Integrated

Case XYZ, Inc.

Financial Statements and Taxes

Marco Xavier, a 2007 graduate of the Florida Atlantic University with 4 years of banking
experience, was recently brought in as assistant to the chairperson of the Board of XYZ, Inc., a
small food producer that operates in South Florida and whose specialty is high-quality pecan
and other nut products sold in the snack foods market. XYZ president, Savior Yadkin’s, decided
in 2011 to undertake a major expansion and to “go national” in competition with Toasted Lays,
Fried Almonds, and other major snack foods companies. Yadkin’s believed that XYZ’s products
were of higher quality than the competitors; that this quality differential would enable it to
charge a premium price; and that the end result would be greatly increased sales, profits, and
stock price.

The company doubled its plant capacity, opened new sales offices outside its home
territory, and launched an expensive advertising campaign. XYZ’s results were not satisfactory,
to put it mildly. Its board of directors, which consisted of its president, vice president, and major
shareholders (who were all local business people), was most upset when directors learned how
the expansion was going. Unhappy suppliers were being paid late; and the bank was
complaining about the deteriorating situation, threatening to cut off credit. As a result, Yadkin
was informed that changes would have to be made—and quickly; otherwise, he would be fired.
Also, at the board’s insistence, Marco Xavier was brought in and given the job of assistant to
Frizzy Zami, a retired banker who was XYZ’s chairperson and largest shareholder. Zami agreed
to give up a few of her physical fitness days and help nurse the company back to health, with
Xavier’s help.

Xavier began by gathering the financial statements and other data given in Tables 3.1, 3.2,
3.3, and 3.4. Assume that you are Xavier’s assistant.

You must help him answer the following questions for Frizzy. Provide clear
explanations
Table 3.1
Statement of Financial Position

2012 2011
Assets
Cash P 7,282 P 57,600
Accounts receivable 632,160 351,200
Inventories _1,287,360 715,200
Total current assets P1,926,802 P1,124,000
Gross fixed assets 1,202,950 491,000
Less accumulated depreciation 263,160 146,200
Net fixed assets P 939,790 P 344,800
Total assets P2,866,592 P1,468,800

Liabilities and Equity

Accounts payable P 524,160 P 145,600
Notes payable 636,808 200,000
Accruals 489,600 136,000
Total current liabilities P1,650,568 P 481,600
Long-term debt 723,432 323,432
Ordinary share capital (100,000 shares) 460,000 460,000
Retained earnings 32,592 203,768
Total equity P 492,592 P 663,768
Total liabilities and equity P2,866,592 P1,468,800
Table 3.2
Income Statements
2012 2011
Sales P6,034,000 P3,432,000
Cost of goods sold 5,528,000 2,864,000
Other expenses 519,988 358,672
Total operating costs excluding
depreciation and amortization P6,047,988 P3,222,672
Depreciation and amortization 116,960 18,900
EBIT P( 130,948) P 190,428
Interest expense 136,012 43,828
EBT P( 266,960) P 146,600
Taxes (40%) (106,784)a 58,640
Net income(net loss) P( 160,176) P 87,960

Earnings Per Share P( 1.602) P 0.880

Dividend Per Share P 0.110 P 0.220
Book value per share P 4.926 P 6.638
Share price P 2.25 P 8.50
Shares outstanding 100,000 100,000
Tax rate 40.00% 40.00%
Lease payments P 40,000 P 40,000
Sinking fund payments 0 0
Note:
a
The firm had sufficient taxable income in 2010 and 2011 to obtain its full tax refund in 2012.
Table 3.3
Statement of Changes in Shareholders’ Equity, 2012
Total
Ordinary Share Capital Retained Shareholders
Shares Amount Earnings ’
Equity
Balances, 12/31/11 100,000 P460,000 P203,768 P663,768
2012 Net Income(Loss) (160,176)
Cash Dividends (11,000)
Addition (Subtraction)
to Retained Earnings (171,176)
Balances, 12/31/12 100,000 P460,000 P 32,592 P492,592

Table 3.4
Statement of Cash Flows, 2012
Operating
Activities Net P(160,176)
income(loss)
Depreciation and amortization 116,960
Increase in accounts payable 378,560
Increase in accrued expenses 353,600
Increase in accounts receivable (280,960)
Increase in inventories (572,160)
Net cash provided by operating activities P(164,176)

Investing Activities
Additions to property, plant, and equipment P(711,950)
Net cash used in investing activities P(711,950)

Financing Activities
Increase in notes P436,808
payable
Increase in long-term debt 400,000
Payment of cash dividends (11,000)
 Net cash provided by financing activities P825,808

Summary
Net increase (decrease) in cash P( 50,318)
Cash at beginning of year 57,600
Cash at end of year P 7,282

QUESTIONS:

1. What effect did the expansion have on sales, after-tax operating income, net operating working capital
(NOWC), and net income? (Hint: NOWC = Current Assets – Current Liabilities)
2. What effect did the company’s expansion have on its free cash flow?
3. XYZ Inc. purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30
days of receipt. Judging from its 2012 statement of financial position, do you think that XYZ pays suppliers
on time? Explain, including what problems might occur if suppliers are not paid in a timely manner.

4. XYZ, Inc. spends money for labor, materials, and fixed assets (depreciation) to make products—and
spends still more money to sell those products. Then the firm makes sales that result in receivables, which
eventually result in cash inflows. Does it appear that XYZ’s sales price exceeds its costs per unit sold?
How does this affect the cash balance?

5. Suppose XYZ’s sales manager told the sales staff to start offering 60-day credit terms rather than the
30-day terms now being offered. XYZ’s competitors react by offering similar terms, so sales remain
constant. What effect would this have on the cash account? How would the cash account be affected if
sales doubled as a result of the credit policy change?

6. Can you imagine a situation in which the sales price exceeds the cost of producing and selling a unit of
output, yet a dramatic increase in sales volume causes the cash balance to decline? Explain.

7. Did XYZ, Inc. finance its expansion program with internally generated funds (additions to retained earnings
plus depreciation) or with external capital? How does the choice of financing affect the company’s
financial strength?
8. Refer to Tables 3.2 and IC 3.4. Suppose XYZ, Inc. broke even (Hint: To break even means no income and no
loss) in 2012 in the sense that sales revenues equaled total operating costs plus interest charges. Would
the asset expansion have caused the company to experience a cash shortage that required it to raise
external capital? Explain.

9. If XYZ, Inc. starts depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the
physical stock of assets, (2) the statement of financial position account for fixed assets, (3) the company’s
reported net income, and (4) the company’s cash position? Assume that the same depreciation method is
used for shareholder reporting and for tax calculations, and that the accounting change has no effect on
assets’ physical lives.

10. Explain how earnings per share, dividends per share, and book value per share are calculated and what
they mean. Why does the market price per share not equal the book value per share?

11. Explain briefly the tax treatment of (a) interest and dividends paid, (b) interest earned and dividends
received,
(c) capital gains, and (d) tax loss carry-backs and carry-forwards. How might each of these items affect
XYZ’s taxes?

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Answer:

1. Comparing 2012 with 2011, sales have increased by almost 76%, from P3,432,000 to P6,034,000,
which is a significant growth due to the expansion efforts. But even if the sales increased significantly, it is
still notable that the after-tax operating income turned negative in 2012, indicating a loss of P266,960
compared to a profit of P146,600 in 2011. This outcome implies that XYZ Inc. did not generate enough
profits to cover the increased costs associated with the expansion.

Net Operating Working Capital (NOWC) decreased from P642,400 in 2011 to P276,234 in 2012. This decrease has a
positive and negative impact on XYZ Inc. This indicates efficient management of current assets and liabilities and suggests
that the company is effectively utilizing its resources to generate revenue without tying up excessive funds in non-productive
assets. On the other hand, A significant reduction in working capital may indicate liquidity constraints, making it challenging
for the company to meet short-term obligations which happened to XYZ Inc. wherein suppliers were being paid late.

Despite expansion, XYZ's financial results have been unsatisfactory, as evidenced by declining net income from P87,960 in
2011 to net loss of P160,176 in 2012. While lower net income during expansion is not uncommon for growing companies, it
is essential to assess its impact on the company's long-term viability and sustainability. Strategic adjustments and prudent
financial management are crucial to navigate through challenging periods and achieve successful growth.

2. The company's expansion resulted in a negative Free Cash Flow of P547,774. This means that the cash
generated from operating activities (P164,176) was not enough to cover the spending on new property,
equipment, and facilities (P711,950). While it's normal for growing companies like XYZ Inc. to have
negative Free Cash Flow due to investments in expanding production, continuous negative Free Cash
Flow could signal financial concerns. It might make it challenging for the company to meet immediate
expenses or handle unexpected costs. It may also affect the company's creditworthiness and access to
financing which could also be the reason why the company faces credit risks with banks threatening to cut
off credit, highlighting financial instability and potential liquidity issues

3. Based on the 2012 financial statement, Accounts Payable rose sharply from P145,600 in 2011 to
P524,160 in 2012. This increase suggests that XYZ Inc. may not be paying its suppliers promptly, leading
to a growing amount owed to them. These late payments to suppliers can strain supplier relationships and
result in penalties or strained credit terms. Suppliers may also reduce credit or refuse to extend future
credit terms, affecting the company's ability to operate smoothly. Continuously, late payments can damage
the company's reputation and credibility in the industry, impacting future supplier relationships.
4.To determine whether XYZ, Inc.'s sales price exceeds its costs per unit sold, we look at the company's
Earnings Before Interest and Taxes and Net Income.

In 2011:

EBIT: P190,428 (positive, indicating operational profitability)

Net Income: P87,960 (positive)

These figures suggest that, in 2011, XYZ's sales price was exceeding the cost of producing and
selling their products since the company was able to generate a profit.

In 2012:

EBIT: P130,948 (negative, indicating operational losses)

Net Income: P160,176 (negative)

However, the situation in 2012 was different. The company incurred a loss, as indicated by negative
EBIT and Net Income. Despite higher sales, the costs of goods sold, other expenses, and depreciation
increased more proportionally, leading to operational losses. While the sales might cover the variable cost
per unit, when considering all costs, including fixed costs (such as depreciation), the sales price did not
cover the total cost per unit sold.

This financial situation has a direct impact on the cash balance:

❖ The increase in costs, while sales prices remain constant or do not increase proportionally, results
in reduced profitability and hence a lower cash inflow.

❖ The company's Statement of Cash Flows for 2012 shows a negative net cash provided by operating
activities (P164,176), which is a direct reflection of operational losses impacting the cash balance.

❖ Additionally, the Cash at the end of the year in 2012 was P7,282, markedly less than the beginning
balance, demonstrating that the cash balance was adversely affected overall during the fiscal year.

Therefore, the cash balance dips as a consequence of the sales price failing to cover all costs,
leading to a consumption of cash reserves, highlighting the requirement for effective cost management
and price setting strategies.

5. Offering a 60-day credit term instead of a 30-day term would decrease the cash in the cash account in
the short term.

Here's why:

❖ With a 30-day term, customers pay for their purchases 30 days after the sale.
❖ With a 60-day term, customers now have 60 days to pay, delaying the inflow of cash from sales.

This creates a temporary cash flow lag. The company will still collect the same amount for the sales eventually, but it
will receive the money 30 days later on average.

Impact on Cash Account with Sales Remaining Constant:

If sales remain constant, the amount of cash collected from customers will eventually catch up to the previous level
but with a delay. There will be a temporary decrease in the cash account balance until the outstanding receivables are
collected.

Impact on Cash Account with Doubled Sales:

If sales double due to the credit policy change, the effect on the cash account depends on how quickly the company
collects the receivables.

❖ Scenario 1: Slow Collections: In this scenario, if the company is slow to collect the receivables even with the
doubled sales volume, the cash account will experience a significant decrease. The outflow of cash for new
purchases (assuming credit is also purchased on a 60-day term) may even exceed the inflow of cash from
collections, leading to a cash flow shortage.

❖ Scenario 2: Fast Collections: If the company manages to collect the receivables quickly despite the extended credit
terms, the cash account might not experience a major decrease. The increased sales volume would be offset by the
faster collections, potentially leading to a similar or even increased cash balance.

In conclusion, the effect of the credit policy change on the cash account depends on the collection speed and
whether sales volume is impacted. A temporary decrease is likely in the short term, but the long-term impact depends on the
company's collection efficiency and sales response.
6. Scenario: Imagine XYZ Inc. whose specialty is high-quality pecan and other nut products sold in the
snack foods market. That their product is being sold for $50.00 for each Nut product with a cost of
production and sales ( including materials, labor, marketing and shipping) of $40.00 per unit. This
generates a healthy profit margin of $10 per Nut Product. Initially XYZ Inc. started small, selling a few
hundred Nut products per month. Their cash flow is positive as they receive $50.00 from each customer,
covering their $40.00 cost and leaving $10.00 profit. They can comfortably reinvest this profit back into the
business for marketing or inventory.

However, things get interesting when XYZ Inc. experiences a sudden surge in popularity. Their
marketing campaign goes viral, and they receive thousands of orders per month. While it seems a dream
come true, it creates a cash flow crunch.

Here’s why:

● Increased inventory needs: To fulfill the surge in orders, XYZ Inc. needs to purchase a much
larger quantity of raw materials upfront to produce the Nut Products. This ties up a significant
amount of cash inventory.
● Payment Terms: Most suppliers require payment terms, meaning XYZ Inc. might have to pay for
the raw materials before they receive customer payments. This creates a cash flow gap.
● Production Lead time: Even with efficient production, there might be a lead time between ordering
raw materials and producing the finished product. During this period, XYC Inc. incurs cost but hasn’t
received any customer cash.

The result: Declining Cash Balance

Solutions for XYZ Inc.

● Negotiate payment terms: They can try to negotiate extended payments terms with suppliers to
reduce the upfront cash outlay.
● Inventory Financing: Secure short-term financing to bridge the gap between material purchases and
customer payments.
● Demand forecasting: Improve demand forecasting to optimize inventory levels and maximize cash
tied up in excess stocks.

Conclusions:

This scenario highlights that a healthy profit margin doesn’t guarantee positive cash flow.
Companies experiencing rapid growth need to manage their working capital effectively to ensure they have
sufficient cash on hand to meet their obligations, even when sales are booming.
7. XYZ Inc. financed its expansion program with external capital because of an increase in Accounts
payable and Notes payable. Here’s the potential effect:

Positive Effects of Positive EWC:

● Improved Liquidity: A positive EWC indicates that a company's current assets (cash, receivables, inventory)
exceed its current liabilities (accounts payable, accrued expenses). This provides a buffer for unexpected expenses
and allows for smoother operations during expansion. The company has more resources readily available to invest
in growth opportunities.
● Stronger Creditworthiness: Positive EWC signifies better short-term debt repayment ability, making the company
more attractive to lenders and creditors. This can translate into favorable loan terms for financing expansion plans.
● Enhanced Operational Efficiency: Efficient management of EWC ensures optimal inventory levels and faster
collection of receivables. This frees up cash that can be used for expansion activities without sacrificing core
operations.

Negative Effects of Negative EWC:

● Liquidity Constraints: A negative EWC indicates that current liabilities exceed current assets. This can limit a
company's ability to meet short-term obligations, hindering its capacity to invest in expansion. The company might
struggle to access financing due to perceived higher risk.
● Operational Bottlenecks: Excessive inventory or slow receivables collection can tie up cash, hindering a
company's ability to invest in growth initiatives. This can also lead to storage costs and potential inventory
obsolescence.
● Vulnerability to Disruptions: A negative EWC makes a company more susceptible to external disruptions that
impact cash flow, such as delays in customer payments or supplier price increases. This can derail expansion
plans or force cutbacks.

Optimizing EWC for Expansion:

● Managing Inventory Levels: Maintaining optimal inventory levels reduces carrying costs and frees up cash for
expansion. Techniques like Just-in-Time (JIT) inventory management can be helpful.
● Efficient Receivables Collection: Implementing stricter credit policies, offering early payment discounts, and
streamlining collection processes can accelerate cash inflows.
● Negotiating Payment Terms: Negotiating favorable payment terms with suppliers can extend payment deadlines
and improve cash flow.
Conclusion:

Effective management of external working capital is crucial for a company's financial strength during expansion. By
maintaining a positive EWC, a company can ensure sufficient liquidity, improve creditworthiness, and optimize operational
efficiency. This creates a strong foundation for supporting growth initiatives and achieving long-term success.

8.

Asset expansion has a positive or negative impact on the company’s cash position depending on the strategic
financial decisions and priorities of the company’s management.

Assuming that XYZ, Inc. is operating at break-even, asset expansion would increase the company’s production
capacity resulting in an increase in inventory count which would lead to an increased sale. This would have a positive
impact on the cash inflow to the company.

On the other hand, asset expansion entails costs that if not properly managed could significantly reduce cash
reserves. Some of the asset expansion costs that will likely decrease cash reserves are (1) the cost of purchasing the
asset including interest (2) repairs and maintenance (3) an increase in utilities usage. These costs have a negative
impact on the cash flow of the company.

At break even, for XYZ, Inc. not to incur additional losses due to asset expansion, management should ensure that
the increase in contribution margin is higher than the increase in fixed cost due to expanding the assets.

Break-Even Point Formula:

· Break-Even Point (sales) = Fixed Cost / (Salling Price – Variable Cost)

· Break-Even Point (units) = Fixed Cost / (Sales Price per Unit – Variable Cost Per Unit)

The break-even point (BEP) is a critical measure of the business’s financial stability. It measures the level of
production or sales at which the company’s total sales equal its total cost. The break-even point (BEP) can be
measured at a specific period or on a particular product or service.
9.

a. If the fixed asset is depreciated over 7 years rather than 10 years, the physical stock of assets won’t be affected. The
impact of the change in depreciation method is largely on P&L due to the recognition of depreciation expense.

b. Changing the recognition of depreciation expense from 10 years to 7 years would mean an accelerated decrease in
the book value of the asset due to an increase in the recognition of accumulated depreciation.

If you refer to the table below, the company’s asset expansion at Year 3 for example is valued at Php 498,365.00 if
depreciated over 10 years. Since we changed the depreciation to 7 years, the book value is now at Php 406,828.57.
The impact in the Statement of Financial Position due to the change is decreased by Php 91,536.43 for year 3.

c. Changing the recognition of depreciation expense from 10 years to 7 years would mean an increase in depreciation
expense recognition for the year. The impact is a net decrease in the reported net income of the company due to the
change.

If you refer to the table below, in Year 3, the company will recognize Php 71,195.00 depreciation expense under 10
years depreciation period, on the other hand, it will recognize Php 101,707.14 depreciation if the company will
 depreciate the asset in 7 years. The impact is a Php 30,512.14 decrease in reported net income due to the change.

d. Depreciation has no direct impact on the company’s cash position. Depreciation however impacts tax calculation that
indirectly affects cash flow.

Higher depreciation expense means lower income tax payable for the company, on the other hand, lower
depreciation expense means higher income tax payable for the company.

10. Earnings Per Share (EPS):

EPS is a measure of a company's profitability on a per-share basis. It indicates how much profit the
company has generated for each outstanding share of common stock.
The formula to calculate EPS is:
EPS = Net Income /Weighted Average Number of Shares Outstanding

​ PS = (P160,176) / P100,000
E
EPS = (P1.602)

Net income is typically taken from the income statement, and the weighted average number of shares
outstanding is calculated by taking the average of the number of shares outstanding during the period.
EPS is important for investors as it provides insight into the company's profitability and can be used to
compare performance across different companies.
Dividends Per Share (DPS):
DPS is the portion of a company's earnings that is paid out to shareholders in the form of dividends on a
per-share basis.
The formula to calculate DPS is:
DPS= Total Dividends Paid/Number of Shares Outstanding
DPS = P11,000 / P100,000
DPS = P0.110

Total dividends paid can be obtained from the cash flow statement, and the number of shares outstanding
is usually the same as the number of ordinary shares outstanding.DPS is important for investors who rely
on dividends for income and can also signal the company's financial health and management's confidence
in its future prospects.

Book Value Per Share:

Book value per share represents the net asset value of a company on a per-share basis. It reflects the
amount of equity attributable to each outstanding share.
The formula to calculate book value per share is:
Book Value Per Share= Total Equity/Number of Shares Outstanding
​
BVPS = P492,592 / P100,000
BVPS = P4.926

Total equity can be obtained from the balance sheet, and the number of shares outstanding is usually the
same as the number of ordinary shares outstanding.Book value per share is important for investors as it
provides an indication of the intrinsic value of a company's shares. It represents what shareholders would
theoretically receive if the company were liquidated at its book value.
Now, regarding why the market price per share does not always equal the book value per share:

The market price per share is determined by supply and demand in the stock market, reflecting investors'
perceptions of the company's future earnings potential, growth prospects, and overall market conditions.
Market price per share can be influenced by factors such as investor sentiment, macroeconomic trends,
industry dynamics, and company-specific news or events.Book value per share, on the other hand, is
based on historical accounting data and may not fully capture intangible assets, such as brand value or
intellectual property, which can contribute significantly to a company's market value.
Discrepancies between market price and book value per share can occur due to market inefficiencies,
investor expectations, and the subjective nature of valuation. In many cases, the market price per share
trades at a premium or discount to book value per share based on these factors.
In summary, while EPS, DPS, and book value per share provide valuable insights into a company's
financial performance and value, market price per share reflects broader market dynamics and investor
perceptions, which may not always align with book value.

11.
Interest and Dividends Paid:
Interest paid by XYZ on debt is typically tax-deductible as a business expense, reducing taxable income.
Dividends paid by XYZ to its shareholders are not tax-deductible for the company and are instead
considered distributions of after-tax profits.For XYZ, Inc,the interest expense in 2012 was P136,012, which
would have reduced the company's taxable income by the same amount.

Interest Earned and Dividends Received:

Interest earned by XYZ on investments or cash holdings is generally considered taxable income and must
be reported on the company's tax return.For XYZ, Inc., there is no interest earned or dividends received
reported in the income statement for 2012.

Dividends received by XYZ from investments in other companies may qualify for special tax treatment,
such as the dividends received deduction or preferential tax rates, depending on various factors including
the type of investment and holding period.

Capital Gains:
Capital gains arise when XYZ sells assets, such as stocks or real estate, for more than their original
purchase price.
Depending on the holding period of the asset, capital gains may be subject to either short-term or
long-term capital gains tax rates, which are typically lower than ordinary income tax rates.
Capital losses can offset capital gains, reducing the overall tax liability.For XYZ, Inc., there is no capital
gains reported in the income statement for 2012

Tax Loss Carry-backs and Carry-forwards:

Tax loss carry-backs allow XYZ to apply current year net operating losses (NOLs) against past years'
taxable income, resulting in a refund of taxes paid in those years. Tax loss carry-forwards enable XYZ to
carry forward NOLs to future years and offset future taxable income, reducing future tax liabilities.
The availability and limitations of tax loss carry-backs and carry-forwards depend on tax regulations and
XYZ's specific financial situation.For XYZ, Inc., there is no mention of tax loss carry-backs or
carry-forwards in the income statement for 2012.

How these items might affect XYZ's taxes:

Interest paid by XYZ can reduce taxable income, thus lowering its tax liability.
Interest earned and dividends received are taxable income for XYZ, increasing its tax liability.
Capital gains or losses from asset sales can impact XYZ's taxable income, depending on the gains or
losses realized.Tax loss carry-backs and carry-forwards can help XYZ mitigate tax liabilities by offsetting
current or future taxable income with prior or future losses.Overall, understanding the tax treatment of
these items can help XYZ optimize its tax strategy and manage its tax liabilities effectively.