36PGB - Horngren'S Financial And Managerial Accounting

Question

Completing a comprehensive financial statement analysis

In its annual report, XYZ Athletic Supply, Inc. includes the following five-year financial summary:

XYZ ATHLETIC SUPPLY, INC.
Five-Year Financial Summary (Partial; adapted)
(Dollar amounts in thousands except per share data)	2018	2017	2016	2015	2014	2016
Net sales revenue	\(275,000	\)222,000	\(199,000	\)171,000	131,000
Net Sales Revenue Increase	24%	12%	16%	31%	17%
Domestic Comparative Store Sales Increase	6%	6%	5%	8%	10%
Other Income—Net	2,090	1,780	1,770	1,700	1,310
Cost of Goods Sold	208,725	169,386	154,822	134,235	103,883
Selling and Administrative Expenses	41,280	36,340	31,670	27,450	22,540
Interest:
Interest Expense	(1,070)	(1,370)	(1,330)	(1,100)	(800)
Interest Income	140	155	150	230	140
Income Tax Expense	4,420	3,900	3,610	3,390	2,730
Net Income	21,735	12,939	9,488	6,755	2,497
Per Share of Common Stock:
Net Income	1.10	0.80	0.70	0.50	0.28
Dividends	0.45	0.43	0.39	0.35	0.31
Financial Position
Current Assets, Excluding Merchandise Inventory	\(30,900	\)27,200	\(26,800	\)24,400	$21,800
Merchandise Inventory	24,700	22,400	21,600	19,300	17,000	16,800
Property, Plant, and Equipment, Net	51,600	46,200	40,500	35,000	25,200
Total Assets	107,200	95,800	88,900	78,700	64,000
Current Liabilities	32,600	27,800	28,800	25,600	17,000
Long-term Debt	23,000	21,200	16,800	18,600	12,900
Stockholders’ Equity	51,600	46,800	43,300	35,500	34,100
Financial Ratios
Acid-Test Ratio	0.9	1.0	0.9	1.0	1.3
Rate of Return on Total Assets	22.5%	15.5%	12.8%	10.9%	9.9%
Rate of Return on Common Stockholders’ Equity	44.2%	28.7%	24.1%	19.4%	18.9%

 

Requirements 

Analyze the company’s financial summary for the fiscal years 2014–2018 to decide whether to invest in the common stock of XYZ. Include the following sections in your analysis. 

1. Trend analysis for net sales revenue and net income (use 2014 as the base year). 

2. Profitability analysis. 

3. Evaluation of the ability to sell merchandise inventory. 

4. Evaluation of the ability to pay debts. 

5. Evaluation of dividends. 

6. Should you invest in the common stock of XYZ Athletic Supply, Inc.? Fully explain your final decision        

Step-by-Step Solution

Answer

1. Trend analysis compares the performance of the company in different years.
2. Profitability analysis reflects that the business entity’s profitability is increasing.
3. The ability of the business entity to sell its merchandise reflects improvement.
4. The business entity’s ability to repay its debt has improved.
5. Although the dividend per share has increased, the payout ratio of the business entity is declining. 
6. An investor can invest in the business entity. 

Step 1: Definition of Financial Ratios

The figures that are calculated by comparing various line items of the financial statement to arrive at a conclusive decision regarding liquidity, solvency, and profitability are known as financial ratios. 

Step 2: Trend analysis of sales revenue and net income

Particular	Current year amount	Base year amount (2014)	Change in amount  $\mathrm{(}\mathrm{Current}\mathrm{ }\mathrm{year}\mathrm{ }\mathrm{amount}\mathrm{-}\mathrm{Base}\mathrm{ }\mathrm{year}\mathrm{ }\mathrm{amount}\mathrm{)}$	Percentage change  $\left(\frac{\mathrm{Change} \mathrm{in} \mathrm{amount}}{\mathrm{Base} \mathrm{year} \mathrm{amount}}\times 100\right)$
Net sales revenue
2015	$171,000	$131,000	$40,000	30.53%
2016	$199,000	$131,000	$68,000	51.91%
2017	$222,000	$131,000	$91,000	69.47%
2018	$275,000	$131,000	$144,000	109.92%
Net income
2015	$6,755	$2,497	$4,258	170.52%
2016	$9,488	$2,497	$6,991	297.98%
2017	$12,939	$2,497	$10,442	418.18%
2018	$21,735	$2,497	$19,238	770.44%

 

Analysis: According to the above analysis, it can be said the business entity is improving its profitability because the percentage change reflects that the net income and the net sales revenue of the business entity are increasing each year.

 

Step 3: Profitability analysis

Particular	2018	2017	2016	2015	2014
Profit margin ratio	7.77%	5.83%	4.77%	3.95%	1.90%
Rate of return on total assets	22.5%	15.5%	12.8%	10.9%	9.9%
Asset turnover ratio	2.71	2.40	2.35	2.37	3.93
Rate of return on common stockholder equity	44.2%	28.7%	24.1%	19.4%	18.9%

 

Analysis: All the ratios of profitability analysis reflect that the profitability of the business entity is increasing in each succeeding year. Therefore, the business entity can invest in the stock of the company. 

 

Working note:

Formulas to be used:

1. Profit margin ratio:

$\mathbf{Profit}\mathbf{ }\mathbf{margin}\mathbf{ }\mathbf{ratio}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}}{\mathbf{Net}\mathbf{ }\mathbf{sales}\mathbf{ }\mathbf{revenue}}$

1. Rate of return on total assets:

$\mathbf{Rate}\mathbf{ }\mathbf{of}\mathbf{ }\mathbf{return}\mathbf{ }\mathbf{on}\mathbf{ }\mathbf{total}\mathbf{ }\mathbf{assets}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}\mathbf{+}\mathbf{Interest}\mathbf{ }\mathbf{expenses}}{\mathbf{Average}\mathbf{ }\mathbf{total}\mathbf{ }\mathbf{assets}}$

1. Asset turnover ratio:

$$\begin{gathered} \mathbf{Asset}\mathbf{ }\mathbf{turnover}\mathbf{ }\mathbf{ratio}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{sales}\mathbf{ }\mathbf{revenue}}{\mathbf{Average}\mathbf{ }\mathbf{total}\mathbf{ }\mathbf{assets}} \\ \mathbf{Average}\mathbf{ }\mathbf{total}\mathbf{ }\mathbf{assets}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}\mathbf{+}\mathbf{Interest}\mathbf{ }\mathbf{expenses}}{\mathbf{Rate}\mathbf{ }\mathbf{of}\mathbf{ }\mathbf{return}\mathbf{ }\mathbf{on}\mathbf{ }\mathbf{total}\mathbf{ }\mathbf{assests}} \end{gathered}$$

1. Rate of return on common stockholders’ equity:

$\mathbf{Rate}\mathbf{ }\mathbf{of}\mathbf{ }\mathbf{return}\mathbf{ }\mathbf{on}\mathbf{ }\mathbf{common}\mathbf{ }\mathbf{stockholder}\mathbf{\text{'}}\mathbf{s}\mathbf{ }\mathbf{equity}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}\mathbf{-}\mathbf{Preferred}\mathbf{ }\mathbf{dividend}}{\mathbf{Average}\mathbf{ }\mathbf{common}\mathbf{ }\mathbf{stockholder}\mathbf{\text{'}}\mathbf{s}\mathbf{ }\mathbf{equity}}$

1. Earnings per share:

$\mathbf{Rate}\mathbf{ }\mathbf{of}\mathbf{ }\mathbf{return}\mathbf{ }\mathbf{on}\mathbf{ }\mathbf{common}\mathbf{ }\mathbf{stockholder}\mathbf{\text{'}}\mathbf{s}\mathbf{ }\mathbf{equity}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}\mathbf{-}\mathbf{Preferred}\mathbf{ }\mathbf{dividend}}{\mathbf{Weighted}\mathbf{ }\mathbf{average}\mathbf{ }\mathbf{number}\mathbf{ }\mathbf{of}\mathbf{ }\mathbf{common}\mathbf{ }\mathbf{shares}\mathbf{ }\mathbf{outstanding}\mathbf{ }}$

Step 4: Ability to sell merchandise

Particular	2018	2017	2016	2015	2014
Inventory turnover ratio	8.86	7.70	7.57	7.40	6.15
Days’ sales in inventory	41 days	47 days	48 days	49 days	59 days

 

Analysis: In each succeeding year, the company can sell its inventory more efficiently, which is reflected by the number of days calculated in the day’s sales in inventory and the inventory turnover ratio. Therefore, the business entity can invest in the company.

 

Working note:

$$\begin{gathered} \mathbf{Inventoy}\mathbf{ }\mathbf{turnover}\mathbf{ }\mathbf{ratio}\mathbf{=}\frac{\mathbf{Cost}\mathbf{ }\mathbf{of}\mathbf{ }\mathbf{goods}\mathbf{ }\mathbf{sold}}{\mathbf{Average}\mathbf{ }\mathbf{merchandise}\mathbf{ }\mathbf{inventory}} \\ \mathbf{Day}\mathbf{\text{'}}\mathbf{s}\mathbf{ }\mathbf{sales}\mathbf{ }\mathbf{in}\mathbf{ }\mathbf{inventory}\mathbf{=}\frac{\mathbf{365}}{\mathbf{Inventoy}\mathbf{ }\mathbf{turnover}\mathbf{ }\mathbf{ratio}} \end{gathered}$$

Step 5: Ability to pay debts

Particular	2018	2017	2016	2015	2014
Debt ratio	0.52	0.51	0.51	0.56	0.47
Debt to equity ratio	1.08	1.05	1.05	1.24	0.88
Times-interest earned ratio	25.44	13.29	10.84	10.22	7.53

 

Analysis: The times interest earned ratio increases each year, reflecting that the business entity is efficient in covering its interest expenses. A debt ratio and debt-equity reflect that the debts of the business entity are increasing and decreasing. It states that the business entity is paying off its debt.  

 

Working note:

1. Debt ratio:

$\mathbf{Debt}\mathbf{ }\mathbf{ratio}\mathbf{=}\frac{\mathbf{Total}\mathbf{ }\mathbf{liabilities}}{\mathbf{Total}\mathbf{ }\mathbf{assets}}$

1. Debt-to-equity ratio:

$\mathbf{Debt}\mathbf{-}\mathbf{to}\mathbf{-}\mathbf{equity}\mathbf{ }\mathbf{ratio}\mathbf{=}\frac{\mathbf{Total}\mathbf{ }\mathbf{liabilities}}{\mathbf{Total}\mathbf{ }\mathbf{equity}}$

1. Times interest earned:

$\mathbf{Time}\mathbf{ }\mathbf{interest}\mathbf{ }\mathbf{earned}\mathbf{ }\mathbf{ratio}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}\mathbf{+}\mathbf{Income}\mathbf{ }\mathbf{tax}\mathbf{ }\mathbf{expenses}\mathbf{+}\mathbf{Interest}\mathbf{ }\mathbf{expenses}}{\mathbf{Interest}\mathbf{ }\mathbf{expenses}}$

Step 6: Evaluation of dividends

Particular	2018	2017	2016	2015	2014
Earnings per share	1.10	0.80	0.70	0.50	0.28
Dividend	0.45	0.43	0.39	0.35	0.31
Dividend payout	0.4090	0.5375	0.5571	0.7	1.14

 

Analysis: Earnings per share of the company reflect an increase which means that the business entity can generate higher income for each of its shares. Still, the dividend payout ratio is declining, which means that the business entity is paying fewer dividends.

 

Working note:

1. Earnings per share:

$\mathbf{Earnings}\mathbf{ }\mathbf{per}\mathbf{ }\mathbf{share}\mathbf{=}\frac{\mathbf{Net}\mathbf{ }\mathbf{income}\mathbf{-}\mathbf{Preferred}\mathbf{ }\mathbf{dividend}}{\mathbf{Weighted}\mathbf{ }\mathbf{average}\mathbf{ }\mathbf{common}\mathbf{ }\mathbf{shares}\mathbf{ }\mathbf{outstanding}}$

1. Dividend payout ratio:

$\mathbf{Dividend}\mathbf{ }\mathbf{payout}\mathbf{ }\mathbf{=}\frac{\mathbf{Annual}\mathbf{ }\mathbf{dividend}\mathbf{ }\mathbf{per}\mathbf{ }\mathbf{share}}{\mathbf{Earnings}\mathbf{ }\mathbf{per}\mathbf{ }\mathbf{share}}$

Step 7: Investment decision

The business entity can be considered for investment because it shows constant performance growth. Earnings per share reflect growth from $0.28 per share in 2014 to $1.10 per share in 2018.