Solution Manual for Financial Reporting Financial

Statement Analysis and Valuation 8th Edition by Wahlen

Baginski and Bradshaw ISBN 1285190904
9781285190907
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Chapter 5—Risk Analysis

MULTIPLE CHOICE

1. Economic theory teaches that differences in market returns must relate to differences in
a. book value
b. perceived risk
c. price-earnings ratio
d. bankruptcy risk
ANS: B PTS: 1

2. Market equity beta measures the covariability of a firm's returns with the return's of
a. all industry competitors in the market.
b. risk free securities.
c. all securities in the market.
d. all firms of comparable market value.
ANS: C PTS: 1

3. The Johnson company has a current ratio of 1.45. The company has just sold $600,000 worth of
merchandise on credit. What will the current ratio be after the sales on credit?
a. greater than 1.45
b. 1.45
c. less than 1.45
d. unable to determine without more information
ANS: A PTS: 1

4. One common problem with the current ratio is that it is susceptible to "window dressing." If prior to
the end of the accounting period Saxon Company has a current ratio of 1.5 and management wishes to
boost its current ratio it may decide to
a. pay off accounts payable prior to year end.
b. purchase more inventory on account.
c. purchase short-term investments with cash.
d. purchase more inventory with cash.

5-1
 ANS: A PTS: 1

Mobile Company
Mobile Company manufactures computer technology devices. Selected financial data for Mobile is
presented below, use the information to answer the following questions:

Current Assets As of Dec. 31, 2010 Dec. 31, 2009

Cash and short-term investments $1,267,038 $ 616,604
Accounts Receivable (net) 490,816 665,828
Inventories 338,599 487,505
Prepaid Expenses and other current assets 292,511 291,915
Total Current Assets $2,388,964 $2,061,852

Current Liabilities
Short-term borrowings $ 25,190 $ 38,108
Current portion of long-term debt 182,295 210,090
Accounts payable 296,307 334,247
Accrued liabilities 941,912 743,999
Income taxes payable 203,049 239,793
Total Current Liabilities 1,648,753 1,566,237

Selected Income Statement Data - for the year ending December 31, 2010:
Net Sales $4,885,340
Cost of Goods Sold 2,542,353
Operating Income 733,541
Net Income 230,101

Selected Statement of Cash Flow Data - for the year ending December 31, 2010:
Cash Flows from Operations $1,156,084

5. Refer to the information for Mobile Company. Mobile's current ratio in 2010 was
a. 1.07
b. 1.45
c. 1
d. .69
ANS: B
$2,388,964 / 1,648,753 = 1.45

PTS: 1

6. Refer to the information for Mobile Company. Mobile's quick ratio changed by what percentage from
2009 to 2010?
a. 30%
b. 107%
c. 25%
d. 82%
ANS: A
2010 Quick ratio = 1,757,854 / 1,648,753 = 1.07
2009 Quick ratio = 1,282,432 / 1,566,237 = .82

(1.07 - .82) / .82 = .30

5-2
 PTS: 1

7. Refer to the information for Mobile Company. Mobile's Operating Cash Flow to Current Liabilities
ratio in 2010 was
a. .70
b. 1.39
c. 1.00
d. .72
ANS: D
$1,156,084 / [($1,648,753 + 1,566,237)  .5] = .72

PTS: 1

8. Refer to the information for Mobile Company. Mobile's days receivables outstanding at the end of
2010 was
a. 43.20 days
b. 40.50 days
c. 45.25 days
d. 8.50 days
ANS: A
$4,885,340 / [(490,816 + 665,828)  .5 ] = 8.45 A/R Turnover

365 / 8.45 = 43.20 days

PTS: 1

9. Refer to the information for Mobile Company. Mobile's days accounts payable outstanding at the end
of 2010 is
a. 7.53 days
b. 48.09 days
c. 45.51 days
d. 50 days
ANS: B
Purchases = $2,542,353 + 338,599 - 487,505 = 2,393,447

Average A/P = (296,307 + 334,247)  .5 = 315,277

A/P Turnover = 7.59

Days = 365 / 7.59 = 48.09 days

PTS: 1

10. Refer to the information for Mobile Company. Days of other financing required by Mobile at the end
of 2010 would be
a. 54.36 days
b. 75.36 days
c. 102.94 days
d. 5.27 days
ANS: A

5-3
 Days A/R + Days Inv. - Days A/P = Days Other Financing
43.20 + 59.25 - 48.09 = 54.36

PTS: 1

11. Refer to the information for Mobile Company. Mobile's 2010 Inventory Turnover ratio is
a. 7.46
b. 11.83
c. 6.16
d. 5.62
ANS: C
$2,542,353 / [(338,599 + 487,505)  .5] = 6.16

PTS: 1

12. The best indicator for assessing a firm's long-term solvency risk is its ability to generate what over a
period of years?
a. Sales
b. Earnings
c. Positive cash flows
d. Income from continuing operations
ANS: B PTS: 1

13. Which of the following ratios is not a measure of long-term solvency risk?
a. Debt /Equity Ratio
b. Interest Coverage Ratio
c. Operating Cash Flows to Current Liabilities Ratio
d. Liabilities to Assets Ratio
ANS: C PTS: 1

14. Univariate bankruptcy prediction models help identify factors related to bankruptcy, but they do not
provide information about
a. specific ratios that are important.
b. the amount of Type I and Type II errors.
c. which specific company will go bankrupt.
d. the relative importance of individual financial statement ratios.
ANS: D PTS: 1

15. Bankruptcy prediction research has identified three broad factors influencing long-term solvency risk,
which of the following is not one of the factors?
a. Investment factors
b. Financing factors
c. Operating factors
d. Credit factors
ANS: D PTS: 1

16. Which of the following is not one of the three explanatory variables that determines a firm's market
beta?
a. Degree of investing leverage.
b. Degree of operating leverage.

5-4
 c. Degree of financial leverage.
d. Variability of sales.
ANS: A PTS: 1

17. Here are several ratios calculated from Midas Company's financial statements:
Days in Receivables = 45
Days in Payables = 36
Days in Inventory = 30

How many days of working capital financing does Midas need to obtain from other sources?
a. 39 days
b. 36 days
c. 56 days
d. 26 days
ANS: A PTS: 1

18. Which of the following states of financial distress would be considered the most troubling for an
investor or creditor?
a. failing to make a required interest payment on time
b. paying an accounts payable after the billing date
c. restructuring debt
d. defaulting on a principal payment on debt
ANS: D PTS: 1

19. If a customer wanted to obtain bank financing which of the following will the bank inquire about
before granting a loan?
a. Firms credit history
b. financial position of the firms creditors
c. firms cash flow
d. a and c
ANS: D PTS: 1

20. Doran Corp. has a current ratio of 6. Under which of the following scenarios might this indicate a
problem?
a. inventories are increasing due to the introduction of a new product
b. the company is holding cash in expectation of making a large investment in equipment
c. receivables are increasing due to increasing sales
d. inventories are increasing and the industry in which Doran Corp. operates is experiencing
a recession
ANS: D PTS: 1

Below is selected information from Marker’s 2012 financial statements:

As of Dec. 31, 2012 Dec. 31, 2011

Cash and short-term investments $ 958,245 $ 745,800
Accounts Receivable (net) 125,850 135,400
Inventories 195,650 175,840
Prepaid Expenses and other current assets 45,300 30,860
Total Current Assets $1,325,045 $1,087,900
Plant, Property and Equipment, net 1,478,320 1,358,700

5-5
 Intangible Assets 125,600 120,400
Total Assets $2,928,965 $2,567,000

Short-term borrowings $ 25,190 $

38,108
Current portion of long-term debt 45,000 40,000
Accounts payable 285,400 325,900
Accrued liabilities 916,722 705,891
Income taxes payable 125,400 115,600
Total Current Liabilities $1,397,712 $1,225,499
Long-term Debt 450,000 430,000
Total Liabilities $1,847,712 $1,655,499
Shareholders' Equity $1,081,253 $ 911,501
Total Liabilities and Shareholders' Equity $2,928,965 $2,567,000

Selected Income Statement Data - for the year ending December 31, 2012:
Net Sales $3,210,645
Cost of Goods Sold (2,310,210)
Operating Income $ 900,435
Net Income $ 324,850

Selected Statement of Cash Flow Data - for the year ending December 31, 2012:
Cash Flows from Operations $584,750
Interest Expense 42,400
Income Tax Expense 114,200

21. Marker’s Liabilities to Assets Ratio for 2012 is

a. 105.1%
b. 63.1%
c. 78.3%
d. 100.0%
ANS: B
$1,847,712 / $2,928,965 = 63.1%

PTS: 1

22. Marker’s 2012 Liabilities to Shareholders’ Equity ratio is

a. 100.0%
b. 170.9%
c. 63.1%
d. 129.3%
ANS: B
$1,847,712 / $1,081,253 = 170.9%

PTS: 1

23. Marker’s 2012 Long-term Debt to Long-Term Capital ratio is

a. 31.4%
b. 29.4%
c. 34.0%
d. 25.4%

5-6
 ANS: A
(45,000 + 450,000) / ( 1,081,253 + 450,000 + 45,000) = 31.4%

PTS: 1

24. Marker’s 2012 Long-term Debt to Shareholders’ Equity ratio is

a. 31.4%
b. 29.4%
c. 34.0%
d. 45.8%
ANS: D
(45,000 + 450,000) / 1,081,253 = 45.8%

PTS: 1

25. Marker’s 2012 Interest Coverage ratio is

a. 7.66
b. 1.00
c. 11.35
d. 4.35
ANS: C PTS: 1

26. The quick acid test ratio contains all of the following except:
a. cash
b. accounts receivable
c. marketable securities
d. prepaid assets
ANS: D PTS: 1

27. All of the following are common industry risks faced by companies except:
a. litigation
b. technology
c. regulation
d. competition
ANS: A PTS: 1

28. All of the following are common domestic risks faced by companies except:
a. recessions
b. technology
c. inflation
d. demographic shifts
ANS: B PTS: 1

29. All of the following are common international risks faced by companies except:
a. asset expropriation
b. exchange rate changes
c. political unrest
d. dependence on one or a few suppliers
ANS: D PTS: 1

5-7
30. All of the following typically drive firm-specific risks except:
a. the nature of the business
b. competition
c. supplier relationships
d. demographic shifts
ANS: D PTS: 1

31. Which of the following can companies use as collateral for a loan?
a. prepaid insurance
b. prepaid rent
c. property, plant, and equipment
d. retained earnings
ANS: B PTS: 1

32. Changes in foreign exchange rates can affect a firm in all of the following ways except:
a. The prices a firm pays to acquire raw materials from suppliers abroad.
b. The amount of cash a firm receives when it collects an account receivable, a loan
receivable, or another receivable denominated in a currency other than its own.
c. The value of domestic liabilities with fixed interest rates.
d. The prices a firm charges for products sold to customers abroad.
ANS: C PTS: 1

33. Changes in interest rates can typically affect firms in all of the following ways except:
a. The value of investments in bonds or other investment securities with fixed interest
rates.
b. The value of liabilities with fixed interest rates.
c. The returns a firm generates from pension fund investments.
d. The cash-equivalent value of assets invested abroad.
ANS: D PTS: 1

34. Below are various states of financial distress:

1. defaulting on a principal payment on debt
2. restructuring debt
3. liquidating a firm
4. filing for bankruptcy
5. failing to make a required interest payment on time

What is the order of increasing gravity that analysts typically consider when assessing credit risk and
bankruptcy risk according to a continuum of financial distress?
a. 5, 1, 2, 3, 4
b. 5, 2, 1, 4, 3
c. 1, 5, 2, 4, 3
d. 1, 5, 2, 3, 4
ANS: B PTS: 1

35. Which of the following properly links the factors affecting a firm’s ability to generate cash with its
need to use cash in operations?

Ability to generate cash Need to use cash

a. Profitability of goods and services sold Working capital requirements

5-8
 b. Sales of existing plant assets Plant capacity requirements
c. Borrowing capacity Debt service requirements
d. Profitability of goods and services sold Debt service requirements
ANS: A PTS: 1

36. Which of the following properly links the factors affecting a firm’s ability to generate cash with its
need to use cash in investing?

Ability to generate cash Need to use cash

a. Profitability of goods and services sold Working capital requirements
b. Sales of existing plant assets Plant capacity requirements
c. Borrowing capacity Debt service requirements
d. Profitability of goods and services sold Debt service requirements
ANS: B PTS: 1

37. Which of the following properly links the factors affecting a firm’s ability to generate cash with its
need to use cash in financing?

Ability to generate cash Need to use cash

a. Profitability of goods and services sold Working capital requirements
b. Sales of existing plant assets Plant capacity requirements
c. Borrowing capacity Debt service requirements
d. Profitability of goods and services sold Debt service requirements
ANS: C PTS: 1

COMPLETION

1. Short-term ____________________________ represents a firm's near-term ability to generate cash to

service working capital needs and debt service requirements.

ANS: liquidity risk

PTS: 1

2. Long-term ______________________________ represents the longer-term ability of the firm to

generate cash internally or from external sources to satisfy plant capacity and debt repayment needs.

ANS: solvency risk

PTS: 1

3. The source of risk related to political unrest and exchange rate changes are
_________________________.

ANS: international

PTS: 1

4. The source of risk related interest rate changes and demographic changes is ____________________.

ANS: domestic

5-9
 PTS: 1

5. The source of risk related to technology, regulation and availability of raw materials is
____________________.

ANS: industry

PTS: 1

6. The source of risk related to management competence, strategic direction and lawsuits is
_________________________.

ANS: firm specific

PTS: 1

7. The operating cycle must not only generate cash to supply

________________________________________ needs, it must generate sufficient cash to service
debt.

ANS: operating working capital

PTS: 1

8. When management takes deliberate steps at a balance sheet date to produce a better current ratio than
is normal it is called ______________________________.

ANS: window dressing

PTS: 1

9. By adding the number of days that inventory is held to the number of days that accounts receivable is
outstanding an analyst can calculate the number of days of
_____________________________________________ the firm requires.

ANS: working capital financing

PTS: 1

10. In general, the shorter the number of days of needed financing, the ____________________ is the cash
flow from operations to average current liabilities.

ANS: larger

PTS: 1

11. Common shareholders benefit with increasing proportions of debt in the capital structure as long as the
firm maintains an excess of ____________________ over the after-tax cost of debt

ANS: ROA

PTS: 1

5-10
12. One problem with debt ratios is that they provide no information about the ability of the firm to
generate ________________________________________ to service debt.

ANS: cash flow from operations

PTS: 1

13. In bankruptcy prediction analysis a type ____________________ error is classifying a firm as

nonbankrupt when it ultimately goes bankrupt.

ANS: I

PTS: 1

14. In bankruptcy prediction analysis a type ____________________ error is classifying a firm as

bankrupt and it ultimately survives.

ANS: II

PTS: 1

15. The beta coefficient measures the ____________________ of a firm's returns with those of all shares
traded in the market (in excess of the risk-free interest rate).

ANS: covariability

PTS: 1

16. The current ratio is one of the measures of__________ of the firm.

ANS:liquidity
PTS: 1

17. _________________________ concerns a firm’s ability to make interest and principal payments on
borrowings as they become due.

ANS: Credit risk

PTS: 1

18. The analysis of short-term liquidity risk requires an understanding of the

_________________________ of a firm.

ANS: operating cycle

PTS: 1

19. Financially healthy firms frequently close any cash flow gaps in their operating cycles with
________________________________________.

ANS: short-term borrowing

PTS: 1

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 20. Large current ratios indicate the availability of cash and near cash assets to repay
____________________ coming due within the next year.

ANS: obligations

PTS: 1

21. When calculating the quick ratio, an analyst would include in the numerator cash,
________________________________________, and receivables.

ANS: marketable securities

PTS: 1

22. Cash flow from operations indicates the amount of cash that the firm derived from operations after
funding ______________________________.

ANS: working capital

PTS: 1

23. An analyst can view the revenues to cash ratio as a ________________________________________.

ANS: cash turnover ratio

PTS: 1

24. When the excess of ROA over the after-tax cost of borrowing declines, additional
________________________________________ begins to reduce the return to common shareholders.

ANS: financial leverage

PTS: 1

25. The ________________________________________ ratio indicates the number of times that net
income before interest expense and income taxes exceeds interest expense.

ANS: interest coverage

PTS: 1
26. When a company wants to calculate the current ratio the would divide the current assets by the
___________
ANS: current liabilities

27. Working capital is defined as ______________________ minus _____________________.

ANS: current assets, current liabilities

SHORT ANSWER

1. The current risk-free rate of return in the economy is 6%. In addition, the market rate of return is
currently 8.5%
A. Given this information, what would be the expected return on common stock for a company with a
systemic risk level (Beta) of 1.3? Show your calculations.

5-12
 B. Describe systemic risk.

ANS:

A. Expected Return = Risk-free Interest Rate + Market Beta [Market Return - Risk-free Interest]

Expected Return = =.06 +1.3[.085-.06]=9.25%

B. Systemic Risk is the risk that affects all investments in common; it is the risk that cannot be
reduced by a well diversified portfolio.

PTS: 1

2. A. What are the three measures that are used to analyze long term solvency risk?
B- describe each measure briefly
Answer part A:
1) Debt ratios
2) Interest coverage ratios
3) Operating cash flow to total liabilities ratio
ANS part B:
1) Debt ratios- measure the relative amount of liabilities especially long term debt that a
business has in its capital structure. The higher the debt ratio the greater the long term
solvency risk.
2) Interest coverage ratios- measure the number of times a firms income or cash flows can
cover interest payments when they become due.
3) Operating cash flow to total liabilities ratio- measures what percentage of the cash flows
the firm has to pay its liabilities.

PTS: 1

3. When a financial analyst examines the credit risk of a company, it is common that he or she uses a set
of factors that all begin with the letter "C." Each factor provides a consideration that enters into the
lending decision. List and discuss how each of the factors affects a company's credit risk.

ANS:
1. Circumstances leading to need for the loan - The reasons that the company needs to borrow
affect the riskiness of the loan and the likelihood of repayment.
2. Credit History - Has the firm borrowed in the past and successfully repaid the loan.
3. Cash flows - Is the lender generating sufficient cash flows to pay interest and repay the
principal on a loan rather than having to rely on selling the collateral.
4. Collateral - Is the collateral sufficient to repay the loan and does the lender have the right to
take possession of the collateral.
5. Capacity for debt - Has the company borrowed up to its capacity or is there a margin of
safety remaining.
6. Contingencies - Are there any events on the horizon that would harm the company if their
outcome is negative.
7. Character of management - An intangible factor, has the management team been successful
in difficult times, are they honest and forthcoming.
8. Communication - Developing relations with lenders requires effective communication both
initially and on an ongoing basis.
9. Conditions - What are the restrictions or covenants put in place to protect the lender.

5-13
 Each of these factors must be examined in the multivariate manner so that the total credit risk profile
of the company can be determined.

PTS: 1

4. Bankruptcy analysis research has gone through many iterations, from univariate bankruptcy prediction
models to sophisticated logit models. However, after examining the results of the research there appear
to be a number of common factors that consistently explain bankruptcy. These factors can be grouped
into investment factors, financing factors, operating factors. For each of the three groups discuss
specific factors that have been found to significantly explain bankruptcy.

ANS:
Investment factors:
1. Relative liquidity of a firm's assets - The higher the proportion of current assets relative to
current liabilities, the less likely the company will experience bankruptcy.
2. Rate of asset turnover - The faster that a company turns over its assets, the more quickly
funds work their way toward cash on the balance and the less chance that the company will
experience bankruptcy.

Financing factors:
1. Relative proportion of debt in the capital structure - The higher the proportion of liabilities
in the capital structure, the more likely the company will experience bankruptcy.
2. Relative proportion of short-term debt in the capital structure - Just as in the above factor,
the higher the proportion of short-term liabilities in the capital structure that will be
coming due within one fiscal period, the more likely the company will experience
bankruptcy.

Operating factors:
1. Relative level of profitability - Because profitable firms ultimately turn profits into cash,
they are less likely to experience bankruptcy.
2. Variability of operations - Firms that experience a cyclical sales pattern are often more at
risk for bankruptcy due to their need for cash during the down times in the cycle, which
may extend beyond the point of safety.

PTS: 1

5. In the empirical research on earnings manipulation discussed in the chapter a number of firm
characteristics are found to be associated with the likelihood of engaging in earnings manipulation. For
each of the characteristics listed below, discuss the rationale for their inclusion in the model:

a. Gross Margin Index

b. Asset Quality Index
c. Sales Growth Index
d. Depreciation Index
e. Leverage Index

ANS:
a. Gross Margin Index - Firms with weaker profitability in a given year are more likely to
engage in earnings manipulation in the future.
b. Asset Quality Index - Represents the proportion of total assets comprising assets other than
current assets and PP&E and investments in securities. The index represents the proportion
of lower quality assets relative to the prior year. An increase in this factor suggests the
company may be trying to capitalize and defer costs that should have been expensed.

5-14
 c. Sales Growth Index - Sales growth this period relative to the prior period. The need for low
cost external financing might motivate managers to manipulate earnings and sales.
d. Depreciation Index - Depreciation expense as a proportion of PP&E before depreciation,
this period relative to the prior period. A higher ratio implies that the company has slowed
down its rate of depreciation resulting in increased earnings.
e. Leverage Index - The proportion of total financing comprised of current liabilities and
long-term debt for the current year relative to the prior period. An increase in the
proportion of debt puts the company at greater risk of violating debt covenants and needing
to manipulate earnings and sales.

PTS: 1

6. The main ratio used by many financial analysts to examine a company's short-term liquidity risk is the
current ratio. However, there are a number of problems that arise when this ratio is used to examine
short-term liquidity risk that may make the current ratio less useful than initially thought. Discuss the
interpretative problems of using the current ratio.

ANS:
There are a number of interpretative problems with using the current ratio as a measure of short-term
liquidity risk:

1. One of the main inputs into the numerator, inventories, is stated at acquisition cost, which
is an amount less than what the company should expect the asset to generate in sales
dollars. This will result in understating the current ratio.
2. When the current ratio is above one, an equal increase in current assets and current
liabilities will result in a decrease in the ratio. This is opposite the result if the current ratio
is below one. This makes analysis difficult.
3. A very high current ratio may not be the result of prosperous business conditions, while a
decreasing current ratio may end up being good news. The current ratio must be examined
within the context of the total business.
4. The current ratio is susceptible to "window dressing." At fiscal period ends, managers can
take steps to improve the current ratio without actually improving the business.

PTS: 1

7. For each of the following factors, determine if the given change or level of that factor would lead an
analyst to believe that managers of a firm are more or less likely to engage in earnings manipulation:

Earnings Manipulation
More likely/less likely
1. Days Sales in Receivable Index increases
2. Gross Margin index decreases below 1
3. Asset Quality index increases
4. Depreciation index decreases to below 1
5. Leverage Index increases

ANS:

Earnings Manipulation
More likely/less likely
1. Days Sales in Receivable Index increases more likely
2. Gross Margin index decreases below 1 less likely

5-15
 3. Asset Quality index increases more likely
4. Depreciation index decreases to below 1 less likely
5. Leverage Index increases more likely

PTS: 1

8. One criticism of the interest and fixed charges coverage ratios as measures of long-term solvency risk
is that they use earnings rather than cash flows in the numerator. Detail how the interest coverage ratio
and fixed charges coverage ratio are calculated. In addition, discuss why using earnings in the
numerator is a problem and what method could be used to alleviate this problem.

ANS:
Net Income + Interest Expense
Interest Coverage Ratio = + Income Tax Expense + Minority Interest in Earnings
Interest Expense

If a firm must make other required periodic payments (for example, pensions, leases), then the analyst
could include these amounts in the calculation as well. If so, the analyst refers to the ratio as the fixed
charges coverage ratio.

One criticism of the interest and the fixed charges coverage ratios as measures of long-term solvency
risk is that they use earnings rather than cash flows in the numerator. Firms pay interest and other fixed
charges with cash, not with earnings. The analyst can create cash-flow-based variations of these
coverage ratios by using cash flow from operations (before interest and income taxes) in the
numerator.

PTS: 1

9. For each of the following scenarios, determine if it is an indicator of potential cash flow problems:

Potential future cash

flow problems
Yes/No
a. Growth in accounts receivable or inventories that is less
the growth rate in sales.
b. Increases in accounts payable that exceed the increase in
inventories.
c. Capital expenditures that substantially exceed cash flow
from operations.
d. Sales of marketable securities are less than purchases of
marketable securities.
e. Other operating current liabilities that grow at a lesser
rate than sales.
f. A reduction or elimination of dividend payments
g. A substantial shift from long-term borrowing to short-
term borrowing.

ANS:
Potential future cash
flow problems

5-16
 Yes/No
a. Growth in accounts receivable or inventories that is less No
the growth rate in sales.
b. Increases in accounts payable that exceed the increase in Yes
inventories.
c. Capital expenditures that substantially exceed cash flow Yes
from operations.
d. Sales of marketable securities are less than purchases of No
marketable securities.
e. Other operating current liabilities that grow at a lesser No
rate than sales.
f. A reduction or elimination of dividend payments Yes
g. A substantial shift from long-term borrowing to short- Yes
term borrowing.

PTS: 1

10. Discuss the differences between Chapter 7 and Chapter 11 bankruptcy filings?

ANS:
Under Chapter 11, firms have six months in which to present a plan of reorganization to the court.
After that period elapses, creditors, employees, and others can file their plans of reorganization. One
such plan might include immediately selling the assets of the business and paying creditors the
amounts due. The court decides which plan provides the fairest treatment for all parties concerned.
While in bankruptcy, creditors cannot demand payment of their claims. The court oversees the
execution of the reorganization. When the court determines that the firm has executed the plan of
reorganization successfully and appears to be a viable entity, the firm is released from bankruptcy.

A Chapter 7 filing entails an immediate sale, or liquidation, of the firm’s assets and a distribution of
the proceeds to the various claimants in the order of their priority.

PTS: 1
11. What is the effect of the declaration of diviends have on the liquidity of a corporation?
ANS: When dividends are declared retained earnings is debited for the amount of the dividends and a
current liability is established. Increases in liabilities will lower the current ratio. When the dividends
are paid in cash there will be no effect on the working capital as an asset and a liability will decrease
by the same amount.

PROBLEM

1. Given the following information, calculate for Year 2 the number of days of working capital financing
the firm will need to obtain from other sources?

Year 1 Year 2
Accounts Receivable, net $ 518 $ 562
Accounts Payable 203 192
Inventory 535 564

Credit Sales 3,205 3,636

Cost of Goods Sold 2,037 2,294

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 Selling and Admin. Expense 1,081 1,131

ANS:
The student will need to calculate the number of days in receivables, inventory, and accounts payable.

Days in Receivables = 365 days / $3,636 / [(518 + 562)/2] = 54.21 days

Days in Inventory = 365 days / $2,294 / [(535 + 564)/2] = 87.43 days
Days in Payables = 365 days / ($2,294 +564 - 535) / [(203 + 192)/2] = 31.03 days

Days of working capital financing the firm will need to obtain from other sources = 110.61 days

PTS: 1

2. Refer to the financial statement data for Patriot Corp. for 2011 and 2010. Complete the table by
computing the ratios.

Patriot Corp.
Balance Sheet
As of December 31, 2011 2010
Assets:
Cash and Cash Equivalents $ 69,000 $ 55,250
Accounts Receivable 126,500 80,750
Inventory 92,000 63,750
Current Assets 287,500 199,750

Equipment 194,063 148,750

Less: Accumulated depreciation -38,813 -29,750
Equipment-Net 155,250 119,000
Land 132,250 106,250

Total assets: $575,000 $425,000

Liabilities:
Accounts Payable $ 69,000 $ 42,500
Accrued Salaries Payable 51,750 42,500
Rent Expense Payable 35,750 28,500
Income Tax Payable 4,788 1,250
Current Liabilities 161,288 114,750

Long-term note payable 172,500 102,000

Total Liabilities 333,788 216,750

Stockholders’ Equity:
Common stock 115,000 89,250
Retained earnings 126,212 119,000

Total liabilities and stockholders’ equity: $575,000 $425,000

Patriot Corp.
Income Statement
For the year ended December 31, 2011

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Revenues $ 373,750
Cost of goods sold (224,250)
Gross Profit $149,500

Operating Expenses
Depreciation expense (9,062)
Salary expense (56,063)
Insurance Expense (44,850)
Rent Expense (18,688)
Interest Expense (6,120)
Total Operating Expenses (134,783)

Income from Operations 14,717

Income Tax Expense (4415)

Net income $ 10,302

Dividends paid to Common Shareholders $ 3,090

Financial Ratio to be calculated:

2011 2010
Current Ratio
Quick Ratio
Days Accounts Receivable N/A
Days Inventory N/A
Days Accounts Payable N/A
Net Days Working Capital N/A
Long-term Debt to Long-term Capital Ratio
Long-term Debt to Shareholders’ Equity ratio
Liabilities to Total Assets
Interest Coverage ratio N/A
N/A - Not Applicable for the given year

ANS:
2011 2010
Current Ratio 1.78 1.74
Quick Ratio 1.21 1.19
Days Accounts Receivable 101.20 N/A
Days Inventory 126.75 N/A
Days Accounts Payable 80.59 N/A
Net Days Working Capital 147.36 N/A
Long-term Debt to Long-term Capital Ratio 41.70% 32.88%
Long-term Debt to Shareholders’ Equity ratio 71.51% 48.98%
Liabilities to Total Assets 58.05% 51.00%
Interest Coverage Ratio 3.40 N/A
N/A - Not Applicable for the given year

PTS: 1

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3. Below is information from Darren Company’s 2012 financial statements.

As of Dec. 31, 2012 Dec. 31, 2011

Cash and short-term investments $ 958,245 $ 745,800
Accounts Receivable (net) 125,850 135,400
Inventories 195,650 175,840
Prepaid Expenses and other current assets 45,300 30,860
Total Current Assets $1,325,045 $1,087,900
Plant, Property and Equipment, net 1,478,320 1,358,700
Intangible Assets 125,600 120,400
Total Assets $2,928,965 $2,567,000

Short-term borrowings $ 25,190 $ 38,108

Current portion of long-term debt 45,000 40,000
Accounts payable 285,400 325,900
Accrued liabilities 916,722 705,891
Income taxes payable 125400 115600
Total Current Liabilities $1,397,712 $1,225,499
Long-term Debt 450,000 430,000
Total Liabilities $1,847,712 $1,655,499
Shareholders' Equity $1,081,253 $911,501
Total Liabilities and Shareholders' Equity $2,928,965 $2,567,000

Selected Income Statement Data - for the year ending December 31, 2012:
Net Sales $3,210,645
Cost of Goods Sold (2,310,210)
Operating Income 900,435
Net Income 324,850

Selected Statement of Cash Flow Data - for the year ending December 31, 2012:
Cash Flows from Operations $584,750
Interest Expense 42,400
Income Tax Expense 114,200

Using this information calculate the following ratios:

2012 2011
Liabilities to Assets Ratio
Liabilities to Shareholders' Equity Ratio
LT Debt to LT Capital Ratio
LT Debt to Shareholders' Equity Ratio

Interest Coverage Ratio N/A

Operating Cash Flow to Total Liabilities Ratio N/A

ANS:

2012 2011
Liabilities to Assets Ratio 63.1% 64.5%
Liabilities to Shareholders' Equity Ratio 170.9% 181.6%

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 LT Debt to LT Capital Ratio 31.4% 34.0%
LT Debt to Shareholders' Equity Ratio 45.8% 51.6%

Interest Coverage Ratio 11.35

Operating Cash Flow to Total Liabilities Ratio 33.38%

PTS: 1

4. Falcon Corporation has current assets of $400,000 and current liabilities of $275,000.
Required:
Compute the effect of each of the following transactions on Falcon's current ratio:
a. Refinanced a $60,000 long-term mortgage with a short-term note.
b. Purchasing $108,000 of merchandise inventory with short-term accounts payable.
c. Paying $50,000 of short-term accounts payable.
d. Collecting $90,000 of short-term accounts receivable.

ANS:
a. The refinancing of a $60,000 long-term mortgage with a short-term note would increase Falcon’s
current liabilities, decreasing the current ratio to 1.19 (= $400,000  $335,000).
b. Purchasing $108,000 of inventory with a short-term account payable would increase Falcon’s
current assets to $508,000, and increase the current liabilities to $383,000, making the current ratio
1.33.
c. Paying $50,000 of short-term accounts payable decreases both the current assets and liabilities by
$50,000, making the current ratio 1.56.
d. Collection of $90,000 of short-term accounts receivable has no effect on Falcon’s current ratio.

PTS: 1

5 A. Hammer Corporation wrote off $185,000 of obsolete inventory at December 31, 2011.
Required:
What effect did this write-off have on the company's 2011 current and quick ratios?

ANS:

The write-off of obsolete inventory would decrease Hammer Corporation's current assets, thus
decreasing the current ratio. The quick ratio would be unaffected by the inventory write-off because
the quick ratio takes only the most liquid assets (cash, marketable securities, and receivables) into
account.

5B. Assume that Hammer company did not write off their inventory. How will this affect the
company’s financial position?

ANS: If a company keeps obsolete inventory on the books they are artificially pumping up their
current ratio. Obsolete inventory cannot be sold and will not be contributing to a companies earnings.
This is considered a manipulation of the accounting information and if a company loans Hammer
company money based on the current ratio and the obsolete inventory and the company files
bankruptcy the company will be charged with fraud.

PTS: 1

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6. Selected risk ratios are presented for 2011 and 2010 for Techtron Company. Also, refer to the
financial statement data for the company.
2011 2010
Revenues to Cash Ratio 6.8 7.7
Days Revenues Held in Cash 54 47
Current Ratio 1.5 1.5
Quick Ratio 1.1 1.1
Operating Cash Flow to Average Current Liabilities
Ratio 47.3% 55.7%
Days Accounts Receivable 68 73
Days Inventory 51 68
Days Accounts Payable 47 49
Net Days Working Capital 72 91
Liabilities to Assets Ratio 0.559 0.621
Liabilities to Shareholders’ Equity Ratio 1.266 1.639
Long-Term Debt to Long-Term Capital Ratio 0.330 0.418
Long-Term Debt to Shareholders’ Equity Ratio 0.492 0.720
Operating Cash Flow to Total Liabilities Ratio 0.243 0.242
Interest Coverage Ratio 5.6 2.3

Financial Statements

INCOME STATEMENT (in millions)

Fiscal year end 2012 2011 2010

Sales $2,500 $ 3,139 $ 2,816
Cost of Goods Sold (1,252) (1,288) (1,099)
Selling, General & Admin. Exp.
Advertising (387) (364) (297)
Research and Development (157) (143) (154)
Royalty Expense (223) (248) (296)
Other Selling and Administrative (385) (799) (788)
Interest expense (32) (53) (78)
Income tax expense (64) (69) (29)
Net income $ 196 $ 175 $ 75

Balance Sheet
Fiscal year end 2012 2011 2010 2009
ASSETS (in millions)
Cash $ 625 $421 $ 496 $233
Accounts Receivable 579 607 555 572
Inventories 195 169 190 217
Prepayments 219 212 191 346
Total current assets $1,618 $1,409 $1,432 $1,368
Property, plant & equipment 207 200 213 236
Other Assets 1,416 1,554 1,498 1,765
Total assets $3,241 $3,163 $3,143 $3,369
LIABILITIES
Accounts payable $ 168 $ 159 $ 166 $ 123
Short-term borrowing 342 24 223 36
Other current liabilities 584 749 578 599

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Total current liabilities $1,094 $ 939 $ 967 $ 758
Long term debt 303 687 857 1,166
Other noncurrent liabilities 149 141 128 92
Total liabilities $1,546 $1,767 $1,952 $2,016

Common stock $ 105 $ 105 $ 105 $ 105

Additional Paid-in Capital 381 398 458 455
Retained earnings 1,776 1,558 1,430 1,622
Accumulated Other Comprehensive Income 82 30 (47) (68)
Treasury Stock (649) (695) (755) (761)
Total Shareholders' equity $1,695 $1,396 $1,191 $1,353
Total Liabilities & Shareholders’ Equity $3,241 $3,163 $3,143 $3,369

STATEMENT OF CASH FLOWS (in millions)

Operations 2012 2011 2010

Net Income $ 196 $ 175 $ 75
Depreciation & Amortization 146 164 184
(Increase) Decrease Accounts Receivables 28 (52) 17
(Increase) Decrease Inventories (26) 21 27
(Increase) Decrease Prepayments 7 (21) 155
(Decrease) Increase Accounts Payable & Other
Current Liabilities (90) 17 23
Net Addbacks and Subtractions from operations (147) 112 221
Cash flows from operations $ 195 $451 $480
Investing
Property Plant and Equipment acquired ($79) ($63) ($59)
Other Investing Transactions (6) (2) (3)
Cash Flows from Investing ($85) ($65) ($62)
Financing
Increase in Common Stock 0 0 0
Increase (Decrease) in Short-term Borrowing (318) 199 (187)
Increase (Decrease) in Long-term Borrowing (384) (170) 309
Acquisition of Common Stock (46) 60 (6)
Dividends (37) (21) (21)
Other Financing Transactions 879 243 (250)
Cash flow from Financing $94 ($311) ($155)
Change in Cash $204 $75 $263
Cash - Beginning of Year 421 496 233
Cash - End of Year $ 625 $ 421 $ 496

Required:
a. Calculate the amounts of these ratios for 2012.
b. Assess the changes in the short-term liquidity risk of Techtron between 2010 and
2012 and the level of that risk at the end of 2012.
c. Assess the changes in the long-term solvency risk of Techtron between 2010 and
2012 and the level of that risk at the end of 2012.

ANS:
a.

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 Calculations Answer
Revenues to Cash Ratio: $2,500/.5($421 + $625) = 4.8
Days Revenues in Cash: 365/4.8 = 76 days
Current Ratio $1,618/$1,094 = 1.5

Quick Ratio: ($625 + $579)/$1,094 = 1.1

Operating Cash Flow to $195/.5($939 + $1,094) = 0.192
Current Liabilities Ratio:

Days Accounts $2,500/.5($607 + $579) = 4.2

Receivable: 365/4.2 = 87 days
Days Inventory: $1,252/.5($169 + $195) = 6.9
365/6.9 = 53 days
Days Accounts Payable: ($1,252 + $195 – $169)/.5($159 + $168)
= 7.8
365/7.8 = 47 days
Net Days Working Capital: 87 + 53 – 47 = 78 days 93 days
Liabilities to Assets Ratio: $1,546/$3,241 = 0.477
Liabilities to Shareholders’ $1,546/$1,695 = 0.912
Equity Ratio:
Long-Term Debt Ratio to $303/($303 + $1,695) = 0.152
Long-Term Capital Ratio:

Long-Term Debt to $303/$1,695 = 0.179

Shareholders’ Equity
Ratio:
Operating Cash Flow to $195/$.5($1,767 + $1,546) = 0.118
Total Liabilities Ratio:

Interest Coverage Ratio: ($196 + $32 + $64)/$32 = 9.1

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 b.) The changes in the short-term liquidity risk ratios present mixed signals. Techtron has
built up its balance in cash so that it has more days of revenue held in cash. This trend
provides Techtron with liquidity and reduces its short-term liquidity risk. The current and
quick ratios were steady during the three years and at healthy levels. Again, these results
suggest low short-term liquidity risk. The operating cash flow to current liabilities ratio
declined, and by 2012, it was less than the 40 percent found for healthy companies. The
decrease in this ratio is the result of declining cash flow from operations and increasing
current liabilities. Net income increased each year so that the declining cash flow from
operations is the result of changes in non-cash revenues and expenses and in operating
working capital accounts. The financial statements indicate that the addback for depreciation
and amortization decreased during the three years. Depreciation and amortization do not
affect cash flows; the smaller addback simply offsets the smaller expense. Thus, changes in
depreciation and amortization do not explain the declining cash flow from operations. It
appears that the explanation lies primarily in a decrease in prepayments in 2010 and a
decrease in accounts payable and other current liabilities in 2012. The analyst would be
concerned with a decrease in current liabilities only if it signaled pressure from suppliers of
various goods and services to pay their amounts due. However, Techtron has more than
sufficient cash and accounts receivable to cover all current liabilities. The net days of
working capital declined sharply between 2010 and 2011 as a result of reducing the days
accounts receivable and inventory being held, a positive sign in terms of reducing short-term
liquidity risk. This occurred in a year when sales increased. The net days of working capital
increased again in 2012, a year in which sales decreased. It would not appear that Techtron is
unduly risky in terms of short-term liquidity risk at the end of 2012. Its current and quick
ratios are at healthy levels and its days inventory and accounts payable have been fairly steady
for the past two years. The only troublesome aspect is the declining operating cash flow to
current liabilities ratio. This ratio is a concern in 2012 and continuation of this trend could
become troublesome.

c. Techtron’s long-term solvency risk has decreased significantly during the three-year
period. Debt levels have declined as Techtron has redeemed debt. (See Techtron’s statement
of cash flow.) Its interest coverage ratio has increased from a worrisome level in 2010 to a very
healthy level in 2012. The latter occurred because of a reduction in borrowing and an increase
in net income. Its operating cash flow to total liabilities ratio was good in 2010 and 2011 but
has declined below the 20 percent threshold for a healthy company. The reduced debt offset
the declining cash flow from operations to provide a relatively stable cash flow ratio, but the
off-balance sheet financing transactions (see other financing transactions) and limited investing
transactions appear to have consequences for the level of long-term solvency risk at the end of
2012.

PTS: 1

7. Below is selected data of Pronto Company:

Balance Sheet Data As of December 31:

2012 2011
Accounts receivable $671,000 $642,000
Allowance for doubtful accounts 31,000 22,000
Net accounts receivable $640,000 $620,000

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 Inventories - LCM $542,500 $642,500

Income Statement Data

Net credit sales $3,150,000 $3,000,000
Net cash sales 800,000 600,000
Net sales $3,950,000 $3,600,000
Cost of goods sold $2,370,000 $2,160,000
Selling, general and adm. expenses 475,000 350,000
Other 150,000 125,000
Total operating expenses $2,995,000 $2,635,000
Net income $ 955,000 $ 965,000

Required:
a. What is the accounts receivable turnover for 2012?
b. What is the inventory turnover for 2012?

ANS:
a.) Accounts receivable turnover = 5.0 times.
b.) Inventory turnover = 4.0 times.
Calculations: Average trade receivables = ($640,000 + $620,000)  2 = $630,000
Accounts receivable turnover = Net credit sales  Average trade receivables = $3,150,000 
$630,000 = 5.0 times.
Average inventory = ($542,500 + $642,500)  2 = $592,500
Inventory turnover = Cost of goods sold  average inventory = $2,370,000  $592,500 = 4.0
times.

PTS: 1

8. On January 1, 2012, Deputron Company's beginning inventory was $600,000. During 2012,
the company purchased $2,600,000 of additional inventory, and on December 31, 2012
Creek's ending inventory was $565,000.

Required:
What was Deputron’s inventory turnover for 2012?

ANS:
4.5 times.
Calculations: Cost of goods sold = $600,000 + $2,600,000 - $565,000 = $2,635,000
Average inventory = ($600,000 + $565,000)  2 = $582,500
Inventory turnover = Cost of goods sold  average inventory = $2,635,000  $582,500 = 4.5
times.

PTS: 1

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 9. Caraway Company's net accounts receivable was $300,000 at December 31, 2012 and
$450,000 at December 31, 2013. Net cash sales for 2008 were $425,000. The accounts
receivable turnover for 2013 was 7.0, and this turnover figure was computed from net credit
sales for the year.

Required:
What were Caraway’s total net sales for 2013?

ANS:

$3,050,000

Calculations: Total net sales equals total credit sales plus total cash sales. The accounts
receivable ratio is used to find total credit sales. Average receivables = ($300,000 + $450,000)
 2 = $375,000. Accounts receivable turnover = Total credit sales  average receivables. 7.0 =
Total credit sales  $375,000. Total credit sales = $2,625,000. Total net sales = $2,625,000 +
$425,000 = $3,050,000

PTS: 1

10. Foxmoor Company's merchandise inventory and other related accounts for 2012 follow:
Sales $3,100,000
Cost of Goods Sold 2,153,200
Merchandise Inventory
Beginning of Year 850,000
End of Year 995,000

Required:
Calculate Foxmoor’s inventory turnover during 2012 assuming that the merchandise inventory buildup
was relatively constant during the year.

ANS:
3.1 times
Calculations: Average inventory = ( ($850,000+$995,000)  2 = $922,500
Inventory turnover = Cost of goods sold  Average inventory = $2,153,200/$922,500=2.33

PTS: 1

11. Bragdon Company is consistently profitable. Its normal financial statement relationships are as
follows:
Current ratio 3.5:1
Inventory turnover 4.5 times
Liabilities to assets ratio 0.8: 1

Required: Determine whether each transaction or event that follows increased, decreased or had no
effect on each ratio.

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1. Bragdon declared but did not pay a cash dividend.
2. Customers returned invoiced goods for which they had not paid.
3.Accounts payable were paid at year-end.
4. Bragdon recorded both a receivable from an insurance company and a loss on a building due to fire
damage.
5. Early in the year, Bragdon increased the selling price of one of its products because customer
demand far exceeded production capacity. The number of units sold this year was the same as last
year.

ANS:

1. Bragdon declared but did not pay a cash dividend:

This transaction would decrease the current ratio, have no effect on the inventory turnover ratio, and
increase the liabilities to assets ratio. Bragdon’s current liabilities are increased by the declaration of a
cash dividend.

2. Customers returned invoiced goods for which they had not paid:
If customers returned invoiced goods for which they had not paid, Bragdon’s current ratio and
inventory turnover would decrease, and the liabilities to assets ratio would increase.

3.Accounts payable were paid at year-end:

The payment of accounts payable would increase the current ratio, have no effect on inventory
turnover ratio, and decrease the liabilities to assets ratio.

4. Bragdon recorded both a receivable from an insurance company and a loss on a building due to fire
damage:
This transaction would increase the current ratio and the total liabilities to assets ratio, and have no
effect on inventory turnover.

5. Early in the year, Bragdon increased the selling price of one of its products because customer
demand far exceeded production capacity. The number of units sold this year was the same as last
year:
The increase in selling price would increase the current ratio, have no effect on inventory turnover, and
decrease the total debt/total asset ratio.

PTS: 1

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