UKFF3083 FINANCIAL STATEMENT ANALYSIS

UNIVERSITI TUNKU ABDUL RAHMAN

ACADEMIC YEAR 2020/2021

BACHELOR OF SCIENCE (HONOURS) ACTUARIAL SCIENCE

BACHELOR OF SCIENCE (HONOURS) FINANCIAL MATHEMATICS

TUTORIAL 7 (Questions)
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Q1. Falcon.Com purchases its merchandise at current market Costs and resells the product at a
price 20 cents higher. Its inventory costs are constant throughout the current year. Data on
the number of units in inventory at the beginning of the year, unit purchases, and unit sales
are shown below:
Number of units in inventory—beginning of year 0 (RM1 per unit cost) 1,000 units
Number of units purchased during year 0 RM1.50 per unit cost 1,000 units
Number of units sold during year 0 RM1.70 per unit selling price 1,000 units

The beginning-of-year balance sheet for Falcon.Com reports the following:

Inventory (1,000 units © RM1) RM1,000
Total equity RM1,000

Required:
a. Compute the after-tax profit of Fatcon.Com separately for both the (1) FIFO and (2)
AVCO methods of inventory valuation assuming the company has no expenses other
than cost of goods sold and its income tax rate is 50%. Taxes are accrued currently and
paid the following year.
b. If all sales and purchases are for cash, construct the balance sheet at the end of this year
separately for both the (1) FIFO and (2) AVCO methods of inventory valuation.
c. Describe the significance of each of these methods of inventory valuation for income
determination and financial position in a period of increasing costs.

FIFO (RM) AVCO (RM)

Sales (1,000 units @RM1.70) 1700 1700
COGS
Beginning inventory (1,000 units @RM1) 1000 1000
+Purchases (1,000 units @RM 1.50) 1500 1500
-Ending inventory (1,000 units) (1500) (1000) (1250) (1250)
Gross Profit / Profit before tax 700 450
Tax (50%) (350) (225)
Net Profit 350 225

FIFO (RM) AVCO (RM)

Cash (Sales – Purchase) 200 200
Inventory 1500 1250
Total assets 1700 1450

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Tax payable 350 225

Total equity (Net profit + Previous equity) 1350 1225
Total liabilities and total equity 1700 1450

During the period of rising cost, AVCO is more conservative in profit determination
than FIFO. The evaluation of financial position is higher in FIFO because AVCO
allocates average cost of inventories to sales. The oldest and lowest cost is applied in
sales in FIFO, so the profit is higher; and the recent cost is applied to remaining
inventories, so the financial position of FIFO is higher. The profit before tax is higher,
so the tax is higher for FIFO.

Q2. Sports Biz, a profitable company, built and equipped a $2,000,000 plant brought into
operation early in Year 1. Earnings of the company (before depreciation on the new plant
and before income taxes) is projected at: $1,500,000 in Year 1; $2,000,000 in Year 2;
$2,500,000 in Year 3; $3,000,000 in Year 4; and $3,500,000 in Year 5. The company can
use straight-line, double-declining-balance, or sum-of-the-years’-digits depreciation for
the new plant. Assume the plant’s useful life is 10 years (with no salvage value) and an
income tax rate of 50%.

Required:
Compute the separate effect that each of these three methods of depreciation would have
on:
a. Depreciation
b. Income taxes
c. Net income
d. Cash flow (assumed equal to net income before depreciation)
Straight line method Year 1 Year 2 Year 3 Year 4 Year 5
Earnings before taxes $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000
and depreciation
Depreciation $200,000 $200,000 $200,000 $200,000 $200,000
($2,000,000 – 0)/10
Profit before tax $1,300,000 $1,800,000 $2,300,000 $2,800,000 $3,300,000
Income tax (50%) $650,000 $900,000 $1,150,000 $1,400,000 $1,650,000
Net income $650,000 $900,000 $1,150,000 $1,400,000 $1,650,000
Depreciation $200,000 $200,000 $200,000 $200,000 $200,000
Cash flow $850,000 $1,100,000 $1,350,000 $1,600,000 $1,850,000

Sum-of-the-years’- Year 1 Year 2 Year 3 Year 4 Year 5

digit method
Earnings before taxes $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000
and depreciation
Depreciation $363,636 $327,273 $290,909 $254,545 $218,182
($2,000,000) x 10/55
Profit before tax $1,136,364 $1,672,727 $2,209,091 $2,745,455 $3,281,818
Income tax (50%) $568,182 $836,364 $1,104,545 $1,372,727 $1,640,909
Net income $568,182 $836,364 $1,104,545 $1,372,727 $1,640,909
Depreciation $363,636 $327,273 $290,909 $254,545 $218,182

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Cash flow $931,818 $1,163,636 $1,395,455 $1,627,273 $1,859,091

Double declining Year 1 Year 2 Year 3 Year 4 Year 5
balance method
Earnings before taxes $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000
and depreciation
Depreciation $400,000 $320,000 $256,000 $204,800 $163,840
($2,000,000 – 0) * 2 *
10%
Profit before tax $1,100,000 $1,680,000 $2,244,000 $2,795,200 $3,336,160
Income tax (50%) $550,000 $840,000 $1,122,000 $1,397,600 $1,668,080
Net income $550,000 $840,000 $1,122,000 $1,397,600 $1,668,080
Depreciation $400,000 $320,000 $256,000 $204,800 $163,840
Cash flow $950,000 $1,160,000 $1,378,000 $1,602,400 $1,831,920

Cash flow of versus straight line is higher except in Year 5, whereas the opposite happens for s-
y-d.
Net income of ddb versus straight line is always lower except in year 5, whereas the net income
of s-y-d is always higher except in year 1.
This is because of the depreciation expense of each method. The depreciation for ddb is higher
than straight line method in year 5. The higher the depreciation, the lower the net income. In year
5, the depreciation amount for ddb is lower, so only year 5 the net income is higher. With higher
depreciation, there will be a higher cash flow because depreciation will reduce the taxable
income. A reduction in tax is an improvement in cash. The depreciation of ddb is higher than syd
only in year 1. This explains how the cash flow and net income is higher and lower respectively
in year 1 only. Different method yields different depreciation expense, net income and cash flow.

Q3. Analysts maintain that two of the most important ratios are Inventory turnover and
Accounts receivable turnover.
a.You are analyzing ABC Company, a computer manufacturer. You notice that inventory
turnover this year is significantly lower than prior years. Provide three explanations that
would be consistent with this observation. Explain whether these would be of concern
to you and what the effect might be on next period's financial results.
b.You are analyzing ABC Company, a computer manufacturer. You notice that accounts
receivable turnover this year is significantly lower than prior years. Provide three
explanations that would be consistent with this observation. Explain whether these
would be of concern to you.

On average, inventories is being held at a longer period of time before it is sold. The average age
of inventory will be higher. Decrease in inventory turnover indicates that it is obsolete inventory.
It is hard to sell and can only be sold at a huge discount. It is a serious concern. We expect to see
inventories write down in the next period as analyst. It could be a planned increase in purchasing
or manufacturing in anticipation of increasing demand of the goods, which is a good sign. In the
next period, we would expect a huge increase in sales. Another explanation is less demand than
prior period. In order to sell off, we have to resort to sell at discounted price. We would expect a
lower gross profit margin.

The accounts receivables are increasing in relative to sales. There may be more sales made on
credit while sales remaining unchanged. It could be change in credit policy or employees fail to
follow the credit policy. Customers might be paying less quickly. Poorer quality of goods and
economic condition also causes customers to pay slowly. Finance department might be failing to

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track accounts receivables or follow up customers. There could be a change in allowance for
uncollectable accounts receivable. The company might allocates lower uncollectable account
receivable, which increases its net income and increases its accounts receivables. There might be
a change in allowance for merchandise sales return. Again, lower allowance increases net
income and accounts receivables. We need to look further whether the decrease is based on
better past experience or manipulation for higher net income.