CHAPTER 3 Discussion Questions 3-1. Short-term lenders - liquidity because their concern is with the firm's ability to pay short-term obligations as they come due. Long-term lenders - leverage 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. Shareholders - profitability, with secondary consideration given to debt utilization, liquidity, and other ratios. Since shareholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment. 3-2. a. Return on investment = Net income Total assets Inflation may cause net income to be overstated and total assets to be understated. Too high a ratio could be reported. b. Inventory turnover = Sales or COGS Inventory *Sales may be used when COGS is not available (rival private firms)/ 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. Capital asset turnover = Sales . Capital assets Capital assets will be understated relative to sales and too high a ratio could be reported. d. Debt to total assets = Total debt . Total assets Since both are based on historical costs, no major inflationary impact will take place in the ratio. Assets are likely understated, however, causing ratio to be overstated. 3-3. The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover. ROA = Profit Margin × Asset Turnover Net income Total assets = Net income Sales × Sales . Total assets 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 foodprocessing firm may suffer from low profit margins, but enjoy a rapid turnover of assets. The modified Du Pont formula shows: ROE = ROA × Return on equity = Return on assets (investment) × Equity multiplier Total assets Equity This indicates that return on shareholders' 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 shareholders' equity that is influenced by large amounts of debt. 3-4. 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. In both instances, we would not reflect a very significant cost of doing business. Of course, one could argue that, to the extent that differential tax rates of financing plans (and associated interest costs) did not reflect the operating capability of the firm, omission of these changes could provide new insights. 3-6. 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-ofthumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information. 3-7. 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 ten years. Trend analysis must also be compared to industry patterns of change. The change in accounting rules with the use of IFRS for public companies and ASPE for private enterprises results in financial statements being significantly different with those prepared before January 1, 2011 which makes trend analysis inappropriate for decision making. However, the conversion of previous years’ statements will make the years prior to 2011 comparative and useful for trend analysis. 3-8. Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm's income statement resulting in decreased net income. This is particularly true for firms in highly cyclical industries, such as oil based products, where prices tend to rise and fall quickly. 3-9. Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar. Lower inflation also means that the required return that investors demand on financial assets will be lower, and with this lower demanded return, future earnings or interest should receive a higher current valuation. 3-10. There are many different methods of financial reporting accepted by the accounting profession as promulgated by the Canadian Institute of Chartered Accountants. The implementation of IFRS (public firms) and ASPE (private firms) should result in better comparison of statements among companies using the same rules of accounting.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. Internet Resources and Questions 1. 2. 3. 4. www.adviceforinvestors.com www.sedar.com/search/search_form_pc_en.htm www.bmo.com www.rbc.com Problems 3-1. Griffey Junior Wear a. Return on assets = b. Net income $100,000 = = .125 = 12.5% Total assets $800,000 Shareholders' equity = Total asssets - total debt = $800,000 − $200,000 = $600,000 Return on equity = Net income $100,000 = = .1667 = 16.67% Shareholders' equity $600,000 OR Total assets $800,000 = = 1.33 Equity $600,000 ROE = ROA × Equity multiplier = 12.5% × 1.33 = 16.67% Equity multiplier = c. Sales = total assets × asset turnover = $800,000 × 2.75 = $2,200,000 Net income $100,000 Profit margin = = = .0455 = 4.55% Sales $2,200,000 3-2. Easter Egg and Poultry Company a. Return on assets = b. Net income $200,000 = = .10 = 10.0% Total assets $2,000,000 Shareholders' equity = Total asssets - total debt = $2,000,000 − $1,400,000 = $600,000 Return on equity = Net income $200,000 = = .3333 = 33.33% Shareholders' equity $600,000 OR Total assets $2,000,000 Equity multiplier = = = 3.33 Equity $600,000 ROE = ROA × Equity multiplier = 10.0% × 3.33 = 33.33% c. Sales = total assets × asset turnover = $2,000,000 × 2.5 = $5,000,000 Net income $200,000 Profit margin = = = .04 = 4.0% Sales $5,000,000 3-3. Diet Health Foods Inc. Division A: Profit margin = Net income / Sales = $100,000 / $2,000,000 = 5% Division B: Profit margin = Net income / Sales = $25,000 / $300,000 = 8.33% 3-4. a. Dr. Gupta Diagnostics Profit margin (2012) = Net income $175,000 = = .0875 = 8.75% Sales $2,000,000 b. Sales ($2,000,000 × 1.10)…….………………….. Cost of goods sold ($1,400,000 × 1.20)………… Gross profit…………………………………... Selling and administration expense………........... Operating profit……………………………… Interest expense…………………………………. Income before taxes..………………………… Taxes @ 30% …………………………………… Income after taxes….………………………… Profit margin (2013) = 3-5. 3-6. Net income $119,000 = = .0541 = 5.41% Sales $2,200,000 Watson Data Systems Net income = = = $2,200,000 1,680,000 520,000 300,000 220,000 50,000 170,000 51,000 $ 119,000 Sales × profit margin $1,200,000 × 6% $72,000 Return on assets (investment) = Net income = = = Net income Total assets = $ 72,000 $500,000 = 0.144= 14.4% Walker Glove and Bat Shop Sales × profit margin $1,250,000 × 0.08 $100,000 Sales Total asset turnover = $1,250,000/ 3.4 = $367,647 = Assets Return on Assets (investments) = 3-7. Hugh Snore Bedding Sales = = = Total assets × total asset turnover $400,000 × 1.5 $600,000 Net income = = = Total assets × return on assets $400,000 × 12% $48,000 Profit margin = 3-8. Net income $100,000 = = 0.2720 = 27.2% Total assets $367,647 Net income $48,000 = = 0.08 = 8.0% Sales $600,000 Sharpe Razor Company Total assets ─ Current assets $2,500,000 ─ 1,000,000 = Capital assets = $1,500,000 Sales = Capital assets × Capital asset turnover = $1,500,000 × 5 = $7,500,000 Total assets ─ debt = Shareholders’ equity $2,500,000 ─ 700,000 = $1,800,000 Net income = Sales × profit margin = $7,500,000 × 3% = $225,000 ROE = $225,000 Net income = = .125 = 12.5% Shareholders' equity $1,800,000 3-9. Global Heathcare Products Global Heathcare has a higher asset turnover ratio than the industry. ROA = Asset turnover × profit margin Asset turnover = 3-10. ROA 18% 12% = = 9 × versus = 1.2 × Profit margin 2% 10% Acme Transportation Company Acme Transportation has a lower debt/ total assets than the industry and therefore a lower equity multiplier. ROE = ROA × equity multiplier Equity turnover = ROE 12% 24% = = 1.33 × versus = 4.0 × ROA 9% 6% 3-11. a. King Card Company Equity multiplier = 100% Total assets = = 1.667 Equity 1 − 40% ROE = ROA × Equity multiplier = 12% × 1.667 = 20.0% b. With no debt ROE = ROA. In this case 12%. 3-12. Lollar Corporation a. Total asset turnover × Profit margin = Return on total assets (ROA) ? × 5% = 13.5% 13.5% Total asset turnover = = 2.7 × 5% b. Equity multiplier = Total assets 100% = = 2.5 Equity 1 − 60% ROE = ROA × Equity multiplier = 13.5% × 2.5 = 33.75% c. Equity multiplier = Total assets 100% = = 1.67 Equity 1 − 40% ROE = ROA × Equity multiplier = 13.5% × 1.67 = 22.50% 3-13. Trace Manufacturing a. Total asset turnover × Profit margin = Return on total assets (ROA) 1.2 × ? = 7.2% 7.2% Profit margin = = 6.0% 1.2 b. Total asset turnover × Profit margin = Return on total assets (ROA) 1.0 × 7.2% = 7.2% It did not change at all because the increase in profit margin made up for the decrease in the asset turnover. 3-14. Donovan Bailey’s Shoe Stores a. Net income = Sales × profit margin = $3,000,000 × 6.2% = $186,000 Shareholders equity = Total assets − total liabilities Total assets = Sales/Total asset turnover = $3,000,000/3.75 = $800,000 Total liabilities = Current liabilities + long-term liabilities = $90,000 + $200,000 = $290,000 Shareholders' equity = $800,000 − $290,000 = $510,000 Return on equity (ROE) = b. Sales Net income = = = Total assets × total asset turnover $800,000 × 3 $2,400,000 = = = Sales × Profit margin $2,400,000 × 6.2% $148,800 Return on equity(ROE) = 3-15. Net income $186,000 = = .3647 = 36.47% Shareholders' equity $510,000 Net income $148,800 = = 0.2918 = 29.18% Shareholders' equity $510,000 Interactive Technology and Silicon Software Interactive Net income $15,000 a. ROE = = = 15% Equity $100,000 Silicon $50,000 = 31.25% $160,000 Net income $15,000 $50,000 = = 10% = 5% Sales $150,000 $1,000,000 Net income $15,000 $50,000 ROA = = = 9.375% = 12.5% Total assets $160,000 $400,000 Sales $150,000 $1,000,000 = = 0.9375 × = 2.5 × Total assets $160,000 $400,000 Debt $60,000 $240,000 = = 37.5% = 60% Total assets $160,000 $400,000 b. Profit margin = c. Silicon Software has a significantly higher return on equity (31.25% versus 15%). This is despite a lower profit margin (10% vs. 5%). However Silicon has achieved a higher return on total assets (12.5% vs. 9.375%) through a strong total asset turnover (2.5× vs. 0.9375×). The superior return on equity is further enhanced with higher use of debt (60% vs. 37.5%). This is called leverage and can magnify shareholder returns. 3-16. A Firm Accounts receivable Average daily credit sales $360,000 = ($1,200,000 × 90% ) / 365 $360,000 = = 122 days $2,959 Average collection period = 3-17. Chamberlain Corporation Average credit sales = Credit sales 365 To determine credit sales, multiply accounts receivable by accounts receivable turnover. $90,000 × 12 = $1,080,000 Average credit sales = $1,080,000 = $2,959 365 3-18. 2GFU Corporation 2004 2005 a. Inventory turnover = Sales $3,500,000 = = 14 × Inventory $250,000 $4,200,000 = 14 × $300,000 COGS $2,500,000 = = 10 × Inventory $250,000 $3,600,000 = 12 × $300,000 b. Inventory turnover = c. Based on the sales to inventory ratio the turnover ratio has remained constant at 14 ×. However based on the cost of goods sold to inventory ratio, it has improved from 10 × to 12 ×. The later ratio may be providing a false picture of improvement in this example simply because COGS has gone up as a percentage of sales (from 71 percent to 86 percent). Inventory is not really turning over any faster. Nevertheless, COGS is used by many analysts in the numerator of the inventory turnover ratio because it is stated on a ‘cost’ basis as inventory. This is an important theoretical consideration. Dun and Bradstreet, the most widely quoted source for ratio analysis uses sales in the numerator. Furthermore, for private companies, information may be only available for sales and net COGS. 3-19. Jim Kovacs Company a. 1. Accounts receivable turnover = Sales/Accounts Receivable $4,000,000 = 5x 800,000 2. Inventory turnover = Sales/Inventory $4,000,000 = 10 x 400,000 3. Fixed asset turnover = Sales/(Net Plant & Equipment) $4,000,000 = 8x 500,000 4. Total asset turnover = Sales/Total Assets $4,000,000 = 2.22 x 1,800,000 b. 1. Accounts receivable turnover $5,000,000 = 5.56 x 900,000 2. Inventory turnover $5,000,000 = 5.13 x 975,000 3. Fixed asset turnover $5,000,000 = 9.09 x 550,000 4. Total asset turnover $5,000,000 = 1.98 x 2,525,000 c. 3-20. There is a decline in total asset turnover from 2.22 to 1.98. This development has taken place because of the slowdown in inventory turnover (10x down to 5.13x). The other two ratios are slightly improved. Bryan Corporation a. Current ratio = b. Quick ratio = Current assets $650,000 = = 2.6 × Current liabilities $250,000 Current assets - inventory $300,000 = = 1.2 × Current liabilities $250,000 c. Debt to total assets = d. Asset turnover = $400,000 Total debt = = 38% Total assets $1,060,000 Sales $3,040,000 = = 2.87 × Total assets $1,060,000 e. Accounts receivable Average daily credit sales $240,000 $240,000 = = = 38.42 days ($3,040,000 × 75% ) / 365 6,247 Average collection period = 3-21. Simmons Corporation Income before interest and taxes (EBIT) Interest $60,000 = = 5× $12,000 Times interest earned = a. Income before fixed charges and taxes Fixed charges $60,000 + $24,000 $84,000 = = = 2.33 × $12,000 + $24,000 $36,000 Fixed charge coverage = b. 3-22. Sports Car Tire Company a. Times interest earned = EBIT $6,000 = = 12 × Interest $500 b. Income before fixed charges and taxes Fixed charges $6,000 + $1,000 $7,000 = = = 4.67 × $1,000 + $500 $1,500 Fixed charge coverage = c. Profit margin = Net income $3,300 = = .165 = 16.5% Sales $20,000 d. Asset turnover = Sales $20,000 = = 0.5 × Total assets $40,000 e. Return on assets (ROA) = Net income $3,300 = = 0.0825 = 8.25% Total assets $40,000 OR ROA = Profit margin × asset turnover = 16.5% × 0.5 = 8.25% 3-23. a. Times interest earned = b. A Firm EBIT $96,000 = = 4× Interest $24,000 Income before fixed charges and taxes Fixed charges $96,000 + $40,000 $136,000 = = = 2.13 × $24,000 + $40,000 $64,000 Fixed charge coverage = 3-24. Status Quo Company a. The return on assets for Status Quo will increase over time as the assets are amortized and the denominator gets smaller. Capital assets at the beginning of 2003 equal $300,000 with a ten-year life which means the amortization expense will be $30,000 per year. Book values at year-end are as follows: Year 2003 2005 2008 2010 2011 Capital $270,000 $210,000 $120,000 $60,000 0 Current + $200,000 + $200,000 + $200,000 + $200,000 + $200,000 Return on assets = 2006 2008 2011 2013 2015 Total = $470,000 = $410,000 = $320,000 = $260,000 = $200,000 Income aftertaxes Total assets $26,000/$470,000 $26,000/$410,000 $26,000/$320,000 $26,000/$260,000 $26,000/$200,000 = 5.53% = 6.34% = 8.13% = 10.00% = 13.00% b. The increasing return on assets over time is due solely to the fact that annual amortization 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. 3-25. JAS Clocks Corp. a. Net income/ total assets 2008 $110,000/ $1,500,000 = 0.0733 = 7.33% 2009 $125,000/ $1,900,000 = 0.0658 = 6.58% 2010 $150,000/ $2,400,000 = 0.0625 = 6.25% 2011 $175,000/ $3,000,000 = 0.05.83 = 5.83% Comment: There is a strong downward trend in return on assets over the period. b. Net income/ shareholders’ equity 2008 $110,000/ $ 750,000 = 0.1467 = 14.67% 2009 $125,000/ $ 825,000 = 0.1515 = 15.15% 2010 $150,000/ $ 900,000 = 0.1667 = 16.67% 2011 $175,000/ $1,000,000 = 0.1750 = 17.50% Comment: The return on shareholders’ equity is going up each year. The difference in trends from a to b is due to the increasing portion of assets financed with debt. This can be confirmed (not required) with: Total debt/ total assets 2008 $ 750,000/ $1,500,000 = 0.5000 = 50.00% 2009 $1,075,000/ $1,900,000 = 0.5658 = 56.58% 2010 $1,500,000/ $2,400,000 = 0.6250 = 62.50% 2011 3-26. $2,000,000/ $3,000,000 = 0.6667 = 66.67% Quantum Moving Company a. Net income/total assets Year Quantum Ratio 2009 2010 2011 12.5% 11.7% 10.0% Industry Ratio 11.5% 8.4% 5.5% Although the company has shown a declining return on assets since 2003, it has performed much better than the industry. Praise may be more appropriate than criticism. b. Debt/total assets Year Quantum Ratio 2009 2010 2011 58.0% 54.1% 50.7% Industry Ratio 54.1% 42.0% 33.4% While the company's debt ratio is improving, it is not improving nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise. 3-27. Global Products Corporation a. Net income/sales Medical 6.0% Machinery Electronics 3.8% 8.0% The machinery division has the lowest return on sales. b. Medical Net income/total assets 15.00% Machinery Electronics 2.375% 10.67% The medcal division has the highest return on assets. c. Corporate net income = $1,200,000 + $190,000 + $320,000 = $1,710,000 Corporate total assets = $8,000,000 + $8,000,000 + $3,000,000 =$19,000,000 ROA = Net income $1,710,000 = = 0.09 = 9.0% Total assets $19,000,000 d. Return on redeployed assets in medical supplies: 15% × $8,000,000 = $1,200,000 Return on assets for the entire corporation: New corporate net income = $1,200,000 + $1,200,000 + $320,000 = $2,720,000 ROA = Net income $2,720,000 = = 0.1432 = 14.32% Total assets $19,000,000 3-28. a. Quinn Corporation Income Statement for Dec. 31, 2012 Sales................................... $110,000 (10,000 units at $11) Cost of goods sold.............. 50,000 (10,000 units at $5) Gross profit.................. 60,000 Selling and adm. Expense... 5,500 (5% of sales) Amortization ...................... 10,000 Operating profit............ 44,500 Taxes (34%)........................ 15,130 After tax income.................. $ 29,370 b. Gain in after tax income = $29,370 − $23,100 = $6,270 Increase = $ 6,270 Base value (2012) $23,100 = 27.14% Aftertax 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 amortization (which did not change). c. Income Statement for Dec. 31, 2013 Sales.................................. $ 93,500 (10,000 units at $9.35*) Cost of goods sold............ 55,000 (10,000 units at $5.50) Gross profit................ 38,500 Selling and adm. expense.. 4,675 (5% of sales) Amortization ................... 10,000 Operating profit......... 23,825 Taxes (34%)..................... 8,100 After tax income................ $15,725 *$11.00 × 0.85 = $9.35 The low profits indicate the effect of inflation followed by disinflation. 3-29. Current assets = 2 × $80,000 = $160,000 Current assets (without inventory) = 1.25 × $80,000 = $100,000 Inventory = $160,000 − $100,000 = $60,000 Account rec. = ($420,000/ 365) × 36 = $41,425 Cash = $160,000 − $60,000 − $41,425 = $58,575 Current assets Cash Accounts receivable Inventory Total current assets 3-30. $ 58,575 41,425 60,000 $160,000 Shannon Corporation Sales/total assets Total assets Total assets Cash Cash = 2.5 times = $750,000/ 2.5 = $300,000 = 2% of total assets = 2% × $300,000 = $6,000 Sales/ accounts receivable = 10 times Accounts receivable Accounts receivable = $750,000/ 10 = $75,000 COGS/ inventory Inventory Inventory = 10 times = $500,000/ 10 = $50,000 Current asset = = Capital assets = = = $6,000 + $75,000 + $50,000 $131,000 Total assets − current assets $300,000 − $131,000 $169,000 Current assets/ current debt = Current debt = Current debt = Current debt = 2 Current assets/ 2 $131,000/ 2 $65,500 Total debt/total assets Total debt Total debt = 45% = 45% × $300,000 = $135,000 Long-term debt Long-term debt Long-term debt = Total debt − current debt = $135,000 − $65,500 = $69,500 Net worth Net worth Net worth = Total assets − total debt = $300,000 − $135,000 = $165,000 Balance Sheet Dec. 31, 2012 Cash....................... A/R........................ $ 6,000 $ 75,000 Current debt.......... Long−term debt.... $ 65,500 $ 69,500 Inventory................ Total current assets Capital assets.......... Total assets............. $ 50,000 $131,000 $169,000 $300,000 3-31. Total debt........... $135,000 Equity.................... $165,000 Total debt and $300,000 shareholders’ equity Pettit Corporation a. Accounts receivable = Sales/ receivables turnover = $3,000,000/ 6× = $500,000 b. Current Assets = Current ratio × current liabilities = 2.5 × $700,000 = $1,750,000 Marketable securities c. Capital assets = Current assets − (cash + accts rec. + inventory) = $1,750,000 − ($150,000 + $500,000 + $850,000) = $1,750,000 − 1,500,000 = $250,000 = Total assets − current assets Total assets = Sales/ asset turnover = $3,000,000/ 1.25x = $2,400,000 Capital assets = $2,400,000 - $1,750,000 = $650,000 = Debt to assets × total assets = 40% × $2,400,000 = $960,000 d. Total debt = Total debt − current liabilities = $960,000 − $700,000 = $260,000 Long-term debt 3-32. U Guessed It Company Sales/total assets Total assets Total assets = 2.0 × = $20 million/ 2 = $10 million Total debt/total assets = 40% Total debt = $10 million × 0.40 Total debt = $ 4 million COGS/inventory Inventory Inventory Average daily sales = 4.0 × = $20 million × 80%/ 4.0 × = $4 million = = Accounts receivable = = Sales × $20 million/ 365 days $54,795 per day 18 days × $54,795 $986,301 (or) # of days 18 = $20 million × = $986,301 365 365 Capital assets = $20 million/ 5.0 × Current assets = = = = $ 4 million Total asset − Capital assets $10 million − $4 million $6 million Cash = Total assets − inventory − accounts receivable − capital assets = $10 million − $4 million − $986,301 − $4 million = $1,013,699 Current liabilities = Current assets/ 3 × = $6 million/ 3 × = $2 million Long-term debt = Total debt − current debt = $4 million − $2 million = $2 million Equity = Total assets − total debt = $10 million − $4 million = $6 million Cash........................... Accounts receivable... Inventory.................... Total current assets.... U Guessed It Company December 31, 2012 (Millions) $ 1.014 Current debt........ 0.986 Long-term debt... 4.000 Total debt............ 6.000 Equity.................. $ 2.000 2.000 4.000 6.000 Capital assets............. Total assets................... 3-33. 4.000 $10.000 Total debt & equity........... $10.000 Snider Corporation Profitability ratios Profit margin = $120,000/ $1,980,000 = 6.06% Return on assets (investment) = $120,000/ $900,000 = 13.3% Return on equity = $120,000/ $580,000 = 20.69% Assets utilization ratios Receivables turnover = $1,980,000/ $160,000 = Average daily sales = $1,980,000/ 365 = Average collection period = $160,000/ $5,425 = Inventory turnover = $1,980,000/ $200,000 = OR = $1,280,000/ $180,000 = Average daily COGS = $1,280,000/ 365 = Inventory holding period = $200,000/ $3,507 = 12.38 × $5,425 29.49 days 9.9 × 6.4 × $3,507 57 days Accounts payable turnover = $1,280,000/ $90,000 = 14.22 × Accounts payable period = $90,000/ $3,507 = 25.67 days Capital asset turnover = $1,980,000/ $410,000 = Total asset turnover = $1,980,000/ $900,000 = 4.83 × 2.2 × Liquidity ratio Current ratio = $430,000/ $170,000 = 2.53 × Quick ratio = $230,000/ $170,000 = 1.35 × Debt utilization ratios Debt to total assets = $320,000/ $900,000 = Times interest earned = $225,000/ $25,000 = Fixed charge coverage = $260,000/ $60,000 = 3-34. 35.56% 9× 4.33 × Jet Boat Ltd. Profitability ratios Profit margin = $72,800/ $2,900,000 = 2.5% Return on assets (investment) = $72,800/ $1,200,000 = 6.1% Return on equity = $72,800/ $450,000 = 16.18% Assets utilization ratios Receivables turnover = $2,900,000/ $100,000 = Average daily sales = $2,900,000/ 365 = Average collection period = $100,000/ $7,945= 29 × $7,945 12.59 days Inventory turnover = $2,900,000/ $375,000 = OR = $2,465,000/ $375,000 = Average daily COGS = $2,465,000/ 365 = Inventory holding period = $375,000/ $6,753 = 7.73 × 6.57 × $6,753 56 days Accounts payable turnover = $2,465,000/ $100,000 = 25 × Accounts payable period = $100,000/ $6,753 = 15 days Capital asset turnover = $2,900,000/ $600,000 = Total asset turnover = $2,900,000/$1,200,000 = Liquidity ratio 4.83 × 2.42 × Current ratio = $600,000/ $250,000 = Quick ratio = $225,000/ $250,000 = 2.40 × .90 × Debt utilization ratios Debt to total assets = $750,000/ 1,200,000 = Times interest earned = $185,000/ $94,000 = Fixed charge coverage = $185,000/ $144,000 = 62.50% 1.97 × 1.28 × Note: Sinking fund provision included in denominator only. Comments: Jet Boat is a good vehicle to introduce seasonal and location considerations into ratio analysis. Note that the year-end is December 31st. Based on that and assuming that Jet Boat is a retailer, the receivable and inventory turnover that look promising at first glance may indicate potentially devastating write-offs/ downs. If Jet Boat is located on Georgian Bay, for example, it would be in mid-off season. If it is located in Sydney, Australia, the threat of stock-outs might be a concern as it would be in mid-selling season. Jet Boat Ltd. has a low profit margin, but a reasonable return on equity. This comes from a strong asset turnover and a high debt load. Du Pont analysis shows return on equity as 2.5% (profit margin) × 2.42 (asset turnover) × 2.67 (equity multiplier) = 16.2%. Equity multiplier = Total assets/ equity = 1/ (1 − debt/assets) = 1/ (1 − .625) = 2.67. The asset utilization ratios show good efficiency but perhaps hint at over utilization. Sales may be lost if the firm is under capitalized and is trying to make due by overusing existing assets. The average collection period is very good. Is a discount offered? The liquidity ratios also appear good, with a heavy reliance on inventory. The debt utilization ratios reveal that Jet Boat Ltd. has only a small margin for error. The debt load is heavy. 3-35. Jones and Smith Comparison One way of analyzing the situation for each company is to compare the respective ratios for each one, examining those ratios which would be most important to a supplier or short-term lender and a shareholder. Jones Corp. Profit margin Smith Corp. 7.4% 5.25% Return on assets (investments) 18.5% 12.0% Return on equity 28.9% 34.4% Receivable turnover 15.6 × 14.3 × 23.4 days 25.6 days 15 × or 25 × 8 × or 13.3 × 24.3 days 45.6 days 7.5 × 8× 49 days 46 days 3.57 × 4× Total asset turnover 2.5 × 2.28 × Current ratio 1.5 × 2.5 × Quick ratio 1.0 × 1.5 × Debt to total assets 36% 65% Times interest earned 24.12 × 6× Fixed charge coverage 13.33 × 4.75 × Average collection period Inventory turnover Inventory holding period Accounts payable turnover Accounts payable period Capital asset turnover Fixed charge calculation Jones Corp. (200/ 15) Smith Corp. (133/ 28) 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. Shareholders 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 shortterm asset management, and that point was covered in part a. Note: Remember that to make actual financial decisions more than one year's comparative data is usually required. Industry comparisons should also be made. 3-36. Retail Company Gross margin is healthy. Profit is weakening. This suggests higher fixed costs reducing profitability. Receivable and inventory turnovers are good indicating good management, but asset turnover ratios have weakened. This suggests a concern with sales volume. Has the company expanded too fast? Is an intensified sales effort required? Liquidity is good. Debt coverage is good. Weak return on equity is a combination of less than satisfactory profit margin and asset turnover. Comprehensive Problems 3-37. Wizard Industries 2012 2011 2010 Industry 0.1% 5.1% 0.1% 10.2% 0.4% 29.6% 0.4% 0.7% 1.8% 5.8% 8.1% 20.3% 3.9× 93 4.9× 6.3× 74 8.6× 42 9.9× 1.8× 5.1× 72 4.2× 5.6× 86 7.1× 51 10.6× 2.0× 5.2× 70 4.1× 5.3× 90 5.6× 65 8.4× 1.9× 6.3× 58 4.3× 5.7× 85 8.1× 45 8.0× 1.7× 1.72 1.08 1.71 .93 1.55 0.82 1.6 1.1 Profitability Ratios Profit margin Return on assets Return on equity Asset Utilization Ratios Receivable turnover Avg. Collection period Inventory turnover Inventory turnover (sales) Inventory holding period Accounts payable turnover Accounts payable period Capital asset turnover Total asset turnover Liquidity Ratios Current ratio Quick ratio Debt Utilization Ratios Debt to total assets Times interest earned Fixed charge coverage 71.4% 65.3% 64.7% 1.02× 3.42× 1.15× 1.02× 3.42× 1.15× 60% 4.3× − The profitability ratios do not appear healthy. Even in 2011 the profit margin did not reach the industry average. The relatively good performance in year 2011 seems to be dependent on strong sales. Good return on assets results from high asset turnover and the high return on equity is due to high debt levels. When sales aren’t maintained the results are evident in year 2012. The asset utilization ratios reveal problems. The slowdown in the collection of accounts receivable is of considerable concern. The working capital position has become more dependent on A/R and we must question the quality of these receivables. Turnover is far below the industry average. The accounts payable period is now below the industry average which suggests Wizard is not taking advantage of supplier credit to the full extent possible or suppliers are starting to cut back on credit to Wizard. Capital asset turnover is above the industry average and probably reveals that Wizard is overtrading and may not be reinvesting in assets. The increased inventory turns may also indicate overtrading. The liquidity ratios appear to be good. We should ask why. We have already identified the increasing A/R position. This would increase the liquidity ratios but it is hardly a healthy position. Furthermore, the long-term debt position has been increasing, perhaps as a substitute for short-term borrowings. The debt utilization ratios suggest an increasingly precarious position. The profit failure has severely impacted on the debt load. Interestingly, dividends have been maintained, Creditors are increasingly holding the bag. Do not grant credit! Debt loads are increasing and shareholders are not showing a full commitment to the firm. An equity contribution and reduction of dividends is required. Furthermore sales are weak and this is impacting on profitability measures. Those sales that are made are being collected in a longer time. Are they less creditworthy? There is also evidence of a reluctance to reinvest in equipment (capital assets). 3-38. Watson Leisure Time Sporting Goods 2012 2011 (Company) 20% 20% (Industry) 10.02% 9.98% (Company) 5.56% 5.63% 6.26% (Industry) 5.81% 5.80% 5.75% (Company) 6.34% 7.79% 9.39% (Industry) 8.48% 8.24% 8.22% (Company) 14.25% 15.73% 17.07% (Industry) 14.16% 13.62% 13.26% Receivable turnover (Company) 6.55 × 7.83 × 10.0 × (Industry) 10.1 × 9.5 × 10.0 × Average collection period (Company) 55.8days 46.6days 36.5 days (Industry) 35.6 days 37.9 days 36 days Inventory turnover (Company) 6.65 × or 4× 6.32 × or 3.93 × 6.0 × or 3.8 × (Industry) 5.84 × 5.62 × 5.71 × (Company) 1.85 × 2.50 × 2.73 × (Industry) 2.20 × 2.66 × 2.75 × Growth in sales Profit margin Return on assets Return on equity Capital asset turnover 2010 Total asset (Company) 1.14 × 1.38 × 1.50 × turnover (Industry) 1.44 × 1.42 × 1.43 × Current ratio (Company) 1.45 × 1.78 × 2.25 × (Industry) 2.15 × 2.08 × 2.10 × (Company) 0.80 × 0.91 × 1.00 × (Industry) 1.10 × 1.02 × 1.05 × Debt to total assets (Company) 55.48% 50.47% 45.0% (Industry) 40.10% 39.50% 38.0% Times interest earned (Company) 3.18 × 4.75 × 5.67 × (Industry) 5.26 × 5.20 × 5.0 × Fixed charge coverage (Company) 2.76 × 3.50 × 3.80 × (Industry) 3.97 × 3.95 × 3.85 × Growth in E.P.S. (Company) 3.2% 7.7% − (Industry) 9.8% 9.7% − Quick ratio Discussion of Ratios While Watson Leisure 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 44% increase in sales over two years (20% 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 2010 above the industry average (9.39 percent versus 8.22 percent) and ends up well below it (6.34 percent versus 8.48 percent) in 2012. The decline in 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 1.5 × to 1.14 ×). 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 10 × to 6.55 ×. This can also be stated in terms of an average collection period that has increased from 37 days to 56 days. While inventory turnover has been and remains superior to the industry, the same cannot be said for capital asset turnover. A decline from 2.73 × to 1.85 × was caused by an increase of 112.5 percent in capital assets (representing $619,000). We can summarize the discussion of the turnover ratios by saying that despite a 44% increase in sales, assets grew even more rapidly causing a decline in total asset turnover from 1.50 × to 1.14 ×. The liquidity ratios also are not encouraging. Both the current and quick ratios are falling against a stable industry norm of approximately two and one respectively. The debt to total assets ratio is particularly noticeable in regard to industry comparisons. Watson Leisure Time has gone from being 7% over the industry average to 15% above the norm (55.48% versus 40.1%). 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 6,000 shares in 2012). 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. It does not appear that this is an attractive investment opportunity. Investment Comments In 2012 a total of 6,000 common shares were sold for $90,000 or $15 per share. The P/E ratio was 5.75 ($15/ $2.61). Book value is $18.33 ($843,260/ 46,000). Market value is therefore modest. At $15 and 9,200 shares (46,000 × 20%) Mr. Thomas would require an investment of $138,000. He would probably have difficulty justifying such an investment based on the performance of the firm. There is no dividend payout, 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. Thomas would be buying a minority interest (20%) and would not have control of the firm. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
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