You are on page 1of 32

CHAPTER 3

Evaluating A Firms 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 firms financial data at
different points in time and with other firms.

III.

We could use ratios to answer the following important questions about a firms
operations.
A.

B.

Question 1: How liquid is the firm?


1.

The liquidity of a business is defined as its ability to meet maturing debt


obligations. That isdoes 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 firms 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 firms liquid assets are being
converted into cash.

Question 2: Is management generating adequate operating profits on the firms


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

30

distribution expenses. Net income includes the unwanted effects of the


firms financing policies. This leaves operating profits as our best choice
in measuring the firms operating profitability. Thus, the appropriate
measure is the operating income return on investment (OIROI):
OIROI =
C.

D.

IV.

V.

operating income
total assets

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 firms capacity to service its
debt.

Question 4: Are the owners (stockholders) receiving an adequate return on their


investment?
1.

We want to know if the earnings available to the firms 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) = common equity

3.

We demonstrate the effect of using debt on net income through an


example showing how the use of debt affects a firms return on equity.

4.

Return on equity is presented as a function of:

net income

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.

An Integrative Approach to Ratio Analysis: The DuPont Analysis


A.

The DuPont analysis is another approach used to evaluate a firms 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 firms net profit margin, total asset turnover,
and debt ratio.

Limitations of Ratio Analysis


A.

This list warns of the many pitfalls that may be encountered in computing and
interpreting financial ratios.

31

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 firms
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 firms 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

32

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 RMAs
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 firms financial health.

3-4.

Liquidity is the ability to repay short-term debt. We measure liquidity by comparing the
firms liquid assetscash 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
firms assets, while the latter measures the profitability on the sales.

3-6.

We can compute operating income return on investment (OIROI) as:


Operating Income
Return on Invesment

Operating Income
Total Assets

or as:
Operating Income
Return on Investment

Operating
= Profit Margin

Total Asset
Turnover

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
firms assets), as measured by the asset turnover ratio.

33

3-7.

Gross profit margin measures a firms 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 firms financing costs,
such as interest expense. Thus, the gross profit margin measures the firms 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 firms 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 firms 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
AccountsReceivable*
Inventory
CurrentAssets
NetFixedAssets
TotalAssets

201,875
175,000
223,125
600,000
1,500,000
2,100,000

AccountsPayable
LongTermDebt
TotalLiabilities
CommonEquity

100,000
320,000
420,000
1,680,000

TotalLiability&Equity

2,100,000

*Basedon360days.
Currentratio
Totalassetturnover
Grossprofitmargin
Inventoryturnover
Averagecollectionperiod
Debtratio
Sales
Costofgoodssold
Totalliabilities

6
1
15%
8
30
20%
2,100,000
1,785,000
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)
34

x = $0.5 million, or $500,000


3-3A. Instructors 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
Debt ratio

current assets
current liabilities

total debt
total assets

$3,500
$2,000

$4,000
$8,000

operating income
interest expense

Times interest earned =


Average collection period

1.75X

.50 or 50%

$1,700
$367

accounts receivable
credit sales / 365

4.63X

$2,000
$8,000 / 365

= 91

days
Inventory turnover

cost of
goods sold
inventory

Fixed asset turnover

net sales
=
fixed assets

Total asset turnover

net sales
total assets

Gross profit margin

Operating
income return
on investment

Return on

equity

operating income
net sales

or, we can calculate return on equity as:


= Return on assets (1- debt ratio)
=
=

Total debt
Net income

1
Total assets
Total assets

800
1 - .50
8,000

= .20 or 20%

35

1.78X

$1,700
$8,000

$1,700
$8,000

3.3X

$4,700
$8,000

$800
$4,000

net income
=
common equity

$8,000
$8,000

operating income
total assets

$8,000
$4,500

gross profit
net sales

Operating profit margin

$3,300
$1,000

1X
.59 or 59%
=

.21 or 21%

.21 or 21%

.20 or 20%

3-4A. a.
b.

Total Assets Turnover


3.5

sales
=
total assets

$10m
$5m

= 2x

sales
$5m

Sales =

$17.5m

Thus, the needed sales growth is $7.5 million ($17.5m - $10m), or an increase of
75%:
$7.5m
$10m

c.

75%

For last year,


Operating Income
Return on Investment

operating
profit margin

total asset
turnover

10%

2.0

20%

If sales grow by 75%, then for next year-end assuming a 10% operating profit
margin:
Operating Income
Return on Investment

3-5A. a.

Average Collection
Period

operating
profit margin

total asset
turnover

10%

3.5

35%

Accounts Receivable
Credit Sales/365

Avg Collection Period

$562,500
(.75 x $9m)/365

Avg Collection Period

30 days

Note that the average collection period is based on credit sales, which are 75%
of total firm sales.
b.

Average
collection period

20

Accounts Receivable
(.75 x $9m)/365

Solving for accounts receivable:

Accounts
receivable

$369,863

Thus, Brenmar would reduce its accounts receivable by


$562,500 - $369,863

36

$192,637.

c.

Inventory Turnover
9
Inventories

Cost of Goods Sold


Inventories

.70 x Sales
Inventories

.70 x $9m
=
9

$700,000

3-6A. a.
RATIO
Liquidity:
Current Ratio
Acid-test (Quick) Ratio
Average Collection Period
Inventory Turnover

2002

2003

Industry
Norm

6.0x
3.25x
137 days
1.27x

4.0x
1.92x
107 days
1.36x

5.0x
3.0x
90 days
2.2x

Operating profitability:
Operating Profit Margin
Total Asset Turnover
Average Collection Period
Inventory Turnover
Fixed Asset Turnover

20.8%
.5x
137 days
1.27x
1.00x

24.8%
.56x
107 days
1.36x
1.04x

20.0%
.75x
90 days
2.2x
1.00x

Financing:
Debt Ratio
Times Interest Earned

0.33
5.0x

Return on common stockholders investment:


Return on Common Equity
7.5%

b.

0.35
5.63x
10.5%

0.33
7.0x
9.0%

Regarding the firms 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.

37

c.

In evaluating Pamplins 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:
Operating income
return on investment

Operating
profit margin

Total asset
turn over

Industry:

20%

0.75 = 15%

Pamplin 2002:

20.8%

0.50 = 10.4%

Pamplin 2003:

24.8%

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 firms 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 Pamplins management not using the firms 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 wellnote
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:
Pamplins times interest earned is below the industry norm5.0 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 companys times interest earned
is affected by (1) the level of the firms 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 firms 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, Pamplins low times interest
earned is not the consequence of using more debt.

3.

We do not have any information about Pamplins interest rate, so we


cannot make any observation about the effect of the interest rate. But

38

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 firms 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.

Salcos total asset turnover, operating profit margin, and operating income
return on investment.
Total Asset Turnover

Sales
Total Assets

$4,500,000
$2,000,000

2.25 times
Operating Income
Sales

Operating Profit Margin =

Operating Income
Return on Investment

or

$500,000
$4,500,000

11.11%

Operating Income
Total Assets

$500,000
$2,000,000

25%

Operating Income
Sales
x
Sales
Total Assets

.1111 X 2.25

25%

39

b.

The new operating income return on investment for Salco after the plant
renovation:
Operating Income
Return on Investment

c.

Operating Income
Sales

.13

.13 x 1.5

19.5%

Sales
Total Assets

$4,500,000
$3,000,000

Return earned on the common stockholders investment:


Post-Renovation Analysis:
Return on common
equity

Net Income Available


= to Common Stockholders
Common Equity

$217,500
$1,000,000 $500,000

14.5%

Net income available to common stockholders following the renovation was


calculated as follows:
Operating Income (.13 x $4.5m)
Less: Interest ($100,000 + $50,000)

$ 585,000
(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)


Increase in equity to finance purchase

(500,000)
$ 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.

40

Pre-renovation Analysis:
The pre-renovation rate of return on common equity is calculated as follows:
Return on Common Equity

$200,000
=
$1,000,000

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 years 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.
Instructors 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 firms 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
Instructors 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 firms credit request
relate to its liquidity and use of financial leverage. However, the credit analyst
can also evaluate the firms profitability ratios as a general indication as to how
effective the firms 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.

41

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 Jarmons only
deficiency, that relating to its relatively large investment in inventories.
However, even this potential weakness is largely overcome by the firms
strengths. The firms return on assets and its return on owner capital (return on
common equity) both compare well with the respective industry norms.
Instructors 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.

42

Ratio

Formula

$138,300
$75,000

Current Ratio
Acid-Test Ratio

Current Assets - Inventory


Current Liabilities

Industry
Average

Calculation
= 1.84

$138,300 84,000
$75,000
$225,000
$408,300

Debt Ratio
$80,000
$10,000

= 8

43

Accounts Receivable
Credit Sales per Day

1.8
= .72

= .55

.9
.5

10
$33,000
$600,000 / 365

20.1
days

20
days

Inventory Turnover

$460,000
$84,000

= 5.48

Operating Income
Return on Investment

$80,000
$408,300

= .196

16.8%

= .133

14%

or

19.6%

$80,000
$600,000

or

13.3%

Ratio

Formula

Calculation
$140,000
$600,000

or

44

Return on Assets

Net Income
Total Assets

= .233

Industry
Average
25%

23.3%

$600,000
$408,300

= 1.47

1.2

$600,000
$270,000

= 2.22

1.8

$42,900
$408,300

= .1051

6%

or 10.51%

Return on Equity

Earnings Available to
Common Stockholders
Common Equity

$42,900
$183,300

= .234

or 23.4%

12%

Return on Equity
23.4%

Return on Assets
10.51%

Net Profit Margin


7.15%

Net Income

Equity
Total Assets
0.45

divided by

Total Asset Turnover

multipled by

1.47

divided by

$42,900

Sales
$600,000

Sales
$600,000

divided by Total Assets


$408,300

Sales
$600,000

Fixed Assets

Current Assets
$138,300

$270,000

Other Assets
$0

less
Total costs and expenses
$557,100
Cost of goods sold
$460,000

Cash and
Marketable
Securites
$20,200

Accounts
Receivable
$33,000

Cash operating expenses


$30,000
Depreciation
$30,000

Inventory
Collection Period

Sales
$600,000

Fixed
Assets
$270,000

Other Current
Assets
$1,100

20.08 days

Interest Expense
$10,000
Taxes
$27,100

$84,000

Fixed Assets
Turnover
2.22

Inventory Turnover
5.48

Daily Credit
Accounts
Sales
Receivables divided by
$33,000
$1,644

Cost of
Goods Sold divided by
$460,000

45

Inventory
$84,000

39A. HiTech
RATIO
Liquidity:
Current Ratio
Acid-test (Quick) Ratio
Average Collection Period
Accounts Receivable Turnover
Inventory Turnover

2003

Industry
Norm

2.51
2.30
45.95
7.94
6.13

2.01
1.66
72.64
5.02
4.42

Operating profitability:
Operating Income
Return on Investment
Operating Profit Margin
Total Asset Turnover
Accounts Receivable Turnover
Inventory Turnover
Fixed Asset Turnover

23.2%
34.6%
.67
7.94
6.13
2.51

9.0%
13.0%
.69
5.02
4.42
2.27

Financing:
Debt Ratio
Times Interest Earned

.26
247.78

Return on common stockholders investment:


Return on Common Equity

22.4%

.44
8.87
12.0%

TheaboveanalysisofHiTechrevealsastrongcompanyinmanyareas.First,letslookatthe
liquidityquestion. HowliquidisHiTechsbalancesheet? Thecurrentratiosurpassesthe
industry,andwhenwesubtractinventoriesintheacidtestratio,HiTechstillsurpassesthe
industry. Itisthesamewiththeinventoryturnoverratio. ThissuggeststhatHiTechhasa
lowerthannormalinventorylevel.Thereceivableturnoverandaveragecollectionperiodalso
revealthatHiTechcontrolsthisassetbetterthanitscompetitors. Theseratiostellusthat
HiTechsliquidityreliesonassetsotherthaninventoryandreceivables.Whenwereviewthe
balancesheet,thisassumptionissupportedforweseethat$11.8millionofthe$17.8million
of HiTechs 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
marginratios. TheOIROIratiotellsusthateitherHiTechmustbedoingasuperiorjobat
sales,expenses,orgeneratinggreatersalesfromalowerassetlevel.Whenwelookatthetotal
asset turnover, HiTech rates slightly lower than normal. HiTech is generating the same
proportionatelevelofsalesfromthesamelevelofassetsasitscompetitors. Weknowthat
HiTechisdoingagoodjobofturningoveritscurrentassets.Thefixedassetturnovertellsus
thatpartoftheproblemisintheleveloffixedassetsthatHiTechismaintaining.Aswelook
atthebalancesheet,weseethatHiTechalsomaintainsahighlevelofotherinvestments.
HiTechmustbedoinganexcellentjobatcontrollingcosts,whichissupportedbytheexcellent
operatingprofitmarginratio.Wenowlookatthefinancingquestion.HiTechismaintaininga
lowlevelofdebtascomparedtotheindustryandismorethanabletoserviceitsinterest
expense. ThismeansthatHiTechisfinancingitsassetsthroughequity. Letslookatthe
returnthattheseownersarereceivingfromtheirinvestmentthroughthefinalratio.HiTech
alsoratesfavorablyonreturnoncommonequity,22.4%ascomparedtothe12.0%industry
average.
46

INTEGRATIVE PROBLEM
1.
Blake International

1999

2000

2001

2002

2003

Current ratio
3.11
2.83
2.54
Acid-test ratio
1.64
1.78
1.56
Average collection period
53.16
62.00
56.29
Accounts receivable turnover
6.87
5.89
6.48
Inventory turnover
3.28
3.87
4.00
Operating income return on
0.22
0.15
0.16
investment
Gross profit margin
0.40
0.39
0.38
Operating profit margin
0.10
0.08
0.08
Total asset turnover
2.10
1.95
2.07
Fixed asset turnover
18.13
18.81
23.21
Debt ratio
0.43
0.79
0.71
Times interest earned
14.00
6.31
4.31
Return on equity
0.18
0.36
0.27
Note: Above ratio calculations may be subject to rounding errors.

2.22
1.35
58.63
6.23
3.73
0.08

1.99
1.33
52.48
6.95
4.21
0.09

0.38
0.04
1.85
18.64
0.69
2.30
0.04

0.40
0.05
1.85
16.29
0.66
2.78
0.02

Question #1
It is apparent that Blakes 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 Blakes 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.
47

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,
Blakes 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
Acid-test ratio
1.28
1.22
1.33
Average collection period
80.75
75.92
69.69
Accounts receivable turnover
4.52
4.81
5.24
Inventory turnover
4.45
4.11
4.01
Operating income return on
0.21
0.24
0.25
investment
Gross profit margin
0.41
0.41
0.42
Operating profit margin
0.14
0.14
0.15
Total asset turnover
1.51
1.64
1.71
Fixed asset turnover
8.58
10.06
9.96
Debt ratio
0.37
0.38
0.41
Times interest earned
27.54
23.45
24.73
Return on equity
0.20
0.23
0.25
Note: Above ratio calculations may be subject to rounding errors.

2.07
1.25
63.96
5.71
4.21
0.16

2.26
1.43
64.71
5.64
4.42
0.16

0.38
0.09
1.77
8.28
0.40
12.60
0.12

0.40
0.10
1.67
6.93
0.36
16.41
0.14

Question #1
Scotts 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.

48

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 Scotts and Blakes financial performance are easy to find. Scott
continues to be a thriving company while Blake seems to have many financial problems.
Scotts sales have grown 84% while Blakes sales have decreased by 17%. However,
they also have many similarities. Lets 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 OIROIs 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 Scotts 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 Scotts and Blakes times interest earned have decreased due to increasing
operating expenses, Blake is dangerously close to losing its ability to service its debt.
Return on Investment Once again, Scott and Blake are more similar than different,
except as to the severity of the amount. Scott and Blake have decreased their return on
investment. Blake has increased its debt while Scotts stayed the same. Both have
decreased their net income as compared to sales. This is the result of increased
operating and interest costs, as gross profit margins have stayed the same.

49

Solutions for Set B


3-1B. Cash
AccountsReceivable*
Inventory
CurrentAssets
NetFixedAssets
TotalAssets

174,363
80,137
45,500
300,000
1,000,000
1,300,000

AccountsPayable
LongTermDebt
TotalLiabilities
CommonEquity
TotalLiability&Equity

100,000
290,000
390,000
910,000
1,300,000

*Basedon360days.
Currentratio
Totalassetturnover
Grossprofitmargin
Inventoryturnover
Averagecollectionperiod
Debtratio
Sales
Costofgoodssold
Totalliabilities

3
0.5
30%
10
45
30%
650,000
455,000
390,000

3-2B. Allandales 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 firms line of credit (which also equals the
addition to current assets), we can solve for that level of x which forces the firms current
ratio down to 2 to 1, i.e.,
2 = ($3.0 million + x) / ($1.09 million + x)
x = $.82 million
3-3B. Instructors 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

Debt Ratio

Times Interest Earned

$3,500
$1,800

=
=

= 1.94X

$3,900
$8,000

$1,500
$367

Average Collection Period =

= 4.09X
$1,500
$7,500 365

days
Inventory Turnover =

Fixed Asset Turnover = =


Total Asset Turnover =

Net Sales
=
Total Assets

50

= .49 or 49%

$3,000
$1,000

= 3.0X

$7,500
$4,500

= 1.67X

$7,500
$8,000

= .94X

= 73

Gross Profit Margin =


=

$4,500
Gross Profits
=
$
7,500
Net Sales

= .60 or 60%

$1,500
$7,500

= .20 or 20%

Operating Income
=
Net Sales

= =

$1,500
$8,000

= .19 or 19%
$680
$4,100

Return on Equity = =

=.17 or 17%

or, we can calculate return on equity as:

3-4B. a.

b.

Return on assets (1- debt ratio)

Total debt
Net income

1
Total assets
Total assets

680
1 - .49 =
8,000

Total Assets Turnover

2.5
Sales

.17 or 17%

Sales
Total Assets

$11m
$6m

= 1.83X

=
=

$15m

Thus, the needed sales growth is $4 million ($15m - $11m) or an increase of


36%:
= 36%

51

c.

Last year,
=

6%

11%

1.83

If sales grow by 36%, then for next year-end assuming a 6% operating profit
margin:
=

3-5B. a.

6%

15%

Average Collection
Period

Avg Collection Period

$562,500
(.75 x $9.75m)/365

Avg Collection Period

28.08 days

2.5

Note that the average collection period is based on credit sales, which are 75%
of total firm sales.
b.

= 20 =

Accounts Receivable
(.75 x $9.75m)/365

Solving for accounts receivable:


Accounts
=
Receivable

$400,685

Thus, Brenda Smith, Inc. would reduce its accounts receivable by


$562,500 - $400,685 =
c.

Inventory Turnover
8
Inventories

$161,815

=
=
=

52

$914,062.50

3-6B. a.
RATIO
Liquidity:
Current Ratio
Acid-test (Quick) Ratio
Average Collection Period
Inventory Turnover

2002

2003

5.00
2.70
131.40
1.22

5.35
2.63
108.24
1.40

5.00
3.00
90.00
2.20

Operating profitability:
Operating Income
Return on Investment
Operating Profit Margin
Total Asset Turnover
Average Collection Period
Inventory Turnover
Fixed Asset Turnover

12.24%
24.00%
.51
131.40
1.22
1.04

13.04%
22.76%
.57
108.24
1.40
1.12

15.00%
20.00%
.75
90.00
2.20
1.00

34.69%
6.00

32.81%
5.50

33.00%
7.00

9.53%

13.43%

Financing:
Debt Ratio
Times Interest Earned

Rate of return on common stockholders investment:


Return on Common Equity
9.38%
b.

Industry
Norm

Regarding the firms 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.

53

c.

In evaluating Chavezs 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:
=

Industry:

20.00%

0.75 = 15.00%

Chavez 2002:

24.00%

0.51 = 12.24%

Chavez 2003:

22.76%

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 firms 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 Chavezs management not using the firms 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 wellnote
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:
Chavezs times interest earned is below the industry norm6.0 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 companys times interest earned is
affected by (1) the level of the firms 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 firms 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, Chavezs low times interest
earned is not the consequence of using more debt.

3.

We do not have any information about Chavezs 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.
54

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 firms 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.

Mels total asset turnover, operating profit margin, and operating income return
on investment.
Total Asset Turnover

=
=

$5,000,000
$2,000,000

2.50 times

Operating Profit Margin =


=

$500,000
$5,000,000

10.00%

Operating Income
Return on Investment =

or

$500,000
$2,000,000

25%

=
=

b.

Operating Income
Total Assets

X
10%

2.50 = 25%

The new operating income return on investment for Mels after the plant
renovation:
=

.13 X

.13 X 1.67

21.67%

55

$5,000,000
$3,000,000

c.

Return earned on the common stockholders investment:


Post-Renovation Analysis:
Return on Common Equity

Net Income Available to Common Stockholders


Common Equity

=
=

$306,000
$1,000,000 $500,000

.204 = 20.4%

Net income available to common stockholders following the renovation was


calculated as follows:
Operating Income (.13 x $5m)
Less: Interest ($100,000 + $40,000)
Earnings Before Taxes
Less: Taxes (40%)
Net Income Available to Common Stockholders

$ 650,000
(140,000)
510,000
(204,000)
$ 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)


Increase in equity to finance purchase

(500,000)
$ 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

56

$240,000
=
$1,000,000

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 years 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.
Instructors 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 firms 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.
b.

See the accompanying table.


The most important ratios to consider in evaluating the firms credit request
relate to its liquidity and use of financial leverage. However, the credit analyst
can also evaluate the firms profitability ratios as a general indication as to how
effective the firms 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.

57

Ratio

Formula

Acid-Test Ratio

Current Assets Inventory


Current Liabilities

Debt Ratio

58

Operating Income
Interest Expense

Inventory Turnover

Calculation
$156,300
$73,000

Current Ratio

Industry
Average

= 2.14

1.8

$156,300 93,000
= .87
$73,000

.9

$223,000
$446,300

= .50

.5

$120,000
$10,000

= 12

10

$38,000
$700,000 / 365

$500,000
$93,000

5.38

19.81
days

20
days
7

Ratio

Formula

$120,000
$446,300

Operating Income
Return on Investment

or
$120,000
$700,000

or
$200,000
$700,000

or

59
Return on Assets

Net Income
Total Assets

Return on Equity

= .2689

16.8%

26.89%
=

.171

14%

17.1%
=

.2857

25%

28.57%

$700,000
$446,300

= 1.57

1.2

$700,000
$290,000

= 2.41

1.8

$82,900
$446,300

= .1857

or

Earnings Available to
Common Stockholders
Common Equity

Industry
Average

Calculation

$82,900
$223,300

or

6.0%

18.57%
=

.3712

37.12%

12%

Return on Equity
37.1%

Return on Assets
18.57%

Net Profit Margin


11.84%

Net Income

Equity
Total Assets
0.50

divided by

Total Asset Turnover

multipled by

1.57

divided by

$82,900

Sales
$700,000

Sales
$700,000

Fixed Assets

Current Assets
$156,300

less

divided by Total Assets


$446,300

Sales
$700,000

Other Assets
$0

$290,000

Fixed Assets
Turnover
2.41

Total costs and expenses


$617,100
Cost of goods sold
$500,000

Cash and
Marketable
Securites
$24,200

Accounts
Receivable
$38,000

Cash operating expenses


$50,000
Depreciation
$30,000

Inventory
Collection Period

$93,000

Fixed
Assets
$290,000

Other Current
Assets
$1,100

19.81 days

Interest Expense
$10,000
Taxes
$27,100

Sales
$700,000

Inventory Turnover
5.38

Daily Credit
Accounts
Sales
Receivables divided by
$38,000
$1,918

Cost of
Goods Sold divided by
$500,000

60

Inventory
$93,000

3-9B. Reynolds Computer


RATIO
2003
Liquidity:
Current Ratio
1.48
Acid-test (Quick) Ratio
1.40
Average Collection Period
38.69
Accounts Receivable Turnover
9.43
Inventory Turnover
50.87
Operating profitability:
Operating Income
Return on Investment
21.4%
Operating Profit Margin
9.7%
Total Asset Turnover
2.20
Accounts Receivable Turnover
9.43
Inventory Turnover
50.87
Fixed Asset Turnover
33.02
Financing:
Debt Ratio
.54
Times Interest Earned
72.26
Rate of return on common stockholders investment:
Return on Common Equity
31.3%

Norm
1.49
1.36
53.38
6.84
20.87

9.0%
6.0%
1.58
6.84
20.87
13.02
.47
14.79
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. Lets 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 Computers 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 Computers 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.

61

You might also like