CHAPTER 3

MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 4 Financial Statements Analysis - IFinancial Statements Analysis - I Chapter 4

CHAPTER 4

FINANCIAL STATEMENTS ANALYSIS - I

I.Questions1.The objective of financial statements analysis is to determine the extent of a firms success in attaining its financial goals, namely:

a. To earn maximum profit

b. To maintain solvency

c. To attain stability

2.Some of the indications of satisfactory short-term solvency or working capital position of a business firm are:1. Favorable credit position

2. Satisfactory proportion of cash to the requirements of the current volume

3. Ability to pay current debts in the regular course of business

4. Ability to extend more credit to customers

5. Ability to replenish inventory promptly

3.These tests are:

1. Improvement in the financial position

2. Well-balanced financial structure between borrowed funds and equity

3. Effective employment of borrowed funds and equity

4. Ability to declare satisfactory amount of dividends to shareholders

5. Ability to withstand adverse business conditions

6. Ability to engage in research and development in an attempt to provide new products or improve old products, methods or processes

4.Some indicators of managerial efficiency are:

1. Ability to earn a reasonable return on its investment of borrowed funds and equity

2. Ability to control operating costs within reasonable limits

3. No overinvestment in fixed assets, receivables and inventories

5.The techniques used in Financial Statement Analysis are:

I.Vertical analysis which shows the relationships of the items in the same year: also referred to as static measure.

a.Financial ratios

b.Common-size statements

II.Horizontal analysis which shows the changes or tendencies of an item for 2 or more years; also referred to as dynamic measure.

a.Comparative statements - showing changes in absolute amount and percentages

b.Trend percentages

III.Use of special reports or statements

a.Statements of Changes in Financial Position

b.Gross Profit / Net Income Variation Analysis

6.Refer to page 133 of the textbook.

7.Horizontal analysis involves the comparison of items on financial statements between years. Analysis of comparative financial statements or the increase/decrease method of analysis and trend percentages are the two techniques that may be applied under horizontal analysis.

Vertical analysis involves the study of items on a single statement for a single year, such as the analysis of an income statement for some given year. Common-size statement and financial ratios are techniques used in vertical analysis.

8.Trends can indicate whether a situation is improving, remaining the same or deteriorating. They can also give insight to the probable future course of events in a firm.

9.Trend percentages represent the expression of several years financial data in percentage form in terms of a base year.

10.Refer to page 133 of the textbook.

11.Observation of trends is useful primarily in determining whether a situation is improving, worsening, or remaining constant. By comparing current data with similar data of prior periods we gain insight into the direction in which future results are likely to move.

Some other standards of comparison include comparison with other similar companies, comparison with industry standards, and comparison with previous years information. By comparing analytical data for one company with some independent yardstick, the analyst hopes to determine how the position of the company in question compares with some standard of performance.12.Trend percentages are used to show the increase or decrease in a financial statement amount over a period of years by comparing the amount in each year with the base-year amount. A component percentage is the percentage relationship between some financial amount and a total of which it is a part.

Measuring the change in sales over a period of several years would call for use of trend percentages. The sales in the base year are assigned a weight of 100%. The percentage for each later year is computed by dividing that years sales by the sales in the base year.

13.Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Premiere is apparently having difficulty in effectively controlling its expenses.14.A corporate net income of P1 million would be unreasonably low for a large corporation, with, say, P100 million in sales, P50 million in assets, and P40 million in equity. A return of only P1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return.

On the other hand, a profit of P1 million would be unreasonably high for a corporation which had sales of only P5 million, assets of, say, P3 million, and equity of perhaps one-half million pesos. In other words, the net income of a corporation must be judged in relation to the scale of operations and the amount invested.

II.True or False

1. True3. True5. False7. True9. True

2. False4. True6. False8. False 10. True

III.ProblemsProblem 1 (Percentage Changes)a.Accounts receivable decreased 16% (P24,000 decrease ( P150,000 = 16% decrease).

b.Marketable securities decreased 100% (P250,000 decrease ( P250,000 = 100% decrease).

c.A percentage change cannot be calculated because retained earnings showed a negative amount (a deficit) in the base year and a positive amount in the following year.

d.A percentage change cannot be calculated because of the zero amount of notes receivable in 2005, the base year.

e.Notes payable increased 7 % (P60,000 increase ( P800,000 = 7 % increase).

f.Cash increased 3% (P2,400 increase ( P80,000 = 3% increase).

g.Sales increased 10% (P90,000 increase ( P900,000 = 10% increase).

Problem 2 (Computing and Interpreting Rates of Change)Requirement (a)Computation of percentage changes:

1.Net sales increased 10% (P200,000 increase ( P2,000,000 = 10% increase).

2.Total expenses increased 11% (P198,000 increase ( P1,800,000 = 11% increase).

Requirement (b)

1.Total expenses grew faster than net sales. Net income cannot also have grown faster than net sales, or the sum of the parts would exceed the size of the whole.

2.Net income must represent a smaller percentage of net sales in 2006 than it did in 2005. Again, the reason is that the expenses have grown at a faster rate than net sales. Thus, total expenses represent a larger percentage of total sales in 2006 than in 2005, and net income must represent a smaller percentage.

Problem 3 (Financial Statement Analysis using Comparative Statements or Increase-Decrease Method)Requirement 1

XYZ Corporation

Balance Sheet

As of December 31

Change

Peso %

20052006

Assets

Cash and equivalents14,00016,0002,00014.29%

Receivables28,80055,60026,80093.06%

Inventories54,00085,60031,60058.52%

Prepayments and others 4,800 7,4002,60054.17%

Total current assets101,600164,60063,00062.01%

Property, plant & equipment - net of dep. 30,200 73,40043,200143.05%

Total assets131,800238,000106,20080.58%

Liabilities and Equity

Notes payable to banks10,00054,00044,000440.00%

Accounts payable31,60055,40023,80073.32%

Accrued liabilities4,2006,8002,60061.90%

Income taxes payable 5,800 7,0001,20020.69%

Total current liabilities51,600123,20071,600138.76%

Share capital 44,60044,60000.00%

Retained earnings 35,600 70,20034,60097.19%

Total equity 80,200114,80034,60043.14%

Total liabilities and equity131,800238,000106,20080.58%

XYZ Corporation

Income Statement

Years ended December 31

(P thousands)

Change

Peso %

20052006

Net sales266,400424,000157,60059.16%

Cost of goods sold191,400314,600123,20064.37%

Gross profit 75,000109,40034,40045.87%

Selling, general and administrative expenses 35,500 58,40022,90064.51%

Income before income taxes39,50051,00011,50029.11%

Income taxes 12,300 16,4004,10033.33%

Net income 27,200 34,6007,40027.21%

Requirement 2Short-term financial position

1.Current Assetsincreased by 62.01%whileCurrent Liabilitiesincreased by 138.76%

(Unfavorable

2.Quick Assetsincreased by 62.40%whileCurrent Liabilitiesincreased by 138.76%

(Unfavorable

3.Net

Salesincreased by 59.16%whileAccounts Receivableincreased by 93.06%

(Unfavorable

4.Cost of Goods Soldincreased by 64.37%whileInventoriesincreased by 58.52%

(Favorable

Leverage

5.Total Assetsincreased by 80.58%whileTotal Liabilitiesincreased by 138.76%

(Unfavorable

6.Total Liabilitiesincreased by 138.76%whileTotal Equityincreased by 43.14%

(Unfavorable

Profitability

7.Net

Salesincreased by 59.16%whileCost of Goods Soldincreased by 64.37%

(Unfavorable

8.Net

Salesincreased by 59.16%whileSelling, General &

Administrative Expensesincreased by 64.51%

(Unfavorable

9.Net

Salesincreased by 59.16%whileNet Incomeincreased by 27.21%

(Unfavorable

10.Net Incomeincreased by 27.21%whileTotal Assetsincreased by 80.58%

(Unfavorable

Problem 4 (Trend Percentages)Requirement (1)

The trend percentages are:

Year 5Year 4Year 3Year 2Year 1

Sales

125.0120.0110.0105.0100.0

Cash

80.090.0105.0110.0100.0

Accounts receivable

140.0124.0108.0104.0100.0

Inventory

112.0110.0102.0108.0100.0

Total current assets

118.8113.1104.1106.9100.0

Current liabilities

130.0106.0108.0110.0100.0

Requirement (2)

Sales:The sales are increasing at a steady rate, with a particularly strong gain in Year 4.

Assets:Cash declined from Year 3 through Year 5. This may have been due to the growth in both inventories and accounts receivable. In particular, the accounts receivable grew far faster than sales in Year 5. The decline in cash may reflect delays in collecting receivables. This is a matter for management to investigate further.

Liabilities:The current liabilities jumped up in Year 5. This was probably due to the buildup in accounts receivable in that the company doesnt have the cash needed to pay bills as they come due.

Problem 5 (Use of Trend Percentages)a.1.An unfavorable tendency could be observed in Receivables in relation to Net Sales from 2003 2005 because receivables had been increasing at a much faster rate than Net Sales. This could indicate inefficiency in the collection of receivables or simply poor company credit policy. The situation however, improved in 2006 and 2007 when sales started to move up at a faster rate than accounts receivable. This would indicate improvement in the credit and collection policy or more cash sales were being generated.

2.Unfavorable tendency in inventory persisted from 2003 to 2007 because it had been going up at a much faster rate than Net Sales. If this continues, the company will end up with over-investment in inventory because the buying rate is faster than the selling price.

3.Favorable tendencies could be noted in Fixed Assets in relation to Net Sales because inspite of the minimal additions to fixed assets made by the company from 2003 through 2007, sales had been increasing at a very encouraging rate.

4.Net Income had likewise been increasing at a much faster rate than net sales. This is favorable because this would indicate that the company had been successfully controlling the increases in Cost of Sales and Operating Expenses.

b.Review computations of the Trend Percentages. It will be noted that the Trend Percentages in Total Noncurrent Liabilities and Equity from 2005 to 2007 were interchanged. Correction should be made first before interpretation is done.

1.The upward tendency in current assets had been accompanied by an upward trend in current liabilities. It could be noted that current assets had been moving up at a much faster rate than current liabilities. This is favorable because the margin of safety of the short-term creditors is widened.

2.Favorable tendencies could also be observed in noncurrent assets which had been increasing and which increases had been accompanied by downward trend in noncurrent liabilities. This would mean better security on the part of creditors and stronger financial position.

3.There is an unfavorable tendency in Net Sales in relation to non-current assets. Sales had not been increasing at the same rate as the increases in fixed assets. This could indicate that more investments are made in noncurrent assets without considering whether or not they could sell the additional units of product they are producing.

c.The unfavorable trend in net income could be attributed to the following tendencies:

1. Higher rates of increases in cost of sales as compared to sales.

2. Higher rates of increases in selling, general and administrative expenses in relation to net sales.

3. Higher rates of increases in other financial expenses than the rates of increases in net sales.

IV.Multiple Choice Questions1. D11. A, C, D

2. A12. B*

3. A13. D

4. B

5. D

6. C

7. C

8. A

9. D

10. C

* (P400,000 P160,000) ( P160,000 = 150%4-1

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