CHAPTER 2
THE FINANCIAL STATEMENTS BRIEF EXERCISES BE2-1 Excerpts from the annual report of AT&T, Inc., are as follows.
Compute the missing values and briefly discuss AT&T’s sources and uses of cash during the three-year period. 2008
2007
2006
Net cash flow from operating activities .................. Net cash flow from investing activities ................... Net cash flow from financing activities ...................
$ 33,656 (29,143) (4,691)
$ 34,242 (18,616) (16,074)
$ 15,688 (8,366) (6,128)
Net change in cash .................................................
$ ( 178)
$
$ 1,194
Cash at beginning of period ................................... 1,224 Cash at end of period……………………………….
1,970 $ 1,792
(448) 2,418
$
1,970
$ 2,418
AT & T’s cash management activities over the three-year period of 2006 - 2008 appear to be extremely strong. The company is generating significant amounts of cash flow from operating activities, with 2007 and 2008 at roughly twice the level of 2006. AT & T is then able to reinvest substantial amounts in its asset base. At the same time AT & T is also able to fund its financing activities from its operating cash flow. The large amount of funds being used in investing activities indicates that AT & T is growing its capital-intensive business.
BE2–2 A summary of a recent balance sheet for Boeing Co. is as follows (dollars in billions):
Chapter 2 - Page 1
What amount and what percentage of Boeing’s assets were financed by (1) current liabilities, (2) long-term debt, and (3) shareholders’ equity? (1)
Current Liabilities financed $32 billion of the assets. Current Liabilities divided by Total assets = $32/$59 = 54.2%
(2)
Long-term debt financed $18 billion of the assets. Long-term debt divided by total assets = $18/$59 = 30.5%
(3)
Stockholders’ equity financed $9 billion of the assets. Stockholders’ equity divided by total assets = $9/$59 = 15.3%
BE2–3 In BE2–2, Boeing’s current assets consisted primarily of cash and short-term investments of $9.3 billion, accounts receivable of $5.7 billion, inventory of $9.6 billion, and miscellaneous current assets of $2.4 billion. Does the company appear solvent? Why or why not? Can Boeing pay off its current liabilities with liquid assets? Would it be more or less solvent if the dollar amounts in accounts receivable and inventory were reversed? (a)
Working capital = current assets – current liabilities. Boeing’s current assets total $27 billion, less $32 billion of current liabilities, gives the company negative working capital of $5 billion. Another measure of solvency would be the current ratio. The current ratio is current assets divided by current liabilities or $27 billion divided by $32 billion = 0.84. 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 $15 billion of liquid current assets (cash, short term investments, and accounts receivable) but it has $32 billion of current liabilities.
(c)
Boeing would be more solvent if accounts receivable were $9.6 billion and inventory was $5.7 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.
BE2–4 A recent balance sheet of Royal Dutch Shell, a huge oil and gas company that prepares financial statements using IFRS, reported the following dollar amounts (in millions).
First, format these balance sheet sections in a manner that is used by many non-U.S. companies (see the Unilever analysis in this chapter), and then format the sections in the manner most common in the U.S. Comment on the differences, and how they highlight different concepts.
Chapter 2 - Page 2
IFRS Format Non-current assets Current assets Less: Current liabilities Total
154,073 115,397 (94,384) 175,086
Non-current liabilities Equity Total
49,118 125,968 175,086
GAAP Format Non-current assets Current assets Total
154,073 115,397 269,470
Current liabilities Non-current liabilities Equity Total
94,384 49,118 125,968 269,470
Many non-US companies begin with non-current assets, add current assets, and then subtract current liabilities to reflect the resources available to generate revenues and profits. The IFRS balance sheet then lists non-current liabilities and shareholders’ equity, which represent the financing sources of company resources; this amount is often labeled “capital employed.” GAAP balance sheets, on the other hand, list all assets owned (current and long-term) and then categorizes the financing sources (current and long-term liabilities, as well as shareholder equity) for those assets.
BE2–5 Revenues and expenses for PepsiCo during 2008 were $43.3 billion and $38.2 billion, respectively. The December 31, 2007 and 2008 balances in retained earnings were $28.2 billion and $30.6 billion, respectively. Compute dividends paid by PepsiCo during 2008. What percentage of net income did PepsiCo pay out in dividends during 2008? 2008 2008 Beginning Retained Earnings $28.2
+ +
2008 Revenues $43.3 X
– – =
2008 Expenses $38.2 $2.7
– –
2008 Dividends X
2008 Dividends as a percentage of 2008 net income: 2008 Dividends 2008 Net income ($43.3-$38.2)
= $ 5.1
Chapter 2 - Page 3
$ 2.7 = 52.9%
= =
2008 Ending Retained Earnings $30.6
EXERCISES E2–1 Listed below are accounts that may appear on either the balance sheet or the income statement.
For each account, indicate whether a company would ordinarily disclose the account on the balance sheet or the income statement. a. b. c. d. e. f.
Balance sheet Income statement Balance sheet Income statement Balance sheet Income statement
g. h. i. j. k. l.
Balance seet Balance sheet Balance sheet Balance sheet Income statement Income statement
m. n. o. p. q. r.
Balance sheet Balance sheet Balance sheet Income statement Balance sheet Balance sheet
E2–2 Listed below are eight transactions. In each case, identify whether the transaction is an example of financing, investing, or operating activities and which of the financial statements it would affect.
1 2 3 4 5 6 7 8
Operating, Investing, or Financing Financing Operating Operating Investing Financing Financing Investing Operating
Balance Sheet Yes Yes Yes Yes Yes Yes Yes Yes
Income Statement No Yes Yes No No No No No
Statement of Cash Flows Yes Cannot tell Yes Cannot tell Yes Yes Yes Yes
Chapter 2 - Page 4
Statement of Stockholders Equity Yes Yes Yes No No Yes No No
E2–3 Listed below are eight transactions. In each case, identify whether the transaction is an example of financing, investing, or operating activities and which of the financial statements it would affect.
1 2 3 4 5 6 7 8
Operating, Investing, or Financing Financing Operating Operating Operating Investing Investing Financing Operating
Balance Sheet Yes Yes Yes Yes Yes Yes Yes Yes
Income Statement No No Yes Yes No Cannot tell No No
Statement of Cash Flows Yes No Yes No Yes Yes Yes Yes
Statement of Shareholders Equity No No Yes Yes No Cannot tell No No
E2–4 At the end of 2009 a fast-growing advertising agency had a negative balance of $596 million in its retained earnings account. Compute the missing amounts in the following table, and comment on the company’s performance. Specifically, analyze the company’s sales growth, profits, profits as a percentage of sales, and dividends declared as a percentage of net income (dollars in millions).
2007 2007 Ending Retained Earnings or 2008Beginning Retained Earnings ($523) X
= =
($499) $1,407
=
2007 Beginning Retained Earnings + Revenues for 2007 – Expenses for 2007 – Dividends for 2007
+
$1,383
–
X
–
$0
+
$1,522
–
$1,608
–
X
Expenses for 2007 are $1,407. 2008 ($758) X
= =
($523) $149
Dividends declared for 2008 are $149.
Chapter 2 - Page 5
2009 ($596) X
= =
($758) $1,717
+
X
–
$1,550
–
$5
Revenue for 2009 is $1,717.
Sales growth (%) ................................................... Profits ..................................................................... Profits as a percentage of sales ............................. Dividends ................................................................ Dividends as a percentage of net income..............
2007
2008
N/A ($24) (1.7%) $ 0 N/A
10.0% ($86) (5.7%) $ 149 N/A
2009 12.8% 167 9.7% $ 5 3.0%
$
The advertising agency had modest sales growth from 2007 to 2009. However, from 2008 to 2009, the Company was able to go from losses to a profit. Even though the Company had a loss in 2008 the Company paid a healthy dividend. Then in 2009, when the Company showed a profit, it virtually eliminated the dividend. There is reason to be optimistic going forward. In 2009 the Company was able to show a nice growth in its sales while at the same time showing a reduction in its expenses.
E2–5 Assume a banker is interested in finding answers to the following questions about a company applying for a loan. In each case, indicate which of the four financial statements the banker should examine first to answer the question. If appropriate, also indicate which other financial statement(s) would provide further support for the answer.
1. Statement of Stockholders’ Equity (Retained Earnings); Statement of Cash Flow, Income Statement 2. Income Statement 3. Balance Sheet 4. Statement of Cash Flow, Balance Sheet 5. Statement of Stockholders’ Equity; Statement of Cash Flow 6. Income Statement, Balance Sheet 7. Income Statement 8. Balance Sheet, Income Statement
Chapter 2 - Page 6
E2–6 Duke Energy Corporation is one of America’s leading diversified energy companies. At the end of 2008 the company had a balance in its retained earnings account of $1.6 billion. Compute the missing amounts in the following table, and comment on the company’s performance. Specifically, analyze the company’s sales growth, profits, profits as a percentage of sales, and dividends declared as a percentage of net income (dollar amounts in billions).
2006 2006 Beginning Retained Earnings $5.3
+ +
2006 Revenues $10.6 X
2007* 2007 Beginning Retained Earnings $5.7
2008 2008 Beginning Retained Earnings X
+ +
+ +
2007 Revenues $12.7 X
2008 Revenues $13.2 X
– – =
– – =
– – =
2006 Expenses $8.7 $1.5
2007 Expenses X $11.2
2008 Expenses 11.8 $1.4
– –
– –
– –
2006 Dividends X
2007 Dividends $5.8
2008 Dividends $1.2
= =
2006 Ending Retained Earnings $5.7
= =
2007 Ending Retained Earnings $1.4
= =
2008 Ending Retained Earnings $1.6
*you must calculate the 2008 equation before you can calculate the 2007 equation
Sales growth ($) Sales growth (%) Profits ($) Profits (% of sales) Dividends (% of net income)
2008 $0.5 3.9% $1.4 10.6% 85.7%
2007 $2.1 19.8% $1.5 11.8% 386.7%
2006 N/A N/A $1.9 17.9% 78.9%
The company saw significant sales growth, but profits were relatively flat (meaning that profits as a percentage of sales decreased). Dividends are a consistently high percentage of profits (well above profits in 2007), which is common in the utility industry.
Chapter 2 - Page 7
E2–7 La-Z-Boy Incorporated included the following information in its 2009 annual report (dollars in millions).
Define solvency and discuss how this information might be useful in assessing the company’s solvency position. What drawbacks are associated with using this information in such a way? Solvency primarily indicates a company’s ability to meet its debt payments as they come due. Current liabilities are obligations that will be settled within one year or the company’s operating cycle, whichever is longer, through the use of current assets or the creation of new current liabilities. Current assets are those assets that will be consumed or converted to cash within one year or the company’s operating cycle, whichever is longer. Consequently, comparing current assets to current liabilities provides an indication of a company’s ability to meet its short-term debts. In this case, current assets were 2.76 ($348/$126) and 2.60 ($427/$164) times greater than current liabilities as of December 31, 2009 and December 31, 2008, respectively. Although comparing current assets to current liabilities provides a measure of a company’s solvency, this measure is not perfect. A true test of a company’s short-term solvency would be to compare the cash value of its current assets to the cash value of its current liabilities. For current liabilities, the book value is usually a good approximation of the cash value, since a company cannot, from a legal viewpoint, unilaterally change its debts. The situation is different for current assets though. The book value may or may not bear any relation to the cash value. Consequently, comparing the book value of current assets to current liabilities may not give an accurate measure of a company’s solvency.
E2–8 Suppose that La-Z-Boy in E2–7 signed a debt covenant specifying that current assets must exceed current liabilities by $200 million. Assume further that in early January 2010, the company planned to purchase a $200-million piece of machinery and had two possible methods of paying for it: (1) short-term note payable or (2) long-term note payable. Compute the effect of each alternative on the difference between current assets and current liabilities, and discuss which method seems to be the most feasible.
Chapter 2 - Page 8
Working capital as of 12/31/2009 ($348 – $126) ......................................................... Impact of method on current assets....................... Impact of method on current liabilities ................... New working capital as of January 2010 ...............
Method 1
Method 2
$
$
222 0 (200) $ 22
$
222 0 0 222
It seems that only the second method would be acceptable to the company in terms of maintaining compliance with the minimum working capital covenant.
E2–9 Southwest Airlines is a major airline. The following information was taken from its 2008 annual report. As of the end of 2008, Southwest had a cash balance of $1.4 billion. Compute the missing amounts in the following table. Describe and evaluate the company’s cash management activities in each of the three years (dollars in millions).
2008
2007
2006
Beginning cash balance ......................................... Net cash flow from operating activities .................. Net cash flow from investing activities ................... Net cash flow from financing activities ................... Ending cash balance ..............................................
$
2,213** (1,521) X 1,654 $ 1,368
$
1,390 2,845 (1,529) X $ 2,213
$
$
X 1,406 (1,495) (801) 1,390*
X equals
$
$
$
2,280
.............................................................
(978)
(493)
*2007 Beginning balance = 2006 Ending balance **2008 Beginning balance = 2007 Ending balance. Southwest Airlines’ cash management activities appear to be very good for the years 2006 and 2007, but significantly deteriorated in 2008 (due to the economic recession). The company generated a net cash inflow from its operating activities for the first two years shown, but dropped to a negative operating cash flow in 2008. A look at its investing activities reveals that the company is expanding its asset base, but had to curtail the amount spent in the third year due to the downturn. During 2008, the company had a cash inflow due to financing activities, possibly in response to a need for cash due to the poor operations. Overall, Southwest Airlines is a strong company experiencing a difficult time in its cyclical business.
Chapter 2 - Page 9
E2–10 Mary began a business, and after collecting $30,000 from an equity investor and borrowing $15,000 from a bank, she purchased a piece of land for $40,000. During the year, she leased the land to Karl and received $12,000 in cash, paying $14,000 cash for expenses. She paid a $1,000 dividend to the equity investor at year-end. Prepare an income statement, a statement of shareholders’ equity, a balance sheet, and a statement of cash flows for the period. Evaluate Mary’s decision to pay the $1,000 dividend. Mary’s Business Income Statement For the Year Ended Lease revenue ....................................................................................... Expenses ............................................................................................... Net income .............................................................................................
$ 12,000 14,000 $ (2,000)
Mary’s Business Statement of Stockholders’ Equity For the Year Ended
Beginning Balance Stock Issue Net Income (Loss) Cash Dividends Ending Balance
Contributed Capital $ 0 30,000 ______ $30,000
Retained Earnings $ 0 (2,000) (1,000) $ (3,000)
Mary’s Business Balance Sheet As of Assets Cash ...................................................................................................... Land ...................................................................................................... Total assets ............................................................................................
$ 2,000 40,000 $ 42,000
Liabilities & Stockholders’ Equity Note payable .......................................................................................... Contributed capital ................................................................................. Retained earnings .................................................................................. Total liabilities & stockholders’ equity ....................................................
$ 15,000 30,000 (3,000) $ 42,000
Chapter 2 - Page 10
Mary’s Business Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collections from customers .......................................... $ 12,000 Cash payments for expenses ............................................... (14,000) Net cash flow from operating activities ............................ $ (2,000) Cash flows from investing activities: Purchase of land ................................................................... $ (40,000) Net cash flow from investing activities ............................. (40,000) Cash flows from financing activities: Proceeds from equity investor .............................................. $ 30,000 Proceeds from borrowing ...................................................... 15,000 Cash payments for dividends................................................ (1,000) Net cash flow from financing activities ............................. 44,000 Increase in cash ......................................................................... $ 2,000 Beginning cash balance............................................................. 0 Ending cash balance ................................................................. $ 2,000 Mary should not have paid a cash dividend of $1,000 because of her dwindling cash position and negative earnings during the year. The dividend was a return of capital rather than a return on capital.
E2–11 George began a business, and after collecting $6,000 from an equity investor and borrowing $5,000 from a bank, he purchased a piece of land for $8,000. During the year, he leased the land to Sheila and received $3,000 in cash. He paid $2,500 cash for expenses during the year and paid an $800 dividend to the equity investor. Prepare an income statement, a statement of shareholders’ equity, a balance sheet, and statement of cash flows for the period. What did George do that may have concerned the bank? Explain. George’s Business Income Statement For the Year Ended Lease revenue ....................................................................................... Expenses ............................................................................................... Net income .............................................................................................
George’s Business Statement of Stockholders’ Equity For the Year Ended
Beginning Balance Stock Issue Net Income Cash Dividends Ending Balance
Contributed Capital $ 0 6,000 _____ $6,000
Retained Earnings $ 0 500 (800) $ (300)
Chapter 2 - Page 11
$3,000 2,500 $ 500
George’s Business Balance Sheet As of Assets Cash ...................................................................................................... Land ...................................................................................................... Total assets ............................................................................................
$ 2,700 8,000 $ 10,700
Liabilities & Stockholders’ Equity Note payable .......................................................................................... Contributed capital ................................................................................. Retained earnings .................................................................................. Total liabilities & stockholders’ equity ....................................................
$ 5,000 6,000 (300) $ 10,700
George’s Business Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collections from customers .......................................... Cash payments for expenses ............................................... Net cash flow from operating activities ............................ Cash flows from investing activities: Purchase of land ................................................................... Net cash flow from investing activities ............................. Cash flows from financing activities: Proceeds from equity investor .............................................. Proceeds from borrowing ...................................................... Cash payments for dividends................................................ Net cash flow from financing activities ............................. Increase in cash ......................................................................... Beginning cash balance............................................................. Ending cash balance .................................................................
$ 3,000 (2,500) $
500
$ (8,000) (8,000) $ 6,000 5,000 (800) 10,200 $ 2,700 0 $ 2,700
Upon examining George’s financial statements the bank would certainly be concerned because George paid out more in dividends than the net income he realized during the year. George’s statement of retained earnings shows a negative balance, which means that the payment to equity investors which was disguised as return on capital was in fact a return of capital. Generally, dividend payments cannot exceed the Retained Earnings balance.
Chapter 2 - Page 12
E2–12 From the following transactions, prepare a statement of cash flows for Lana and Sons in the proper form. The company began the year with a cash balance of $13,000. Describe and evaluate the company’s cash management activities during the year.
Lana & Son Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collection from services provided ....................................... Cash payment for expenses ........................................................ Net cash increase (decrease) from operating activities ........ Cash flows from investing activities: Purchase of machinery ................................................................ Net cash increase (decrease) from investing activities ......... Cash flows from financing activities: Proceeds from stockholders’ contributions .................................. Payment of dividends ................................................................... Net cash increase (decrease) from financing activities......... Increase (decrease) in cash balance ................................................. Beginning cash balance ..................................................................... Ending cash balance ..........................................................................
$4,000 (3,000) $1,000 $(3,000) (3,000) $7,000 (1,500) 5,500 $ 3,500 13,000 $ 16,500
Based on just one year’s statement of cash flows it is difficult to comment adequately on Lana & Son’s cash management activities. However, one can observe that most of the cash during the year was generated as a result of issuing equity. The company seems to be investing in its asset base. That will certainly help it grow in the future. Cash flows from operations is positive, which certainly is a good sign.
Chapter 2 - Page 13
E2–13 From the following transactions, prepare a statement of cash flows for Emory Inc. in the proper form. The company began the year with a cash balance of $25,000. Describe and evaluate the company’s cash management activities during the year.
Emory Inc. Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collection from services provided ....................................... Cash payment for expenses ........................................................ Net cash increase (decrease) from operating activities ........ Cash flows from investing activities: Purchase of equipment ................................................................ Net cash increase (decrease) from investing activities ......... Cash flows from financing activities: Proceeds from the bank loan ....................................................... Payment of dividends Net cash increase (decrease) from financing activities......... Increase (decrease) in cash balance ................................................. Beginning cash balance ..................................................................... Ending cash balance ..........................................................................
$40,000 (23,000) $17,000 $(23,000) (23,000) $30,000 (24,000) 6,000 0 25,000 $ 25,000 $
Based on just one year’s statement of cash flows, it is difficult to comment adequately on Emory’s cash management activities. However, it seems that the company is generating a substantial portion of its cash flows from operating activities. The company is taking some loans to finance its asset base which would be helpful in the future. Return on total assets and return on equity would probably increase.
Chapter 2 - Page 14
E2–14 The information below was taken from the 2009 annual report of Cisco Systems, a worldwide leader in networking for the Internet. As of the end of 2009, Cisco had a cash balance of $5.7 billion. Compute the missing amounts in the following table. Describe and evaluate the company’s cash management activities in each of the three years (dollars in millions).
2009
2008
Beginning cash balance ......................................... Net cash flow from operating activities .................. Net cash flow from investing activities ................... Net cash flow from financing activities ................... Ending cash balance ..............................................
$ 5,191 9,897 (9,959) X $ 5,718
Y* X (4,193) (6,433) $ 5,191
3,297 10,104 X (1,331) $ 3,728
X equals
$
$
$ (8,342)
.............................................................
589
$
2007
12,089
$
*Beginning cash balance for 2008 = Ending cash balance for 2007. Cisco Systems’ cash management activities over the three-year period of 2007, 2008, and 2009 appear to be strong. The Company is generating a significant amount of net cash flow from operations each year (with 2008 being especially strong) and then is investing in its business. Financing activities (including dividends and/or share repurchases) reduced cash in 2007 and 2008, but turned positive in 2009.
Chapter 2 - Page 15
PROBLEMS P2–1 The main section headings of the income statement are:
Classify the following descriptions under the appropriate headings and prepare an income statement in proper form without account balances. 1. Office salary expense 2. Sales of services provided 3. Insurance expense 4. Sales of inventories 5. Salespeople commission expense 6. Depreciation expense 7. Office supplies expense 8. Loss on sale of equipment 9. Income from interest on savings account 10. Income from dividends on investments 11. Advertising expense 12. Loss on sale of building 13. Interest expense on outstanding loans 14. Cost of sold inventories 15. Gain on sale of short-term investments 1. 2. 3. 4. 5.
e b e a e
6. 7. 8. 9. 10.
e e f c c
11. 12. 13. 14. 15.
e f f d c
X Company Income Statement For the Period Ended Revenues: Sales........................................................................... Fees earned ............................................................... Interest income ........................................................... Dividend income ......................................................... Gain on sale of short-term investments ..................... Total revenues ....................................................... Expenses: Cost of goods sold ..................................................... Operating expenses: Office salary expense ............................................ Insurance expense ................................................ Salesmen commission expense ........................... Depreciation expense ............................................ Office supplies expense ........................................ Chapter 2 - Page 16
$XX XX XX XX XX $XX $XX $XX XX XX XX XX
Advertising expense .............................................. Total operating expenses ................................. Other expenses: Interest expense .................................................... Loss on sale of equipment .................................... Loss on sale of building ......................................... Total other expenses ........................................ Total expenses ........................................................... Net income ......................................................................
XX XX $XX XX XX XX XX $XX
P2–2 Presented below are the main section headings of the balance sheet:
Classify the following accounts under the appropriate headings, and prepare a balance sheet in proper form without account balances.
1. 2. 3. 4. 5. 6. 7. 8.
e e a a g c f c
9. 10. 11. 12. 13. 14. 15. 16.
a a c d c b e a
17. 18. 19. 20. 21. 22. 23.
c a d b e e e
Chapter 2 - Page 17
X Company Balance Sheet (Date) Assets Current assets: Cash ........................................................................... Short-term investments .............................................. Accounts receivable ................................................... Less: Allowance for uncollectible accounts ............... Inventory ..................................................................... Prepaid rent ................................................................ Total current assets ............................................... Long-term investments: Land held for investment ............................................ Investment fund for plant expansion .......................... Total long-term investments .................................. Property, plant, & equipment: Property ...................................................................... Building ....................................................................... Less: Accumulated depreciation (building) ................ Net book value of building.......................................... Machinery and equipment.......................................... Less: Accumulated depreciation (machinery & equipment) ............................................................. Net book value of machinery and equipment ............ Total property, plant, & equipment ........................ Intangible assets: Patents ....................................................................... Trademarks ................................................................ Total intangible assets ........................................... Total assets ..................................................................... Liabilities and Stockholders' Equity Current liabilities: Accounts payable ....................................................... Wages payable .......................................................... Dividend payable ........................................................ Short-term notes payable ........................................... Current portion due of long-term debt ....................... Payments received in advance .................................. Total current liabilities ............................................ Long-term liabilities: Bonds payable............................................................ Total long-term liabilities........................................ Stockholders' equity: Capital stock ............................................................... Retained earnings ...................................................... Total stockholders' equity ...................................... Total liabilities and stockholders' equity .........................
Chapter 2 - Page 18
$XX XX $XX XX
XX XX XX $XX $XX XX XX $XX
$XX XX XX $XX XX XX XX $XX XX XX $XX
$XX XX XX XX XX XX $XX $XX XX $XX XX XX $XX
P2–3 Excerpts from the financial statements for Kroger, a major supermarket retailer, are as follows (dollars in millions).
Organize these numbers into income statement and balance sheets, and comment on Kroger’s solvency and earning power positions. Kroger Balance Sheet December 31, 2009, 2008 2009 Assets Cash ..................................................................................... Accounts receivable ............................................................. Inventory ............................................................................... Property, plant, and equipment (net) ................................... Other assets ......................................................................... Total assets .......................................................................... Liabilities and Stockholders’ Equity Accounts payable ................................................................. Other short-term debts ......................................................... Long term debt ..................................................................... Stockholders’ Equity ............................................................. Total liabilities and stockholders’ equity...............................
2008
$
263 944 4,859 13,161 3,984 $ 23,211
$
242 786 4,849 12,498 3,918 $ 22,293
$ 3,822 3,807 10,406 5,176 $ 23,211
$ 3,867 4,816 8,696 4,914 $ 22,293
Income Statement For the Years Ended December 31, 2009, 2008 Sales ..................................................................................... Expenses .............................................................................. Net income ...........................................................................
2009 $ 76,000 74,751 $ 1,249
2008 $ 70,235 69,054 $ 1,181
Solvency refers to a company’s ability to pay its obligations as they come due. The current ratio provides a measure of solvency by comparing those obligations that are coming due in the near future against those assets that the company expects to convert into cash or consume in the near future. Based on its current ratio, Kroger does not have sufficient current assets to cover its existing current liabilities in either year. In 2009 the current ratio was 0.80 ($6,066/$7,629), while it was 0.68 ($5,877/$8,683) in 2008. The Company’s solvency has improved in the time period shown. Earning power refers to a company’s ability to generate net assets through operations. Income has been fairly constant, as measured in terms of dollars and as a percentage of sales. Margins are thin in the company’s industry, but Kroger has shown consistent earnings in the time period. Chapter 2 - Page 19
P2–4 Compute the missing values for the following chart and analyze the financial performance and position of this company. The first year of operations is 2005.
2008 Contributed Capital: Total assets = Total liabilities + Total stockholders' equity ($300 + $200 + $500 + $100 + $700) = ($200 + $500) + (Contributed cap. + $400) Contributed capital = $700 Net Income: Net income = Sales – Expenses = $1,000 – $400 = $600 Dividends: Ending retained earnings = Beginning retained earnings + Net income – Dividends $400 = $0 + $600 – Dividends Dividends = $200 2009 Inventory: Total assets = Total liabilities + Total stockholders' equity ($300 + $300 + Inventory + $200 + $600) = ($300 + $600) + ($400 + $800) Inventory = $700 Expenses: Net income = Sales – Expenses $400 = $1,100 – Expenses Expenses = $700 Dividends: Ending retained earnings = Beginning retained earnings + Net income – Dividends $800 = $400 + $400 – Dividends Dividends = $0 2010 Accounts Receivable: Total assets ($200 + Accts. rec. + $400 + $400 + $700) Accounts receivable
= Total liab. + Total stockholders' equity = ($500 + $800) + ($600 + $300) = $500
Chapter 2 - Page 20
Expenses: Net income = Sales – Expenses ($100) = $700 – Expenses Expenses = $800 Dividends: Ending retained earnings = Beginning retained earnings + Net income – Dividends $300 = $800 + ($100) – Dividends Dividends = $400 2011 Accounts Payable: Total assets = Total liabilities + Total stockholders' equity ($500 + $700 + $400 + $400 + $800) = (Accts. pay. + $700) + ($600 + $600) Accounts payable = $900 Net income: Ending retained earnings = Beginning retained earnings + Net income – Dividends $600 = $300 + Net income – $200 Net income = $500 Sales: Net income = Sales – Expenses $500 = Sales – $600 Sales = $1,100 In order to assess the financial performance of this company, we need to calculate the measures of solvency and earning power. Respective measures are computed as follows: Measures of Solvency
2008
2009
2010
2011
Current Ratio: Working Capital: Debt/Equity Ratio:
5 $800 .64
4.33 $1,000 .75
2.20 $600 1.44
1.78 $700 1.33
The only measure of earning power that we can compute for this company is Return on Equity. The other measures, such as EPS and P/E Ratio, cannot be computed since the relevant information is not available. Measures of Earning Power
2008
2009
2010
2011
Return on Equity: .55 .33 —* .42 *No return on stockholder’s equity during 2010 since the company suffered a loss of $100. Overall, looking at the measures of solvency and earning power, one can safely conclude that the financial performance and position of the company has deteriorated since its inception in 2008. The current ratio has continued to decline and working capital has also gone down. While the company has taken more debt, it has been unable to leverage against the interest of the stockholders, since the return on equity has declined considerably. In one year, 2010, the company even suffered a loss. The company paid dividends even during the year of loss, indicating a poorly devised dividend policy.
Chapter 2 - Page 21
P2–5 Review Figure 2–7, and complete the blanks below to show the relationships among the four financial statements for Nimmo Brothers Corporation:
Nimmo Brothers Corporation Statement of Cash Flows for the year ending 12/31/2011 Cash-Operating 275 Cash-Investing (200) Cash-Financing 330 ∆ in Cash 405 Cash-12/31/10 420 Cash-12/31/11 825
Balance Sheet as of 12/31/2011 Cash Other Current Assets Long-term Assets Total Assets
Income Statement for the year ending 12/31/2011 Revenue 4,200 Expenses 4,050 Net Income 150
Current Liabilities Long-term Liabilities Contributed Capital Retained Earnings Total
Statement of Stockholders’ Equity for the year ending 12/31/2011 Contributed Capital 12/31/10 1,000 Net Income Dividends Stock Issuance 200 12/31/11 1,200
Retained Earnings 500 150 (70) ___ 580
Chapter 2 - Page 22
825 1,550 1,600 3,975
995 1,200 1,200 580 3,975
P2–6 The following information is available relating to the activities of Johnson Co. as of December 31, 2011.
Prepare a balance sheet as of 12/31/11 in proper form for Johnson Co. Would you invest in this company? Why or why not? Reformat the balance using the balance sheet format used by Unilever, illustrated on pp. 54. Does this format highlight anything differently? Johnson Company Balance Sheet December 31, 2011 Assets Current assets: Cash ....................................................................................... Short-term investments .......................................................... Accounts receivable ............................................................... Less: Allowance for uncollectible accounts .......................... Net accounts receivable .................................................. Inventory ................................................................................. Total current assets ......................................................... Property, plant, & equipment: Buildings ................................................................................. Less: Accumulated depreciation ............................................ Total property, plant, & equipment .................................. Total assets .................................................................................. Liabilities & Stockholders' Equity Current liabilities: Accounts payable ................................................................... Taxes payable ........................................................................ Total current liabilities ...................................................... Long-term notes payable.............................................................. Stockholders' equity: Contributed capital ................................................................. Retained earnings .................................................................. Total stockholders' equity ................................................ Total liabilities & stockholders' equity ..........................................
$
8,000 40,000
$125,000 2,400 122,600 161,000a $331,600 $ 35,000 8,000 27,000 $358,600
$110,000 29,400 $139,400 79,100 $100,000b 40,100c
______________________
a b c
Inventory is reported at the lower of its cost or its market value. $100,000 = $12,500 shares × $8 per share. $40,100 = $65,000 cumulative earnings – $24,900 cumulative declared dividends. Chapter 2 - Page 23
140,100 $358,600
Based on only one year’s balance sheet it is a very difficult question to answer. This fact proves the point that (1) all the financial statements must be interpreted as a whole, and (2) that the information should be analyzed over a number of years to draw any meaningful conclusions. However, based on what we have, I would not invest in this company. The current ratio is 2.379 but debt/equity ratio is 1.560, which is a cause for concern in the long term. Further, the company seems to be paying approximately 38% of its retained earnings beginning balance in dividends, which is good for the investors who are looking for short-term return on their capital. Johnson Company Balance Sheet December 31, 2011 Property, plant, & equipment: Buildings ................................................................................. $ 35,000 Less: Accumulated depreciation ............................................ 8,000 Total property, plant, & equipment .................................. $ 27,000 Current assets: Cash ....................................................................................... $ 8,000 Short-term investments .......................................................... 40,000 Accounts receivable ............................................................... $125,000 Less: Allowance for uncollectible accounts .......................... 2,400 Net accounts receivable .................................................. 122,600 Inventory ................................................................................. 161,000a Total current assets ......................................................... 331,600 Less: Current liabilities: Accounts payable ................................................................... $110,000 Taxes payable ........................................................................ 29,400 Total current liabilities ...................................................... 139,400 Total…………………………………………………………………… $219,200 Capital Employed: Long-term notes payable.............................................................. Stockholders' equity: Contributed capital ................................................................. Retained earnings .................................................................. Total stockholders' equity ................................................ Total ...................................................................................
79,100 $100,000 40,100 140,100 $219,200
Many non-US companies begin with non-current assets, add current assets, and then subtract current liabilities to reflect the resources available to generate revenues and profits. The IFRS balance sheet then lists non-current liabilities and shareholders’ equity, which represent the financing sources of company resources; this amount is often labeled “capital employed.” GAAP balance sheets, on the other hand, list all assets owned (current and long-term) and then categorizes the financing sources (current and long-term liabilities, as well as shareholder equity) for those assets.
P2–7 The chief executive officer of Romney Heights has included the following information from the financial statements in a loan application submitted to Acme Bank. Chapter 2 - Page 24
The company intends to acquire additional equipment and wishes to finance the purchase with a long-term note.
Assume that you, a bank loan officer, review the financial statements and recommend whether Romney Heights should be considered for a loan. Support your recommendation with calculations. First, let us compute some relevant ratios that would help to evaluate the financial statements submitted by Romney Heights in support of its loan application to Acme Bank. Ratios
2011
2010
Liquidity Current Ratio (Current Assets ÷ Current Liabilities) Working Capital (Current Assets – Current Liabilities)
2.00
2.00
$7,000
$6,000
1.06
0.96
0.45
0.33
Long-Term Debt Paying Ability Debt/Equity Ratio (Total Liabilities ÷ Stockholders’ Equity) Operating Cash Flow to Total Debt (Operating Cash Flow ÷ Total Debt)
Chapter 2 - Page 25
Ratios
2011
Profitability Net Profit Margin (Net Income ÷ Sales) Total Asset Turnover (Sales ÷ Total Assets) Return on Assets (Net Income ÷ Total Assets) Return on Assets (Net Profit Margin × Total Asset Turnover) Return on Equity (Net Income ÷ Stockholders’ Equity)
2010
0.34
0.19
0.55
0.58
0.19
0.11
0.187
.110
0.39
0.21
A thorough review of the various ratios reveals that Romney Heights is worth the risk. The bank should consider its loan application, at least for a short-term loan. The short-term solvency position is reasonably good. Working capital is positive and the current assets are twice the current liabilities. Regarding long-term debt paying ability the company seems to be heavily leveraged. The debt to equity ratio is more than 1 and has increased from 2010 to 2011. However, the concern is somewhat mitigated by a substantial increase in the proportion of operating cash flows to the total debt held by the company. The overall profitability of the company is on the rise, but the asset utilization is poor and flat. Since the return on equity has almost doubled, the company seems to be able to effectively leverage the increment in its debt to the advantage of its stockholders. Regarding the statement of cash flows, the company seems to be doing fine. Net cash flow from operating activities is positive. The company is investing in its asset base, probably intending to expand in the future by supplementing its cash flow from operating activities with financing either from bank loans or from equity.
Chapter 2 - Page 26
P2–8 Ted Tooney has operated a small service company for several years. The following information is from the financial statements prepared by Ted’s accountant.
Assume that you have some capital to invest and that Ted asked you to consider making an equity investment in his company. Review the financial statements and describe how you would respond to Ted’s request. Support your recommendation with calculations. First, let us compute some relevant ratios that would help us evaluate the financial statements of Ted Tooney. 2011
Ratios
2010
Liquidity Current Ratio (Current Assets ÷ Current Liabilities)
1.29
2.00
Working Capital (Current Assets – Current Liabilities)
$2,000
$4,000
Debt/Equity Ratio (Total Liabilities ÷ Stockholders’ Equity)
1.45
0.92
Operating Cash Flow to Total Debt (Operating Cash Flow ÷ Total Debt)
0.75
1.36
Long-Term Debt Paying Ability
Chapter 2 - Page 27
Profitability Net Profit Margin (Net Income ÷ Sales)
0.15
0.19
Total Asset Turnover (Sales ÷ Total Assets)
3.41
3.87
Return on Assets (Net Income ÷ Total Assets)
0.52
0.74
Return on Assets (Net Profit Margin × Total Asset Turnover)
0.51
0.74
Return on Equity (Net Income ÷ Stockholders’ Equity)
1.27
1.42
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.
Chapter 2 - Page 28
P2–9 A summary of the December 31, 2011 balance sheet of Ellington Industries follows:
On January 1, 2012, the company borrowed $40,000 (long-term debt) to purchase additional land. The debt covenant states that Ellington must maintain a current asset balance at least twice as large as its current liability balance over the period of the loan. a.
As of January 1, 2012, how much of the $40,000 can Ellington invest in land without violating the debt covenant?
b.
Assume that Ellington invested the maximum allowable in land. Prepare Ellington’s balance sheet as of January 1, 2012. Compute the following ratios: current assets/current liabilities and total liabilities/total assets.
c.
Assume that Ellington invested the maximum allowable in land and that during 2012 it generated $150,000 in revenues (all cash), paid off the accounts payable outstanding as of December 31, 2011, and incurred $130,000 in expenses, of which $123,000 was paid in cash. The company neither purchased nor sold any of its long-term land investments, made no principal payments on the long-term debt, and issued no equity during 2012. Prepare a balance sheet as of the end of 2012, and compute how large a dividend the company can pay without violating the debt covenant. Compute total liabilities/total assets assuming that the company declares the maximum allowable dividend.
a. As of 12/31/11 the current asset balance of Ellington Industries is 1.33 times the current liability balance. Since the debt covenant requires this balance to be 2 times the current liability balance, Ellington Industries must have current assets of at least $18,000. Since, it already has $12,000 invested in current assets, it will need to invest an additional $6,000 out of the long-term borrowing of $40,000 to comply with the debt covenant. That would leave $34,000 ($40,000 – $6,000) for additional investment in the land.
Chapter 2 - Page 29
b. Ellington Industries Balance Sheet January 1, 2012 Assets Current assets ................................................................. Land investment.............................................................. Total assets ..................................................................... Liabilities & Stockholders’ Equity Accounts payable............................................................ Long-term liabilities ......................................................... Stockholders’ equity ........................................................ Total liabilities and stockholders’ equity .........................
$ 18,000 89,000 $ 107,000 $
9,000 70,000 28,000 $ 107,000
Ratios Current assets/Current liabilities = $18,000/$9,000 = 2 Total liabilities/Total assets = $79,000/$107,000 = .74 c. Ellington Industries Balance Sheet December 31, 2012 Assets Current assets ................................................................. Land investment.............................................................. Total assets ..................................................................... Liabilities & Stockholders’ Equity Accounts payable............................................................ Long-term liabilities ......................................................... Stockholders’ equity ........................................................ Total liabilities and stockholders’ equity .........................
$ 36,000 89,000 $ 125,000
$
7,000 70,000 48,000 $ 125,000
Since the dividend has to be paid in cash, it will come out of the current assets. According to the restrictions imposed by the debt covenant, the current assets must be twice the current liabilities, i.e., at least $14,000. This would result in an excess of $22,000 ($36,000 – $14,000) in the current assets. Therefore, the company can pay a maximum of $22,000 in dividends without violating the debt covenant. If the company declares and pays $22,000 in dividends, then total liabilities/total assets would be equal to .75 ($77,000/$103,000).
Chapter 2 - Page 30
P2–10 Because of consistent losses in the past several years, Eat and Run, a fast-food franchise, is in danger of bankruptcy. Its most current balance sheet follows.
Additional information:
a. The book value (balance sheet assets less liabilities) of Eat and Run is $63,000. Comment on why this balance sheet value may not be a good indication of the value of the company in the case of bankruptcy. b. If Eat and Run goes bankrupt, what would you consider to be the value of the company? c. When a company goes bankrupt, the creditors are usually paid off first with the existing assets, and then, if assets remain, the shareholders are paid. If Eat and Run goes bankrupt, would the shareholders receive anything? If so, how much? a. Assets are, for the most part, recorded at original cost. Over a period of time, the value of an item will change. For instance, the value of Eat and Run's property, plant, and equipment will most likely change as the items becoπme older. Consequently, over time the cost of an item may have no relation to the item's market value. Since the cash received from selling an asset is based on the asset's market value, the asset's book value is not an accurate indicator of a company's value. b. The value of the firm would equal the sum of the fair market value of the assets less the sum of liabilities. The value of Eat and Run would, therefore, be as follows:
Chapter 2 - Page 31
Market Value Cash ........................................................................... Short-term investments .............................................. Accounts receivable ................................................... Inventory..................................................................... Prepaid insurance ...................................................... Property, plant, & equipment ..................................... Other assets ............................................................... Total market value of assets ...................................... Less: Total liabilities .................................................. Value of Eat and Run .................................................
$
25,000 19,000 25,000 33,000 0 100,000 0 $ 202,000 196,000 $ 6,000
c. If Eat and Run were to go bankrupt, the stockholders would receive anything left after all the assets were sold and the creditors were paid. In this case the fair market value of the assets exceeds the total liabilities, so the stockholders would receive the residual, which would be $6,000. As a practical matter, Eat and Run might have to hire lawyers and accountants for the bankruptcy proceedings. If this were the case, the lawyers and accountants would have to be paid before the stockholders received anything. So in this particular case, there may be nothing left for the stockholders once the creditors, lawyers, and accountants are paid.
Chapter 2 - Page 32
ISSUES FOR DISCUSSION ID2–1 The following information was taken from the 2008 annual report—statements of cash flows—of Goodrich Corporation, a major company in the aerospace and defense industry (dollars in millions).
Each of these companies shows a different cash flow pattern. Explain what these patterns might indicate about each company. 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, and that the amounts generated are increasing substantially 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 increasing operational cash flow is an understandable trend. 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, with the amounts increasing over the period shown (as the company’s operations throw off more cash). Overall, cash balances have remained relatively constant, as the strong cash inflows from operations have been used for the outflows of investing and financing.
Chapter 2 - Page 33
ID2–2 The following information was taken from the 2008 annual reports—statements of cash flows—of Hewlett-Packard, Southwest Airlines, and The Boeing Co., Inc. (dollars in millions).
Each of these companies shows a different cash flow pattern. Explain what these patterns might indicate about each company. Hewlett Packard – HP is able to generate strong cash flow from its current operations ($14,591). The company appears to invest heavily ($13,711) in long term assets, probably for acquisitions and growth in its manufacturing operations. The company also spends significant funds ($2,020) by either retiring debt or returning money to the shareholders (in dividends and stock repurchases). The company’s strong cash flow from operations fuels its investments and its outflow of cash for financing. Southwest Airlines – Southwest operates in a very cyclical business that suffered greatly from the economic downturn. Cash from its operations (-$1,521) was negative, meaning the company lost cash by operating its core business. Due to the capital-intensive nature of its business, Southwest must continually purchase and upgrade aircraft to remain competitive, thus the large outflow ($978) even in a difficult year. Southwest has raised cash from its financing activities, either from debt or equity proceeds, necessitated by the weak operating year. Boeing – Boeing suffered from the same macro economic problems that affected Southwest Airlines; the company generated negative cash from operations (-$401). Boeing differed from Southwest in that it was actively selling long term assets instead of purchasing additional ones. The positive cash from investing ($1,888) indicates the company is selling more long term assets than it is purchasing. Perhaps the company was downsizing its operations due to the recession. Finally, the company heavily used cash in financing, for debt repayments and/or share repurchases and dividend payments.
ID2–3 The following balance sheet (prepared according to IFRS) was taken from the 2008 annual report of GlaxoSmithKline, a British pharmaceutical company (British pounds in millions). Identify where the format of this balance sheet differs from that required under U.S. GAAP, and prepare a balance sheet as close as possible in accordance with U.S. GAAP.
Chapter 2 - Page 34
Chapter 2 - Page 35
A U.S. GAAP balance sheet shows the most liquid accounts first and then lists accounts in the order that they are convertible to cash. Those accounts being closest to cash are listed first. Secondly, liabilities are not shown in parentheses. Finally, some of the equity accounts carry slightly different titles. GlaxoSmithKline Consolidated Balance Sheet As of 12/31/2008 2008
2007
ASSETS: Cash Short term investments Accounts receivable Inventory Other assets Current assets
5,623 1,247 6,265 4,056 78 17,269
3,379 1,628 5,495 3,062 62 13,626
Non-Current Assets Investment in Affiliates Property, Plant & Equipment Other Investments Total
552 9,678 3,924 14,154
329 7,821 3,401 11,551
7,970
5,826
Goodwill & Other Total Assets
39,393
LIABILITIES Loans Accounts payable Other current liabilities Current liabilities
956 6,075 2,986 10,017
3,504 4,861 1,980 10,345
Long term liabilities Loans Long term payables Long term liabilities
15,231 5,827 21,058
7,067 3,681 10,748
1,415 1,326 387 5,190 8,318
1,503 1,266 307 6,834 9,910
Shareholders’ Equity Common stock Additional paid in capital Minority Interest Retained earnings Total shareholder’s equity Total Liabilities and Shareholders’ Equity
Chapter 2 - Page 36
39,393
31,003
31,003
ID2–4 In late 2009 General Electric, Vivendi SA, and the cable television company Comcast entered into a complicated transaction to change the ownership of the television and production company NBC Universal. Prior to the transaction, GE owned 80 percent of NBC, and Vivendi owned a minority share of 20 percent. GE bought the 20 percent of NBC owned by Vivendi (giving GE the entire company), and then sold 51 percent of NBC to Comcast. Both purchases were paid for with cash. Explain why GE and Comcast would enter into such a transaction, and describe how these exchanges would affect the balance sheet and statement of cash flows of GE. Both GE and Comcast are interested in focusing efforts on core business activities: for GE, running a television network did not fit in with its manufacturing and financial businesses, while Comcast saw a television network as a logical vertical extension of its core business of providing cable television services to consumers. The NBC transaction was completed simultaneously, with NBC’s ownership switching from GE/Vivendi to Comcast/GE. From GE’s perspective, it saw a net cash inflow (cash from investing activities decreased to purchase Vivendi’s 20% share and then increased when the 51% stake was sold to Comcast), while its balance sheet ultimately showed a decrease in NBC-related assets (from a consolidation of all NBC assets to a line item investment in NBC).
ID2–5 Up until 2007 non-U.S. firms that published IFRS-based financial statements and wished to raise capital on the U.S. stock markets (e.g., New York Stock Exchange) were required to file with the SEC a Form 20-F that included reconciliations of both net income and shareholder’s equity as measured under U.S. GAAP and IFRS. The reconciliations provided detailed explanation of the different ways in which net income and shareholders’ equity were measured under the two systems. Assume that you are an analyst attempting to compare the financial condition and performance of NIKE, which publishes U.S. GAAP–based financial statements, and adidas, which publishes IFRS-based financial statements. Would you be pleased with the SEC’s decision to drop the reconciliation requirement? Explain. An analyst following both Nike (GAAP) and Adidas (IFRS) would not be pleased with the SEC decision. An analyst would like to review the financial results of the companies in a side-by-side, “apples-to-apples” comparison. With the previous requirement, the analyst could take the reconciliation prepared by Adidas and compare its net income and stockholders’ equity to those of Nike. Once the requirement was dropped, the analyst (with the same need for industry peer comparison) would effectively have to do the reconciliation by herself. The analyst would therefore need to be an expert in both GAAP and IFRS in order to compare the results of the two footwear and athletic apparel firms.
Chapter 2 - Page 37
ID2–6 The Wall Street Journal (April 16, 2004) reports, “For as long as companies have published cash-flow statements, investors have used them to gauge the credibility of earnings. The most closely watched portion of these reports is the part called cash flow from operating activities. If a company shows strong earnings but generates little cash flow from its core operations, it could be a warning sign that the earnings are illusory. Conversely, many investors take comfort in the quality of a company’s earnings if they also see robust operating cash flow.” Comment on this quote. Earnings according to GAAP are accrual numbers, meaning that they don’t represent cash. For example, net income is derived by subtracting expenses from revenue, but revenue can be recognized even if the company has yet to receive the cash (accounts receivable are booked). If the accounts receivable, which represent a promise from a customer to pay cash, never convert into cash, the accrual net income figure is an overstatement of the company’s earnings power. Investors, therefore, look at net income in conjunction with operating cash flow to determine if the various components of accrual net income are supported by cash flows.
ID2–7 For over a year, Center Energy Corporation, a utility company in Ohio, had negative cash flow from operating activities, caused primarily by the escalating costs of one of its nuclear plants outside Cleveland. Yet the company reported positive earnings and paid a dividend to its shareholders of $2.56 per share. a. Briefly explain how a company could have negative cash flow from operating activities, have a positive net income, and still pay dividends. b. Could a company continue such a strategy over an extended period? Why or why not? 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.
Chapter 2 - Page 38
ID2–8 The following excerpt was taken from a financial report of Cummins Engine Company, a manufacturer of heavy-duty truck engines. Loan agreements contain covenants that impose restrictions on the payment of dividends and distributions of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings. Under the most restrictive covenants, retained earnings of approximately $351 million were available for payment of dividends. a. Briefly explain the meaning of this excerpt. b. Why would a bank or other creditor impose such restrictions on a borrowing company? c. Explain the role of financial accounting numbers in the restrictions described above. a. The excerpt indicates that the Cummins Engine Company's creditors have imposed restrictions on Cummins as part of the borrowing agreement. The covenants restrict Cummins' abilities to pay dividends and borrow money and the relative amount of its current assets and current liabilities. If Cummins fails to comply with the covenants, its creditors could require Cummins to repay the loans immediately. b. A bank or other creditor would impose such restrictions to protect itself from a loan default. That is, creditors impose restrictions on borrowers, such as the amount of cash that can be paid out for dividends, that increase the probability that the borrower will have sufficient resources to be able to make the interest and principal payments required under the borrowing agreement. c. Debt covenants are often explicitly based on financial accounting numbers. For example, the current ratio is based on the amount of current assets and current liabilities reported on Cummins' balance sheet. Similarly, compliance with the dividend restriction can be assessed by examining the amount of dividends declared reported in the statement of retained earnings.
ID2–9 In early May 2007, Walt Disney Company released its earnings for its fiscal second quarter. In the release, the company discussed its various operations, including
Discuss how the areas outlined above would be presented and classified on the income statement of Disney. The income statement of Disney would have shown increases in service revenue due to the movie Wild Hogs and increases in sales revenue from the products tied in to the movie Cars. The income statement would not yet reflect the upcoming two movies, as revenue cannot be recognized until the earnings process is substantially completed (which will not occur until the movies are released). Assuming the ESPN mobile phone licensing agreement has started, Disney would show an increase in service revenue (which would help to offset the softer service revenue from the theme parks). Finally, on the expenses portion of the income statement, the increase in programming costs for events shown on ESPN would be reflected as higher operating expenses (which would, of course, result in lower profitability). Chapter 2 - Page 39
