Q29PGA - Horngren'S Financial And Managerial Accounting

Question

Completing a comprehensive financial statement analysis 

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

ABC ATHLETIC SUPPLY, INC. Five-Year Financial Summary (Partial; adapted)
(Dollar amounts in thousands except per share data)	2018	2017	2016	2015	2014	2013
Net Sales Revenue	\(250,000	\)216,000	\(191,000	\)161,000	\(134,000
Net Sales Revenue Increase	16%	13%	19%	20%	17%
Domestic Comparative Store Sales Increase	5%	6%	4%	7%	9%
Other Income—Net	2,110	1,840	1,760	1,690	1,330
Cost of Goods Sold	189,250	164,592	148,216	126,385	106,396
Selling and Administrative Expenses	41,210	36,330	31,620	27,440	22,540
Interest:
Interest Expense	(1,080)	(1,380)	(1,400)	(1,020)	(830)
Interest Income	125	165	155	235	190
Income Tax Expense	4,470	3,900	3,700	3,320	2,700
Net Income	16,225	11,803	7,979	4,760	3,054
Per Share of Common Stock:
Net Income	1.60	1.30	1.20	1.00	0.78
Dividends	0.40	0.38	0.34	0.30	0.26
Financial Position
Current Assets, Excluding Merchandise Inventory	\)30,700	\(27,200	\)26,700	\(24,400	\)21,500
Merchandise Inventory	24,500	22,600	21,700	19,000	17,500	$16,700
Property, Plant, and Equipment, Net	51,400	45,200	40,000	35,100	25,600
Total Assets	106,600	95,000	88,400	78,500	64,600
Current Liabilities	32,300	28,000	28,300	25,000	16,500
Long-term Debt	23,000	21,500	17,600	19,100	12,000
Stockholders’ Equity	51,300	45,500	42,500	34,400	36,100
Financial Ratios
Acid-Test Ratio	1.0	1.0	0.9	1.0	1.3
Rate of Return on Total Assets	17.2%	14.4%	11.2%	8.1%	7.1%
Rate of Return on Common Stockholders’ Equity	35.5%	26.%	20.8%	13.5%	13.0%

Requirements 

Analyze the company’s financial summary for the fiscal years 2014–2018 to decide whether to invest in the common stock of ABC. 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 ABC Athletic Supply, Inc.? Fully explain your final decision

Step-by-Step Solution

Answer

1. Positively, net income and net sales revenue trends are rising.
2. Over the five years under consideration, the profit margin, return on assets turnover ratio, and return on equity grew.
3. Gross profit percentage and inventory turnover increase over the period.
4. The company can pay its creditors because the current and quick ratios are relatively high.
5. The earnings per share ratio and the dividends per share ratio rise over time.
6. Invest in ABC Athletic Supply, Inc. for increasing dividends per share and steady growth.

Step 1: Meaning of Ratio analysis

A common tool for financial analysis is ratio analysis. It is a tool for extracting data from financial accounts and visualising it. It concentrates on numbers that show an organisation’s profitability, efficiency, financial leverage, and other pertinent data.

Step 2: (1) Trend analysis for net sales revenue and net income

Particulars	2018	2017	2016	2015	2014
Net sales Revenues	$250,000	$216,000	$191,000	$161,000	$134,000
Trend percentages	187%	161%	143%	120%	100.00%
Net income	$16,225	$11,803	$7,979	$4,760	$3,054
Trend percentages	531%	386%	261%	156%	100.0%

 

Analysis: The net sales revenue and the net income increases mean showing an upward and positive trend.

Note: The formula used to calculate the trend percentage is:

 $\mathrm{Trend}\mathrm{percentage}=\frac{\mathrm{Net}\mathrm{sales}\mathrm{revenue}/\mathrm{Net}\mathrm{income}}{\mathrm{Base}\mathrm{year}\mathrm{value}\left(2014\right)}$

Step 3: (2) Profitability analysis

  a) Profit margin ratio

Particulars	2018	2017	2016	2015	2014
Net income	$16,225	$11,803	$7,979	$4,760	$3,054
Net sales	$250,000	$216,000	$191,000	$161,000	$134,000
Profit margin ratio	6.5%	5.5%	4.2%	3.0%	2.3%

 

Working notes:

The formula used to calculate the profit margin ratio is as follows:

$\mathrm{Profit}\mathrm{margin}\text{\hspace{0.33em}}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Net}\text{\hspace{0.33em}}\mathrm{sales}\mathrm{revenue}}$ 

There is an increase in the profit margin every year, which is favorable for the company.

   b) Rate of return on total assets

The data is given 

Particulars	2018	2017	2016	2015	2014
Given in data	17.2%	14.4%	11.2%	8.1%	7.1%

 

    c) Asset turnover ratio

Particulars	2018	2017	2016	2015
Net sales revenue	$250,000	$216,000	$191,000	$161,000
Total assets beginning	$95,000	$88,400	$78,500	$64,600
Total assets ending	$106,000	$95,000	$88,840	$78,500
Average total assets	$100,500	$91,700	$83,450	$71,550

 

Particulars	2018	2017	2016	2015
Asset turnover  Ratio	2.48	2.36	2.29	2.25

 

Notes: Following formula is used to calculate the asset turnover ratio

$\mathrm{Asset}\mathrm{turnover}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{sales}}{\mathrm{Average}\mathrm{total}\mathrm{asset}}$ 

    d) Rate on return on common stockholder’s equity

Particulars	2018	2017	2016	2015	2014
Given in data	33.5%	26.8%	20.8%	13.5%	13.0%

 

   e) Earnings per share

Particulars	2018	2017	2016	2015	2014
Given in data	$1.60	$1.30	$1.20	$1.00	$0.78

 

Analysis: The profit margin ratio, returns on assets turnover ratio, and return on equity increased over the five years examined. The return on assets and the return on equity are both very respectful. The earnings per share increase over time, so the stock is attractive.

Step 4: (3) valuation of the ability to sell merchandise inventory

  a) Gross profit percentage

Particulars	2018	2017	2016	2015	2014
Net sales revenue	$250,000	$216,000	$191,000	$161,000	$134,000
Cost of goods sold	189,250	164,592	148,216	126,385	106,396
Gross profit	$60,750	$51,408	$42,784	$34,615	$27,604
Gross profit %	24.3%	23.8%	22.4%	21.5%	20.6%

 

Note: Following formula is used to calculate the gross profit percentage

 $\mathrm{Gross}\mathrm{profit}\mathrm{percentage}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Net}\mathrm{sales}}$

b) Inventory turnover 

 

Particulars	2018	2017	2016	2015	2014
Beginning inventory	$22,600	$21,700	$19,000	$17,500	$16,700
Ending inventory	24,500	22,600	21,700	19,000	17,500
Average inventory	$23,550	$22,150	$20,350	$18,250	$17,100
Inventory turnover	8.04	7.43	7.28	6.93	6.22
Day’s sales in inventory	45.4 days	49.1 days	50.1 days	52.7 days	58.7 days

 

Note: Following formula is used to calculate inventory turnover

$\mathrm{Inventory}\mathrm{turnover}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{merchandise}\mathrm{inventory}}$ 

$\mathrm{Day}\text{'}\mathrm{s}\mathrm{sales}\mathrm{in}\mathrm{inventory}=\frac{365\mathrm{days}}{\mathrm{Inventory}\mathrm{turnover}}$ 

Analysis: The gross profit percentage is around 24% and has been increasing, which is a positive sign. Inventory turnover has increased over the period examined, which is a positive sign. The company is selling inventory more rapidly.

Step 5: (4) Evaluation of the ability to pay debts.

a) Acid test ratio

Particulars	2018	2017	2016	2015	2014
Given in data	1.0	1.0	0.9	1.0	1.3

 

Note: Formula for acid test ratio

 $\mathrm{Acid}-\mathrm{test}\mathrm{ratio}=\frac{\mathrm{Cash}+\mathrm{Cash}\mathrm{equivalent}+\mathrm{Short}-\mathrm{term}\mathrm{investments}+\mathrm{Net}\mathrm{current}\mathrm{receivables}}{\mathrm{Current}\mathrm{liabilities}}$

b) Current ratio

Particulars	2018	2017	2016	2015	2014
Current assets
Current liabilities	$32,300	$28,000	$28,300	$25,000	$16,500
Current ratio	1.70	1.78	1.71	1.74	2.36

 

Note: Following formula is used to calculate the current ratio

$\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{asset}}{\mathrm{Current}\mathrm{liabilities}}$ 

c) Debt ratio

Particulars	2018	2017	2016	2015	2014
Total liabilities
Total  assets	$106,000	$95,000	$88,400	$78,500	$64,600
Debt ratio	52.1%	52.1%	51.9%	56.2%	44.1%

 

Note: Following formula used to find debt ratio

 $\mathrm{Debt}\mathrm{ratio}=\frac{\mathrm{Total}\text{\hspace{0.33em}}\mathrm{liabilities}}{\mathrm{Total}\mathrm{assets}}$

d) Debt to equity ratio

Particulars	2018	2017	2016	2015	2014
Total liabilities
Total  equity	$51,300	$45,500	$42,500	$34,400	$36,100
Debt to equity ratio	1.08	1.09	1.08	1.28	0.79

 

Note: Following formula is used to calculate the debt to equity ratio

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

e) Times interest earned ratio

Particulars	2018	2017	2016	2015	2014
Net income	$16,225	$11,803	$7,979	$4,760	$3,054
Income tax expense	4,470	3,900	3,700	3,320	2,700
Interest expense	1,080	1,380	1,400	1,020	830
Total	$21,775	$17,083	$13,079	$9,100	$6,584
Times interest earned ratio	20.16	12.38	9.34	8.92	7.93

 

Note: Formula used to find times interest earned ratio

$\mathrm{Times}\mathrm{interest}\mathrm{earned}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{income}+\mathrm{Income}\mathrm{tax}\mathrm{expense}+\mathrm{Interest}\mathrm{expense}}{\mathrm{Interest}\mathrm{expense}}$ 

Analysis: The current and quick ratios are relatively high. It indicates that the company can pay its liabilities. The company debt to total assets is not extraordinary high, which will facilitate the company making all payments for a debt. The time’s interest earned ratio has increased from 2014 to 2018, which is favourable.

Step 6: (5) Evaluation of dividends

Dividend payout

Particulars	2018	2017	2016	2015	2014
Annual dividend per share (given in data)	$0.40	$0.38	$0.34	$0.30	$0.26
Earnings per share	$1.60	$1.30	$1.20	$1.00	$0.78
Dividend payout	25%	29%	28%	30%	33%

 

Note: Formula used to calculate the dividend payout 

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

Analysis: The dividends per share and earnings per share ratios increase over time. These are probably the two watched financial measures, so the stock is attractive.

Step 7: (6) Explaining the investment decision

The net sales revenue, net income, inventory turnover, EPS, and times-interest-earned trends for ABC have all improved. All other metrics have remained the same or gotten better. The data from ABC shows no apparent issues. Consequently, buy ABC to benefit from rising dividends per share and consistent growth.