Financial Management 2

Answer the Following Questions and Problems

1. Explain the following statement: “While the statement of financial position can be thought of as a

snapshot of firm’s financial position at a point in time, the income statement reports on operations

over a period of time”

Answer:

The statement of financial position may be thought of as a snapshot of the firm’s financial position

at a point in time- for example, on December 31, 2018. The statement of financial position

changes every day as inventories are increased or decreased, as fixed assets are added or

retired, as bank loans are increased or decreased, and so on. The income statement reports on

operations over a period of time, for example during 2018. The income statement is also known

as the statement of operations, the profit and loss statement, or P&L. It presents a company's

revenues, expenses, gains, losses and net income for a specified period of time such as a year,

quarter, month, 13 weeks, etc.

2. If a typical firm reports P20 million of retained earnings on its statement of financial position, could

its directors declare a P20 million cash dividend without having any qualms about ehat they are

doing? Explain your answer.

Answer:

No, because the P20 million of retained earnings would probably not be held as cash. The

retained earnings figure represents the reinvestment of earnings by the firm over its life.

Consequently, the 20 million would be an investment in all of the firm’s assets.

3. Comment on why inflation may restrict the usefulness of the statement of financial position as

normally presented.

Answer:

Inflation is a general increase in prices and fall in the purchasing value of money. This said,

inflation puts the usefulness of the statement of financial position into a constant change, as most

of the values are based on original price or the historical price. The price of the inventory will keep

changing as the statement of financial position does not account for inflation. Although, this will

not affect the statement position on a day to day basis, it will gradually deter the price by a month

or year.

4. Why would the inventory turnover ratio be more important for someone analyzing a grocery store

chain than an insurance company?

Answer:

The inventory turnover ratio is important to a grocery store because of the much larger inventory

required and because some of that inventory is perishable. An insurance company would have no
 inventory to speak of since its line of business is selling insurance policies or other similar

financial products—contracts written on paper and entered into between the company and the

insured. This question demonstrates that the student should not take a routine approach to

financial analysis but rather should examine the business that he or she is analysing before

conducting a ratio analysis.

5. Financial ratio analysis is conducted by three main groups of analysis: credit analysis, stock

analysis and managers. What is the primary emphasis of each group and how would that

emphasis affects the ratios they focus on?

Answer:

The emphasis of the various types of analysts is by no means uniform nor should it be.

Management is interested in all types of ratios for two reasons. First, the ratios point out

weaknesses that should be strengthened; second, management recognizes that the other parties

are interested in all the ratios and those financial appearances must be kept up if the firm is to be

regarded highly by creditors and equity investors. Equity investors (stockholders) are interested

primarily in profitability, but they examine the other ratios to get information on the riskiness of

equity commitments. Credit analysts are more interested in the debt, TIE, and EBITDA coverage

ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most

carefully at the current ratio.

6. Explain the concept of liquidity and why it is crucial to company survival.

Answer:

Liquidity means cash availability. It refers to how much cash a company has and how much it can

raise on short notice. Cash is crucial because the company pay their debt and different expenses

by cash.

7. Inflation can have significant effects on income statements and balance sheets and therefore on

the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and

explain the direction of the impact based on your assumptions.

a. Return on investment

b. Inventory turnover

c. Fixed asset turnover

d. Debt-to-assets ratio

Answer:

a. Return on investment = Net income

Total assets

Inflation may cause net income to be overstated and total assets to be understated causing

an artificially high ratio that is misleading.

 b. Inventory turnover = Sales

Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will

also reflect “inflation-influenced” dollars and the net effect will be nil.

If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio

could be reported.

c. Fixed assets turnover = Sales

Fixed assets

Fixed assets will be understated relative to their replacement cost and to sales and too high a

ratio could be reported.

d. Debt to total assets = Total debt

Total assets

Since both are based on historical costs, no major inflationary impact will take place in the

ratio.

8. What are the free cash flows for a firm? What does it mean when a firm’s free cash flow is

negative?

Answer:

Free cash flow to the firm (FCFF) represents the cash flows from operations available for

distribution after depreciation expenses, taxes, working capital, and investments are accounted

for. Free cash flow is arguably the most important financial indicator of a company's stock value.

A positive FCFF value indicates that the firm has cash remaining after expenses. A negative

value indicates that the firm has not generated enough revenue to cover its costs and investment

activities.

9. “The principal purpose of the cash budget is to see how much cash the company will have in the

bank at the end of the year,” Do you agree?

Answer:

No, although this is clear one of the purposes of the cash budget. The principal purpose is to

provide information on probable cash needs during the budget period, so that bank loan and

other source of financing can be anticipated and arranged well in advance of the actual time of

need.

10. What is master budget? Briefly describe its contents.

 Answer:

Master budget is a summation of a number of separate but interdependent budgets. In other

words it is a consolidated summary of the entire functional budgets. Master budget is prepared by

the budget committee by coordinating various functional budgets once a master budget is

approved by the budget committee it becomes a set of goals to be achieved by the organization

during the budget period. This budget is generally in three parts Budgeted income statement,

Budgeted balance sheet at the end of budget period and Budget ratios relating to above two

statements, such as profit ratio, turnover ratio, working capital ratio and debt equity ratio etc.

Problems:

1. ( construction of Income Statement and Statement of Financial Position)

For December 31, 2017, the statement of financial position of Shadow Corporation is as follows:

Assets Liabilities and Owners’ Equity

Current Assets Liabilities
Cash P 10,000 Accounts payable P 12,000
Accounts receivable 15,000 Notes Payable 20,000
Inventory 25,000 Bonds payable 50,000
Prepaid expenses 12,000
Total Current Assets 62,000 Total liabilities 82,000
Fixed Assets
Plant and Equipment (gross) P 250,000 Owners/Equity
Less: Accumulated Depreciation 50,000 Common stock 75,000
Net plant & equipment 200,000 Paid-In capital 25,000
Total assets P 262,000 Retained earnings 80,000
========= Total equity 180,000
Total Liabilities & Owners’ Equity P262,000

Sales for 2018 were P220,000, and the cost of goods sold was 60 percent of sales. Selling and
administrative expense was P22,000. Depreciation expense was 8 percent of plant and equipment
(gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, and interest
expense on the bonds payable was 12 percent. These interest expenses are based on December 31,
2017 balances. The tax rate averaged 20 percent. Two thousand pesos in preferred stock dividends were
paid and P8,400 in dividends were paid to common stockholders. There were 10,000 shares of common
stock outstanding. During 2018, the cash balance and prepaid expenses balance were unchanged,
accounts receivable and inventory increased by 10 percent. A new machine was purchased on
December 31, 2018 at a cost of P35,000. Accounts payable increased by 25 percent. Notes payable
increased by P6,000 and bonds payable decreased by P10,000, both at the end of the year. The common
stock and paid-in capital in excess of par accounts did not change.

Required: (a ) Prepare an income statement for 2018 ( b. ) Prepare a statement of retained earnings
for 2018 (c,) Prepare statement of financial position as of December 31, 2018.

(a ) Prepare an income statement for 2018

Answer:

Shadow Corporation
2018 Income Statement
 Sales P 220,000
Cost of goods sold (60%) 132,000
Gross profit P 88,000
Selling and administrative expenses 22,000
Depreciation expense (8%) 20,000
Operating profit P 46,000
Interest expense 8,000
Earnings before taxes P 38,000
Taxes (20%) 7,600
Earnings after taxes P 30,400
Preferred stock dividends 2,000
Earnings available to common stockholder P 28,400
Shares outstanding 10,000
Earnings per share P 2.84

( b. ) Prepare a statement of retained earnings for 2018

Answer:
Shadow Corporation
2018 Income Statement

Retained earnings balance, January 1, 2018 P 80,000

Add: Earnings available to common stockholders, 2018 28,400
Less: Cash dividend declared in 2018 8,400

Retained earnings balance, December 31, 2018 P 100,000

(c,) Prepare statement of financial position as of December 31, 2018

Answer:

Shadow Corporation
Statement of Financial Position as at 31st December 2018

Assets Liabilities and Owners’ Equity

Current Assets Liabilities
Cash P 10,000 Accounts payable P 15,000
Accounts receivable 16,500 Notes Payable 26,000
Inventory 27,500 Bonds payable 40,000
Prepaid expenses 12,000
Total Current Assets P 66,000 Total liabilities P 81,000
Owners/Equity
Fixed Assets Preferred stock P 20,000
Plant and Equipment (gross) P 285,000 Common stock 55,000
Less: Accumulated Depreciation 70,000 Paid-In capital in excess par 25,000
Net plant & equipment 215,000 Retained earnings 100,000
Total assets P 281,000 Total Liability & Equity P 281,000

2. Victoria’s Apparel has forecast credit sales for the fourth quarter of the year as:

September (actual) P50,000

Fourth Quarter
October P40,000
November 35,000
December 60,000
Experience has shown that 20 percent of sales are collected in the month of sale, 70 percent in the
following month, and 10 percent are never collected.

Prepare a schedule of cash receipts for Victoria’s Apparel covering the fourth quarter (October through
December)

Answer:

Victoria’s Apparel
 September October November December
Credit sales P50,000 P40,000 P35,000 P60,000
20% collected in
month of sales P8,000 P7,000 P12,000
70% Collected in
month after sales P35,000 P28,000 P24,500

Total cash receipts P43,000 P35,000 P36,000