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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

CA16-4 WRITING (Stock Compensation Plans) The following two items appeared on the Internet concerning the GAAP requirement to expense stock options.

WASHINGTON, D.C.—February 17, 2005 Congressman David Dreier (R–CA), Chairman of the House Rules Committee, and Congresswoman Anna Eshoo (D–CA) reintroduced legislation today that will preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.

“Last year, the U.S. House of Representatives overwhelmingly voted for legislation that would have ensured the continued ability of innovative companies to offer stock options to rank-and-file employees,” Dreier stated. “Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) continue to ignore our calls to address legitimate concerns about the impact of FASB’s new standard on workers’ ability to have an ownership stake in the New Economy, and its failure to address the real need of shareholders: accurate and meaningful information about a company’s use of stock options.”

In December 2004, FASB issued a stock option expensing standard that will render a huge blow to the 21st century economy,” Dreier said. “Their action and the SEC’s apparent lack of concern for protecting shareholders, requires us to once again take a firm stand on the side of investors and economic growth. Giving investors the ability to understand how stock options impact the value of their shares is critical. And equally important is preserving the ability of companies to use this innovative tool to attract talented employees.”

“Here We Go Again!” by Jack Ciesielski (2/21/2005, http://www.accountingobserver.com/blog/2005/02/here-we-go-again) On February 17, Congressman David Dreier (R–CA), and Congresswoman Anna Eshoo (D–CA), officially entered Silicon Valley’s bid to gum up the launch of honest reporting of stock option compensation: They co-sponsored a bill to “preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.” You know what “critical information” they mean: stuff like the stock compensation for the top five officers in a company, with a rigged value set as close to zero as possible. Investors crave this kind of information. Other ways the good Congresspersons want to “help” investors: The bill “also requires the SEC to study the effectiveness of those disclosures over three years, during which time, no new accounting standard related to the treatment of stock options could be recognized. Finally, the bill requires the Secretary of Commerce to conduct a study and report to Congress on the impact of broad-based employee stock option plans on expanding employee corporate ownership, skilled worker recruitment and retention, research and innovation, economic growth, and international competitiveness.”

It’s the old “four corners” basketball strategy: stall, stall, stall. In the meantime, hope for regime change at your opponent, the FASB.

Instructions

(a) What are the major recommendations of the stock-based compensation pronouncement?

(b) How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)

(c) The bill in Congress urges the FASB to develop a rule that preserves “the ability of companies to use this innovative tool to attract talented employees.” Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.

Petrenko Corporation has outstanding 2,000 \(1,000 bonds, each convertible into 50 shares of \)10 par value common stock. The bonds are converted on December 31, 2017, when the unamortized discount is \(30,000 and the market price of the stock is \)21 per share. Record the conversion using the book value approach.

CA16-3 WRITING (Stock Warrants—Various Types) For various reasons a corporation may issue warrants to purchase shares of its common stock at specified prices that, depending on the circumstances, may be less than, equal to, or greater than the current market price. For example, warrants may be issued:

1. To existing stockholders on a pro rata basis.

2. To certain key employees under an incentive stock-option plan.

3. To purchasers of the corporation’s bonds.

Instructions

For each of the three examples of how stock warrants are used:

(a) Explain why they are used.

(b) Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company’s stock, and (2) the length of time over which they can be exercised.

(c) Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above

On January 1, 2017 (the date of grant), Lutz Corporation issues 2,000 shares of restricted stock to its executives. The fair value of these shares is \(75,000, and their par value is \)10,000. The stock is forfeited if the executives do not complete 3 years of employment with the company. Prepare the journal entry (if any) on January 1, 2017, and on December 31, 2017, assuming the service period is 3 years.

Explain the treasury-stock method as it applies to options and warrants in computing dilutive earnings per share data.

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