Solution manual financial management 10e by keown chapter 03

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.

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 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.

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

30


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.

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 firm’s 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 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:

net income
common equity

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 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.

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 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

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
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:
Operating Income
=
Return on Invesment

Operating Income
Total Assets

Operating Income
=
Return on Investment

Operating
Profit Margin

or as:
X

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 firm’s assets), as measured by the asset turnover ratio.

33


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
Accounts Receivable *
Inventory
Current Assets
Net Fixed Assets
Total Assets

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

Accounts Payable
Long-Term Debt
Total Liabilities
Common Equity

100,000
320,000
420,000

1,680,000

Total Liability & Equity

2,100,000

* Based on 360 days.
Current ratio
Total asset turnover
Gross profit margin
Inventory turnover
Average collection period
Debt ratio
Sales
Cost of goods sold
Total liabilities

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)
x = $0.5 million, or $500,000

34


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.
Current ratio =
Debt ratio =

current assets
current liabilities

total debt
total assets

Average collection period

=

Fixed asset turnover

=

net sales
=

fixed assets

Total asset turnover

=

net sales
total assets

Gross profit margin

=

gross profit
net sales

Operating profit margin =

$8,000
$4,500

operating income
net sales

Operating
operating income
income return =
total assets
on investment

=

Return on
net income
=
equity
common equity

$800
$4,000

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

$8,000
$8,000
$4,700
$8,000

=

=

= .20 or 20%

35

=

$3,300
$1,000

=

.50 or 50%

$1,700
$367

=

=

1.75X

=

accounts receivable
credit sales / 365

cost of
goods sold
inventory

=

=

$4,000
$8,000

=

operating income
interest expense

Times interest earned =

Inventory turnover

$3,500
$2,000

=

=

4.63X

$2,000
= 91 days
$8,000 / 365
=

=

3.3X

1.78X
=

1X

=

.59 or 59%

$1,700
=
$8,000

.21 or 21%

$1,700
$8,000
=

=

=

.21 or 21%

.20 or 20%


3-4A. a.
b.

Total Assets Turnover
3.5

$10m
$5m

sales
=
total assets

=

= 2x

sales
$5m

=

Sales =

$17.5m

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

c.

$7.5m
$10m

=

Operating Income
Return on Investment

=

75%

For last year,
operating
profit margin

=

10%

=

20%

X

total asset
turnover

X

2.0

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

3-5A. a.

=

operating
profit margin

X

total asset
turnover

=

10%

X

3.5

=

35%

Average Collection
Accounts Receivable
=
Period
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 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.

37


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:

Operating income
return on investment

=

Operating
profit margin

Total asset
turn over

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.

38


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

=

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 x

=

.13 x 1.5

=

19.5%

x

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)

$ 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)
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 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.

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 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.

42


Ratio

Formula

$138,300
$75,000

Current Ratio

Acid-Test Ratio

Current Assets - Inventory
Current Liabilities

$80,000
$10,000

= 8

43

Accounts Receivable
Credit Sales per Day

Inventory Turnover
Operating Income
Return on Investment

= 1.84

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

Debt Ratio

Industry
Average

Calculation

1.8

= .72

= .55

.9

.5

10
$33,000

$600,000 / 365
$460,000
$84,000

=

= 5.48

$80,000
= .196
$408,300
or 19.6%
$80,000
= .133
$600,000
or 13.3%

20.1
days

20
days
7

16.8%

14%


Ratio

Formula

Calculation
$140,000
= .233
$600,000
or 23.3%

44

Return on Assets

Net Income
Total Assets

Return on Equity

Earnings Available to
Common Stockholders
Common Equity

Industry
Average
25%

$600,000
$408,300

= 1.47

1.2

$600,000
$270,000

= 2.22

1.8

$42,900
= .1051
$408,300
or 10.51%
$42,900
$183,300

= .234

or 23.4%

6%

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


3-9A. 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%

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.

46


INTEGRATIVE PROBLEM
1.
Blake International

1999

2000

2001

2002

2003

Current ratio
3.11
2.83
2.54
2.22
Acid-test ratio
1.64
1.78
1.56
1.35
Average collection period
53.16
62.00
56.29
58.63
Accounts receivable turnover
6.87
5.89
6.48

6.23
Inventory turnover
3.28
3.87
4.00
3.73
Operating income return on
0.22
0.15
0.16
0.08
investment
Gross profit margin
0.40
0.39
0.38
0.38
Operating profit margin
0.10
0.08
0.08
0.04
Total asset turnover
2.10
1.95
2.07
1.85
Fixed asset turnover
18.13
18.81 23.21

18.64
Debt ratio
0.43
0.79
0.71
0.69
Times interest earned
14.00
6.31
4.31
2.30
Return on equity
0.18
0.36
0.27
0.04
Note: Above ratio calculations may be subject to rounding errors.

1.99
1.33
52.48
6.95
4.21
0.09
0.40
0.05
1.85
16.29
0.66
2.78

0.02

Question #1
It is apparent that Blake’s liquidity is decreasing over time, as the current and acidtest 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.
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, 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

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.

2002

2003

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
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.

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 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.
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 Scott’s 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
Accounts Receivable *
Inventory
Current Assets
Net Fixed Assets
Total Assets

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

Accounts Payable
Long-Term Debt

Total Liabilities
Common Equity

100,000
290,000
390,000
910,000

Total Liability & Equity

1,300,000

* Based on 360 days.
Current ratio
Total asset turnover
Gross profit margin
Inventory turnover
Average collection period
Debt ratio
Sales
Cost of goods sold
Total liabilities

3
0.5
30%
10
45
30%
650,000

455,000
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

=

Debt Ratio

=

$3,500
$1,800

=

=

Times Interest Earned =

=

Average Collection Period =
Inventory Turnover =

$3,900
= .49 or 49%
$8,000
$1,500
$367
=

=

Fixed Asset Turnover = =
Total Asset Turnover =

= 1.94X

Net Sales
=
Total Assets
50

= 4.09X
$1,500
$7,500 ÷ 365

$3,000
=

$1,000

3.0X

$7,500
=
$4,500

1.67X

$7,500
=
$8,000

.94X

= 73 days


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,
=

X

=

6%

=

11%

X

1.83

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

3-5B. a.

X

=

6%

=

15%

X

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 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.

53


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.
54