of repairs are needed on the physical plant?
 Is there a mortgage on the physical plant?
 What assets would be included in the purchase of the business?
 What liabilities does the business have?
 How would Fritz expect to be paid for the business?
 Would he consider financing or lease options?

463
Solution to Making Business Decisions – Continued
   How many employees does Fritz have?
   Are all the employees repair personnel, or are there office workers or sales
personnel?
 What services do the subcontractors provide?
 Why did the company not incur any income tax during the past two years?
 What type of advertising does he employ?
 What insurance is required?
 What are the licensing requirements for the shop?
 How many hours per week is the shop open?
 Which hours are the busiest?
 Has he noticed a seasonal aspect for this business?
 What will Fritz do if he sells the business?
 Will he sign a covenant not to compete?
 What assets were sold in 2004? What assets were purchased in 2003?
 What liability is related to the debt servicing cost (loan interest)?
4. Students answers to this will vary depending on the amount of analysis and types of
analyses done in the other parts of this case. Items they should consider are what
caused the sizeable increase in revenues from 2003 to 2004 and whether the repair
portion of the business will provide an acceptable level of profit for Peter.
14-1 Explain in your own words the meaning of each of the following terms and how
each can be used.
a. Return on common stockholders’ equity ratio: The return on common
stockholders’ equity ratio indicates the rate of return earned by investors on their common stock
investment. It is determined by dividing net income less preferred stock dividends declared
by average common stockholders’ equity.
b. Return on assets ratio: The return on assets ratio indicates management’s
performance in using assets to generate earnings and is calculated by dividing net income by
average total assets.
c. Du Pont Formula: The Du Pont Formula brings together the asset turnover ratio
and the profit margin ratio and shows how these ratios interact to produce the return on assets
ratio that is also referred to as return on investment.
d. Price-earnings ratio: The price-earnings ratio indicates how much an investor is
willing to pay for one share of a particular company in excess of what that share currently earns.
e. Book value per share: The book value per share is a ratio that indicates the
value of the net assets less any preferred stock per share of common stock. It is determined by
dividing common stock equity by the number of common shares outstanding.
f. Dividend yield: The dividend yield is the ratio of the dividend per common share to
the market price per common share. It provides investors some idea of the rate of return that
will be received in cash dividends from their investment.
g. SIC Code: The Standard Industrial Classification Code (SIC Code) is a simple
coding system established by the U.S. government that identifies companies as belonging to
specific industry groups. Identifying companies this way helps all users of financial information
to gather and analyze comparable information.

464
A Note about the Capstone Projects
The capstone projects are open-ended projects encouraging students to apply the skills
and concepts learned throughout the text. There is no definitive response to these
projects, but student solutions should include much the same information detailed in the
“Making a Business Decision: In Which Company Should You Invest?” assignment
earlier. Please refer to that assignment for suggestions as to what to include in the
capstone projects.

Solutions to Appendix 14-2 Reinforcement Exercises

AE14-1 Calculating Specific Statement of Cash Flow Effects

Gym Equipment                           Accumulated Depreciation
2,400,000                                                     760,000
130,000  (a)        70,000          (b)      20,000         120,000
2,460,000                                                     860,000

Cash (Plug)                                     (c)   55,300
Accumulated Depreciation                              20,000
Gym Equipment                                                    70,000
Gain on Sale                                                      5,300

Equipment Cost                    \$70,000 Selling Price                  \$55,300
Less: Accum. Depreciation          20,000 Less: Book Value                 50,000
Equipment Book Value              \$50,000 Gain on Sale                    \$ 5,300

(d)
Cash Flows From Investing Activities:
Proceeds From Sale of Equipment                           \$ 55,300
Acquisition of Equipment                                  (130,000)

AE14-2 Calculating Specific Statement of Cash Flow Effects

a. Cash Basis Sales

Accounts Receivable
150,000
800,000         760,000
190,000

465
Solutions to Appendix 14-2 Reinforcement Exercises – Continued
b. Interest Income Collected During the Year

Interest Receivable
700
1,500               1,700
500

c. Cash Paid For Insurance During the Year

Prepaid Insurance
1,000
2,800                2,000
1,800

d. Cash Paid For Inventory During the Year

Inventories                              Accounts Payable
200,000                                                       190,000
620,000              600,000                580,000           620,000
220,000                                                       230,000

e. Cash Paid For Operating Expenses During the Year

Accrued Liabilities
10,000
79,000              77,000
8,000

f. Cash Flows from Operating Activities

Cash Collected From Customers                  \$760,000
Cash Paid For Insurance                          (2,800)
Cash Paid For Inventory                        (580,000)
Cash Paid For Operating Expenses                (79,000)   \$99,900

466
Solutions to Appendix 14-2 Critical Thinking Problems
AP14-1 Preparing a Statement of Cash Flows

Tyson Corporation
Statement of Cash Flows
For The Year Ended December 31, Year 2

Cash Flows From Operating Activities:
Cash Collected From Customers                            \$ 39,600
Cash Paid For Merchandise Purchases                       (21,800)
Cash Paid For Selling and Administrative Expense          (13,900)
Interest Paid                                                (440)
Income Taxes Paid                                          (1,000)
Net Cash Provided By Operating Activities                              \$ 2,460

Cash Flows From Investing Activities:
Acquisition of Buildings & Equipment                      \$(1,800)
Proceeds From Sale of Equipment                                40
Net Cash Used In Investing Activities                                  \$(1,760)

Cash Flows From Financing Activities:
Partial Payment of Note Payable                              (100)
Proceeds From Issuance of Common Stock                        400
Payment of Cash Dividend                                     (800)
Net Cash Used In Financing Activities                                    (500)

Net Increase In Cash                                                    \$ 200
Cash at Beginning of Year                                               1,200
Cash at End of Year                                                    \$1,400

Supplemental Schedule Of Noncash Investing And Financing Activities:
- NONE -

Analysis Underlying Solution:

Cash Flows from Operating Activities:

a. Cash Basis Sales

Accounts Receivable
3,600
40,000           39,600
4,000

467
Solutions to Appendix 14-2 Critical Thinking Problems – Continued
b. Cash Paid For Inventory During the Year:

Merchandise Inventory                          Accounts Payable
6,300                                                         4,500
22,100           22,000                      21,800           22,100
6,400                                                         4,800

c. Cash Paid For Selling and Administrative Expense:

Accumulated Depreciation                   Selling & Admin. Expense
16,000                      13,900
400             1,100                       1,100
16,700                      15,000

Cash Flows from Investing and Financing Activities:

d.   Cash (Book Value - Proceeds = Loss)                   40
Accumulated Depreciation (Given - #1)                400
Loss (From Income Statement)                          60
Buildings and Equipment (Given - #1)                       500 

Posting the \$500 credit to the Buildings & Equipment T-account shown below to derive
the amount of the expenditure made to acquire buildings and equipment completes the
analysis required.

Buildings & Equipment
30,000
1,800        500 
31,300

e. Payment of Cash Dividend:

Retained Earnings
6,300
800        1,500  Net income
7,000

468
Solutions to Appendix 14-2 Critical Thinking Problems – Continued
AP14-2 Preparing a Statement of Cash Flows

Footloose Corporation
Statement of Cash Flows
For The Year Ended December 31, Year 2

Cash Flows From Operating Activities:
Cash Collected From Customers                                 \$ 2,298
Cash Paid For Merchandise Purchases                            (1,657)
Cash Paid For Selling and Administrative Expense                 (242)
Interest Paid                                                     (60)
Income Taxes Paid                                                 (93)
Net Cash Provided By Operating Activities                                      \$ 246

Cash Flows From Investing Activities:
Acquisition of Buildings & Equipment                          \$ (245)
Proceeds From Sale of Equipment                                   30
Net Cash Used In Investing Activities                                          \$(215)

Cash Flows From Financing Activities:
Partial Retirement of Bonds Payable                              (24)
Proceeds From Issuance of Common Stock                             9
Payment of Cash Dividend                                         (43)
Net Cash Used In Financing Activities                                            (58)

Net Decrease In Cash                                                            \$ (27)
Cash at Beginning of Year                                                        267
Cash at End of Year                                                            \$ 240

Supplemental Schedule Of Noncash Investing And Financing Activities:
Land was acquired by issuing common stock having a fair market value of \$11.

Analysis Underlying Solution:

Cash Flows from Operating Activities:

a. Cash Basis Sales:

Accounts Receivable
223
2,400           2,298
325

469
Solutions to Appendix 14-2 Critical Thinking Problems – Continued
b. Cash Paid For Inventory During the Year:

Merchandise Inventory                          Accounts Payable
521                                                             138
1,750            1,600                       1,657              1,750
671                                                             231

c. Cash Paid For Selling and Administrative Expense:

Cash (Given)                                                     30
Accumulated Depreciation (If Gain = \$3, BV = \$27)                26
Gain (From Income Statement)                                             3
Equipment (Given - #1)                                                  53

Accum. Depreciation             S & A Expense                   Accrued Liabilities
857                333                                           301
26        210                210                              242          333
1,041                543                                           392

\$333 above represents the amount of selling and administrative expenses other than
depreciation expense. If you assume that each dollar of this expense was initially
credited to the Accrued Liabilities account, the debit that emerges represents the
desired amount of cash paid for selling and administrative expenses.

d. Income Taxes Paid:

Income Tax Payable
117
93               80
104

Cash Flows from Investing and Financing Activities:

e. Acquisition of Building:

Buildings & Equipment
3,364
245                53
3,556

470
Solutions to Appendix 14-2 Critical Thinking Problems – Continued
f. Proceeds From Issuance of Common Stock:

Common Stock
807
11 (Given #4)
9
827

g. Payment of Cash Dividend:

Retained Earnings
1,302
43               120
1,379

AP14-3 Preparing a Statement of Cash Flows

Vincent Corporation
Statement of Cash Flows
For The Year Ended December 31, Year 2

Cash Flows From Operating Activities:
Cash Collected From Customers                               \$ 174,000
Cash Paid For Merchandise Purchases                         (124,000)
Cash Paid For Selling and Administrative Expense              (11,000)
Interest Paid                                                  (2,000)
Net Cash Provided By Operating Activities                                \$38,000

Cash Flows From Investing Activities:
None                                                                          -0-

Cash Flows From Financing Activities:
Partial Retirement of Mortgage Payable                      \$ (5,000)
Payment of Cash Dividend                                      (3,000)
Net Cash Used In Financing Activities                                    \$(8,000)

Net Increase In Cash                                                     \$30,000
Cash at Beginning of Year                                                \$40,000
Cash at End of Year                                                      \$70,000

471
Solutions to Appendix 14-2 Critical Thinking Problems – Continued
T-Account documentation:

Accounts Receivable           Interest Receivable         Merchandise Inventory
38                             0                          55
176       174                    3          1              131        136
40                             2                          50

Accounts Payable               S & A Expense                 Salaries Payable
46              12                                           1
124         131               4                             11           12
53              16                                           2

Retained Earnings
78
3                25
100

Note: Since depreciation expense has no effect on cash, only the \$12 salaries expense
is used in the analysis of the Selling and Administrative Expense account.

472

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