Chapter Two - Wiley

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8956d_ch02_076 9/26/03 3:33 PM Page 76 mac76 mac76:385_reb: 76 CHAPTER 2 A Further Look at Financial Statements operating activities was $34,900,000 in 2001 and $1,700,000 in 2000. Assume that average shares outstanding during all of fiscal 2001 were 22.9 million and were 18.4 million during all of fiscal 2000. There was no preferred stock outstanding. The stock price was $13.64 on September 30, 2001, and $36.31 on September 30, 2000. Instructions Using these statements, answer the following questions: 1. Calculate the current ratio for Tweeter for 2001 and 2000 and the current cash debt coverage ratio for 2001, and discuss its liquidity position. 2. Calculate the debt to total assets ratio for Tweeter for 2001 and 2000 and the cash debt coverage ratio for 2001, and discuss its solvency. 3. Calculate the earnings per share and price-earnings ratio for Tweeter for 2001 and 2000, and discuss its change in profitability. 4. Best Buy’s accounting year-end was March 3, 2001, whereas Tweeter’s was September 30, 2001. How does this difference affect your ability to compare their profitability? Solution 1. Current ratio: 2001 ($171.3$100.8) 1.70 2000 ($138.9$55.4) 2.51 Tweeter’s liquidity declined from 2000 to 2001. In 2000 there was $2.51 of current assets available for every dollar of current liabilities. In 2001 there was $1.70. Tweeter’s 2001 current ratio would probably be considered acceptable, but not strong. It is higher than that of Best Buy, but it is a much smaller company than Best Buy. Often, larger companies can get by with a lower current ratio. Current cash debt coverage ratio: $34.9 2001 .45 times ($100.8 $55.4)2 A value above .40 times for this ratio is generally considered acceptable. This measure of .45 times reduces our concern about Tweeter’s marginal current ratio. 2. Debt to total assets ratio: 2001 ($148.0$480.4) 31% 2000 ($60.1$235.0) 26% Based on the change in its ratio of debt to total assets, Tweeter’s reliance on debt financing increased from 2000 to 2001. The increase in the value of this ratio suggests the company’s solvency declined. Cash debt coverage ratio: $34.9 2001 .34 times ($148.0 $60.1)2 Tweeter’s value of .34 times is higher than the generally acceptable level of .20 times. This would suggest that the company’s solvency appears good. 3. Earnings per share: 2001 ($16.922.9) $0.74 per share 2000 ($16.418.4) $0.89 per share Price-earnings ratio: 2001 ($13.64$0.74) 18.4 2000 ($36.31$0.89) 40.8
8956d_ch02_077 9/26/03 3:33 PM Page 77 mac76 mac76:385_reb: Summary of Study Objectives 77 Tweeter’s earnings per share declined from $0.89 to $0.74, even though its net income increased. This happened because the number of shares increased. Its price-earnings ratio declined sharply. This decline mirrored a decline in P-E ratios in the stock market as a whole at that time. 4. Tweeter’s income statement covers seven months not covered by Best Buy’s. Suppose that the economy changed dramatically during this seven-month period, either improving or declining. This change in the economy would be reflected in Tweeter’s income statement but would not be reflected in Best Buy’s income statement until the following March, thus reducing the usefulness of a comparison of the income statements of the two companies. ■✓ THE NAVIGATOR Summary of Study Objectives 1 Explain the meaning of generally accepted accounting principles and describe the basic objective of financial reporting. Generally accepted accounting principles are a set of rules and practices recognized as a general guide for financial reporting purposes. The basic objective of financial reporting is to provide information that is useful for decision making. 2 Discuss the qualitative characteristics of accounting information. To be judged useful, information should possess these qualitative characteristics: relevance, reliability, comparability, and consistency. 3 Identify two constraints in accounting. The major constraints are materiality and conservatism. 4 Identify the sections of a classified balance sheet. In a classified balance sheet, assets are classified as current assets; long-term investments; property, plant, and equipment; or intangibles. Liabilities are classified as either current or long-term. There is also a stockholders’ equity section, which shows common stock and retained earnings. 5 Identify and compute ratios for analyzing a company’s profitability. Profitability ratios, such as earnings per share (EPS) and the price-earnings (P-E), ratio, measure aspects of the operating success of a company for a given period of time. 6 Explain the relationship between a retained earnings statement and a statement of stockholders’ equity. The retained earnings statement presents the factors that changed the retained earnings balance during the period. A statement of stockholders’ equity presents the factors that changed stockholders’ equity during the period, including those that changed retained earnings. Thus, a statement of stockholders’ equity is more inclusive. 7 Identify and compute ratios for analyzing a company’s liquidity and solvency using a balance sheet. Liquidity ratios, such as the current ratio, measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to total assets ratio, measure the ability of an enterprise to survive over a long period. 8 Identify and compute ratios for analyzing a company’s liquidity and solvency using a statement of cash flows. The current cash debt coverage ratio measures a company’s liquidity. The cash debt coverage ratio measures a company’s solvency. ■✓ THE NAVIGATOR
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Chapter Two - Wiley

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