Question

Complete the following problems: 1. For this problem, use the following randomly generated list of accounts, placing them in appropriate order to prepare an income statement. Accounts ($000,000) Depreciation 25 General and administrative expenses 22 Sales 345 Sales expenses 18 Cost of goods sold 255 Lease expense 4 Interest expense 3 The following randomly constructed table requires that as part of your Critical Thinking Assignment you arrange the accounts into a well-labeled income statement. Make sure you label and solve for gross profit, operating profit, and net profit before taxes. Using a 35% tax rate, calculate taxes paid and net profit after taxes. Assuming a dividend of $1.10 per share with 4.25 million shares outstanding, calculate EPS and additions to retained earnings. 2. Explain why the income statement can also be called a “profit-and-loss statement.” What exactly does the word balance mean in the title of the balance sheet? Why do we balance the two halves? 3. CS Industries, Inc. began 2016 with retained earnings of $25.32 million. During the year, it paid four quarterly dividends of $0.35 per share to 2.75 million common stockholders. Preferred stockholders, holding 500,000 shares, were paid two semiannual dividends of $0.75 per share. The firm had a net profit after taxes of $5.15 million. Prepare the statement of retained earnings for the year ended December 31, 2016. 4. Sky Metals, Inc. is a metal fabrication firm that manufactures prefabricated metal parts for customers in a variety of industries. The firm’s motto is “If you need it, we can make it.” The CEO of Sky Metals recently held a board meeting during which he extolled the virtues of the corporation. The company, he stated confidently, had the capability to build any product and could do so using a lean manufacturing model. The firm would soon be profitable, claimed the CEO, because the company used state-of-the-art technology to build a variety of products while keeping inventory levels low. As a business press reporter, you have calculated some ratios to analyze the financial health of the firm. Sky Metals' current ratios and quick ratios for the past 6 years are shown in the following table: 2010 2011 2012 2013 2014 2015 2015 Current ratio 1.2 1.4 1.3 1.6 1.8 2.2 2.2 Quick ratio 1.1 1.3 1.2 0.8 0.6 0.4 0.4 What do you think of the CEO’s claim that the firm is lean and soon to be profitable? 5. If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72, and a financial leverage multiplier of 1.43, what is its ROE? What is the advantage to using the DuPont system to calculate ROE over the direct calculation of earnings available for common stockholders divided by common stock equity?

Answer 1

(1):

	Amount in $ 000,000
Sales	345.00
less: cost of goods sold	255.00
Gross profit	90.00
Operating expenses:
General & Administrative	22.00
Sales expense	18.00
Lease expense	4.00
Total operating expense	44.00
Operating profit	46.00
less: Interest expenses	3.00
Net profit before tax	43.00
Tax @ 35% on net profit before tax	15.05
Net profit	27.95

(I have assumed that lease expenses relate to an operating lease and hence they are part of operating expenses).

EPS = Net income/no. of shares = 27.95 million/4.25 million shares = $6.58 per share

Additions to retained earnings = Net income – dividends = $27.95 million – ($1.1 per share*4.25 million shares) = $23.275 million.

(2): Income statement is also called profit and loss statement because income statement helps in determining the amount of profit or loss earned by a company during a particular period of time (it can be a quarter, 6 months or full year).

The word balance means that the amount of assets = amount of liabilities. The two halves should be balanced as a natural and prudent form of accounting and relates to double entry book keeping system. For each transaction there are two aspects and at any point of time if books of accounts are properly maintained then the sum of all assets = sum of all liabilities + shareholders equity.

(3):

	Amount in $ millions
Retained earnings as on 1st January 2016	25.32
Add: net income earned in 2016	5.15
Subtotal	30.47
less: Preferred dividends (500,000*0.75*2/10^6)	0.75
less: Dividends to common stockholders (0.35*4*2.75)	3.85
Retained earnings as on 31st December 2016	25.870

(4):

Year	Current ratio	Quick ratio
2010	1.20	1.10
2011	1.40	1.30
2012	1.30	1.20
2013	1.60	0.80
2014	1.80	0.60
2015	2.20	0.40

We know that current ratio = current assets/current liabilities and quick ratio = (current assets - inventories)/current liabilities.

From the above table we can see that fro 2012 on wards while the current ratio is increasing the quick ratio is declining. This means that the company is decreasing its level of inventory on hand from 2012 on wards. Thus we can safely say that the firm is becoming lean and is most probably using the principles of just in time for its inventory. Lower levels of inventory is associated with quicker sales and hence, most likely, the company's  profits are also increasing. Thus the CEO's claim can be said to be valid.

(5): RoE = net profit margin*total asset turnover*financial leverage multiplier

= 4.5% * 0.72 * 1.43

= 4.63%

The advantage of using the Dupont system to calculate ROE over the direct calculation of earnings available for common stockholders ÷ common stock equity is that ROE, the most common measure for stockholders, is broken into three distinct components. Each component can be compared with industry standards to see if the firm is underperforming or over performing in any one of the three areas.