Financial reporting financial statement analysis and valuation 8th edition wahlen test bank download

Solution Manual for Financial Reporting Financial

Statement Analysis and Valuation

Baginski and Bradshaw

8th Edition by Wahlen

ISBN 1285190904

9781285190907

Full download link at:

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Chapter 5 Risk Analysis

MULTIPLE CHOICE

1. Economic theory teaches that differences in market returns must relate to differences in

a. book value

b. perceived risk

c. price-earnings ratio

d. bankruptcy risk

ANS: B PTS: 1

2. Market equity beta measures the covariability of a firm's returns with the return's of

a. all industry competitors in the market.

b. risk free securities.

c. all securities in the market.

d. all firms of comparable market value.

ANS: C PTS: 1

3. The Johnson company has a current ratio of 1.45. The company has just sold $600,000 worth of merchandise on credit. What will the current ratio be after the sales on credit?

a. greater than 1.45

b. 1.45

c. less than 1.45

d. unable to determine without more information

ANS: A PTS: 1

4. One common problem with the current ratio is that it is susceptible to "window dressing." If prior to the end of the accounting period Saxon Company has a current ratio of 1.5 and management wishes to boost its current ratio it may decide to

a. pay off accounts payable prior to year end.

b. purchase more inventory on account.

c. purchase short-term investments with cash.

d. purchase more inventory with cash.

ANS: A PTS: 1

Mobile Company

Mobile Company manufactures computer technology devices. Selected financial data for Mobile is presented below, use the information to answer the following questions:

- for the year ending December 31, 2010:

5. Refer to the information for Mobile Company. Mobile's current ratio in 2010 was

/ 1,648,753 = 1.45

PTS: 1

6. Refer to the information for Mobile Company. Mobile's quick ratio changed by what percentage from 2009 to 2010?

(1.07 - .82) / .82 = .30

PTS: 1

7. Refer to the information for Mobile Company. Mobile's Operating Cash Flow to Current Liabilities ratio in 2010 was

a. .70

b. 1.39

c. 1.00

d. .72

ANS: D

$1,156,084 / [($1,648,753 + 1,566,237)  .5] = .72

PTS: 1

8. Refer to the information for Mobile Company. Mobile's days receivables outstanding at the end of 2010 was

a. 43.20 days

b. 40.50 days

c. 45.25 days

d. 8.50 days

ANS: A

$4,885,340 / [(490,816 + 665,828)  .5 ] = 8.45 A/R Turnover

365 / 8.45 = 43.20 days

PTS: 1

9. Refer to the information for Mobile Company. Mobile's days accounts payable outstanding at the end of 2010 is

a. 7.53 days

b. 48.09 days

c. 45.51 days

d. 50 days

ANS: B

Purchases = $2,542,353 + 338,599 - 487,505 = 2,393,447

Average A/P = (296,307 + 334,247)  .5 = 315,277

A/P Turnover = 7.59

Days = 365 / 7.59 = 48.09 days

PTS: 1

10. Refer to the information for Mobile Company. Days of other financing required by Mobile at the end of 2010 would be

a. 54.36 days

b. 75.36 days

c. 102.94 days

d. 5.27 days

ANS: A

Days A/R + Days Inv. - Days A/P = Days Other Financing

43.20 + 59.25 - 48.09 = 54.36

PTS: 1

11. Refer to the information for Mobile Company. Mobile's 2010 Inventory Turnover ratio is

a. 7.46

b. 11.83

c. 6.16

d. 5.62

ANS: C

$2,542,353 / [(338,599 + 487,505)  .5] = 6.16

PTS: 1

12. The best indicator for assessing a firm's long-term solvency risk is its ability to generate what over a period of years?

a. Sales

b. Earnings

c. Positive cash flows

d. Income from continuing operations

ANS: B PTS: 1

13. Which of the following ratios is not a measure of long-term solvency risk?

a. Debt /Equity Ratio

b. Interest Coverage Ratio

c. Operating Cash Flows to Current Liabilities Ratio

d. Liabilities to Assets Ratio

ANS: C PTS: 1

14. Univariate bankruptcy prediction models help identify factors related to bankruptcy, but they do not provide information about

a. specific ratios that are important.

b. the amount of Type I and Type II errors.

c. which specific company will go bankrupt.

d. the relative importance of individual financial statement ratios.

ANS: D PTS: 1

15. Bankruptcy prediction research has identified three broad factors influencing long-term solvency risk, which of the following is not one of the factors?

a. Investment factors

b. Financing factors

c. Operating factors

d. Credit factors

ANS: D PTS: 1

16. Which of the following is not one of the three explanatory variables that determines a firm's market beta?

a. Degree of investing leverage.

b. Degree of operating leverage.

c. Degree of financial leverage.

d. Variability of sales.

ANS: A PTS: 1

17. Here are several ratios calculated from Midas Company's financial statements: Days in Receivables = 45 Days in Payables = 36 Days in Inventory = 30

How many days of working capital financing does Midas need to obtain from other sources?

a. 39 days

b. 36 days

c. 56 days

d. 26 days

ANS: A PTS: 1

18. Which of the following states of financial distress would be considered the most troubling for an investor or creditor?

a. failing to make a required interest payment on time

b. paying an accounts payable after the billing date

c. restructuring debt

d. defaulting on a principal payment on debt

ANS: D PTS: 1

19. If a customer wanted to obtain bank financing which of the following will the bank inquire about before granting a loan?

a. Firms credit history

b. financial position of the firms creditors

c. firms cash flow

d. a and c

ANS: D PTS: 1

20. Doran Corp. has a current ratio of 6. Under which of the following scenarios might this indicate a problem?

a. inventories are increasing due to the introduction of a new product

b. the company is holding cash in expectation of making a large investment in equipment

c. receivables are increasing due to increasing sales

d. inventories are increasing and the industry in which Doran Corp. operates is experiencing a recession

ANS: D PTS: 1

Below is selected information from Marker’s 2012 financial statements:

22.

23.

170.9% PTS: 1

-term

Long-Term Capital ratio

ANS: A

(45,000 + 450,000) / ( 1,081,253 + 450,000 + 45,000) = 31.4%

PTS: 1

24. Marker’s 2012 Long-term Debt to Shareholders’ Equity ratio is

a. 31.4%

b. 29.4%

c. 34.0%

d. 45.8%

ANS: D

(45,000 + 450,000) / 1,081,253 = 45.8%

PTS: 1

25. Marker’s 2012 Interest Coverage ratio is

a. 7.66

b. 1.00

c. 11.35

d. 4.35

ANS: C PTS: 1

26. The quick acid test ratio contains all of the following except:

a. cash

b. accounts receivable

c. marketable securities

d. prepaid assets

ANS: D PTS: 1

27. All of the following are common industry risks faced by companies except:

a. litigation

b. technology

c. regulation

d. competition

ANS: A PTS: 1

28. All of the following are common domestic risks faced by companies except:

a. recessions

b. technology

c. inflation

d. demographic shifts

ANS: B PTS: 1

29. All of the following are common international risks faced by companies except:

a. asset expropriation

b. exchange rate changes

c. political unrest

d. dependence on one or a few suppliers

ANS: D PTS: 1

30. All of the following typically drive firm-specific risks except:

a. the nature of the business

b. competition

c. supplier relationships

d. demographic shifts

ANS: D PTS: 1

31. Which of the following can companies use as collateral for a loan?

a. prepaid insurance

b. prepaid rent

c. property, plant, and equipment

d. retained earnings

ANS: B PTS: 1

32. Changes in foreign exchange rates can affect a firm in all of the following ways except:

a. The prices a firm pays to acquire raw materials from suppliers abroad.

b. The amount of cash a firm receives when it collects an account receivable, a loan receivable, or another receivable denominated in a currency other than its own.

c. The value of domestic liabilities with fixed interest rates.

d. The prices a firm charges for products sold to customers abroad.

ANS: C PTS: 1

33. Changes in interest rates can typically affect firms in all of the following ways except:

a. The value of investments in bonds or other investment securities with fixed interest rates.

b. The value of liabilities with fixed interest rates.

c. The returns a firm generates from pension fund investments.

d. The cash-equivalent value of assets invested abroad.

ANS: D PTS: 1

34. Below are various states of financial distress:

1. defaulting on a principal payment on debt

2. restructuring debt

3. liquidating a firm

4. filing for bankruptcy

5. failing to make a required interest payment on time

What is the order of increasing gravity that analysts typically consider when assessing credit risk and bankruptcy risk according to a continuum of financial distress?

a. 5, 1, 2, 3, 4

b. 5, 2, 1, 4, 3

c. 1, 5, 2, 4, 3

d. 1, 5, 2, 3, 4

ANS: B PTS: 1

35. Which of the following properly links the factors affecting a firm’s ability to generate cash with its need to use cash in operations?

Ability to generate cash

Need to use cash

a. Profitability of goods and services sold Working capital requirements

b. Sales of existing plant assets

Plant capacity requirements

c. Borrowing capacity Debt service requirements

d. Profitability of goods and services sold Debt service requirements

ANS: A PTS: 1

36. Which of the following properly links the factors affecting a firm’s ability to generate cash with its need to use cash in investing?

Ability to generate cash

Need to use cash

a. Profitability of goods and services sold Working capital requirements

b. Sales of existing plant assets

c. Borrowing capacity

Plant capacity requirements

Debt service requirements

d. Profitability of goods and services sold Debt service requirements

ANS: B PTS: 1

37. Which of the following properly links the factors affecting a firm’s ability to generate cash with its need to use cash in financing?

Ability to generate cash

Need to use cash

a. Profitability of goods and services sold Working capital requirements

b. Sales of existing plant assets

Plant capacity requirements

c. Borrowing capacity Debt service requirements

d. Profitability of goods and services sold Debt service requirements

ANS: C PTS: 1

COMPLETION

1. Short-term ____________________________ represents a firm's near-term ability to generate cash to service working capital needs and debt service requirements.

ANS: liquidity risk

PTS: 1

2. Long-term ______________________________ represents the longer-term ability of the firm to generate cash internally or from external sources to satisfy plant capacity and debt repayment needs.

ANS: solvency risk

PTS: 1

3. The source of risk related to political unrest and exchange rate changes are _________________________.

ANS: international

PTS: 1

4. The source of risk related interest rate changes and demographic changes is ____________________.

ANS: domestic

PTS: 1

5. The source of risk related to technology, regulation and availability of raw materials is ____________________.

ANS: industry PTS: 1

6. The source of risk related to management competence, strategic direction and lawsuits is _________________________.

ANS: firm specific PTS: 1

7. The operating cycle must not only generate cash to supply ________________________________________ needs, it must generate sufficient cash to service debt.

ANS: operating working capital PTS: 1

8. When management takes deliberate steps at a balance sheet date to produce a better current ratio than is normal it is called ______________________________.

ANS: window dressing

PTS: 1

9. By adding the number of days that inventory is held to the number of days that accounts receivable is outstanding an analyst can calculate the number of days of _____________________________________________ the firm requires.

ANS: working capital financing

PTS: 1

10. In general, the shorter the number of days of needed financing, the ____________________ is the cash flow from operations to average current liabilities.

ANS: larger PTS: 1

11. Common shareholders benefit with increasing proportions of debt in the capital structure as long as the firm maintains an excess of ____________________ over the after-tax cost of debt

ANS: ROA PTS: 1

12. One problem with debt ratios is that they provide no information about the ability of the firm to generate ________________________________________ to service debt.

ANS: cash flow from operations

PTS: 1

13. In bankruptcy prediction analysis a type ____________________ error is classifying a firm as nonbankrupt when it ultimately goes bankrupt.

ANS: I

PTS: 1

14. In bankruptcy prediction analysis a type ____________________ error is classifying a firm as bankrupt and it ultimately survives.

ANS: II

PTS: 1

15. The beta coefficient measures the ____________________ of a firm's returns with those of all shares traded in the market (in excess of the risk-free interest rate).

ANS: covariability

PTS: 1

16. The current ratio is one of the measures of__________ of the firm.

ANS:liquidity

PTS: 1

17. _________________________ concerns a firm’s ability to make interest and principal payments on borrowings as they become due.

ANS: Credit risk

PTS: 1

18. The analysis of short-term liquidity risk requires an understanding of the _________________________ of a firm.

ANS: operating cycle

PTS: 1

19. Financially healthy firms frequently close any cash flow gaps in their operating cycles with ________________________________________.

ANS: short-term borrowing

PTS: 1

20. Large current ratios indicate the availability of cash and near cash assets to repay ____________________ coming due within the next year.

ANS: obligations

PTS: 1

21. When calculating the quick ratio, an analyst would include in the numerator cash, ________________________________________, and receivables.

ANS: marketable securities

PTS: 1

22. Cash flow from operations indicates the amount of cash that the firm derived from operations after funding ______________________________.

ANS: working capital

PTS: 1

23. An analyst can view the revenues to cash ratio as a ________________________________________.

ANS: cash turnover ratio

PTS: 1

24. When the excess of ROA over the after-tax cost of borrowing declines, additional ________________________________________ begins to reduce the return to common shareholders.

ANS: financial leverage

PTS: 1

25. The ________________________________________ ratio indicates the number of times that net income before interest expense and income taxes exceeds interest expense.

ANS: interest coverage

PTS: 1

26. When a company wants to calculate the current ratio the would divide the current assets by the

ANS: current liabilities

27. Working capital is defined as ______________________ minus _____________________.

ANS: current assets, current liabilities

SHORT ANSWER

1. The current risk-free rate of return in the economy is 6%. In addition, the market rate of return is currently 8.5%

A. Given this information, what would be the expected return on common stock for a company with a systemic risk level (Beta) of 1.3? Show your calculations.

B. Describe systemic risk.

ANS:

A. Expected Return = Risk-free Interest Rate + Market Beta [Market Return - Risk-free Interest]

Expected Return = =.06 +1.3[.085-.06]=9.25%

B. Systemic Risk is the risk that affects all investments in common; it is the risk that cannot be reduced by a well diversified portfolio.

PTS: 1

2. A. What are the three measures that are used to analyze long term solvency risk?

B- describe each measure briefly

Answer part A:

1) Debt ratios

2) Interest coverage ratios

3) Operating cash flow to total liabilities ratio

ANS part B:

1) Debt ratios- measure the relative amount of liabilities especially long term debt that a business has in its capital structure. The higher the debt ratio the greater the long term solvency risk.

2) Interest coverage ratios- measure the number of times a firms income or cash flows can cover interest payments when they become due.

3) Operating cash flow to total liabilities ratio- measures what percentage of the cash flows the firm has to pay its liabilities.

PTS: 1

3. When a financial analyst examines the credit risk of a company, it is common that he or she uses a set of factors that all begin with the letter "C." Each factor provides a consideration that enters into the lending decision. List and discuss how each of the factors affects a company's credit risk.

ANS:

1. Circumstances leading to need for the loan - The reasons that the company needs to borrow affect the riskiness of the loan and the likelihood of repayment.

2. Credit History - Has the firm borrowed in the past and successfully repaid the loan.

3. Cash flows - Is the lender generating sufficient cash flows to pay interest and repay the principal on a loan rather than having to rely on selling the collateral.

4. Collateral - Is the collateral sufficient to repay the loan and does the lender have the right to take possession of the collateral.

5. Capacity for debt - Has the company borrowed up to its capacity or is there a margin of safety remaining.

6. Contingencies - Are there any events on the horizon that would harm the company if their outcome is negative.

7. Character of management - An intangible factor, has the management team been successful in difficult times, are they honest and forthcoming.

8. Communication - Developing relations with lenders requires effective communication both initially and on an ongoing basis.

9. Conditions - What are the restrictions or covenants put in place to protect the lender.

Each of these factors must be examined in the multivariate manner so that the total credit risk profile of the company can be determined.

PTS: 1

4. Bankruptcy analysis research has gone through many iterations, from univariate bankruptcy prediction models to sophisticated logit models. However, after examining the results of the research there appear to be a number of common factors that consistently explain bankruptcy. These factors can be grouped into investment factors, financing factors, operating factors. For each of the three groups discuss specific factors that have been found to significantly explain bankruptcy.

ANS:

Investment factors:

1. Relative liquidity of a firm's assets - The higher the proportion of current assets relative to current liabilities, the less likely the company will experience bankruptcy.

2. Rate of asset turnover - The faster that a company turns over its assets, the more quickly funds work their way toward cash on the balance and the less chance that the company will experience bankruptcy.

Financing factors:

1. Relative proportion of debt in the capital structure - The higher the proportion of liabilities in the capital structure, the more likely the company will experience bankruptcy.

2. Relative proportion of short-term debt in the capital structure - Just as in the above factor, the higher the proportion of short-term liabilities in the capital structure that will be coming due within one fiscal period, the more likely the company will experience bankruptcy.

Operating factors:

1. Relative level of profitability - Because profitable firms ultimately turn profits into cash, they are less likely to experience bankruptcy.

2. Variability of operations - Firms that experience a cyclical sales pattern are often more at risk for bankruptcy due to their need for cash during the down times in the cycle, which may extend beyond the point of safety.

PTS: 1

5. In the empirical research on earnings manipulation discussed in the chapter a number of firm characteristics are found to be associated with the likelihood of engaging in earnings manipulation. For each of the characteristics listed below, discuss the rationale for their inclusion in the model:

a. Gross Margin Index

b. Asset Quality Index

c. Sales Growth Index

d. Depreciation Index

e. Leverage Index

ANS:

a. Gross Margin Index - Firms with weaker profitability in a given year are more likely to engage in earnings manipulation in the future.

b. Asset Quality Index - Represents the proportion of total assets comprising assets other than current assets and PP&E and investments in securities. The index represents the proportion of lower quality assets relative to the prior year. An increase in this factor suggests the company may be trying to capitalize and defer costs that should have been expensed.

c. Sales Growth Index - Sales growth this period relative to the prior period. The need for low cost external financing might motivate managers to manipulate earnings and sales.

d. Depreciation Index - Depreciation expense as a proportion of PP&E before depreciation, this period relative to the prior period. A higher ratio implies that the company has slowed down its rate of depreciation resulting in increased earnings.

e. Leverage Index - The proportion of total financing comprised of current liabilities and long-term debt for the current year relative to the prior period. An increase in the proportion of debt puts the company at greater risk of violating debt covenants and needing to manipulate earnings and sales.

PTS: 1

6. The main ratio used by many financial analysts to examine a company's short-term liquidity risk is the current ratio. However, there are a number of problems that arise when this ratio is used to examine short-term liquidity risk that may make the current ratio less useful than initially thought. Discuss the interpretative problems of using the current ratio.

ANS:

There are a number of interpretative problems with using the current ratio as a measure of short-term liquidity risk:

1. One of the main inputs into the numerator, inventories, is stated at acquisition cost, which is an amount less than what the company should expect the asset to generate in sales dollars. This will result in understating the current ratio.

2. When the current ratio is above one, an equal increase in current assets and current liabilities will result in a decrease in the ratio. This is opposite the result if the current ratio is below one. This makes analysis difficult.

3. A very high current ratio may not be the result of prosperous business conditions, while a decreasing current ratio may end up being good news. The current ratio must be examined within the context of the total business.

4. The current ratio is susceptible to "window dressing." At fiscal period ends, managers can take steps to improve the current ratio without actually improving the business.

PTS: 1

7. For each of the following factors, determine if the given change or level of that factor would lead an analyst to believe that managers of a firm are more or less likely to engage in earnings manipulation: Earnings

More likely/less likely

ANS:

More likely/less likely

more likely

less likely

3. Asset Quality index increases more likely

4. Depreciation index decreases to below 1 less likely

5. Leverage Index increases more likely

PTS: 1

8. One criticism of the interest and fixed charges coverage ratios as measures of long-term solvency risk is that they use earnings rather than cash flows in the numerator. Detail how the interest coverage ratio and fixed charges coverage ratio are calculated. In addition, discuss why using earnings in the numerator is a problem and what method could be used to alleviate this problem.

ANS:

Net Income + Interest Expense

Interest Coverage Ratio = + Income Tax Expense + Minority Interest in Earnings Interest Expense

If a firm must make other required periodic payments (for example, pensions, leases), then the analyst could include these amounts in the calculation as well. If so, the analyst refers to the ratio as the fixed charges coverage ratio.

One criticism of the interest and the fixed charges coverage ratios as measures of long-term solvency risk is that they use earnings rather than cash flows in the numerator. Firms pay interest and other fixed charges with cash, not with earnings. The analyst can create cash-flow-based variations of these coverage ratios by using cash flow from operations (before interest and income taxes) in the numerator.

PTS: 1

9. For each of the following scenarios, determine if it is an indicator of potential cash flow problems:

Potential future cash flow problems

Yes/No

a. Growth in accounts receivable or inventories that is less the growth rate in sales.

b. Increases in accounts payable that exceed the increase in inventories.

c. Capital expenditures that substantially exceed cash flow from operations.

d. Sales of marketable securities are less than purchases of marketable securities.

e. Other operating current liabilities that grow at a lesser rate than sales.

f. A reduction or elimination of dividend payments

g. A substantial shift from long-term borrowing to shortterm borrowing.

ANS:

Potential future cash flow problems

a. Growth in accounts receivable or inventories that is less the growth rate in sales. No

b. Increases in accounts payable that exceed the increase in inventories. Yes

c. Capital expenditures that substantially exceed cash flow from operations. Yes

d. Sales of marketable securities are less than purchases of marketable securities. No

e. Other operating current liabilities that grow at a lesser rate than sales. No

f. A reduction or elimination of dividend payments Yes

g. A substantial shift from long-term borrowing to shortterm borrowing. Yes

PTS: 1

10. Discuss the differences between Chapter 7 and Chapter 11 bankruptcy filings?

ANS:

Under Chapter 11, firms have six months in which to present a plan of reorganization to the court. After that period elapses, creditors, employees, and others can file their plans of reorganization. One such plan might include immediately selling the assets of the business and paying creditors the amounts due. The court decides which plan provides the fairest treatment for all parties concerned. While in bankruptcy, creditors cannot demand payment of their claims. The court oversees the execution of the reorganization. When the court determines that the firm has executed the plan of reorganization successfully and appears to be a viable entity, the firm is released from bankruptcy.

A Chapter 7 filing entails an immediate sale, or liquidation, of the firm’s assets and a distribution of the proceeds to the various claimants in the order of their priority.

PTS: 1

11. What is the effect of the declaration of diviends have on the liquidity of a corporation?

ANS: When dividends are declared retained earnings is debited for the amount of the dividends and a current liability is established. Increases in liabilities will lower the current ratio. When the dividends are paid in cash there will be no effect on the working capital as an asset and a liability will decrease by the same amount.

PROBLEM

1. Given the following information, calculate for Year 2 the number of days of working capital financing the firm will need to obtain from other sources?

ANS: The student will need to calculate the number of days in receivables, inventory, and accounts payable.

Days in Receivables = 365 days / $3,636 / [(518 + 562)/2] = 54.21 days

Days in Inventory = 365 days / $2,294 / [(535 + 564)/2] = 87.43 days

Days in Payables = 365 days / ($2,294 +564 - 535) / [(203 + 192)/2] = 31.03 days

Days of working capital financing the firm will need to obtain from other sources = 110.61 days

PTS: 1

2. Refer to the financial statement data for Patriot Corp. for 2011 and 2010. Complete the table by computing the ratios.

For the year ended December 31, 2011

3. Below is information from Darren Company’s 2012 financial statements.

Operating Cash Flow to Total Liabilities Ratio

PTS: 1

33.38%

4. Falcon Corporation has current assets of $400,000 and current liabilities of $275,000.

Required:

Compute the effect of each of the following transactions on Falcon's current ratio:

a. Refinanced a $60,000 long-term mortgage with a short-term note.

b. Purchasing $108,000 of merchandise inventory with short-term accounts payable.

c. Paying $50,000 of short-term accounts payable.

d. Collecting $90,000 of short-term accounts receivable.

ANS:

a. The refinancing of a $60,000 long-term mortgage with a short-term note would increase Falcon’s current liabilities, decreasing the current ratio to 1.19 (= $400,000  $335,000).

b. Purchasing $108,000 of inventory with a short-term account payable would increase Falcon’s current assets to $508,000, and increase the current liabilities to $383,000, making the current ratio 1.33.

c. Paying $50,000 of short-term accounts payable decreases both the current assets and liabilities by $50,000, making the current ratio 1.56.

d. Collection of $90,000 of short-term accounts receivable has no effect on Falcon’s current ratio.

PTS: 1

5 A Hammer Corporation wrote off $185,000 of obsolete inventory at December 31, 2011.

Required: What effect did this write-off have on the company's 2011 current and quick ratios?

ANS:

The write-off of obsolete inventory would decrease Hammer Corporation's current assets, thus decreasing the current ratio. The quick ratio would be unaffected by the inventory write-off because the quick ratio takes only the most liquid assets (cash, marketable securities, and receivables) into account.

5B. Assume that Hammer company did not write off their inventory. How will this affect the company’s financial position?

ANS: If a company keeps obsolete inventory on the books they are artificially pumping up their current ratio. Obsolete inventory cannot be sold and will not be contributing to a companies earnings. This is considered a manipulation of the accounting information and if a company loans Hammer company money based on the current ratio and the obsolete inventory and the company files bankruptcy the company will be charged with fraud.

PTS: 1

6. Selected risk ratios are presented for 2011 and 2010 for Techtron Company. Also, refer to the financial statement data for the company.

STATEMENT OF CASH FLOWS (in millions)

Required:

a. Calculate the amounts of these ratios for 2012.

b. Assess the changes in the short-term liquidity risk of Techtron between 2010 and 2012 and the level of that risk at the end of 2012.

c. Assess the changes in the long-term solvency risk of Techtron between 2010 and 2012 and the level of that risk at the end of 2012.

ANS:

b.) The changes in the short-term liquidity risk ratios present mixed signals. Techtron has built up its balance in cash so that it has more days of revenue held in cash. This trend provides Techtron with liquidity and reduces its short-term liquidity risk. The current and quick ratios were steady during the three years and at healthy levels. Again, these results suggest low short-term liquidity risk. The operating cash flow to current liabilities ratio declined, and by 2012, it was less than the 40 percent found for healthy companies. The decrease in this ratio is the result of declining cash flow from operations and increasing current liabilities. Net income increased each year so that the declining cash flow from operations is the result of changes in non-cash revenues and expenses and in operating working capital accounts. The financial statements indicate that the addback for depreciation and amortization decreased during the three years. Depreciation and amortization do not affect cash flows; the smaller addback simply offsets the smaller expense. Thus, changes in depreciation and amortization do not explain the declining cash flow from operations. It appears that the explanation lies primarily in a decrease in prepayments in 2010 and a decrease in accounts payable and other current liabilities in 2012. The analyst would be concerned with a decrease in current liabilities only if it signaled pressure from suppliers of various goods and services to pay their amounts due. However, Techtron has more than sufficient cash and accounts receivable to cover all current liabilities. The net days of working capital declined sharply between 2010 and 2011 as a result of reducing the days accounts receivable and inventory being held, a positive sign in terms of reducing short-term liquidity risk. This occurred in a year when sales increased. The net days of working capital increased again in 2012, a year in which sales decreased. It would not appear that Techtron is unduly risky in terms of short-term liquidity risk at the end of 2012. Its current and quick ratios are at healthy levels and its days inventory and accounts payable have been fairly steady for the past two years. The only troublesome aspect is the declining operating cash flow to current liabilities ratio. This ratio is a concern in 2012 and continuation of this trend could become troublesome.

c. Techtron’s long-term solvency risk has decreased significantly during the three-year period. Debt levels have declined as Techtron has redeemed debt. (See Techtron’s statement of cash flow.) Its interest coverage ratio has increased from a worrisome level in 2010 to a very healthy level in 2012. The latter occurred because of a reduction in borrowing and an increase in net income. Its operating cash flow to total liabilities ratio was good in 2010 and 2011 but has declined below the 20 percent threshold for a healthy company. The reduced debt offset the declining cash flow from operations to provide a relatively stable cash flow ratio, but the off-balance sheet financing transactions (see other financing transactions) and limited investing transactions appear to have consequences for the level of long-term solvency risk at the end of 2012.

PTS: 1

7. Below is selected data of Pronto Company:

Required:

a. What is the accounts receivable turnover for 2012?

b. What is the inventory turnover for 2012?

ANS:

a.) Accounts receivable turnover = 5.0 times.

b.) Inventory turnover = 4.0 times.

Calculations: Average trade receivables = ($640,000 + $620,000)  2 = $630,000

Accounts receivable turnover = Net credit sales  Average trade receivables = $3,150,000  $630,000 = 5.0 times.

Average inventory = ($542,500 + $642,500)  2 = $592,500

Inventory turnover = Cost of goods sold  average inventory = $2,370,000  $592,500 = 4.0 times.

PTS: 1

8. On January 1, 2012, Deputron Company's beginning inventory was $600,000. During 2012, the company purchased $2,600,000 of additional inventory, and on December 31, 2012 Creek's ending inventory was $565,000.

Required:

What was Deputron’s inventory turnover for 2012?

ANS: 4.5 times.

Calculations: Cost of goods sold = $600,000 + $2,600,000 - $565,000 = $2,635,000

Average inventory = ($600,000 + $565,000)  2 = $582,500

Inventory turnover = Cost of goods sold  average inventory = $2,635,000  $582,500 = 4.5 times.

PTS: 1

9. Caraway Company's net accounts receivable was $300,000 at December 31, 2012 and $450,000 at December 31, 2013. Net cash sales for 2008 were $425,000. The accounts receivable turnover for 2013 was 7.0, and this turnover figure was computed from net credit sales for the year.

Required: What were Caraway’s total net sales for 2013?

ANS:

$3,050,000

Calculations: Total net sales equals total credit sales plus total cash sales. The accounts receivable ratio is used to find total credit sales. Average receivables = ($300,000 + $450,000)  2 = $375,000. Accounts receivable turnover = Total credit sales  average receivables. 7.0 = Total credit sales  $375,000. Total credit sales = $2,625,000. Total net sales = $2,625,000 + $425,000 = $3,050,000

PTS: 1

10. Foxmoor Company's merchandise inventory and other related accounts for 2012 follow:

Required: Calculate Foxmoor’s inventory turnover during 2012 assuming that the merchandise inventory buildup was relatively constant during the year.

ANS:

3.1 times

Calculations: Average inventory = ( ($850,000+$995,000)  2 = $922,500

Inventory turnover = Cost of goods sold  Average inventory = $2,153,200/$922,500=2.33

PTS: 1

11. Bragdon Company is consistently profitable. Its normal financial statement relationships are as follows:

Required: Determine whether each transaction or event that follows increased, decreased or had no effect on each ratio.

1. Bragdon declared but did not pay a cash dividend.

2. Customers returned invoiced goods for which they had not paid.

3.Accounts payable were paid at year-end.

4. Bragdon recorded both a receivable from an insurance company and a loss on a building due to fire damage.

5. Early in the year, Bragdon increased the selling price of one of its products because customer demand far exceeded production capacity. The number of units sold this year was the same as last year.

ANS:

1. Bragdon declared but did not pay a cash dividend: This transaction would decrease the current ratio, have no effect on the inventory turnover ratio, and increase the liabilities to assets ratio. Bragdon’s current liabilities are increased by the declaration of a cash dividend.

2. Customers returned invoiced goods for which they had not paid: If customers returned invoiced goods for which they had not paid, Bragdon’s current ratio and inventory turnover would decrease, and the liabilities to assets ratio would increase.

3.Accounts payable were paid at year-end: The payment of accounts payable would increase the current ratio, have no effect on inventory turnover ratio, and decrease the liabilities to assets ratio.

4. Bragdon recorded both a receivable from an insurance company and a loss on a building due to fire damage: This transaction would increase the current ratio and the total liabilities to assets ratio, and have no effect on inventory turnover.

5. Early in the year, Bragdon increased the selling price of one of its products because customer demand far exceeded production capacity. The number of units sold this year was the same as last year: The increase in selling price would increase the current ratio, have no effect on inventory turnover, and decrease the total debt/total asset ratio.

PTS: 1