Cheng, Janna Frances

Co Soriano, Caitlin
Ong, Jared Darren
Sy, Rainier Godfrey
Module 2 Exercises

1. Income statement preparation

On January 1, 2019, Belle Florist opened a store in an upmarket area of Soho, London. The
business is owned by Boris Kimmel, the sole proprietor. During the year, Boris has kept a record
of all transactions.
● On December 31, 2019, his records show that he has sold goods worth $280,000 which
were purchased for $80,000 from vendors in Rotterdam, the Netherlands.
● He has withdrawn $42,000 as his annual salary.
● The business has paid $15,000 towards gas, electricity and council taxes for the year.
● Lease payments for the office space rented for the year were $24,000, including a
refundable deposit of $4,000
● Belle florist employed two full-time shop assistants each receiving annual salaries of
$24,000 before tax.
● Depreciation expense on the office furniture and fixtures were $1,000 per month
● They also have paid $2,200 toward interest and charges on an overdraft facility they have
from their bankers
● The business is supposed to pay an average tax rate of 25% during 2019

Requirements:
● Prepare an income statement for Belle Florist for the year ended December 31, 2019

Belle Florist
Income Statement (in USD)
For the Year Ended December 31, 2019
Sales revenue 280,000
Less: Cost of goods sold 80,000
Gross profit 200,000
Less: Operating expenses
Salary expense 90,000
Gas, electricity, and council taxes 15,000
Lease expense 20,000
Depreciation expense 12,000
Total operating expenses 137,000
Operating profit 63,000
Less: Interest expense 2,200
Net profit before taxes 60,800
Less: Taxes (25%) 15,200
Net profit after taxes 45,600

● Evaluate the financial performance of the business

 Boris Kimmell was able to cover all his operating expenses and earned a net profit of
45,600 on revenues of 280,000 in his first year of business.

2. Balance sheet preparation

Use the appropriate items from the following list to prepare Mellark’s Baked Goods balance
sheet at December 31, 2010

Item Value (in USD thousands)

Accounts payable 220
Accounts receivable 450
Accruals 55
Accumulated depreciation 265
Buildings 225
Cash 215
Common stock (at par) 90
Cost of goods sold 2,500
Depreciation expense 45
Equipment 140
Furnitures and fixtures 170
General expense 320
Inventory 375
Land 100
Long-term debts 420
Machinery 420
Marketable securities 75
Notes payable 475
Paid-in capital in excess of par 360
Preferred stock 100
Retained earnings 210
Sales revenue 3,600
Vehicles 25

Mellark’s Baked Goods

Balance Sheet (in USD thousands)
As of December 31, 2010
Assets
Cash 215
Marketable securities 75
Accounts receivable 450
Inventory 375
Total current assets 1,115
Equipment 140
Machinery 420
 Vehicles 25
Furnitures and fixtures 170
Buildings 225
Land 100
Gross fixed assets 1,080
Less: Accumulated depreciation 265
Net fixed assets 815
Total assets 1,930
Liabilities and Equity
Accounts payable 220
Notes payable 475
Accruals 55
Total current liabilities 750
Long-term debt 420
Total liabilities 1,170
Preferred stock 100
Common stock 90
Paid-in capital in excess of par 360
Retained earnings 210
Total equity 760
Total liabilities and equity 1,930

3. Liquidity management

Bauman Company’s total current assets, total current liabilities and inventory for each of the past
4 years follow:

2016 2017 2018 2019

Total current assets 16,950 21,900 22,500 27,000
Total current liabilities 9,000 12,600 12,600 17,400
Inventory 6,000 6,900 6,900 7,200

a. Calculate the firm’s current and quick ratios for each year. Compare the resulting time
series for these measures of liquidity

2016 2017 2018 2019

Current ratio 1.8833 1.7381 1.7857 1.5517
Quick ratio 1.2167 1.1905 1.2381 1.1379

Where
Current ratio = Total current assets / Total current liabilities, and
Quick ratio = (Total current assets – Inventory) / Total current liabilities.
 Over the 2016-2019 period, the current and quick ratios of Bauman Company alternately fell
then rose. With 2016 as the base year, both ratios fell in 2017, rose in 2018, and fell again in
2019. Comparing the 2016 and 2019 ratio turnouts shows an overall decrease in both ratios.

b. Comment on the firm’s liquidity over the 2016-2019 period

The firm’s liquidity could be diagnosed by its current and quick ratios. Higher ratios mean
that the firm is more liquid. Over the 2016-2019 period, the firm’s liquidity alternately fell then
rose. With 2016 as the base year, liquidity fell in 2017, rose in 2018, and fell again in 2019.
Comparing the 2016 and 2019 ratio turnouts shows an overall decrease in liquidity.

c. If you were told that Bauman Company’s inventory turnover for each year in the 2016-
2019 period and the industry averages were as follows, would this information support or
conflict with your evaluation in part b? Why?

Inventory 2016 2017 2018 2019

turnover
Bauman 6.3 6.8 7.0 6.4
Company
Industry average 10.6 11.2 10.8 11.0

Inventory -4.3 -4.4 -3.8 -4.6

turnover
difference

Where
Inventory turnover difference = Bauman Company inventory turnover - Industry average.

Yes; the information would support our evaluation in part b. The lesser the inventory
turnover of a firm compared to its industry average, the lesser its inventory can be considered
liquid, and the lesser the firm is liquid overall. Thus, the information given supports the
evaluations that over the 2016-2019 period, the liquidity of Bauman Company alternately fell
then rose, and comparing the 2016 and 2019 ratio turnouts shows an overall decrease in liquidity.

4. Inventory management

Three companies that compete in Scotland’s home furniture industry are Loch
Furnishing, Highland Furnishing and Fell Furniture. The table below shows cost of goods sold
and average inventory levels for 2015, 2016 and 2017 fiscal years. Calculate the inventory
turnover ratio for each company in each year and present your conclusions. All values are in $
thousands:

Loch 2015 2016 2017

Cost of goods sold 4,652 4,826 4,100
Inventory 1,213 1,284 1,326
 Highland      
Cost of goods sold 1,245 1,315 1,406
Inventory 304 552 577
Fell      
Cost of goods sold 1,648 1,842 2,100
Inventory 427 480 512

Inventory turnover 2015 2016 2017

Loch 3.8351 3.7586 3.0920
Highland 4.0954 2.3822 2.4367
Fell 3.8595 3.8375 4.1016

Where
Inventory turnover = Cost of goods sold / Average Inventory.

Over the 2015-2017 period, the inventory turnovers of Loch and Highland steadily decreased
while that of Fell decreased then increased. Highland had the highest inventory turnover in 2015
but Fell took over the top spot in the following year (2016) and maintained its position for
another year (2017). One reason for this could be that in 2016 Loch and Highland began stocking
their inventories with furniture that are replaced less frequently in greater quantities while Fell
placed more focus stocking on furniture that are replaced more frequently. Another reason for
this could be that the promotions of Loch and Highland grew weaker with time compared to that
of Fell, which grew stronger with time. Hence, more buyers could have bought from Fell than
from the other two companies, and this meant Fell had to turnover their inventory faster.

5. Accounts receivable management

Speedy Manufacturing Company’s end-of-year accounts receivable consist of amounts

originating in the months indicated in the following table. The company had annual sales of $3.2
million. The company extends 30-day credit terms.

Month of origin Accounts receivable

July 2,500
August 3,600
September 63,250
October 21,100
November 54,000
December 298,000
Total 442,450

a. Use the year-end total to evaluate the company’s collection system.

Average day’s sales = Annual sales / 365

= $3,200,000 / 365 = $ 8,767.1233 (approximation)
Days receivables = Total accounts receivable / Average day’s sales
= 442,450 / (3,200,000 / 365) = 50.4670 days (approximation)

The collection system of Speedy Manufacturing Company is slow because days receivables
exceed its credit term period.

b. If 75% of the company’s sales occur between July and December, would this information
affect the validity of your conclusions in part a? Explain.
Yes, the information would diminish the validity of our conclusions in part A. The
accounts receivables earned from company’s sales that occur between July and December have
increasingly less time to be collected before the year ends as compared to those earned from
sales that occur between January and June. Hence, it is normal for each month from July to
December to have more uncollected accounts receivables by the end of the year than their
previous months. This is especially true for December whose end-of-year accounts receivable is
larger than all the other receivables from the other months. The information that 75% percent of
the company’s sales occurred between July and December could entail that the company earned
most of its accounts receivables during those months. Since those months had increasingly less
time before the year ended, it would not be surprising to uncover that the majority of the
company’s accounts receivables were not collected before the year ended. In this case, the
calculated days receivables is high even though the company’s collection system is not
necessarily slow. Spreading the company’s sales evenly among all months of the year allows the
company to collect more accounts receivables and reduces the days receivables. The days
receivables could be reduced enough to fall within the time period of the company’s credit terms,
and this shows that the company collection system is not necessarily slow.

6. Debt analysis

Springfield Bank is evaluating Creek Enterprises, which has requested a $4,000,000 loan to
assess the firm’s financial leverage and financial risk. One the basis of the debt ratios for Creek,
along with the industry average and creek’s recent financial statements (following), evaluate and
recommend appropriate action on the loan request.

Creek Enterprises Income Statement

For the Year Ended December 31, 2019
Sales revenue 30,000,000
Less: Cost of goods sold 21,000,000
Gross profits 9,000,000
Less: Operating expenses
Selling expenses 3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expense 6,000,000
Operating profits 3,000,000
Less: Interest expense 1,000,000
 Net profits before taxes 2,000,000
Less: Taxes (21%) 420,000
Net profits after taxes 1,580,000
Less: Preferred stock dividends 100,000
Earnings available for common stockholders 1,480,000

Creek Enterprises Balance Sheet

As of December 31, 2019
Assets
Cash 1,000,000
Marketable securities 3,000,000
Accounts receivable 12,000,000
Inventories 7,500,000
Total current assets 23,500,000
Land and buildings 11,000,000
Machinery and equipment 20,500,000
Furniture and fixtures 8,000,000
Gross fixed assets 39,500,000
Less: Accumulated depreciation 13,000,000
Net fixed assets 26,500,000
Total assets 50,000,000
Liabilities and Stockholder's Equity
Accounts payable 8,000,000
Notes payable 8,000,000
Accruals 500,000
Total current liabilities 16,500,000
Long-term debt 20,000,000
Preferred stock 2,500,000
Common stock 5,000,000
Paid-in capital in excess of par value 4,000,000
Retained earnings 2,000,000
Total stockholder's equity 13,500,000
Total liabilities and stockholder's equity 50,000,000

Industry averages
Debt ratio 0.51
Times interest earned ratio 7.30
Fixed-payment coverage ratio 1.85

Debt ratio = Total debt / Total assets = (Total current liabilities + Long-term debt) / Total assets
= (16,500,000 + 20,000,000) / 50,000,000 = 0.73
Times interest earned ratio = Net profit before taxes and interest/Interest
= 3,000,000/100,000 = 3
Fixed-payment coverage ratio
= (Earnings before interest and taxes + Lease payments)/ [Interest + Lease payments + (Principal
payments + Preferred stock dividends) / (1-T)]
=(3,000,000 + 200,000) / [1,000,000 + 200,000 + (0 + 100,000) / (1-0.21)] = 2.4122

The loan request poses high risks of loss for both Springfield Bank and Creek Enterprises.
The debt ratio reveals the effect of financial leverage. The higher debt ratio, the greater the
financial leveraging. Comparing the debt ratio of Creek Enterprises to the industry average
shows that, before its $ 4 million loan application, the firm was already more financially
leveraged than an average firm in its industry. Highly leveraged firms have greater risk of
insolvency when their profits and cash flows fall compared to less-leveraged firms. Comparing
the size of the loan to the firm’s earnings available for stockholders made in the year 2019 shows
that the firm would take many years to repay the loan with interest. From its times interest earned
ratio, the same conclusion can also be drawn as its ability to pay its debt obligations is lower than
that of the industry average. Furthermore, any profit or cash flow falls that the firm experiences
during those many years could push it to insolvency. The only redeeming ratio for Creek
Enterprises is its fixed-payment coverage ratio that is higher than industry average, and it means
that the company could pay its fixed payments without much trouble. We recommend to
postpone the loan request until Creek Enterprises decreases their debt ratio, increases their
annual earnings available for stockholders, then maintains those for a few years. Springfield
Bank could also ask Creek Enterprises for collateral assets or guarantors with high credit ratings
before accepting the loan request.

7. Profitability analysis

The table below shows 2017 total revenues, cost of goods sold, earnings available for common
stockholders, total assets, and stockholder’s equity for three competing companies in the local
beverages market in Thailand—Gold Drinks, Tropical fresh, and Sun Supplies. All the values are
in Thai Baht (THB) thousands.

Gold Drinks Tropical Fresh Sun Supplies

Revenues 125,577 188,385 19,308
Cost of goods sold 49,377 84,615 7,734
Earnings 16,869 18,975 2,529
Total assets 261,798 222,375 29,361
Shareholder’s equity 69,174 33,726 6,390

a. Use the information given to calculate each firm’s profitability in as many different ways
as you can. Which firm is most profitable? Explain why it might be difficult to pick one
as the most profitable.

Gold Drinks Tropical Fresh Sun Supplies

Gross profit margin 0.6068 0.5508 0.5994
 Net profit margin 0.1343 0.1007 0.1310
ROA 0.06444 0.08529 0.08613
ROE 0.2439 0.5626 0.3958

Where
Gross profit margin = (Revenues – Cost of goods sold) / Revenues,
Net profit margin = Earnings / Revenues,
ROA = Return on assets = Earnings / Total assets, and
ROE = Return on equity = Earnings / Shareholder’s equity

In terms of gross and net profit margins, Gold Drinks is the most profitable among the three
companies. In terms of ROA, Sun Supplies is the most profitable among the three companies. In
terms of ROE, Tropical Fresh is the most profitable among the three companies. It might be
difficult to pick one of the three companies as the most profitable because none of them are the
most profitable in terms of all of the profitability ratios. Even if one of them would be, there are
still other measures of profitability to consider, such as Return on Investment Capital. In the end,
choosing the most profitable could depend on which ratio is most vital for a specific situation.

b. For each firm, ROE is greater than ROA. Explain why this is the case. Compare the ROE
and ROA for each firm. Can you determine which one has the least proportion of debt in
its capital structure?

For each firm, ROE is greater than ROA because all of the firms have assets that do not come
from the sale of stocks to shareholders. These assets are gained by incurring liabilities, for
example a bank loan grants firms more cash assets. The total shareholder’s equity for each firm
is lesser than their respective total assets. Thus, for the same level of earnings, ROE would be
greater than ROA for each firm.

Gold Drinks Tropical Fresh Sun Supplies

ROE - ROA 0.1795 0.4773 0.3097
Total liabilities 192,624 188,649 22,971
Debt ratio 0.7358 0.8483 0.7823

Where
Total liabilities = Total assets - Shareholder’s equity, and
Debt ratio = Total liabilities / Total assets.

Gold Drinks has the least proportion of debt in its capital structure because it has the lowest
debt ratio, and it has the lowest ROE and ROA difference.

8. DuPont analysis

Steve Steaks and Barry Sizzle are two restaurant chains that are competing across Europe. Use
the following 2016 financial information to conduct a DuPont system of analysis for each
company.
 Steve Steaks Barry Sizzle
Sales 2,129,195 1,637,717
Earnings available for common stockholders 173,306 176,881
Total assets 5,249,650 3,174,317
Stockholders’ equity 1,613,407 312,393

a. Which company has a higher net profit margin? Higher asset turnover?

Steve Steaks Barry Sizzle

Net profit margin 0.08140 0.1080
Asset turnover 0.4056 0.5159

Where
Net profit margin = Earnings available for common stockholders / Sales, and
Asset turnover = Sales / Total assets.

Barry Sizzle has a higher profit margin and a higher asset turnover compared to Steve Steaks.

b. Which company has the lower ROA? Lower ROE?

Steve Steaks Barry Sizzle

ROA 0.03301 0.05572
Asset-to-equity ratio 3.2538 10.1613
ROE 0.1074 0.5662

Where
ROA = Return on assets = Earnings available for common stockholders / Total assets,
Asset-to-equity ratio = Total assets / Shareholders’ equity
ROE = Return on equity = Earnings available for common stockholders / Shareholders’ equity
= ROA * Net profit margin * Asset-to-equity ratio

Steve Steaks has a lower ROA and a lower ROE compared to Barry Sizzle.