CHAPTER 3
Evaluating A Firm’s Financial
Performance
CHAPTER
ORIENTATION
Financial analysis can be defined
as the process of assessing the financial condition of a firm. The principal
analytical tool of the financial analyst is the financial ratio. In this chapter, we provide a set of key
financial ratios and a discussion of their effective use.
CHAPTER OUTLINE
I Financial
ratios help us identify some of the financial strengths and weaknesses of a
company.
II. The ratios give us a way of making meaningful comparisons of
a firm’s financial data at different points in time and with other firms.
III. We could use ratios to answer the following important
questions about a firm’s operations.
A. Question 1: How liquid
is the firm?
1. The liquidity
of a business is defined as its ability to meet maturing debt obligations. That is—does or will the firm have the
resources to pay the creditors when the debt comes due?
2. There are two ways to approach the liquidity question.
a. We can look at the firm’s assets that are relatively liquid
in nature and compare them to the amount of the debt coming due in the near
term.
b. We can look at how quickly the firm’s liquid assets are
being converted into cash.
B. Question 2: Is management generating adequate operating
profits on the firm’s assets?
1. We want to know if the profits are sufficient relative to
the assets being invested.
2. We have several choices as to how we measure profits: gross profits, operating profits, or net
income. Gross profits would not be
acceptable because it does not include important information such as marketing
and distribution expenses. Net income
includes the unwanted effects of the firm’s financing policies. This leaves operating profits as our best
choice in measuring the firm’s operating profitability. Thus, the appropriate measure is the
operating income return on investment (OIROI):
OIROI = 
C. Question 3: How is the
firm financing its assets?
1. Here we are concerned with the mix of debt
and equity capital the firm is using.
2. Two primary ratios used to answer this
question are the debt ratio and times interest earned.
a. The debt ratio is the proportion of
total debt to total assets.
b. Times interest earned compares
operating income to interest expense for a crude measure of the firm’s capacity
to service its debt.
D. Question 4: Are the owners (stockholders) receiving an
adequate return on their investment?
1. We want to know if the earnings available to the firm’s
owners, or common equity investors, are attractive when compared to the returns
of owners of similar companies in the same industry.
2. Return on equity (ROE)
= 
3. We demonstrate the effect of using debt on net income
through an example showing how the use of debt affects a firm’s return on
equity.
4. Return on equity is presented as a function of:
a. the operating income return on investment less the interest
rate paid, and
b. the amount of debt used in the capital structure relative to
the equity.
IV. An Integrative Approach to Ratio
Analysis: The DuPont Analysis
A. The DuPont analysis is another approach used to evaluate a
firm’s profitability and return on equity.
B. Its graphic technique may be helpful in seeing how ratios
relate to one another and the account balances.
C. Return on Equity is a function of a firm’s net profit margin,
total asset turnover, and debt ratio.
V. Limitations of Ratio Analysis
A. This list warns of the many pitfalls
that may be encountered in computing and interpreting financial ratios.
B. Ratio users should be aware of these
concerns prior to making decisions based solely on ratio analysis.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
3-1. In learning about ratios, we could simply study the different
types or categories of ratios. These
categories have conventionally been classified as follows:
Liquidity ratios are used to measure the ability
of a firm to pay its bills on time.
Example ratios include the current ratio and acid-test ratio.
Efficiency ratios reflect how effectively the firm
has utilized its assets to generate sales.
Examples of this type of ratio include accounts receivable turnover,
inventory turnover, fixed asset turnover, and total asset turnover.
Leverage ratios are used to measure the extent
to which a firm has financed its assets with outside (non-owner) sources of
funds. Example ratios include the debt
ratio and times interest earned ratio.
Profitability ratios serve as overall measures of the
effectiveness of the firm’s management relative to sales and/or to
investment. Examples of profitability
ratios include the net profit margin, return on total assets, operating profit
margin, operating income return on investment, and return on common equity.
Instead, we have chosen to
cluster the ratios around important questions that may be addressed to some
extent by certain ratios. These
questions, along with the related ratios may be represented as follows:
1. How liquid is the firm?
Current ratio
Quick ratio
Accounts receivable turnover
(average collection period)
Inventory turnover
2. Is management generating adequate operating profits on the
firm’s assets?
Operating income return on
investment
Operating profit margin
Gross profit margin
Asset turnover ratios, such as
for total assets, accounts receivable, inventory, and fixed assets
3. How is the firm financing its assets?
Debt to total assets
Debt to equity
Times interest earned
4. Are the owners (stockholders) receiving an adequate return
on their investment?
Return on common equity
In answering questions 2 through
4, we can see the linkage between operating activities and financing activities
as they influence return on common equity.
3-2. The two sources of standards or norms used in performing ratio
analysis consist of similar ratios for the firm being analyzed over a number of
past operating periods, and similar ratios for firms which are in the same
general industry or have similar product mix characteristics.
3-3. The financial analyst can obtain norms from a variety of
sources. Two of the most well known are
the Dun & Bradstreet Industry Norms and Key Business Ratios and RMA’s
Annual Statement Studies. Industry norms
often do not come from "representative" samples, and it is very
difficult to categorize firms into industry groups. In addition, the industry norm is an average
ratio which may not represent a desirable standard. Thus, industry averages only provide a
"rough guide" to a firm’s financial health.
3-4. Liquidity is the ability to repay short-term debt. We measure liquidity by comparing the firm’s
liquid assets—cash or assets that will be turned into cash in the operating
cycle—to the amount of short-term debt outstanding, which is the measurement
provided by the current ratio and the quick, or acid-test, ratio. We can also measure liquidity by computing
how quickly accounts receivables turn over (how long it takes to collect them
on average) and how quickly inventories turn over. The more quickly these assets can be turned
over, the more liquid the firm.
3-5. Operating income return on investment is the amount of
operating income produced relative to $1 of assets invested (total assets),
while operating profit margin is the amount of operating income per $1 of
sales. The first ratio measures the
profitability on the firm’s assets, while the latter measures the profitability
on the sales.
3-6. We can compute operating income return on investment (OIROI)
as:
= 
or as:
= 
X 
Thus, we see
that OIROI is a function of how well we manage the income statement, as
measured by the operating profit margin, and how well we manage the balance
sheet (the firm’s assets), as measured by the asset turnover ratio.
3-7. Gross profit margin measures a firm’s pricing decisions and its
ability to manage its cost of goods sold per dollar of sales. Operating profit margin is likewise a
function of pricing and cost of goods sold, but also the amount of operating
expenses (marketing expenses and general and administrative expenses) for every
dollar of sales. Net profit margin
builds on the above relationships, but then includes the firm’s financing
costs, such as interest expense. Thus,
the gross profit margin measures the firm’s pricing decisions and the ability
to acquire or produce its product cheaply.
The operating profit margin then adds the cost of distributing the
product to the customer. Finally, the
net profit margin adds the firm’s financing decisions to the operating
performance.
3-8. Return on equity is equal to net income divided by the total
equity. But knowing how to compute
return on equity is not the same as understanding what decisions drive return
on equity. It helps to know that return
on equity is driven by the spread between operating income return on investment
and the interest rate paid on the firm’s debt.
The greater the OIROI compared to the interest rate, the higher the
return on equity will be. If OIROI is
higher (lower) than the interest rate, as a firm increases its use of debt,
return on equity will be higher (lower).
SOLUTIONS TO
END-OF-CHAPTER
PROBLEMS
3-1A. Cash 201,875
Accounts Payable 100,000
Accounts
Receivable * 175,000 Long-Term Debt
320,000
Inventory 223,125
Total Liabilities 420,000
Current
Assets 600,000
Common Equity 1,680,000
Net
Fixed Assets 1,500,000
Total
Assets 2,100,000 Total
Liability & Equity 2,100,000
*
Based on 360 days.
Current
ratio 6
Total
asset turnover 1
Gross
profit margin 15%
Inventory
turnover 8
Average
collection period 30
Debt
ratio 20%
Sales 2,100,000
Cost
of goods sold 1,785,000
Total
liabilities 420,000
3-2A. Mitchem's present current ratio of 2.5 to 1 in conjunction with
its $2.5 million investment in current assets indicates that its current
liabilities are presently $1 million.
Letting x represent the additional borrowing against the firm's line of
credit (which also equals the addition to current assets) we can solve for that
level of x which forces the firm's current ratio down to 2 to 1; i.e.,
2 = ($2.5 million + x) / ($1.0
million + x)
x = $0.5 million, or
$500,000
3-3A. Instructor’s Note:
This is a very rudimentary "getting started" exercise. It requires no analysis beyond looking up the
appropriate formula and plugging in the corresponding figures.
= 
= 1.75X
= 
= .50 or 50%
Times interest earned = 
= 
= 4.63X
= = 4.63X
Average collection period = 
= 
= 91 days
= = 91 days
Inventory turnover = 
= 
= 3.3X
= = 3.3X
Fixed asset turnover = 
= 
= 1.78X
= = 1.78X
Total asset turnover = 
= 
= 1X
= = 1X
Gross profit margin =
= 
= .59 or 59%
= = .59 or 59%
Operating profit margin
= 
= .21 or 21%
= = .21 or 21%
= = .21 or 21%
= 
= .20 or 20%
or, we can calculate return on
equity as:
= Return on assets ÷ (1- debt ratio)
=
÷ 
÷
= 
= .20 or 20%
= .20 or 20%
3-4A. a. Total Assets Turnover = 
= 
= 2x
= = 2x
b. 3.5 = 
Sales = $17.5m
Thus, the needed sales growth is
$7.5 million ($17.5m - $10m), or an increase of 75%:
= 75%
c. For last year,
= 
X 
= 10% X 2.0
=
20%
If sales grow by 75%, then for
next year-end assuming a 10% operating profit margin:
= X
= 10% X 3.5
= 35%
3-5A. a. 
Avg Collection Period = 
Avg Collection Period = 30
days
Note that the average collection
period is based on credit sales, which are 75% of total firm sales.
b. 
= 20 = 
= 20 =
Solving
for accounts receivable:
= $369,863
Thus, Brenmar would reduce its
accounts receivable by
$562,500 - $369,863 =
$192,637.
c. Inventory Turnover = 
9 = 
Inventories = 
= $700,000
= $700,000
3-6A. a. Industry
RATIO 2002 2003 Norm
Liquidity:
Current
Ratio 6.0x 4.0x 5.0x
Acid-test
(Quick) Ratio 3.25x 1.92x 3.0x
Average
Collection Period 137 days 107 days 90
days
Inventory
Turnover 1.27x 1.36x 2.2x
Operating
profitability:
Operating
Profit Margin 20.8% 24.8% 20.0%
Total
Asset Turnover .5x .56x .75x
Average
Collection Period 137 days 107 days 90 days
Inventory
Turnover 1.27x 1.36x 2.2x
Fixed
Asset Turnover 1.00x 1.04x 1.00x
Financing:
Debt
Ratio 0.33 0.35 0.33
Times
Interest Earned 5.0x 5.63x 7.0x
Return
on common stockholders’ investment:
Return
on Common Equity 7.5% 10.5% 9.0%
b. Regarding the firm’s liquidity in 2003, the current and
acid-test (quick) ratios are both well below the industry averages and have
decreased considerably from the prior year.
Also, the average collection period and inventory turnover do not
compare favorably against the industry averages, which suggests that accounts
receivable and inventories are not of equal quality of these assets in other
firms in the industry. So, we may
reasonably conclude that Pamplin is less liquid than the average company in its
industry.
c. In evaluating Pamplin’s operating
profitability relative to the average firm in the industry, we must first
analyze the operating income return on investment (OIROI) both for Pamplin and
the industry. From the information given,
this computation may be made as follows:
= 
X 
Industry: 20% X 0.75 = 15%
Pamplin 2002: 20.8% X 0.50
= 10.4%
Pamplin 2003: 24.8% X 0.56
= 13.9%
Thus, given the low operating
income return on investment for Pamplin relative to the industry, we must
conclude that management is not doing an adequate job of generating operating
profits on the firm’s assets. However,
they did improve between 2002 and 2003.
The problem lies not with the operating profit margin, which addresses
the operating costs and expenses relative to sales. Instead, the problem arises from Pamplin’s
management not using the firm’s assets efficiently, as indicated by the low
asset turnover ratios. Here the problem
occurs in managing accounts receivable and inventories, where we see the low
turnover ratios. The firm does appear to
be using the fixed assets reasonably well—note the satisfactory fixed assets
turnover.
d. Financing decisions
A balance-sheet perspective:
The debt ratio for Pamplin in
2003 is around 35%, an increase from 33% in 2002; that is, they finance
slightly more than one-third of their assets with debt and a little less than
two-thirds with common equity. Also, the
average firm in the industry uses about the same amount of debt per dollar of
assets as Pamplin.
An income-statement perspective:
Pamplin’s times interest earned
is below the industry norm—5.0 and 5.63 in 2002 and 2003, respectively,
compared to 7.0 for the industry average.
In thinking about why, we should remember that a company’s times
interest earned is affected by (1) the level of the firm’s operating
profitability (EBIT), (2) the amount of debt used, and (3) the interest
rate. Items 2 and 3 determine the amount
of interest paid by the company. Here is
what we know about Pamplin:
1. The firm’s operating income return on
investment is below average, but improving.
Thus, we would expect this fact to contribute to a lower, but also
improving, times interest earned. The
evidence is consistent with this thought.
2. Pamplin uses about the same amount of
debt as the average firm, which should mean that its times interest earned, all
else equal, would be about the same as for the average firm. Thus, Pamplin’s low times interest earned is
not the consequence of using more debt.
3. We do not have any information about
Pamplin’s interest rate, so we cannot make any observation about the effect of
the interest rate. But we know if
Pamplin is paying a higher interest rate than its competitors, such a situation
would also be contributing to the problem.
e. Pamplin has improved its return on
common equity from 7.5% in 2002 to 10.5% in 2003, compared to an industry norm
of 9%. The sharp improvement has come
from a significant increase in the firm’s operating income return on investment
and a modest increase in the use of debt financing. It is also possible that the higher return on
equity comes from Pamplin paying a lower interest rate on its debt, but we do
not have enough information to know for certain. Nevertheless, Pamplin has enhanced the
returns to its owners, but with a touch of additional financial risk (slightly
higher debt ratio) in the process.
3-7A. a. Salco’s
total asset turnover, operating profit margin, and operating income return on
investment.
Total Asset Turnover = 
= 
= 2.25
times
Operating
Profit Margin = 
= 
= 11.11%
=
= 
= 25%
or = 
x
x
= .1111
X 2.25
= 25%
b. The new operating income return on
investment for Salco after the plant renovation:
= x
= 
= .13
x 1.5
= 19.5%
c. Return earned on the common
stockholders’ investment:
Post-Renovation
Analysis:
= 
= 
= 14.5%
Net income available to common
stockholders following the renovation was calculated as follows:
Operating Income (.13 x $4.5m) $ 585,000
Less: Interest ($100,000 +
$50,000) (150,000)
Earnings Before Taxes 435,000
Less: Taxes (50%) (217,500)
Net Income Available to Common
Stockholders $ 217,500
The increase in Common equity was
calculated as follows:
Total assets purchased $
1,000,000
Less: Increase in debt
($1,500,000 - $1,000,000) (500,000)
Increase in equity to finance
purchase $ 500,000
The computation above is
measuring the return on equity based on the beginning-of-the-year common
equity. The equity would increase
$217,500 by year end.
Pre-renovation Analysis:
The pre-renovation rate of
return on common equity is calculated as
follows:
Return on Common Equity = 
= 20%
= 20%
Comparative Analysis:
A comparison of the two rates of
return would argue that the renovation not be undertaken. However, since investments in fixed assets
generally produce cash flows over many years, it is not appropriate to base
decisions about their acquisition on a single year’s ratios. There are additional problems with this
approach to fixed asset decision making which we will discover when we discuss
capital budgeting in a later chapter.
Instructor’s Note:
To help convince those students who simply cannot accept the fact that
the renovation may be worthwhile even though the return on common equity falls
in the first year, we note that the existing plant is recorded on the firm’s
books at original cost less accounting depreciation. In a period of rising replacement costs, this
means that the return on common equity of 20% without renovation may actually overstate
the true return earned on a more realistic “replacement cost” common equity
base. In addition, the issue is probably
one of when to renovate (this year or next) rather than whether or not to
renovate. That is, the existing facility
may require renovation in the next two years to continue to operate. These considerations simply cannot be
incorporated in the ratio analysis performed here. We find this a very useful point to make at
this juncture of the course since industry practice still frequently involves
use of rules of thumb and ratio guides to the analysis of capital expenditures.
3-8A. T.P. Jarmon
Instructor’s note:
This problem serves to integrate the use of the DuPont analysis with
financial ratios. The student is guided
through a thorough analysis of a loan applicant that (on the surface) appears
acceptable. However, an in-depth
analysis reveals that the firm is not nearly so liquid as it first appears and
has used a substantial amount of current debt to finance its assets.
a. See the accompanying table.
b. The most important ratios to consider
in evaluating the firm’s credit request relate to its liquidity and use of
financial leverage. However, the credit
analyst can also evaluate the firm’s profitability ratios as a general
indication as to how effective the firm’s management has been in managing the
resources available to it. This latter
analysis would be useful in evaluating the prospects for a long and fruitful
relationship with the new client.
c. The DuPont Analysis for Jarmon is shown
in the graph on the next page. The earning power analysis provides an in-depth
basis for analyzing Jarmon’s only deficiency, that relating to its relatively
large investment in inventories.
However, even this potential weakness is largely overcome by the firm’s
strengths. The firm’s return on assets
and its return on owner capital (return on common equity) both compare well
with the respective industry norms.
Instructor’s Note
At this point, we usually note
the one major deficiency of DuPont Analysis.
This relates to the lack of any liquidity ratios. Thus, the analysis of earning power alone is
not appropriate for credit analysis since no indicators of liquidity are
calculated. This deficiency can, of
course, be easily corrected by appending one or more liquidity ratios to the
analysis.
Industry
Ratio Formula Calculation Average
Current
Ratio 
= 1.84 1.8
= 1.84 1.8
Acid-Test
Ratio 
= .72 .9
= .72 .9
Debt
Ratio 
= .55 .5
= .55 .5
= 8 10
= 
Inventory
Turnover 
= 5.48 7
= 5.48 7
= .196 16.8%
or 19.6%
= .133 14%
or 13.3%
Industry
Ratio Formula Calculation Average
= .233 25%
or 23.3%
= 1.47 1.2
= 2.22 1.8
Return on Assets 
= .1051 6%
or
10.51%
Return on Equity 
= .234 12%
= .234 12%
or
23.4%
3-9A. HiTech
Industry
RATIO 2003
Norm
Liquidity:
Current
Ratio 2.51 2.01
Acid-test
(Quick) Ratio 2.30 1.66
Average
Collection Period 45.95 72.64
Accounts
Receivable Turnover 7.94 5.02
Inventory
Turnover 6.13 4.42
Operating
profitability:
Operating
Income
Return on Investment 23.2% 9.0%
23.2% 9.0%
Operating
Profit Margin 34.6% 13.0%
Total
Asset Turnover .67 .69
Accounts
Receivable Turnover 7.94 5.02
Inventory
Turnover 6.13 4.42
Fixed
Asset Turnover 2.51 2.27
Financing:
Debt
Ratio .26 .44
Times
Interest Earned 247.78 8.87
Return
on common stockholders’ investment:
Return
on Common Equity 22.4% 12.0%
The above analysis of HiTech
reveals a strong company in many areas.
First, let’s look at the liquidity question. How liquid is HiTech’s balance sheet? The current ratio surpasses the industry, and
when we subtract inventories in the acid-test ratio, HiTech still surpasses the
industry. It is the same with the
inventory turnover ratio. This suggests
that HiTech has a lower than normal inventory level. The receivable turnover and average
collection period also reveal that HiTech controls this asset better than its
competitors. These ratios tell us that
HiTech’s liquidity relies on assets other than inventory and receivables. When we review the balance sheet, this
assumption is supported for we see that $11.8 million of the $17.8 million of
HiTech’s current assets is in cash and cash equivalents alone. We next turn to the profitability
question. HiTech compares impressively
on the OIROI and operating profit margin ratios. The OIROI ratio tells us that either HiTech
must be doing a superior job at sales, expenses, or generating greater sales
from a lower asset level. When we look
at the total asset turnover, HiTech rates slightly lower than normal. HiTech is generating the same proportionate
level of sales from the same level of assets as its competitors. We know that HiTech is doing a good job of
turning over its current assets. The
fixed asset turnover tells us that part of the problem is in the level of fixed
assets that HiTech is maintaining. As we
look at the balance sheet, we see that HiTech also maintains a high level of
“other investments”. HiTech must be
doing an excellent job at controlling costs, which is supported by the
excellent operating profit margin ratio.
We now look at the financing question.
HiTech is maintaining a low level of debt as compared to the industry
and is more than able to service its interest expense. This means that HiTech is financing its
assets through equity. Let’s look at the
return that these owners are receiving from their investment through the final
ratio. HiTech also rates favorably on
return on common equity, 22.4% as compared to the 12.0% industry average.
INTEGRATIVE
PROBLEM
1.
|
Blake International
|
1999
|
2000
|
2001
|
2002
|
2003
|
|
Current ratio
|
3.11
|
2.83
|
2.54
|
2.22
|
1.99
|
|
Acid-test ratio
|
1.64
|
1.78
|
1.56
|
1.35
|
1.33
|
|
Average collection
period
|
53.16
|
62.00
|
56.29
|
58.63
|
52.48
|
|
Accounts receivable
turnover
|
6.87
|
5.89
|
6.48
|
6.23
|
6.95
|
|
Inventory turnover
|
3.28
|
3.87
|
4.00
|
3.73
|
4.21
|
|
Operating income return
on investment
|
0.22
|
0.15
|
0.16
|
0.08
|
0.09
|
|
Gross profit margin
|
0.40
|
0.39
|
0.38
|
0.38
|
0.40
|
|
Operating profit margin
|
0.10
|
0.08
|
0.08
|
0.04
|
0.05
|
|
Total asset turnover
|
2.10
|
1.95
|
2.07
|
1.85
|
1.85
|
|
Fixed asset turnover
|
18.13
|
18.81
|
23.21
|
18.64
|
16.29
|
|
Debt ratio
|
0.43
|
0.79
|
0.71
|
0.69
|
0.66
|
|
Times interest earned
|
14.00
|
6.31
|
4.31
|
2.30
|
2.78
|
|
Return on equity
|
0.18
|
0.36
|
0.27
|
0.04
|
0.02
|
Note: Above ratio calculations may be subject to
rounding errors.
Question #1
It is apparent that Blake’s
liquidity is decreasing over time, as the current and acid-test ratios
indicate. However, the receivable
turnover and average collection period stayed relatively constant while the
inventory turnover actually increased.
When we review the balance sheet, we note that the cash balance has
actually increased while the receivable and inventory balances decreased,
creating more liquidity within the total current assets, even though the net
current asset balance decreased in total.
The real problem lies with the increase in current liabilities over time
in combination with the decrease in current assets.
Question #2
Also of great concern is the
decrease in operating profitability that is shown in the OIROI ratios over
time. The problem does not seem to be in
the cost of goods sold as indicated by the gross profit margin ratio. The problem appears in the operating profit
margin having also decreased over time.
Upon review of the income statement, we will see that while sales have decreased,
the operating expenses have stayed the same.
The total asset turnover and fixed asset turnover have also decreased,
although not to the same degree. Blake
has lowered the asset balances as sales have lowered, but still needs to work
further to lower fixed assets, decrease expenses, and increase sales.
Question #3
While sales and assets have
decreased over time, the level of debt to equity has increased. As of 2003, 66% of Blake’s assets are being
financed through the use of debt. The company
is quickly becoming over-leveraged and soon will lose its ability to pay
interest as the times interest earned ratio shows.
Question #4
Return on common equity has
declined, especially in the last two years.
This can be the result of two factors, a lower rate of return or
financing through less debt. As noted
above, Blake has increased debt greatly over the last five years. As we have also noted, Blake’s operating
profitability has also decreased over the last few years as a result of
decreasing sales and higher interest costs.
We can safely assume that the decreasing return is the result of
decreasing profits.
|
Scott Corp.
|
1999
|
2000
|
2001
|
2002
|
2003
|
|
Current ratio
|
1.85
|
1.86
|
2.05
|
2.07
|
2.26
|
|
Acid-test ratio
|
1.28
|
1.22
|
1.33
|
1.25
|
1.43
|
|
Average collection period
|
80.75
|
75.92
|
69.69
|
63.96
|
64.71
|
|
Accounts receivable turnover
|
4.52
|
4.81
|
5.24
|
5.71
|
5.64
|
|
Inventory turnover
|
4.45
|
4.11
|
4.01
|
4.21
|
4.42
|
|
Operating income return on investment
|
0.21
|
0.24
|
0.25
|
0.16
|
0.16
|
|
Gross profit margin
|
0.41
|
0.41
|
0.42
|
0.38
|
0.40
|
|
Operating profit margin
|
0.14
|
0.14
|
0.15
|
0.09
|
0.10
|
|
Total asset turnover
|
1.51
|
1.64
|
1.71
|
1.77
|
1.67
|
|
Fixed asset turnover
|
8.58
|
10.06
|
9.96
|
8.28
|
6.93
|
|
Debt ratio
|
0.37
|
0.38
|
0.41
|
0.40
|
0.36
|
|
Times interest earned
|
27.54
|
23.45
|
24.73
|
12.60
|
16.41
|
|
Return on equity
|
0.20
|
0.23
|
0.25
|
0.12
|
0.14
|
Note: Above ratio calculations may be subject to
rounding errors.
Question #1
Scott’s liquidity increased over
the last five years, despite its growth.
While current liabilities increased, current assets grew by over
60%. This is reflected in the positive
trend of the current ratio. Despite
inventory growth of 90%, the acid-test ratio and inventory turnover both
increased positively over time due to strong growth in other areas such as
receivables and sales (which in turn impacted cost of goods sold on which the
inventory turnover ratio is based). The
receivable turnover ratio and average collection period also trended positively
due to a slight increase in receivables as compared to an 84% increase in
sales.
Question #2
Operating profitability seems to
have decreased slightly over the last five years. Upon review of the ratios in combination with
the financial statements, this seems to be the result of two factors. One, operating expenses have grown
disproportionately to sales over the years.
Depreciation has grown due to the fixed asset growth, which is the
second factor. The total asset turnover
has increased as a result of the positive use of receivables and
inventories. However, fixed assets have
grown considerably, affecting both the OIROI and the fixed asset turnover.
Question #3
Upon initial review of the debt
ratio, Scott seems to be successively financing its growth with the same
proportion of debt over the last five years.
However, Scott does need to be aware that the times interest earned is
trending down due to the fact that the operating expenses have grown
disproportionately. This will impact its
ability to service debt over future years.
Question #4
Scott has decreased its return on
common equity especially in the last two years.
Since Scott has not decreased its debt ratio, we must review the income
statement for the explanation. Even
though Scott has almost doubled its sales, net income has remained the same. This is the result of decreased operating
profit margin and increased interest.
The increased interest is either the result of increased debt or a
higher cost of debt.
2. The differences in Scott’s and Blake’s financial performance
are easy to find. Scott continues to be
a thriving company while Blake seems to have many financial problems. Scott’s sales have grown 84% while Blake’s
sales have decreased by 17%. However,
they also have many similarities. Let’s
look at the differences and similarities by question.
Liquidity – Both Blake and Scott have done
a good job of controlling their inventories and receivables. Both had positive trends in these areas. The difference is that Scott has considerable
liquidity while Blake is losing this ability due to its increasing current
liabilities.
Profitability – Both Scott and Blake are
having problems with operating profitability.
Their OIROI’s have trended downward over time due to increasing
operating expenses and increasing fixed assets as compared to sales.
Financing – The true differences appear in
how Blake and Scott are financing their assets.
While Scott’s debt ratio has stayed the same, Blake has increased its
debt ratio to 66%. This has
significantly increased the risk to the
financial health of Blake. While both
Scott’s and Blake’s times interest earned have decreased due to increasing
operating expenses, Blake is dangerously close to losing its ability to service
its debt.
Solutions for Set B
3-1B. Cash 174,363
Accounts Payable 100,000
Accounts
Receivable * 80,137
Long-Term Debt 290,000
Inventory 45,500
Total Liabilities 390,000
Current
Assets 300,000
Common Equity 910,000
Net
Fixed Assets 1,000,000
Total
Assets 1,300,000 Total
Liability & Equity 1,300,000
*
Based on 360 days.
Current
ratio 3
Total
asset turnover 0.5
Gross
profit margin 30%
Inventory
turnover 10
Average
collection period 45
Debt
ratio 30%
Sales 650,000
Cost
of goods sold 455,000
Total
liabilities 390,000
3-2B. Allandale’s present current ratio of 2.75 in conjunction with its
$3.0 million investment in current assets indicates that its current
liabilities are presently $1.09 million.
Letting x represent the additional borrowing against the firm’s line of
credit (which also equals the addition to current assets), we can solve for
that level of x which forces the firm’s current ratio down to 2 to 1, i.e.,
2
= ($3.0 million + x) / ($1.09 million + x)
x
= $.82 million
3-3B. Instructor’s Note:
This is a very rudimentary "getting started" exercise. It requires no analysis beyond looking up the
appropriate formula and plugging in the corresponding figures.
Current Ratio = = 
= 1.94X
= 1.94X
Debt Ratio = = 
= .49 or 49%
= .49 or 49%
Times Interest Earned = = 
= 4.09X
= 4.09X
Average Collection Period = = 
= 73
days
= 73
days
Inventory Turnover = = 
= 3.0X
= 3.0X
Fixed Asset Turnover = = 
= 1.67X
= 1.67X
Total Asset Turnover = 
= 
= .94X
= = .94X
Gross Profit Margin = 
= 
= .60
or 60%
= = .60
or 60%
= 
= 
= .20 or 20%
= = .20 or 20%
=
= 
= .19 or 19%
= .19 or 19%
Return on Equity = = 
=.17 or 17%
=.17 or 17%
or, we can calculate return on
equity as:
= Return on assets ÷ (1- debt ratio)
= ÷
÷
= 
= .17 or 17%
= .17 or 17%
3-4B. a. Total Assets
Turnover =
= 
= 1.83X
= 1.83X
b. 2.5 =
Sales =
$15m
Thus, the needed sales growth is
$4 million ($15m - $11m) or an increase of 36%:
=
36%
c. Last year,
= X
= 6%
X 1.83
= 11%
If sales grow by 36%, then for
next year-end assuming a 6% operating profit margin:
= X
= 6%
X 2.5
= 15%
3-5B. a. 
=
=
Avg Collection Period = 
Avg Collection Period = 28.08
days
Note that the average collection
period is based on credit sales, which are 75% of total firm sales.
b. =
20 = 
Solving for accounts receivable:
= $400,685
Thus, Brenda Smith, Inc. would
reduce its accounts receivable by
$562,500 -
$400,685 = $161,815
c. Inventory Turnover =
8 =
Inventories = = $914,062.50
3-6B. a.
Industry
RATIO 2002 2003 Norm
Liquidity:
Current Ratio 5.00 5.35 5.00
Acid-test (Quick) Ratio 2.70 2.63 3.00
Average Collection Period 131.40 108.24 90.00
Inventory Turnover 1.22 1.40 2.20
Operating profitability:
Operating Income
Return on Investment 12.24% 13.04% 15.00%
Operating Profit Margin 24.00% 22.76% 20.00%
Total Asset Turnover .51 .57 .75
Average Collection Period 131.40 108.24 90.00
Inventory Turnover 1.22 1.40 2.20
Fixed Asset Turnover 1.04 1.12 1.00
Financing:
Debt Ratio 34.69% 32.81% 33.00%
Times Interest Earned 6.00 5.50 7.00
Rate of return on common
stockholders’ investment:
Return on Common Equity 9.38% 9.53% 13.43%
b. Regarding the firm’s liquidity, the
acid-test (quick) ratios are below the industry average and have decreased from
the prior year. Also, the average
collection period and inventory turnover are well below the industry averages,
which suggests that inventories and receivables are not of equal quality of
these assets in other firms in the industry.
Since the current ratio is satisfactory, the problem apparently lies in
the management of inventories and receivables.
So, we may reasonably conclude that Chavez is less liquid than the
average company in its industry because it has a greater investment in
inventories and receivables than the industry average.
c.
In
evaluating Chavez’s operating profitability relative to the average firm in the
industry, we must first analyze the operating income return on investment
(OIROI) both for Chavez and the industry.
From the information given, this computation may be made as follows:
= X
Industry: 20.00% X 0.75 =
15.00%
Chavez 2002: 24.00% X 0.51 =
12.24%
Chavez 2003: 22.76% X 0.57 =
12.97%
Thus, given the low operating
income return on investment for Chavez relative to the industry, we must
conclude that management is not doing an adequate job of generating operating
profits on the firm’s assets. However,
they did improve between 2002 and 2003.
The problem lies not with the operating profit margin, which addresses
the operating costs and expenses relative to sales. Instead, the problem arises from Chavez’s
management not using the firm’s assets efficiently, as indicated by the low
asset turnover ratios. Here, the problem
occurs in managing accounts receivable and inventories, where we see the low
turnover ratios. The firm does appear to
be using the fixed assets reasonably well—note the satisfactory fixed assets
turnover.
d. Financing decisions
A balance-sheet perspective:
The debt ratio for Chavez in 2003
is around 33%, a decrease from 34.7% in 2002; that is, they finance about
one-third of their assets with debt and a little more than two-thirds with
common equity. The average firm in the industry uses about the same amount of
debt per dollar of assets as Chavez.
An income-statement perspective:
Chavez’s times interest earned is
below the industry norm—6.0 and 5.5 in 2002 and 2003, respectively, compared to
7.0 for the industry average. In
thinking about why, we should remember that a company’s times interest earned is
affected by (1) the level of the firm’s operating profitability (EBIT), (2) the
amount of debt used, and (3) the interest rate.
Items 2 and 3 determine the amount of interest paid by the company. Here is what we know about Chavez:
1. The firm’s operating profitability is
below average, but improving. Thus, we
would expect this fact to contribute to a lower times interest earned. The evidence is consistent with this thought.
2. Chavez uses about the same amount of
debt as the average firm, which should mean that its times interest earned, all
else equal, would be about the same as for the average firm. Thus, Chavez’s low times interest earned is
not the consequence of using more debt.
3. We do not have any information about
Chavez’s interest rate, so we cannot make any observation about the effect of
the interest rate. But we know if Chavez
is paying a higher interest rate than its competitors, such a situation would
also be contributing to the problem.
e. Chavez has improved its return on
common equity from 9.38% in 2000 to 9.53% in 2001, compared to an industry norm
of 13.43%. The improvement has come from
an increase in the firm’s operating income return on investment, despite a
slight decrease in the use of debt financing.
Thus, Chavez has enhanced the returns to its owners, and with a small
decline of financial risk (slightly lower debt ratio) in the process.
3-7B. a. Mel’s
total asset turnover, operating profit margin, and operating income return on
investment.
Total Asset Turnover =
= 
= 2.50
times
Operating
Profit Margin =
= 
= 10.00%
=
= 
=
25%
or = X
= 10% X 2.50 = 25%
b. The new operating income return on
investment for Mel’s after the plant renovation:
= x
= .13
X 
= .13
X 1.67
= 21.67%
c. Return earned on the common stockholders’ investment:
Post-Renovation
Analysis:
Return on Common Equity = 
= 
= .204
= 20.4%
Net income available to common
stockholders following the renovation was calculated as follows:
Operating Income (.13 x $5m) $ 650,000
Less: Interest ($100,000 +
$40,000) (140,000)
Earnings Before Taxes 510,000
Less: Taxes (40%) (204,000)
Net Income Available to Common
Stockholders $ 306,000
The increase in Common equity was
calculated as follows:
Total assets purchased $
1,000,000
Less: Increase in debt
($1,500,000 - $1,000,000) (500,000)
Increase in equity to finance
purchase $ 500,000
The computation above is
measuring the return on equity based on the beginning-of-the-year common
equity. The equity would increase
$217,500 by year end.
Pre-renovation Analysis:
The pre-renovation rate of
return on common equity is calculated as follows:
Return on Common Equity = 
= 24%
= 24%
Comparative Analysis:
A comparison of the two rates of
return would argue that the renovation not be undertaken. However, since investments in fixed assets
generally produce cash flows over many years, it is not appropriate to base
decisions about their acquisition on a single year’s ratios. There are additional problems with this
approach to fixed asset decision making which we will discover when we discuss
capital budgeting in a later chapter.
Instructor’s Note:
To help convince those students who simply cannot accept the fact that
the renovation may be worthwhile even though the return on common equity falls
in the first year, we note that the existing plant is recorded on the firm’s
books at original cost less accounting depreciation. In a period of rising replacement costs, this
means that the return on common equity of 24% without renovation may actually overstate
the true return earned on a more realistic "replacement cost" common
equity base. In addition, the issue is
probably one of when to renovate (this year or next) rather than whether or not
to renovate. That is, the existing
facility may require renovation in the next two years to continue to
operate. These considerations simply cannot
be incorporated in the ratio analysis performed here. We find this a very useful point to make at
this juncture of the course, since industry practice still frequently involves
use of rules of thumb and ratio guides to the analysis of capital expenditures.
3-8B. a. See
the accompanying table.
b. The most important ratios to consider in evaluating the
firm’s credit request relate to its liquidity and use of financial
leverage. However, the credit analyst
can also evaluate the firm’s profitability ratios as a general indication as to
how effective the firm’s management has been in managing the resources
available to it. This latter analysis
would be useful in evaluating the prospects for a long and fruitful
relationship with the new client.
Industry
Ratio Formula Calculation Average
Current
Ratio 
= 2.14 1.8
= 2.14 1.8
Acid-Test
Ratio 
= .87 .9
= .87 .9
Debt
Ratio 
= .50 .5
= .50 .5
= 12 10
= 
Inventory
Turnover 
= 5.38 7
= 5.38 7
Industry
Ratio Formula Calculation Average
= .2689 16.8%
or 26.89%
= .171 14%
or 17.1%
= .2857 25%
or 28.57%
= 1.57 1.2
= 2.41 1.8
Return
on Assets 
= .1857 6.0%
= .1857 6.0%
or 18.57%
Return
on Equity 
= .3712 12%
= .3712 12%
or 37.12%
3-9B. Reynolds Computer
RATIO 2003 Norm
Liquidity:
Current
Ratio 1.48 1.49
Acid-test
(Quick) Ratio 1.40 1.36
Average
Collection Period 38.69 53.38
Accounts
Receivable Turnover 9.43 6.84
Inventory
Turnover 50.87 20.87
Operating
profitability:
Operating
Income
Return on Investment 21.4% 9.0%
21.4% 9.0%
Operating
Profit Margin 9.7% 6.0%
Total
Asset Turnover 2.20 1.58
Accounts
Receivable Turnover 9.43 6.84
Inventory
Turnover 50.87 20.87
Fixed
Asset Turnover 33.02 13.02
Financing:
Debt
Ratio .54 .47
Times
Interest Earned 72.26 14.79
Rate
of return on common stockholders’ investment:
Return
on Common Equity 31.3% 13.0%
Liquidity – Based on the
current and acid-test ratios, Reynolds Computer is performing as well as the
industry average in the area of liquidity. At a detail level, Reynolds Computer
is doing much better than average in managing both receivables and inventory.
As you can observe, the acid-test ratio changes little from the current ratio.
Based upon the small effect that inventory has on the current ratio, we might
assume that Reynolds Computer is not holding a large amount of inventory. Upon
review of the balance sheet, inventory only accounts for 5% of total current
assets. Cash accounts for 54% of the total current assets making Reynolds
Computer much more liquid than the current ratio indicates.
Profitability – Reynolds
Computer seems to be doing an excellent job at operating profitability based on
the OIROI ratio. Let’s break down this
ratio into its two components We have already ascertained that Reynolds
Computer is managing its accounts receivable and inventory effectively. From
the fixed asset ratio, Reynolds Computer is also managing a much lower amount
of fixed assets as compared to sales than the industry. Overall, Reynolds
Computer is generating more sales from every $1 of assets than its competitors.
Reynolds Computer is also doing a good job at managing its income statement. The operating profit margin shows that
Reynolds Computer is controlling costs efficiently. Both the asset turnover and
profit margin contribute to Reynolds Computer’s favorable operating
profitability.
Financing – Reynolds
Computer finances more of its assets through debt than its competitors. This
involves more risk, but it can also provide higher returns as we will note in
the next section. Reynolds Computer must
be careful not to over-leverage itself. However, Reynolds Computer’s times
interest earned ratio indicates that Reynolds Computer can service its debt
more easily than the average firm.
Return on Investment- As noted above, Reynolds Computer finances more of its
assets through debt than the industry average. With more debt and less equity,
this will provide a higher return to its owners as long as the earned rate of
return is higher than the cost of debt. Based on the high operating
profitability and times interest earned ratios, we can assume this is the case.
As a result, the common equity owners are receiving a higher return on their
investment than the industry average.
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