Tutorial 1.docx

Tutorial 1.docx

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Tutorial1

Tutorial1

EXERCISE1–1

Discretionin

ComparativeFinancial

StatementAnalysis

Thepreparationandanalysisofcomparativebalancesheetsandincomestatementsare

commonlyappliedtoolsoffinancialstatementanalysisandinterpretation.

Required:

a.Discusstheinherentlimitationsofanalyzingandinterpretingfinancialstatementsforasingleyear.Includeinyourdiscussiontheextentthattheselimitationsareovercomebyuseofcomparativefinancialstatementscomputedovermorethanoneyear.

Comparativefinancialstatementanalysisforasingleyearreflectsabriefperiodofacompany'shistory.Itisessentiallyaninterimanalysisofacompany‘sbusinessactivitiesforthatyear.Moreover,theaccountingsystem‘sallocationofcostsandrevenuestosuchshortperiodsoftimeis,toaconsiderableextent,baseduponconvention,judgment,andestimates.Theshorterthetimeperiod,themoredifficultisthematchingandrecognitionprocessandthemoreitissubjecttoerror.Inaddition,single-yearcomparativeanalysismaynotaccuratelyreflectacompany'slong-runperformance.Thisisbecauseofthepossibilityofunusuallyfavorableorunfavorableeconomicorotherconditionsexperiencedinanyparticularyear.

Consequently,anycomparativefinancialstatementanalysisforasingleyearcannotprovideinformationontrendsandchangingrelationsthatmightoccurovertime.Forthisreason,theinformationgeneratedbycomparativeanalysisofasetofsingle-yearstatementsisoflimitedinterpretivevalue.Moreover,thefinancialstatementsthemselveshavelimitationsforanalyticalandinterpretivepurposesbyvirtueoftheinherentlimitationsoftheaccountingfunctionappliedtoasingleyear.Also,manyfactorsthatsignificantlyaffecttheprogressandsuccessofafirmarenotofafinancialcharacterandarenot,therefore,expressedexplicitlyinfinancialstatements.Theseincludefactorssuchasgeneraleconomicconditions,laborrelations,andcustomerattitudes.Thepreparationofcomparativestatementsforasingleyearwouldnotalleviatetheselimitations.

b.Ayear-to-yearanalysisofcomparativebalancesheetsandincomestatementsisausefulanalysistool.Still,withoutpropercare,suchanalysiscanbemisleading.Discussfactorsorconditionsthatcontributetosuchapossibility.Howcanadditionalinformationandsupplementarydata（beyondfinancialstatements）helppreventthispossibility?

Changesorinconsistenciesinaccountingmethods,policies,orclassificationsfortheyearscoveredbycomparativefinancialstatementanalysiscanyieldmisleadinginferencesregardingtrendsorchangingrelations.Forexample,achangeinafirm'sdepreciationorinventorymethods,eventhoughthealternativeproceduresareacceptableorpreferable,caninhibitthecomparabilityofcorrespondingitemsintwoormoreoftheperiodscovered.Further,theexistenceoferrors（andtheircorrectioninsubsequentperiods）,nonrecurringgainsorlosses,mergersandacquisitions,andchangesinbusinessactivitiescanyieldmisleadinginferencesfromcomparativeanalysisperformedoverseveralyears.

Toavoidthepotentialformisleadinginferencesfromthesefactors,wemustcarefullyexaminefootnotes,explanations,andqualificationsthataredisclosedaspartoffinancialreporting.Ourcomparativeanalysismustbeadjustedforsuchpossibilities.Also,changingpricelevelsfortheperiodsofanalysiscandistortcomparativefinancialstatements.Forexample,evenitemsonacomparativebalancesheetorincomestatementthatpertaintoasingleyeararenotallexpressedindollarshavingthesamepurchasingpower.Namely,inaneraofrisingprices,agivenyear'sdepreciationrepresentsolderdollarshavinggreaterpurchasingpowercomparedwithmostotherincomestatementitems.Further,inventorymethodsotherthanLIFOcanaddtotheinflationarydistortionoftheincomestatement.Similarly,balancesheetitemsforagivenyearareexpressedindollarsofvaryingpurchasingpower.

Beyondtheseverticaldistortionsthatexistwithinindividualyearscoveredbycomparativefinancialstatements,arehorizontaldistortionsinthetrendsandrelationsofcorrespondingitemsacrossyears.Forexample,anupwardtrendinsalesmayactuallyreflectaconstantlevelof,orevendeclinein,actualsalesvolumebecauseofincreasesinprices.Becauseofthepotentialformisleadinginferencesfromcomparativeanalysisduringperiodsofchangingpricelevels,itsusefulnessasananalyticalandinterpretativetoolisseverelyrestricted.Thisisbecausepricelevelchangescanlimitthecomparabilityofthedatainfinancialstatementsacrosstime.Ofcourse,analysisofprice-leveladjustedfinancialstatementscanrestorethecomparabilityofthesestatementsacrosstimeand,thereby,enhancetheirusefulnessastoolsofanalysisandinterpretation.

Problem1-11

a.Theliquidityofthecompanyappearsreasonable.Currentassetsare3.45timescurrentliabilitiesandevencash-likeassetsarefully2.58timescurrentliabilities.Thecompanyissellingitsinventoryinreasonabletime（18days）.However,thecollectionperiodforreceivablesisabitslow（42days）.

Thecapitalstructureandsolvencyofthecompanyalsoappearsreasonable.Long-termdebtisonly37percentofequityandtotaldebtis67%oftotalequity.Thisdebttotalwouldseemtobeonthehighendoftheacceptablerange.Likewise,thereturnonassetsandequityarequitegood（31%and53%,respectively）.Thisisapositivesignforlong-termsolvencyandforlong-termgrowth.Profitmarginsappearrelativelystrongaswell.

Thestrongprofitmarginsreflecthealthyassetutilization.Thecompanyisturningoveritsinventory30timesperyearandturningoverreceivables7timesperyear.Themarketmeasuresreflecttheserelativelystrongoperatingresults.Thepricetoearningsratioof27.8reflectsastrongstockmarketvaluation.Thelackofdividendsforthiscompanyisnotsurprisinggiventhegrowthratethatthecompanyisachieving.

b.Theliquidityofthecompanyisstrong.Thecompanyhasacurrentratiothatisstrong（3.45）andslightlyaboveindustryaverage（3.1）.Thenearcashassetsarealsostrong（acid-testratioof2.58versus1.85）.Thesizeoftheacid-testratiocoupledwiththereceivablescollectionperiod（42.19daysversus36.6days）raisesaquestionaboutthequalityofthereceivablesforBest.Thatrelationshipwarrantssomeadditionalinvestigation.Nevertheless,Bestappeartobeadequatelyliquid.

Bestalsoappearsstrongintermsofsolvencyandcapitalstructure.Thecompanyapproximatesaverageindustrylevelsofdebtandinterestcoverage.Likewise,thecompanyisslightlyaboveindustryaveragesintermsofreturnonassetsandreturnonequity.ThisprovidesadditionalcomfortaboutBest‘sabilitytoremainsolventandtogrow.

Theassetutilizationratiosreflectreasonablyhealthyoperations.Thecompanyisturningoverinventoryslightlyabovetheindustryaverageandutilizingitsfixedassetsefficientlyrelativetoindustrynorms.Again,theaccountsreceivableturnoverwarrantsinvestigation.Thecompanyisturningoverreceivablessignificantlyslowerthanindustryaverages.

Themarketmeasuresreflectahealthymarketcapitalizationforthecompany.Theslightlylowerp/eratioforBestisinterestinggiventhecompany‘saboveaverageperformance.Thiscouldreflectthemarket‘sconcernaboutBest‘sabilitytoconvertitssalesintocash（i.e.,accountsreceivablecollection）.

c.Thefollowingratiosdeviatefromindustrynormsandwarrantsomeinvestigation:

Acid-testratio,collectionperiod,accountsreceivableturnover,workingcapitalturnover.Theseareallrelatedtoaccountsreceivable.Specifically,accountsreceivableishigherthannormalfortheindustry.Onepossibleexplanationisthatthecompanyoffersloosercollectiontermsthantheindustry.Anotherpossibilityisthatthecompanyextendscredittolesscreditworthycustomers.Itcouldalsoberandomvariationbutthisisunlikelygiventhemagnitudeofthedifference.

Also,thetimesinterestearnedratioisinteresting.Whileitisnearindustrynorms,itislowconsideringthefollowing.Onewouldexpectthistobehigherthantheindustryaveragebecausethecompanyhaslowerthanaveragedebtandhigherthanaverageearnings.Onepossibleexplanationforthisrelationshipisthatthecompanypaiddowndebtlateintheyear.Thus,thedebtratioslookloweratyear-endthantheyweremostoftheyear.Anotherpossibilityisthatthecompanyhashigherpriceddebtthanindustryaverage.

CASE1-2

CASE1-4

a.No.Althoughthecurrentratioimprovedoverthethree-yearperiod,theacid-testratiodeclinedandaccountsreceivableandmerchandiseinventoryturnedmoreslowly.Theseconditionsindicatethatanincreasingportionofthecurrentassetsconsistedofaccountsreceivableandinventoriesfromwhichcurrentdebtscouldnotbepaid.

b.No.Thedecreasingturnoverofaccountsreceivableindicatesthecompanyiscollectingitsdebtmoreslowly.

c.No.Salesareincreasingandaccountsreceivableareturningmoreslowly.Eitherofthesetrendswouldproduceanincreaseinaccountsreceivable,eveniftheotherremainedunchanged.

d.Probablyyes.Sincethereisnothingtoindicatethecontrary,costofgoodssoldisprobablyincreasinginproportiontosales.Consequently,withsalesincreasing,costofgoodssoldincreasinginproportion,andmerchandiseturningmoreslowly,theamountofmerchandiseintheinventorymustbeincreasing.

e.Yes.Toillustrate,ifsalesareassumedtoequal$100in2004,thesalestrendshowsthattheywouldequal$125in2005and$137in2006.Then,dividingeachsalesfigurebyitsratioo