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Financial Statement Analysis Case

Ragatz, Inc.

Ragatz, Inc., a drug company, reported the following information. The company prepares its financial statements in accordance with GAAP.

2017 (000)

Current liabilities

\(554,114

Convertible subordinated debts

648,020

Total liabilities

1,228,313

Stockholder’s equity

176,413

Net income

58,333

Analysts attempting to compare Ragatz to drug companies that issue debt with detachable warrants may face a challenge due to differences in accounting for convertible debt.

Instructions

(a) Compute the following ratios for Ragatz, Inc. (Assume that year-end balances approximate annual averages.)

(1) Return on assets.

(2) Return on common stock equity.

(3) Debt to assets ratio.

(b) Briefly discuss the operating performance and financial position of Ragatz. Industry averages for these ratios in 2017 were ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis, would you make an investment in the company’s 5% convertible bonds? Explain.

(c) Assume you want to compare Ragatz to an IFRS company like Merck (which issues nonconvertible debt with detachable warrants). Assuming that the fair value of the equity component of Ragatz’s convertible bonds is \)150,000, how would you adjust the analysis above to make valid comparisons between Ragatz and Merck?

Short Answer

Expert verified

(a) Financial ratios

Return on assets

4.15%

Return on equity

33.06%

Debt to asset

87.44%

(b) The company is performing well, but the company's financial position is not good.

(c) Financial ratios under IFRS

Return on assets

4.15%

Return on equity

17.87%

Debt to asset

76.76%

Step by step solution

01

Definition of Financial Ratios

The comparison made for financial analysis between the various items reported on the financial statement is known as financial ratios. These ratios are used for making a summarized report on the company’s performance.

02

Calculation of ratios

(1) Return on assets

Returnonassets=NetIncomeTotalAssets×100=$58,333$176,413+$1,228,313×100=$58,333$1,404,726×100=4.15%

(2) Return on common stock equity

Returnonequity=NetIncomeStockholdersequity×100=$58,333$176,413×100=33.06%

(3) Debt to assets ratio

Debttoassetsratio=Total DebtsTotal Assets=$1,228,313$176,413+$1,228,313×100=$1,228,313$1,404,726×100=87.44%

03

Operating performance of the company

  1. According to the industry average return on assets, the business entity is performing well because the actual ratio of the business entity is more than the industry average.

2.The industry average return on common stock equity is 16%, and the actual return on the common stock company is generating equals 33.06%. It means that the company generates more profit for stockholders than industry averages.

3.The company's debt to asset ratio is 87.44%, which is more than the industry average of 75%, which means that the company is not in a good financial position as most of its assets are financed through debt.

Even if the company is performing well, the debt to the asset is very high, reflecting that investing in the company’s bonds is riskier. But the investors might be attracted to the convertible bonds because the return on equity is higher than might increase the price of the shares, and investors can generate gain from such an increase in the prices.

04

Adjustments in the financial ratios

Under IFRS, the convertible bonds' equity and debt components of the convertible bonds are recorded separately. While under GAAP, these are not reported separately; therefore, the equity component of convertible bonds will be reported separately, which will affect the ratios.

2017 (000)

Current liabilities

$554,114

Convertible subordinated debts

($648,020$150,000)

498,020

Total liabilities ($1,228,313$150,000)

1,078,313

Stockholder’s equity

($176,413+$150,000)

326,413

Net income

58,333

(1) Return on assets

Returnonassets=NetIncomeTotalAssets×100=$58,333$176,413+$1,228,313×100=$58,333$1,404,726×100=4.15%

(2) Return on common stock equity

Returnonequity=NetIncomeStockholdersequity×100=$58,333$326,413×100=17.87%

(3) Debt to assets ratio

Debttoassetsratio=Total DebtsTotal Assets=$1,078,313$176,413+$1,228,313×100=$1,078,313$1,404,726×100=76.76%

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Most popular questions from this chapter

On January 1, 2017, Barwood Corporation granted 5,000 options to executives. Each option entitles the holder to purchase one share ofBarwood’s \(5 par value common stock at \)50 per share at any time during the next 5 years. The market price of the stock is \(65 per share on the date of grant. The fair value of the options at the grant date is \)150,000. The period of benefit is 2 years. Prepare Barwood’s journal entries for January 1, 2017, and December 31, 2017 and 2018.

On July 1, 2017, Roberts Corporation issued \(3,000,000 of 9% bonds payable in 20 years. The bonds include detachable warrants giving the bondholder the right to purchase for \)30 one share of \(1 par value common stock at any time during the next 10 years. The bonds were sold for \)3,000,000. The value of the warrants at the time of issuance was $100,000. Prepare the journal entry to record this transaction.

What are the arguments for giving separate accounting recognition to the conversion feature of debentures?

Tomba Corporation had 300,000 shares of common stock outstanding on January 1, 2017. On May 1, Tomba issued 30,000 shares. (a) Compute the weighted-average number of shares outstanding if the 30,000 shares were issued for cash. (b) Compute the weighted-average number of shares outstanding if the 30,000 shares were issued in a stock dividend.

Angela Corporation issues 2,000 convertible bonds at January 1, 2016. The bonds have a 3-year life, and are issued at par with a face value of \(1,000 per bond, giving total proceeds of \)2,000,000. Interest is payable annually at 6%. Each bond is convertible into 250 ordinary shares (par value of $1). When the bonds are issued, the market rate of interest for similar debt without the conversion option is 8%.

Instructions

(a) Compute the liability and equity component of the convertible bond on January 1, 2016.

(b) Prepare the journal entry to record the issuance of the convertible bond on January 1, 2016.

(c) Prepare the journal entry to record the repurchase of the convertible bond for cash at January 1, 2019, its maturity date.

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