The Financial Statements

CHAPTER 2

The Financial Statements

BRIEF EXERCISES

BE2–2

(1)  Current Liabilities financed $30 billion of the assets.

Current Liabilities divided by Total assets = $30/$52 = 57.7%

(2)  Long-term debt financed $17 billion of the assets.

Long-term debt divided by total assets = $17/$52 = 32.7%

(3)  Stockholders’ equity financed $5 billion of the assets.

Stockholders’ equity divided by total assets = $5/$52 = 9.6%

BE2–3

(a)  Working capital = current assets – current liabilities. Boeing’s current assets total $23 billion, less $30 billion of current liabilities, gives the company negative working capital of $7 billion. Another measure of solvency would be the current ratio. The current ratio is current assets divided by current liabilities or $23 billion divided by $30 billion = 0.77. Both measures indicate that Boeing appears to have a solvency problem. Current assets are not sufficient to cover current liabilities. Under existing circumstances the Company will have to look to other sources to pay its current obligations.

(b)  No, Boeing has $11.7 billion of liquid current assets (cash, short term investments, and accounts receivable) but it has $30 billion of current liabilities.

(c)  Boeing would be more solvent if accounts receivable were $8.1 billion and inventory was $5.3 billion. Accounts receivable are closer to cash than inventory. This means that accounts receivable are expected to be converted to cash in a shorter period of time than inventory.

EXERCISES

E2–1

E2–3

a. Balance sheet g. Balance sheet m. Balance sheet

b. Income statement h. Balance sheet n. Balance sheet

c. Balance sheet i. Balance sheet o. Balance sheet

d. Income statement j. Balance sheet p. Income statement

e. Balance sheet k. Income statement q. Balance sheet

f. Income statement l. Income statement r. Balance sheet

PROBLEMS

P2–1

1. e 9. a 17. c

2. e 10. a 18. a

3. a 11. c 19. d

4. a 12. d 20. b

5. g 13. c 21. e

6. c 14. b 22. e

7. f 15. e 23. e

8. c 16. a

X Company

Balance Sheet

(Date)

Assets

Current assets:

Cash $XX

Short-term investments XX

Accounts receivable $XX

Less: Allowance for uncollectible accounts XX XX

Inventory XX

Prepaid rent XX

Total current assets $XX

Long-term investments:

Land held for investment $XX

Investment fund for plant expansion XX

Total long-term investments XX

Property, plant, & equipment:

Property $XX

Building $XX

Less: Accumulated depreciation (building) XX

Net book value of building XX

Machinery and equipment $XX

Less: Accumulated depreciation (machinery &

equipment) XX

Net book value of machinery and equipment XX

Total property, plant, & equipment XX

Intangible assets:

Patents $XX

Trademarks XX

Total intangible assets XX

Total assets $XX

Liabilities and Stockholders' Equity

Current liabilities:

Accounts payable $XX

Wages payable XX

Dividend payable XX

Short-term notes payable XX

Current portion due of long-term debt XX

Payments received in advance XX

Total current liabilities $XX

Long-term liabilities:

Bonds payable $XX

Total long-term liabilities XX

Stockholders' equity:

Capital stock $XX

Retained earnings XX

Total stockholders' equity XX

Total liabilities and stockholders' equity $XX

P2–2

1. e 6. e 11. e

2. b 7. e 12. f

3. e 8. f 13. f

4. a 9. c 14. d

5. e 10. c 15. c

X Company

Income Statement

For the Period Ended

Revenues:

Sales $XX

Fees earned XX

Interest income XX

Dividend income XX

Gain on sale of short-term investments XX

Total revenues $XX

Expenses:

Cost of goods sold $XX

Operating expenses:

Office salary expense $XX

Insurance expense XX

Salesmen commission expense XX

Depreciation expense XX

Office supplies expense XX

Advertising expense XX

Total operating expenses XX

Other expenses:

Interest expense $XX

Loss on sale of equipment XX

Loss on sale of building XX

Total other expenses XX

Total expenses XX

Net income $XX

P2–8

First, let us compute some relevant ratios that would help us evaluate the financial statements of Ted Tooney.

Ratios 2008 2007

Liquidity

Current Ratio 1.29 2.00

(Current Assets ÷ Current Liabilities)

Working Capital $2,000 $4,000

(Current Assets – Current Liabilities)

Long-Term Debt Paying Ability

Debt/Equity Ratio 1.45 0.92

(Total Liabilities ÷ Stockholders’ Equity)

Operating Cash Flow to Total Debt 0.75 1.36

(Operating Cash Flow ÷ Total Debt)

Profitability

Net Profit Margin 0.15 0.19

(Net Income ÷ Sales)

Total Asset Turnover 3.41 3.87

(Sales ÷ Total Assets)

Return on Assets 0.52 0.74

(Net Income ÷ Total Assets)

Return on Assets 0.51 0.74

(Net Profit Margin ´ Total Asset Turnover)

Return on Equity 1.27 1.42

(Net Income ÷ Stockholders’ Equity)

Looking at the declining trends of all financial indicators, it would be safe to decline Ted’s request for an equity investment in his company.

The short-term liquidity of the company is going down. The working capital as well as the current ratio has declined. The company is becoming highly leveraged and the amount of operating cash flow as a percentage of total debt has considerably declined. This all indicates a worsening position.

The profitability and return on assets are mediocre and declining. The return on equity has also declined as the company is not able to leverage its debt to the advantage of its stockholders.

Even though the overall liquidity position is not that serious, the trend is towards the decline. In summary, a loan position may be taken with the company, but certainly not an equity position.

ISSUES FOR DISCUSSION

ID2–1

a.  Net income represents the change in net assets (i.e., assets less liabilities) generated during the year from operating activities. Alternatively, cash flows from operating activities is the amount of cash the company generated during the year from operating activities. Since cash is simply one of many assets a company has, it is obvious that net income and cash flows from operating activities are not the same. Thus, it is quite possible for a company to have an increase in net assets from operating activities (i.e., net income) and at the same time have negative cash flows from operating activities.

The ability of a company to pay dividends is a function of how much cash the company has available. A company could generate negative cash flows from operating activities but have large cash reserves from generating cash from operating activities in prior years. Alternatively, a company may have obtained enough cash to pay a dividend by borrowing the money or by selling assets. Remember, companies can generate cash from investing activities and financing activities in addition to cash from operating activities.

b.  A company could not continue generating negative cash flows from operating activities and expect to continue in business. A company cannot borrow money or issue stock indefinitely. At some point the creditors will demand to be repaid and the owners will demand some return on their investment. Sooner or later the company will have to generate cash from its operations to repay the creditors. Paying out dividends while generating negative cash flows from operating activities will only increase the company's cash problems.

ID2–4

EDS – EDS is able to generate strong cash flow from its current operations ($1,933). The company appears to invest a relatively small sum ($33) in long term assets. More significant funds ($827) have been spent by either retiring debt or returning money to the shareholders (in dividends and stock repurchases). Total cash balances have increased as the company’s cash flow from operations are currently more than the company has re-invested into its business and returned to shareholders.

Southwest Airlines – Southwest is also able to generate significant cash from its operations ($2,188), but the company has been more active than EDS in investing in long term assets ($1,146). Due to the capital-intensive nature of its business, Southwest must continually purchase and upgrade aircraft to remain competitive. Southwest has raised cash from its financing activities, either from debt or equity proceeds. Overall, cash balances have increased, driven by the strong operations.

The Gap – The Gap has kicked off solid cash from operations ($1,551) but appears to be actively selling long term assets instead of purchasing additional. The positive cash from investing ($286) indicates the company is selling more long term assets than it is purchasing. Finally, the company has decreased its overall cash balances because its heavy use of cash in financing ($2,040) has outstripped the cash generated by its stores and the sale of unwanted long term assets. The company has been active with share repurchases and with dividend payments.

ID2–5

From the data given about the Goodrich Corporation it can be surmised that Goodrich has done a good job of generating positive operating cash flow, but that the amounts generated are decreasing over the time period shown. Given the fact that the company is a defense contractor and that defense spending has been heavy in the years shown, the decreasing operational cash flow is a trend that causes some concern. Strategically, the large investment in long term assets shown by the company’s cash from investing activities implies that the company is investing in long term assets such as equipment that will be used in the operations of the business. The performance of cash from financing activities shows that Goodrich has been able to return cash to shareholders and/or pay down debt, although the amounts have been decreasing over the period shown. Overall, cash balances have dropped each year. The amount generated by operating activities has been insufficient to cover the amounts used by investing and financing activities. The downward trend of cash thrown off by the company’s daily operations merits further investigation and analysis.