Chapter 3, Solutions

Cornett, Adair, and Nofsinger

CHAPTER 3 – ANALYZING FINANCIAL STATEMENTS Questions LG1-LG5 1. Classify each of the following ratios according to a ratio category (liquidity ratio, asset management ratio, debt management ratio, profitability ratio, or market value ratio). a. Current ratio – liquidity ratio b. Inventory turnover ratio – asset management ratio c. Return on assets – profitability ratio d. Accounts payable period – asset management ratio e. Times interest earned – debt management ratio f. Capital intensity ratio – asset management ratio g. Equity multiplier – debt management ratio h. Basic earnings power ratio – profitability ratio LG1 2. For each of the actions listed below, determine what would happen to the current ratio. Assume nothing else on the balance sheet changes and that net working capital is positive. a. Accounts receivable are paid in cash – Current ratio does not change b. Notes payable are paid off with cash – Current ratio increases c. Inventory is sold on account – Current ratio does not change d. Inventory is purchased on account– Current ratio decreases e. Accrued wages and taxes increase – Current ratio decrease f. Long-term debt is paid with cash – Current ratio decreases g. Cash from a short-term bank loan is received – Current ratio decreases LG1-LG5 3. Explain the meaning and significance of the following ratios a. Quick ratio - Inventories are generally the least liquid of a firm’s current assets. Further, inventory is the current asset for which book values are the least reliable measures of market value. In practical terms, what this means is that if the firm must sell inventory to pay upcoming bills, the firm is most likely to have to discount inventory items in order to liquidate them, and so therefore they are the assets on which losses are most likely to occur. Therefore, the quick (or acid-test) ratio measures a firm’s ability to pay off short-term obligations without relying on inventory sales. The quick ratio measures the dollars of more liquid assets (cash and marketable securities and accounts receivable) available to pay each dollar of current liabilities. b. Average collection period - The average collection period (ACP) measures the number of days accounts receivable are held before the firm collects cash from the sale. In general, a firm wants to produce a high level of sales per dollar of accounts receivable, i.e., it wants to collect its accounts receivable as quickly as possible to reduce any cost of financing inventories and accounts receivable, including interest expense on liabilities used to finance inventories and accounts receivable, and defaults associated with accounts receivable.

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Chapter 3. A high level of sales per dollar of inventory implies reduced warehousing. the less debt and more equity the firm uses to finance its assets (i. Accounts payable turnover . but also by the amount of financial leverage or debt that firm uses. Without this incentive. The value of a firm’s ROE is affected not only by net income. Is this a good or poor sign about the management of the firm’s accounts receivable? If the ACP is extremely low. LG3 5. By offering firm customers the accounts receivable privilege. that is. Adair.The market-to-book ratio compares the market (current) value of the firm’s equity to their historical costs. g. f. In general. ROE is the net income earned per dollar of common stockholders’ equity. it wants to turn inventory over (from raw materials to finished goods to sold goods) as quickly as possible. Stockholders are entitled to any residual cash flows―those left after 2 . the lower the debt.e. h. the bigger the firm’s equity cushion). and any other costs of servicing the inventory. Days’ sales in inventory . or equity multiplier ratios. The industry average ACP is 25 days. a firm wants to produce a high level of sales per dollar of inventory. it gives the debtholders first claim to a fixed amount of its cash flows. The industry average debt ratio is 65%. management allows customers to buy (more) now and pay later. d. In general. Market-to-book ratio . So. Debt ratio . So extremely low ACP levels may be a sign of bad firm management. e. a high inventory turnover ratio or a low days’ sales in inventory is a sign of good management.The accounts payable turnover ratio measures the dollar cost of goods sold per dollar of accounts payable. a high APP or a low accounts payable turnover ratio is generally a sign of good management. In general. Thus.The debt ratio measures the percentage of total assets financed with debt. Firms offer accounts receivable terms as an incentive to get customers to buy products from their firm rather than a competing firm. LG2 4..The profit margin is the percent of sales left after all firm expenses are paid. the firm’s accounts receivable policy may be so strict that customers prefer to do business with competing firms. and Nofsinger c. A firm has an average collection period of 10 days. The debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity financing. The equity multiplier ratio measures the dollars of assets on the balance sheet for every dollar of equity financing. debt-to-equity. customers may chose to buy the goods from the firm’s competitors who offer better credit terms. So. if managers require customers to pay for their purchases very quickly. the less the firm will need other costly sources of financing such as notes payable or long-term debt. The days’ sales in inventory ratio measures the number of days that inventory is held before the final product is sold. Is this a good or poor sign about the management of the firm’s financial leverage? When a firm issues debt to finance its assets. Return on equity . all three measures are related. Solutions Cornett. insurance. As you might suspect. The more slowly it can pay for its supply purchases. A firm has a debt ratio of 20%.Return on equity (ROE) measures the return on the common stockholders’ investment in the assets of the firm. monitoring. a firm wants to pay for its purchases as slowly as possible.. that is. the higher the market-to-book ratio. the better the firm. Profit margin .

Adair. However. LG4 6. The industry average ROE is 12%. So a change in one ratio may well affect the value of several ratios. This magnification is one reason that firm stockholders encourage the use of debt financing. Thus. With this tool. Often these interrelations can help evaluate firm performance. but the total asset turnover (efficiency in using assets) increased. If the firm has a bad year and can not make promised debt payments. Clearly. LG6 9. the DuPont equation may show that the net profit margin was constant. How can the DuPont system of analysis help the firm’s managers identify the reasons for this difference? The basic DuPont equation looks at the firm’s overall profitability as a function of the profit the firm earns per dollar of sales (operating efficiency) and the dollar of sales produced per dollar of assets on the balance sheet (efficiency in asset use). but profit margins (operating efficiency) increased. a high ROE is considered to be a positive sign of firm performance. A firm has an ROE of 10%.Chapter 3. The industry average ROE is 15%. debtholders can force the firm into bankruptcy. financial leverage also increases the firm’s potential for financial distress and even failure. if performance comes from a high degree of financial leverage. and Nofsinger debtholders are paid. the DuPont analysis system uses the balance sheet and income statement to break the ROA and ROE ratios into component pieces. or that total asset turnover remained constant. Popularized by the DuPont Corporation. managers must consider the trade-off between maximizing cash flows to the firm’s stockholders versus the risk of being unable to make promised debt payments. a high ROE can indicate a firm with an unacceptably high level of bankruptcy risk as well. Managers can then break down operating efficiency and efficiency in asset use further using the ratios described above to more specifically identify the reasons for an ROA change. financial leverage increases the reward to shareholders since the amount of cash flows promised to debtholders is constant and capped. Is this a good or poor sign about the management of the firm? Generally. However. When a firm does well. Solutions Cornett. So when firms do well. In deciding the level of debt versus equity financing to hold on the balance sheet. A firm has an ROE of 20%. LG6 7. What is the difference between the internal growth rate and the sustainable growth rate? 3 . Why is the DuPont system of analysis an important tool when evaluating firm performance? Many of the ratios discussed in the chapter are interrelated. managers can see the reason for any changes in ROA in more detail. the greater the need for an equity cushion. Managers and investors often perform a detailed analysis of ROA (Return on Assets) and ROE (Return on Equity) using the DuPont analysis system. the larger the fluctuations or variability of a firm’s cash flows. financial leverage creates more cash flows to share with stockholders—it magnifies the return to the stockholders of the firm. For example. Managers’ choice of capital structure―the amount of debt versus equity to issue―affects the firm’s viability as a long-term entity. if ROA increases. LG6 8. a firm’s current and potential debtholders (and even stockholders) look at equity financing as a safety cushion that can absorb fluctuations in the firm’s earnings and asset values and guarantee debt service payments.

while another uses LIFO (last-in. In this case. along with absolute ratio levels. the depreciation method used to value a firm’s fixed assets over time may vary across firms. managers finance asset growth with new debt and retained earnings. a decreasing debt ratio (increasing equity financing) dilutes their return. analysts. LG8 12. the increased relative size of the inventories is good for the firm. One firm may use FIFO (first-in. and operate in a similar manner to the firm being analyzed. or cross-sectional analysis. Likewise. retained earnings—to finance future growth. So as firms grow. Looking at one firm’s financial ratios. give managers. are not being used as well as they were in the past. even through time.Chapter 3. analysts. the choice of companies to use in cross-sectional analysis is at best subjective. Adair. inventory methods can vary. Thus. The maximum growth rate that can be achieved this way is the sustainable growth rate. have similar assets sizes. and investors information about whether a firm’s financial condition is improving or deteriorating. ratio analysis may reveal that the days’ sales in inventory is increasing. its debt ratio will fall because as asset values grow. as assets grow the debt ratio decreases. Ratio analysis almost always includes a comparison of one firm’s ratios relative to the ratios of other firms in the industry. Key to cross-sectional analysis is identifying similar firms in that they compete in the same markets. If this increase is the result of a deliberate policy to increase inventories to offer customers a wider choice and if it results in higher future sales volumes or increased margins that more than compensate for increased capital tied up in inventory. As we noted above shareholders often become disgruntled if. and investors only a limited picture of firm performance. transferring inventory at the first purchase price. A problem arises when a firm relies only on internal financing to support asset growth: Through time. and Nofsinger The internal growth rate is the growth rate a firm can sustain if it uses only internal financing—that is. If total debt remains constant. LG7 11. relative to the sales they support. This suggests that inventories. obtaining such a comparison group is no easy task. For example. transferring inventory at the last purchase price. Why is it important to know a firm’s accounting rules before making any conclusions about its performance from ratios analysis? Firms use different accounting procedures. managers must often try to maintain a debt ratio that they view as optimal. as the firm grows. first-out). and investors? Analyzing ratio trends over time. on the other hand. LG7 10. if increased inventories result from declining sales but steady purchases of supplies and production. Cross-sectional analysis evaluates the performance of the firm against one or more companies in the same industry. analysts. Solutions Cornett. first-out). Since no two firms are identical. What is the difference between time series analysis and cross-sectional analysis? Time series analysis evaluates the performance of the firm over time. For example. One firm may use straight-line depreciation while another may use an accelerated depreciation 4 . What information does time series and cross-sectional analysis provide for firm managers. gives managers. Managers and investors should be concerned. total debt stays constant—only retained earnings finance asset growth.

to improve liquidity ratios calculated with year-end balance sheets.000.000 Cash ratio = —————————————— = 0. differences in accounting rules can affect balance sheet values and financial ratios. $225m.200.’s 2008 and 2009 balance sheets is listed below (in millions of dollars).000 + $800. it is often more accurate to use other than year-end financial statements to conduct performance analysis.000.000 + $600. Particularly when reviewing cross-sectional ratios.000 + $1.g.000. ——— = 1.200. equipment.$110m.000 + $800.100. MACRS).9565 times $115m. LG1 Accounts payable = $800.000 .000. ———— = 1. Current assets: Cash and marketable securities Accounts receivable Inventory Total 2008 $ 15 75 110 $200 2009 $ 20 84 121 $225 Current liabilities: Accrued wages and taxes Accounts payable Notes payable Total 2008 $ 18 45 40 $103 2009 $ 19 51 45 $115 Calculate Ramakrishnan Inc.000 + $1.200. and Cash ratio for 2008 and 2009.000 + $2.9417 times $103m.000 Quick ratio (acid-test ratio) = —————————————————————— = 0.100. Quick ratio.000 + $800.000. 5 .. . .100.100.000 + $2.$2.000. $200m. Accounts receivable = $1. 2008 Current ratio = $200m.$121m.000 LG1 3-2 Liquidity Ratios The top part of Ramakrishnan Inc.000 + $600. For example. 2009 $225m. to build up their liquid accounts and thus their liquidity ratios.000 + $600. Inventory = $2.21053 times $500. From the Problems balance sheet you find the following balances: Cash and marketable securities = $400.’s Current ratio. Adair. It is important to know which accounting rules the firms under consideration are using before making any conclusions about its performance from ratio analysis. etc. Accrued wages and taxes = $500. LG8 13. Problems Basic 3-1 Liquidity Ratios You are evaluating the balance sheet for Goodman’s Bees Corporation. Solutions Cornett. and Cash ratio.84211 times $500.Chapter 3.000 $400. loans.000 Current ratio = ———————————————— = 1. What does it mean when a firm window dresses its financial statements? Firms often window dress their financial statements to make annual results look better.000 $400.9474 times $500. Quick ratio. If possible. $400. and Notes payable = $600. Calculate Goodman Bee’s Current ratio. firms often delay payments for raw materials. and Nofsinger method (e.

Inc./1.). Inc. reported a debt-to-equity ratio of 1. ended the year 2008 with an average collection period of 32 days. LotsofDebt. x 365 Days’ sales in inventory = —————— = 88.75 = ————— => Total equity = $25m.75 = 14. Using a 365 day year. Total equity Total equity LG3 3-6 Debt Management Ratios You are considering a stock investment in one of two firms (LotsofDebt. how many days did Tater and Pepper’s inventory stay on the premises? How many times per year did Tater and Pepper’s inventory turn over? $5. finances its $25 million in assets with $1 million in debt and $24 million in equity. Inc. finances its $25 million in assets with $24 million in debt and $1 million in equity. => Accounts receivable = 32 days x $33 m.14563 times $103m. —————— = 0. Adair. Lotsof Equity $1m ——— = 4. ———— = 0. LotsofDebt $24m. equity multiplier. Inventory turnover ratio = ———— = 4. and debt-to-equity ratio for the two firms./365 = $2. Inc.00% $25m 6 . Calculate the debt ratio. $20m. LG2 3-3 Asset Management Ratios Tater and Pepper Corp. both of which operate in the same industry.6 million of inventory on its balance sheet.1071 days $5.90435 times $103m. Debt ratio = ——— = 96. and LotsofEquity.8696 days $23m.8738 times ———————— = 0. $23m. Tater and Pepper listed $5.89m. The firm’s credit sales for 2008 were $33 million.00% $25m.17391 times $115m. and Nofsinger Quick ratio (acid-test ratio) = ——————— = 0. how much equity does Tiggie’s have? Total debt $25 m.Chapter 3. If the firm’s total debt at year-end was $25 million. Husker’s Tuxedos? Accounts receivable x 365 Average collection period (ACP) = ——————————— = 32 days $33m.29m. Debt-to-equity ratio = ————— = 1. LG3 3-5 Debt Management Ratios Tiggie’s Dog Toys. Cash ratio = $15m.6m. Husker’s Tuxedos. $115m.75 times at the end of 2008.6m. Corp. What is the year-end 2008 balance in accounts receivable for Mr. Calculate Tater and Pepper’s 2008 EBIT. Solutions Cornett. Inc. LotsofEquity. LG2 3-4 Asset Management Ratios Mr. reported sales for 2008 of $23 million.

$1m. = $1. Dividend payout ratio = ——— = 37. Return on assets (ROA) = ——— = 6. ——— = 1.412.5m.5 million. Inc. LG4 3-8 Profitability Ratios In 2008. .5m. announced an ROA of 8. ROE.2m.2m.5 m.2 million.6 million.042 times $24m.095% $52. LG4 $25m.2m. ROA.5m. Debt-to-equity ratio = ——— = 24 times $1m. Calculate the 2008 values of net income available to common stockholders’.5%. EBIT = $5. Solutions Cornett.5m. Profit margin = ——————— = 16.5 million at year-end 2008. and common stock dividends = $1.2m. Basic earnings power ratio (BEP) = ——— = 10. and Nofsinger $25m.5 million.400 7 .2m. Adair. The 2008 year-end balance sheet listed total assets = $52. and profit margin of 20. ROE of 14.Chapter 3.0856 = ——————————————————— $16.00% $12. Calculate the profit margin. and dividend payout ratio. common stockholders’ equity.67% $52.50% $3. $3. $24m.2m. Inc.’s 2008 income statement listed net sales = $12. The firm had total assets of $16. $3.24% $21m. $5.0856 x $16. Jake’s Jamming Music. $1.56%. Return on equity (ROE) = ——— = 15. Equity multiplier ratio = ——— = 25 times $1m. net income available to common stockholders = $3. 3-7 Profitability Ratios Maggie’s Skunk Removal. ——— = . and net sales for Jake’s Jamming Music.5%.$1. $3. Corp. basic earnings power ratio.2 million. and common stockholders equity = $21 million with 2 million shares outstanding. Net income available to common stockholders Return on assets (ROA) = 0.6m. => Net income available to common stockholders = 0.042 times $24m.

00% Capital intensity ratio = 1/48% = 2. If Gambit Golf’s common stock is currently selling at $12.412. + $2. and sales of $10 million.75 = $1. During the last year the firm’s income statement listed addition to retained earnings = $4. Solutions Cornett.75 times = ————————— => Earnings per share = $12.50 = ————————— => Book value per share = $12.)/10m.70 LG5 3-10 Market Value Ratios Gambit Golf’s market-to-book ratio is currently 2.18/(.740.50 per share Earnings per share = ($4. Inc.145 = $9.2m. has an ROE = 18%.50 per share.75%.2 million.400/0. Roxie’s year-end balance sheet shows common stockholders’ equity = $35 million with 10 million shares of common stock outstanding. The common stock’s market price per share = $9. what is the book value per share and earnings per share? $12.85 Earnings per share LG6 3-11 DuPont Analysis If Silas 4-Wheeler. 8 .8 million and common stock dividends = $2.145 = ———————————— Common stockholders’ equity => Common stockholders’ equity = $1.00 Book value per share $12. what is the total asset turnover ratio and the capital intensity ratio? ROE = ./10m.8m. a profit margin of 12%.205 = $6. Adair.5%.86 times $0.5 times and PE ratio is 6.205 = ————— => Sales = $1. Corp.690 $1.50/2.1875x Total asset turnover x 2 => Total asset turnover = .756 Sales LG5 3-9 Market Value Ratios You are considering an investment in Roxie’s Bed & Breakfast.50 Market-to-book ratio = 2.Chapter 3.083333 times LG6 3-12 DuPont Analysis Last year Hassan’s Madhatter.412. Calculate Hassan’s Madhatter’s total assets.18 = . What is Roxie’s Bed & Breakfast’s book value per share and earnings per share? Calculate the market-to-book ratio and PE ratio.57 times $3.1875 x 2) = 48.50/6.50 $9. Book value per share = $35m.50 = $5. had an ROA of 7.400 Return on equity (ROE) = 0.50 Price-earnings (PE) ratio = 6.400/0.00. and Nofsinger $1.889.75 times. Inc.412. = $0.00 Market-to-book ratio = ——— = 2.412. a profit margin of 18.00 Price-earnings (PE) ratio = ——— = 12.400 Profit margin = 0. = $3. equity multiplier = 2.70 per share $9.

0. => Accounts receivable = 30 x $40m.075 = .14% (1.333.125 x (1 .$3.671 => Cash and marketable securities = $10m.1 times.5m.333. => Current assets = 2. => Inventory = $31.6m. = $15. Cash makes up 10 percent of the current assets and accounts receivable makes up another 40 percent of current assets.20) Sustainable growth rate = ————————— = 9.. $40m.11% (1 .Chapter 3. = $10m. and Nofsinger ROA = 0. Calculate the value of inventory listed on the firm’s balance sheet.333 Inventory Accounts receivable x 365 Average collection period (ACP) = 30 days = ——————————— $40m. inventory turnover ratio = 12 times.75m.40 x $31. = $3.20) Intermediate 3-15 Liquidity Ratios Brenda’s Bar and Grill has current liabilities of $15 million. average collection period = 30 days...075 x (1 . Inventory turnover ratio = 12 times = ———— => Inventory = $40m. .075 = $16m. Adair. LG1 Current ratio = 2. LG6 3-13 Internal Growth Rate Last year Lakesha’s Lounge Furniture Corporation had an ROA of 7./12 = $3. What is the internal growth rate? 0.$3. current ratio = 2 times.5% and a dividend payout ratio of 25%. has current liabilities = $5 million. Calculate the value of cash and marketable securities.15m..$3.1 = Current assets/$15m. Cash = 0. Inc. Accounts receivable = 0. $5m./365 = $3.$12.15m.5m. and sales = $40 million. = $12.12 x $10m.5m.25) LG6 3-14 Sustainable Growth Rate Last year Lakesha’s Lounge Furniture Corporation had an ROE of 12.96 9 .287. . Current assets Current ratio = 2 times = ———————— => Current assets = 2 x $5m.25) Internal growth rate = ————————— = 8.671 = $3. = $31.6m./Total assets) => Total assets = .12 x ($10m.0. Solutions Cornett.125) x (1 .075) x (1 .1 x $15m./.287.378. Problems Brenda’s current ratio = 2.5% and a dividend payout ratio of 20% What is the sustainable growth rate? 0.333 .10 x $31. . LG1-LG2 3-16 Liquidity and Asset Management Ratios Mandesa.5m.

reported a debt to equity ratio of 1. Inc.2m.000.: sales to working capital = 4. = $4. profit margin = 20%. – Total debt) => 1._____ Step 1 $ __$10.333m. 10 . => Total equity = $25m.92m.75m.43m. how much of their assets are financed with debt and how much with equity? Debt to equity = 1./2. Sales = $5.922m. Assets Current assets Step 5 Fixed assets Step 4 Total assets $6. Liabilities and Equity Total liabilities Total equity Step 2 Step 3 $____$6.2 times. dividends per share = $1.55 = Total debt/$10.587m. . and Nofsinger LG2 LG4 3-17 Asset Management and Profitability Ratios You have the following information on Els’ Putters.91m.55 x $10.2 = $4. capital intensity ratio = 2.___ Total liabilities and equity $____$10. $4./Fixed assets => Fixed assets = $5. Adair.000.2m.6 times. – Total debt) = Total debt => (1. = 2. => Total debt = .000.587m. = $10.333m.2 = $25m Sales/(Current assets – Current liabilities) = 4.$4.6) + 6m. depreciation expense = $100. net income available to common stockholders = $5 million. = $6.75m.2 million.1 x $5.75 = Total debt/Total equity = Total debt/(Total assets – Total debt) 1.$6.500.333m. LaTonaya’s Flop Shops has no preferred stock outstanding./.09m.914m.$6m. .914m. = $11. and current liabilities = $6 million. tax rate = 30%.92m.92m.92m. Step 1: Capital intensity ratio = 2. Solutions Cornett. addition to retained earnings = $97. debt ratio = 55%.91m. Inc.92m. LG3 3-20 Debt Management Ratios Calculate the times interest earned ratio for LaTonya’s Flop Shops. Inc.$15.75 = $15. .75 x Total debt) = Total debt => $43. Step 2: Debt ratio = .006m.) – (1.6 = $25m./1.75 x $25m.10 = Total assets/$5. If the firm’s total assets at year-end were $25 million.2 = $5m.75 = Total debt/($25m. and Total liabilities and equity = $10.Chapter 3./Sales => Sales = $5m.75 x ($25m.____ LG3 3-19 Debt Management Ratios Tiggie’s Dog Toys.) => Current assets = ($25m. Step 5: Current assets = $10.92m./(Current assets . using the following information. cost of goods sold = $600. = $6. Step 4: Fixed asset turnover = 1.75 x Total debt => Total debt = $43. => Total assets = 2. What is the firm’s balance of current assets? Profit margin = .92m./4.006m.2m. and number of shares of common stock outstanding = 60. Sales = $1 million.75 times at the end of 2008.10 times._____ ____$4.2 = $5.2m. and fixed asset turnover ratio = 1. = $9. Step 3: Total equity = $10.006m. LG2 LG3 3-18 Asset Management and Debt Management Ratios Use the following information to complete the balance sheet below.

000 .18 = Net income/$2.000 = $75.$100. step 3.25m. EBIT – Interest = EBT => Interest = EBIT .Chapter 3.000 – $600./.000/$2.75m.545m. . step 1. => Total equity = $4. Inc. = $2.000 $400. total debt = $1.$2.000 Step 6.000 = $400. and Nofsinger Net sales (all credit) Less: Cost of goods sold Gross profits Less: Depreciation Earnings before interest and taxes (EBIT) Less: Interest Earnings before taxes (EBT) Less: Taxes Net income Less: Common stock dividends Addition to retained earnings step 4.500 = $157.000 => ROA = $405.000 $300.500 $60.000/$3.5m.000.000 600.000 $157.22% LG4 3-22 Profitability Ratios Rick’s Travel Service has asked you to help piece together financial information on the firm for the most current year.5m/.75m. = 10.55 = $2.045m. = $405. Net income = Common stock dividends + Addition to retained earnings = $60. => ROE = $250.000 Step 2.000 Step 4.000 => Times interest earned = $300.5m. What is Nikki T’s ROE for 2008? Debt ratio = .8 million.045m. $1.55 = $4. calculate Rick’s ROA. => ROE = .5m. Gross profits = Net sales – Cost of goods sold = $1. step 5.25m.000 $97.000/$75.000.000 Step 5./Total assets => Total assets = $2.000 = $300.4 = $3. step 6. Common stock dividends = $1 x 60. total debt = $2.5 million. Solutions Cornett. Using this information. Gross profits – Depreciation = EBIT = $400./Total assets => Total assets = $1. Debt ratio = . Adair.18 x $2.000 $75.5m.8% 11 .000 + $97.000 $225. .500 Step 1.000 = 4. => Net income = . EBT (1 – tax rate) = Net income => EBT = Net income/(1 – tax rate) = $157.EBT = $300.000 . ROE = 18%. debt ratio = 40%. step 2.545m. => Total equity = $3.3) = $225.$1.$225.75m.500 Step 3.25m. debt ratio = 55%.00 times LG2 LG4 3-21 Profitability and Asset Management Ratios You are thinking of investing in Nikki T’s.000 100.40 = $1.500/(1-. = $2.5 million.000 = $60. You have only the following information on the firm at year-end 2008: net income = $250.000. = 12.5m. Managers give you the following information: sales = $4.

) – 1.65 x $50m.3125m.273m.375% LG6 3-27 Internal Growth Rate Dogs R Us reported a profit margin of 10.5m. = $17.75m.5m. – Total debt) => (1.2m. What is Dogs R Us’ internal growth rate? ROA = Profit Margin x Total asset turnover = 10. = $8.518. Adair.5 million. Solutions Cornett.2 x 16m.08 x $18.2 = Total debt/Total equity = Total debt/(Total assets – Total debt) 1. ACP = 25 days. Calculate the ROE for the firm. => Book value of equity = $17. = $5. . = $1.000.75m. Calculate the PE ratio for Leonatti Labs.25 times. => ROE = $2. accounts receivable = $2.727.2 times.2 x Total debt = Total debt => 19./2.2m. x . = $0.25 x $15m.2 x Total debt => Total debt = 19./3/m.75m. You have been able to locate the following information on the firm: total assets = $16 million. The firm has a profit margin of 8%.50 per share => PE ratio = $15/$0.75 = 7. Calculate the net income for Stumble-on-Inn last year. reported an ROE = 18%.4375m.727m. . The firm has no preferred stock outstanding.$200. and the capital intensity ratio was 1.2 = $8.08 = Net income/$18. total assets of $25 million.5%.2m.000 .$8. net income of $500.55 x $18.000. = $1. sales were $15 million. => Total debt = ./3m.65 = Total debt/$50m.5m.000)/$500. and dividends paid to common stockholders of $200.Chapter 3. = $32. = $10. and debt-to-equity ratio = 1. => Sales = $25m.4375m.75m.5m.55 = Total debt/$18.83333 = 6 times LG5 3-24 Market Value Ratios Leonatti Labs’ year-end price on its common stock is $15.5m.$32.75m.875% RR = ($500.50 = 30 times LG6 3-25 DuPont Analysis Last year. debt-to-equity ratio of 0. => Total equity = $50m.75m.2 million.18 x $8. no preferred stock. net income = $2.3125m.75 = $18. Calculate the market-to-book ratio for Leonatti Labs. Debt ratio = . and there are 3 million shares of common stock outstanding. Total asset turnover = . Inc. total asset turnover ratio of 0. and Nofsinger LG5 3-23 Market Value Ratios Leonatti Labs’ year-end price on its common stock is $35. the debt ratio is 65%.2 = Total debt/(16m.75 = Sales/$25m. => Total assets = 1.750 LG6 3-26 DuPont Analysis You are considering investing in Nuran Security Services. Capital intensity ratio = 1. = 2. = $7. => Total equity = $18. and there are 3 million shares of common stock outstanding. => Total equity = $19. The firm has total assets of $50 million. => Debt ratio = .5m.75.75m. => ROE = . The firm’s debt ratio was 55%.5m => EPS = $1.5% x 0. => Profit margin = .000 = . => Net income = . = 34.4375m. => Net income = . Stumble-on-Inn. => Total debt = . = $18./$7.80 times.25 = Total assets/$15. a total asset turnover ratio of 0.75 times.$10. Debt-to-equity = 1.273m.83333 per share => Market to book ratio = $35/$5.18 = Net income/$8. no preferred stock.60 12 . .

07875) x .60 3-28 Sustainable Growth Rate You have located the following information on Webb’s Heating & Air Conditioning: debt ratio = 54%.548% (1 . Adair.. and dividend payout ratio = 40%.125 x 1/1.1739 ROE = Profit Margin x Total asset turnover x Equity multiplier = .54 = 1. Inc. profit margin = 12.5%.70% Retention ratio (RR) = 1 .10 times..81% (1 .46 = 2.46 = 1/Equity multiplier => Equity multiplier = 1/.60 Sustainable growth rate = ——————— = 32.07875 x .Chapter 3.60 LG1-LG7 Use the following financial statements for Lake of Egypt Marina to answer problems 3-29 through 3-32.60 . and Nofsinger ROA x RR Internal growth rate = —————— = (1-ROA) x RR LG6 0. Lake of Egypt Marina.10 x 2. 2007 and 2008 (in millions of dollars) 2007 2008 Liabilities & Equity 2007 Current liabilities Accrued wages and taxes Accounts payable Notes payable Total Long-term debt: $ 471 $ 580 100 110 $ 371 $ 470 49 50 $ 420 $ 520 $ 785 $ 910 Stockholders’ equity: Preferred stock (5 million shares) Common stock and paid-in surplus (65 million shares) Retained earnings Total Total liabilities and equity : $ 43 $ 40 80 90 70 80 $ 193 $ 210 $ 300 $ 5 65 Assets Current assets: Cash and marketable securities Accounts receivable Inventory Total Fixed assets: Gross plant and equipment Less: Depreciation Net plant and equipment Other long-term assets Total Total assets 2008 $ 65 110 190 $ 365 $ 75 115 200 $ 390 $ 280 $ 5 65 242 330 $ 312 $ 400 $ 785 $ 910 13 .0. Solutions Cornett.54 = . Balance Sheet as of December 31.1739 = 24. capital intensity ratio = 1. Calculate the sustainable growth rate for Webb.40 = .2470 x .2470) x ..dividend payout ratio = 1 . Equity multiplier = Total assets/Total equity => 1/Equity multiplier = Total equity/Total assets Debt ratio = Total debt/Total assets = (Total assets – Total equity)/Total assets = 1 – (Total equity/Total assets) .(Total equity/Total assets) => Total equity/Total assets = 1 .60 ——————— = 8.

55 Common stock and 47.00% 100.65 paid-in surplus 8. Adair.40% 10.48% 4. Spread the balance sheet: Lake of Egypt Marina.21 21.000 $6.877 $1.83 36.89 8.723 $12.19 9.92 8.95 100.Chapter 3.63 0. Balance Sheet as of December 31.86 Total Long-term debt: 60.24% taxes 14.79 24.59 23.50 42.98 Notes payable 46.00% 100.74 63.67 32.97 Stockholders’ equity: Preferred stock (5 million shares) 0.550 $ 5 $ 138 $ 65 $ 73 $2.28 7. 2007 and 2008 (in millions of dollars) 2007 2008 Liabilities & Equity 2007 Current liabilities: Accrued wages and 8.750 3-29 Spreading the Financial Statements Spread the balance sheets and income statements of Lake of Egypt Marina.00 12.09 Assets Current assets: Cash and marketable securities Accounts receivable Inventory Total Fixed assets: Gross plant and equipment Less: Depreciation Net plant and equipment Other long-term assets Total Total assets 2008 5.00% Total liabilities and equity 100.01 12. for 2007 and 2008.24 5.74 12.123 $1. Inc.64 Accounts payable 24.50 57. Solutions Cornett.077 $14.08 35. Inc.26 51.00% 14 .14 6. and Nofsinger Lake of Egypt Marina.26 Total 39.14 Retained earnings 30.000 $4. Inc.49 (65 million shares) 53.74 43. 2007 and 2008 (in millions of dollars) 2007 2008 Net sales (all credit) $ 432 $ 515 Less: Cost of goods sold 200 260 Gross profits 232 255 Less: Depreciation 20 22 Earnings before interest and taxes (EBIT) 212 233 Less: Interest 30 33 Earnings before taxes (EBT) 182 200 Less: Taxes 55 57 Net income $ 127 $ 143 Less: Preferred stock dividends Net income available to common stockholders Less: Common stock dividends Addition to retained earnings Per (common) share data: Earnings per share (EPS) Dividends per share (DPS) Book value per share (BV) Market value (price) per share (MV) $ 5 $ 122 $ 65 $ 57 $1. Income Statement for Years Ending December 31.28% 8.

95 times Industry 2.88% 35% 2.04% (210+300)/400=1. 390/210=1.94 6.86 times (390-200)/210=0.99 times 515/(390-210)=2.0 times 1.73 11.49 Gross profits 53.39 days 32.50 days 45 days 1.55 times 15.00% Less: Cost of goods sold 46.18 times 62.67 times 8.85 times 1. Dividend payout ratio v. ROE u. and Nofsinger Spreading the income statement: Lake of Egypt Marina.27 Earnings before interest and taxes (EBIT) 49. Times interest earned p.28 times 910/400=2. ROA t.16% 138/400=34.13 38.50% 15 .123=6.36 times 515/200=2.75 times 28.2 times 0.25 times 4.07 Net income 29. Equity multiplier o.70 49.28 times 233/33=7. PE ratio Lake of Egypt Marina.75 days (115x365)/515=81. Inc.77 times (210+300)/910=56. Days’ sales in inventory f.50 days (90x365)/260=126. Debt-to-equity ratio n. Average payment period h.50% 19. Solutions Cornett. Adair. Fixed asset turnover ratio i.50% 65/138=47. Quick ratio c. Cash ratio d.83 Less: Taxes 12.28 times = 34.58 times (200x365)/515=141.750/6.86 times 515/910=0.30 50. Profit margin r. Basic earnings power ratio s.57 times = 15. Average collection period g.750/2. Sales to working capital j. Total asset turnover ratio k.75% 32. Market-to-book ratio w.57 times 901/515=1.Chapter 3.60% 138/910=15.00% 100.75% 36.80% x 0. Inc. ROA = Profit Margin x Total asset turnover = 26.50 times 8.25 times 0.57 times x 2.35 days 515/520=0.25 times 3. 2007 and 2008 (in millions of dollars) 2007 2008 Net sales (all credit) 100.76% 3-30 Calculating Ratios Calculate the following ratios for Lake of Egypt Marina.16% ROE = Profit Margin x Total asset turnover x Equity multiplier = 26.51 Less: Depreciation 4.43 times 14.80% 233/910=25.50% 1.90 times 75/210=.80% x 0. Income Statement for Years Ending December 31.06 times (233+22)/33=7. Debt ratio m.60 times 101. Capital intensity ratio l. Cash coverage ratio q.73 times 138/515=26.077=2. Current ratio b. Inc.07 45.40% 27.60 times 3-31 DuPont Analysis Construct the DuPont ROA and ROE breakdowns for Lake of Egypt Marina.10% 14.67 times 2. Inc. as of year-end 2008.24 Less: Interest 6. Inventory turnover ratio e.41 Earnings before taxes (EBT) 42. a.63 4.

$2.) = Long-term Debt=> (.5 = $800m.  ROE = 20% = $210m.Chapter 3.050m.5m.. = $1. asset management is poorer. Advanced 3-34 Ratio Analysis Use the following information to complete the balance sheet below.55) = $1.050m. Liquidity is lower.3450 x (1 . => Current assets = 2.. Step 2: Average collection period = 60 days = (Accounts receivable x 365)/$1.1516) x (1 ./. = $210m.5 x $370m.4710) .283m.5 times = Current assets/$370m..703m. Step 3: Long-term debt/Long-term Debt and Equity = 55% => .283m.20 = $1.  Accounts receivable = (60 x $1.1516 x (1 . Current Assets Step 1 Fixed Assets Step 5 $925m. Current Liabilities Long-term Debt Step 3 $370m.876% (1 .200m. => Current assets = 2.. and the industry. Step 2: Profit Margin = 10% = Net income/$2./1. Step 1: Current ratio = 2.3450) x (1 .778m.050m.55x Long-term Debt) + (.200m. Solutions Cornett.2 times = Current assets/$500m.100m. Problems LG1-LG5 Step 1: Current Ratio = 2. => Net income = .100m. and profit ratios are lower.)/365 = $197m.. 16 .) = Long-term Debt => $577. what can you conclude about Lake of Egypt Marina’s financial performance for 2008. Inc.4710) Internal growth rate = ——————————— = 17. 1.5 times = $1..4710) Sustainable growth rate = —————————— = 52.200m.55(Long-term Debt + $1.050m.  Step 3: Inventory turnover = 1.703m./(1. $1. Lake of Egypt Marina is performing below the industry in all areas. Adair.200m..67% (1 . and Nofsinger 3-32 Internal and Sustainable Growth Rates Calculate the internal and sustainable growth rate for Lake of Egypt Marina.10 x $2.4710) 3-33 Cross-sectional Analysis Using the ratios from question 3-30 for Lake of Egypt Marina.55) x Long-term Debt => Long-term Debt = $577. Step 4 Total Liabilities & Equity LG1-LG5 3-35 Ratio Analysis Use the following information to complete the balance sheet below.2 x $500m. = $925m. Stockholders’ Equity Step 2 Total Assets $2. 1. Inc.100m. = (1./Inventory => Inventory = $1./Total equity => Total equity = $210m.55 x $1. 0.0.5m.

Current liabilities Long-term debt Total debt Stockholders’ equity Total liabilities & equity $500m.200m. 640m. Step 6: Fixed assets = $1. 800m. . $1.60 x $1. $960m. 500m.$800m. . Solutions Cornett.600m. $1.$197m.100m. Cash Step 4 Accounts receivable Step 2 Inventory Step 3 Current assets Step 1 Fixed assets Step 6 Total assets $103m. Step 9 Step 7 Step 8 Step 5 17 .75 times = $1. => Total debt = ./Total assets => Total assets = $1. = $500m. and Nofsinger Step 4: Cash = $1. 197m. = $960m.600m.600m. Adair.100m.600m. Step 5: Total asset turnover = 0.600m./0. Step 7: Debt ratio = 60% = Total debt/$1.100m.$1.600m. . 460m.200m. $1.75 = $1. = $103m.Chapter 3.

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