CH-3 Financial Analysis – Foundations of Financial Management : Book Guide

Chapter 3 Financial Analysis Discussion Questions 3-1. If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons? Short-term lenders—Liquidity ratios because their concern is with the firm’s ability to pay short-term obligations as they come due. Long-term lenders—Leverage ratios because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made. Stockholders—Profitability ratios, with secondary consideration given to debt utilization, liquidity, and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment. 3-2. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity. The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover. Return on assets = Profit margin × Asset turnover In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a company in the capital goods industry may have a high profit margin and a low asset turnover, while a food processing firm may suffer from low profit margins, but enjoy a rapid turnover of assets. The modified form of the Du Pont formula shows: This indicates that return on stockholders’ equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on stockholders’ equity that is influenced by large amounts of debt. 3-3. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period? If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer period of time. This means the average collection period will be increasing. 3-4. What advantage does the fixed charge coverage ratio offer over simply using times interest earned? The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm. 3-5. Is there any validity in rule-of-thumb ratios for all corporations (for example, a current ratio of 2 to 1 or debt to assets of 50 percent)? No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information. 3-6. Why is trend analysis helpful in analyzing ratios? Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last 10 years. Trend analysis must also be compared to industry patterns of change. 3-7. 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. a. Inflation may cause net income to be overstated and total assets to be understated causing an artificially high ratio that is misleading. b. 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 will be understated relative to their replacement cost and to sales and too high a ratio could be reported. d. Since both are based on historical costs, no major inflationary impact will take place in the ratio. 3-8. What effect will disinflation following a highly inflationary period have on the reported income of the firm? Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm’s income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly. 3-9. Why might disinflation prove to be favorable to financial assets? Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar, lessening inflation also means that the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current evaluation. 3-10. Comparisons of income can be very difficult for two companies even though they sell the same products in equal volume. Why? There are many different methods of financial reporting accepted by the accounting profession as promulgated by the Financial Accounting Standards Board. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items. Chapter 3 Problems 1. Profitability ratios (LO2) Low Carb Diet Supplement Inc. has two divisions. Division A has a profit of $156,000 on sales of $2,010,000. Division B is only able to make $28,800 on sales of $329,000. Based on the profit margins (returns on sales), which division is superior? 3-1. Solution: Low Carb Diet Supplements Division A Division B Division B is superior. 2. Profitability ratios (LO2) Database Systems is considering expansion into a new product line. Assets to support expansion will cost $380,000. It is estimated that Database can generate $1,410,000 in annual sales, with an 8 percent profit margin. What would net income and return on assets (investment) be for the year? 3-2. Solution: Database Systems 3. Profitability ratios (LO2) Polly Esther Dress Shops Inc. can open a new store that will do an annual sales volume of $837,900. It will turn over its assets 1.9 times per year. The profit margin on sales will be 8 percent. What would net income and return on assets (investment) be for the year? 3-3. Solution: Polly Esther Dress Shops Inc. 4. Profitability ratios (LO2) Billy’s Crystal Stores Inc. has assets of $5,960,000 and turns over its assets 1.9 times per year. Return on assets is 8 percent. What is the firm’s profit margin (return on sales)? 3-4. Solution: Billy’s Crystal Stores Inc. 5. Profitability ratios (LO2) Elizabeth Tailors Inc. has assets of $8,940,000 and turns over its assets 1.9 times per year. Return on assets is 13.5 percent. What is the firm’s profit margin (returns on sales)? 3-5. Solution: Elizabeth Tailors Inc. 6. Profitability ratios (LO2) Dr. Zhivàgo Diagnostics Corp. income statements for 2013 are as follows: Sales $2,790,000 Cost of goods sold 1,790,000 Gross profit 1,000,000 Selling and administrative expense 302,000 Operating profit 698,000 Interest expense 54,800 Income before taxes 643,200 Taxes (30%) 192,960 Income after taxes $ 450,240 a. Compute the profit margin for 2013. b. Assume in 2014, sales increase by 10 percent and cost of goods sold increases by 20 percent. The firm is able to keep all other expenses the same. Once again, assume a tax rate of 30 percent on income before taxes. What is income after taxes and the profit margin for 2014? 3-6. Solution: Dr. Zhivàgo Diagnostics a. Profit margin for 2013 b. Sales $3,069,000* Cost of goods sold 2,148,000** Gross profit 921,000 Selling and administrative expense 302,000 Operating profit 619,000 Interest expense 54,800 Income before taxes 564,200 Taxes (30%) 169,260 Income after taxes (2014) $ 394,940 3-6. (Continued) * $2,790,000 × 1.10 = $3,069,000 ** $1,790,000 × 1.20 = $2,148,000 Profit margin for 2014 7. Profitability ratios (LO2) The Haines Corp. shows the following financial data for 2012 and 2013. 2012 2013 Sales $ 3,230,000 $3,370,000 Cost of goods sold 2,130,000 2,850,000 Gross profit 1,100,000 520,000 Selling & administrative expense 298,000 227,000 Operating profit 802,000 293,000 Interest expense 47,200 51,600 Income before taxes 754,800 241,400 Taxes (35%) 264,180 84,490 Income after taxes $490,620 $156,910 For each year, compute the following and indicate whether it is increasing or decreasing profitability in 2013 as indicated by the ratio. a. Cost of goods sold to sales. b. Selling and administrative expense to sales. c. Interest expenses to sales. 3-7. Solution: Haines Corp. 2012 2013 a. It is decreasing profitability. b. It is increasing profitability. c. It is not changing profitability. 8. Profitability ratios (LO2) Easter Egg and Poultry Company has $2,000,000 in assets and $1,400,000 of debt. It reports net income of $200,000. a. What is the firm’s return on assets? b. What is its return on stockholders’ equity? c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin (return on sales)? 3-8. Solution: Easter Egg and Poultry Company a. b. 3-8. (Continued) c. 9. Profitability ratios (LO2) Network Communications has total assets of $1,500,000 and current assets of $612,000. It turns over its fixed assets three times a year. It has $319,000 of debt. Its return on sales is 8 percent. What is its return on stockholders’ equity? 3-9. Solution: Network Communications Total assets $1,500,000 – Current assets 612,000 Fixed assets $ 888,000 Total assets $1,500,000 – Debt 319,000 Stockholders’ equity $1,181,000 10. Profitability ratios (LO2) Fondren Machine Tools has total assets of $3,310,000 and current assets of $879,000. It turns over its fixed assets 3.6 times per year. Its return on sales is 4.8 percent. It has $1,750,000 of debt. What is its return on stockholders’ equity? 3-10. Solution: Fondren Machine Tools Total assets $3,310,000 – Current assets 879,000 Fixed assets $2,431,000 Total assets $3,310,000 – Debt 1,750,000 Stockholders’ equity $1,560,000 11. Profitability ratios (LO2) Baker Oats had an asset turnover of 1.6 times per year. a. If the return on total assets (investment) was 11.2 percent, what was Baker’s profit margin? b. The following year, on the same level of assets, Baker’s assets turnover declined to 1.4 times and its profit margin was 8 percent. How did the return on total assets change from that of the previous year? 3-11. Solution: Baker Oats a. Total asset turnover × Profit margin = Return on total assets 1.6 × ? = 11.2% b. 1.4 × 8% = 11.2% It did not change at all because the increase in profit margin made up for the decrease in the asset turnover. 12. Du Pont system of analysis (LO3) AllState Trucking Co. has the following ratios compared to its industry for 2013. AllState Trucking Industry Return on sales……….. 3% 8% Return on assets……… 15% 10% Explain why the return-on-assets ratio is so much more favorable than the return-on-sales ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required. 3-12. Solution: AllState Trucking Company AllState Trucking Company has a higher asset turnover ratio than the industry. Calculations are not necessary to answer the question, but just in case a student did the calculations here is the comparison. AllState’s turnover 5x versus 1.25x Industry turnover 13. Du Pont system of analysis (LO3) Front Beam Lighting Company has the following ratios compared to its industry for 2013. Front Beam Lighting Industry Return on assets…………… 12% 5% Return on equity…………… 16% 20% Explain why the return-on-equity ratio is so much less favorable than the return-on-assets ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required. 3-13. Solution: Front Beam Lighting Company Front Beam has a lower debt-to-total-assets ratio than the industry. For those who did a calculation, Front Beam’s debt-to-assets was 75 percent versus 25 percent for the industry. 14. Du Pont system of analysis (LO3) Gates Appliances has a return-on-assets (investment) ratio of 8 percent. a. If the debt-to-total-assets ratio is 40 percent, what is the return on equity? b. If the firm had no debt, what would the return-on-equity ratio be? 3-14. Solution: Gates Appliances a. b. The same as return on assets (8%). 15. Du Pont system of analysis (LO3) Using the Du Pont method, evaluate the effects of the following relationships for the Butters Corporation. a. Butters Corporation has a profit margin of 7 percent and its return on assets (investment) is 25.2 percent. What is its assets turnover? b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the firm’s return on equity be? c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 35 percent? 3-15. Solution: Butters Corporation a. b. 3-15. (Continued) c. 16. Du Pont system of analysis (LO3) Jerry Rice and Grain Stores has $4,780,000 in yearly sales. The firm earns 4.5 percent on each dollar of sales and turns over its assets 2.7 times per year. It has $123,000 in current liabilities and $349,000 in long-term liabilities. a. What is its return on stockholders’ equity? b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities. 3-16. Solution: Jerry Rice and Grain Stores a. 3-16. (Continued) b. The new level of sales will be: 17. Interpreting results from the Du Pont system of analysis (LO3) Assume the following data for Cable Corporation and Multi-Media Inc. Cable Multi- Corporation Media Inc. Net income $ 31,200 $ 140,000 Sales 317,000 2,700,000 Total assets 402,000 965,000 Total debt 163,000 542,000 Stockholders’ equity 239,000 423,000 a. Compute return on stockholders’ equity for both firms using ratio 3a. Which firm has the higher return? b. Compute the following additional ratios for both firms. Net income/Sales Net income/Total assets Sales/Total assets Debt/Total assets c. Discuss the factors from part b that added or detracted from one firm having a higher return on stockholders’ equity than the other firm as computed in part a. 3-17. Solution: Cable Corporation and Multi-Media Inc. a. Cable Multi- Corporation Media Inc. Multi-Media Inc. has a much higher return on stockholders’ equity than Cable Corporation. 3-17. (Continued) b. Cable Multi- Corporation Media Inc. c. As previously indicated, Multi-Media Inc. has a substantially higher return on stockholders’ equity than Cable Corporation (33.1 percent versus 13.05 percent). The reason is certainly not to be found on return on the sales dollar where Cable Corporation has a higher return than Multi-Media Inc. (9.84 percent versus 5.19 percent). However, Multi-Media Inc. has a higher return than Cable Corporation on total assets (14.51 percent versus 7.76 percent). The reason is clearly to be found in total asset turnover, which strongly favors Multi-Media Inc. over Cable Corporation (2.8x versus .79x). This factor alone leads to the higher return on total assets. Multi-Media Inc.’s superior return on stockholders’ equity is further enhanced by a higher debt ratio than Cable Corporation (56.17 percent versus 40.55 percent). This means that a smaller percentage of Multi-Media Inc.’s total assets are being financed by stockholders’ equity and thus the potentially higher return on stockholders’ equity. 3-17. (Continued) Although not requested in the question, one could show the following: Multi-Media Inc. = 14.51%/(1–.5617) = 14.51%/.4383 = 33.1% Cable Corporation = 7.76%/(1–.4055) = 7.76%/.5945 = 13.05% 18. Average collection period (LO2) A firm has sales of $3 million, and 10 percent of the sales are for cash. The year-end accounts receivable balance is $285,000. What is the average collection period? (Use a 360-day year.) 3-18. Solution: 19. Average daily sales (LO2) Martin Electronics has an accounts receivable turnover equal to 15 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales? 3-19. Solution: Martin Electronics To determine credit sales, multiply accounts receivable by accounts receivable turnover. 20. Inventory turnover (LO2) Perez Corporation has the following financial data for the years 2010 and 2011: 2010 2011 Sales………………………… $8,000,000 $10,000,000 Cost of goods sold…………… 6,000,000 9,000,000 Inventory…………………….. 800,000 1,000,000 a. Compute inventory turnover based on ratio number 6, Sales/Inventory, for each year. b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year. c. What conclusions can you draw from part a and part b? 3-20. Solution: Perez Corporation 2010 2011 a. b. c. Based on the sales-to-inventory ratio, the turnover has remained constant at 10x. However, based on the cost of goods sold to inventory ratio, it has improved from 7.5x to 9x. The latter ratio may be providing a false picture of improvement in this example simply because cost of goods sold has gone up as percentage of sales has (from 75 percent to 90 percent). Inventory is not really turning over any faster. 21. Turnover ratios (LO2) Jim Short’s Company makes clothing for schools. Sales in 2013 were $4,820,000. Assets were as follows: Cash………………………………………. $ 163,000 Accounts receivable………………………. 889,000 Inventory………………………………….. 411,000 Net plant and equipment………………….. 520,000 Total assets…………………………… $1,983,000 a. Compute the following: 1. Accounts receivable turnover 2. Inventory turnover 3. Fixed asset turnover 4. Total asset turnover b. In 2014, sales increased to $5,740,000 and the assets for that year were as follows: Cash………………………………………... $ 163,000 Accounts receivable……………………….. 924,000 Inventory…………………………………... 1,063,000 Net plant and equipment…………………... 520,000 Total assets…………………………….. $2,670,000 Once again, compute the four ratios. c. Indicate if there is an improvement or decline in total asset turnover, and based on the other ratios, indicate why this development has taken place. 3-21. Solution: Jim Short’s Company a. 1. Accounts receivable turnover = Sales/Accounts Receivable 2. Inventory turnover = Sales/Inventory 3-21. (Continued) 3. Fixed asset turnover = Sales/(Net Plant & Equipment) 4. Total asset turnover = Sales/Total assets b. 1. Accounts receivable turnover 2. Inventory turnover 3. Fixed asset turnover 4. Total asset turnover c. There is a decline in total asset turnover from 2.43 to 2.15. This development has taken place because of the slowdown in inventory turnover (11.73 down to 5.4). The other two ratios are slightly improved. 22. Overall ratio analysis (LO2) The balance sheet for Stud Clothiers is shown next. Sales for the year were $2,400,000, with 90 percent of sales sold on credit. STUD CLOTHIERS Balance Sheet 200X Assets Liabilities and Equity Cash…………………… $ 60,000 Accounts payable…………….. $ 220,000 Accounts receivable…... 240,000 Accrued taxes………………… 30,000 Inventory……………… 350,000 Bonds payable (long-term)…………………… 150,000 Plant and equipment…... 410,000 Common stock……………….. 80,000 Paid-in capital………………… 200,000 Retained earnings…………….. 380,000 Total assets………... $1,060,000 Total liabilities and equity… $1,060,000 Compute the following ratios: a. Current ratio. b. Quick ratio. c. Debt-to-total-assets ratio. d. Asset turnover. e. Average collection period. 3-22. Solution: Stud Clothiers a. 3-22. (Continued) b. c. d. e. 23. Debt utilization ratios (LO2) The Lancaster Corporation’s income statement is given next. a. What is the times-interest-earned ratio? b. What would be the fixed-charge-coverage ratio? LANCASTER CORPORATION Sales $246,000 Cost of goods sold 122,000 Gross profit 124,000 Fixed charges (other than interest) 27,500 Income before interest and taxes 96,500 Interest 21,800 Income before taxes 74,700 Taxes (35%) 26,145 Income after taxes $ 48,555 3-23. Solution: Lancaster Corporation a. b. 24. Debt utilization and Du Pont system of analysis (LO3) Using the income statement for Times Mirror and Glass Co., compute the following ratios: a. The interest coverage. b. The fixed charge coverage. The total assets for this company equal $80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e. c. Profit margin. d. Total asset turnover. e. Return on assets (investment). PASTE MANAGEMENT COMPANY Sales $126,000 Less: Cost of goods sold 93,000 Gross profit 33,000 Less: Selling and administrative expense 11,000 Less: Lease expense 4,000 Operating profit* $ 18,000 Less: Interest expense 3,000 Earnings before taxes $ 15,000 Less: Taxes (30%) 4,500 Earnings after taxes $ 10,500 *Equals income before interest and taxes. 3-24. Solution: Times Mirror and Glass Co. a. 3-24. (Continued) b. c. d. e. 25. Debt utilization (LO2) A firm has net income before interest and taxes of $193,000 and interest expense of $28,100. a. What is the times-interest-earned ratio? b. If the firm’s lease payments are $48,500, what is the fixed charge coverage? 3-25. Solution: a. b. 26. Return on assets analysis (LO2) In January 2004, the Status Quo Company was formed. Total assets were $544,000, of which $306,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation of $30,600 per year, and in 2004 it estimated its fixed assets to have useful lives of 10 years. After tax income has been $29,000 per year each of the last 10 years. Other assets have not changed since 2004. a. Compute return on assets at year-end for 2004, 2006, 2009, 2011, and 2013. (Use $29,000 in the numerator for each year.) b. To what do you attribute the phenomenon shown in part a? c. Now assume income increased by 10 percent each year. What effect would this have on your preceding answers? (A comment is all that is necessary.) 3-26. Solution: Status Quo Company a. The return on assets for Status Quo will increase over time as the assets depreciate and the denominator gets smaller. Fixed assets at the beginning of 2004 equal $306,000 with a 10-year life, which means the depreciation expense will be $30,600 per year. Book values at year-end are as follows: 2004 = $275,400; 2006 = $214,200; 2009 = $122,400; 2011 = $ 61,200; 2013 = -0- 2004 = $29,000/$513,400 = 5.65% 2006 = $29,000/$452,200 = 6.41% 2009 = $29,000/$360,400 = 8.05% 2011 = $29,000/$299,200 = 9.69% 2013 = $29,000/$238,000 = 12.18% 3-26. (Continued) b. The increasing return on assets over time is due solely to the fact that annual depreciation charges reduce the amount of investment. The increasing return is in no way due to operations. Financial analysts should be aware of the effect of overall asset age on the return-on-investment ratio and be able to search elsewhere for indications of operating efficiency when ROI is very high or very low. c. As income rises, return on assets will be higher than in part (b) and would indicate an increase in return partially from more profitable operations. 27. Trend analysis (LO4) Jodie Foster Care Homes Inc. shows the following data: Year Net Income Total Assets Stockholders’ Equity Total Debt 2010 $155,000 $2,390,000 $ 761,000 $1,629,000 2011 191,000 2,700,000 966,000 1,734,000 2012 208,000 2,730,000 1,770,000 960,000 2013 192,000 2,470,000 2,220,000 250,000 a. Compute the ratio of net income to total assets for each year and comment on the trend. b. Compute the ratio of net income to stockholders’ equity and comment on the trend. Explain why there may be a difference in the trends between parts a and b. 3-27. Solution: Jodie Foster Care Homes Inc. a. 2010 $155,000/$2,390,000 = 6.49% 2011 $191,000/$2,700,000 = 7.07 2012 $208,000/$2,730,000 = 7.62 2013 $192,000/$2,470,000 = 7.77 Comment: There is a strong upward movement in return on assets over the four-year period. b. 2010 $155,000/$761,000 = 20.37% 2011 $191,000/$966,000 = 19.77% 2012 $208,000/$1,770,000 = 11.75% 2013 $192,000/$2,220,000 = 8.65% Comment: The return on stockholders’ equity ratio is going down each year. The difference in trends between a and b is due to the larger portion of assets that are financed by stockholders’ equity as opposed to debt. 3-27. (Continued) Optional: This can be confirmed by computing total debt to total assets for each year. 2010 68.2% 2011 64.2% 2012 35.2% 2013 10.1% 28. Trend analysis (LO4) Quantum Moving Company has the following data. Industry information also is shown. Industry Data on Company Data Net Income/Total Assets Year Net Income Total Assets 2011 $424,000 $2,843,000 14.0% 2012 428,000 3,267,000 9.8 2013 412,000 3,834,000 3.9 Industry Data on Year Debt Total Assets Debt/Total Assets 2011 $1,722,000 $2,843,000 56.6% 2012 1,732,000 3,267,000 42.0 2013 1,950,000 3,834,000 38.0 As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of: a. Net income/Total assets. b. Debt/Total assets. 3-28. Solution: Quantum Moving Company a. Net income/total assets Year Quantum Ratio Industry Ratio 2011 14.9% 14.0% 2012 13.1% 9.8% 2013 10.7% 3.9% Although the company has shown a declining return on assets since 2011, it has performed much better than the industry. Praise may be more appropriate than criticism. 3-28. (Continued) b. Debt/total assets Year Quantum Ratio Industry Ratio 2011 60.6% 56.6% 2012 53.0% 42.0% 2013 50.9% 38.0% While the company’s debt ratio is declining, it is not declining nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise. 29. Analysis by divisions (LO2) The Global Products Corporation has three subsidiaries. Medical Supplies Heavy Machinery Electronics Sales $20,040,000 $5,980,000 $4,730,000 Net income (after taxes) 1,700,000 592,000 402,000 Assets 8,340,000 8,760,000 3,570,000 . a. Which division has the lowest return on sales? b. Which division has the highest return on assets? c. Compute the return on assets for the entire corporation. d. If the $8,760,000 investment in the heavy machinery division is sold off and redeployed in the medical supplies subsidiary at the same rate of return on assets currently achieved in the medical supplies division, what will be the new return on assets for the entire corporation? 3-29. Solution: Global Products Corporation a. Medical Heavy Supplies Machinery Electronics Net income/Sales 8.48% 9.90% 8.50% The medical supplies division has the lowest return on sales. b. Medical Heavy Supplies Machinery Electronics Net income/ 20.38% 6.76% 11.26% Total assets The medical supplies division has the highest return on assets. 3-29. (Continued) c. d. Return on redeployed assets in heavy machinery. 20.38% × $8,760,000 = $1,785,288 Return on assets for the entire corporation: 30. Analysis by affiliates (LO1) Omni Technology Holding Company has the following three affiliates: Personal Foreign Software Computers Operations Sales $40,200,000 $60,080,000 $100,680,000 Net income (after taxes) 2,086,000 2,880,000 8,510,000 Assets 5,820,000 25,790,000 60,630,000 Stockholders’ equity 4,090,000 10,170,000 50,950,000 a. Which affiliate has the highest return on sales? b. Which affiliate has the lowest return on assets? c. Which affiliate has the highest total asset turnover? d. Which affiliate has the highest return on stockholders’ equity? e. Which affiliate has the highest debt ratio? (Assets minus stockholders’ equity equals debt.) f. Returning to question b, explain why the software affiliate has the highest return on total assets. g. Returning to question d, explain why the personal computer affiliate has a higher return on stockholders’ equity than the foreign operations affiliate even though it has a lower return on total assets. 3-30. Solution: Omni Technology Holding Company a. Net income/Sales The foreign operation affiliate has the highest return on sales. b. Net income/Total assets The personal computer affiliate has the lowest return on assets. 3-30. (Continued) c. Sales/Total assets The software affiliate has the highest return on total asset turnover. d. Net income/ Stockholders’ equity The software affiliate has the highest return on stockholders’ equity. e. Debt/Total assets The personal computer affiliate has the highest debt-to-total-assets ratio. f. This is because of its high total asset turnover ratio of 6.91x in part c. g. This is because the personal computer affiliate has a higher debt ratio (60.57%) than the foreign operations affiliate (15.97%). 31. Inflation and inventory accounting effect (LO5) The Canton Corporation shows the following income statement. The firm uses FIFO inventory accounting. CANTON CORPORATION Income Statement for 2013 Sales $272,800 (17,600 units at $15.50) Cost of goods sold 123,200 (17,600 units at $7.00) Gross profit 149,600 Selling and administrative expense 13,640 Depreciation 15,900 Operating profit 120,060 Taxes (30%) 36,018 After tax income $ 84,042 a. Assume in 2014 that the same 17,600-unit volume is maintained, but that the sales price increases by 10 percent. Because of FIFO inventory policy, old inventory will still be charged off at $7 per unit. Also assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute After tax income for 2014. b. In part a, by what percent did After tax income increase as a result of a 10 percent increase in the sales price? Explain why this impact took place. c. Now assume that in 2015 the volume remains constant at 17,600 units, but the sales price decreases by 15 percent from its year 2014 level. Also, because of FIFO inventory policy, cost of goods sold reflects the inflationary conditions of the prior year and is $7.50 per unit. Further, assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute the After tax income. 3-31. Solution: Canton Corporation a. 2014 Sales $300,080 (17,600 units at $17.05) Cost of goods sold 123,200 (17,600 units at $7) Gross profit $ 176,880 Selling and adm. expense 15,004 (5% of sales) Depreciation 15,900 Operating profit $ 145,976 Taxes (30%) $ 43,793 After tax income $ 102,183 3-31. (Continued) b. Gain in After tax income 2014 $102,183 2013 84,042 Increase $18,141 After tax income increased much more than sales because of FIFO inventory policy (in this case, the cost of old inventory did not go up at all), and because of historical cost depreciation (which did not change). c. 2015 Sales $255,024 (17,600 units at $14.49*) Cost of goods sold 132,000 (17,600 units at $7.50) Gross profit $123,024 Selling and adm. expense 12,751 (5% of sales) Depreciation 15,900 Operating profit $ 94,373 Taxes (30%) $ 28,312 After tax income $66,061 *$17.05 × 0.85 = $14.49 The low profits indicate the effect of inflation followed by disinflation. 32. Using ratios to construct financial statements (LO2) Construct the current assets section of the balance sheet from the following data. (Use cash as a plug figure after computing the other values.) Yearly sales (credit) $420,000 Inventory turnover 7 times Current liabilities $80,000 Current ratio 2 Average collection period 36 days Current assets: $ Cash ______ Accounts receivable ______ Inventory ______ Total current assets ______ 3-32. Solution: Inventory = $420,000/7 = $60,000 Current assets = 2 × $80,000 = $160,000 Account rec. = ($420,000/360) × 36 = $42,000 Cash = $160,000 – $60,000 – $42,000 = $ 58,000 Cash $ 58,000 Accounts receivable 42,000 Inventory 60,000 Total current assets $160,000 33. Using ratios to construct financial statements (LO2) The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in the following balance sheet. Total assets turnover 2.4 times Cash to total assets 2.0% Accounts receivable turnover 8.0 times Inventory turnover 10.0 times Current ratio 2.0 times Debt to total assets 61.0% GRIGGS CORPORATION Balance Sheet 2011 Assets Liabilities and Stockholders’ Equity Cash _____ Current debt _____ Accounts receivable _____ Long-term debt _____ Inventory _____ Total debt _____ Total current assets _____ Equity _____ Fixed assets _____ Total debt and stockholders’ equity _____ Total assets _____ 3-33. Solution: Griggs Corporation Sales/Total assets = 2.4 times Total assets = $1,200,000/2.4 Total assets = $500,000 Cash = 2% of total assets Cash = 2% × $500,000 Cash = $10,000 Sales/Accounts receivable = 8 times Accounts receivable = $1,200,000/8 Accounts receivable = $150,000 Sales/Inventory = 10 times Inventory = $1,200,000/10 Inventory = $120,000 3-33. (Continued) Fixed assets = Total assets – Current assets Current asset = $10,000 + $150,000 + $120,000 = $280,000 Fixed assets = $500,000 – $280,000 = $220,000 Current assets/Current debt = 2 Current debt = Current assets/2 Current debt = $280,000/2 Current debt = $140,000 Total debt/Total assets = 61% Total debt = 0.61 × $500,000 Total debt = $305,000 Long-term debt = Total debt – Current debt Long-term debt = $305,000 – 140,000 Long-term debt = $165,000 Equity = Total assets – Total debt Equity = $500,000 – $305,000 Equity = $195,000 Griggs Corporation Balance Sheet 2011 Cash $ 10,000 Current debt $140,000 A/R 150,000 Long-term debt 165,000 Inventory $120,000 Total debt $305,000 Total current assets 280,000 Fixed assets 220,000 Equity 195,000 Total assets $500,000 Total debt and stockholders’ equity $500,000 34. Using ratios to determine account balances (LO2) We are given the following information for the Pettit Corporation. Sales (credit) $3,549,000 Cash 179,000 Inventory 911,000 Current liabilities 788,000 Asset turnover 1.40 times Current ratio 2.95 times Debt-to-assets ratio 40% Receivables turnover 7 times Current assets are composed of cash, marketable securities, accounts receivable, and inventory. Calculate the following balance sheet items. a. Accounts receivable. b. Marketable securities. c. Fixed assets. d. Long-term debt. 3-34. Solution: Pettit Corporation a. Accounts receivable = Sales/Receivable turnover = $3,549,000/7x = $507,000 b. Marketable securities = Current assets – (Cash + Accounts rec. + Inventory) Current assets = Current ratio × Current liabilities = 2.95 × $788,000 = $2,324,600 Marketable securities = $2,324,600 – ($179,000 + $507,000 + $911,000) = $2,324,600 – $1,597,000 = $727,600 3-34. (Continued) c. Fixed assets = Total assets – Current assets Total assets = Sales/Asset turnover = $3,549,000/1.40x = $2,535,000 Fixed assets = $2,535,000 – $2,324,600 = $210,400 d. Long-term debt = Total debt – Current liabilities Total debt = Debt to assets × Total assets = 40% × $2,535,000 = $1,014,000 Long-term debt = $1,014,000 – $788,000 = $226,000 35. Using ratios to construct financial statements (LO2) The following information is from Harrelson Inc.’s, financial statements. Sales (all credit) were $28.50 million for 2013. Sales to total assets 1.90 times Total debt to total assets 35% Current ratio 2.50 times Inventory turnover 10.00 times Average collection period 20 days Fixed asset turnover 5.00 times Fill in the balance sheet: Cash ______ Current debt ______ Accounts receivable ______ Long-term debt ______ Inventory ______ Total debt ______ Total current assets ______ Equity ______ Fixed assets ______ Total debt and equity ______ Total assets ______ 3-35. Solution: Harrelson Inc. Sales/Total assets = 1.90 Total assets = $28.50 million/1.90 Total assets = $15 million Total debt/Total assets = 35% Total debt = $15 million × .35 Total debt = $5.25 million Sales/inventory = 10x Inventory = $28.50 million/10x Inventory = $2.85 million Average daily sales = $28.50 million/360 days = $79,166.67 per day Accounts receivable = 20 days × $79,166.67 = $1.58 million (or) 3-35. (Continued) Fixed assets = $28.50 million/5x = $5.70 million Current assets = Total assets – Fixed assets = $15.00 million – $5.70 million = $9.30 million Cash = Current assets – Accounts receivable – Inventory = $9.30 mil. – $1.58 mil. – $2.85 mil. = $4.87 million Current liabilities = Current assets/2.50 = $9.30 million/2.50 = $3.72 million Long-term debt = Total debt – Current debt = $5.25 million – $3.72 million = $1.53 million Equity = Total assets – Total debt = $15.00 million – $5.25 million = $9.75 million 3-35. (Continued) Cash................ $ 4.87 million Current debt........... $ 3.72 million Accounts receivable........ $ 1.58 Long-term debt....... $ 1.53 Inventory......... $ 2.85 Total debt....... $ 5.25 Total current assets............... $ 9.30 Equity............. $ 9.75 Fixed assets..... $ 5.70 Total assets..... $15.00 million Total debt and equity........... $15.00 million 36. Comparing all the ratios (LO2) Using the financial statements for the Snider Corporation, calculate the 13 basic ratios found in the chapter. SNIDER CORPORATION Balance Sheet December 31, 2013 Assets Current assets: Cash $ 52,200 Marketable securities 24,400 Accounts receivable (net) 222,000 Inventory 238,000 Total current assets $536,000 Investments 65,900 Plant and equipment 615,000 Less: Accumulated depreciation (271,000) Net plant and equipment 344,000 Total assets $946,500 Liabilities and Stockholders’ Equity Current liabilities Accounts payable $93,400 Notes payable 70,600 Accrued taxes 17,000 Total current liabilities 181,000 Long-term liabilities: Bonds payable 153,200 Total liabilities $334,200 Stockholders’ equity Preferred stock, $50 per value 100,000 Common stock, $1 par value 80,000 Capital paid in excess of par 190,000 Retained earnings 242,300 Total stockholders’ equity 612,300 Total liabilities and stockholders’ equity $946,500 SNIDER CORPORATION Income statement For the Year Ending December 31, 2013 Sales (on credit) $2,064,000 Less: Cost of goods sold 1,313,000 Gross profit 751,000 Less: Selling and administrative expenses 496,000* Operating profit (EBIT) 255,000 Less: Interest expense 26,900 Earnings before taxes (EBT) 228,100 Less: Taxes 83,300 Earnings after taxes (EAT) $ 144,800 *Includes $36,100 in lease payments. 3-36. Solution: Snider Corporation Profitability ratios Profit margin = $144,800/$2,064,000 = 7.02% Return on assets (investment) = $144,800/$946,500 = 15.3% Return on equity = $144,800/$612,300 = 23.65% Assets utilization ratios Receivable turnover = $2,064,000 /$222,000 = 9.30x Average collection period = $222,000/$5,733 = 38.72 days Inventory turnover = $2,064,000 /$238,000 = 8.67x Fixed asset turnover = $2,064,000 /$344,000 = 6.00x Total asset turnover = $2,064,000 /$946,500 = 2.18x Liquidity ratio Current ratio = $536,600/$181,000 = 2.96x Quick ratio = $298,600/$181,000 = 1.65x Debt utilization ratios Debt to total assets = $334,200/$946,500 = 35.31% Times interest earned = $255,000/$26,900 = 9.48x Fixed charge coverage = $291,100/$63,000 = 4.62x 37. Ratio computation and analysis (LO2) Given the financial statements for Jones Corporation and Smith Corporation shown here: a. To which one would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering. b. In which one would you buy stock? Why? JONES CORPORATION Current Assets Liabilities Cash $ 20,000 Accounts payable $100,000 Accounts receivable 80,000 Bonds payable (long-term) 80,000 Inventory 50,000 Long-Term Assets Stockholders’ Equity Fixed assets $500,000 Common stock $150,000 Less: Accumulated depreciation (150,000) Paid-in capital 70,000 Net fixed assets* 350,000 Retained earnings 100,000 Total assets $500,000 Total liab. and equity $500,000 Sales (on credit) $1,250,000 Cost of goods sold 750,000 Gross profit 500,000 Selling and administrative expense† 257,000 Less: Depreciation expense 50,000 Operating profit 193,000 Interest expense 8,000 Earnings before taxes 185,000 Tax expense 92,500 Net income $ 92,500 *Use net fixed assets in computing fixed asset turnover. †Includes $7,000 in lease payments. SMITH CORPORATION Current Assets Liabilities Cash $ 35,000 Accounts payable $ 75,000 Marketable securities 7,500 Bonds payable (long-term) 210,000 Accounts receivable 70,000 Inventory 75,000 Long-Term Assets Stockholders’ Equity Fixed assets $500,000 Common stock $ 75,000 Less: Accum. dep. (250,000) Paid-in capital 30,000 Net fixed assets* 250,000 Retained earnings 47,500 Total assets $437,500 Total liab. and equity $437,500 *Use net fixed assets in computing fixed asset turnover. SMITH CORPORATION Sales (on credit) $1,000,000 Cost of goods sold 600,000 Gross profit 400,000 Selling and administrative expense† 224,000 Less: Depreciation expense 50,000 Operating profit 126,000 Interest expense 21,000 Earnings before taxes 105,000 Tax expense 52,500 Net income $ 52,500 †Includes $7,000 in lease payments. 3-37. Solution: Jones and Smith Comparison One way of analyzing the situation for each company is to compare the respective ratios for each. Examining those ratios which would be most important to a supplier or short-term lender and a stockholder. Jones Corp. Smith Corp. Profit margin 7.4% 5.25% Return on assets (investments) 18.5% 12.00% Return on equity 28.9% 34.4% Receivable turnover 15.63x 14.29x Average collection period 23.04 days 25.2 days Inventory turnover 25x 13.3x Fixed asset turnover 3.57x 4x Total asset turnover 2.5x 2.29x Current ratio 1.5x 2.5x Quick ratio 1.0x 1.5x Debt to total assets 36% 65.1% Times interest earned 24.13x 6x Fixed charge coverage 13.33x 4.75x Fixed charge coverage calculation (200/15) (133/28) 3-37. (Continued) a. Since suppliers and short-term lenders are most concerned with liquidity ratios, Smith Corporation would get the nod as having the best ratios in this category. One could argue, however, that Smith had benefited from having its debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios. b. Stockholders are most concerned with profitability. In this category, Jones has much better ratios than Smith. Smith does have a higher return on equity than Jones, but this is due to its much larger use of debt. Its return on equity is higher than Jones’ because it has taken more financial risk. In terms of other ratios, Jones has its interest and fixed charges well covered and in general its long-term ratios and outlook are better than Smith’s. Jones has asset utilization ratios equal to or better than Smith and its lower liquidity ratios could reflect better short-term asset management. This point was covered in part a. Note: Remember that, in order to make actual financial decisions, more than one year’s comparative data is usually required. Industry comparisons should also be made. SMITH CORPORATION Sales (on credit) $1,000,000 Cost of goods sold 600,000 Gross profit 400,000 Selling and administrative expense 224,000 Less: Depreciation expense 50,000 Operating profit 126,000 Interest expense 21,000 Earnings before taxes 105,000 Tax expense 52,500 Net income $ 52,500 Includes $7,000 in lease payments. COMPREHENSIVE PROBLEM Comprehensive Problem 1. Lamar Swimwear (trend analysis and industry comparisons)(LO3) Bob Adkins has recently been approached by his first cousin, Ed Lamar, with a proposal to buy a 15 percent interest in Lamar Swimwear. The firm manufactures stylish bathing suits and sunscreen products. Mr. Lamar is quick to point out the increase in sales that has taken place over the last three years as indicated in the income statement, Exhibit 1. The annual growth rate is 25 percent. A balance sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in Exhibit 3. Note the industry growth rate in sales is only 10 to 12 percent per year. There was a steady real growth of 3 to 4 percent in gross domestic product during the period under study. Comprehensive Problem 1 (Continued) Exhibit 1 LAMAR SWIMWEAR Income Sheet 201X 201Y 201Z Sales (all on credit) $1,200,000 $1,500,000 $1,875,000 Cost of goods sold 800,000 1,040,000 1,310,000 Gross profit $ 400,000 $ 460,000 $ 565,000 Selling and administrative expense* 239,900 274,000 304,700 Operating profit (EBIT) $ 160,100 $ 186,000 $ 260,300 Interest expense 35,000 45,000 85,000 Net income before taxes $ 125,100 $ 141,000 $ 175,300 Taxes 36,900 49,200 55,600 Net income $ 88,200 $ 91,800 $ 119,700 Shares 30,000 30,000 38,000 Earnings per share $ 2.94 $ 3.06 $ 3.15 *Includes $15,000 in lease payments for each year. Exhibit 2 LAMAR SWIMWEAR Balance Sheet Assets 201X 201Y 201Z Cash $ 30,000 $ 40,000 $ 30,000 Marketable securities 20,000 25,000 30,000 Accounts receivable 170,000 259,000 360,000 Inventory 230,000 261,000 290,000 Total current assets $ 450,000 $ 585,000 $ 710,000 Net plant and equipment 650,000 765,000 1,390,000 Total assets $1,100,000 $1,350,000 $ 2,100,000 Liabilities and Stockholders’ Equity Accounts payable $ 200,000 $ 310,000 $ 505,000 Accrued expenses 20,400 30,000 35,000 Total current liabilities $ 220,400 $ 340,000 $ 540,000 Long-term liabilities 325,000 363,600 703,900 Total liabilities $ 545,400 $ 703,600 $ 1,243,900 Common stock ($2 par) 60,000 60,000 76,000 Capital paid in excess of par 190,000 190,000 264,000 Retained earnings 304,600 396,400 516,100 Total stockholders’ equity $ 554,600 $ 646,400 $ 856,100 Total liabilities and stockholders’ equity $1,100,000 $1,350,000 $2, 100,000 Exhibit 3 Selected Industry Ratios 201X 201Y 201Z Growth in sales — 10.00% 12.00% Profit margin 7.71% 7.82% 7.96% Return on assets (investment) 7.94% 8.86% 8.95% Return on equity 14.31% 15.26% 16.01% Receivable turnover 9.02x 8.86x 9.31x Average collection period 39.9 days 40.6 days 38.7 days Inventory turnover 4.24x 5.10x 5.11x Fixed asset turnover 1.60x 1.64x 1.75x Total asset turnover 1.05x 1.10x 1.12x Current ratio 1.96x 2.25x 2.40x Quick ratio 1.37x 1.41x 1.38x Debt to total assets 43.47% 43.11% 44.10% Times interest earned 6.50x 5.99x 6.61x Fixed charge coverage 4.70x 4.69x 4.73x Growth in EPS — 10.10% 13.30% The stock in the corporation has become available due to the ill health of a current stockholder, who is in need of cash. The issue here is not to determine the exact price for the stock, but rather whether Lamar Swimwear represents an attractive investment situation. Although Mr. Adkins has a primary interest in the profitability ratios, he will take a close look at all the ratios. He has no fast and firm rules about required return on investment, but rather wishes to analyze the overall condition of the firm. The firm does not currently pay a cash dividend, and return to the investor must come from selling the stock in the future. After doing a thorough analysis (including ratios for each year and comparisons to the industry), what comments and recommendations do you offer to Mr. Adkins? CP 3-1. Solution: Lamar Swimwear 201X 201Y 201Z Growth in sales (Company) 25% 25% (Industry) 10% 12% Profit margin (Company) 7.35% 6.12% 6.38% (Industry) 7.71% 7.82% 7.96% Return on assets (Company) 8.02% 6.80% 5.70% (Industry) 7.94% 8.68% 8.95% Return on equity (Company) 15.90% 14.20% 13.98% (Industry) 14.31% 15.26% 16.01% Receivable turnover (Company) 7.06x 5.79x 5.21x (Industry) 9.02x 8.86x 9.31x Average collection period (Company) 51.0 days 62.2 days 69.1 days (Industry) 39.9 days 40.6 days 38.7 days Inventory turnover (Company) 5.22x 5.75x 6.47x (Industry) 4.24x 5.10x 5.11x Fixed asset turnover (Company) 1.85x 1.96x 1.35x (Industry) 1.60x 1.64 1.75x Total asset turnover (Company) 1.09x 1.11x 0.89x (Industry) 1.05x 1.10x 1.12x Current ratio (Company) 2.04x 1.72x 1.31x (Industry) 1.96x 2.25x 2.40x Quick ratio (Company) 1.00x .95x 0.78x (Industry) 1.37x 1.41x 1.38x Debt to total assets (Company) 49.58% 52.12% 59.23% (Industry) 43.47% 43.11% 44.10% Times interest earned (Company) 4.57x 4.13x 3.06x (Industry) 6.50x 5.99x 6.61x Fixed charge coverage (Company) 3.50x 3.35x 2.75x (Industry) 4.70x 4.69x 4.73x Growth in E.P.S. (Company) ---- 4.1% 2.9% (Industry) ---- 10.1% 13.3% CP 3-1. (Continued) Discussion of Ratios While Lamar Swimwear is expanding its sales much more rapidly than others in the industry, there are some clear deficiencies in their performance. These can be seen in terms of a trend analysis over time as well as a comparative analysis with industry data. In terms of profitability, the profit margin is declining over time. This is surprising in light of the 56.25 percent increase in sales over two years (25 percent per year). There obviously are no economies of scale for this firm. Higher costs of goods sold and interest expense appear to be causing the problem. The return-on-asset ratio starts out in 201X above the industry average (8.02 percent versus 7.94 percent) and ends up well below it (5.70 percent versus 8.95 percent) in 201Z. The decline of 2.32 percent for return on assets is serious, and can be attributed to the previously mentioned declining profit margin as well as a slowing total asset turnover (going from 1.09x to 0.89x). Return on equity is higher than the industry average the first year, and then also falls far below it. This decline is particularly significant in light of the progressively larger debt that the firm is using. High debt utilization tends to contribute to high return on equity, but not in this case. There is simply too much deterioration in return on assets translating into low return on equity. The previously mentioned slower turnover of assets can be analyzed through the turnover ratios. A problem can be found in accounts receivable where turnover has gone from 7.06x to 5.21x. This can also be stated in terms of an average collection period that has increased from 51 days to 69.1 days. While inventory turnover has been and remains superior to the industry, the same cannot be said for fixed asset turnover. A decline from 1.85x to 1.35x was caused by an increase in 113.8 percent in fixed assets (representing $740,000). We can summarize the discussion of the turnover ratios by saying that despite a 56.25 percent increase in sales, assets grew even more rapidly causing a decline in total asset turnover from 1.09x to 0.89x. CP 3-1. (Continued) The liquidity ratios also are not encouraging. Both the current and quick ratios are falling against a stable industry norm of approximately two to one and one to one, respectively. The debt-to-total-assets ratio is particularly noticeable in regard to industry comparisons. Lamar Swimwear has gone from being only 6.11 percent over the industry average to 15.13 percent above the norm (59.23 percent versus 44.10 percent). Their heavy debt position is clearly out of line with their competitors. Their downtrend in times interest earned and fixed charge coverage confirms the heavy debt burden on the company. Finally, we see that the firm has a slower growth rate in earnings per share than the industry. This is a function of less rapid growth in earnings as well as an increase in shares outstanding (with the sale of 8,000 shares in 201Z). Once again, we see that the rapid growth in sales is not being translated down into significant earnings gains. This is true in spite of the fact that there is a very stable economic environment. Investment Comments: He would probably have difficulty justifying such an investment based on the performance of the firm. There are no dividend payouts, so return to the investor would have to come in the form of capital appreciation if and when he was able to resell the shares. The prospects, at this point, would not appear to justify the purchase. This is particularly true when one considers that Mr. Adkins would be buying a minority interest (15 percent) and would not have control of the firm. Comprehensive Problem 2 Sun Microsystems (trends, ratios stock performance) (LO3) Sun Microsystems is a leading supplier of computer-related products, including servers, workstations, storage devices, and network switches. In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G. McNealy offered the following remarks: Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still, we finished with revenue growth of 16 percent—and that’s significant. We believe it’s a good indication that Sun continued to pull away from the pack and gain market share. For that, we owe a debt of gratitude to our employees worldwide, who aggressively brought costs down— even as they continued to bring exciting new products to market. The statement would not appear to be telling you enough. For example, McNealy says the year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can delve further by examining the income statement in Exhibit 1. Also, for additional analysis of other factors, consolidated balance sheet(s) are presented in Exhibit 2 on page 92. 1. Referring to Exhibit 1, compute the annual percentage change in net income per common share-diluted (second numerical line from the bottom) for 1998–1999, 1999–2000, and 2000–2001. 2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years. Begin with 1998. 3. What is the major reason for the change in the answer for Question 2 between 2000 and 2001? To answer this question for each of the two years, take the ratio of the major income statement accounts to net revenues (sales). Cost of sales Research and development Selling, general and administrative expense Provision for income tax 4. Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 1 and 2. Comprehensive Problem 2 (Continued) Exhibit 1 SUN MICROSYSTEMS INC. Summary Consolidated Statement of Income (in millions) 2001 2000 1999 1998 Dollars Dollars Dollars Dollars Net revenues $18,250 $15,721 $11,806 $9,862 Costs and expenses: Cost of sales 10,041 7,549 5,670 4,713 Research and development 2,016 1,630 1,280 1,029 Selling, general and administrative 4,544 4,072 3,196 2,826 Goodwill amortization 261 65 19 .4 In-process research and development 77 12 121 176 Total costs and expenses 16,939 13,328 10,286 8,748 Operating Income 1,311 2,393 1,520 1,114 Gain (loss) on strategic investments (90) 208 – – Interest income, net 363 170 85 48 Litigation settlement – – – – Income before taxes 1,584 2,771 1,605 1,162 Provision for income taxes 603 917 575 407 Cumulative effect of change in accounting principle, net (54) – – – Net income $ 927 $ 1,854 $ 1,030 $ 755 Net income per common share—diluted $ 0.27 $ 0.55 $ 0.31 $ 0.24 Shares used in the calculation of net income per common share—diluted 3,417 3,379 3,282 3,180 5. Analyze your results to Question 4 more completely by computing ratios 1, 2a, 2b, and 3b (all from this chapter) for 2000 and 2001. Actually, the answer to ratio 1 can be found as part of the answer to question 2, but it is helpful to look at it again. What do you think was the main contributing factor to the change in return on stockholders’ equity between 2000 and 2001? Think in terms of the Du Pont system of analysis. 6. The average stock prices for each of the four years shown in Exhibit 1 were as follows: 1998 11¼ 1999 16¾ 2000 28½ 2001 9½ a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown above and divide by net income per common stock-dilution from Exhibit 1. b. Why do you think the P/E has changed from its 2000 level to its 2001 level? A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio Applied to Earnings per Share in Chapter 2. Comprehensive Problem 2 (Continued) Exhibit 2 SUN MICROSYSTEMS, INC Consolidated Balance Sheets (in millions) Assets 2001 2000 Current assets: Cash and cash equivalents $ 1,472 $ 1,849 Short-term investments 387 626 Accounts receivable, net allowances of $410 in 2001 and $534 in 2000 2,955 2,690 Inventories 1,049 557 Deferred tax assets 1,102 673 Prepaids and other current assets 969 482 Total current assets 7,934 6,877 Property, plant and equipment, net 2,697 2,095 Long-term investments 4,677 4,496 Goodwill, net of accumulated amortization of $349 in 2001 and $88 in 2000 2,041 163 Other assets, net 832 521 $18,181 $14,152 Liabilities and Stockholders’ Equity Current liabilities: Short-term borrowings $ 3 $ 7 Accounts payable 1,050 924 Accrued payroll-related liabilities 488 751 Accrued liabilities and other 1,374 1,155 Deferred revenues and customer deposits 1,827 1,289 Warranty reserve 314 211 Income taxes payable 90 209 Total current liabilities 5,146 4,546 Deferred income taxes 744 577 Long-term debt and other obligations 1,705 1,720 Total debt $ 7,595 $ 6,843 Commitments and contingencies Stockholders’ equity: Preferred stock, $0.001 par value, 10 shares authorized (1 share which has been designated as Series A Preferred participating stock): no shares issued and outstanding – – Common stock and additional paid-in-capital, $0.00067 par value, 7,200 shares authorized; issued: 3,536 shares in 2001 and 3,495 shares in 2000 6,238 2,728 Treasury stock, at cost: 288 shares in 2001 and 301 shares in 2000 (2,435) (1,438) Deferred equity compensation (73) (15) Retained earnings 6,885 5,959 Accumulated other comprehensive income (loss) (29) 75 Total stockholders’ equity 10,586 7,309 $18,181 $14,152 7. The book values per share for the same four years discussed in the preceding question were: 1998 $1.18 1999 $1.55 2000 $2.29 2001 $3.26 a. Compute the ratio of price to book value for each year. b. Is there any dramatic shift in the ratios worthy of note? CP 3-2. Solution Sun Microsystems 1. Percentage change in net income per common share—diluted 1999 $ .31 2000 $ .55 2001 $ .27 1998 $ .24 1999 $ .31 2000 $ .55 $ .07 $ .24 $–.28 +29.2% +77.4% –50.9% 2. Profit margin 1998 1999 2000 2001 7.66% 8.72% 11.79% 5.08% 3. Percent of net revenue 2000 2001 Net revenues $15,721 $18,250 Cost of sales 7,549 48.02% 10,041 55.02% Research and development 1,630 10.37 2,016 11.05 S, G, and A 4,072 25.90 4,544 24.90 Provision for income taxes 917 5.83 603 3.30 The main problem between 2000 and 2001 was the increase in cost of sales as a percentage of net revenue (48.02 percent to 55.02 percent). CP 3-2. (Continued) 4. Return on stockholders’ equity 2000 2001 25.37% 8.76% 5. 2000 2001 1. 11.79% 5.08% 2.a. 13.1% 5.10% 2.b. 13.09% 5.08% 3.b. 25.37% 8.73% The main contributing factor to the decline in the return on stockholders’ equity (25.37 percent to 8.73 percent) was the decline in the profit margin (11.79 percent versus 5.08 percent). The decrease in asset turnover (1.11 to 1.00) made a small contribution to the decline, as did the decline in the debt ratio (48.4 percent to 41.8 percent). CP 3-2. (Continued) 6.a. P/E = Stock price/Net income per common share—diluted (EPS) 1998 1999 2000 2001 P/E 46.9 54.0 51.8 35.2 b. The sharp decline in performance caused investors to pay a lower multiple for the stock. 7.a. Price to book value = Stock price/book value 1998 1999 2000 2001 P/BV 9.53 10.81 12.45 2.91 b. Once again, the sharp falloff in price to book value between 2000 and 2001 can be attributed to the decline in performance (and the impact on the stock prices). Book value was going up, but the ratio declined sharply due to the declining stock prices. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160