Chapter 1

Overview of Financial Statement Analysis

Problem 1
You are planning to analyze Voltek Company’s December 31, Year 6, balance
sheet. The following information is available:
1. Beginning and ending balances are identical for both accounts receivable
and inventory.
2. Net income is $1,300.
3. Times interest earned is 5 (income taxes are zero). Company has 5%
bonds outstanding and issued at par.
4. Net profit margin is 10%. Gross profit margin is 30%. Inventory turnover
is 5.
5. Day’s sales in receivables is 72 days.
6. Sales to end-of-year working capital is 4. Current ratio is 1.5.
7. Acid-test ratio is 1.0 (excludes prepaid expenses)
8. Plant and equipment (net) is $6,000. It is one-third depreciated.
9. Dividends paid on 8% nonparticipating preferred stock are $40. There is
no change in common shares outstanding during Year 6. Preferred shares
were issued two years ago at par.
10. Earnings per common share are $3.75.
11. Common stock has a $5 par value and was issued at par.
12. Retained earnings at January 1, Year 6, are $350.

Required:
a. Given the information available, prepare this company’s balance sheet as
of December 31, Year 6 (include the following account classifications:
cash, accounts receivable, inventory, prepaid expenses, plant and
equipment (net), current liabilities, bonds payable, and stockholder’s
equity).
b. Determine the amount of dividends paid on common stock in Year 6.

Problem 2
Selected ratios for three different companies that operate in three different
industries (merchandising, pharmaceuticals, utilities) are reported in the table
below:

Ratio Co. A Co. B Co. C

Gross profit margin ratio 18% 53% n.a.
Net profit margin ratio 2% 14% 8%
Research and development to sales 0% 17% 0.1%
Advertising to sales 7% 4% 0.1%
Interest expense to sales 1% 1% 15%
Return on assets 11% 12% 7%
Account receivable turnover 95 times 5 times 11 times
Inventory turnover 9 times 3 times n.a.
Long-term debt to equity 64% 45% 89%
n.a. = not applicable
Required:
Identify the industry that each of the companies, A, B, and C, operate in. Give it at
least two reasons supporting each of your selections.

Problem 3
Ace Co. is to be taken over by Beta Ltd. at the end of year 2007. Beta agrees to
pay the shareholders of Ace the book value per share at the time of the takeover.
A reliable analyst makes the following projections for Ace (assume cost of capital
is 10% per annum):

($ per share) 2002 2003 2004 2005 2006 2007

Dividends - 1.00 1.00 1.00 1.00 1.00
Operating - 2.00 1.50 1.00 0.75 0.50
cash flows
Capital - - - 1.00 1.00 -
expenditures
Debt - (1.00) (0.50) 1.00 1.25 0.50
increase
(decrease)
Net income - 1.45 1.10 0.60 0.25 (0.10)
Book Value 9.00 9.45 9.55 9.15 8.40 7.30

Required:
a. Estimate Ace Co.’s value per share at the end of year 2002 using the
dividend discount model.
b. Estimate Ace Co.’s value per share at the end of year 2002 using the
residual income model.
c. Attempt to estimate the value of Ace Co. at the end of year 2002 using the
free cash flow to equity model.
 Chapter 2
Financial Reporting and Analysis

Problem 1
A standard setter recently made a private remark that conservatism was a
“barbaric relic” that violated the “neutrality” requirement of accounting
information and that financial statements would be far more informative without
conservatism.

Required:
a. What is conservatism? What are the reason why conservatism continues
to be dominant in financial statements?
b. Do you agree with the observation by the standard setter?
c. As an analyst would you prefer conservative accounting? Does your
answer depend on your analysis objective? For example, would you
prefer conservative accounting if you were an equity analyst?
d. Many regard conservative accounting as “high-quality” accounting. Do
you agree with this statement? Provide arguments for why you think
conservative accounting increases or impedes accounting quality.
e. Academics refer to two forms of conservatism. What are they? Which
form of conservatism do you think is more useful for an analyst?

Problem 2
Consider the following: While accrual accounting infomartion is imperfect,
ignoring it and making cash flows the basis of all analysis and business is like
throwing the baby out with bath water.

Required:
a. Do you agree or disagree with this statement? Explain
b. How does accrual accounting provide superior information to cash flows?
c. What are the imperfections of accrual accounting? Is it possible for
accrual accounting to depict economic reality? Explain
d. What is the prudent approach to analysis using accrual accounting
information?
Problem 3
The FASB in SEAS No.123, “Accounting for stock-based options,” encourages (but
does not require) companies to recognize compensation expense based on the
fair value of stock options awarded to their employees and managers. Early
drafts of this proposal required the recognition of the fair value of the options.
But the FASB met opposition from companies and chose to only encourage the
recognition of the fair value. Recently, however, FASB has revised this standard
(SEAS 123R) so as to require recognition of option compensation expense

Required:
a. Discuss the role you believe the following parties should play in the
accounting standard promulgation process:
1. FASB
2. SEC
3. AICPA
4. Congress
5. Companies (CEOs)
6. Accounting firms
7. Investors
b. Discuss which parties likely lobbied for the change from requiring
expense recognition to only encouraging the expensing of stock options.
 Chapter 3
Analyzing Financing Activities

Problem 1
On January 1, Year 1, Burton Company leases equipment from Nelson Company
for an annual lease rental of $10.000. The lease term is five years, and the
lessor’s interest rate implicit in the lease is 8%. The lessee’s incremental
borrowing rate is 8,25%. The useful life of the equipment is five years, and its
estimated residual value equals its removal cost. Annuity tables indicate that the
present value of an annual lease rental of $1 (at 8% rate) is $3,993. The fair value
of leased equipment equals the present value of rentals. (Assume the lease is
capitalized)
a) Prepare accounting entries by Burton Company for Year 1
b) Compute and illustrate the effect on the income statement for the year
ended December 31, Year 1, and for the balance sheet as of December
31, Year 1.
c) Construct a table showing payments of interest and principal made
every year for the five-year lease term.
d) Construct a table showing expenses charged to the income statement
for the five-year lease term if the equipment is purchased. Show a
column for (1) amortization (2) interest (3) total expenses.
e) Discuss the income and cash flow implications from the capital lease!

Problem 2
Cybernetics Inc. issued $60 million of 5% three-year bonds, with coupon paid at
the end of every year. The effective interest rate at the beginning of Years 1,2,
and 3 was 8%, 5%, and 2%.

Required:
a) Determine what Cybernetics would have raised from the bond issue.
b) Assume Cybernetics decides to account for the bonds using the amortized
cost method. Determine the interest and bond amortization for each of
the three years.
a) Assume Cybernetics decides to account for the bonds using the fair value
method. Determine the interest, unrealized gain/loss, and total expense
for each of the three years.
b) Explain why the amounts charged to income every year differ fewer than
two methods!
Problem 3
The weighted-average discount rate used in determining General Energy Co.’s
actuarial present value of its pension obligation is 8,5%, and the assumed rate of
increase in future compensation is 7,5%. The expected long-term rate f return on
its plan assets is 11,5%. Its pension obligation at the end of Year 6 is $2,212,000,
and its accumulated benefit obligation is $479,000. Fair value of its assets is
$3,238,000. The service cost for Year 6 is $586,000.

Required:
Predict General Energy Co.’s Year 7 net periodic pension expense given a 10%
growth in service cost, the amortization of deferred loss over 30 years, and no
change in the other assumed rates. Show calculations!
 Chapter 4
Analyzing Investing Activities

Problem 1
BigBook.Com uses LIFO inventory accounting. Notes to BigBook.Com’s Year 9
financial statements disclose the following (it has a marginal tax rate of 35%):

Inventories Year 8 Year 9

Raw materials $392,675 $369,725
Finished products $401,342 $377,104
794,017 746,829
Less LIFO reserve (46,000) (50,000)
$748,017 $696,829

Required:
a. Determine the amount by which Year 9 retained earnings of BigBook.Com
changes if FIFO is used.
b. Determine the amount by which Year 9 net income of BigBook.Com
changes if FIFO is used for both Years 8 and 9.
c. Discuss the usefulness of LIFO to FIFO restatements in an analysis of
BigBook.Com.

Problem 2
Sports Biz, a profitable company, built and equipped a $2,000,000 plant brought
into operation PROBLEM 4–6 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).
Problem 3
Assume that a machine costing $300,000 and having a useful life of five years
(with no salvage value) generates a yearly income before depreciation and taxes
of $100,000.

Required:
Compute the annual rate of return on this machine (using the beginning-of-year
book value as the base) for each of the following depreciation methods (assume
25% tax rate):
a. Straight-line
b. Sum-of-the-years’ digits
 Chapter 5
Analyzing Investing Activities: Intercorporate Investment

Problem 1
Spellman Company acquires 90% of Moore Company in a business combination.
The total consideration is agreed upon, but the exact nature of Spellman’s
payment is not yet fully specified. This business combination is accounted for a
purchase. It is expected that at the date of the business combination, the fair
value will exceed the book value of Moore’s assets minus liabilities. Spellman
desires to prepare consolidated financial statements that include the financial
statement of Moore.

Required:
a. Explain how the method of accounting for a business combination
affects whether goodwill is reported.
b. If goodwill is recorded, explain how to determine the amount of
goodwill.
c. From a conceptual standpoint, explain why consolidated financial
statements should be prepared.

Problem 2
A company can have passive interest (non-influential) investment, significant
investment, or controlling interest. Passive interest investment can be trading,
available-for-sale, or held-to-maturity securities.
a. Describe the valuation basis at which each of these types of
investment is reported on the balance sheet
b. If the investment type is reported at fair value, indicate where any
value fluctuation is reported (net income or comprehensive income)
c. What is the rationale for reporting held-to-maturity securities at cost?
Does this rationale make economic scale?

Problem 3
An important element in accounting for investment securities concerns the
distinction between its noncurrent and current classification.
Required:
a. Why do most companies maintain an investment portfolio consisting
of both current and noncurrent securities?
b. What factors should an analyst consider when evaluating whether
investment in marketable equity securities are properly classified as
current or noncurrent? How do these factors affect the accounting
treatment for unrealized losses?
 Chapter 6
Analyzing Operating Activities

Problem 1
The unaudited income statements of Disposal Corporation are reproduced
below.
Year 8 Year 7
Sales $1,100 $900
Costs and expenses 990 860
Loss on asset disposal 10 —
Income before taxes 100 40
Tax expense 50 20
Net income $ 50 $20

Note: On August 15, Year 8, the company decided to discontinue its Metals Division.
The business was sold on December 31, Year 8, at book value except for a factory
building with a book value of $25 that was sold for $15. Operations of the Metals
Division were:

Income
Sales
(Loss)
Year 7 $300 $8
Jan. 1 to Aug. 15, Year 8 250 (3)
Aug. 16 to Dec. 31, Year 8 75 (1)

Required:
Correct the Year 7 and Year 8 income statements to reflect the proper reporting
of discontinued operations.

Problem 2
Cendant was formed on December 18, 1997, via the merger of CUC International
and HFS, Inc. The company owns the rights to franchises and brands including
Avis, Century 21 Real Estate, Coldwell Banker, Days Inn, Howard Johnson, and
Ramada. The consolidated entity got off to a bad start when it was revealed that
CUC International executives had been committing “widespread and systemic”
accounting fraud with intent to deceive investors. When the company announced
that it had discovered “potential accounting irregularities” the stock dropped
from $36 to $19 per share. Eventually the stock would fall to as low as $6 per
share as the company struggled to convince investors about management"s
integrity. According to the company"s own investigation, CUC executives had
inflated earnings by over $650 million over a three-year period using several
tactics, including: (1) failing to timely record returned credit card purchases and
membership cancellations, (2) improperly capitalizing and amortizing expenses
related to attracting new members, and (3) recording fictitious sales.

Required:
a. For each of three fraudulent tactics employed by CUC, identify an analysis
technique that could have identified the accounting improprieties.
b. Both the investors and the management of HFS had relied on audited
financial statements in making decisions regarding CUC International.
What do you believe was the external auditor’s culpability in not
detecting these fraudulent practices?

Problem 3
Big-Deal Construction Company specializes in building dams. During Years 3, 4,
and 5, three dams were completed. The first dam was started in Year 1 and
completed in Year 3 at a profit before income taxes of $120,000. The second and
third dams were started in Year 2. The second dam was completed in Year 4 at a
profit before income taxes of $126,000, and the third dam was completed in Year
5 at a profit before income taxes of $150,000. The company uses percentage of-
completion accounting for financial reporting and the completed-contract
method of accounting for income tax purposes. The applicable income tax rate is
50% for each of the Years 1 through 5. Data relating to progress toward
completion of work on each dam as reported by the company’s engineers are
given here:

Dam Year 1 Year 2 Year 3 Year 4 Year 5

1 20% 60% 20%
2 30 60 10%
3 10 30 50 10%

Required:
For each of the five years, Year 1 through Year 5, computes:
a. Financial reporting (book) income.
b. Taxable income.
c. Change in deferred income taxes.
 Chapter 7
Cash Flow Analysis

Problem 1
In reviewing the financial statements of Nano Tech Co., you discover that net
income increased while operating cash flow decreased for the most recent two
consecutive years.

Required:
a) Explain how net income could increase for Nano Tech Co. while its
operating cash flow decreased. Your answer should include three
illustrative examples.
b) Describe how operating cash flow can serve as one indicator of
earnings quality.

Problem 2
Convert Campbell’s statement of cash flow for year 11 to show cash flow
operations (CFO) using direct method. For purpose of this problem only, assume
the following:
a) Net changes in other current assets and current liabilities of $30.6
consist of:
Decrease in prepaid expenses $ (25.3)
Decrease in accounts payable 42.8
Increase in taxes payable (21.3)
Increase in accruals and payrolls (26.8)
$ (30.6)
b) Campbell disposed of a division year 11 reporting revenues of $7.5
million and an after tax loss of $5.3 million. The loss is included in
expense. The CFO presentation should include revenues and
expenses of the discontinued operations in year 11.

Problem 3
Analysts often exploit the relation between a company’s life cycle and its cash
flows to better understand company performance and financial condition.

Required:
a. Explain how a company’s transition from the growth stage to “cash cow”
is reflected in the statement of cash flows
b. Describe how the decline of a “cash cow” is reflected in the statement of
cash flows.
 Chapter 8
Return on Invested Capital and Profitability Analysis

Problem 1
Zear Company produces an electronic processor and sells it wholesale to
manufacturing and retail outlets at $10 each. In Zear’s Year 8 fiscal period, it sold
500,000 processors. Fixed costs for Year 8 total $1,500,000, including interest
costs on its 7.5% debentures. Variable costs are $4 per processor for materials.
Zear employs about 20 hourly paid plant employees, each earning $35,000 in
Year 8.
Zear is currently confronting labor negotiations. The plant employees are
requesting substantial increases in hourly wages. Zear forecasts a 6% increase in
fixed costs and no change in either the processor’s price or in material costs for
the processors. Zear also forecasts a 10% growth in sales volume for Year 9. To
meet the necessary increase in production due to sales demand, Zear recently
hired two additional hourly plant employees.
The condensed balance sheet for Zear at the end of fiscal Year 8 follows (the tax
rate is 50%):

Required:
a. Compute Zear’s return on invested capital for Year 8 where invested
capital is:
(1) Net operating assets at end of Year 8 (assume all assets and current
liabilities are operating)
(2) Common equity capital at the end of Year 8
b. Calculate the maximum annual wage increase Zear can pay each plant
employee and show a 10% return on net operating assets.

Problem 2
Selected financial statement data from Texas Telecom, Inc., for Years 5 and 9 are
reproduced below ($millions):

Year 5 Year 9
Income Statement Data
Revenues $542 $979
Operating Income 35 68
Interest Expense 7 0
Pretax Income 28 68
Income Taxes 14 34
Net Income 14 34
 Balance Sheet Data
Long term Operating Assets $ 52 $ 63
Working Capital 123 157
Total Liabilities 50 0
Total Shareholders Equity 125 220

Required:
a. Calculate return on common equity and disaggregate ROCE for Years 5
and 9 using end-of-year values for computations requiring an average
(assume fixed assets and working capital are operating and a 50% tax
rate).
b. Comment on Texas Telecom’s use of financial leverage.

Problem 3
Selected data from Kemp Corporation are reproduced below:
Required:
a. For year 4, compute the following ratio:
i. Inventory/Sales
ii. Inventory/Income Contribution
b. Compute the percentage of each product line’s income contribution to the
total for each year. Interpret this evidence.
c. Comment on the desirability of an investment in each product line.
 Chapter 9
Prospective analysis

Problem 1
Comparative income statements and balance sheets for Coca-Cola are shown
below ($ millions):

Year 2 Year 1
Income Statement
Net Sales...................................................................................... $20,092 $19,889
Cost of Goods.............................................................................. 6,044 6,204
Gross Profit..................................................................................
Selling, general, and administrative expense.............................. 14,048 13,685
Depreciation and amortization expense....................................... 803 773
Interest expense (revenue)........................................................... (308) 292
Income before tax........................................................................ 5,660 3,399
Income tax expense...................................................................... 1,691 1,222
Net Income................................................................................... $3,969 $2,177
Outstanding Shares...................................................................... 3,491 3,481

Year 2 Year 1
Balance Sheet
Cash................................................................................................. $ 1,934 $ 1,892
Receivables..................................................................................... 1,882 1,757
Inventories....................................................................................... 1,055 1,066
Other Current Assets....................................................................... 2,300 1,905
Total Current Assets....................................................................... 7,171 6,620
Property, plant, and equipment....................................................... 7,105 6,614
Accumulated depreciation.............................................................. 2,652 2,446
Net property, plant, and equipment................................................. 4,453 4,168
Other noncurrent assets.................................................................. 10,793 10,046
Total assets..................................................................................... $22,417 $20,834

Account Payable and accrued liabilities......................................... $3,679 $3,905

Short term debt and current maturities of long term debt... 3,899 4,816
Income tax liabilities....................................................................... 851 600
Total Current Liabilities.................................................................. 8,420 9,321

Deferred income taxes and other liabilities................................. 1,403 1,362

Long-term debt................................................................................ 1,219 835
Total Noncurrent Liabilities............................................................ 2,622 2,197

Common stock................................................................................ 873 870

Capital surplus................................................................................ 3,520 3,196
Retained earning............................................................................. 20,655 18,543
Treasury stock................................................................................. 13,682 13,293
Shareholders equity......................................................................... 11,366 9,316
Total Liabilities and equity.......................................................... $22,417 $20,834
Required:
a. Use the following ratios to prepare projected income statement, balance
sheet, and statement of cash flows for year 3
Sales growth................................................................................... 1.02%
Gross profit margin......................................................................... 69.92%
Selling, general, and administrative expense/Sales.................... 39.28%
Depreciation expense/Prior-year PPE gross................................... 12.14%
Interest expense/Prior-year long-term debt................................. 5.45%
Income tax expense/Pretax income................................................ 29.88%
Account receivable turnover........................................................... 10,68
Taxes payable/Tax expense............................................................ 50.33%
Total assets/stockholders equity (financial leverage)................ 2.06
Dividends per share........................................................................ $1.37
Capital expenditures/Sales.............................................................. 5.91%

a. Based on your initial projections, how much external financing (long-term

debt and/or stockholders equity) will Coca-Cola need to fund its growth
at projected increases in sales?

Problem 2
Following are financial statement information for Welmark Corporation as of
year 2 and year 3

WELMARK CORPORATION
Year 2 Year 3
Sales Growth 8.50% 10.65%
Net profit margin 6.71% 8.22%
Net working capital turnover 8.98 9.33
Fixed asset turnover 1.67 1.64
Total operating assets/Total equity 1.96 2.01
Number of shares outstanding 1,737 1,737
($ thousands)
Sales 25,423 28,131
Net income 1,706 2,312
Net working capital 2,832 3,015
Fixed assets 15,232 17,136
Total operating assets 18,064 20,151
Long-term liabilities 8,832 10,132
Total stockholders’ equity 9,232 10,019
Required:
Using the residual income model, prepare a valuation of the common stock of
Welmark Corporation as of Year 3 under the following assumptions:
a. Forecast horizon of five years.
b. Sales growth of 10.65% per year over the forecast horizon and 3.5%
thereafter.
a. All financial ratios remain at year 3 levels.
b. Cost of equity capital is 12.5%.

Problem 3
The Lyon Corporation is a merchandising company. Prepare a short-term cash
forecast for July of Year 6. Selected financial data from Lyon Corporation as of
July 1 of Year 6 are reproduced below:

Cash, July 1, Year 6 $20,000

Accounts receivable, July 1, Year 6 $20,000
Forecasted sales for July $150,000
Forecasted accounts receivable, July 31, Year 6 $21,000
Inventory, July 1, Year 6 $25,000
Desired Inventory, July 31, Year 6 $15,000
Depreciation expense for July $4,000
Miscellaneous outlays for July $11,000
Minimum cash balance desired $30,000
Accounts payable, July 1, Year 6 $18,000

Additional Information:
1. Gross profit equals 20% of cost of goods sold.
2. Lyon purchases all inventory on the second day of the month and receives
it the following week.
3. Lyon pays 75% of payable within the month of purchase and the balance
in the following month.
4. Lyon pays all remaining expenses in cash.
 Chapter 10
Credit Analysis

Problem 1
As lending officer for Prudent Bank, you are analyzing the financial statements of
ZETA Corp. as part of ZETA’s loan application. Your superior requests you
evaluate ZETA’s liquidity using the two-year financial information available. The
following additional information is acquired (in $ thousands): Inventory at
January 1, Year 5, $32,000.

Required:
a. Compute the following measures for both years 5 and 6:
1) Current ratio
2) Days’ sales in receivables
3) Inventory turnover
4) Days’ sales in inventory
5) Days’ purchases in accounts payable (assume all cost of sales items
are purchased)
6) Cash flow ratio
b. Comment on any significant year-to-year changes identified from the
analysis in (a)

Problem 2
You are analyzing the bonds of ZETA Company as a potential long-term
investment. As part of your decision-making process, you compute various ratios
for Years 5 and 6. Additional data and information to be considered only for
purposes of this problem follow ($ thousands):
1. Interest consist of the following:
2. Depreciation includes amortization of previously capitalized interest of
$1,200 for Year 6 and $1,000 for Year 5.
3. Interest portion of operating rental expense considered a fixed charge:
$20 in Year 6 and $16 in Year 5.
4. The associated company is less than 50% owned.
5. Deferred taxes constitute a long-term liability.
6. Present value of non-capitalized financing leases is $200 for both years.
7. Excess of the projected pension benefit obligation over the accumulated
pension benefit obligation is $2,800 for both years.
8. End of Year 4 total assets and equity capital are $94,500 and $42,000,
respectively.
9. Average market price per share of ZETA’s common stock is $40 and $45
for year 6 and Year 5, respectively.

Required:
a. Compute the following analytical measures for both Year 6 and 5:
1. Total debt to total assets
2. Total debt to equity
3. Long-term debt to equity
4. Earnings o fixed charges
5. Cash flow to fixed charges
b. Analyze and interpret both the level and year-to-year trend in these
measures.
Problem 3
The Lux Company experiences the following unrelated events and transactions
during Year 1, The company’s existing current ratio is 2:1 and its quick ratio is
1.2:1.
1. Lux wrote off $5,000 of accounts receivable as uncollectible.
2. A bank notifies Lux that a customer’s check for $411 is returned marked
insufficient funds. The customer is bankrupt.
3. The owners of Lux Company make additional cash investment of $7,500.
4. Inventory costing $600 is judged obsolete when a physical inventory is
taken.
5. Lux declares a $5,000 cash dividend to be paid during the first week of the
next reporting period.
6. Lux declares long-term investments for $10,000.
7. Accounts payable of $90,000 is paid.
8. Lux borrows $1,200 from a bank and fives a 90-day, 6% promissory note
in exchange.
9. Lux sells a vacant lot for $20,000 that had been used in its operations.
10. A three-year insurance policy is purchased for $1,500.

Required:
Separately evaluate the immediate effect of each transaction on the company’s:
a. Current ratio
b. Quick (acid-test) ratio
c. Working capital
 Chapter 11
Equity Analysis and Valuation

Problem 1
Aspero, Inc., has sales of approximately $500,000 per year. Aspero requires a
short-term loan of $100,000 to finance its working capital requirements. Two
banks are considering Aspero’s loan request but each bank requires certain
minimum conditions be satisfied. Bank America requires at least a 25% gross
margin on sales, and Bank Boston requires a 2:1 current ratio. The following
information is available for Aspero for the current year:
 Sales returns and allowances are 10% of sales.
 Purchases returns and allowances are 2% of purchases.
 Sales discounts are 2% of sales.
 Purchase discounts are 1% of purchases.
 Ending inventory is $138,000.
 Cash is 10% of accounts receivable.
 Credit terms to Aspero’s customers are 45 days.
 Credit terms Aspero receives from its supplier are 90 days.
 Purchases for the year are $400,000.
 Ending inventory is 38% greater than beginning inventory.
 Accounts payable are the only current liability.

Required:
Assess whether Aspero, Inc., meets the credit constraint for a loan from either or
both banks Show computations.

Problem 2
After careful financial statement analysis, we obtain these predictions for Colin
Technology:

Year Net Income ($) Beginning Book Value ($)

1 1,034 5,308
2 1,130 5,292
3 1,218 5,834
4 1,256 6,338
5 1,278 6,728
6 1,404 7,266
7 1,546 7,856

Colin Technology’s cost of equity capital is estimated at 13%.

Required:
a. Abnormal earnings are expected to be $0 per year after Year 7. Use the
accounting-based equity valuation model to estimate Colin’s value at the
beginning of Year 1.
b. Determine Colin’s PB ratio using the results in (a). Colin’s actual market-
based PB ratio is 1.95. what do you conclude from this PB comparison?
 c. Determine Colin’s PE ratio using the results in (a). Colin’s actual market-
based PE ratio is 10. What do you conclude from this PE comparison?
d. If we expect Colin’s sales and profit margin to remain unchanged after
Year 7 with a stable book value of $8.506, use the accounting-based
equity valuation model to estimate Colin’s value at the beginning of Year
1.

Problem 3
Interim accounting statements comprise a major part of financial reporting.
There is ongoing discussion considering the relevance of reporting on business
for interim periods.

Required:
a. Discuss how revenues are recognized for interim periods. Comment on
differences on revenue recognition for companies (1) subject to large
seasonal fluctuations in revenue, and (2) having long-term contracts
accounted for using percentage of completion for annual periods.
b. Explain how product and period costs are recognized for interim periods.
c. Discuss how inventory and cost of goods sold can be given special
accounting treatment for interim periods.
d. Describe how the provision for income taxes is computed and reported in
interim reports.