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Reading 27: Analysis of Financial Statements: A Synthesis

 

Q12. Melinda McKay, CFA, an analyst at Integrity Equity, is considering an investment in Earthmovers Inc., whose most recent

     financial data is provided below.

Earthmovers Inc.

Income Statement

Year ended Dec 31, 2006

($U.S. thousands)

Revenues

20,152

Gross profit

10,022

Operating income

4,819

Depreciation

823

Interest expense

1,040

Income before taxes

2,956

Taxes

887

Net Income

2,069

 

 

 

Earthmovers Inc.

Balance Sheet

Year ended Dec 31, 2006

($U.S. thousands)

Assets

 

 

Liabilities & Owner’s Equity

 

Cash

600

 

Accounts payable

5,500

Marketable Securities

200

 

Notes payable

3,500

Accounts Receivable

8,500

 

Total current liabilities

9,000

Inventories

3,500

 

 

 

Total current assets

12,800

 

Long-term debt

13,000

 

 

 

 

 

Net P,P&E

17,000

 

Preferred stock (100,000 shares)

1,000

Pension Asset

1,500

 

Common Stock (500,000 shares)

2,000

Intangible Assets

1,000

 

Retained earnings

8,300

Goodwill

1,000

 

Total stockholder’s equity

11,300

Total Assets

33,300

 

Total liabilities & Equity

33,300

The footnotes to Earthmovers Inc. include the following information:

  • Inventories are valued at cost under the last in, first out (LIFO) method, the LIFO reserve is $1.2 million, up $120,000 from the previous year.
  • Capitalized interest for 2006 is $550,000.
  • Earthmovers recently sold $400,000 worth of accounts receivable with recourse. To date only $100,000 has been collected.
  • The funded status of the pension fund is a pension liability of $1,000,000.
  • Due to an increase in yields on corporate debt, the market value of the long-term debt is $12.35 million.
  • The preferred stock is redeemable at the option of the preferred stockholder.
  • The market value of the preferred stock is $9.50.
  • Management viewed the potential liability of $5 million associated with a pending lawsuit as an improbable event. There is no insurance in place to cover any potential loss.

Following the release of the financial statements, Earthmovers publicly acknowledged that the loss related to the lawsuit was a probable event and was working out a settlement for $3 million.

What is the value of the times interest earned ratio (earnings before interest, tax, depreciation and amortization (EBITDA) / interest expense) using the adjusted data?

A)   2.8.

B)   3.0.

C)   4.6.

 

Q13. What is the value of the current ratio using the adjusted data?

A)   1.45.

B)   1.54.

C)   1.41.

 

[2009] Session 7 - Reading 27: Analysis of Financial Statements: A Synthesis

Q12. Melinda McKay, CFA, an analyst at Integrity Equity, is considering an investment in Earthmovers Inc., whose most recent fficeffice" />

     financial data is provided below.

Earthmovers Inc.

Income Statement

Year ended Dec 31, 2006

($ffice:smarttags" />U.S. thousands)

Revenues

20,152

Gross profit

10,022

Operating income

4,819

Depreciation

823

Interest expense

1,040

Income before taxes

2,956

Taxes

887

Net Income

2,069

 

 

 

Earthmovers Inc.

Balance Sheet

Year ended Dec 31, 2006

($U.S. thousands)

Assets

 

 

Liabilities & Owner’s Equity

 

Cash

600

 

Accounts payable

5,500

Marketable Securities

200

 

Notes payable

3,500

Accounts Receivable

8,500

 

Total current liabilities

9,000

Inventories

3,500

 

 

 

Total current assets

12,800

 

Long-term debt

13,000

 

 

 

 

 

Net P,P&E

17,000

 

Preferred stock (100,000 shares)

1,000

Pension Asset

1,500

 

Common Stock (500,000 shares)

2,000

Intangible Assets

1,000

 

Retained earnings

8,300

Goodwill

1,000

 

Total stockholder’s equity

11,300

Total Assets

33,300

 

Total liabilities & Equity

33,300

The footnotes to Earthmovers Inc. include the following information:

  • Inventories are valued at cost under the last in, first out (LIFO) method, the LIFO reserve is $1.2 million, up $120,000 from the previous year.
  • Capitalized interest for 2006 is $550,000.
  • Earthmovers recently sold $400,000 worth of accounts receivable with recourse. To date only $100,000 has been collected.
  • The funded status of the pension fund is a pension liability of $1,000,000.
  • Due to an increase in yields on corporate debt, the market value of the long-term debt is $12.35 million.
  • The preferred stock is redeemable at the option of the preferred stockholder.
  • The market value of the preferred stock is $9.50.
  • Management viewed the potential liability of $5 million associated with a pending lawsuit as an improbable event. There is no insurance in place to cover any potential loss.

Following the release of the financial statements, Earthmovers publicly acknowledged that the loss related to the lawsuit was a probable event and was working out a settlement for $3 million.

What is the value of the times interest earned ratio (earnings before interest, tax, depreciation and amortization (EBITDA) / interest expense) using the adjusted data?

A)   2.8.

B)   3.0.

C)   4.6.

Correct answer is A)

The income statement needs the following adjustments: 

§   Capitalized interest should be included on the income statement.  Inclusion will not affect EBITDA but will increase interest expense to 1,590,000 (1,040,000 + 550,000).

§   EBITDA should be reduced by $300,000 ($400,000 ? $100,000) to $4,519,000 due to the sale of accounts receivable that are yet to be collected.

Therefore, EBITDA / interest expense is 2.8 (= 4,519,000 / 1,590,000).

 

Q13. What is the value of the current ratio using the adjusted data?

A)   1.45.

B)   1.54.

C)   1.41.

Correct answer is B)

Current assets need the following adjustments: 

§   Increase accounts receivable by $300,000 for the uncollected receivables sold with recourse.

§   Increase inventories by the amount of the LIFO reserve or $1.2 million to reflect first in, first out (FIFO) accounting.

Current liabilities should increase by $300,000 to reflect the “borrowing” related to the sale of the receivables.  

The adjusted current ratio is 1.54 [(12,800,000 + 300,000 + 1,200,000) / (9,000,000 + 300,000)]

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