Chapter 13, Problem 1EYK

a)

To determine

Prepare a 5-year trend analysis, using 2010 as a base year, of (1) net sales, (2) net income, (3) total assets and comment on the findings.

Explanation of Solution

Trend Analysis: Trend analysis is type of horizontal analysis used to calculate the changes in economic cycle of a business for several years in terms of changes in percentage using one of the years as base year.

$\text{Trend percentage }=\frac{\text{Amount for the particular year }}{\text{Amount for the year 1 }\left(\text{2010}\right)}\times 100$

Prepare a 5-year trend analysis, using 2010 as a base year, of (1) net sales, (2) net income, (3) total assets:

Net Sales, Net Income, and Total Assets
Trend Analysis
(Amount in thousands of dollars)
Particulars	Year 1 (2010)	Year 2 (2011)	Year 3 (2012)	Year 4 (2013)	Year 5 (2014)
Net sales	$1,483,524	$1,693,985	$1,669,563	$1,684,996	$2,100,590
Trend percentages	100%	114.2%	112.5%	113.6%	141.6%
Net income	$77,037	$103,479	$99,859	$94,341	$137,173
Trend percentages	100%	134.3%	129.6%	122.5%	178.1%
Total assets	$1,294,754	$1,382,542	$1,458,842	$1,605,588	$1,792,209
Trend percentages	100%	106.8%	112.7%	124.0%	138.4%

Table (1)

Comments:

• Net sales of the company increased from 2010 to 2011 and decreased in 2012. But in 2013 it increased slightly and in 2014 it increased dramatically.
• Net income of the company increased from 2010 to 2011 and decreased in 2012. But in 2013 it increased slightly and in 2014 it increased dramatically.
• Trend of Total assets of the company indicates that there is an increase in assets from 2010 to 2014.

b)

To determine

Calculate 1) gross profit percentage, 2) return on sales, and 3) return on assets for 2013 and 2014 and comment on profitability of the Company CS.

Explanation of Solution

1) Calculate gross profit percentage for 2013 and 2014:

Gross Profit Percentage: Gross profit is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the net sales revenue, and the cost of goods sold. It can be calculated by dividing gross profit and net sales.

$\text{Gross Profit percentage}=\frac{\text{Gross}\text{Profit}}{\text{Net Sales Revenue}}\times 100$

$\text{Gross profit = net sales – cost of goods sold}$

Calculate gross profit percentage for 2013.

Net sales = $1,684,996

Gross profit on sales = $743,655

$\begin{array}{c}\text{Gross profit percentage }=\frac{\text{Gross profit}}{\text{Net sales}}\times 100\\ =\frac{\$743,655}{\$1,684,996}\times 100\\ =44.13\%\end{array}$

Calculate gross profit percentage for 2014.

Net sales = $2,100,590

Gross profit on sales = $954,951

$\begin{array}{c}\text{Gross profit percentage }=\frac{\text{Gross profit}}{\text{Net sales}}\times 100\\ =\frac{\$954,951}{\$2,100,590}\times 100\\ =45.46\%\end{array}$

Gross profit percentage for 2013 and 2014 are 44.13% and 45.46% respectively.

2) Calculate return on sales ratio for 2013 and 2014.

Return on sales ratio: The ratio which evaluates the amount of net income earned for every dollar of net sales is referred to as return on sales ratio. Higher ratio indicates highly profitable company.

$\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}$

Compute the return on sales ratio for 2013.

Net sales = $1,684,996

Net income = $94,341

$\begin{array}{c}\text{Return on sales ratio }=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$94,341}{\$1,684,996}\\ =\text{0}\text{.0559 or 5}\text{.59\%}\end{array}$

Compute the return on sales ratio for 2014.

Net sales = $2,100,590

Net income = $137,173

$\begin{array}{c}\text{Return on sales ratio }=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$137,173}{\$2,100,590}\\ =\text{0}\text{.0653 or 6}\text{.53\%}\end{array}$

Return on sales ratio for 2013 and 2014are 5.59% and 6.53% respectively.

3) Calculate the return on assets for 2013 and 2014.

Return on assets:

Return on assets is the financial ratio which determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings with relative to its total assets.

$\text{Return on Assets }\left(\text{ROA}\right)=\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Assets}}$

Compute return on assets for 2013.

Average total assets = $1,532,215 (Refer working note)

Net income = $94,341

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net}\text{income}}{\text{Average total assets}}\\ =\frac{\$94,341}{\$1,532,215}\times 100\\ =6.15\%\end{array}$

Compute return on assets for 2014.

Average total assets = $1,698,898.5 (Refer working note)

Net income = $137,173

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net}\text{income}}{\text{Average total assets}}\\ =\frac{\$137,173}{\$1,698,898.5}\times 100\\ =8.07\%\end{array}$

Return on assets for 2013 and 2014 are 6.15% and 8.07% respectively.

Working note:

Calculate average total assets for 2013:

$\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Beginning balance of total assets}\\ +\text{Ending balance of total assets}\end{array}\right)}{2}\\ =\frac{\$1,458,842+\$1,605,588}{2}\\ =\$1,532,215\end{array}$

Calculate average total assets for 2014:

$\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Beginning balance of total assets}\\ +\text{Ending balance of total assets}\end{array}\right)}{2}\\ =\frac{\$1,605,588+\$1,792,209}{2}\\ =\$1,698,898.5\end{array}$

Comment on profitability:

• Profitability of Company CS is measured by gross profit percentage, return on sales ratio, and return on assets ratio.
• The all three ratio has increased from 2013 to 2014.
• This shows that the company’s profitability has increased.

c)

To determine

Calculate 1) current ratio, 2) quick ratio, and 3) operating cash flow to current liabilities ratio for 2013 and 2014 and comment on liquidity of the Company CS.

Explanation of Solution

1) Calculate current ratio for 2013 and 2014:

Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. The ideal current ratio is 2:1. The following formula is used to calculate current ratio.

$\text{Current ratio}\text{=}\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$

Compute current ratio for 2013.

Current assets = $1,250,472

Current liabilities = $301,254

$\begin{array}{c}\text{ Current ratio }=\frac{\text{Current asset}}{\text{ Current liabilities}}\\ =\frac{\$1,250,472}{\$301,254}\\ =4.15\end{array}$

Compute current ratio for 2014.

Current assets = $1,266,041

Current liabilities = $373,120

$\begin{array}{c}\text{ Current ratio }=\frac{\text{Current asset}}{\text{ Current liabilities}}\\ =\frac{\$1,266,041}{\$373,120}\\ =3.39\text{times}\end{array}$

Current ratio for 2013 and 2014 are 4.15 times and 3.39 times respectively.

2) Calculate the quick ratio for 2013 and 2014:

Quick Ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

$\text{Quick Ratio}\text{=}\frac{\left(\begin{array}{l}\text{Cash and cash equivalents }+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current}\text{Liabilities}}$

Compute Quick ratio for 2013:

$\begin{array}{c}\text{Quick ratio}=\frac{\left(\begin{array}{l}\text{Cash and cash equivalents }+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\$\text{437,489}+\$\text{91,755}+\$\text{306,878}}{\$\text{301,254}}\\ =2.77\text{times}\end{array}$

Compute Quick ratio for 2014:

$\begin{array}{c}\text{Quick ratio}=\frac{\left(\begin{array}{l}\text{Cash and cash equivalents }+\text{Short-term investments}\\ +\text{Accounts receivable}\end{array}\right)}{\text{Current liabilities}}\\ =\frac{\$\text{413,558}+\$\text{27,267}+\$\text{344,390}}{\$\text{373,120}}\\ =2.10\text{times}\end{array}$

Quick ratio for 2013 and 2014 are 2.77 times and 2.10 times respectively.

3) Calculate operating cash flows to current liabilities ratio for 2013 and 2014.

Operating cash flows to current liabilities ratio: It indicates the ratio of the amount of cash flows from operating activities to settle the current liabilities.

$\text{Operating cash flows to current liabilities }=\frac{\text{Cash flows from operating activities}}{\text{Average current liabilities}}$

Compute operating cash flows to current liabilities ratio for 2013:

$\begin{array}{c}\text{Operating cash flows to current liabilities }=\frac{\text{Cash flows from operating activities}}{\text{Average current liabilities}}\\ =\frac{\$\text{274,275}}{\left(\frac{\$252,059+\$301,254}{2}\right)}\\ =0.99\text{times}\end{array}$

Compute operating cash flows to current liabilities ratio for 2014:

$\begin{array}{c}\text{Operating cash flows to current liabilities }=\frac{\text{Cash flows from operating activities}}{\text{Average current liabilities}}\\ =\frac{\text{\$185,783}}{\left(\frac{\$301,254+\$\text{373,120}}{2}\right)}\\ =0.55\text{times}\end{array}$

Operating cash flows to current liabilities ratio for 2013 and 2014 are 0.99 times and 0.55 times respectively.

Comments:

• Liquidity of Company CS is measured by current ratio, quick ratio, and operating cash flows to current liabilities ratio.
• The current ratio of company for both the year is more than 2:1. This indicates that the company has good ability in meeting its short-term liabilities.
• The quick ratio of company for both the year is more than 1:1. This indicates that Company has more liquid assets that the standard requirement to settle the current liabilities.
• The Operating cash flows to current liabilities ratio of 2013 is more than 2014. It indicates that the company has more cash in 2013 than 2014 to settle the current liabilities.

d)

To determine

Determine debt to equity ratio for 2014 and 2013 and comment on the solvency of Company CS.

Explanation of Solution

Debt-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity.

$\text{Debt-equity ratio}\text{=}\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$

Compute debt to equity ratio for Company C S for the year 2013 and 2014.

For 2013:

Total stockholders’ equity = $1,252,864

Total liabilities = $352,724

$\begin{array}{c}\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}\\ =\frac{\$352,724}{\$1,252,864}\\ =0.28\end{array}$

For 2014:

Total stockholders’ equity = $1,355,234

Total liabilities = $436,975

$\begin{array}{c}\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}\\ =\frac{\$436,975}{\$1,355,234}\\ =0.32\end{array}$

Comments:

• Solvency of Company C S is measured by debt-to-equity ratio.
• Debt-to-equity ratio of Company C S is higher in the years 2014 as compared to 2013.
• This shows that decline in company’s potential to pay for the creditors in 2014.