• Author / Uploaded
• Asiful Mowla

Citation preview

Chapter 3 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 Net income  Total assets

= Net income  Sales

Profit Margin

×

Asset Turnover

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 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: Return on equity =

Return on assets  investment   1  Debt/Assets 

S3-1

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 ten 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. b. c. d.

Return on investment. Inventory turnover. Fixed asset turnover. Debt-to-assets ratio.

S3-2

a. Return on investment 

Net income Total assets

Inflation may cause net income to be overstated and total assets to be understated causing an artificially high ratio that is misleading. Sales

b. Inventory turnover  Inventory 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 asset turnover 

Sales Fixed assets

Fixed assets will be understated relative to their replacement cost and 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. 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.

S3-3

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.

S3-4

Chapter 3 Problems 1.

3-1.

Dental Delights has two divisions. Division A has a profit of $200,000 on sales of $4,000,000. Division B is only able to make $30,000 on sales of $480,000. Based on the profit margins (returns on sales), which division is superior?

Solution: Dental Delights Division A Net Income Sales

Division B

$200,000 $30,000  5%  6.25% 4,000,000 $480,000

Division B is superior

S3-5

2.

3-2.

Griffey Junior Wear, Inc., has $800,000 in assets and $200,000 of debt. It reports net income of $100,000. a. What is the return on assets? b. What is the return on stockholders’ equity?

Solution: Griffey Junior Wear a.

Return on assets (investment) =

Net income Total assets

$100,000  12.5% $800,000 b.

Return on equity 

Net income Stockholders' equity

Stockholders' equity  total assets  total debt  $800,000  $200,000  $600,000 Net income $100,000   16.67% Stockholder's equity $600,000 Return on equity 

Debt/Assets 

Return on equity 

Return on assets (investment) (1  Debt/Assets) $200,000  25% $800,000 12.5% (1  .25)

S3-6



12.5%  16.67% .75

3.

3-3.

Bass Chemical, Inc., is considering expanding into a new product line. Assets to support this expansion will cost $1,200,000. Bass estimates that it can generate $2 million in annual sales, with a 5 percent profit margin. What would net income and return on assets (investment) be for the year?

Solution: Bass Chemical, Inc. Net income  Sales  profit margin  $2,000,000  0.05  $100,000 Return on assets  Net income (investment) Total assets 

$100,000 $1,200,000

 8.33%

S3-7

4.

3-4.

Franklin Mint and Candy Shop can open a new store that will do an annual sales volume of $750,000. It will turn over its assets 2.5 times per year. The profit margin on sales will be 6 percent. What would net income and return on assets (investment) be for the year?

Solution: Franklin Mint and Candy Shop Net income  Sales  Profit Margin  $750,000  0.06  $45,000 Assets  

Sales Total asset turnover $750,000 2.5

 $300,000 Return on assets (invesment)  

Net income Total assets $45,000 $300,000

 15%

S3-8

5.

3-5.

Hugh Snore Bedding, Inc., has assets of $400,000 and turns over its assets 1.5 times per year. Return on assets is 12 percent. What is its profit margin (return on sales)?

Solution: Hugh Snore Bedding, Inc. Sales  Assets  total asset turnover  $400,000  1.5%  $600,000 Net income  Assets  Return on assets $48,000  $400,000  12% Net income  $48,000 / $600,000  8% Sales

6.

One-Size-Fits-All Casket Co.’s income statement for 2008 is as follows: Sales.......................................................................................$3,000,000 Cost of goods sold.................................................................. 2,100,000 Gross profit............................................................................ 900,000 Selling and administrative expense........................................ 450,000 Operating profit...................................................................... 450,000 Interest expense...................................................................... 75,000 Income before taxes............................................................... 375,000 Taxes (30%)........................................................................... 112,500 Income after taxes.................................................................. $262,500 a. Compute the profit margin for 2008. b. Assume in 2009, sales increase by 10 percent and cost of goods sold increases by 25%. 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 are income after taxes and the profit margin for 2009?

S3-9

3-6.

Solution: One Size-Fits-All Casket Co. a. Profit margin for 2008 Net Income $262,500   8.75% Sales $3,000,000 b. Sales............................................................. $3,300,000* Cost of goods sold........................................ 2,625,000** Gross profit.................................................. 675,000 Selling and administrative expense.............. 450,000 Operating profit............................................ 225,000 Interest expense............................................ 75,000 Income before taxes..................................... 150,000 Taxes (30%)................................................. 45,000 Income after taxes (2008)............................. $105,000 * $3,000,000 × 1.10 = $3,300,000 ** $2,100,000 × 1.25 = $2,625,000 Profit Margin for 2009 Net Income $105,000   3.18% Sales $3,300,000

S3-10

7.

3-7.

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)?

Solution: Easter Egg and Poultry Company a.

Return on assets (investment) 

Net income Total assets

$200,000  10% $2,000,000 Net income Stockholders' equity Stockholders' equity  total assets  total debt  $2,000,000  $1,400,000  $600,000 Return on equity 

Net income $200,000   33% Stockholders' equity $600,000 b.

OR Return on equity  Debt/Assets  Return on equity 

Return on assets (investment) (1  Debt/Assets) $1,400,000  70% $2,000,000 10% (1  .70)

S3-11

10%  33% .30

3-7. (Continued) Sales  total assets  total assets turnover  $2,000,000  2.5 c.

 $5,000,000 Profit margin 

8.

Net income $200,000   4% Sales $5,000,000

Sharpe Razor Company has total assets of $2,500,000 and current assets of $1,000,000. It turns over its fixed assets 5 times a year and has $700,000 of debt. Its return on sales is 3 percent. What is Sharpe’s return on stockholders’ equity?

3-8. Solution: Sharpe Razor Company total assets – current assets Fixed assets

$2,500,000 1,000,000 $1,500,000

Sales  Fixed assets  Fixed asset turnover  $1,500,000  5  $7,500,000 total assets –debt Stockholders’ equity

$2,500,000 700,000 $1,800,000

Net income = Sales  profit margin = $7,500,000  3% = $225,000 Net income Stockholders' equity $225,000   12.5% $1,800,000

Return on stockholders' equity 

S3-12

9.

3-9.

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?

Solution: Baker Oats a.

Total asset turnover × Profit Margin = Return on Total assets 1.6 × ? = 11.2% Profit margin =

b. 1.4

×

11.2%  7.0% 1.6

8% = 11.2%

It did not change at all because the increase in profit margin made up for the decrease in the asset turnover.

S3-13

10.

Global Healthcare Products has the following ratios compared to its industry for 2008.

Return on sales……….. Return on assets………

Global Healthcare 2% 18%

Industry 10% 12%

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.

3-10. Solution: Global Healthcare Products Global Healthcare Products has a higher asset turnover ratio than the industry. Return on Assets =Asset Turnover Return on Sales 18% 12% vs 2% 10% 9  vs1.2 

S3-14

11.

Acme Transportation Company has the following ratios compared to its industry for 2009.

Return on assets…………… Return on equity……………

Acme Transportation 9% 12%

Industry 6% 24%

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.

3-11. Solution: Acme Transportation Company Acme Transportation has a lower debt/total assets ratio than the industry. For those who did a calculation, Acme’s debt to assets were 25% vs 75% for the industry.

S3-15

12.

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?

3-12. Solution: Gates Appliances Return on equity 

a.

Return on assets (investment) (1  Debt/Assets)



8% (1  0.40)



8% 0.60

 13.33% b. The same as return on assets (8%).

S3-16

13.

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?

3-13. Solution: Butters Corporation Profit margin  Total asset turnover  Return on asset (investment) 7%  ?  25.2%

a.

Total asset turnover 

25.2% 7%

 3.6x

Return on equity 

b.

Return on assets (investment) (1  Debt/Assets)



25.2% (1  0.50)



25.2% 0.50

 50.40%

S3-17

3-13. (Continued) Return on equity 

c.

Return on assets (investment) (1  Debt/Assets)



25.2% (1  .35)



25.2% 0.65

 38.77%

S3-18

14.

Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3.5 percent on each dollar of sales and turns over its assets 2.5 times per year. It has $100,000 in current liabilities and $300,000 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.

3-14. Solution: Jerry Rice and Grain Stores Net income  Sales  profit margin  $4,000,000  3.5%  $140,000

a.

Stockholders equity  Total assets  Total liabilities Total assets  Sales/Total asset turnover  $4,000,000/2.5  $1,600,000 Total liabilities  Current liabilities  Long  term liabilities  $100,000  $300,000  $400,000

Stockholders' equity  $1,600,000  $400,000  $1,200,000 Net income Stockholders' equity $140,000   11.67% $1,200,000

Return on stockholders' equity 

S3-19

3-14. (Continued) b. The new level of sales will be: Sales  Total assets  Total assets turnover  $1,600,000  3  $4,800,000 Net income  Sales  Profit margin  $4,800,000  3.5%  $168,000 Return on stockholders' equity  

15.

Net income Stockholders' equity $168,000  14% $1,200,000

Assume the following data for Interactive Technology and Silicon Software.

Net income………………….. Sales………………………… Total assets………………….. Total debt……………………. Stockholders’ equity………….

Interactive Technology (IT) $ 15,000 150,000 160,000 60,000 100,000

Silicon Software (SS) $ 50,000 1,000,000 400,000 240,000 160,000

a. Compute return on stockholders’ equity for both firms using ratio 3a in the text. 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.

3-15. Solution

S3-20

Interactive Technology and Silicon Software a.

Interactive Technology (IT)

Silicon Software (SS)

Net income $15,000 $50,000   15%  31.25% Stockholders' equity $100,000 $160,000 Silicon Software (SS) has a much higher return on stockholders’ equity than Interactive Technology (IT).

S3-21

3-15. (Continued) b.

Interactive Technology (IT) Net income Sales Net income Total assets Sales Total assets Debt Total assets

Silicon Software (SS)

$15,000 $150,000 $15,000  $160,000 $150,000  $160,000 $60,000  $160,000 

 10%  9.37%  .937x  37.5%

$50,000  5% $1,000,000 $50,000  12.5% $400,000 $1,000,000  2.5x $400,000 $240,000  60% $400,000

c. As previously indicated, Silicon Software (SS) has a substantially higher return on stockholder’s equity than Interactive Technology (IT). The reason is certainly not to be found on return on the sales dollar where Interactive Technology has a higher return than Silicon Software (10% vs. 5%). However, Silicon Software has a higher return than Interactive Technology on total assets (12.5% versus 9.37%). The reason is clearly to be found in total asset turnover, which strongly favors Silicon Software over Interactive Technology (2.5x versus .937x). This factor alone leads to the higher return on total assets.

S3-22

16.

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.)

3-16. Solution: Accounts receivable Average daily credit sales ($3,000,000  90%)  $285,000 / 360 days $285,000  $7,500 per day  38 days

Average collection period 

17.

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?

3.17. Solution: Martin Electronics Average daily credit sales 

Credit sales 360

To determine credit sales, multiply accounts receivable by accounts receivable turnover. $80,000  15  $1,200,000 Average daily credit sales 

$1,200,000  $3,333 360

S3-23

18.

Perez Corporation has the following financial data for the years 2007 and 2008: 2007 $8,000,000 6,000,000 800,000

Sales………………………… Cost of goods sold…………… Inventory……………………..

2008 $10,000,000 9,000,000 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?

3-18. Solution: Perez Corporation 2007

2008

a.

Sales $8,000,000 $10,000,000   10x  10x Inventory 8,00,000 1,000,000

b.

Cost of goods sold $6,000,000 $9,000,000   7.5x  9x Inventory 800,000 1,000,000

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 (from 75 percent to 90 percent). Inventory is not really turning over any faster.

S3-24

19.

The Speed-O Company makes scooters for kids. Sales in 2008 were $8,000,000. Assets were as follows: Cash………………………………………. $200,000 Accounts receivable………………………. 1,600,000 Inventory………………………………….. 800,000 Net plant and equipment………………….. 1,000,000 Total assets…………………………… $3,600,000 a. Compute the following: 1. Accounts receivable turnover 2. Inventory turnover 3. Fixed asset turnover 4. Total asset turnover b. In 2009, sales increased to $10,000,000 and the assets for that year were as follows: Cash………………………………………... $200,000 Accounts receivable……………………….. 1,800,000 Inventory…………………………………... 2,200,000 Net plant and equipment…………………... 1,050,000 Total assets…………………………….. $5,250,000 Once again, compute the four ratios listed in 19a. 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.

S3-25

3-19. Solution: Speed-O Company a. 1. Accounts receivable turnover = Sales/Accounts Receivable $8,000,000  5x 1,600,000 2. Inventory turnover = Sales/Inventory $8,000,000  10 x 800,000 3. Fixed asset turnover = Sales/(Net Plant & Equipment) $8,000,000  8x 1,000,000 4. Total asset turnover = Sales/Total Assets $8,000,000  2.22 x 3,600,000 b. 1. Accounts receivable turnover $10,000,000  5.56 x 1,800,000 2. Inventory turnover $10,000,000  4.55 x 2,200,000

S3-26

3-19. (Continued) 3. Fixed asset turnover $10,000,000  9.52 x 1,050,000 4. Total asset turnover $10,000,000  1.90 x 5,250,000 c. There is a decline in total asset turnover from 2.22 to 1.90. This development has taken place because of the slowdown in inventory turnover (10x down to 4.55x). The other two ratios are slightly improved.

S3-27

20.

The balance sheet for Stud Clothiers is shown below. Sales for the year were $2,400,000, with 90 percent of sales sold on credit. STUD CLOTHIERS Balance Sheet 200X Liabilities and Equity $ 60,000 Accounts payable…………….. $ 220,000 240,000 Accrued taxes………………… 30,000 350,000 Bonds payable 150,00 (long-term)…………………… 0 410,000 Common stock……………….. 80,000 Paid-in capital………………… 200,000 Retained earnings…………….. 380,000 $1,060,000 Total liabilities and equity… $1,060,000

Assets Cash…………………… Accounts receivable…... Inventory……………… Plant and equipment…... Total assets………...

Compute the following ratios: a. b. c. d. e.

Current ratio. Quick ratio. Debt-to-total-assets ratio. Asset turnover. Average collection period.

3-20. Solution: Stud Clothiers Current ratio  a.



Current assets Current liabilities $650,000 $250,000

 2.6x

S3-28

3-20. (Continued) Quick ratio 

b.

(Current assets  inventory) Current liabilities



$650,000  $350,000 $250,000



$300,000 $250,000

 1.2x Debt to total assets 

Total debt Total assets



$400,000 $1,060,000

c.

 37.74% Asset turnover 

Sales Total assets



$2,400,000 $1,060,000

d.

 2.26x Average collection period  e.  $240,000 /

Accounts receivable Average daily credit sales

($2,400,000  0.90) $240,000   40 days 360 days $6,000 per day

S3-29

21.

Neeley Office Supplies income statement is given below. a. What is the times interest earned ratio? b. What would be the fixed charge coverage ratio? NEELEY OFFICE SUPPLIES Sales.............................................................................. Cost of goods sold......................................................... Gross profit................................................................... Fixed charges (other than interest)................................ Income before interest and taxes................................... Interest........................................................................... Income before taxes...................................................... Taxes............................................................................. Income after taxes.........................................................

$200,000 115,000 85,000 25,000 60,000 15,000 45,000 15,300 $ 29,700

3-21. Solution: Neeley Office Supplies Times interested earned  a.



Income before interest and taxes Interest $60,000 15,000

 4x Fixed charge coverage 

b.

Income before fixed charges and taxes Fixed charges



$60,000  25,000 $15,000  25,000



$85,000 $40,000

 2.125x

S3-30

22.

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. d. e.

Profit margin. Total asset turnover. Return on assets (investment). TIMES MIRROR AND GLASS COMPANY Sales.............................................................................. Less: Cost of goods sold......................................... Gross profit................................................................... Less: Selling and administrative expense............... Less: Lease expense................................................ Operating profit*........................................................... Less: Interest expense............................................. Earnings before taxes.................................................... Less: Taxes (30%)................................................... Earnings after taxes....................................................... *Equals income before interest and taxes.

$126,000 93,000 $ 33,000 11,000 4,000 $ 18,000 3,000 $ 15,000 4,500 $ 10,500

3-22. Solution: Times Mirror and Glass Co. Times interest earned  a.



Income before interest and taxes Interest $18,000 $3,000

 6x

S3-31

3-22. (Continued) Fixed charge coverage 

b.

Income before fixed charges and taxes Fixed charges



$18,000  4,000 $3,000  $4,000



$22,000 $7,000

 3.14x

Profit Margin  c.



Net Income Sales $10,500 $126,000

 8.33% Total asset turnover  d.



Sales Total assets $126,000 $80,000

 1.575x Return on assets (investments)  e.

Net income Sales  Sales Total assets

 8.33%  1.575x  13.12%

S3-32

23.

A firm has net income before interest and taxes of $120,000 and interest expense of $24,000. a. What is the times interest earned ratio? b. If the firm’s lease payments are $40,000, what is the fixed charge coverage?

3-23. Solution: Times interest earned  a.

Income before interest and taxes Interest

 120,000 / $24,000  5x Fixed charge converage 

b. 

IBIT + Before tax fixed charges Interest + Fixed charges $120,000  $40,000 $24,000  $40,000

 2.5x

S3-33

24.

In January 1999, the Status Quo Company was formed. Total assets were $500,000, of which $300,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation, and in 1999 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $26,000 per year each of the last 10 years. Other assets have not changed since 1999. a. Compute return on assets at year-end for 1999, 2001, 2004, 2006, and 2008. (Use $26,000 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 above answers? Merely comment.

3-24. Solution: Status Quo Company a.

Return on assets (investment) = Income after taxes/Total assets. 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 1995 equal $300,000 with a ten-year life which means the depreciation expense will be $30,000 per year. Book values at year-end are as follows: 1999 = $270,000; 2001 = $210,000; 2004 = $120,000; 2006 = $ 60,000; 2008 = -0Return on assets (investment) =

Income after taxes Current assets + Fixed assets

1999 = $26,000/$470,000 = 5.53% 2001 = $26,000/$410,000 = 6.34% 2004 = $26,000/$320,000 = 8.13% 2006 = $26,000/$260,000 = 10.00% 2008 = $26,000/$200,000 = 13.00%

S3-34

3-24. (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.

S3-35

25.

Calloway Products has the following data. Industry information is also shown.

Year 2006 2007 2008

Net Income $360,000 380,000 380,000

Year 2006 2007 2008

Debt $1,600,000 1,750,000 1,900,000

Total Assets $3,000,000 3,400,000 3,800,000

Industry Data on Net Income/Total Assets 11% 8 5

Total Assets $3,000,000 3,400,000 3,800,000

Industry Data on Debt/Total Assets 52% 40 31

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?

3-25. Solution: Calloway Products a. Net income/total assets Year 2006 2007 2008

Calloway Ratio 12.0% 11.18% 10.0%

Industry Ratio 11.0% 8.0% 5.0%

Although the company has shown a declining return on assets since 2006, it has performed much better than the industry. Praise may be more appropriate than criticism.

S3-36

3-25. (Continued) b. Debt/total assets Year 2006 2007 2008

Calloway Ratio 53.33% 51.47% 50.0%

Industry Ratio 52.0% 40.0% 31.0%

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. 26.

Jodie Foster Care Homes, Inc., shows the following data: Year 2005 2006 2007 2008 a. b.

Net Income $118,000 131,000 148,000 175,700

Total Assets $1,900,000 1,950,000 2,010,000 2,050,000

Stockholders’ Equity $ 700,000 950,000 1,100,000 1,420,000

Total Debt $1,200,000 1,000,000 910,000 630,000

Compute the ratio of net income to total assets for each year and comment on the trend. 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.

3-26. Solution: Jodie Foster Care Homes, Inc. a.

Net income Total assets 2005 2006 2007 2008

$118,000/$1,900,000 = 6.21% $131,000/$1,950,000 = 6.72% $148,000/$2,010,000 = 7.36% $175,700/$2,050,000 = 8.57%

Comment: There is a strong upward movement in return on assets over the four year period. S3-37

3-26. (Continued) Net income b. Stockholders' equity 2005 2006 2007 2008

$118,000/$700,000 $131,000/$950,000 $148,000/$1,100,000 $175,700/$1,420,000

= 16.86% = 13.79% = 13.45% = 12.37%

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. Optional: This can be confirmed by computing total debt to total assets for each year. Total debt Total assets 2005 2006 2007 2008

63.2% 51.3% 45.3% 30.7%

S3-38

27.

The United World Corporation has three subsidiaries.

Sales....................................... Net income (after taxes)......... Assets.....................................

Computers

Magazines

Cable TV

$16,000,000 1,000,000 5,000,000

$4,000,000 160,000 2,000,000

$8,000,000 600,000 5,000,000

.

a. b. c. d.

Which division has the lowest return on sales? Which division has the highest return on assets? Compute the return on assets for the entire corporation. If the $5,000,000 investment in the cable TV division is sold off and redeployed in the computer division at the same rate of return on assets currently achieved in the computer division, what will be the new return on assets for the entire corporation?

3-27. Solution: United World Corporation a.

b.

Computers Magazines Cable TV 6.25% 4.00% 7.50% The magazine division has the lowest return on sales. Net income/sales

Computers Magazines Cable TV 20.0% 8.00% 12.00% The computer division has the highest return on assets. Net income/total assets

Corporate net income $1,000,000  $160,000  $600,000  Corporate total assets $5,000,000  $2,000,000  $5,000,000

c. 

$1,760,000 $12,000,000

 14.67%

S3-39

3-27. (Continued) d. Return on redeployed assets in computers. 20% × $5,000,000 = $1,000,000 Return on assets for the entire corporation: Corporate net income $1,000,000  $160,000  $1,000,000  Corporate total asset $12,000,000 

$2,160,000 $12,000,000

 18%

S3-40

28.

Omni Technology Holding Company has the following three affiliates:

Sales................................. Net income (after taxes)... Assets............................... Stockholders’ equity......... a. b. c. d. e. f. g.

Software

Personal Computers

Foreign Operations

$40,000,000 2,000,000 5,000,000 4,000,000

$60,000,000 2,000,000 25,000,000 10,000,000

$100,000,000 8,000,000 60,000,000 50,000,000

Which affiliate has the highest return on sales? Which affiliate has the lowest return on assets? Which affiliate has the highest total asset turnover? Which affiliate has the highest return on stockholders’ equity? Which affiliate has the highest debt ratio? (Assets minus stockholders’ equity equals debt.) Returning to question b, explain why the software affiliate has the highest return on total assets. 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.

3-28. Solution: Omni Technology Holding Company a.

Net income/sales

Personal  Foreign  Software Computers Operations 5.0% 3.3% 8.0%

The foreign operation affiliate has the highest return on sales. Personal  Foreign  b. Net income/total assets Software Computers Operations 40.0% 8.0% 13.3% The personal computer affiliate has the lowest return on assets

S3-41

3-28. (Continued) c.

Sales/total assets

Software 8.0x

Personal  Foreign  Computers Operations 2.4x 1.7x

The software affiliate has the highest return on total asset turnover. Personal

Foreign

20.0%

16.0%

d. Net income/ Software Computers Operations Stockholders’ equity 50.0%

The Software affiliate has the highest return on stockholder’s equity.

e.

Debt/total assets

Personal  Foreign  Software Computers Operations 20.0% 60.0% 16.7%

The personal computer affiliate has the highest debt/total assets ratio. f.

This is because of its high total turnover ratio of 8.0x times in part c.

g. This is because the personal computer affiliate has a higher debt ratio (60.0%) than the foreign operations affiliate (16.7%).

S3-42

29.

Bard Corporation shows the following income statement. The firm uses FIFO inventory accounting. BARD CORPORATION Income Statement for 2008 Sales..................................................................... Cost of goods sold................................................ Gross profit.......................................................... Selling and administrative expense...................... Depreciation......................................................... Operating profit.................................................... Taxes (30%)......................................................... Aftertax income................................................... a.

b. c.

$200,000 (10,000 units at $20) 100,000 (10,000 units at $10) 100,000 10,000 20,000 70,000 21,000 $ 49,000

Assume in 2009 the same 10,000-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 $10 per unit. Also assume that selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute aftertax income for 2009. In part a, by what percent did aftertax income increase as a result of a 10 percent increase in the sales price? Explain why this impact occurred. Now assume that in 2010 the volume remains constant at 10,000 units, but the sales price decreases by 15 percent from its year 2009 level. Also, because of FIFO inventory policy, cost of goods sold reflects the inflationary conditions of the prior year and is $11 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 aftertax income.

3-29. Solution: Bard Corporation a.

2009 Sales................................ Cost of goods sold.......... Gross profit................... Selling and adm. expense Depreciation................... Operating profit............ Taxes (30%).................... After tax income........... S3-43

$220,000 (10,000 units at $22) 100,000 (10,000 units at $10) $120,000 11,000 (5% of sales) 20,000 $ 89,000 $ 26,700 $ 62,300

3-29. (Continued) b. Gain in aftertax income 2009 2008 Increase

$62,300 49,000 $13,300

Increase $13,300   27.14% Base value (2008) $49,000 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 depreciation (which did not change). c.

2010 Sales................................ Cost of goods sold.......... Gross profit................... Selling and adm. expense Depreciation................... Operating profit............ Taxes (30%).................... After tax income........... *$22 × 0.85 = $18.70

$187,000 (10,000 units at $18.70*) 110,000 (10,000 units at $11.00) $ 77,000 9,350 (5% of sales) 20,000 $ 47,650 $ 14,295 $ 33,355

The low profits indicate the effect of inflation followed by disinflation.

S3-44

30.

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)..................................................................... Inventory turnover....................................................................... Current liabilities......................................................................... Current ratio................................................................................. Average collection period............................................................ Current assets: Cash......................................................................... $______ Accounts receivable................................................ ______ Inventory................................................................. ______ Total current assets............................................... ______

$720,000 6 times $105,000 2 35 days

3-30. Solution: Inventory Account rec. Current assets Cash Cash................................ Accounts receivable....... Inventory........................ Total current assets

= $720,000/6 = $120,000 = ($720,000/360) × 35 = $70,000 = 2 × $105,000 = $210,000 = $210,000 – $120,000 – $70,000 = $ 20,000 $ 20,000 70,000 120,000 $210,000

S3-45

31.

The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in the balance sheet below. Total assets turnover................................... Cash to total assets...................................... Accounts receivable turnover..................... Inventory turnover...................................... Current ratio................................................ Debt to total assets......................................

2.4 times 2.0% 8.0 times 10.0 times 2.0 times 61.0%

GRIGGS CORPORATION Balance Sheet 2008 Assets Cash .............................. Accounts receivable...... Inventory....................... Total current assets . Fixed assets .................. Total assets ...................

Liabilities and Stockholders’ Equity _____ _____ _____ _____ _____ _____

Current debt............................................. Long-term debt......................................... Total debt............................................ Equity.......................................................

_____ _____ _____ _____

Total debt and stockholders’ equity

_____

3-31. Solution: Griggs Corporation Sales/total assets Total assets Total assets

= 2.4 times = $1,200,000/2.4 = $500,000

Cash Cash Cash

= 2% of total assets = 2% × $500,000 = $10,000

Sales/accounts receivable Accounts receivable Accounts receivable

= 8 times = $1,200,000/8 = $150,000

Sales/inventory Inventory Inventory

= 10 times = $1,200,000/10 = $120,000

S3-46

3-31. (Continued) Fixed assets Current asset

= Total assets – current assets = $10,000 + $150,000 + $120,000 = $280,000 = $500,000 – $280,000 = $220,000

Fixed assets Current assets/current debt Current debt Current debt Current debt

=2 = Current assets/2 = $280,000/2 = $140,000

Total debt/total assets Total debt Total debt

= 61% = .61 × $500,000 = $305,000

Long-term debt Long-term debt Long-term debt

= Total debt – current debt = $305,000 – 140,000 = $165,000

Equity Equity Equity

= Total assets – total debt = $500,000 – $305,000 = $195,000 Griggs Corporation Balance Sheet 2008

Cash..................... A/R....................... Inventory.............. Total current assets Fixed assets.......... Total assets...........

$ 10,000 Current debt.......... 150,000 Long-term debt..... $120,000 Total debt........... 280,000 220,000 Equity.................... $500,000 Total debt and stockholders’ equity

S3-47

$140,000 165,000 $305,000 195,000 $500,000

32.

We are given the following information for the Coleman Machine Tools Corporation. Sales (credit)....................................................................... Cash..................................................................................... Inventory............................................................................. Current liabilities................................................................ Asset turnover..................................................................... Current ratio........................................................................ Debt-to-assets ratio............................................................. Receivables turnover...........................................................

$7,200,000 300,000 2,150,000 1,400,000 1.20 times 2.50 times 40% 8 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.

3-32. Solution: Coleman Machine Corporation a. Accounts receivable

= Sales/Receivable turnover = $7,200,000/8x = $900,000

b. Marketable securities = Current assets – (cash + accounts rec. + inventory) Current Assets

= Current ratio × Current liabilities = 2.5 × $1,400,000 = $3,500,000

Marketable securities = $3,500,000 – ($300,000 + $900,000 + $2,150,000) = $3,500,000 – $3,350,000 = $150,000

S3-48

3-32. (Continued) c. Fixed assets Total assets

Fixed assets d. Long-term debt Total debt

Long-term debt

= Total assets – Current assets = Sales/Asset turnover = $7,200,000/1.20x = $6,000,000 = $6,000,000 – $3,500,000 = $2,500,000 = Total debt – current liabilities = Debt to assets × total assets = 40% × $6,000,000 = $2,400,000 = $2,400,000 – $1,400,000 = $1,000,000

S3-49

33.

The following data are from Sharon Stone and Gravel, Inc., financial statements. The firm manufactures home decorative material. Sales (all credit) were $60 million for 2008. Sales to total assets......................................... Total debt to total assets................................. Current ratio................................................... Inventory turnover......................................... Average collection period.............................. Fixed asset turnover.......................................

3.0 times 40% 2.0 times 10.0 times 18.0 days 7.5 times

Fill in the balance sheet: Cash..................................... ..............................._____t_ Accounts receivable............ Inventory............................. Total current assets........ Fixed assets......................... Total assets....................

______

Current debt..........................................

______ ______ ______ ______ ______

Long-term debt...................................... Total debt......................................... Equity....................................................

______ ______ ______

Total debt and stockholders’ equity

______

3-33. Solution: Sharon Stone and Gravel, Inc. Sales/total assets Total assets Total assets

= 3.0x = $60 million/3.0 = $20 million

Total debt/total asset Total assets Total assets

= 40% = $20 million x .4 = $8 million

Sales/inventory Inventory Inventory Average daily sales

= 10.0x = $60 million/10.0x = $6 million = $60 million/360 days = $166,667 per day = 18 days × $166,667 = $3 million (or)

Accounts receivable

S3-50

3-33. (Continued) Accounts receivable =

$60 million  $3,000,000 360 18

Fixed assets

= $60 million/7.5x = $8 million

Cash

= Total assets – inventory – accounts receivable – fixed assets = $20 million – $6 million – $3 million – $8 million = $3 million

Current assets

= Cash + accounts receivable + inventory = $3 million + $3 million + $6 million = $12 million

Current debt

= Current assets/2× = $12 million/2 = $6 million

Long-term debt

= Total debt – current debt = $8 million – $6 million = $2 million

Equity

= Total assets – total debt = $20 million – $8 million = $12 million

S3-51

3-33. (Continued) Cash................. $ 3.0 million Current debt............. Accounts Long-term receivable..... $ 3.0 debt............. Inventory......... $ 6.0 Total debt....... Total current Equity............. assets............ $12.0 Fixed assets..... $ 8.0 Total assets..... $20.0 million Total debt and equity...........

S3-52

$ 6.0 million $ 2.0 $ 8.0 $12.0 $20.0 million

34.

Using the financial statements for the Goodyear Calendar Company, calculate the 13 basic ratios found in the chapter. GOODYEAR CALENDAR COMPANY Balance Sheet December 31, 2008 Assets Current assets: Cash .................................................................................................... Marketable securities .................................................................................................... Accounts receivable (net) .................................................................................................... Inventory .................................................................................................... Total current assets ................................................................................................. Investments........................................................................................ Plant and equipment.......................................................................... Less: Accumulated depreciation .................................................................................................... Net plant and equipment ................................................................................................. Total assets........................................................................................

$ 40,000 30,000 120,000 180,000 $370,000 40,000 450,000 (100,000) 350,000 $760,000

GOODYEAR CALENDAR COMPANY Liabilities and Stockholders’ Equity Current liabilities: Accounts payable .................................................................................................... Notes payable .................................................................................................... Accrued taxes .................................................................................................... Total current liabilities ................................................................................................. Long-term liabilities: Bonds payable .................................................................................................... Total liabilities ................................................................................................. Stockholders’ equity.......................................................................... Preferred stock, $100 par value .................................................................................................... Common stock, $1 par value .................................................................................................... Capital paid in excess of par S3-53

$ 90,000 10,000 10,000 110,000 170,000 280,000 90,000 60,000 230,000

.................................................................................................... Retained earnings .................................................................................................... Total stockholders’ equity ................................................................................................. Total liabilities and stockholders’ equity...........................................

S3-54

100,000 480,000 $760,000

GOODYEAR CALENDAR COMPANY Income Statement For the Year Ending December 31, 2008 Sales (on credit)................................................................................. Less: Cost of goods sold .................................................................................................... Gross profit........................................................................................ Less: Selling and administrative expenses .................................................................................................... Operating profit (EBIT).................................................................... Less: Interest expense .................................................................................................... Earnings before taxes (EBT)............................................................. Less: Taxes .................................................................................................... Earnings after taxes (EAT)................................................................ *Includes $10,000 in lease payments.

$2,000,000 1,300,000 700,000 400,000* 300,000 20,000 280,000 112,000 $ 168,000

3-34. Solution: Goodyear Calendar Company Profitability ratios Profit margin = $168,000/$2,000,000 = 8.40% Return on assets (investment) = $168,000/$760,000 = 22.1% Return on equity = $168,000/$480,000 = 35% Assets utilization ratios Receivable turnover = $2,000,000/$120,000 = 16.66x Average collection period = $120,000/$5,555 = 21.6 days Inventory turnover = $2,000,000/$180,000 = 11.11x Fixed asset turnover = $2,000,000/$350,000 = 5.71x Total asset turnover = $2,000,000/$760,000 = 2.63x Liquidity ratio Current ratio = $370,000/$110,000 = 3.36x Quick ratio = $190,000/$110,000 = 1.72x Debt utilization ratios Debt to total assets = $280,000/$760,000 = 36.84% Times interest earned = $300,000/$20,000 = 15x Fixed charge coverage = $310,000/$30,000 = 10.33x S3-55

35.

Given the following financial statements for Jones Corporation and Smith Corporation: a. To which company 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 Cash................................ $ 20,000 Accounts receivable....... 80,000 Inventory........................ 50,000

Liabilities Accounts payable................... Bonds payable (long-term).....

Long-Term Assets Fixed assets.................... $500,000 Less: Accumulated depreciation............. (150,000 ) *Net fixed assets........ 350,000 Total assets.............. $500,000

Stockholders’ Equity Common stock....................... Paid-in capital ................................................ Retained earnings ................................................ Total liabilities and equity

$100,000 80,000

$150,000 70,000 100,000

$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.

S3-56

SMITH CORPORATION Current Assets Cash................................. $ 35,000 Marketable securities...... 7,500 Accounts receivable........ 70,000 Inventory......................... 75,000

Liabilities Accounts payable.................. Bonds payable (long-term)....

$ 75,000 210,000

Long-Term Assets Fixed assets..................... $500,000 Less: Accumulated depreciation ....................................... (250,000) *Net fixed assets 250,000 ....................................... Total assets .................................... $437,500

Stockholders’ Equity Common stock....................... Paid-in capital........................ Retained earnings..................

$ 75,000 30,000 47,500

Total liabilities and equity...

$437,500

Sales (on credit).......................................................... Cost of goods sold....................................................... Gross profit................................................................. †Selling and administrative expense....................... Less: Depreciation expense..................................... Operating profit........................................................... Interest expense........................................................... Earnings before taxes.................................................. Tax expense................................................................. Net income.................................................................. *Use net fixed assets in computing fixed asset turnover. †Includes $7,000 in lease payments.

S3-57

$1,000,000 600,000 400,000 224,000 50,000 126,000 21,000 105,000 52,500 $ 52,500

3-35. Solution: Jones and Smith Comparison One way of analyzing the situation for each company is to compare the respective ratios for each on, examining those ratios which would be most important to a supplier or short-term lender and a stockholder. Profit margin Return on assets (investments) Return on equity Receivable turnover Average collection period Inventory turnover Fixed asset turnover Total asset turnover Current ratio Quick ratio Debt to total assets Times interest earned Fixed charge coverage Fixed charge coverage calculation

Jones Corp. 7.4% 18.5% 28.9% 15.63x 23.04 days 25x 3.57x 2.5x 1.5x 1.0x 36% 24.13x 13.33x (200/15)

Smith Corp. 5.25% 12.00% 34.4% 14.29x 25.2 days 13.3x 4x 2.29x 2.5x 1.5x 65.1% 6x 4.75x (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.

S3-58

3-35. (Continued) 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 longterm 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, 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.

S3-59

COMPREHENSIVE PROBLEM Comprehensive Problem 1. Al Thomas has recently been approached by his brother-in-law, Robert Watson, with a proposal to buy a 20 percent interest in Watson Leisure Time Sporting Goods. The company manufactures golf clubs, baseball bats, basketball goals, and other similar items. Mr. Watson is quick to point out the increase in sales over the last three years as indicated in the income statement, Exhibit 1. The annual growth rate is 20 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 approximately 10 percent per year. There was a steady real growth of 2 to 3 percent in gross domestic product during the period under study. The rate of inflation was in the 3 to 4 percent range. The stock in the corporation has become available due to the ill health of a current stockholder, who needs cash. The issue here is not to determine the exact price for the stock, but rather whether Watson Leisure Time Sporting Goods represents an attractive investment situation. Although Mr. Thomas 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. Thomas?

S3-60

Comprehensive Problem 1. (Continued) Exhibit 1 WATSON LEISURE TIME SPORTING GOODS Income Statement 200X 200Y Sales (all on credit)....................................... $1,500,000 $1,800,000 Cost of goods sold........................................ 950,000 1,120,000 Gross profit................................................... 550,000 680,000 Selling and administrative expense*............ 380,000 490,000 Operating profit............................................ 170,000 190,000 Interest expense............................................ 30,000 40,000 Net income before taxes............................... 140,000 150,000 Taxes............................................................. 46,120 48,720 Net income.................................................... $ 93,880 $ 101,280 Shares............................................................ 40,000 40,000 Earnings per share........................................ $2.35 $2.53 *Includes $20,000 in lease payments for each year.

200Z $2,160,000 1,300,000 860,000 590,000 270,000 85,000 185,000 64,850 $ 120,150 46,000 $2.61

Exhibit 2 WATSON LEISURE TIME SPORTING GOODS Balance Sheet 200X 200Y Assets Cash.............................................................. $ 20,000 $ 30,000 Marketable securities.................................... 30,000 35,000 Accounts receivable...................................... 150,000 230,000 Inventory....................................................... 250,000 285,000 Total current assets.................................. 450,000 580,000 Net plant and equipment............................... 550,000 720,000 Total assets.................................................... $1,000,000 $1,300,000 Liabilities and Stockholders’ Equity Accounts payable.......................................... $ 100,000 $ 225,000 Notes payable (bank).................................... 100,000 100,000 Total current liabilities............................ 200,000 325,000 Long-term liabilities..................................... 250,000 331,120 Total liabilities......................................... 450,000 656,120 Common stock ($10 par).............................. 400,000 400,000 Capital paid in excess of par......................... 50,000 50,000 Retained earnings......................................... 100,000 193,880 Total stockholders’ equity....................... 550,000 643,880 Total liabilities and stockholders’ equity...... $1,000,000 $1,300,000

S3-61

200Z $

20,000 50,000 330,000 325,000 725,000 1,169,000 $1,894,000 $ 200,000 300,000 500,000 550,740 1,050,740 460,000 80,000 303,260 843,260 $1,894,000

Comprehensive Problem 1 (Continued) Exhibit 3 Selected Industry Ratios 200X

200Y

200Z

Growth in sales.............................................

—

9.98%

10.02%

Profit margin.................................................

5.75%

5.80%

5.81%

Return on assets (investment).......................

8.22%

8.24%

8.48%

Return on equity...........................................

13.26%

13.62%

14.16%

Receivable turnover......................................

10x

Average collection period.............................

36 days

Inventory turnover........................................

9.5x

10.1x

37.9 days

35.6 days

5.71x

5.62x

5.84x

Fixed asset turnover......................................

2.75x

2.66x

2.20x

Total asset turnover.......................................

1.43x

1.42x

1.46x

Current ratio..................................................

2.10x

2.08x

2.15x

Quick ratio....................................................

1.05x

1.02x

1.10x

Debt to total assets........................................

38%

39.5%

Times interest earned....................................

5.00x

5.20x

5.26x

Fixed charge coverage..................................

3.85x

3.95x

3.97x

9.7%

9.8%

Growth in EPS..............................................

S3-62

—

40.1%

CP 3-1.

Solution: Watson Leisure Time Sporting Goods 200X

Growth in sales

(Company) (Industry) Profit margin (Company) (Industry) Return on assets (Company) (Industry) Return on equity (Company) (Industry) Receivable turnover (Company) (Industry) Average collection (Company) period (Industry) Inventory turnover (Company) (Industry) Fixed asset turnover (Company) (Industry) Total asset turnover (Company) (Industry) Current ratio (Company) (Industry) Quick ratio (Company) (Industry) Debt to total assets (Company) (Industry) Times interest (Company) earned (Industry) Fixed charge (Company) coverage (Industry) Growth in E.P.S. (Company) (Industry)

6.26% 5.75% 9.39% 8.22% 17.07% 13.26% 10.0x 10.0x 36 days 36 days 6.0x 5.71x 2.73x 2.75x 1.50x 1.43x 2.25x 2.10x 1.00x 1.05x 45.0% 38.0% 5.67x 5.0x 3.80x 3.85x ------S3-63

200Y 20% 9.98% 5.63% 5.80% 7.79% 8.24% 15.73% 13.62% 7.83x 9.5x 46.0 days 37.9 days 6.32x 5.62x 2.50x 2.66x 1.38x 1.42x 1.78x 2.08x .91x 1.02x 50.47% 39.50% 4.75x 5.20x 3.50x 3.95x 7.7% 9.7%

200Z 20% 10.02% 5.56% 5.81% 6.34% 8.48% 14.25% 14.16% 6.55x 10.1x 55.0 days 35.6 days 6.65x 5.84x 1.85x 2.20x 1.14x 1.44x 1.45x 2.15x 0.80x 1.10x 55.48% 40.10% 3.18x 5.26x 2.76x 3.97x 3.2% 9.8%

CP 3-1. (Continued) Discussion of Ratios While Watson Leisure Time Sporting Goods 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 percent increase in sales over two years (20 percent per year). There obviously are no economies of scale for this firm. Higher selling and administrative costs and interest expense appear to be causing the problem. The return-on-asset ratio starts out in 200X 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 200Z. The decline of 3.05 percent for return on assets at Watson Sporting Goods is serious, and can be attributed to the previously mentioned declining profit margin as well as a slowing total asset turnover (going from 1.5X to 1.14X). Return on equity is higher than the industry ratio, but in a downtrend. It is superior to the industry average for one reason: the firm has a heavier debt position than the industry. Lower returns on assets are translated into higher returns on equity because of the firm’s high debt. The previously mentioned slower turnover of assets can be analyzed through the turnover ratios. A very real problem can be found in accounts receivable where turnover has gone from 10X to 6.55X. This can also be stated in terms of an average collection period that has increased from 36 days to 55 days. While inventory turnover has been and remains superior to the industry, the same cannot be said for fixed asset turnover. A decline from 2.73X to 1.85X was caused by an increase in 112.5 percent in fixed assets (representing $619,000). We can summarize the discussion of the turnover ratios by saying that despite a 44 percent increase in sales, assets grew even more rapidly causing a decline in total asset turnover from 1.50X to 1.14X. S3-64

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 and one respectively. The debt to total assets ratio is particularly noticeable in regard to industry comparisons. Watson Sporting Goods has gone from being seven percent over the industry average to 15.38 percent above the norm (55.48 percent versus 40.1 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 6,000 shares in 200Z). 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. Optional Discussion: Although the student was not specifically asked to address the issue, the instructor may wish to comment on the shares that were sold in 200Z. Looking at the capital section of the balance sheet, it appears that 6,000 shares were sold for a total value of $90,000. $60,000 30,000 $90,000

increase in par value increase in capital paid in excess of par total value of 6,000 shares

S3-65

CP 3-1. (Continued) The $90,000 proceeds indicates the 6,000 shares were sold at an average price of $15.00 each. The $15.00 represents a fairly low multiplier of 200Z earnings of $2.61. The price/earnings ratio is 5.75X. Book value per share (including the new shares) is $18.33 ($843,260/46,000), so once again the price of $15 is fairly modest (81.8 percent of book value). If Mr. Thomas were to purchase 20 percent of the shares outstanding at $15 per share, the total cost would be: 92,000 $15

shares (20 percent of 46,000) price per share

$138,000 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. Thomas would be buying a minority interest (20%) and would not have control of the firm.

S3-66

Comprehensive Problem 2 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. 1. 2. 3.

Referring to Exhibit 1, compute the annual percentage change in net income per common share-diluted (2nd numerical line from the bottom) for 1998–1999, 1999–2000, and 2000–2001. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years. Begin with 1998. 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 (which follow Exhibit 1 on the next page) to net revenues (sales). Cost of sales Research and development Selling, general and administrative expense Provision for income tax

S3-67

Comprehensive Problem 2 (Continued) Exhibit 1 SUN MICROSYSTEMS, INC. Summary Consolidated Statement of Income (in millions) 2001 Dollars Net revenues.......................................... $18,250 Costs and expenses: Cost of sales 10,041 ............................................................... Research and development 2,016 ............................................................... Selling, general and 4,54 administrative 4 ................................................... Goodwill amortization 261 ............................................................... In-process research and 7 development 7 ................................................... Total costs and expenses....................... 16,939

2000 Dollars $15,721

1999 Dollars $11,806

1998 Dollars $9,862

7,549

5,670

4,713

1,630

1,280

1,029

4,07 2

3,19 6

2,82 6

65

19

4

1 2

12 1

17 6

13,328

10,286

8,748

Operating income.................................. 1,311 Gain (loss) on strategic investments..... (90) Interest income, net............................... 363 Litigation settlement............................. — Income before taxes.............................. 1,584 Provision for income taxes.................... 603 Cumulative effect of change in accounting principle, net (54) ....................................................... Net income............................................ $ 927

2,393 208 170 — 2,771 917

1,520 — 85 — 1,605 575

1,114 — 48 — 1,162 407

—

—

—

$ 1,854

$ 1,030

$ 755

$

$

0.31

$ 0.24

3,282

3,180

Net income per common share— diluted ....................................................... Shares used in the calculation of net income per common share— diluted .......................................................

$

0.27

3,417

0.55

3,379

4.

Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 1 and 2.

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. S3-68

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.

S3-69

Comprehensive Problem 2 (Continued) 6.

The average stock prices for each of the four years shown in Exhibit 1 were as follows: 1998 1999 2000 2001

11¼ 16¾ 28½ 9½

Exhibit 2 SUN MICROSYSTEMS, INC. Consolidated Balance Sheets (in millions) 2001 Assets Current assets: Cash and cash equivalents................................................................... $ 1,472 Short-term investments....................................................................... 387 Accounts receivable, net of allowances of $410 in 2001 and $534 in 2000 2,955 ............................................................................................... Inventories...........................................................................................1,049 Deferred tax assets..............................................................................1,102 Prepaids and other current assets........................................................ 969 Total current assets 7,934 .................................................................................................. Property, plant and equipment, net...........................................................2,697 Long-term Investments............................................................................4,677 Goodwill, net of accumulated amortization of $349 in 2001 2,04 and $88 in 2000................................................................................... 1 Other assets, net....................................................................................... 832 $18,181

S3-70

2000 $ 1,849 626 2,690 557 673 482 6,877 2,095 4,496 163 521 $14,152

Comprehensive Problem 2 (Continued) Liabilities and Stockholders’ Equity Current liabilities: Short-term borrowings........................................................................ $ 3 Accounts payable................................................................................1,050 Accrued payroll-related liabilities....................................................... 488 Accrued liabilities and other...............................................................1,374 Deferred revenues and customer deposits...........................................1,827 Warranty reserve.................................................................................. 314 Income taxes payable.......................................................................... 90 Total current liabilities 5,146 .................................................................................................. Deferred income taxes.............................................................................. 744 Long-term debt and other obligations......................................................1,705 Total debt $ 7,595 ................................................................................................... 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 .................................................................................................. Treasury stock, at cost: 288 shares in 2001 and 301 shares in 2000 .................................................................................................. (2,435) Deferred equity compensation............................................................ (73) Retained earnings................................................................................6,885 Accumulated other comprehensive income (loss)............................... (29) Total stockholders’ equity 10,586 .................................................................................................. $18,181

$

7 924 751 1,155 1,289 211 209 4,546

577 1,720 $ 6,843

—

2,728

(1,438) (15) 5,959 75 7,309 $14,152

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. 7.

The book values per share for the same four years discussed in the preceding question were: 1998 1999 2000

$1.18 $1.55 $2.29 S3-71

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?

S3-72

CP 3-2.

Solution Sun Microsystems, Inc.

1. Percentage change in net income per common share-diluted 1999 1998

$ .31 $ .24 $ .07 +29.2%

2000 1999

$ .55 $ .31 $ .24 +77.4%

2001 2000

$ .27 $ .55 $–.28 –50.9%

2. Profit margin 1998 Net income $755 = Net revenues 9,862 7.66%

1999

2000

2001

$1,030 11,806

$1,854 15,721

$927 18, 250

8.72%

11.79% 5.08%

3. Percent of net revenue 2000 Net revenues Cost of sales Research and development S, G, and A Provision for income taxes

$15,721 7,549

2001 48.02%

$18,250 10,041

55.02%

1,630 4,072

10.37 25.90

2,016 4,544

11.05 24.90

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% to 55.02%).

S3-73

CP 3-2. (Continued) 4. Return on stockholders’ equity

Net income Stockholders' equity

5. 1.

Net income Net revenues (sales)

Net income 2.a. Total assets 2.b.

3.b.

Net income Sales  Sales Total assets

2000

2001

$1,854 7,309

$ 927 10,586

25.37%

8.76%

2000

2001

11.79%

5.08%

13.1%

5.10%

11.79%  1.11 5.08%  1.00

Return on assets  1  Debt/Assets) 

13.09%

5.08%

13.09%  1  .484 

5.08%  1  .418

25.37%

8.73%

The main contributing factor to the decline in the return on stockholders’ equity (25.37% to 8.73%) was the decline in the profit margin (11.79% vs. 5.08%). 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% to 41.8%).

S3-74

CP 3-2. (Continued) 6.a. P/E = Stock price/net income per common share-diluted (EPS) 1998

1999

2000

2001

Shares prices EPS

$11.25 .24

$16.75 .31

$28.50 .55

$9.50 .27

P/E

46.9

51.8

35.2

54.0

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

Shares prices Book value

$11.25 1.18

$16.75 1.55

$28.50 2.29

$9.50 3.26

P/BV

9.53

12.45

2.91

10.81

b. Once again, the sharp fall off 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.

S3-75