BFM 1014 FUNDAMENTALS OF FINANCE

Trimester 2, 2016-2017

CHAPTER 3: UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOW

CRITICAL THINKING AND CONCEPT REVIEW

1. What effect would the following actions have on a firm’s current ratio? Assume that net
working capital is positive.
a. inventory purchase
b. a supplier paid
c. a short term loan bank is repaid
d. a long term debt is paid off early
e. a customer pays off a credit account

1. a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is
purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.

b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.

c. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.

d. As long-term debt approaches maturity, the principal repayment and the remaining interest
expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was
initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce
the current ratio since current liabilities are not affected.

e. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.

f. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.

g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio
increases.

4. Fully explain the kind of information the following financial ratios provide about a firm.
a. Quick ratio
b. Cash ratio
c. Capital intensity ratio
d. Total asset turnover
e. Equity multiplier
f. Times interest earned ratio
g. Profit margin
h. Return on assets
i. Return on equity
j. Price earnings ratio

4. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the
effects of inventory, generally the least liquid of the firm’s current assets.

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 b. Cash ratio represents the ability of the firm to completely pay off its current liabilities balance with
its most liquid asset (cash).

c. The capital intensity ratio tells us the dollar amount investment in assets needed to generate one
dollar in sales.

d. Total asset turnover measures how much in sales is generated by each dollar of firm assets.

e. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the
dollar worth of firm assets each equity dollar has a claim to.

f. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings
can cover current interest obligations.

g. Profit margin is the accounting measure of bottom-line profit per dollar of sales.

h. Return on assets is a measure of bottom-line profit per dollar of total assets.

i. Return on equity is a measure of bottom-line profit per dollar of equity.

j. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting
earnings for a firm.

7. Why is DuPont identity a valuable tool for analysing the performance of a firm? Discuss the
types of information it reveals as compared to ROE considered by itself.

Return on equity is probably the most important accounting ratio that measures the bottom-
line performance of the firm with respect to the equity shareholders. The Du Pont identity
emphasizes the role of a firm’s profitability, asset utilization efficiency, and financial leverage
in achieving a ROE figure. For example, a firm with ROE of 20% would seem to be doing well,
but this figure may be misleading if it were a marginally profitable (low profit margin) and
highly levered (high equity multiplier). If the firm’s margins were to erode slightly, the ROE
would be heavily impacted.

QUESTIONS AND PROBLEM

1. SDJ. Inc has net working capital of $1,730, current liabilities of $5,140 and inventory of $2,170.
What is the current ratio? What is the quick ratio?

To find the current assets, we must use the net working capital equation. Doing so, we find:
NWC = Current assets – Current liabilities
$1,730 = Current assets – $5,140
Current assets = $6,870

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 Now, use this number to calculate the current ratio and the quick ratio. The current ratio is:

Current ratio = Current assets / Current liabilities

Current ratio = $6,870 / $5,140
Current ratio = 1.34 times

And the quick ratio is:

Quick ratio = (Current assets – Inventory) / Current liabilities

Quick ratio = ($6,870 – 2,170) / $5,140
Quick ratio = .91 times

2. Remi, Inc has sales of $15 million, total assets of $9 million and total debt of $3.7 million. If the
profit margin is 7% what is the net income? What is the ROA? What is the ROE?

To find the return on assets and return on equity, we need net income. We can calculate the
net income using the profit margin. Doing so, we find the net income is:

Profit margin = Net income / Sales

.07 = Net income / $15,000,000
Net income = $1,050,000

Now we can calculate the return on assets as:

ROA = Net income / Total assets

ROA = $1,050,000 / $9,000,000
ROA = .1167, or 11.67%

We do not have the equity for the company, but we know that equity must be equal to total
assets minus total debt, so the ROE is:

ROE = Net income / (Total assets – Total debt)

ROE = $1,050,000 / ($9,000,000 – 3,700,000)
ROE = .1981, or 19.81%

3. Pujols Lomber Yard has a current accounts receivable balance of $527,167. Credit sales for the
year ended were $5,938,261. What is the receivables turnover? The days’ sales in receivables?
How long did it take on average for credit customers to pay off their accounts during the past
year?

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Receivables turnover = Credit sales / Receivables
Receivables turnover = $5,938,261 / $527,167
Receivables turnover = 11.26 times

Using the receivables turnover, we can calculate the days’ sales in receivables as:

Days’ sales in receivables = 365 days / Receivables turnover

Days’ sales in receivables = 365 days / 11.26
Days’ sales in receivables = 32.40 days

The average collection period, which is the same as the days’ sales in receivables, was 32.40
days.

4. Allen Inc has a total debt ratio of 0.34. What its debt-equity ratio? What is its equity
multiplier?

To find the debt-equity ratio using the total debt ratio, we need to rearrange the total debt
ratio equation. We must realize that the total assets are equal to total debt plus total equity.
Doing so, we find:
Total debt ratio = Total debt / Total assets
.34 = Total debt / (Total debt + Total equity)
.66(Total debt) = .34(Total equity)
Total debt / Total equity = .34 / .66
Debt-equity ratio = .52
And the equity multiplier is one plus the debt-equity ratio, so:
Equity multiplier = 1 + D/E
Equity multiplier = 1 + .52
Equity multiplier = 1.52

5. Rossdale Inc had additional to the retained earnings for the year just ended of $575,000.
The firm paid out $140,000 in cash dividends, and it has ending total equity of $7.3 million. If
the company currently has 490,000 shares of common stock outstanding, what are the earning
per share? Dividend per share? What is the book value per share? If the stock currently sells
for $47 per share, what is the market to book ratio? The price earnings ratio? If the total sales
were $15.4 million, what is the price sales ratio?

We need to calculate the net income before we calculate the earnings per share. The sum of
dividends and addition to retained earnings must equal net income, so net income must have
been:

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Net income = Addition to retained earnings + Dividends
Net income = $575,000 + 140,000
Net income = $715,000

So, the earnings per share were:

EPS = Net income / Shares outstanding

EPS = $715,000 / 490,000
EPS = $1.46 per share

The dividends per share were:

Dividends per share = Total dividends / Shares outstanding

Dividends per share = $140,000 / 490,000
Dividends per share = $.29 per share

The book value per share was:

Book value per share = Total equity / Shares outstanding

Book value per share = $7,300,000 / 490,000
Book value per share = $14.90 per share

The market-to-book ratio is:

Market-to-book ratio = Share price / Book value per share

Market-to-book ratio = $47 / $14.90
Market-to-book ratio = 3.15 times

The P/E ratio is:

P/E ratio = Share price / EPS

P/E ratio = $47 / $1.46
P/E ratio = 32.21 times

Sales per share are:

Sales per share = Total sales / Shares outstanding

Sales per share = $15,400,000 / 490,000
Sales per share = $31.43

The P/S ratio is:

P/S ratio = Share price / Sales per share

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 P/S ratio = $47 / $31.43
P/S ratio = 1.50 times

6. Bobaflex Corporation has ending inventory of $426,163 and cost of goods sold for the year
ended was $6,238,615. What is the inventory turnover? The days’ sales in inventory? How long
on average did a unit of inventory sit on the shelf before it was sold?

The inventory turnover for the company was:

Inventory turnover = COGS / Inventory

Inventory turnover = $6,238,615 / $426,163
Inventory turnover = 14.64 times

Using the inventory turnover, we can calculate the days’ sales in inventory as:

Days’ sales in inventory = 365 days / Inventory turnover

Days’ sales in inventory = 365 days / 14.64
Days’ sales in inventory = 24.93 days

On average, a unit of inventory sat on the shelf 24.93 days before it was sold.

7. If JPhone Inc. has an equity multiplier of 1.65, total asset turnover of 1.8 and a profit margin of
6%, what is its ROE?

With the information given, we must use the Du Pont identity to calculate return on equity.
Doing so, we find:

ROE = (Profit margin)(Total asset turnover)(Equity multiplier)

ROE = (.06)(1.80)(1.65)
ROE = .1782, or 17.82%

10. Rainbow Company has debt equity ratio of 0.95. Return on assets is 7.5% and total equity if
$735,000. What is the equity multiplier, Return on Equity? Net Income?

With the information provided, we need to calculate the return on equity using an extended
return on equity equation. We first need to find the equity multiplier which is:

Equity multiplier = 1 + Debt-equity ratio

Equity multiplier = 1 + .95
Equity multiplier = 1.95
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 Now we can calculate the return on equity as:

ROE = (ROA)(Equity multiplier)

ROE = .075(1.95)
ROE = .1463, or 14.63%

The return on equity equation we used was an abbreviated version of the Du Pont identity. If
we multiply the profit margin and total asset turnover ratios from the Du Pont identity, we get:

(Net income / Sales)(Sales / Total assets) = Net income / Total assets = ROA

With the return on equity, we can calculate the net income as:

ROE = Net income / Total equity

.1463 = Net income / $735,000
Net income = $107,494

11. If Nuber Inc. has an ROA of 8% and a payout ratio of 25%, what is its internal growth rate?

To find the internal growth rate, we need the plowback, or retention, ratio. The plowback ratio
is:
b = 1 – .25
b = .75

Now, we can use the internal growth rate equation to find:

Internal growth rate = [(ROA)(b)] / [1 – (ROA)(b)]

Internal growth rate = [.08(.75)] / [1 – .08(.75)]
Internal growth rate = .0638, or 6.38%

12. If the Crash Davis Driving School has an ROE of 14.5% and a payout ratio 30%, what is its
sustainable growth rate?

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To find the sustainable growth rate we need the plowback, or retention, ratio. The plowback ratio
is: b = 1 – .30

b = .70

Now, we can use the sustainable growth rate equation to find:

Sustainable growth rate = [(ROE)(b)] / [1 – (ROE)(b)]

Sustainable growth rate = [.145(.70)] / [1 – .145(.70)]

Sustainable growth rate = .1130, or 11.30%

15. Prepare 2013 and 2014 common size balance sheet for Bethesda Mining Company.

To calculate the common-size balance sheet, we divide each asset account by total assets, and each liability
and equity account by total liabilities and equity. For example, the common-size cash percentage for 2013 is:

Cash percentage = Cash / Total assets

Cash percentage = $21,396 / $917,617
Cash percentage = .0233, or 2.33%

Repeating this procedure for each account, we get:

2013 2014
Assets
Current assets
Cash $21,396 2.33% $24,385 2.48%
Accounts receivable 51,552 5.62% 58,318 5.93%
Inventory 121,807 13.27% 143,615 14.60%
Total $194,755 21.22% $226,318 23.01%
Fixed assets
Net plant and equipment $722,862 78.78% $757,328 76.99%
Total assets $917,617 100% $983,646 100%

Liabilities and owners' equity

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 Current liabilities
Accounts payable $214,414 23.37% $192,480 19.57%
Notes payable 99,022 10.79% 134,508 13.67%
Total $313,436 34.16% $326,988 33.24%
Long-term debt $271,700 29.61% $285,300 29.00%
Owners' equity
Common stock and paid-in
surplus $200,000 21.80% $200,000 20.33%
Accumulated retained earnings 132,481 14.44% 171,358 17.42%
Total $332,481 36.23% $371,358 37.75%
Total liabilities and owners' equity $917,617 100% $983,646 100%
16. Based on the balance sheets given for Bethesda Mining, calculate the following ratios for each
year.
a. Current ratio
b. Quick ratio
c. Cash ratio
d. Debt equity ratio and equity multiplier
e. Total debt ratio

a. The current ratio is calculated as:

Curent ratio = Current assets / Current liabilities

Current ratio2013 = $194,755 / $313,436

Current ratio2013 = .62 times

Current ratio2014 = $226,318 / $326,988

Current ratio2014 = .69 times

b. The quick ratio is calculated as:

Quick ratio = (Current assets – Inventory) / Current liabilities

Quick ratio2013 = ($194,755 – 121,807) / $313,436

Quick ratio2013 = .23 times

Quick ratio2014 = ($226,318 – 143,615) / $326,988

Quick ratio2014 = .25 times

c. The cash ratio is calculated as:

Cash ratio = Cash / Current liabilities

Cash ratio2013 = $21,396 / $313,436

Cash ratio2013 = .07 times

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 Cash ratio2014 = $24,385 / $326,988
Cash ratio2014 = .07 times

d. The debt-equity ratio is calculated as:

Debt-equity ratio = Total debt / Total equity

Debt-equity ratio = (Current liabilities + Long-term debt) / Total equity

Debt-equity ratio2013 = ($313,436 + 271,700) / $332,481

Debt-equity ratio2013 = 1.76 times

Debt-equity ratio2014 = ($326,988 + 285,300) / $371,358

Debt-equity ratio2014 = 1.65 times

And the equity multiplier is:

Equity multiplier = 1 + Debt-equity ratio

Equity multiplier2013 = 1 + 1.76

Equity multiplier2013 = 2.76 times

Equity multiplier2014 = 1 + 1.65

Equity multiplier2014 = 2.65 times

e. The total debt ratio is calculated as:

Total debt ratio = Total debt / Total assets

Total debt ratio = (Current liabilities + Long-term debt) / Total assets

Total debt ratio2013 = ($313,436 + 271,700) / $917,617

Total debt ratio2013 = .64 times
Total debt ratio2014 = ($326,988 + 285,300) / $983,646
Total debt ratio2014 = .62 times

17. Suppose that the Bethesda Mining Company had sales of $2,945,376 and net income of
$89,351 for the year ending December 31,2014. Calculate the DuPont identity.

Using the Du Pont identity to calculate ROE, we get:

ROE = (Profit margin)(Total asset turnover)(Equity multiplier)
ROE = (Net income / Sales)(Sales / Total assets)(Total asset / Total equity)
ROE = ($89,351 / $2,945,376)($2,945,376 / $983,646)($983,646 / $371,358)
ROE =.2406, or 24.06%

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