Chapter 3Discussion Questions3-1. If we divide users of ratios into short-term lenders, long-term lenders, andstockholders, in which ratios would each group be most interested, and for whatreasons?Short-term lenders-Iiquidity ratios because their concern is with the firm's ability topay short-term obligations as they come due.Long-term lenders-leverage ratios because they are concerned with the relationshipof debt to total assets- They also will examine profitability to insure that interestpayments can be made・Stockholders-profitability ratios, with secondary consideration given to debtutilization, liquidity, and other ratios. Since stockholders are the ultimate owners ofthe firm, they are primarily concerned with profits or the return on their investment. 3-2. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders' equity.The Du Pont system of analysis breaks out the return on assets between the profitmargin and asset turnover.Return on Assets 二Profit Margin x Asset TurnoverNet income Net income Sales = xTotal assets Sales Total assetsIn this fashion, we can assess the joint impact of profitability and asset turnover onthe overall return on assets. This is a particularly useful analysis because we candetermine the source of strength and weakness for a given firm. For example, acompany in the capital goods industry may have a high profit margin and a low assetturnover, while a food processing firm may suffer from low profit margins, but enjoya rapid turnover of assets.The modified form of the Du Pont formula shows:“• Return on assets (investment)Return on equity = ---------- r-~. 丄----------- ；-----M)(1-Debt/Assets)This indicates that return on stockholders' equity may be influenced by return onassets, the debt-to-assets ratio or a combination of both. Analysts or investorsshould be particularly sensitive to a high return on stockholders9 equity that isinfluenced by large amounts of debt.3-3. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?If the accounts receivable turnover ratio is decreasing, accounts receivable will beon the books for a longer period of time. This means the average collection periodwill be increasing.3-4. What advantage does the fixed charge coverage ratio offer over simply using times interest earned?The fixed charge coverage ratio measures the finrTs ability to meet all fixedobligations rather than interest payments alone, on the assumption that failure tomeet any financial obligation will endanger the position of the firm.3-5.Is there any validity in rule-of-thumb ratios for all corporations, for example, acurrent ratio of 2 to 1 or debt to assets of 50 percent?No rule-of-thumb ratio is valid for all corporations- There is simply too muchdifference between industries or time periods in which ratios are computed.Nevertheless, rules-of-thumb ratios do offer some initial insight into the operationsof the firm, and when used with caution by the analyst can provide information.3-6. Why is trend analysis helpful in analyzing ratios?Trend analysis allows us to compare the present with the past and evaluate ourprogress through time. A profit margin of 5 percent may be particularly impressiveif it has been running only 3 percent in the last ten years. Trend analysis must alsobe compared to industry patterns of change.3-7. Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on thefollowing ratios, and explain the direction of the impact based on yourassumptions.a.Return on investment.b.Inventory turnoverc.Fixed asset turnover.d.Debt-to-assets ratio.r • Net income a. Return on investment = ----------------- Total assets Inflation may cause net income to be overstated and total assets to be understated causing an artificially high ratio that is misleading. S ales b ・ Inventory turnover = Inventory In flation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect "inflation-influenced^ dollars and the net effect will be nil. If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported. Fixed assets will be understated relative to their replacement cost and to sales and too high a ratio could be reported.Since both are based on historical costs, no major inflationary impact will take place in the ratio. What effect will disinflation following a highly inflationary period have on thereported income of the firm?Disinflation tends to lower reported earnings as inflation-induced income is squeezedout of the firm 5s income statement. This is particularly true for firms in highlycyclical industries where prices tend to rise and fall quickly.Why might disinflation prove to be favorable to financial assets?Because it is possible that prior inflationary pressures will no longer seriously impairthe purchasing power of the dollar, lessening inflation also means that the requiredreturn that investors demand on financial assets will be going down, and with thislower demanded return, future earnings or interest should receive a higher currentevaluation.c. Fixed asset turnover = Sales Fixed assets d. Debt to total assets = Total debt Total assets 3-8.Comparisons of income can be very difficult for two companies even though they sell 3-10.the same products in equal volume. Why?There are many different methods of financial reporting accepted by the accountingprofession as promulgated by the Financial Accounting Standards Board. Thoughthe industry has continually tried to provide uniform guidelines and procedures,many options remain open to the reporting firm. Every item on the incomestatement and balance sheet must be given careful attention. Two apparently similarfirms may show different values for sales, research and development, extraordinarylosses, and many other items.Chapter 3Problems1. Griffey Junior Wear, Inc., has $800,000 in assets and $200,000 of debt. It reports netincome of $100,000.a.What is the return on assets? b. What is the return on stockholders 9 equity?3-1. Solution:Griffey Junior Wear$800,000a. Return on assets (investment)=Net income Total assetsb. Return on equity =Net income Stockholders' equityDebt/Ass 如沁四= 25%$800,000 Return on equity = 4 (1-.25)Stockholders 1 equity = total assets 一 total debt=$800,000 — $200,000 = $600,000 Net income Stockholders equityReturn on equity = Return on assets (investment) (1- Debt/Assets) 12.5%.75 = 16.67%2.Hugh Snore Bedding, Inc., has assets of $400,000 and turns over its assets 1.5 times per year.Return on assets is 12 percent. What is its profit margin (return on sales)?3-2. Solution:Hugh Snore Bedding, Inc.Sales = Assets x total asset turnover= $400,000x1.5%=$600,000Net income = Assets x Return on assets$48,000 = $400,000x12%Net income = $48,000 / $600,000 = 8% Sales3 One-Size-Fits-All Casket Co/s income statement for 2008 is as follows:Sales ............................................................................................. $3,000,000Cost of goods sold ......................................................................... 2,100,000Gross profit ...................................................................................... 900,000Selling and administrative expense .............................................. 450、000Operating profit ................................................................................ 450,000Interest expense .............................................................................. 75、000Income before taxes ......................................................................... 375,000Taxes (30%) ..................................................................................... 112,500Income after taxes .......................................................................... $262,500pute the profit margin for 2008-b.Assume in 2009, sales increase by 10 percent and cost of goods sold in creases by 25%. Thefirm is able to keep all other expenses the same. Once again, assume a tax rate of 30 percent on income before taxes. What are income after taxes and the profit margin for 2009?b. Sales .......................................................................... $3,300,000*Cost of goods sold............................................... 2,625,000**Gross profit .................................................................... 675,000 Selling and administrative expense ............................... 450Q00 Operating profit ................................................... 225,000Interest expense ................................................................ 75,000 Income before taxes ....................................................... 150,000 Taxes (30%) ..................................................................... 45,000 Income after taxes (2008) ............................................ $105,000 * $3,000,000 x 1.10 = $3,300,000** $2,100,000 x 1.25 = $2,625,000Profit Margin for 2009Net Income _ $105,000 _ 3 冷屮Sales — $3,300,000 一 ’ °3-3. Solution:One Size-Fits-All Casket Co.a. Profit margin for 2008 Net IncomeSales曲54 Using the Du Pont method, evaluate the effects of the following relationships for the ButtersCorporation.a. Butters Corporation has a profit margin of 7 percent and its return on assets (investment) is25.2 percent. What is its assets turnover?b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the firm 5sreturn on equity be?c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 35percent?3-4. Solution:Butters Corporationa. Profit margin xTotal asset turnover = Return on asset (investment) 7% x ? =25.2%丁 .25.2% Total asset turnover = --------- 7% =3.6x Return on assets (investment) 25.2%"(1-0.50) _ 25.2% 0.50=50.40%b. Return on equity =(1 - Debt/Asse ts)3-14. (Continued)“. Return on assets (investment)c.Return on equity = -----------------------------------------(1 - Debt/Asse ⑸_ 25.2%一(1-.35)_ 25.2%0.65= 38.77%5. Assume the following data for Interactive Technology and Silicon Software.InteractiveTechnology (IT)Silicon Software (SS) Net income ............................ …$ 15,000$ 50,000 Sales ...................................... •- 150,000 1,000,000 Total assets ............................… 160,000400,000 Total debt ..............................… 60,000240,000 Stockholders 9 equity ............. .… 100,000160,000a. Compute return on stockholders' equity for both firms using ratio 3a in the text. Which firm has the higher return?b. Compute the following additional ratios for both firms.Net income/SalesNet income/Total assets Sales/Total assets Debt/Total assetsc. Discuss the factors from part b that added or detracted from one firm having a higher returnon stockholders^ equity than the other firm as computed in part a.3-5. SolutionInteractive Technology and Silicon SoftwareSilicon Software (SS) has a much higher return on stockholders 9equity than Interactive Technology (IT).a.Interactive Silicon Technology (IT)Software (SS) Net incomeStockholders* equity$15,000$100,000 = 15%$50,000$160,000 = 31.25%3-5. (Continued)b.InteractiveTechnology (IT) Net income _ $15,000 _ ~~Sales-$150,000 ~°Net income $15,000--------------- = ------------- =9.3 /% Total assets $160,000c. As previously indicated, Silicon Software (SS) has a substantially higher return on stockholder^ equity than Interactive Technology (IT). The reason is certainly not to be found on return on the sales dollar where Interactive Technology has a higher return than Silicon Software (10% vs. 5%). However, Silicon Software has a higher return than InteractiveTechnology on total assets (12.5% versus 9.37%). The reason is clearly to be found in total asset turnover, which strongly favors SiliconSoftware over Interactive Technology (2.5x versus ・937x). This factor alone leads to the higher return on total assets.SiliconSoftware (SS) $50,00° 二 5% $1,000,000 0 时°°° =12.5% $400,000 Sales Total assets $150,000 $160,000= .937x $1,000,000 $400,000 =2.5xDebtTotal assets$240,000$400,000 = 60%2007 and 2008:20072008 Sales ......................................... $8,000,000 $10,000,000 Cost of goods sold ..................... 6,000,000 9,000,000 Inventory ....................................800,0001,000,000a. Compute inventory turnover based on ratio number 6, Sales/Inventory, for each year.b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year.c. What conclusions can you draw from part a and part /??3-6. Solution:Perez Corporation20072008b Cost of goods sold _ $6,000,000 氷 $9,000,000 _Inventory 800,0001,000,000c. Based on the sales to inventory ratio, the turnover has remainedconstant at lOx. However, based on the cost of goods sold to inventory ratio, it has improved from 7.5x to 9x.The latter ratio may be providing a false picture of improvement in this example simply because cost of goods sold has gone up as percentage of sales (from 75 percent to 90 percent)・ Inventory is not really turning over any faster ・a.Sales $& 000,000 1 _---------------- — --------------------- --Inventory & 00,000$10,000,0001,000,000 =lOx7.The balance sheet for Stud Clothiers is shown below. Sales for the year were $2,400,000, with90 percent of sales sold on credit.STUD CLOTHIERSBalance Sheet 200XAssets Liabilities and Equity Cash ............................... • $ 60,000Accounts payable ....................... $ 220.000Accounts receivable ....... 240,000 Accrued taxes ............................. 30,000Inventory ........................ 350,000 Bonds payable(long-term) ................................. 150,000 Plant and equipment ....... . 410.000 Common stock ........................... 80,000Paid-in capital .............................. 200,000Retained earnings ........................ 380.000Total assets ............... .$1.060.000 Total liabilities and equity..•$l・060・000Compute the following ratios:a. b. c. d. e.Current ratio.Quick ratio.Debt-to-total-assets ratio. Asset turnover. Average collection period.3-7.Solution:Stud Clothiers- Current assetsCurrent ratio = -------------------------Current liabilities $650,000$250,000=2.6x3-7. (Continued)1 i (Current assets 一 inventory) b. Quick ratio = --------------------------------------Current liabilities_ $650,000-$350,000 $250,000 _ $300,000 -$250,000 =1.2x-i 1 Total debt c.Debt to total assets = ------------------Total assets$400,000 —$1,060,000 = 37.74%」▲Salesd. Asset turnover = ------------------Total assets_ $2,400,000 —$1，060,000 =2.26xp 。
