Financial Statements
3.5 A FINANCIAL RATIO EXAMPLE .1 Problem Statement
To illustrate the use of the balance sheet and the income statement in determining the financial soundness of a company, an example of a fictitious company, Archem, Inc., will be presented. It was formed over a period of about 15 years through acquisitions, mergers, and buyouts of several small companies. Archem manufactures specialty and fine chemicals. We shall use their balance sheet and income statement for 200X as a typical set of data,Tables 3.8and3.9.Determine the liquidity, leverage, activity, and profitability performance of Archem.
Calculate the Z score for this firm. You may assume that the stock is selling at $10 per share. What do you conclude about the financial performance of this firm?
3.5.2 Problem Solution
The financial ratios for Archem are found inTable 3.15.If these are compared with the CPI averages found in Table 3.14, one can draw the following conclusions:
From the liquidity ratios, the company is able to pay its short-term debts when due.
From the leverage standpoint, the “fixed charge coverage” and the “times interest earned” are a bit low. The debt-to-asset ratio is about average.
The company needs to reduce fixed or interest charges or increase profit or income.
The activity ratios are about average for a company in the CPI, and the company manages its assets effectively.
The profitability ratios are about average, although the return on total assets is low.
Overall, the operating performance appears to be satisfactory. The management seems to operating the company in a satisfactory manner despite some areas as cited above that bear some watching.
The Z score for Archem, Inc., obtained by substituting the appropriate values, is 3.06 (see Table 3.15). The firm is safe from bankruptcy at this time but management must continually monitor the Z score.
3.6 SUMMARY
This chapter introduced the basic elements of accounting that readers are likely to encounter in industry. From accounting records and internal reports, the financial data ultimately become part of the balance sheet or the income statement. The various terms in the balance sheet and the income statement were defined, and an illustration of these documents for a typical company was presented. This information should allow one to determine how well a firm has done and is doing.
All annual reports contain footnotes, which explain how changes in financial information and pending litigation could affect the financial performance of a company. The 10K report was mentioned because it provides the source of detailed backup information not in the annual report.
Financial ratios often used by analysts were introduced because they are indicators of how well the company uses its asset and how well management performs. An equation for determining the Z score was introduced as it measures the financial position of the firm with respect to bankruptcy.
The principles and definitions of terms presented in this chapter will appear many times throughout the text to explain how financial data affect the marketing, manufacturing, engineering, research and development, and administration of a company.
TABLE3.15 Financial Ratios for Archem, Inc.
Liquidity
Current ratio = $391,200/$201,500 = 1.94
Cash ratio = $391,200 2 149,000/$201,500 = 1.20 Leverage
Debt-to-assets = [($448,100 2 201,500)/$705,700] £ 100 = 35%
Times interest earned = $74,500 2 22,000/$22,000 = 4.39 Fixed-charge coverage = $86,500/$22,000 = 3.93
Activity
Inventory turnover = $932,000/$149,000 = 6.25
Average collection period = $135,000/($932,000/365) = 52.8 days Fixed-assets turnover = $932,000/$438,000 = 2.13
Total-assets turnover = $932,000/$705,700 = 1.32 Profitability
Gross profit margin = [($932,000 2 692,000)/$932,000] £ 100 = 25.8%
Net operating margin = $74,500/$932,000 £ 100 = 7.99%
Profit margin on sales = $50,000/$932,000 £ 100 = 5.36%
Return on net worth (return on equity)
= [$50,000/($705,700 2 448,100)] £ 100 = 19.4%
Return on total assets = ($50,000/$705,700) £ 100 = 7.09%
Zscore
Z= 1.2 (working capital/total assets) + 1.4 (retained earnings/total assets) + 3.3 (EBIT/total assets)
+ 0.6 (market value of equity/total liabilities) + (sales/total assets)
Z= 1.2 ($391,200 2 $201,500)/$705,700
+ 1.4 ($268,400/$705,700) + 3.3($96,500/$705,700) + 0.6 ($320,000/$448,100) + $932,000/$705,700 Z= 0.323 + 0.532 + 0.451 + 0.429 + 1.321 ¼ 3.056
REFERENCES
1. JR Couper, OT Beasley, WR Penney. The Chemical Process Industries Infrastructure, New York: Marcel Dekker, 2001.
2. RN Anthony. Management Accounting, Homewood, IL: Irwin, 1964.
3. CB Nickerson. Accounting Handbook for Non-Accountants, 2nd ed. Boston: CBI Publishing, 1979.
4. JA Ness, TG Cucuzza. Harvard Business Review, July – August 1995, pp 130 – 138.
5. Adapted from How To Read An Annual Report, 5th ed. New York: Merrill Lynch, Pierce, Fenner & Smith, 1984.
6. Dow Annual Report. Midland, MI., April 2000.
7. Fortune. Sept 9, 1996, pp 173 –174.
8. Fortune. Nov. 10, 1997, pp 265 – 276.
9. C Kyd. Calculating financial ratios. Lotus. January 1987, pp 44 – 47.
PROBLEMS
3.1 From the transactions in the general journal, prepare a ledger, a balance sheet, and an income statement for the month of February for Nuchem, Inc. (See Table 3.16.)
3.2 From the following transactions for Nuchem, Inc. (see Table 3.17), construct the journal, ledger, balance sheet, and income statement for March. Do not forget to include previous commitments (interest, depreciation, Custer’s salary, etc.).
3.3 In April, the price of Nusolv drops to 50 cents/liter. Nuchem decides not to sell any product but continues to produce Nusolv at 1,000 liters/month. To keep everything running, Custer makes a deal with a bank to borrow $5,000 a month on a continuous basis. Would the income statement and the balance sheets look very bad? What kind of troubles would Nuchem eventually encounter?
3.4 Old Smooky McCarthy was drilling wildcat holes in northern Michigan when he struck oil. The find is estimated at 2 million producible barrels of oil.
The cost of drilling the well was $1.5 million; royalty to the owner is $2.50/barrel plus a bonus of $5,000 for signing the agreement last year. Oil currently sells for
$18/barrel. What should the asset value of this property be on the balance sheet?
3.5 Chuck Adamson built a new indigo plant at a cost of $2 million to capitalize on the world craze for blue denim. He managed to convince the IRS that the craze would last only 2 years so that he should be able to depreciate the plant in 2 years by straight line, even though the plant will physically last 15 years. Let’s assume the blue denim craze lasts strongly into the third year. Will Adamson operate without a plant listed on the balance sheet? Will he have no depreciation expense on this product cost? Can he undersell any would-be newcomers to the market?
TABLE3.16 Page 3 of Nuchem General Journal: For Problem 3.1
Date Account titles and explanation LP Debit Credit
2/1 Accrued wages payable 22 1,000
Cash 10 1,000
Finished goods 14 1,000
Accrued wages payable 22 1,000
Back wages to Davis, owe for February
2/7 Equipment 12 5,000
Prepaid expense 15 2,000
Cash 10 3,000
Equipment arrives, $3000 balance paid in cash
2/10 Accounts payable 24 6,000
Cash 10 6,000
Pay outstanding raw materials account upon delivery
2/20 Finished goods 14 4,000
Raw materials 11 4,000
Make 5000 liters of Nusolv using
$4000 of raw materialsa
2/25 Cash 10 2,000
Bank loan 21 2,000
Take out another $2000 loan at 12% interest; promise to pay back after 1 year
2/26 Cost of goods sold 44 1,000
Finished goods 14 1,000
Cash 10 3,000
Revenue 30 3,000
Sell 1000 liters of Nusolv at $3/literb
2/28 Salaries expense 43 1,500
Salaries payable 26 1,500
Owe Custer his salary Adjusting entries
2/28 Depreciation expense: equipment 41 66.67
Equipment 12 66.67
$8,000 £ 1/12 = $66.67 per month
2/28 Interest expense 42 40.00
Interest payable 23 40.00
To record bank loan interest for February
(continued )
3.6 Sharppencil & Associates, Inc. is a consulting firm operating from rented office space and furniture. It spent $200,000 in the past 2 years developing a set of computer programs for the control of batch-processing chemical plants. It hopes to sell them to domestic as well as foreign CPI firms. How should the firm list this set of programs on the balance sheet? Suppose two buyers, each paying $500,000, could be found each year for the next 3 years. How should these transactions be listed on the books? Should the firm amortize the programs over a period of time?
On the other hand, suppose no buyers can be located for 3 years. How would the programs be entered then?
TABLE3.16 Continued
Date Account titles and explanation LP Debit Credit
2/28 Revenue 30 3,000.00
Income summary 55 3,000.00
To close the revenue account
2/28 Income summary 55 2,606.67
Salaries expense 43 1,500.00
Depreciation expense: equipment 41 66.67
Interest expense 42 40.00
Cost of goods sold 44 1,000.00
To close the expense accounts
2/28 Income summary 55 393.33
Stockholders’ equity 50 393.33
To close out the income summary
aThe book value of the second batch of finished goods is $5000/(5000 liters) or $1/liter.
bThis firm uses the LIFO method, where the goods sold are evaluated at the cost of the last batch manufactured, or $1/liter. So the credit side of the “Finished goods” account shows a withdrawal of 1000 liters at $1/liter. The debit side of the “Cost of goods sold” account records the $1000 cost of the 1000 liters.
TABLE3.17 March Nuchem Data for Problem 3.2
Date Account titles and explanation
3/1 Pay $1000 to Davis, give him a raise, owe him $1500 for March 3/10 Pay $360 for advertisement in a chemical trade journal
3/11 Buy $5500 of raw materials, pay $4000 now, owe $1500 due in April 3/15 Borrow $5000 from bank at 12% interest; promise to pay back after 1 year 3/15 Sell 3000 liters of Nusolv at $3.50/liter
3.7 Inflation has suddenly doubled the cost of all Nusolv raw materials and tripled machinery costs. How is this likely to affect Nuchem’s evaluation of assets under raw materials, plants, and finished goods? The price of Nusolv has also doubled. What will happen to the profit margin? Should the company use LIFO or FIFO accounting? Is it dangerous and unrealistic to keep depreciation charges at the original machine cost once replacement machinery cost has tripled?
3.8 From the 1999 Dow Company Annual Report (Tables 3.10 – 3.12),answer as many of the following questions as possible:
a. What was the year’s income?
b. What was the net income as a percentage of sales?
c. What was the income tax as a percentage of pretax income?
d. What percentage of the cost of plants and properties was shown as depreciation and obsolescence?
e. What percentage of sales was shown as depreciation and obsolescence?
f. What percentage of sales comprised selling, general, and administrative expenses?
g. What was the total revenue from net sales and other income?
h. What percentage of total revenue was spent for materials and services?
i. What percentage of total revenue was spent for wages, salaries, and related expenses?
j. What percentage of total revenue was paid out as dividends?
k. How much was retained for use in the business, including depreciation
“set asides”?
l. How much did it cost to construct (or acquire in other ways) the company’s existing plants and properties?
m. How much of the cost of plants and properties have been charged to date as an operating expense?
n. What percentage of the cost of plants has been charged to cost?
o. What percentage of total assets is in each of the following: cash, marketable securities, accounts receivable, and inventories?
p. What were the total liabilities, excluding stockholders’ equity?
q. What was the stockholders’ equity?
r. How much cash and marketable securities were on hand at the beginning of the year?
s. During the year, the cash and marketable securities increased and decreased. What was the increase due to the sum of net income and depreciation?
t. What were the dividends as a percentage of net income plus depreciation?
u. What were construction expenditures as a percentage of net income plus depreciation?
v. How much cash and marketable securities were left at the end of the year?
3.9 Using data from the 1999 Dow Annual Report, calculate the company’s liquidity, leverage, activity, and profitability ratios. What was the Z score?