Chapter 16
“How Well Am I Doing?”
Financial Statement Analysis
Solutions to Questions
16-1 Horizontal analysis examines how a
particular item on a financial statement
such as sales or cost of goods sold
behaves over time. Vertical analysis
involves analysis of items on an income
statement or balance sheet for a single
period. In vertical analysis of the income
statement, all items are typically stated as
a percentage of sales. In vertical analysis
of the balance sheet, all items are
typically stated as a percentage of total
assets.
16-2 By looking at trends, an analyst
hopes to get some idea of whether a
situation is improving, remaining the
same, or deteriorating. Such analyses can
provide insight into what is likely to
happen in the future. Rather than looking
at trends, an analyst may compare one
company to another or to industry
averages using common-size financial
statements.
16-3 Price-earnings ratios reflect
investors’ expectations concerning future
earnings. The higher the price-earnings
ratio, the greater the growth in earnings
investors expect. For this reason, two

companies might have the same current
earnings and yet have quite different
price-earnings ratios. By definition, a stock
with current earnings of $4 and a priceearnings ratio of 20 would be selling for
$80 per share.
16-4 A rapidly growing tech company
would probably have many opportunities
to make investments at a rate of return
higher than stockholders could earn in

other investments. It would be better for
the company to invest in such
opportunities than to pay out dividends
and thus one would expect the company
to have a low dividend payout ratio.
16-5 The dividend yield is the dividend
per share divided by the market price per
share. The other source of return on an
investment in stock is increases in market
value.
16-6 Financial leverage results from
borrowing funds at an interest rate that
differs from the rate of return on assets
acquired using those funds. If the rate of
return on the assets is higher than the
interest rate at which the funds were
borrowed, financial leverage is positive
and stockholders gain. If the return on the
assets is lower than the interest rate,
financial leverage is negative and the

stockholders lose.
16-7 If the company experiences big
variations in net cash flows from
operations, stockholders might be pleased
that the company has no debt. In hard
times, interest payments might be very
difficult to meet.
On the other hand, if investments
within the company can earn a rate of
return that exceeds the interest rate on
debt, stockholders would get the benefits
of positive leverage if the company took
on debt.
16-8 The market value of a share of
common stock often exceeds the book
value per share. Book value represents the

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cumulative effects on the balance sheet of
past activities, evaluated using historical
prices. The market value of the stock
reflects investors’ expectations about the
company’s future earnings. For most
companies, market value exceeds book
value because investors anticipate future

earnings growth.
16-9 A 2 to 1 current ratio might not be
adequate for several reasons. First, the
composition of the current assets may be
heavily weighted toward slow-turning and
difficult-to-liquidate inventory, or the
inventory may contain large amounts of
obsolete goods. Second, the receivables
may be low quality, including large
amounts of accounts that may be difficult
to collect.

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Exercise 16-1 (15 minutes)
1.

Sales.................................................
Cost of goods sold.............................
Gross margin.....................................
Selling and administrative
expenses:
Selling expenses.............................
Administrative expenses................
Total selling and administrative
expenses........................................

Net operating income.......................
Interest expense...............................
Net income before taxes...................

This
Year
Last Year
100.0% 100.0%
62.3
58.6
37.7
41.4
18.5
8.9

18.2
10.3

27.4
10.3
1.2
9.1%

28.5
12.9
1.4
11.5%

2. The company’s major problem seems to be the increase in cost
of goods sold, which increased from 58.6% of sales last year to

62.3% of sales this year. This suggests that the company is not
passing the increases in costs of its products on to its
customers. As a result, cost of goods sold as a percentage of
sales has increased and gross margin has decreased. This
change has been offset somewhat by reduction in
administrative expenses as a percentage of sales. Note that
administrative expenses decreased from 10.3% to only 8.9% of
sales over the two years. However, this decrease was not
enough to completely offset the increased cost of goods sold,
so the company’s net income decreased as a percentage of
sales this year.

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142


Exercise 16-2 (30 minutes)
1. Calculation of the gross margin percentage:
Gross margin
Sales
$27,000
=
= 34.2%
$79,000

Gross margin percentage =

2. Calculation of the earnings per share:

Net income - Preferred dividends
Average number of common
shares outstanding
$3,540 - $120
=
= $4.28 per share
800 shares

Earnings per share =

3. Calculation of the price-earnings ratio:
Market price per share
Earnings per share
$18
=
= 4.2
$4.28

Price-earnings ratio =

4. Calculation of the dividend payout ratio:
Dividends per share
Earnings per share
$0.25
=
= 5.8%
$4.28

Dividend payout ratio =


5. Calculation of the dividend yield ratio:
Dividends per share
Market price per share
$0.25
=
= 1.4%
$18.00

Dividend yield ratio =

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Exercise 16-2 (continued)
6. Calculation of the return on total assets:
Beginning balance, total assets
(a)................................................. $45,960
Ending balance, total assets (b)..... 50,280
Average total assets [(a) + (b)]/2... $48,120
Net income +
[Interest expense × (1 - Tax rate)]
Return on total assets =
Average total assets
=

$3,540 + [$600 × (1 - 0.40)]
= 8.1%

$48,120

7. Calculation of the return on common stockholders’ equity:
Beginning balance, stockholders’
equity (a)............................................... $31,660
Ending balance, stockholders’ equity
(b).......................................................... 34,880
Average stockholders’ equity [(a) +
(b)]/2..................................................... 33,270
Average preferred stock.......................... 2,000
Average common stockholders’ equity. . .$31,270
Net income - Preferred dividends
Return on common =
stockholders' equity
Average common stockholders' equity
=

$3,540 - $120
= 10.9%
$31,270

8. Calculation of the book value per share:
Book value per share =
=

Total stockholders' equity - Preferred stock
Number of common shares outstanding
$34,880 - $2,000
= $41.10 per share
800 shares


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Exercise 16-3 (30 minutes)
1. Calculation of working capital:
Current assets............. $25,080
Current liabilities......... 10,400
Working capital........... $14,680
2. Calculation of the current ratio:
Current assets
Current liabilities
$25,080
=
= 2.4
$10,400

Current ratio =

3. Calculation of the acid-test ratio:
Cash + Marketable securities
+ Current receivables
Acid-test ratio =
Current liabilities
$1,280 + $0 + $12,300
=
= 1.3

$10,400
4. Calculation of accounts receivable turnover:
Beginning balance, accounts receivable (a)........$ 9,100
Ending balance, accounts receivable (b)............. 12,300
Average accounts receivable balance [(a) +
(b)]/2.................................................................. $10,700
Sales on account
Accounts receivable =
turnover
Average accounts receivable balance
$79,000
=
= 7.4
$10,700
5. Calculation of the average collection period:
365 days
Accounts receivable turnover
365 days
=
= 49.3 days
7.4

Average collection period =

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Exercise 16-3 (continued)
6. Calculation of inventory turnover:
Beginning balance, inventory (a)......................... $8,200
Ending balance, inventory (b).............................. 9,700
Average inventory balance [(a) + (b)]/2.............. $8,950
Cost of goods sold
Average inventory balance
$52,000
=
= 5.8
$8,950

Inventory turnover =

7. Calculation of the average sale period:
365 days
Inventory turnover
365 days
=
= 62.9 days
5.8

Average sale period =

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Exercise 16-4 (15 minutes)
1. Calculation of the times interest earned ratio:
Earnings before interest
expense
and income taxes
Times interest =
earned ratio
Interest expense
=

$6,500
= 10.8
$600

2. Calculation of the debt-to-equity ratio:
Total liabilities
Stockholders' equity
$15,400
=
= 0.4
$34,880

Debt-to-equity ratio =

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Exercise 16-5 (15 minutes)
1. The trend percentages are:
Year
Year Year Year
5
Year 4
3
2
1
Sales.............................. 125.0 120.0 115.0 110.0 100.0
Current assets:
Cash............................ 60.0
80.0 96.0
Accounts receivable.... 190.0 170.0 135.0
Inventory..................... 125.0 120.0 115.0
Total current assets....... 142.1 133.7 120.3

130.0
115.0
110.0
112.6

100.0
100.0
100.0
100.0

Current liabilities........... 160.0 145.0 130.0 110.0 100.0
2.


Sales:

The sales are increasing at a steady and
consistent rate.

Assets:

The most noticeable thing about the assets is that
the accounts receivable have been increasing at a
rapid rate—far outstripping the increase in sales.
This disproportionate increase in receivables is
probably the chief cause of the decrease in cash
over the five-year period. The inventory seems to
be growing at a well-balanced rate in comparison
with sales.

Liabilities
:

The current liabilities are growing more rapidly
than the total current assets. The reason is
probably traceable to the rapid buildup in
receivables in that the company doesn’t have the
cash needed to pay bills as they come due.

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Exercise 16-6 (20 minutes)
1. Return on total assets:
Return on = Net income + [Interest expense × (1 - Tax rate)]
total assets
Average total assets
=

$280,000 + [$60,000 × (1 - 0.30)]
1/2 ( $3,000,000 + $3,600,000)

=

$322,000
= 9.8% (rounded)
$3,300,000

2. Return on common stockholders’ equity:
Average stockholders’ equity:
($2,200,000 + $2,400,000)/2............ $2,300,000
Average preferred stock.......................
900,000
Average common stockholders’
equity (b)........................................... $1,400,000
Return on common = Net income - Preferred dividends
stockholders' equity Average common stockholders' equity
=

$280,000 - $72,000
=14.9% (rounded)

$1, 400,000

3. Leverage is positive because the return on common
stockholders’ equity (14.9%) is greater than the return on total
assets (9.8%). This positive leverage arises from the long-term
debt, which has an after-tax interest cost of only 8.4% [12%
interest rate × (1 – 0.30)], and the preferred stock, which
carries a dividend rate of only 8%. Both of these rates of return
are smaller than the return that the company is earning on its
total assets; thus, the difference goes to the common
stockholders.

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Exercise 16-7 (30 minutes)
1. Gross margin percentage:
Gross margin
$127,500
=
= 30.4% (rounded)
Sales
$420,000
2. Current ratio:
Current assets
$115,000
=

= 2.3
Current liabilities
$50,000
3. Acid-test ratio:
Quick assets
$41,500
=
= 0.83
Current liabilities
$50,000
4. Debt-to-equity ratio:
Total liabilities
$130,000
=
= 0.76 (rounded)
Total stockholders' equity
$170,000
5. Average collection period:
Accounts receivable turnover =

Sales on account
Average accounts receivable

=

$420,000
= 14
($25,000 + $35,000)/2

Average collection period =


365 days
Accounts receivable turnover

=

365 days
= 26.1 days (rounded)
14

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Exercise 16-7 (continued)
6. Average sale period:
Inventory turnover =
=
Average sale period =

Cost of goods sold
Average inventory
$292,500
= 4.5
($60,000 + $70,000)/2
365 days
= 81.1 days (rounded)
4.5


7. Times interest earned:
Earnings before interest
and income taxes
Times interest earned =
Interest expense
=

$38,000
= 4.75
$8,000

8. Book value per share:
Stockholders' equity
$170,000
=
= $28.33 per share
Common shares outstanding
6,000 shares

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Exercise 16-8 (20 minutes)
1. Earnings per share:
Net income to common stock
$21,000

=
= $3.50 per share
Average number of common
6,000 shares
shares outstanding
2. Dividend payout ratio:
Dividends paid per share
$2.10
=
= 60%
Earnings per share
$3.50
3. Dividend yield ratio:
Dividends paid per share
$2.10
=
= 5%
Market price per share
$42.00
4. Price-earnings ratio:
Market price per share
$42.00
=
= 12
Earnings per share
$3.50

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152


Exercise 16-9 (20 minutes)
1. Return on total assets:
é
ù
Return on = Net Income + ëInterest expense × ( 1 - Tax rate) û
total assets
Average total assets
$21,000 + é
$8,000 × ( 1 - 0.30) ù
ë
û
=
1/2 ( $280,000 + $300,000)
=

$26,600
= 9.2% (rounded)
$290,000

2. Return on common stockholders’ equity:
Net income - Preferred dividends
Return on common =
stockholders' equity
Average common stockholders' equity
=

$21,000

1/2 ( $161,600+$170,000)

=

$21,000
= 12.7% (rounded)
$165,800

3. Financial leverage was positive because the rate of return to
the common stockholders (12.7%) was greater than the rate of
return on total assets (9.2%). This positive leverage is traceable
in part to the company’s current liabilities, which may have no
interest cost, and in part, to the bonds payable, which have an
after-tax interest cost of only 7%.
10% interest rate × (1 – 0.30) = 7%

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Exercise 16-10 (15 minutes)
1. Current assets
(Kr90,000 + Kr260,000 + Kr490,000 +
Kr10,000)............................................................. Kr850,000
Current liabilities (Kr850,000 ÷ 2.5)......................
340,000
Working capital...................................................... Kr510,000
2. Acid-test

Cash + Marketable securities + Accounts receivable
=
ratio
Current liabilities
=

Kr90,000 + Kr0 + Kr260,000
= 1.03 (rounded)
Kr340,000

3. a. Working capital would not be affected by a Kr40,000
payment on accounts payable:
Current assets (Kr850,000 – Kr40,000).. . Kr810,000
Current liabilities (Kr340,000 –
Kr40,000).............................................. 300,000
Working capital........................................ Kr510,000
b. The current ratio would increase if the company makes a
Kr40,000 payment on accounts payable:
Current ratio =

Current assets
Current liabilities

=

Kr810,000
= 2.7
Kr300,000

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Problem 16-11 (30 minutes)
1. a. Computation of working capital:
Current assets:
Cash..................................... $ 50,000
Marketable securities........... 30,000
Accounts receivable, net...... 200,000
Inventory.............................. 210,000
Prepaid expenses................. 10,000
Total current assets (a)........... 500,000
Current liabilities:
Accounts payable................. 150,000
Notes due in one year.......... 30,000
Accrued liabilities................. 20,000
Total current liabilities (b)....... 200,000
Working capital (a) – (b).........$300,000
b. Computation of the current ratio:
Current assets
$500,000
=
= 2.5
Current liabilities
$200,000
c. Computation of the acid-test ratio:
Cash + Marketable securities +
Accounts receivable

$280,000
=
= 1.4
Current liabilities
$200,000

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Problem 16-11 (continued)
2.

(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)

The Effect on
Workin

Acidg
Current
Test
Transaction
Capital
Ratio
Ratio
Issued capital stock for cash.... Increase Increase Increase
Sold inventory at a gain........... Increase Increase Increase
Wrote off uncollectible
accounts................................. None
None
None
Decreas Decreas
Declared a cash dividend.........
e
e
Decrease
Paid accounts payable.............. None Increase Increase
Decreas
Borrowed on a short-term note
None
e
Decrease
Decreas Decreas
Sold inventory at a loss............
e
e
Increase
Purchased inventory on

Decreas
account.................................. None
e
Decrease
Paid short-term notes............... None Increase Increase
Decreas Decreas
Purchased equipment for cash.
e
e
Decrease
Sold marketable securities at a Decreas Decreas
loss.........................................
e
e
Decrease
Collected accounts receivable.. None
None
None

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Problem 16-12 (60 minutes)
This Year Last Year
$1,520,00 $1,090,00
1. a. Current assets.....................................
0

0
Current liabilities.................................
800,000
430,000
Working capital................................... $ 720,000 $ 660,000
$1,520,00 $1,090,00
b. Current assets (a)...............................
0
0
Current liabilities (b)........................... $800,000 $430,000
Current ratio (a) ÷ (b).........................
1.90
2.53
c. Quick assets (a).................................. $550,000
Current liabilities (b)........................... $800,000
Acid-test ratio (a) ÷ (b).......................
0.69

$468,000
$430,000
1.09

$5,000,00 $4,350,00
d. Sales on account (a)...........................
0
0
Average receivables (b)...................... $390,000 $275,000
Accounts receivable turnover (a) ÷
(b).....................................................
12.8

15.8
Average collection period: 365 days
÷ Accounts receivable turnover....... 28.5 days

23.1 days

$3,875,00 $3,450,00
e. Cost of goods sold (a).........................
0
0
Average inventory (b)......................... $775,000 $550,000
Inventory turnover ratio(a) ÷ (b)........
5.0
6.3
Average sales period:
365 days ÷ Inventory turnover
ratio.................................................. 73.0 days

57.9 days

$1,400,00 $1,030,00
f. Total liabilities (a)................................
0
0
$1,600,00 $1,430,00
Stockholders’ equity (b).....................
0
0
Debt-to-equity ratio (a) ÷ (b).............
0.875

0.720

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Net income before interest and
g. taxes (a)........................................... $472,000
Interest expense (b)...........................
$72,000
Times interest earned (a) ÷ (b)..........
6.6

$352,000
$72,000
4.9

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Problem 16-12 (continued)
2. a.

Sabin Electronics
Common-Size Balance Sheets

This
Year
Current assets:
Cash..................................................
2.3%
Marketable securities........................
0.0
Accounts receivable, net................... 16.0
Inventory........................................... 31.7
Prepaid expenses..............................
0.7
Total current assets.............................. 50.7
Plant and equipment, net.................... 49.3
Total assets.......................................... 100.0%
Current liabilities.................................. 26.7%
Bonds payable, 12%............................ 20.0
Total liabilities.................................... 46.7
Stockholders’ equity:
Preferred stock, $25 par, 8%.............
8.3
Common stock, $10 par.................... 16.7
Retained earnings............................. 28.3
Total stockholders’ equity.................... 53.3
Total liabilities and equity.................... 100.0%

Last
Year
6.1%
0.7
12.2

24.4
0.9
44.3
55.7
100.0%
17.5%
24.4
41.9
10.2
20.3
27.6
58.1
100.0%

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Problem 16-12 (continued)
b.

Sabin Electronics
Common-Size Income Statements
This
Year
Sales.................................................. 100.0%
Cost of goods sold............................. 77.5
Gross margin..................................... 22.5

Selling and administrative
expenses......................................... 13.1
Net operating income........................
9.4
Interest expense................................
1.4
Net income before taxes...................
8.0
Income taxes.....................................
2.4
Net income........................................
5.6%

Last
Year
100.0%
79.3
20.7
12.6
8.1
1.7
6.4
1.9
4.5%

3. The following points can be made from the analytical work in
parts (1) and (2) above:
a. The company has improved its profit margin from last year.
This is attributable primarily to an increase in gross margin,
which is offset somewhat by a small increase in operating

expenses. Overall, the company’s income statement looks
very good.
b. The company’s current position has deteriorated significantly
since last year. Both the current ratio and the acid-test ratio
are well below the industry average and are trending
downward. At the present rate, it will soon be impossible for
the company to pay its bills as they come due.
c. The drain on the cash account seems to be a result mostly of
a large buildup in accounts receivable and inventory. Notice
that the average age of the receivables has increased by five
days since last year, and now is 10 days over the industry
average. Many of the company’s customers are not taking
their discounts because the average collection period is 28
days and collections terms are 2/10, n/30. This suggests
financial weakness on the part of these customers, or sales
to customers who are poor credit risks.
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Problem 16-12 (continued)
d. The inventory turned only five times this year as compared
to over six times last year. It takes nearly two weeks longer
for the company to turn its inventory than the average for
the industry (73 days as compared to 60 days for the
industry). This suggests that inventory stocks are higher than
they need to be.
e. In the authors’ opinion, the loan should be approved only if

the company gets its accounts receivable and inventory back
under control. If the accounts receivable collection period is
reduced to about 20 days, and if the inventory is pared down
enough to reduce the turnover time to about 60 days,
enough funds could be released to substantially improve the
company’s cash position. Then a loan might not even be
needed.

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Problem 16-13 (60 minutes)
This
Last
Year
Year
$280,00 $196,00
1. a. Net income.......................................
0
0
Less preferred dividends.................. 20,000 20,000
Net income remaining for common $260,00 $176,00
(a)..................................................
0
0
Average number of common
shares (b)......................................


50,000

50,000

Earnings per share (a) ÷ (b)............

$5.20

$3.52

b. Dividends per share (a)....................
Market price per share (b)...............
Dividend yield ratio (a) ÷ (b)...........

$1.80
$40.00
4.5%

$1.50
$36.00
4.2%

c. Dividends per share (a)....................
Earnings per share (b).....................
Payout ratio (a) ÷ (b).......................

$1.80
$5.20
34.6%


$1.50
$3.52
42.6%

d. Market price per share (a)...............
Earnings per share (b).....................
Price-earnings ratio (a) ÷ (b)...........

$40.00
$5.20
7.7

$36.00
$3.52
10.2

Investors regard Sabin Electronics less favorably than other
companies in the industry. This is evidenced by the fact that
they are willing to pay only 7.7 times current earnings for a
share of Sabin’s stock, as compared to 12 times current
earnings for other companies in the industry. If investors
were willing to pay 12 times current earnings for Sabin’s
stock, it would be selling for about $62.40 per share (12 ×
$5.20), rather than for only $40 per share.

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Problem 16-13 (continued)

e.

This Year Last Year
$1,600,00 $1,430,00
Total stockholders’ equity...................
0
0
250,00
Less preferred stock............................ 250,000
0
$1,350,00 $1,180,00
Common stockholders’ equity (a).......
0
0
Number of common shares
outstanding (b).................................

50,000

50,000

Book value per share (a) ÷ (b)............

$27.00

$23.60


The market value is above book value for both years.
However, this does not necessarily indicate that the stock is
overpriced. Market value reflects investors’ perceptions of
future earnings, whereas book value is a result of already
completed transactions.
$ 280,00 $ 196,00
2. a. Net income........................................
0
0
Add after-tax cost of interest paid:
50,40
[$72,000 × (1 – 0.30)]....................
50,400
0
$ 246,40
Total (a)............................................. $ 330,400
0
$2,730,00 $2,380,00
Average total assets (b)....................
0
0
Return on total assets (a) ÷ (b)........

12.1%

10.4%

$ 196,00
b. Net income........................................ $ 80,000

0
20,00
Less preferred dividends...................
20,000
0
Net income remaining for common
$ 176,00
(a)................................................... $ 260,000
0
$1,515,00 $1,379,50
Average total stockholders’ equity.. .
0
0
Less average preferred stock............
250,000
250,00
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163

Managerial Accounting, 13th Edition


0
$1,265,00 $1,129,50
Average common equity (b).............
0
0
Return on stockholders’ common
equity (a) ÷ (b)...............................


20.6%

15.6%

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Solutions Manual, Chapter 16

164