ESSENTIALS OF CORPORATE FINANCE –TUTORIAL TWO

Tutorial Two: Working with Financial Statements

Chapter 3: Question 1, 2 page 83 (Concepts review and critical thinking)

1. Current Ratio [LO2]. What effect would the following actions have on a firm's current ratio'?
Assume that net working capital is positive.

a. Inventory is purchased.

b. A supplier is paid.

c. A short-term bank loan is repaid.

d. A long-term debt is paid off early.

e. A customer pays off a credit account.

f. Inventory is sold at cost.

g. Inventory is sold for a profit.

Solution:

(a) NWC is unchanged. If inventory is purchased with cash, then there is no change

in the current ratio. If inventory is purchased on credit, then there is a decrease

in the current ratio if it was initially greater than 1.0.

(b) NWC is unchanged. Reducing accounts payable with cash increases the current

ratio if it was initially greater than 1.0.

(c) NWC is unchanged. Reducing short-term debt with cash increases the current

ratio if it was initially greater than 1.0.

(d) NWC and current ratio decrease.

(e) NWC and current ratio are unchanged.

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(f) NWC and current ratio are unchanged.

(g) NWC and current ratio increase.

2. Current Ratio and quick ratio [LO2] In recent years, Dixie Co. greatly increased its current
ratio. At the same time, the quick ratio has fallen. What has happened? Has the liquidity of the
company improved?

Solution

The firm has increased its inventory relative to other current assets, assuming that level of
current liabilities mostly remained unchanged. As a result, liquidity has potentially decreased
because inventory is considered the least liquid among current assets.

Chapter 3: Questions 1, 2, 3, 4, 5, 6, 7 pages 84.

1. Calculating Liquidity Ratios [LO2]. SDJ, Inc., has net working capital of $2,710, current
liabilities of $3,950, and inventory of $ 3,420. What is the current ratio? What is the quick ratio?

Solution

NWC = CA – CL = 2710

CL = 3950

 CA = NWC + CL = 2710 + 3950 = 6660

Current ratio = CA/CL = 6660/3950 = 1.69

Quick ratio = (CA – Inventory)/CL = (6660 – 3420)/3950 = 0.82

2. Calculating Profitability Ratios [LO2]. Diamond Eyes, Inc., has sales of $18 million, total
assets of $15.6 million, and total debt of $6.3 million. If the profit margin is 8 percent, what is
net income? What is ROA? What is ROE?

Solution

Sales = $18M

TA = $15.6M; TD = $6.3M  TE = TA – TD = 15.6 – 6.3 = $9.3M

Profit margin = Net Income/Sales = 8%  Net Income (NI) = 8% x 18 = $1.44M

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ROA = NI/TA = 1.44/15.6 = 9.23%

ROE = NI/TE = 1.44/9.3 = 15.48%

3. Calculating the Average Collection Period [LO2]. Boom Lay Corp. has a current accounts
receivable balance of $327,815. Credit sales for the year just ended were $4,238,720. What is
the receivables turnover? The days' sales in receivables? How long did it take on average for
credit customers to pay off their accounts during the past year?

Solution

AR = $327,815; Credit sales = $4,238,720 Receivables turnover = Sales/AR = 12.93 times

Days’ sales in receivables = 365/ Receivables turnover = 28.23 days

The average collection period for an outstanding accounts receivable was 28.23 days.

4. Calculating Inventory Turnover [LO2]. The Cape Corporation has ending inventory of
$483,167, and cost of goods sold for the year just ended was $4,285,131. What is the inventory
turnover? The days' sales in inventory? How long on average did a unit of inventory sit on the
shelf before it was sold?

Solution

Ending inventory = $483,167; COGS = $4,285,131  Inventory turnover = COGS/Inventory=8.87

Days’ sales in inventory = 365/ Inventory turnover = 41.16 days

On average, a unit of inventory sat on the shelf 41.16 days.

5. Calculating Leverage Ratios [LO2]. Perry, Inc., has a total debt ratio of .46. What is its debt-
equity ratio? What is its equity multiplier?

Solution

Total debt ratio = (TA – TE)/TE = 1 – TE/TA = 0.46  TE/TA = 1 - 0.46 = 0.54

 TA/TE (Equity multiplier) = 1/0.54 = 1.85

TA/TE = 1+ D/E  D/E = TA/TE – 1 = 0.85

6. Calculating Market Value Ratios [LO2]. That Wich Corp. had additions to retained earnings
for the year just ended of $375,000. The firm paid out $175,000 in cash dividends, and it has
ending total equity of $4.8 million. If the company currently has 145,000 shares of common
stock outstanding. What are earnings per share? Dividends per share? What is book value per

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share? If the stock currently sells for $79 per share, what is the market-to-book ratio? The
price-earnings ratio? If total sales were $4.7 million, what is the price-sales ratio?

Solution

Additions to retained earnings = $375,000; Dividends = $175,000

 Net Income = Additions to retained earnings + Dividends = $550,000

EPS = NI/number of shares outstanding = 550,000/145,000 = $3.79 per share

Dividends per share = Dividends/ number of shares outstanding = 175/145 = $1.21 per share

Book value per share = TE/ number of shares outstanding = 4,800,000/145,000 = $33.10 per
share

Market-to-book = Price per share/Book value per share= 79/33.1 = 2.39

P/E ratio = Price per share/EPS = 79/3.79 = 20.83 times

Price/Sales ratio = 79/4,700,000/145,000 = 2.44 times

7. Du Pont Identity [LO4]. If Roten Rooters, Inc., has an equity multiplier of 1.45, total asset
turnover of 1.8, and a profit margin of 5.5 percent, what is its ROE?

Solution

ROE = Profit margin x TA turnover x Equity Multiplier

= 5.5% x 1.8 x 1.45

= 14.36%

Chapter 3: Questions 13, 14, 15, 16, 17, 18 pages 85-86

Just Dew It Corporation reports the following balance sheet information for 2011 and 2012. Use
this information to work Problems 13 through 17.

JUST DEW IT CORPORATION (2011 and 2012 Balance Sheet)

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2011 2012 2011 2012

Current Assets Current liabilities
Cash $ 9,279 $ 11,173 Accounts payable $ 41,060 $ 43,805
Accounts receivable 23,683 25,760 Notes payable 16,157 16,843
Inventory 42,636 46,915 Total $ 57,217 $ 60,648
Total $ 75,598 $ 83,848
Long-term debt $ 40,000 $ 35,000

Owners' equity
Common stock and
paid-in surplus $ 50,000 $ 50,000
Retained earnings 200,428 236,167
Net plant and equipment $ 272,047 $ 297,967 Total $ 250,428 $ 286,167

Total liabilities and

Total assets $ 347,645 $ 381,815 owners' equity $ 347,645 $ 381,815

13. Preparing Standardized Financial Statements [LO1]. Prepare the 2011 and 2012 common-
size balance sheets for Just Dew It.
14. Preparing Standardized Financial Statements [LO1]. Prepare the 2012 common-base
balance sheets for Just Dew It.
15. Preparing Standardized Financial Statements [LO1]. Prepare the 2012 combined common-
size, common-base balance sheets for Just Dew It.
2011 #13 2012 #13 #14 #15
Assets
Current assets
Cash $ 9,279 2.67% $ 11,173 2.93% 1.2041 1.0964
Accounts receivable 23,683 6.81% 25,760 6.75% 1.0877 0.9904
Inventory 42,636 12.26% 46,915 12.29% 1.1004 1.0019
Total $ 75,598 21.75% $ 83,848 21.96% 1.1091 1.0099
Fixed assets
Net plant and equipment $ 272,047 78.25% $ 297,967 78.04% 1.0953 0.9973
Total assets $ 347,645 100% $ 381,815 100% 1.0983 1.0000

Liabilites and Owners' Equity

Current liabilities
Accounts payable $ 41,060 11.81% $ 43,805 11.47% 1.0669 0.9714
Notes payable 16,157 4.65% 16,843 4.41% 1.0425 0.9492
Total $ 57,217 16.46% $ 60,648 15.88% 1.0600 0.9651
Long-term debt $ 40,000 11.51% $ 35,000 9.17% 0.8750 0.7967
Owners' equity
Common stock and paid-in surplus $ 50,000 14.38% $ 50,000 13.10% 1.0000 0.9105
Accumulated retained earnings 200,428 57.65% 236,167 61.85% 1.1783 1.0729
Total $ 250,428 72.04% $ 286,167 74.95% 1.1427 1.0404
Total liabilities and owners' equity $ 347,645 100% $ 381,815 100% 1.0983 1.0000

16. Sources and Uses of Cash [LO4] For each account on this company’s balance sheet, show
the change in the account during 2012 and note whether this change was a source or use of

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cash. Do your numbers add up and make sense? Explain your answer for total assets as
compared to your answer for total liabilities and owners’ equity.

2011 Sources/Uses 2012

Assets
Current assets
Cash $ 9,279 $ 1,894 U $ 11,173
Accounts receivable 23,683 2,077 U 25,760
Inventory 42,636 4,279 U 46,915
Total $ 75,598 $ 8,250 U $ 83,848
Fixed assets
Net plant and equipment $ 272,047 $ 25,920 U $ 297,967
Total assets $ 347,645 $ 34,170 U $ 381,815

Liabilites and Owners' Equity

Current liabilities
Accounts payable $ 41,060 $ 2,745 S $ 43,805
Notes payable 16,157 686 S 16,843
Total $ 57,217 $ 3,431 S $ 60,648
Long-term debt $ 40,000 $ (5,000) U $ 35,000
Owners' equity
Common stock and paid-in surplus $ 50,000 0 $ 50,000
Accumulated retained earnings 200,428 35,739 S 236,167
Total $ 250,428 $ 35,739 S $ 286,167
Total liabilities and owners' equity $ 347,645 $ 34,170 S $ 381,815

The firm used

$ 34,170 in cash to acquire new assets. It raised this amount of cash
by increasing liabilities and owners' equity by the same amount. In particular, the
needed frunds were raised entirely by internal financing (on a net basis), out of the
additions to retained earnings, and increase in the current liabilities, and by an issue
of long-term debt.

17. Calculating Financial Ratios [LO2]. Based on the balance sheets given for Just Dew It,
calculate the following financial ratios for each year:
a. Current ratio
b. Quick ratio
c. Cash ratio
d. NWC to total assets ratio
e. Debt-equity ratio and equity Multiplier
f. Total debt ratio and long-term debt ratio.

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2011 2012
a. Current ratio 1.32 1.38
b. Quick ratio 0.58 0.61
c. Cash ratio 0.16 0.18
d. NWC to total assets ratio 5.29% 6.08%
e. Debt-equity 0.39 0.33
Equity mulitplier 1.39 1.33
f. Total debt ratio 0.28 0.25
Long-term debt ratio 0.14 0.11

18. Du Pont Identity [LO3]. Y3K, Inc., has sales of $6,189, total assets of $2,805, and a debt-
equity ratio of 1.40. If its return on equity is 13 percent, what is its net income?

D/E ratio = 1.4; D+ E = 1

 E = 41.667% => total assets/total equity (Equity multiplier) = 1/0.41667= 2.4

ROE = Profit margin x TA turnover x Equity Multiplier

13% = profit margin x sales/total assets x total assets/total equity

13% = profit margin x 6189/2805 x 2.4

 Profit margin = 0.0245

 Net income = profit margin x sales = 151.63

Participation:

Discussion on: “book cooking”, the cases of Enron 2001 and WorldCom 2002

Enron, 2001

Prior to this debacle, Enron, a Houston-based energy trading company was, based on revenue,
the seventh largest company in the U.S. Through some fairly complicated accounting practices
that involved the use of shell companies, Enron was able to keep hundreds of millions worth of
debt off its books. Doing so fooled investors and analysts into thinking this company was more
fundamentally stable, than it actually was. Additionally, the shell companies, run by Enron

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executives, recorded fictitious revenues, essentially recording one dollar of revenue, multiple
times, thus create the appearance of incredible earnings figures.

Eventually, the complex web of deceit unraveled and the share price dove from over $90 to less
than 70 cents. As Enron fell, it took down with it Arthur Andersen, the fifth leading accounting
firm in the world at the time. Andersen, Enron's auditor, basically imploded after David Duncan,
Enron's chief auditor, ordered the shredding of thousands of documents. The fiasco at Enron
made the phrase "cook the books" a household term, once again.

WorldCom, 2002

Not long after the collapse of Enron, the equities market was rocked by another billion-dollar
accounting scandal. Telecommunications giant WorldCom came under intense scrutiny after yet
another instance of some serious "book cooking." WorldCom recorded operating expenses as
investments. Apparently, the company felt that office pens, pencils and paper were an
investment in the future of the company and, therefore, expensed (or capitalized) the cost of
these items over a number of years.

In total, $3.8 billion worth of normal operating expenses, which should all be recorded as
expenses for the fiscal year in which they were incurred, were treated as investments and were
recorded over a number of years. This little accounting trick grossly exaggerated profits for the
year the expenses were incurred; in 2001, WorldCom reported profits of around $1.3 billion. In
fact, its business was becoming increasingly unprofitable. Who suffered the most in this deal?
The employees; tens of thousands of them lost their jobs. The next ones to feel the betrayal
were the investors who had to watch the gut-wrenching downfall of WorldCom's stock price, as
it plummeted from more than $60 to less than 20 cents.

Source: http://www.investopedia.com/articles/00/100900.asp

1) What technique (or “trick”) was used to cook the book?

2) Give some cautions when analyzing the financial statements?

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Page 77. Book 3/ level 1

http://www.sec.gov/litigation/complaints/comp17829.htm

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