Question

Mastery Problem: Financial Statement Analysis

Liquidity and Solvency Measures

Your friend, another accountant, has bet you that with your knowledge of accounting and just the computations for common analytical measures, you can figure out many aspects of a company's financial statements. You take the bet!

Match each computation to one of the liquidity and solvency measures in the table. (Hint: Begin by looking for simple computations and identifying the amounts in those computations. Look for other measures that use those amounts.)

Liquidity and Solvency Measures		Computations
Working capital		$3,093,000 – $900,000
Current ratio		$3,093,000 ÷ $900,000
Quick ratio		$1,866,000 ÷ $900,000
Accounts receivable turnover		$8,260,000 ÷ [($714,000 + $740,000) ÷ 2]
Number  of days' sales in receivables		[($714,000 + $740,000) ÷ 2] ÷ ($8,260,000 ÷ 365)
Inventory turnover		$4,100,000 ÷ [($1,072,000 + $1,100,000) ÷ 2]
Number of days' sales in inventory		[($1,072,000 + $1,100,000) ÷ 2] ÷ ($4,100,000 ÷ 365)
Ratio of fixed assets to long-term liabilities		$2,690,000 ÷ $1,690,000
Ratio of liabilities to stockholders' equity		$2,590,000 ÷ $4,017,000
Times interest earned		($976,800 + $127,000) ÷ $127,000

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Balance Sheet

Use the following balance sheet form to enter amounts you identify from the computations on the Liquidity and Solvency Measures part. You will identify other amounts for the balance sheet on the Profitability Measures part. If you have a choice of two amounts, assume the first amount in the ratio is for the end of the year. Compute any missing amounts.

Balance Sheet December 31, 20Y6
Assets
Current assets:
Cash	$823,000
Marketable securities
Accounts receivable (net)
Inventory
Prepaid expenses
Total current assets	$3,093,000
Long-term investments	824000
Property, plant, and equipment (net)	2,690,000
Total assets	$6,607,000
Liabilities
Current liabilities	$900,000
Long-term liabilities	1,690,000
Total liabilities	$2,590,000
Stockholders' Equity
Preferred stock, $10 par	$
Common stock, $5 par	1,250,000
Retained earnings
Total stockholders' equity	$4,017,000
Total liabilities and stockholders' equity	$6,607,000

Answer 1

Additional notes:-

As given in the question, from the accounts receivable turnover and inventory turnover, the first amount in the denominator is taken as the closing value.

Average inventory = (Opening inventory + closing inventory)/2

Average account receivable =(Opening account receivable+ closing account receivable)/2

Note 2 1 3 4 Assets Current assets: Cash $ 823,000.00 Marketable securities $ 329,000.00 Accounts receivable (net) $ 714,000.00 Inventory $1,072,000.00 Prepaid expenses $ 155,000.00 Total current assets $3,093,000.00 Long-term investments $ 824,000.00 Property, plant, and equipment (net) $2,690,000.00 Total assets $6,607,000.00 Liabilities Current liabilities $ 900,000.00 Long-term liabilities $1,690,000.00 Total liabilities $2,590,000.00 Stockholders' Equity Preferred stock, $10 par $1,790,200.00 Common stock, $5 par $1,250,000.00 Retained earnings $ 976,800.00 Total stockholders' equity $4,017,000.00 Total liabilities and stockholders' equity $6,607,000.00 6 5

Liquidity and Solvency Measures Working capital Current ratio Quick ratio Accounts receivable turnover Number of days' sales in receivables Inventory turnover Number of days' sales in inventory Ratio of fixed assets to long-term liabilities Ratio of liabilities to stockholders' equity Times interest earned Computations Formula $3,093,000 - $900,000 Current Assets - Current Liabilities $3,093,000 = $900,000 Current Assets / Current Liabilities $1,866,000 = $900,000 (Cash +Account Recivable +Marketable securities)/Current liabilities $8,260,000 = [($714,000 + $740,000) = 2] Net Credit Sales/ Average Account Receivables [($714,000 + $740,000) = 2] = ($8,260,000 = 365) 365/ Account Receivable Turnover ratio $4,100,000 = [($1,072,000+ $1,100,000) = 2] Cost of goods sold/ Average inventory [($1,072,000+ $1,100,000) = 2] = ($4,100,000 = 365) 365/ Inventory turnover ratio $2,690,000 - $1,690,000 Fixed Assets/Long term liabilities $2,590,000 = $4,017,000 Total liabilities/Shareholders' equity ($976,800 + $127,000) = $127,000 Earnings before interest and tax/Interest expense Note:- 1 From account receivable turnover ratio, closing accounts receivable is $7,14,000 2 From quick ratio, Marketable security = 18,66,000-8,23,000-7,14,000 3 From inventory turnover ratio, closing inventory is $10,72,000 4 Prepaid expense is the balancing figure of Total current assets 5 From times interest earned, earnings for the year is $9,76,800 (ignoring tax) 6 Preferred stock is the balancing figure of total stockholders' equity

Answer 2

Balance Sheet
Dcember 31 20Y6
Assets
Current Assets
Cash	823000
Marketable securities	329000
Account Receibvables (net)	714000
Inventory	1072000
Prepaid expense	155000
Total Current Assets	30,93,000
Long term Investments	824000
PPE(net)	2690000
Total assets	66,07,000
Liabilities
Current Liabilities	900000
Long term liabilities	1690000
Total liabilities	2590000
Stockholders equity
Preferred stock $ 10 par	487500	(4017000 - 3529500)
Common stock $5 par	1250000
Retained Earnings	2279500	(b/f)
Total stock holders equity	4017000
Total liabilities and stock holders equity	66,07,000

Compartive Income Statement
For the year ended Dec 31 20Y6 and 20Y5
		Increase / Decrease
	20Y6	20Y5	Amount	%
Sales	8260000	7267000	993000	12.02%
Cost of goods sold	-4100000	-3444000	656000	16.00%
Gross Profit	4160000	3823000	337000	8.10%
Selling Expenses	1817200	1453200	364000	20.03%
Administartive expenses	1239000	1103000	136000	10.98%
Total opearting expenses	3056200	2556200	500000	16.36%
Operating Income	1103800	1266800	-163000	-14.77%
Other expenses (interest)	127000	120600	6400	5.04%
Income before income tax expense	976800	1146200	-169400	-17.34%
Income tax expense	185460	179460	6000	3.24%
Net income	791340	966740	-175400	-22.16%

Net Income has decreased significantly from 20Y5 to 20Y6 even though Sales has increased.

However COGS has also increased which slowed down the increase in Gross Profit

In addition Selling expenses has also increased at a faster rate.

The company appears to have decrease in net income.

Considering the EPS and PE ratio, you can invest in this company.

Also it had declared dividend which is an income for the investor.