Evaluating a Firms Financial Performance by Keown by jkm16010

VIEWS: 0 PAGES: 33

More Info
									                                  CHAPTER 3
       Evaluating A Firm’s Financial
               Performance
                            CHAPTER ORIENTATION
Financial analysis can be defined as the process of assessing the financial condition of a firm.
The principal analytical tool of the financial analyst is the financial ratio. In this chapter, we
provide a set of key financial ratios and a discussion of their effective use.


                                CHAPTER OUTLINE
I      Financial ratios help us identify some of the financial strengths and weaknesses of a
       company.
II.    The ratios give us a way of making meaningful comparisons of a firm’s financial data
       at different points in time and with other firms.
III.   We could use ratios to answer the following important questions about a firm’s
       operations.
       A.      Question 1: How liquid is the firm?
               1.      The liquidity of a business is defined as its ability to meet maturing debt
                       obligations. That is—does or will the firm have the resources to pay the
                       creditors when the debt comes due?
               2.      There are two ways to approach the liquidity question.
                       a.     We can look at the firm’s assets that are relatively liquid in
                              nature and compare them to the amount of the debt coming due
                              in the near term.
                       b.     We can look at how quickly the firm’s liquid assets are being
                              converted into cash.
       B.      Question 2: Is management generating adequate operating profits on the firm’s
               assets?
               1.      We want to know if the profits are sufficient relative to the assets being
                       invested.




                                               30
             2.     We have several choices as to how we measure profits: gross profits,
                    operating profits, or net income. Gross profits would not be acceptable
                    because it does not include important information such as marketing and
                    distribution expenses. Net income includes the unwanted effects of the
                    firm’s financing policies. This leaves operating profits as our best
                    choice in measuring the firm’s operating profitability. Thus, the
                    appropriate measure is the operating income return on investment
                    (OIROI):
                                                  operating income
                                    OIROI =
                                                     total assets
      C.     Question 3: How is the firm financing its assets?
             1.     Here we are concerned with the mix of debt and equity capital the firm
                    is using.
             2.     Two primary ratios used to answer this question are the debt ratio and
                    times interest earned.
                    a.      The debt ratio is the proportion of total debt to total assets.
                    b.      Times interest earned compares operating income to interest
                            expense for a crude measure of the firm’s capacity to service its
                            debt.
      D.     Question 4: Are the owners (stockholders) receiving an adequate return on their
             investment?
             1.     We want to know if the earnings available to the firm’s owners, or
                    common equity investors, are attractive when compared to the returns of
                    owners of similar companies in the same industry.
                                                    net income
             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 firm’s return on equity.
             4.     Return on equity is presented as a function of:
                    a.      the operating income return on investment less the interest rate
                            paid, and
                    b.      the amount of debt used in the capital structure relative to the
                            equity.
IV.   An Integrative Approach to Ratio Analysis: The DuPont Analysis
      A.     The DuPont analysis is another approach used to evaluate a firm’s profitability
             and return on equity.
      B.     Its graphic technique may be helpful in seeing how ratios relate to one another
             and the account balances.
      C.     Return on Equity is a function of a firm’s net profit margin, total asset turnover,
             and debt ratio.


                                             31
V.     Limitations of Ratio Analysis
       A.     This list warns of the many pitfalls that may be encountered in computing and
              interpreting financial ratios.
       B.     Ratio users should be aware of these concerns prior to making decisions based
              solely on ratio analysis.


                             ANSWERS TO
                      END-OF-CHAPTER QUESTIONS
3-1.   In learning about ratios, we could simply study the different types or categories of
       ratios. These categories have conventionally been classified as follows:
       Liquidity ratios are used to measure the ability of a firm to pay its bills on time.
       Example ratios include the current ratio and acid-test ratio.
       Efficiency ratios reflect how effectively the firm has utilized its assets to generate
       sales. Examples of this type of ratio include accounts receivable turnover, inventory
       turnover, fixed asset turnover, and total asset turnover.
       Leverage ratios are used to measure the extent to which a firm has financed its assets
       with outside (non-owner) sources of funds. Example ratios include the debt ratio and
       times interest earned ratio.
       Profitability ratios serve as overall measures of the effectiveness of the firm’s
       management relative to sales and/or to investment. Examples of profitability ratios
       include the net profit margin, return on total assets, operating profit margin, operating
       income return on investment, and return on common equity.
       Instead, we have chosen to cluster the ratios around important questions that may be
       addressed to some extent by certain ratios. These questions, along with the related
       ratios may be represented as follows:
       1.     How liquid is the firm?
              Current ratio
              Quick ratio
              Accounts receivable turnover (average collection period)
              Inventory turnover
       2.     Is management generating adequate operating profits on the firm’s assets?
              Operating income return on investment
              Operating profit margin
              Gross profit margin
              Asset turnover ratios, such as for total assets, accounts receivable, inventory,
              and fixed assets




                                              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            Operating Income
                                        =
                Return on Invesment            Total Assets
       or as:
                  Operating Income            Operating
                                        =                  X Total Asset
                Return on Investment         Profit Margin    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                                201,875       Accounts Payable                100,000
      Accounts Receivable *               175,000       Long-Term Debt                  320,000
      Inventory                           223,125       Total Liabilities               420,000
      Current Assets                      600,000       Common Equity                 1,680,000
      Net Fixed Assets                  1,500,000
      Total Assets                      2,100,000       Total Liability & Equity      2,100,000
* Based on 360 days.

       Current ratio                            6
       Total asset turnover                     1
       Gross profit margin                   15%
       Inventory turnover                       8
       Average collection period               30
       Debt ratio                            20%
       Sales                            2,100,000
       Cost of goods sold               1,785,000
       Total liabilities                  420,000

3-2A. Mitchem's present current ratio of 2.5 to 1 in conjunction with its $2.5 million
      investment in current assets indicates that its current liabilities are presently $1 million.
      Letting x represent the additional borrowing against the firm's line of credit (which also
      equals the addition to current assets) we can solve for that level of x which forces the
      firm's current ratio down to 2 to 1; i.e.,
       2 = ($2.5 million + x) / ($1.0 million + x)
       x = $0.5 million, or $500,000

                                                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 assets                          $3,500
       Current ratio                                      =                        =           1.75X
                          current liabilitie s                     $2,000
                        total debt                         $4,000
       Debt ratio                               =                              =           .50 or 50%
                       total assets                        $8,000
                                       operating income                      $1,700
       Times interest earned =                                      =                           =      4.63X
                                       interest expense                       $367
                                              accountsreceivable                          $2,000
       Average collection period          =                                     =                    = 91 days
                                               credit sales / 365                       $8,000 / 365
                                         cost of
                                       goods sold                  $3,300
       Inventory turnover      =                               =                        =       3.3X
                                       inventory                   $1,000
                                          net sales                $8,000
       Fixed asset turnover        =                 =                                  =           1.78X
                                        fixed assets               $4,500
                                         net sales                     $8,000
       Total asset turnover        =                           =                            =        1X
                                        total assets                   $8,000
                                   gross profit                         $4,700
       Gross profit margin     =                               =                            =       .59 or 59%
                                    net sales                           $8,000
                                        operating income                    $1,700
       Operating profit margin                                    =               =                .21 or 21%
                                            net sales                       $8,000
         Operating
                       operating income                            $1,700
       income return                                  =                                =       .21 or 21%
                         total assets                              $8,000
       on investment
       Return on     net income                            $800
                                                =                      =           .20 or 20%
        equity     common equity                          $4,000
       or, we can calculate return on equity as:
                   = Return on assets ÷ (1- debt ratio)
                      Net income        Total debt 
                  =               ÷ 1             
                      Total assets  Total assets 

                              1 - .50  = .20 or 20%
                        800
                  =
                       8,000




                                                     35
                                                      sales                $10m
3-4A. a.   Total Assets Turnover         =                      =                   = 2x
                                                   total assets            $5m
                            sales
      b.   3.5     =
                            $5m
           Sales =          $17.5m
           Thus, the needed sales growth is $7.5 million ($17.5m - $10m), or an increase
           of 75%:
                            $7.5m
                                         =          75%
                            $10m
      c.   For last year,
             Operating Income                        operating               total asset
                                         =                             X
           Return on Investment                    profit margin              turnover

                                         =                 10%         X     2.0
                                         =                 20%
           If sales grow by 75%, then for next year-end assuming a 10% operating profit
           margin:
             Operating Income                        operating                total asset
                                         =                             X
           Return on Investment                    profit margin               turnover

                                         =                 10%         X     3.5
                                         =                 35%
           Average Collection   Accounts Receivable
3-5A. a.                      
                Period           Credit Sales/365
                                                                      $562,500
                       Avg Collection Period               =
                                                                  (.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.
                Average                                        Accounts Receivable
      b.                            =        20        =
           collection period                                    (.75 x $9m)/365
           Solving for accounts receivable:
                            Accounts          =            $369,863
                            receivable
           Thus, Brenmar would reduce its accounts receivable by
                   $562,500 - $369,863            = $192,637.




                                                  36
                                          Cost of Goods Sold
      c.    Inventory Turnover     =
                                             Inventories
                                          .70 x Sales
                           9       =
                                           Inventories
                                          .70 x $9m
                   Inventories     =                     =      $700,000
                                              9


3-6A. a.                                                                         Industry
           RATIO                                2002              2003            Norm
           Liquidity:
           Current Ratio                       6.0x               4.0x             5.0x
           Acid-test (Quick) Ratio             3.25x              1.92x            3.0x
           Average Collection Period         137 days           107 days          90 days
           Inventory Turnover                  1.27x              1.36x            2.2x
           Operating profitability:
           Operating Profit Margin            20.8%              24.8%            20.0%
           Total Asset Turnover                 .5x                .56x             .75x
           Average Collection Period         137 days           107 days          90 days
           Inventory Turnover                  1.27x              1.36x            2.2x
           Fixed Asset Turnover                1.00x              1.04x            1.00x
           Financing:
           Debt Ratio                           0.33              0.35             0.33
           Times Interest Earned                5.0x              5.63x            7.0x
           Return on common stockholders’ investment:
           Return on Common Equity            7.5%               10.5%             9.0%


      b.    Regarding the firm’s liquidity in 2003, the current and acid-test (quick) ratios
            are both well below the industry averages and have decreased considerably from
            the prior year. Also, the average collection period and inventory turnover do
            not compare favorably against the industry averages, which suggests that
            accounts receivable and inventories are not of equal quality of these assets in
            other firms in the industry. So, we may reasonably conclude that Pamplin is
            less liquid than the average company in its industry.




                                           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                 Operating               Total asset
                                =                      X
     return on investment             profit margin             turn over
            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.
                                                  Sales
           Total Asset Turnover      =
                                               Total Assets
                                               $4,500 ,000
                                     =
                                               $2,000 ,000
                                     =       2.25 times
                                               Operating Income
           Operating Profit Margin =
                                                    Sales
                                                $500 ,000
                                     =
                                               $4,500 ,000
                                     =       11.11%
            Operating Income                   Operating Income
                                     =
           Return on Investment                  Total Assets
                                                $500 ,000
                                     =
                                               $2,000 ,000
                                     =       25%
                                               Operating Income      Sales
                          or         =                          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                    Operating Income      Sales
                              =                            x
     Return on Investment                      Sales         Total Assets
                                                   $4,500 ,000
                              =           .13 x
                                                   $3,000 ,000
                              =          .13 x 1.5
                              =          19.5%
c.   Return earned on the common stockholders’ investment:
     Post-Renovation Analysis:
                                          Net IncomeAvailable
     Return on common                    to Common Stockholders
                                     =
           equity                            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)         (500,000)
            Increase in equity to finance purchase                   $ 500,000
     The computation above is measuring the return on equity based on the
     beginning-of-the-year common equity. The equity would increase $217,500 by
     year end.




                                     40
             Pre-renovation Analysis:
             The pre-renovation rate of return on common equity is calculated as follows:
                                                             $200 ,000
                     Return on Common Equity       =                       =      20%
                                                            $1,000 ,000


             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
                                                                                            Industry
         Ratio                          Formula                 Calculation                 Average

                                  Current Assets              $138 ,300
     Current Ratio               Current Liabilities                      = 1.84              1.8
                                                              $75,000

                                 Current Assets - Inventory   $138 ,300  84 ,000
     Acid-Test Ratio                                                                = .72     .9
                                    Current Liabilitie s           $75,000

                                  Total Debt                  $225 ,000
     Debt Ratio                  Total Assets                              = .55              .5
                                                              $408 ,300

     Times Interest          Net Operating Income             $80 ,000
        Earned                 Interest Expense                           = 8                 10
                                                              $10 ,000
43




     Average Collection          Accounts Receivable             $33,000            20.1       20
          Period                                                                =
                                 Credit Sales per Day         $600 ,000 / 365       days      days

                                 Cost of Goods Sold           $460 ,000
     Inventory Turnover               Inventory                            = 5.48             7
                                                               $84 ,000

     Operating Income            Operating Income             $80,000
                                   Total Assets                         = .196                16.8%
      Return on Investment                                    $408 ,300
                                                                 or 19.6%

     Operating Profit            Operating Income              $80 ,000
        Margin                        Sales                             = .133                14%
                                                              $600 ,000
                                                                 or 13.3%
                                                                      Industry
         Ratio             Formula                 Calculation        Average

     Gross Profit       Gross Profit            $140 ,000
       Margin              Sales                          = .233        25%
                                                $600 ,000
                                                      or 23.3%

     Total Asset           Sales                $600 ,000
      Turnover          Total Assets                        = 1.47      1.2
                                                $408 ,300

     Fixed Asset             Sales              $600 ,000
      Turnover          Net Fixed Assets                    = 2.22      1.8
                                                $270 ,000

                        Net Income               $42,900
     Return on Assets                                       = .1051     6%
44




                        Total Assets            $408,300
                                                      or 10.51%

                        Earnings Available to
                        Common Stockholders     $42 ,900
     Return on Equity                                        = .234     12%
                           Common Equity        $183 ,300
                                                       or 23.4%
                                       Return on Equity
                                            23.4%




                Return on Assets                                            Equity
                                              divided by                   Total Assets
                    10.51%                                                  0.45


      Net Profit Margin                                    Total Asset Turnover
                                 multipled by
            7.15%                                                   1.47


  Net Income        divided by                                    divided by Total Assets
                                   Sales             Sales
   $42,900                        $600,000         $600,000                   $408,300


     Sales                               Current Assets        Fixed Assets         Other Assets
   $600,000
                                            $138,300            $270,000                $0
         less
Total costs and expenses                                                              Fixed Assets
                                                                                       Turnover
     $557,100                             Cash and                Accounts                 2.22
                                          Marketable              Receivable
                 Cost of goods sold       Securites                                 Sales            Fixed
                                           $20,200
                                                                  $33,000
                                                                                  $600,000
                                                                                               ÷     Assets
                      $460,000                                                                     $270,000
                    Cash operating expenses
                         $30,000                                                          Other Current
                                                                      Inventory
                                                                                             Assets
                      Depreciation            Collection Period        $84,000               $1,100
                      $30,000
                                                  20.08 days
                    Interest Expense                                 Inventory Turnover
                       $10,000                                             5.48

                       Taxes          Accounts              Daily Credit
                     $27,100         Receivables divided by    Sales
                                      $33,000                 $1,644



                                                              Cost of                        Inventory
                                                            Goods Sold divided by
                                                             $460,000                         $84,000




                                                   45
3-9A. HiTech
                                                                               Industry
       RATIO                                                  2003              Norm
       Liquidity:
       Current Ratio                                          2.51               2.01
       Acid-test (Quick) Ratio                                2.30               1.66
       Average Collection Period                             45.95              72.64
       Accounts Receivable Turnover                           7.94               5.02
       Inventory Turnover                                     6.13               4.42
       Operating profitability:
       Operating Income
         Return on Investment                                23.2%               9.0%
       Operating Profit Margin                               34.6%              13.0%
       Total Asset Turnover                                    .67                .69
       Accounts Receivable Turnover                           7.94               5.02
       Inventory Turnover                                     6.13               4.42
       Fixed Asset Turnover                                   2.51               2.27
       Financing:
       Debt Ratio                                              .26                .44
       Times Interest Earned                                247.78               8.87
       Return on common stockholders’ investment:
       Return on Common Equity                               22.4%              12.0%

The above analysis of HiTech reveals a strong company in many areas. First, let’s look at the
liquidity question. How liquid is HiTech’s balance sheet? The current ratio surpasses the
industry, and when we subtract inventories in the acid-test ratio, HiTech still surpasses the
industry. It is the same with the inventory turnover ratio. This suggests that HiTech has a
lower than normal inventory level. The receivable turnover and average collection period also
reveal that HiTech controls this asset better than its competitors. These ratios tell us that
HiTech’s liquidity relies on assets other than inventory and receivables. When we review the
balance sheet, this assumption is supported for we see that $11.8 million of the $17.8 million
of HiTech’s current assets is in cash and cash equivalents alone. We next turn to the
profitability question. HiTech compares impressively on the OIROI and operating profit
margin ratios. The OIROI ratio tells us that either HiTech must be doing a superior job at
sales, expenses, or generating greater sales from a lower asset level. When we look at the total
asset turnover, HiTech rates slightly lower than normal. HiTech is generating the same
proportionate level of sales from the same level of assets as its competitors. We know that
HiTech is doing a good job of turning over its current assets. The fixed asset turnover tells us
that part of the problem is in the level of fixed assets that HiTech is maintaining. As we look
at the balance sheet, we see that HiTech also maintains a high level of “other investments”.
HiTech must be doing an excellent job at controlling costs, which is supported by the excellent
operating profit margin ratio. We now look at the financing question. HiTech is maintaining a
low level of debt as compared to the industry and is more than able to service its interest
expense. This means that HiTech is financing its assets through equity. Let’s look at the
return that these owners are receiving from their investment through the final ratio. HiTech
also rates favorably on return on common equity, 22.4% as compared to the 12.0% industry
average.


                                              46
INTEGRATIVE PROBLEM
1.

     Blake International                     1999       2000      2001       2002      2003
     Current ratio                            3.11       2.83      2.54       2.22      1.99
     Acid-test ratio                          1.64       1.78      1.56       1.35      1.33
     Average collection period               53.16     62.00      56.29     58.63     52.48
     Accounts receivable turnover             6.87       5.89      6.48       6.23      6.95
     Inventory turnover                       3.28       3.87      4.00       3.73      4.21
     Operating income return on               0.22       0.15      0.16       0.08      0.09
     investment
     Gross profit margin                      0.40       0.39      0.38       0.38      0.40
     Operating profit margin                  0.10       0.08      0.08       0.04      0.05
     Total asset turnover                     2.10       1.95      2.07       1.85      1.85
     Fixed asset turnover                    18.13     18.81      23.21     18.64     16.29
     Debt ratio                               0.43       0.79      0.71       0.69      0.66
      Times interest earned                  14.00       6.31      4.31       2.30      2.78
     Return on equity                         0.18       0.36      0.27       0.04      0.02
     Note: Above ratio calculations may be subject to rounding errors.

     Question #1
     It is apparent that Blake’s liquidity is decreasing over time, as the current and acid-test
     ratios indicate. However, the receivable turnover and average collection period stayed
     relatively constant while the inventory turnover actually increased. When we review
     the balance sheet, we note that the cash balance has actually increased while the
     receivable and inventory balances decreased, creating more liquidity within the total
     current assets, even though the net current asset balance decreased in total. The real
     problem lies with the increase in current liabilities over time in combination with the
     decrease in current assets.
     Question #2
     Also of great concern is the decrease in operating profitability that is shown in the
     OIROI ratios over time. The problem does not seem to be in the cost of goods sold as
     indicated by the gross profit margin ratio. The problem appears in the operating profit
     margin having also decreased over time. Upon review of the income statement, we will
     see that while sales have decreased, the operating expenses have stayed the same. The
     total asset turnover and fixed asset turnover have also decreased, although not to the
     same degree. Blake has lowered the asset balances as sales have lowered, but still
     needs to work further to lower fixed assets, decrease expenses, and increase sales.
     Question #3
     While sales and assets have decreased over time, the level of debt to equity has
     increased. As of 2003, 66% of Blake’s assets are being financed through the use of
     debt. The company is quickly becoming over-leveraged and soon will lose its ability to
     pay interest as the times interest earned ratio shows.
                                              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       2002      2003
Current ratio                            1.85      1.86       2.05       2.07      2.26
Acid-test ratio                          1.28      1.22       1.33       1.25      1.43
Average collection period               80.75     75.92      69.69     63.96      64.71
Accounts receivable turnover             4.52      4.81       5.24       5.71      5.64
Inventory turnover                       4.45      4.11       4.01       4.21      4.42
Operating income return on               0.21      0.24       0.25       0.16      0.16
investment
Gross profit margin                      0.41      0.41       0.42       0.38      0.40
Operating profit margin                  0.14      0.14       0.15       0.09      0.10
Total asset turnover                     1.51      1.64       1.71       1.77      1.67
Fixed asset turnover                     8.58     10.06       9.96       8.28      6.93
Debt ratio                               0.37      0.38       0.41       0.40      0.36
Times interest earned                   27.54     23.45      24.73     12.60      16.41
Return on equity                         0.20      0.23       0.25       0.12      0.14
Note: Above ratio calculations may be subject to rounding errors.

Question #1
Scott’s liquidity increased over the last five years, despite its growth. While current
liabilities increased, current assets grew by over 60%. This is reflected in the positive
trend of the current ratio. Despite inventory growth of 90%, the acid-test ratio and
inventory turnover both increased positively over time due to strong growth in other
areas such as receivables and sales (which in turn impacted cost of goods sold on which
the inventory turnover ratio is based). The receivable turnover ratio and average
collection period also trended positively due to a slight increase in receivables as
compared to an 84% increase in sales.
Question #2
Operating profitability seems to have decreased slightly over the last five years. Upon
review of the ratios in combination with the financial statements, this seems to be the
result of two factors. One, operating expenses have grown disproportionately to sales
over the years. Depreciation has grown due to the fixed asset growth, which is the
second factor. The total asset turnover has increased as a result of the positive use of
receivables and inventories. However, fixed assets have grown considerably, affecting
both the OIROI and the fixed asset turnover.



                                       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                                     174,363               Accounts Payable               100,000
      Accounts Receivable *                     80,137               Long-Term Debt                 290,000
      Inventory                                 45,500               Total Liabilities              390,000
      Current Assets                           300,000               Common Equity                  910,000
      Net Fixed Assets                       1,000,000
      Total Assets                           1,300,000               Total Liability & Equity    1,300,000
* Based on 360 days.

       Current ratio                                  3
       Total asset turnover                         0.5
       Gross profit margin                        30%
       Inventory turnover                            10
       Average collection period                     45
       Debt ratio                                 30%
       Sales                                   650,000
       Cost of goods sold                      455,000
       Total liabilities                       390,000
3-2B. Allandale’s present current ratio of 2.75 in conjunction with its $3.0 million investment
      in current assets indicates that its current liabilities are presently $1.09 million. Letting
      x represent the additional borrowing against the firm’s line of credit (which also equals
      the addition to current assets), we can solve for that level of x which forces the firm’s
      current ratio down to 2 to 1, i.e.,
               2 = ($3.0 million + x) / ($1.09 million + x)
               x = $.82 million
3-3B. Instructor’s Note: This is a very rudimentary "getting started" exercise. It requires no
      analysis beyond looking up the appropriate formula and plugging in the corresponding
      figures.
                                   Current Assets                   $3,500
       Current Ratio       =      Current Liabilities =                          = 1.94X
                                                                    $1,800
                                  Total Liabilities                 $3,900
       Debt Ratio          =       Total Assets               =            = .49 or 49%
                                                                    $8,000
                                EBIT                              $1,500
       Times Interest Earned = Interest               =                  = 4.09X
                                                                   $367
                                        Accounts Receivable                           $1,500
       Average Collection Period =       Credit Sales ÷ 365                  =                       = 73
                                                                                  $7,500  365
       days
                             Cost of
                            goods sold                                $3,000
       Inventory Turnover = Inventory                     =                           =      3.0X
                                                                      $1,000
                               Net Sales     $7,500
       Fixed Asset Turnover = Fixed Assets =        =                        1.67X
                                             $4,500

                                                 50
                                          Net Sales           $7,500
       Total Asset Turnover =                         =              =       .94X
                                         Total Assets         $8,000
                                        Gross Profits   $4,500
       Gross Profit Margin =                          =        =             .60 or 60%
                                         Net Sales      $7,500
         Operating     Operating Income                       $1,500
       Profit Margin =                  =                            =       .20 or 20%
                          Net Sales                           $7,500
        Operating Income      Operating Income                      $1,500
       Return on Investment =   Total Assets                    =              = .19 or 19%
                                                                    $8,000
                            Net Income                           $680
       Return on Equity = Common Equity =                                     =.17 or 17%
                                                                $4,100
or, we can calculate return on equity as:
                           =      Return on assets ÷ (1- debt ratio)
                                  Net income        Total debt 
                           =                  ÷ 1             
                                  Total assets  Total assets 

                                         1 - .49  =
                                   680
                           =                              .17 or 17%
                                  8,000
                                                            Sales
3-4B. a.       Total Assets Turnover            =
                                                         Total Assets
                                                         $11m
                                                =                       = 1.83X
                                                         $6m
                               Sales
       b.      2.5     =       $6m
               Sales       = $15m
               Thus, the needed sales growth is $4 million ($15m - $11m) or an increase of
               36%:
                                        $4m
                                       $11m = 36%




                                                         51
      c.   Last year,
            Operating income                       Operating           Total asset
           return on investment            =      profit margin   X     turnover
                                           =       6%             X     1.83
                                           =       11%
           If sales grow by 36%, then for next year-end assuming a 6% operating profit
           margin:
            Operating income                       Operating           Total asset
           return on investment            =      profit margin   X     turnover
                                           =       6%             X    2.5
                                           =       15%


           Average Collection                   Accounts Receivable
3-5B. a.                               =         Credit Sales/365
                 Period
                                                     $562,500
           Avg Collection Period       =
                                                (.75 x $9.75m)/36 5
           Avg Collection Period       =       28.08 days
           Note that the average collection period is based on credit sales, which are 75%
           of total firm sales.
               Average              Accounts Receivable
      b.   collection period = 20 = (.75 x $9.75m)/36 5

           Solving for accounts receivable:
                          Accounts
                                     = $400,685
                          Receivable
           Thus, Brenda Smith, Inc. would reduce its accounts receivable by
                  $562,500 - $400,685 = $161,815
                                       Cost of Goods Sold
      c.   Inventory Turnover      =       Inventories
                                       .75 x Sales
                         8         =   Inventories
                                       .75 x $9.75m
                  Inventories      =         8              = $914,062.50




                                           52
3-6B. a.
                                                                                     Industry
           RATIO                                       2002             2003          Norm
           Liquidity:
           Current Ratio                                5.00           5.35            5.00
           Acid-test (Quick) Ratio                      2.70           2.63            3.00
           Average Collection Period                  131.40         108.24           90.00
           Inventory Turnover                           1.22           1.40            2.20

           Operating profitability:
           Operating Income
              Return on Investment                     12.24%         13.04%          15.00%
           Operating Profit Margin                     24.00%         22.76%          20.00%
           Total Asset Turnover                          .51            .57             .75
           Average Collection Period                  131.40         108.24           90.00
           Inventory Turnover                           1.22           1.40            2.20
           Fixed Asset Turnover                         1.04           1.12            1.00

           Financing:
           Debt Ratio                                  34.69%          32.81%         33.00%
           Times Interest Earned                        6.00            5.50           7.00

           Rate of return on common stockholders’ investment:
           Return on Common Equity                   9.38%              9.53%         13.43%

      b.   Regarding the firm’s liquidity, the acid-test (quick) ratios are below the industry
           average and have decreased from the prior year. Also, the average collection
           period and inventory turnover are well below the industry averages, which
           suggests that inventories and receivables are not of equal quality of these assets
           in other firms in the industry. Since the current ratio is satisfactory, the problem
           apparently lies in the management of inventories and receivables. So, we may
           reasonably conclude that Chavez is less liquid than the average company in its
           industry because it has a greater investment in inventories and receivables than
           the industry average.




                                           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:
      Operating income                     Operating              Total asset
     return on investment           =     profit margin   X        turnover
            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
      e.   Chavez has improved its return on common equity from 9.38% in 2000 to
           9.53% in 2001, compared to an industry norm of 13.43%. The improvement
           has come from an increase in the firm’s operating income return on investment,
           despite a slight decrease in the use of debt financing. Thus, Chavez has
           enhanced the returns to its owners, and with a small decline of financial risk
           (slightly lower debt ratio) in the process.
3-7B. a.   Mel’s total asset turnover, operating profit margin, and operating income return
           on investment.
                                             Sales
           Total Asset Turnover      =    Total Assets
                                           $5,000 ,000
                                     =
                                           $2,000 ,000
                                     =    2.50 times
                                          Operating Income
           Operating Profit Margin =           Sales
                                            $500 ,000
                                     =
                                           $5,000 ,000
                                     =    10.00%
           Operating Income                Operating Income
            Return on Investment     =       Total Assets


                                            $500,000
                                     =
                                           $2,000,000
                                     =    25%
                                          Operating Income               Sales
                             or      =         Sales             X    Total Assets
                                     =    10%                    X    2.50 = 25%
      b.   The new operating income return on investment for Mel’s after the plant
           renovation:
             Operating Income             Operating Income      Sales
            Return on Investment     =         Sales       x Total Assets

                                                   $5,000 ,000
                                     =    .13 X
                                                   $3,000 ,000
                                     =    .13 X 1.67
                                     =    21.67%




                                          55
c.   Return earned on the common stockholders’ investment:
     Post-Renovation Analysis:
                                           Net Income Available to Common Stockholde rs
     Return on Common Equity =
                                                        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)                            $ 650,000
             Less: Interest ($100,000 + $40,000)                     (140,000)
            Earnings Before Taxes                                     510,000
             Less: Taxes (40%)                                       (204,000)
            Net Income Available to Common Stockholders             $ 306,000
     The increase in Common equity was calculated as follows:
            Total assets purchased                                 $ 1,000,000
              Less: Increase in debt ($1,500,000 - $1,000,000)         (500,000)
            Increase in equity to finance purchase                 $ 500,000
     The computation above is measuring the return on equity based on the
     beginning-of-the-year common equity. The equity would increase $217,500 by
     year end.


     Pre-renovation Analysis:
     The pre-renovation rate of return on common equity is calculated as follows:
                                                      $240 ,000
            Return on Common Equity            =                   =       24%
                                                     $1,000 ,000




                                      56
           Comparative Analysis:
           A comparison of the two rates of return would argue that the renovation not be
           undertaken. However, since investments in fixed assets generally produce cash
           flows over many years, it is not appropriate to base decisions about their
           acquisition on a single year’s ratios. There are additional problems with this
           approach to fixed asset decision making which we will discover when we
           discuss capital budgeting in a later chapter.
           Instructor’s Note: To help convince those students who simply cannot accept
           the fact that the renovation may be worthwhile even though the return on
           common equity falls in the first year, we note that the existing plant is recorded
           on the firm’s books at original cost less accounting depreciation. In a period of
           rising replacement costs, this means that the return on common equity of 24%
           without renovation may actually overstate the true return earned on a more
           realistic "replacement cost" common equity base. In addition, the issue is
           probably one of when to renovate (this year or next) rather than whether or not
           to renovate. That is, the existing facility may require renovation in the next two
           years to continue to operate. These considerations simply cannot be
           incorporated in the ratio analysis performed here. We find this a very useful
           point to make at this juncture of the course, since industry practice still
           frequently involves use of rules of thumb and ratio guides to the analysis of
           capital expenditures.

3-8B. a.   See the accompanying table.
      b.   The most important ratios to consider in evaluating the firm’s credit request
           relate to its liquidity and use of financial leverage. However, the credit analyst
           can also evaluate the firm’s profitability ratios as a general indication as to how
           effective the firm’s management has been in managing the resources available
           to it. This latter analysis would be useful in evaluating the prospects for a long
           and fruitful relationship with the new client.




                                           57
                                                                                   Industry
         Ratio                   Formula                   Calculation             Average


                           Current Assets              $156 ,300
     Current Ratio        Current Liabilities                      = 2.14            1.8
                                                        $73,000

                          Current Assets  Inventory   $156 ,300  93,000
     Acid-Test Ratio                                                      = .87      .9
                             Current Liabilities            $73,000

                           Total Debt                  $223 ,000
     Debt Ratio           Total Assets                             = .50             .5
                                                       $446 ,300

     Times Interest       Operating Income             $120 ,000
        Earned                                                      = 12             10
                          Interest Expense              $10 ,000
58




     Average Collection   Accounts Receivable             $38 ,000
          Period             Sales Per Day                               = 19.81      20
                                                       $700 ,000 / 365     days      days

                          Cost of Goods Sold           $500 ,000
     Inventory Turnover        Inventory                            = 5.38           7
                                                        $93,000
                                                                           Industry
           Ratio                Formula                 Calculation        Average

     Operating Income       Operating Income        $120 ,000
                              Total Assets                     = .2689      16.8%
     Return on Investment                           $446 ,300
                                                           or 26.89%

     Operating Profit       Operating Income        $120 ,000
        Margin                   Sales                          = .171      14%
                                                    $700 ,000
                                                          or    17.1%

     Gross Profit           Gross Profit            $200 ,000
       Margin                  Sales                             = .2857    25%
                                                    $700 ,000
                                                          or    28.57%

     Total Asset               Sales                $700 ,000
      Turnover              Total Assets                        = 1.57      1.2
                                                    $446 ,300
59




     Fixed Asset                 Sales              $700 ,000
      Turnover              Net Fixed Assets                    = 2.41      1.8
                                                    $290 ,000

                            Net Income               $82,900
     Return on Assets                                           = .1857     6.0%
                            Total Assets            $446,300
                                                          or    18.57%
                            Earnings Available to
                            Common Stockholders     $82 ,900
     Return on Equity                                           = .3712     12%
                               Common Equity        $223 ,300
                                                         or     37.12%
                                       Return on Equity
                                            37.1%




                Return on Assets                                           Equity
                                             divided by                   Total Assets
                    18.57%
                                                                           0.50


      Net Profit Margin                                   Total Asset Turnover
                                 multipled by
           11.84%                                                  1.57


  Net Income        divided by                                   divided by Total Assets
                                  Sales             Sales
   $82,900                       $700,000         $700,000                   $446,300


     Sales                               Current Assets       Fixed Assets         Other Assets
   $700,000
                                            $156,300             $290,000              $0
         less
Total costs and expenses                                                             Fixed Assets
                                                                                      Turnover
     $617,100                             Cash and               Accounts                 2.41
                                          Marketable             Receivable
                 Cost of goods sold       Securites                                Sales            Fixed
                                           $24,200
                                                                 $38,000
                                                                                 $700,000
                                                                                              ÷     Assets
                     $500,000                                                                     $290,000
                  Cash operating expenses
                       $50,000                                                           Other Current
                                                                     Inventory
                                                                                            Assets
                      Depreciation           Collection Period        $93,000               $1,100
                      $30,000
                                                 19.81 days
                    Interest Expense                                Inventory Turnover
                       $10,000                                            5.38

                       Taxes          Accounts              Daily Credit
                     $27,100         Receivables divided by    Sales
                                      $38,000                 $1,918



                                                             Cost of                        Inventory
                                                           Goods Sold divided by
                                                            $500,000                         $93,000




                                                  60
3-9B. Reynolds Computer
      RATIO                                        2003                           Norm
      Liquidity:
      Current Ratio                                1.48                           1.49
      Acid-test (Quick) Ratio                      1.40                           1.36
      Average Collection Period                   38.69                          53.38
      Accounts Receivable Turnover                 9.43                           6.84
      Inventory Turnover                          50.87                          20.87
      Operating profitability:
      Operating Income
         Return on Investment                     21.4%                           9.0%
      Operating Profit Margin                      9.7%                           6.0%
      Total Asset Turnover                         2.20                           1.58
      Accounts Receivable Turnover                 9.43                           6.84
      Inventory Turnover                          50.87                          20.87
      Fixed Asset Turnover                        33.02                          13.02
      Financing:
      Debt Ratio                                    .54                            .47
      Times Interest Earned                       72.26                          14.79
      Rate of return on common stockholders’ investment:
      Return on Common Equity                     31.3%                          13.0%
Liquidity – Based on the current and acid-test ratios, Reynolds Computer is performing as well as
the industry average in the area of liquidity. At a detail level, Reynolds Computer is doing much
better than average in managing both receivables and inventory. As you can observe, the acid-test
ratio changes little from the current ratio. Based upon the small effect that inventory has on the
current ratio, we might assume that Reynolds Computer is not holding a large amount of
inventory. Upon review of the balance sheet, inventory only accounts for 5% of total current
assets. Cash accounts for 54% of the total current assets making Reynolds Computer much more
liquid than the current ratio indicates.
Profitability – Reynolds Computer seems to be doing an excellent job at operating profitability
based on the OIROI ratio. Let’s break down this ratio into its two components We have already
ascertained that Reynolds Computer is managing its accounts receivable and inventory effectively.
From the fixed asset ratio, Reynolds Computer is also managing a much lower amount of fixed
assets as compared to sales than the industry. Overall, Reynolds Computer is generating more
sales from every $1 of assets than its competitors. Reynolds Computer is also doing a good job at
managing its income statement. The operating profit margin shows that Reynolds Computer is
controlling costs efficiently. Both the asset turnover and profit margin contribute to Reynolds
Computer’s favorable operating profitability.
Financing – Reynolds Computer finances more of its assets through debt than its competitors.
This involves more risk, but it can also provide higher returns as we will note in the next section.
Reynolds Computer must be careful not to over-leverage itself. However, Reynolds Computer’s
times interest earned ratio indicates that Reynolds Computer can service its debt more easily than
the average firm.
Return on Investment- As noted above, Reynolds Computer finances more of its assets through
debt than the industry average. With more debt and less equity, this will provide a higher return to
its owners as long as the earned rate of return is higher than the cost of debt. Based on the high
operating profitability and times interest earned ratios, we can assume this is the case. As a result,
the common equity owners are receiving a higher return on their investment than the industry
average.
                                                 61

								
To top