Financial Statement Analysis Solutions

9 September 2016

Horizontal analysis examines how a particular item on a financial statement such as sales or cost of goods sold behaves over time. Vertical analysis involves analysis of items on an income statement or balance sheet for a single period. In vertical analysis of the income statement, all items are typically stated as a percentage of sales. In vertical analysis of the balance sheet, all items are typically stated as a percentage of total assets.

By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements. 16-3Price-earnings ratios reflect investors’ expectations concerning future earnings. The higher the price-earnings ratio, the greater the growth in earnings investors expect. For this reason, two companies might have the same current earnings and yet have quite different price-earnings ratios.

Financial Statement Analysis Solutions Essay Example

By definition, a stock with current earnings of $4 and a price-earnings ratio of 20 would be selling for $80 per share. 16-4A rapidly growing tech company would probably have many opportunities to make investments at a rate of return higher than stockholders could earn in other investments. It would be better for the company to invest in such opportunities than to pay out dividends and thus one would expect the company to have a low dividend payout ratio. 16-5The dividend yield is the dividend per share divided by the market price per share. The other source of return on an investment in stock is increases in market value.

Financial leverage results from borrowing funds at an interest rate that differs from the rate of return on assets acquired using those funds. If the rate of return on the assets is higher than the interest rate at which the funds were borrowed, financial leverage is positive and stockholders gain. If the return on the assets is lower than the interest rate, financial leverage is negative and the stockholders lose. 16-7If the company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt.

In hard times, interest payments might be very difficult to meet. On the other hand, if investments within the company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt. 16-8The market value of a share of common stock often exceeds the book value per share. Book value represents the cumulative effects on the balance sheet of past activities, evaluated using historical prices. The market value of the stock reflects investors’ expectations about the company’s future earnings.

For most companies, market value exceeds book value because investors anticipate future earnings growth. 16-9A 2 to 1 current ratio might not be adequate for several reasons. First, the composition of the current assets may be heavily weighted toward slow-turning and difficult-to-liquidate inventory, or the inventory may contain large amounts of obsolete goods. Second, the receivables may be low quality, including large amounts of accounts that may be difficult to collect. Exercise 16-1 (15 minutes) 1. This Year Last Year Sales 100. 0 % 100. 0 % Cost of goods sold 62. 3 58. 6 Gross margin 37. 7 41. 4

Selling and administrative expenses: Selling expenses 18. 5 18. 2 Administrative expenses 8. 9 10. 3 Total selling and administrative expenses 27. 4 28. 5 Net operating income 10. 3 12. 9 Interest expense 1. 2 1. 4 Net income before taxes 9. 1 % 11. 5 % 2. The company’s major problem seems to be the increase in cost of goods sold, which increased from 58. 6% of sales last year to 62. 3% of sales this year. This suggests that the company is not passing the increases in costs of its products on to its customers. As a result, cost of goods sold as a percentage of sales has increased and gross margin has decreased.

This change has been offset somewhat by reduction in administrative expenses as a percentage of sales. Note that administrative expenses decreased from 10. 3% to only 8. 9% of sales over the two years. However, this decrease was not enough to completely offset the increased cost of goods sold, so the company’s net income decreased as a percentage of sales this year. Exercise 16-2 (30 minutes) 1. Calculation of the gross margin percentage: 2. Calculation of the earnings per share: 3. Calculation of the price-earnings ratio: 4. Calculation of the dividend payout ratio: 5. Calculation of the dividend yield ratio:

Exercise 16-2 (continued) 6. Calculation of the return on total assets: Beginning balance, total assets (a) $45,960 Ending balance, total assets (b) 50,280 Average total assets [(a) + (b)]/2 $48,120 7. Calculation of the return on common stockholders’ equity: Beginning balance, stockholders’ equity (a) $31,660 Ending balance, stockholders’ equity (b) 34,880 Average stockholders’ equity [(a) + (b)]/2 33,270 Average preferred stock 2,000 Average common stockholders’ equity $31,270 8. Calculation of the book value per share: Exercise 16-3 (30 minutes) 1. Calculation of working capital: Current assets $25,080

Current liabilities 10,400 Working capital $14,680 2. Calculation of the current ratio: 3. Calculation of the acid-test ratio: 4. Calculation of accounts receivable turnover: Beginning balance, accounts receivable (a) $ 9,100 Ending balance, accounts receivable (b) 12,300 Average accounts receivable balance [(a) + (b)]/2 $10,700 5. Calculation of the average collection period: Exercise 16-3 (continued) 6. Calculation of inventory turnover: Beginning balance, inventory (a) $8,200 Ending balance, inventory (b) 9,700 Average inventory balance [(a) + (b)]/2 $8,950 7. Calculation of the average sale period:

Exercise 16-4 (15 minutes) 1. Calculation of the times interest earned ratio: 2. Calculation of the debt-to-equity ratio: Exercise 16-5 (15 minutes) 1. The trend percentages are: Year 5 Year 4 Year 3 Year 2 Year 1 Sales 125. 0 120. 0 115. 0 110. 0 100. 0 Current assets: Cash 60. 0 80. 0 96. 0 130. 0 100. 0 Accounts receivable 190. 0 170. 0 135. 0 115. 0 100. 0 Inventory 125. 0 120. 0 115. 0 110. 0 100. 0 Total current assets 142. 1 133. 7 120. 3 112. 6 100. 0 Current liabilities 160. 0 145. 0 130. 0 110. 0 100. 0 2. Sales: The sales are increasing at a steady and consistent rate. Assets:

The most noticeable thing about the assets is that the accounts receivable have been increasing at a rapid rate—far outstripping the increase in sales. This disproportionate increase in receivables is probably the chief cause of the decrease in cash over the five-year period. The inventory seems to be growing at a well-balanced rate in comparison with sales. Liabilities: The current liabilities are growing more rapidly than the total current assets. The reason is probably traceable to the rapid buildup in receivables in that the company doesn’t have the cash needed to pay bills as they come due.

Exercise 16-6 (20 minutes) 1. Return on total assets: 2. Return on common stockholders’ equity: Average stockholders’ equity: ($2,200,000 + $2,400,000)/2 $2,300,000 Average preferred stock 900,000 Average common stockholders’ equity (b) $1,400,000 3. Leverage is positive because the return on common stockholders’ equity (14. 9%) is greater than the return on total assets (9. 8%). This positive leverage arises from the long-term debt, which has an after-tax interest cost of only 8. 4% [12% interest rate ? (1 – 0. 30)], and the preferred stock, which carries a dividend rate of only 8%.

Both of these rates of return are smaller than the return that the company is earning on its total assets; thus, the difference goes to the common stockholders. Exercise 16-7 (30 minutes) 1. Gross margin percentage: 2. Current ratio: 3. Acid-test ratio: 4. Debt-to-equity ratio: 5. Average collection period: Exercise 16-7 (continued) 6. Average sale period: 7. Times interest earned: 8. Book value per share: Exercise 16-8 (20 minutes) 1. Earnings per share: 2. Dividend payout ratio: 3. Dividend yield ratio: 4. Price-earnings ratio: Exercise 16-9 (20 minutes) 1. Return on total assets: 2.

Return on common stockholders’ equity: 3. Financial leverage was positive because the rate of return to the common stockholders (12. 7%) was greater than the rate of return on total assets (9. 2%). This positive leverage is traceable in part to the company’s current liabilities, which may have no interest cost, and in part, to the bonds payable, which have an after-tax interest cost of only 7%. 10% interest rate ? (1 – 0. 30) = 7% Exercise 16-10 (15 minutes) 1. Current assets (Kr90,000 + Kr260,000 + Kr490,000 + Kr10,000) Kr850,000 Current liabilities (Kr850,000 ? 2. 5) 340,000 Working capital.

Notes due in one year 30,000 Accrued liabilities 20,000 Total current liabilities (b) 200,000 Working capital (a) – (b) $300,000 b. Computation of the current ratio: c. Computation of the acid-test ratio: Problem 16-11 (continued) 2. The Effect on Working Current Acid-Test Transaction Capital Ratio Ratio (a) Issued capital stock for cash Increase Increase Increase (b) Sold inventory at a gain Increase Increase Increase (c) Wrote off uncollectible accounts None None None (d) Declared a cash dividend Decrease Decrease Decrease (e) Paid accounts payable None Increase Increase (f)

Borrowed on a short-term note None Decrease Decrease (g) Sold inventory at a loss Decrease Decrease Increase (h) Purchased inventory on account None Decrease Decrease (i) Paid short-term notes None Increase Increase (j) Purchased equipment for cash Decrease Decrease Decrease (k) Sold marketable securities at a loss Decrease.

Selling and administrative expenses 13. 1 12. 6 Net operating income 9. 4 8. 1 Interest expense 1. 4 1. 7 Net income before taxes 8. 0 6. 4 Income taxes 2. 4 1. 9 Net income 5. 6 % 4. 5 % 3. The following points can be made from the analytical work in parts (1) and (2) above: a. The company has improved its profit margin from last year. This is attributable primarily to an increase in gross margin, which is offset somewhat by a small increase in operating expenses. Overall, the company’s income statement looks very good. b. The company’s current position has deteriorated significantly since last year.

Both the current ratio and the acid-test ratio are well below the industry average and are trending downward. At the present rate, it will soon be impossible for the company to pay its bills as they come due. c. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. Notice that the average age of the receivables has increased by five days since last year, and now is 10 days over the industry average. Many of the company’s customers are not taking their discounts because the average collection period is 28 days and collections terms are 2/10, n/30.

This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks. Problem 16-12 (continued) d. The inventory turned only five times this year as compared to over six times last year. It takes nearly two weeks longer for the company to turn its inventory than the average for the industry (73 days as compared to 60 days for the industry). This suggests that inventory stocks are higher than they need to be. e. In the authors’ opinion, the loan should be approved only if the company gets its accounts receivable and inventory back under control.

If the accounts receivable collection period is reduced to about 20 days, and if the inventory is pared down enough to reduce the turnover time to about 60 days, enough funds could be released to substantially improve the company’s cash position. Then a loan might not even be needed. Problem 16-13 (60 minutes) This Year Last Year 1. a. Net income $280,000 $196,000 Less preferred dividends 20,000 20,000 Net income remaining for common (a) $260,000 $176,000 Average number of common shares (b) 50,000 50,000 Earnings per share (a) ? (b) $5. 20 $3. 52 b. Dividends per share (a) $1. 80 $1. 50

Market price per share (b) $40. 00 $36. 00 Dividend yield ratio (a) ? (b) 4. 5% 4. 2% c. Dividends per share (a) $1. 80 $1. 50 Earnings per share (b) $5. 20 $3. 52 Payout ratio (a) ? (b) 34. 6% 42. 6% d. Market price per share (a) $40. 00 $36. 00 Earnings per share (b) $5. 20 $3. 52 Price-earnings ratio (a) ? (b) 7. 7 10. 2 Investors regard Sabin Electronics less favorably than other companies in the industry. This is evidenced by the fact that they are willing to pay only 7. 7 times current earnings for a share of Sabin’s stock, as compared to 12 times current earnings for other companies in the industry.

If investors were willing to pay 12 times current earnings for Sabin’s stock, it would be selling for about $62. 40 per share (12 ? $5. 20), rather than for only $40 per share. Problem 16-13 (continued) This Year Last Year e. Total stockholders’ equity $1,600,000 $1,430,000 Less preferred stock 250,000 250,000 Common stockholders’ equity (a) $1,350,000 $1,180,000 Number of common shares outstanding (b) 50,000 50,000 Book value per share (a) ? (b) $27. 00 $23. 60 The market value is above book value for both years. However, this does not necessarily indicate that the stock is overpriced.

The stock’s downside risk seems small because it is now selling for only 7. 7 times earnings to 12 times earnings for other companies in the industry. In addition, its earnings are strong and trending upward, and its return on common equity (20. 6%) is extremely good. Its return on total assets (12. 1%) compares well with that of the industry. The risk, of course, is whether the company can get its cash problem under control. Conceivably, the cash problem could worsen, leading to an eventual reduction in profits through inability to operate, a discontinuance of dividends, and a precipitous drop in the market price of the company’s stock.

This does not seem likely, however, because the company has borrowing capacity available, and can easily control its cash problem through more careful management of accounts receivable and inventory. The client must understand, of course, that there is risk in the purchase of any stock; the risk seems well justified in this case because the upward potential of the stock is great if the company gets its problems under control. Problem 16-14 (90 minutes) This Year Last Year 1. a. Net income $     840,000 $    504,000 Add after-tax cost of interest: $360,000 ? (1 – 0. 30) 252,000 $300,000 ? (1 – 0. 30) 210,000

Total (a) $  1,092,000 $    714,000 Average total assets (b) $15,990,000 $13,920,000 Return on total assets (a) ? (b) 6. 8% 5. 1% b. Net income $? 840,000 $ ? 504,000 Less preferred dividends 144,000 144,000 Net income remaining for common (a) $? 696,000 $ ? 360,000 Average total stockholders’ equity $ 9,360,000 $ 9,084,000 Less average preferred stock 1,800,000 1,800,000 Average common equity (b) $ 7,560,000 $ 7,284,000 Return on common stockholders’ equity (a) ? (b) 9. 2% 4. 9% c. Leverage is positive for this year because the return on common equity (9. 2%) is greater than the return on total assets (6.

For last year, leverage is negative because the return on common equity (4. 9%) is less than the return on total assets (5. 1%). Problem 16-14 (continued) This Year Last Year 2. a. Net income remaining for common [see above] (a) $696,000 $360,000 Average number of common shares outstanding (b) 75,000 75,000 Earnings per share (a) ? (b) $9. 28 $4. 80 b. Dividends per share (a) $2. 88 $1. 44 Market price per share (b) $72. 00 $40. 00 Dividend yield ratio (a) ? (b) 4. 0% 3. 6% c. Dividends per share (a) $2. 88 $1. 44 Earnings per share (b) $9. 28 $4. 80 Dividend payout ratio (a) ? (b) 31. 0% 30.

Market price per share (a) $72. 00 $40. 00 Earnings per share (b) $9. 28 $4. 80 Price-earnings ratio (a) ? (b) 7. 8 8. 3 Notice from the data given in the problem that the typical P/E ratio for companies in Lydex Company’s industry is 10. Since Lydex Company presently has a P/E ratio of only 7. 8, so investors appear to regard it less well than they do other companies in the industry. That is, investors are willing to pay only 7. 8 times current earnings for a share of Lydex Company’s stock, as compared to 10 times current earnings for a share of stock for the typical company in the industry.

Stockholders’ equity $9,600,000 $9,120,000 Less preferred stock 1,800,000 1,800,000 Common stockholders’ equity (a) $7,800,000 $7,320,000 Number of common shares outstanding (b) 75,000 75,000 Book value per share (a) ? (b) $104. 00 $97. 60 Problem 16-14 (continued) Notice that market value of common stock is below its book value for both years. This does not necessarily indicate that the stock is selling at a bargain price. Market value reflects investors’ expectations concerning future earnings, whereas book value is a result of already completed transactions and is geared to the past.

This Year Last Year Gross margin (a) $3,150,000 $2,580,000 Sales (b) $15,750,000 $12,480,000 Gross margin percentage (a) ? (b) 20. 0% 20. 7% This Year Last Year 3. a. Current assets $7,800,000 $5,940,000 Current liabilities 3,900,000 2,760,000 Working capital $3,900,000 $3,180,000 b. Current assets (a) $7,800,000 $5,940,000 Current liabilities (b) $3,900,000 $2,760,000 Current ratio (a) ? (b) 2. 0 2. 15 c. Quick assets (a) $3,660,000 $3,360,000 Current liabilities (b) $3,900,000 $2,760,000 Acid-test ratio (a) ? (b) 0. 94 1. 22 d. Sales on account (a) $15,750,000 $12,480,000

Average receivables (b) $2,250,000 $1,680,000 Accounts receivable turnover (a) ? (b) 7. 0 7. 4 Average collection period, 365 days ? turnover 52. 1 days 49. 3 days Problem 16-14 (continued) This Year Last Year e. Cost of goods sold (a) $12,600,000 $9,900,000 Average inventory balance (b) $3,150,000 $2,160,000 Inventory turnover ratio (a) ? (b) 4. 0 4. 6 Average sale period, 365 days ? Inventory turnover ratio 91. 3 days 79. 3 days f. Total liabilities (a) $7,500,000 $5,760,000 Stockholders’ equity (b) $9,600,000 $9,120,000 Debt-to-equity ratio (a) ? (b) 0. 78 0. 63 g.

Net income before interest and income taxes (a) $1,560,000 $1,020,000 Interest expense (b) $360,000 $300,000 Times interest earned (a) ? (b) 4. 3 3. 4 4. Both net income and sales are up from last year. The return on total assets has improved from 5. 1% to 6. 8%, and the return on common equity is up from 4. 9% to 9. 2%. But this is the only bright spot. Virtually all other ratios are below what is typical of the industry, and, more important, they are trending downward. The deterioration in the gross margin percentage, while not large, is worrisome. Sales and inventories have increased substantially.

Ordinarily, this should result in an improvement in the gross margin percentage due to fixed costs being spread over a greater number of units. However, the gross margin percentage has declined. Notice particularly that the average collection period has lengthened to 52 days—about three weeks over the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Notice also that the debt-to-equity ratio is rising rapidly. If the $3,000,000 loan is granted, the ratio will rise further to 1. 09. What the company probably needs is more equity—not more debt.

Therefore, the loan should not be approved. The company should be encouraged to issue more common stock to provide a broader equity base on which to operate. Problem 16-15 (30 minutes) 1. Lydex Company Comparative Balance Sheets This Year Last Year Current assets: Cash 5. 6 % 8. 5 % Marketable securities 0. 0 2. 0 Accounts receivable, net 15. 8 12. 1 Inventory 22. 8 16. 1 Prepaid expenses 1. 4 1. 2 Total current assets 45. 6 39. 9 Plant and equipment, net 54. 4 60. 1 Total assets 100. 0 % 100. 0 % Current liabilities 22. 8 % 18. 5 % Note payable, 10% 21. 1 20. 2 Total liabilities 43. 9 38. 7 Stockholders’ equity:

Preferred stock, 8%, $30 par value 10. 5 12. 1 Common stock, $80 par value 35. 1 40. 3 Retained earnings 10. 5 8. 9 Total stockholders’ equity 56. 1 61. 3 Total liabilities and equity 100. 0 % 100. 0 % Problem 16-15 (continued) 2. Lydex Company Comparative Income Statements This Year Last Year Sales 100. 0 % 100. 0 % Cost of goods sold 80. 0 79. 3 Gross margin 20. 0 20. 7 Selling and administrative expenses 10. 1 12. 5 Net operating income 9. 9 8. 2 Interest expense 2. 3 2. 4 Net income before taxes 7. 6 5. 8 Income taxes (30%) 2. 3 1. 7 Net income 5. 3 % 4. 0 %* *Due to rounding, figures may not fully reconcile down a column.

The company’s current position has declined substantially between the two years. Cash this year represents only 5. 6% of total assets, whereas it represented 10. 5% last year (cash + marketable securities). In addition, both accounts receivable and inventory are up from last year, which helps to explain the decrease in the cash account. The company is building inventories, but not collecting from customers. (See Problem 16-14 for a ratio analysis of the current assets. ) Apparently a part of the financing required to build inventories was supplied by short-term creditors, as evidenced by the increase in current liabilities.

Looking at the income statement, as noted in the solution to the preceding problem there has been a slight deterioration in the gross margin percentage. Ordinarily, the increase in sales (and in inventories) should have resulted in an increase in the gross margin percentage because fixed manufacturing costs would be spread across more units. Note that the selling and administrative expenses are down as a percentage of sales—possibly because many of them are likely to be fixed. Problem 16-16 (45 minutes) Effect on Ratio Reason for Increase, Decrease, or No Effect 1. Decrease

Declaring a cash dividend will increase current liabilities, but have no effect on current assets. Therefore, the current ratio will decrease. 2. Increase A sale of inventory on account will increase the quick assets (cash, accounts receivable, marketable securities) but have no effect on the current liabilities. For this reason, the acid-test ratio will increase. The same effect would result regardless of whether the inventory was sold at cost, at a profit, or at a loss. That is, the acid-test ratio would increase in all cases; the only difference would be the amount of the increase. 3. Increase The interest rate on the bonds is only 8%.

Since the company’s assets earn at a rate of return of 10%, positive leverage would come into effect, increasing the return to the common stockholders. 4. Decrease A decrease in net income would mean less income available to cover interest payments. Therefore, the times-interest-earned ratio would decrease. 5. Increase Payment of a previously declared cash dividend will reduce both current assets and current liabilities by the same amount. An equal reduction in both current assets and current liabilities will always result in an increase in the current ratio, so long as the current assets exceed the current liabilities.

No Effect The dividend payout ratio is a function of the dividends paid per share in relation to the earnings per share. Changes in the market price of a stock have no effect on this ratio. Problem 16-16 (continued) Effect on Ratio Reason for Increase, Decrease, or No Effect 7. Increase A write-off of inventory will reduce the inventory balance, thereby increasing the turnover in relation to a given level of sales. 8. Decrease Sale of inventory at a profit will increase the assets of a company. The increase in assets will be reflected in an increase in retained earnings, which is part of stockholders’ equity.

An increase in stockholders’ equity will result in a decrease in the ratio of assets provided by creditors as compared to assets provided by owners. 9. Decrease Extended credit terms for customers means that customers on the average will be taking longer to pay their bills. As a result, the accounts receivable will “turn over,” or be collected, less frequently during a given year. 10. Decrease A common stock dividend will result in a greater number of shares outstanding, with no change in the underlying assets. The result will be a decrease in the book value per share. 11.

No Effect Book value per share is dependent on historical costs of already completed transactions as reflected on a company’s balance sheet. It is not affected by current market prices for the company’s stock. 12. No Effect Payments on account reduce cash and accounts payable by equal amounts; thus, the net amount of working capital is not affected. 13. Decrease The stock dividend will increase the number of common shares outstanding, thereby reducing the earnings per share. Problem 16-16 (continued) Effect on Ratio Reason for Increase, Decrease, or No Effect 14. Decrease

Payments to creditors will reduce the total liabilities of a company, thereby decreasing the ratio of total debt to total equity. 15. Decrease A purchase of inventory on account will increase current liabilities, but will not increase the quick assets (cash, accounts receivable, marketable securities). Therefore, the ratio of quick assets to current liabilities will decrease. 16. No Effect Write-off of an uncollectible account against the Allowance for Bad Debts will have no effect on total current assets. For this reason, the current ratio will remain unchanged. 17. Increase

The price-earnings ratio is obtained by dividing the market price per share by the earnings per share. If the earnings per share remains unchanged, and the market price goes up, then the price-earnings ratio will increase. 18. Decrease The dividend yield ratio is obtained by dividing the dividend per share by the market price per share. If the dividend per share remains unchanged and the market price goes up, then the yield will decrease. Problem 16-17 (30 minutes) a. It is becoming more difficult for the company to pay its bills as they come due. Although the current ratio has improved over the three years, the acid-test ratio is down.

Also notice that the accounts receivable and inventory are both turning more slowly, indicating that an increasing portion of the current assets is being made up of these items, from which bills cannot be paid. b. Customers are paying their bills more slowly in Year 3 than in Year 1. This is evidenced by the decline in accounts receivable turnover. c. The total of accounts receivable is increasing. This is evidenced both by a slowdown in turnover and in an increase in total sales. d. The level of inventory undoubtedly is increasing. Notice that the inventory turnover is decreasing.

Even if sales (and cost of goods sold) just remained constant, this would be evidence of a larger average inventory on hand. However, sales are not constant, but rather are increasing. With sales increasing (and undoubtedly cost of goods sold also increasing), the average level of inventory must be increasing as well to service the larger volume of sales. e. The market price is going down. The dividends paid per share over the three-year period are unchanged, but the dividend yield is going up. Therefore, the market price per share of stock must be decreasing. f. The amount of earnings per share is increasing.

Again, the dividends paid per share have remained constant. However, the dividend payout ratio is decreasing. In order for the dividend payout ratio to be decreasing, the earnings per share must be increasing. g. The price-earnings ratio is going down. If the market price of the stock is going down [see Part (e) above], and the earnings per share are going up [see Part (f) above], then the price-earnings ratio must be decreasing. h. In Year 1 and in Year 2 there was negative leverage because in both years the return on total assets exceeded the return on common equity.

Because the quick assets (cash and accounts receivable) total $400,000 of this amount, the inventory must be $480,000. h. Therefore, the cost of goods sold for the year must be $2,730,000. i. Gross margin = $4,200,000 – $2,730,000 = $1,470,000. j. Problem 16-18 (continued) k. The interest expense for the year was $80,000 and the interest rate was 10%, the bonds payable must total $800,000. l. Total liabilities = $320,000 + $800,000 = $1,120,000 m.

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