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Tutorial 05_solutions Ch15 FSA

The document discusses financial analysis using the DuPont framework and common-size financial statements for Clarksville Corporation, comparing profitability and efficiency metrics between two individuals, Frank and Bill. It highlights Clarksville's financial performance over three years, showing improvements in net income and operating expenses, while also analyzing asset efficiency. Additionally, it evaluates alternative investments through financial ratios for Hoffman and McMahon Companies, suggesting that McMahon may be a better investment despite lower returns due to a more favorable price-earnings ratio.

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2 views

Tutorial 05_solutions Ch15 FSA

The document discusses financial analysis using the DuPont framework and common-size financial statements for Clarksville Corporation, comparing profitability and efficiency metrics between two individuals, Frank and Bill. It highlights Clarksville's financial performance over three years, showing improvements in net income and operating expenses, while also analyzing asset efficiency. Additionally, it evaluates alternative investments through financial ratios for Hoffman and McMahon Companies, suggesting that McMahon may be a better investment despite lower returns due to a more favorable price-earnings ratio.

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© © All Rights Reserved
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Tutorial 5: FSA

SSA Chapter 15: E15-24, P 15-5, AA 15-3

E 15-24 (LO4) DuPont Framework

1. Frank Bill
Cash ............................................................................ $ 70 $ 250
Accounts receivable ................................................. 450 1,370
Inventory .................................................................... 1,100 3,050
Property, plant, and equipment ............................... 900 3,150
Total assets ................................................................ $ 2,520 $ 7,820

Total assets (average) .............................................. $ 3,000 $ 7,500


Total liabilities (average) .......................................... $ 1,875 $ 6,000
Total equity (average) ............................................... 1,125 1,500
Sales ........................................................................... $6,000 $ 22,500
Cost of goods sold .................................................... (3,825) (16,050)
Wage expense ........................................................... (650) (2,100)
Other expenses ......................................................... (1,470) (3,880)
Net income ................................................................. $ 55 $ 470

ROE Return on Sales Asset Turnover Assets/Equity


Frank 4.9% 0.9% 2.00 2.67
($55/$1,125) ($55/$6,000) ($6,000/$3,000) ($3,000/$1,125)
Bill 31.3% 2.1% 3.00 5.00
($470/$1,500) ($470/$22,500) ($22,500/$7,500) ($7,500/$1,500)

2. Frank’s return on equity of 4.9% is lower than Bill’s return on equity of 31.3%
because Frank is less profitable than is Bill. Frank’s return on sales is only 0.9%,
compared to 2.1% for Bill, indicating that each dollar in sales is less profitable
for Frank. Frank is also less efficient than Bill at using its assets to generate
sales. Besides, Frank is less aggressive at leveraging stockholders’ investment
than Bill.
Chapter 15

P 15-5 (LO2) Common-Size Financial Statements

1. Clarksville Corporation
Common-Size Statement of Comprehensive Incomes
For the Years Ended December 31, 2023, 2022, and 2021

2023 2022 2021


Amount % Amount % Amount %
Net sales ............................... $5,700,000 100.0 $6,600,000 100.0 $3,800,000 100.0
Cost of goods sold .............. 4,000,000 70.2 4,800,000 72.7 2,520,000 66.3
Gross profit on sales ..... $1,700,000 29.8 $1,800,000 27.3 $1,280,000 33.7
Selling expense .................... $1,120,000 19.6 $1,200,000 18.2 $ 960,000 25.3
General expense .................. 400,000 7.0 440,000 6.7 400,000 10.5
Total operating expenses $1,520,000 26.7* $1,640,000 24.8* $1,360,000 35.8
Operating income (loss)...... $ 180,000 3.1 $ 160,000 2.4* $ (80,000) (2.1)
Other revenue (expense)..... 80,000 1.4 130,000 2.0 160,000 4.2
Income before taxes ...... $ 260,000 4.6* $ 290,000 4.4 $ 80,000 2.1
Income tax ............................ 80,000 1.4 85,000 1.3 20,000 0.5
Net income ...................... $ 180,000 3.2 $ 205,000 3.1 $ 60,000 1.6
*Difference due to rounding.

Clarksville Corporation
Common-Size Balance Sheets

2023 2022 2021


Amount % Amount % Amount %
Assets:
Current assets ................ $ 855,000 15.0 $ 955,500 14.5 $ 673,500 17.7
Land, building, and
equipment ................. 1,275,000 22.4 1,075,000 16.3 925,000 24.3
Intangible assets ............ 100,000 1.8 100,000 1.5 100,000 2.6
Other assets ................... 48,000 0.8 60,500 0.9 61,500 1.6
Total assets .............. $2,278,000 40.0 $2,191,000 33.2 $1,760,000 46.3*
Liabilities:
Current liabilities............ $ 410,000 7.2 $ 501,000 7.6 $ 130,000 3.4
Non-current liabilities .... 400,000 7.0 600,000 9.1 400,000 10.5
Total liabilities .......... $ 810,000 14.2 $1,101,000 16.7 $ 530,000 13.9
Equity:
Capital stock ................... $1,100,000 19.3 $ 800,000 12.1 $1,000,000 26.3
Retained earnings .......... 368,000 6.5 290,000 4.4 230,000 6.1
Total stockholders’
equity ................... $1,468,000 25.8 $1,090,000 16.5 $1,230,000 32.4
Total liabilities and stock-
holders’ equity ............... $2,278,000 40.0 $2,191,000 33.2 $1,760,000 46.3
*Difference due to rounding.
Chapter 15

2. The common-size information reveals that, in 2021, an item selling for $1.00
yielded an average gross profit of 33.7 cents; in 2023, an item selling for $1.00
yielded an average gross profit of only 29.8 cents. The good news is that gross
profit as a percentage of sales is improved in 2023 relative to 2022 (27.3%). In 2023,
bottom line net income was 3.2% of sales, compared to just 1.6% in 2021. Total
operating expenses were 35.8% of sales in 2021, compared to just 26.7% in 2023.

The most informative section of the common-size balance sheet is the asset
section, which can be used to determine how efficiently a company is using its
assets. The common-size balance sheet indicates that each dollar of sales in 2022
required assets in place of 33.2 cents, whereas each dollar of sales in 2023 required
assets of 40.0 cents. So, Clarksville was more efficient at using its assets to
generate sales in 2022 when each dollar of sales required a lower level of assets.
Examination of the individual asset accounts suggests that the primary reason for
less efficient total asset usage in 2023 is land, building, and equipment—a dollar
of sales in 2022 required only 16.3 cents of land, building, and equipment,
compared to 22.4 cents in 2023.

AA 15-3 Evaluating Alternative Investments

Discussion

This case provides an opportunity to discuss the use of financial ratios to evaluate the desirability of an
investment.

Hoffman Company:
Return on average total assets = $126,000 ÷ $560,000 = 22.5%
Return on average equity = $126,000 ÷ $420,000 = 30%
Earnings per share = $126,000 ÷ 12,600= $10.00
Price-earnings ratio = $100 ÷ $10.00 = 10
Book-to-market ratio = $420,000 ÷ ($100  12,600) = 0.33

McMahon Company:
Return on average total assets = $48,750 ÷ $250,000 = 19.5%
Return on average equity = $48,750 ÷ $200,000 = 24.38%
Earnings per share = $48,750 ÷ 5,000 = $9.75
Price-earnings ratio = $78 ÷ $9.75 = 8
Book-to-market ratio = $200,000 ÷ ($78  5,000) = 0.51

Hoffman Company has a higher return on equity than McMahon Company. However, if Snow purchases
the Hoffman Company stock, she must pay 10 times the level of current earnings, compared to only 8 times
earnings for McMahon. Of course, other factors may affect the decision, such as the existence of preferred
stock, differences in dividends paid, and the nature of the two businesses.
Chapter 15

The efficient market hypothesis suggests that historical accounting data cannot be used to predict future
movement in stock prices. However, much research has shown that firms with high book-to-market ratios
have higher future returns. This would suggest that Snow should purchase the shares of McMahon
Company.

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