Module 2

Module 2 - Financial Statement Analysis and Planning (Chapters Two and Three)

All  page numbers are references to Corporate Finance: A Focused Approach, 5th  edition by Ehrhardt and Brigham (Cengage, 2013)

In Chapter 2, we learn the structure and terms of financial statements.  In Chapter 3, we analyze financial statements using ratio analysis.  The more important, and difficult, material is Chapter 2.  Major changes are occurring in Accounting; our textbooks are often years behind these changes.  In my videos, I will discuss some of these changes.

Chapter 2 Things to absorb - For Chapter 2, the main focus is on the format and purpose of balance sheet and income  statement, and the names of items that might appear in these statements (e.g., depreciation is on income statement and accumulated depreciation may be on  balance sheet), names of four required financial statements, the basics of tax  calculations, and understand how to identify/calculate cash flow.

Do  not need to absorb - NA.

Things to Read - You will need to read the chapter.  You will need to search for terms using a search engine.

Things to Do - Make 100 on the quiz.  Be able to answer End of Chapter Questions 1-4, 6, and 7 and Problems 1, 2, 4, 6, and 9-11.

Note,  I will ask you to know the names of many financial accounts that are not listed  in the chapter, so expect to do some Internet searches. Many account names in  financial statements vary by company (Income Statement = Profit and Loss  Statement = Statement of Income = Statement of Operations), thus part of  learning this chapter is learning potential account names. When solving  problems for this chapter, use the Internet to look up terms with which you are  unfamiliar. This is especially applicable when solving the scrambled income  statement/ balance sheet problems.

1.  Watch the Chapter  2 Overview.  You can download the PowerPoint slides from these videos from here.

2.  Read pages 51-59.

3.  Watch this video on the Balance  Sheet and Income Statement.  Most people find this video to be very useful in identifying the various  accounts for these two statements.

4.  Be able to answer end of Chapter 2 Questions 1-4 and Problems 4 and  6.

5.  Read pages 59-72.

6.  Watch this video on the Statement  of Cash Flows and Calculating Cash Flows.  Most people find this video to be very useful in identifying the various  accounts for these two statements.

7.  Be able to answer end of Chapter 2 Questions 6, 7 and Problems 10 and  11.

8.  Read pages 72-76.

9.  If you would like a review of a bunch of accounting terms and Economic Value  Added, watch the Economic  Value Added video. Hint, unless your company uses EVA, you can probably ship this video and  learn the terms/concepts by doing the Chapter quiz multiple times.

10.  Read the rest of the chapter.

11.  Watch the videos on Corporate  Taxes video. Do not focus on the tax code details as these often change. Do be able  to use the equation that Pretax return (1- tax rate) = After tax return (similar  to end of chapter problems 1, 2 and 9), as there is often an exam question on  this topic.

12.  Since the main focus is the on the format of statements, the most complex quiz  problems require you to unscramble and solve for missing numbers in the income  statement and balance sheet. To solve these big problems, you must be able to  solve smaller segments of the statements. Here are audio solutions that focus  on the smaller components:

a.  Audio solution to: In its recent income statement,  Smith Software Inc. reported $26 million of net income, and in its year-end  balance sheet, Smith reported $353 million of retained earnings. The previous  year, its balance sheet showed $339 million of retained earnings. What were the  total dividends paid to shareholders during the most recent year? (Answers are  in $ millions.)

b.  Audio solution to: In its recent income statement,  Smith Software Inc. reported paying $10 million in dividends to common  shareholders, and in its year-end balance sheet, Smith reported $365 million of  retained earnings. The previous year, its balance sheet showed $354 million of  retained earnings. What was the firm's net income during the most recent year?  (Answers are in $ millions.)

c.  Audio solution to: Cox Corporation recently  reported an EBITDA of $66 million and $8 million of net income. The company  has $11 million interest expense and the corporate tax rate is 40.0% percent.  What was the company's depreciation and amortization expense? (Answers are in $  millions.)

d.  Audio solution to: Brooks Sisters' operating  income (EBIT) is $140 million. The company's tax rate is 40.0%, and  its operating  cash flow is $115.3 million. The company's interest expense is $28 million. What  is the company's net cash flow? (Assume that depreciation is the only non-cash  item in the firm's financial statements.) (Answers are in $  millions.)

8.  Here is an audio solution to a complex scramble/unscramble Balance Sheet Income  Statement Problem: Fill  in the missing numbers. Prepaid expenses _________ Additional paid-in capital  _______ Property, plant and equipment, net ________ Total Liabilities and  Equity ________ Net income _______ Tax payable _______ Interest expense  ________ Net sales __________ Deferred (Long term) income tax liabilities  ________ Operating expenses _________ Change in Retained Earnings 177 Total  current assets 2495 Cash 660 Trade Receivables 749 Operating income 557 Income  before provision for income taxes 538 Inventories 872 Income taxes receivable  100 Other long term assets 384 Accounts payable 407 Deferred revenue 38 Accrued  program costs 536 Total Assets 4474 Other long term Liabilities 43 Retained  earnings 1945 Total liabilities 1896 Cost of sales 2097 Gross profit 1713  Intangible assets, net 1071 Income taxes expense 199 Dividends 162 Total  current liabilities 1104 Long-term debt 516 Accrued expenses 101 Common stock  31

13.  Be prepared for a quiz over the Chapter 2 material.

Chapter 3 Need to Absorb - Purpose of financial statement analysis, common size analysis versus  ratio analysis, trend/historical analysis versus benchmarking/competitive  analysis, focus on calculating and interpreting ratios, also on ratio algebra  (i.e., how changes in financial statements affects ratios), and limitations of  ratio analysis.

Do  not need to absorb - Dupont equation and how to use or interpret Dupont equation  (Note, many people find the Dupont discussion useful in understanding ratio  algebra) and qualitative factors in section 3-11.

Need to Read - Read the Chapter.

Need to Do - Make 100 on the quiz.  I do not list suggested questions and problems below. This is because many of the  questions are comprehensive rather than focused. But, after studying this  chapter, you should be able to solve all of the end of chapter questions and  problems, and self-test review questions. However, rather than spending time  completing those questions, I suggest you focus on the Chapter Quiz. Almost all  of the end of chapter questions and problems are in my quiz database.

1.  Watch the Chapter  Introduction and Overview video.  The Powerpoints for all of this chapter's videos are located here.  While not explicitly stated in the videos, videos two to five closely follow the end of chapter minicase.

2.  Read pages 95-103.

3.  Watch the videos on Liquidity  Ratios and Asset Management Ratios. While not explicitly stated in the videos, the next four videos closely follow the end of chapter minicase.

4.  Read pages 103-109.

5.  Watch the videos on Leverage  Ratios and Profitability Ratios.

6.  Read pages 110-115.

7.  Watch the videos on Market  Ratios and Common Size Analysis.

8.  Read the rest of the chapter

9.  Watch the videos on DuPont  Equation and Limitations of Ratio Analysis.

10. Here are audio solutions,  created by Dr. Ronald Best, to several types of ratio  problems:

a.  Audio Solution to: TCBW last year had an average collection period (days sales  outstanding) of 35 days based on accounts receivable  of $460,000. All of the firm's sales are made on credit. The firm expects sales  this year to be the same as last year. However, the company has begun a new  credit policy that should lower the average collection period to 28 days. If the  new average collection period is attained, what will the firm's accounts  receivable balance equal?

b.  Audio Solution to:The RRR Company has a target current ratio of 3.2. Presently, the  current ratio is 4.4 based on current assets of  $6,556,000. If RRR expands its inventory using short-term liabilities  (maturities less than one year), how much additional funding can it obtain  before its target current ratio is reached?

c.  Audio Solution to:AAA's inventory turnover ratio is 22.30 based on sales of  $25,200,000. The firm's current ratio equals 10.21 with  current liabilities equal to $290,000. If the firm's cash and marketable  securities equal $732,342, what is the firm's days sales  outstanding?

d.  Audio Solution to:U KNO, Inc. uses only debt and common equity funds to finance its  assets. This past year the firm's return on total  assets was 19%. The firm financed 39% percent of its assets using equity. What  was the firm's return on common equity?

e.  Audio Solution to:Last year YYY Company had a 5.00% net profit margin based on  $21,000,000 in sales and $14,000,000 of total  assets. During the coming year, the president has set a goal of attaining a 8%  return on total assets. If YYY finances 56% of its assets by borrowing, what  will its return on common equity be next year if the return on assets goal is  achieved?

f.  Audio Solution to:The RRR Company has a target current ratio of 3.6. Presently, the  current ratio is 4.5 based on current assets of  $8,505,000. If RRR expands its fixed assets using short-term liabilities  (maturities less than one year), how much additional funding can it obtain  before its target current ratio is reached?

g.  Audio Solution to:AAA's inventory turnover ratio is 22.30 based on sales of  $25,200,000. The firm's current ratio equals 10.21 with  current liabilities equal to $290,000. What is the firm's quick  ratio?

h.  Audio Solution to: Use the information below to calculate the firm's return on common  equity. (State your answer as a percentage  with two decimal places.) Net profit margin = 11.88%; Debt ratio = 44.29%; Fixed  asset turnover = 7.54; Total asset turnover = 3.50 ; Inventory turnover =  22.3.

i.  Audio Solution to:U KNO, Inc. uses only debt and common equity funds to finance its  assets. This past year the firm's return on total  assets was 19%. The firm financed 30% percent of its assets using debt. What was  the firm's return on common equity?

j.  Audio Solution to:Last year YYY Company had a 7.00% net profit margin based on  $24,000,000 in sales and $13,000,000 of total  assets. During the coming year, the president has set a goal of attaining a 14%  return on total assets. How much must firm sales equal, other things being the  same, for the goal to be achieved?

k.  Audio Solution to:Russell Securities has $267 million in total assets and its  corporate tax rate is 40%. The company recently reported  that its basic earning power (BEP) ratio was 50% and its return on assets (ROA)  was 13%. What was the company's interest expense? (Answers are in  millions.)

l.  Audio Solution to:You are given the following information: Stockholders' equity =  $205 million; price/earnings ratio = 43 shares  outstanding = 11,080,000; and market/book ratio =6.75. Calculate the market  price of a share of the company's stock.

m.  Audio Solution to:Strack Houseware Supplies Inc. has $866 million in total assets.  The other side of its balance sheet consists of  $95.26 million in current liabilities, $251.14 million in long-term debt, and  $519.60 million in common equity. The company has 16,100,000 shares of common  stock outstanding, and its stock price is $59 per share. What is Strack's  market-to-book ratio?

n.  Audio Solution to:Moss Motors has $108 million in assets, and its tax rate is 40%.  The company's basic earning power (BEP) ratio  is 42%, and its return on assets (ROA) is 11%. What is Moss'  times-interest-earned (TIE) ratio?

o.  Audio Solution to:The Wilson Corporation has the following relationships:  Sales/Total assets = 3;Return on assets (ROA) = 15%;  Return on equity (ROE) = 17%. What is Wilson's profit margin?

p.  Audio Solution to:Cleveland Corporation has 13,240,000 shares of common stock  outstanding, its net income is $241 million and  its P/E is 15.1. What is the company's stock price?

q.  Audio Solution to:Peterson Packaging Corp. has $2,072 million in total assets. The  company's basic earning power (BEP) ratio  is 13%, and its times-interest-earned ratio is 4.32. Peterson's depreciation and  amortization expense totals $73 million. It has $55 million in lease payments  and $39 million must go towards principal payments on outstanding loans and  long-term debt. What is Peterson's EBITDA coverage ratio?

r.  Audio Solution to:The Wilson Corporation has the following relationships:  Sales/Total assets = 5; Return on total assets (ROA)  = 13%; Return on common equity (ROE) = 16%. What is Wilson's debt  ratio?

11.  Take the Chapter 3 quiz.

Updated January 17, 2016

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