# Chapter 2

Financial Statements, Cash Flow, and Taxes
Solutions to End-of-Chapter Problems

2-1 NI = \$3,000,000; EBIT = \$6,000,000; T = 40%; Interest = ?
Need to set up an income statement and work from the bottom up.

EBIT \$6,000,000
Interest 1,000,000
EBT \$5,000,000 EBT =
Taxes (40%) 2,000,000
NI \$3,000,000

Interest = EBIT – EBT = \$6,000,000 – \$5,000,000 = \$1,000,000.

2-2 EBITDA \$7,500,000 (Given)
Depreciation 2,500,000 Deprec. = EBITDA – EBIT = \$7,500,000 – \$5,000,000
EBIT \$5,000,000 EBIT = EBT + Int = \$3,000,000 + \$2,000,000
Interest 2,000,000 (Given)
EBT \$3,000,000
Taxes (40%) 1,200,000 Taxes = EBT × Tax rate
NI \$1,800,000 (Given)

2-3 NI = \$50,000,000; R/E
Y/E
= \$810,000,000; R/E
B/Y
= \$780,000,000; Dividends = ?

R/E
B/Y
+ NI – Div = R/E
Y/E

\$780,000,000 + \$50,000,000 – Div = \$810,000,000
\$830,000,000 – Div = \$810,000,000
\$20,000,000 = Div.

2-4 Total assets = \$10,500,000+\$3,000,000+\$5,300,000+\$1,100,000+\$1,100,000
= \$21,000,000
Stockholders’ equity = \$21,000,000 – \$3,664,000 – \$2,900,000 – \$550,000 – \$214,000
– \$7,328,000
= \$13,672,000.

2-5 Statements b and d will decrease the amount of cash on a company’s balance sheet.
Statement a will increase cash through the sale of common stock. Selling stock provides cash
through financing activities. On one hand, Statement c would decrease cash; however, it is also
possible that Statement c would increase cash, if the firm receives a tax refund.

6 . 0
\$3,000,000
T) (1
\$3,000,000
=
÷

6 . 0
000 , 800 , 1 \$
) T 1 (
000 , 800 , 1 \$
=
÷

2-6

Ending R/E = Beg. R/E + Net income ÷ Dividends
\$578,900,000 = \$512,300,000 + Net income ÷ \$22,500,000
\$578,900,000 = \$489,800,000 + Net income
Net income = \$89,100,000.

2-7 a. From the statement of cash flows the change in cash must equal cash flow from operating
activities plus long-term investing activities plus financing activities. First, we must identify
the change in cash as follows:
Cash at the end of the year \$25,000
– Cash at the beginning of the year – 55,000
Change in cash -\$30,000

The sum of cash flows generated from operations, investment, and financing must equal a
negative \$30,000. Therefore, we can calculate the cash flow from operations as follows:
CF from operations + CF from investing + CF from financing = A in cash
CF from operations ÷ \$250,000 + \$170,000 = -\$30,000
CF from operations = \$50,000.

b. Since we determined that the firm’s cash flow from operations totaled \$50,000 in Part a of
this problem, we can now calculate the firm’s net income as follows:
NI + on Depreciati +
s liabilitie
accrued
in Increase
÷
inventory
and A/R
in Increase
=
operations
from CF

NI + \$10,000 + \$25,000 – \$100,000 = \$50,000
NI – \$65,000 = \$50,000
NI = \$115,000.

2-8 a.
Net income \$18,100
Depreciation 7,500
Net cash provided by operating activities \$25,600

b.
FCF = EBIT (1 – T) + Deprec. – Capital expenditures – ΔNWC
= \$33,700 (1 – 0.4) + \$7,500 – 0 – 0
= \$27,720.
Assuming the tax rate is 40% and there are no capital expenditures and there is no change of
working capital.

2-9 a. NWC
2007
= Total CA – (A/P + Accruals)
= \$59,000 – (\$9,000 + \$6,000)
= \$44,000.

NWC
2008
= \$72,125 – (\$10,800 + \$7,600)
= \$53,725.

b. FCF = EBIT (1 – T) + Deprec. – Capital expenditures – ΔNWC
= \$39,000 (1 – 0.4) + \$5,000 – \$8,000 –\$9,725
= \$10,675.

Note: To arrive at capital expenditures you add depreciation to the change in net FA, so
Capital expenditures = \$5,000 + \$3,000 = \$8,000.

c. Statement of Stockholders’ Equity, 2008

Common Stock Retained Total Stockholders’
Shares Amount Earnings Equity

Balances, 12/31/07 5,000 \$50,000 \$20,850 \$70,850
2008 Net Income 22,350
Cash Dividends (11,175)
to retained earnings 11,175 11,175
Balances, 12/31/08 5,000 \$50,000 \$32,025 \$82,025

2-10 Working up the income statement you can calculate the new sales level would be \$12,681,482.

Sales \$12,681,482 S – 0.45S – Deprec. = EBIT
Operating costs (excl. Deprec.) 6,974,815 \$12,681,482 × 0.55
Depreciation 880,000 \$800,000 × 1.10
EBIT \$ 4,826,667 \$4,166,667 + \$660,000
Interest 660,000 \$600,000 × 1.10
EBT \$ 4,166,667 \$2,500,000/(1 ÷ 0.4)
Taxes (40%) 1,666,667 \$4,166,667 × 0.40
Net income \$ 2,500,000

2-11 a. Balance of RE, December 31, 2007 \$1,374
Add: NI, 2008 372
Less: Div. paid to common stockholders (146)
Balance of RE, December 31, 2008 \$1,600

The RE balance on December 31, 2008 is \$1,600 million.
To arrive at this statement, you must work up the statement because you haven’t been given
the 12/31/07 RE balance.

b. \$1,600 million.

c. Cash + Equivalents = \$15 million.

d. Total current liabilities = \$620 million.

2-12 a.
07
capital working
Net
= Current assets – (A/P + Accruals)
= \$360,000,000 – (\$90,000,000 + \$60,000,000)
= \$210,000,000.

08
capital working
Net

= \$372,000,000 – \$180,000,000 = \$192,000,000.

b. FCF08 = EBIT (1 – T) + Deprec. – Cap. expend. - ΔNWC
= \$150,000,000 (0.6) + \$30,000,000 – \$80,000,000 – (-\$18,000,000)
= \$90,000,000 + \$30,000,000 - \$80,000,000 + \$18,000,000
= \$58,000,000.

Note that depreciation must be added to ΔNet P&E to arrive at capital expenditures.

c. The large increase in dividends for 2008 can most likely be attributed to a large increase in
free cash flow from 2007 to 2008, since FCF represents the amount of cash available to be
paid out to stockholders after the company has made all investments in fixed assets, new
products, and working capital necessary to sustain the business.

Chapter 3
Analysis of Financial Statements
Solutions of End-of-Chapter Problems

3-1 DSO = 35 days; S = \$6,800,000; AR = ?

DSO =
365
S
AR

35 =
\$6,800,000/365
AR

35 = AR/\$18,630
AR = \$652,050.

3-2 A/E = 2.2; D/A = ?

D 1
= 1
A A/E
D 1
= 1
A 2.2
D
= 0.5455 = 54.55%.
A
| |
÷
|
\ .
| |
÷
|
\ .

3-3 ROA = 12%; PM = 2.2%; ROE = 16%; S/TA = ?; TA/E = ?
ROA = NI/A; PM = NI/S; ROE = NI/E.

ROA = PM × S/TA
NI/A = NI/S × S/TA
12% = 2.2% × S/TA
S/TA = TATO = 5.45.

ROE = PM × S/TA × TA/E
NI/E = NI/S × S/TA × TA/E
16% = 2.2% × 5.45 × TA/E
16% = 11.99% × TA/E
TA/E = EM = 1.334.

3-4 TA = \$11,000,000,000; CL = \$1,200,000,000; LT debt = \$3,300,000,000; CE = \$6,200,000,000;
Shares outstanding = 846,000,000; P
0
= \$36; M/B = ?

Book value =
\$6, 200, 000, 000
846, 000, 000
= \$7.33.

M/B =
\$36.00
\$7.33
= 4.9113.
3-5 EPS = \$2.40; CFPS = \$3.20; P/CF = 8.2×; P/E = ?

P/CF = 8.2
P/\$3.20 = 8.2
P = \$26.24.

P/E = \$26.24/\$2.40 = 10.9×.

3-6 PM = 2.2%; EM = 2.4; Sales = \$124,000,000; Assets = \$56,000,000; ROE = ?

ROE = PM × TATO × EM
= NI/S × S/TA × A/E
= 2.2% × \$124,000,000/\$56,000,000 × 2.4
= 11.7%.

3-7 In general, the higher the inventory turnover, the better. However, a higher turnover ratio does not
always mean better performance. A number that is too high might suggest that the company is
selling merchandise faster than it can be replenished. A company that stocks out a particular item
too fast may lose customers. A high inventory turnover ratio does not always imply a low level of
inventory. It may be due to high level of sales.

3-8 Total assets = Current assets + Fixed assets and other assets
= \$1,600,000 + \$3,600,000
= \$5,200,000.
Current liabilities = Total assets – Long-term liabilities – Stockholders’ equity
= \$5,200,000 – \$2,000,000 – \$1,500,000
= \$1,700,000.
Current ratio = Current assets/Current liabilities
= \$1,600,000/\$1,700,000
= 0.9412×
Quick ratio = (Current assets – Inventories)/Current liabilities
= (\$1,600,000 – \$700,000)/\$1,700,000
= 0.5294×
3-9 a. Current ratio = Current assets/Current liabilities
= \$3,000,000/Current liabilities
= 1.2×.
Current liabilities = \$3,000,000/1.2
= \$2,500,000.
b. Quick ratio = (Current assets – Inventories)/Current liabilities
= (\$3,000,000 – Inventories)/\$2,500,000
= 0.8×.
Inventories = \$3,000,000 – \$2,500,000×0.8
= \$1,000,000.

3-10 Market/book (M/B) ratio = Market price per share /Book value per share
= (\$1,300 × 15,000) /\$7,500,000
= 2.6×.

3-11 DSO = AR/(Sales/365)
= \$12,000/(\$100,000/365)
= 43.80 days.

3-12 Step 1: Calculate total assets from information given.
Sales = \$6 million.

3.2× = Sales/TA
3.2× =
Assets
000 , 000 , 6 \$

Assets = \$1,875,000.

Step 2: Calculate net income.
There is 50% debt and 50% equity, so Equity = \$1,875,000 × 0.5 = \$937,500.

ROE = NI/S × S/TA × TA/E
0.12 = NI/\$6,000,000 × 3.2 × \$1,875,000/\$937,500
0.12 =
000 , 000 , 6 \$
NI 4 . 6

\$720,000 = 6.4NI
\$112,500= NI.

3-13 ROA = 6%; net income = \$120,000; TA = ?

ROA =
TA
NI

6% =
\$120,000
TA

TA = \$2,000,000.

To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement:

EBIT \$100,615 (\$84,000 + \$923,077)
Interest 84,000 (Given)
EBT \$184,615 \$120,000/0.65
Taxes (35%) 64,615
NI \$120,000

BEP =
TA
EBIT

=
\$100, 615
\$2, 000, 000

= 0.0503 = 5.03%.

3-14 Stockholders’ equity = \$3,750,000,000; M/B = 1.9; P = ?
Total market value = \$3,750,000,000(1.9) = \$7,125,000,000.
Market value per share = \$7,125,000,000/50,000,000 = \$142.50.

Alternative solution:
Stockholders’ equity = \$3,750,000,000; Shares outstanding = 50,000,000; P = ?
Book value per share = \$3,750,000,000/50,000,000 = \$75.
Market value per share = \$75(1.9) = \$142.50.

3-15 We are given ROA = 3.2% and Sales/Total assets = 1.6×.

From the DuPont equation: ROA = Profit margin × Total assets turnover
3.2% = Profit margin(1.6)
Profit margin = 3.2%/1.6 = 2%.

We can also calculate the company’s debt ratio in a similar manner, given the facts of the problem.
We are given ROA(NI/A) and ROE(NI/E); if we use the reciprocal of ROE we have the following
equation:

E NI E D E
= and = 1 , so
A A NI A A
E 1
= 3.2%
A 0.051
E
= 62.7% .
A
D
= 1 0.627 = 0.373 = 37.3%.
A
× ÷
×
÷

Alternatively, using the DuPont equation:

ROE = ROA × EM
5.1% = 3.2% × EM
EM = 5.1%/3.2% = 5.1/3.2 = TA/E.

Take reciprocal: E/TA = 3.2/5.1 = 62.7%; therefore, D/A = 1 – 0.627 = 0.373 = 37.3%.

Thus, the firm’s profit margin = 2% and its debt ratio = 37.3%.

3-16 TA = \$12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?

000 , 000 , 000 , 12 \$
EBIT
= 0.15
EBIT = \$1,800,000,000.

000 , 000 , 000 , 12 \$
NI
= 0.05
NI = \$600,000,000.

Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.

EBIT \$1,800,000,000 See above.
INT 800,000,000
EBT \$1,000,000,000 EBT = \$600,000,000/0.6
Taxes (40%) 400,000,000
NI \$ 600,000,000 See above.

TIE = EBIT/INT
= \$1,800,000,000/\$800,000,000
= 2.25.
3-17 TIE = EBIT/INT, so find EBIT and INT.
Interest = \$500,000 × 0.1 = \$50,000.

Net income = \$2,000,000 × 0.05 = \$100,000.
Pre-tax income (EBT) = \$100,000/(1 – T) = \$100,000/0.7 = \$142,857.
EBIT = EBT + Interest = \$142,857 + \$50,000 = \$192,857.

TIE = \$192,857/\$50,000 = 3.86×.

3-18 ROE = Profit margin × TA turnover × Equity multiplier
= NI/Sales × Sales/TA × TA/Equity.

Now we need to determine the inputs for the DuPont equation from the data that were given. On the left
we set up an income statement, and we put numbers in it on the right:
Sales (given) \$10,000,000
– Cost na
EBIT (given) \$ 1,000,000
– INT (given) 300,000
EBT \$ 700,000
– Taxes (34%) 238,000
NI \$ 462,000

Now we can use some ratios to get some more data:
Total assets turnover = 2 = S/TA; TA = S/2 = \$10,000,000/2 = \$5,000,000.

D/A = 60%; so E/A = 40%; and, therefore,
Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5.

Now we can complete the DuPont equation to determine ROE:
ROE = \$462,000/\$10,000,000 × \$10,000,000/\$5,000,000 × 2.5 = 0.231 = 23.1%.

INT = EBIT – EBT
= \$1,800,000,000 – \$1,000,000,000

3-19 Currently, ROE is ROE
1
= \$15,000/\$200,000 = 7.5%.
The current ratio will be set such that 2.5 = CA/CL. CL is \$50,000, and it will not change, so
we can solve to find the new level of current assets: CA = 2.5(CL) = 2.5(\$50,000) = \$125,000.
This is the level of current assets that will produce a current ratio of 2.5×.
At present, current assets amount to \$210,000, so they can be reduced by \$210,000 –
\$125,000 = \$85,000. If the \$85,000 generated is used to retire common equity, then the new
common equity balance will be \$200,000 – \$85,000 = \$115,000.
Assuming that net income is unchanged, the new ROE will be ROE
2
= \$15,000/\$115,000 =
13.04%. Therefore, ROE will increase by 13.04% – 7.50% = 5.54%.
The new CA level is \$125,000; CL remain at \$50,000; and the new Inventory level = \$150,000
– \$85,000 = \$65,000. Thus, the new quick ratio is calculated as follows:
New quick ratio =
CL
Inv CA ÷

=
000 , 50 \$
000 , 65 \$ 000 , 125 \$ ÷

= 1.2×.

3-20 Known data:
TA = \$1,000,000; Int. rate = 8%; T = 40%; BEP = 0.2 = EBIT/Total assets, so EBIT =
0.2(\$1,000,000) = \$200,000; D/A = 0.5 = 50%, so Equity = \$500,000.

D/A = 0% D/A = 50%
EBIT \$200,000 \$200,000
Interest 0 40,000*
EBT \$200,000 \$160,000
Tax (40%) 80,000 64,000
NI \$120,000 \$ 96,000

ROE =
Equity
NI
=
\$1,000,000
\$120,000
= 12%
\$500,000
\$96,000
= 19.2%

Difference in ROE = 19.2% – 12.0% = 7.2%.

*If D/A = 50%, then half of the assets are financed by debt, so Debt = \$500,000. At an 8% interest rate,
INT = \$500,000 × 0.08 = \$40,000.

3-21 Statement a is correct. Refer to the solution setup for Problem 3-20 and think about it this way:
(1) Adding assets will not affect common equity if the assets are financed with debt. (2) Adding
assets will cause expected EBIT to increase by the amount EBIT = BEP(added assets). (3) Interest
expense will increase by the amount Int. rate(added assets). (4) Pre-tax income will rise by the
amount (added assets)(BEP – Int. rate). Assuming BEP > Int. rate, if pre-tax income increases so
will net income. (5) If expected net income increases but common equity is held constant, then the
expected ROE will also increase. Note that if Int. rate > BEP, then adding assets financed by debt
would lower net income and thus the ROE. Therefore, Statement a is true—if assets financed by
debt are added, and if the expected BEP on those assets exceeds the interest rate on debt, then
the firm’s ROE will increase.
Statements b, c, and d are false, because the BEP ratio uses EBIT, which is calculated before
the effects of taxes or interest charges are felt. Of course, Statement e is also false.

3-22 TA = \$5,000,000,000; T = 40%; EBIT/TA = 10%; ROA = 5%; TIE ?

. 000 , 000 , 500 \$ EBIT
10 . 0
,000 \$5,000,000
EBIT
=
=

. 000 , 000 , 250 \$ NI
05 . 0
,000 \$5,000,000
NI
=
=

Now use the income statement format to determine interest so you can calculate the firm’s TIE
ratio.

EBIT \$500,000,000 See above.
INT 83,333,333
EBT \$416,666,667 EBT = \$250,000,000/0.6
Taxes (40%) 166,666,667
NI \$250,000,000 See above.
TIE = EBIT/INT
= \$500,000,000/\$83,333,333
= 6.0.

3-23 Present current ratio =
\$525,000
\$1,312,500
= 2.5.

Minimum current ratio =
NP + \$525,000
NP + \$1,312,500
A
A
= 2.0.

\$1,312,500 + ANP = \$1,050,000 + 2ANP
ANP = \$262,500.

Short-term debt can increase by a maximum of \$262,500 without violating a 2 to 1 current ratio, assuming
that the entire increase in notes payable is used to increase current assets. Since we assumed that
the additional funds would be used to increase inventory, the inventory account will increase to
\$637,500 and current assets will total \$1,575,000, and current liabilities will total \$787,500.

INT = EBIT – EBT
= \$500,000,000 - \$416,666,667
3-24 Step 1: Solve for current annual sales using the DSO equation:

55 = \$750,000/(Sales/365)
55Sales = \$273,750,000
Sales = \$4,977,272.73.

Step 2: If sales fall by 15%, the new sales level will be \$4,977,272.73(0.85) = \$4,230,681.82.
Again, using the DSO equation, solve for the new accounts receivable figure as follows:
35 = AR/(\$4,230,681.82/365)
35 = AR/\$11,590.91
AR = \$405,681.82 ~ \$405,682.
3-25 The current EPS is \$2,000,000/500,000 shares or \$4.00. The current P/E ratio is then \$40/\$4 =
10.00. The new number of shares outstanding will be 650,000. Thus, the new EPS =
\$3,250,000/650,000 = \$5.00. If the shares are selling for 10 times EPS, then they must be selling
for \$5.00(10) = \$50.

3-26 1. Total debt = (0.50)(Total assets) = (0.50)(\$300,000) = \$150,000.

2. Accounts payable = Total debt – Long-term debt = \$150,000 – \$60,000
= \$90,000.

3. Common stock =
equity and
s liabilitie Total
– Debt – Retained earnings
= \$300,000 – \$150,000 – \$97,500 = \$52,500.

4. Sales = (1.5)(Total assets) = (1.5)(\$300,000) = \$450,000.

5. Inventories = Sales/5 = \$450,000/5 = \$90,000.

6. Accounts receivable = (Sales/365)(DSO) = (\$450,000/365)(36.5) = \$45,000.

7. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable)
Cash + \$45,000 + \$90,000 = (1.8)(\$90,000)
Cash + \$135,000 = \$162,000
Cash = \$27,000.

8. Fixed assets = Total assets – (Cash + Accts rec. + Inventories)
= \$300,000 – (\$27,000 + \$45,000 + \$90,000)
= \$138,000.

9. Cost of goods sold = (Sales)(1 – 0.25) = (\$450,000)(0.75) = \$337,500.

3-27 a. (Dollar amounts in thousands.)
Industry
Firm Average

s liabilitie Current
assets Current

=
\$10,800
\$3,800

= 2.84× 2.0×

s liabilitie Current
s Inventorie assets Current ÷

=
\$10,800 \$5,500
\$3,800
÷

= 1.39× 1.3×
DSO =
365 Sales/
receivable Accounts

=
\$2,800
\$66.61
=
42.0
days
35
days

s Inventorie
Sales
=
\$24,312
\$5,500

= 4.42× 6.7×

assets Total
Sales
=
\$24,312
\$12, 000

= 2.03× 3.0×

Sales
income Net
=
\$412.89
\$24,312

= 1.7% 1.2%

assets Total
income Net
=
\$412.89
\$12, 000

= 3.4% 3.6%

equity Common
income Net

=
\$412.89
\$2, 700

= 15.3% 9.0%

assets Total
debt Total
=
\$9,300
\$12, 000

= 77.5% 60.0%

b. For the firm,
ROE = PM × T.A. turnover × EM = 1.7% × 2.03 ×
\$12, 000
\$2, 700
= 15.3%.

For the industry, ROE = 1.2% × 3 × 2.5 = 9%.

Note: To find the industry ratio of assets to common equity, recognize that 1 – (Total
debt/Total assets) = Common equity/Total assets. So, Common equity/Total assets = 40%,
and 1/0.40 = 2.5 = Total assets/Common equity.

c. The firm’s days sales outstanding ratio is about 1.2 times as long as the industry
average, indicating that the firm should tighten credit or enforce a more stringent
collection policy. The total assets turnover ratio is well below the industry average
so sales should be increased, assets decreased, or both. While the company’s profit
margin is higher than the industry average, its other profitability ratios are low
compared to the industry—net income should be higher given the amount of equity
and assets. However, the company seems to be in an average liquidity position and
financial leverage is similar to others in the industry.

d. If 2008 represents a period of supernormal growth for the firm, ratios based on this year will
be distorted and a comparison between them and industry averages will have little meaning.
Potential investors who look only at 2008 ratios will be misled, and a return to normal
conditions in 2009 could hurt the firm’s stock price.
3-28 a. Industry
Firm Average
Current ratio =
s liabilitie Current
assets Current

=
\$111
\$303

= 2.73× 2×
assets total
to Debt

=
assets Total
Debt
=
\$450
\$135

= 30.00% 30.00%
earned
interest Times

=
Interest
EBIT
=
\$4.5
\$49.5

= 11× 7×
coverage
EBITDA

=
pymts
Lease
pymts
Princ.
INT
pymts Lease EBITDA
+ +
+

=
5 . 6 \$
5 . 61 \$

= 9.46× 9×
turnover
Inventory

=
s Inventorie
Sales
=
\$159
\$795

= 5× 10×
DSO =
5 36 Sales/
receivable Accounts

=
\$795/365
\$66

=
30.3
days
24
days
turnover
A. F.

=
assets fixed Net
Sales
=
\$147
\$795

= 5.41× 6×
turnover
A. T.

=
assets Total
Sales
=
\$450
\$795

= 1.77× 3×
Profit margin =
Sales
income Net
=
\$795
\$27

= 3.40% 3.00%
assets total
on Return

=
assets Total
income Net
=
\$450
\$27

= 6.00% 9.00%
equity common
on Return

=
ROA × EM
= 6% × 1.4286 = 8.57% 12.86%

Alternatively, ROE =
Equity
income Net
=
\$315
\$27
= 8.57% ~ 8.6%.

b. ROE = Profit margin × Total assets turnover × Equity multiplier
=
Sales
income Net
×
assets Total
Sales
×
equity Common
assets Total

=
\$795
\$27
×
\$450
\$795
×
\$315
\$450
= 3.4% × 1.77 × 1.4286 = 8.6%.

Firm Industry Comment
Profit margin 3.4% 3.0% Good
Total assets turnover 1.77× 3.0× Poor
Equity multiplier 1.4286 1.4286* O.K.

* 1 –
TA
D
=
TA
E

1 – 0.30 = 0.7
EM =
E
TA
=
7 . 0
1
= 1.4286 ~ 1.43.

Alternatively, EM = ROE/ROA = 12.86%/9% = 1.4289 ~ 1.43.

c. Analysis of the DuPont equation and the set of ratios shows that the turnover ratio of
sales to assets is quite low. Either sales should be higher given the present level of
assets, or the firm is carrying more assets than it needs to support its sales.

d. The comparison of inventory turnover ratios shows that other firms in the industry seem to be
getting along with about half as much inventory per unit of sales as the firm. If the company’s
inventory could be reduced, this would generate funds that could be used to retire debt, thus
reducing interest charges and improving profits, and strengthening the debt position. There
might also be some excess investment in fixed assets, perhaps indicative of excess capacity, as
shown by a slightly lower-than-average fixed assets turnover ratio. However, this is not nearly
as clear-cut as the overinvestment in inventory.

e. If the firm had a sharp seasonal sales pattern, or if it grew rapidly during the year,
many ratios might be distorted. Ratios involving cash, receivables, inventories, and
current liabilities, as well as those based on sales, profits, and common equity,
could be biased. It is possible to correct for such problems by using average rather
than end-of-period figures.

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