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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.
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

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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.
V. Limitations of Ratio Analysis
A. This list warns of the many pitfalls that may be encountered in computing and
interpreting financial ratios.

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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

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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 Total Asset
= Profit Margin X Turnover
Return on Investment

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.

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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  Long­Term 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)

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x = $0.5 million, or $500,000

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 liabilities $2,000
total debt $4,000
Debt ratio  = = .50 or 50%
total assets $8,000
operating income $1,700
Times interest earned = interest expense
= = 4.63X
$367
accounts receivable $2,000
Average collection period = = = 91
credit sales / 365 $8,000 / 365
days
cost of
goods sold $3,300
Inventory turnover = = = 3.3X
$1,000
inventory
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 
800
=  1 - .50  = .20 or 20%
8,000

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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
= profit margin X turnover
Return on Investment

= 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
= profit margin X turnover
Return on Investment

= 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. collection period = 20 =
(.75 x $9m)/365
Solving for accounts receivable:
Accounts
receivable = $369,863

Thus, Brenmar would reduce its accounts receivable by


$562,500 - $369,863 = $192,637.

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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.

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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
return on investment = profit margin X 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.
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

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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%

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b. The new operating income return on investment for Salco after the plant
renovation:
Operating Income Operating Income Sales
Return on Investment = x
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 Income Available
Return on common
equity = to Common Stockholders
Common Equity
$217,500
=
$1,000,000  $500,000

= 14.5%
Net income available to common stockholders following the renovation was
calculated as follows:
Operating Income (.13 x $4.5m) $ 585,000
Less: Interest ($100,000 + $50,000) (150,000)
Earnings Before Taxes 435,000
Less: Taxes (50%) (217,500)
Net Income Available to Common Stockholders $ 217,500
The increase in Common equity was calculated as follows:
Total assets purchased $ 1,000,000
Less: Increase in debt ($1,500,000 - $1,000,000) (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.

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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.

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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.

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Industry
Ratio Formula Calculation Average

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

Current Assets - Inventory $138,300  84,000


Acid-Test Ratio = .72 .9
Current Liabilities $75,000

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

$80,000
= 8 10
$10,000

Accounts Receivable $33,000 20.1 20


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= days days
Credit Sales per Day $600,000 / 365

$460,000
Inventory Turnover = 5.48 7
$84,000

Operating Income $80,000


= .196 16.8%
Return on Investment $408,300
or 19.6%

$80,000
= .133 14%
$600,000
or 13.3%
Industry
Ratio Formula Calculation Average

$140,000
= .233 25%
$600,000
or 23.3%

$600,000
= 1.47 1.2
$408,300

$600,000
= 2.22 1.8
$270,000

Net Income $42,900


Return on Assets = .1051 6%
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Total Assets $408,300


or 10.51%

Earnings Available to
$42,900
Return on Equity Common Stockholders = .234 12%
$183,300
Common Equity
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 Fixed
$20,200
$33,000 Sales
$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

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3­9A. 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 acid­test 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.

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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  Long­Term 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.
$3,500
Current Ratio = = = 1.94X
$1,800
$3,900
Debt Ratio = = = .49 or 49%
$8,000
$1,500
Times Interest Earned = = = 4.09X
$367
$1,500
Average Collection Period = = = 73
$7,500  365
days
$3,000
Inventory Turnover = = = 3.0X
$1,000
$7,500
Fixed Asset Turnover = = = 1.67X
$4,500
Net Sales $7,500
Total Asset Turnover = = = .94X
Total Assets $8,000

50
Gross Profits $4,500
Gross Profit Margin = = = .60 or 60%
Net Sales $7,500
Operating Income $1,500
= = = .20 or 20%
Net Sales $7,500
$1,500
= = = .19 or 19%
$8,000
$680
Return on 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 
680
=  1 - .49  = .17 or 17%
8,000
Sales
3-4B. a. Total Assets Turnover =
Total Assets
$11m
= = 1.83X
$6m
b. 2.5 =
Sales = $15m
Thus, the needed sales growth is $4 million ($15m - $11m) or an increase of
36%:
= 36%

51
c. Last year,
= X
= 6% X 1.83
= 11%
If sales grow by 36%, then for next year-end assuming a 6% operating profit
margin:
= X
= 6% X 2.5
= 15%

Average Collection
3-5B. a. =
Period
$562,500
Avg Collection Period =
(.75 x $9.75m)/365
Avg Collection Period = 28.08 days
Note that the average collection period is based on credit sales, which are 75%
of total firm sales.
Accounts Receivable
b. = 20 =
(.75 x $9.75m)/365
Solving for accounts receivable:
Accounts
= $400,685
Receivable
Thus, Brenda Smith, Inc. would reduce its accounts receivable by
$562,500 - $400,685 = $161,815
c. Inventory Turnover =
8 =
Inventories = = $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:
= X
Industry: 20.00% X 0.75 = 15.00%
Chavez 2002: 24.00% X 0.51 = 12.24%
Chavez 2003: 22.76% X 0.57 = 12.97%
Thus, given the low operating income return on investment for Chavez relative
to the industry, we must conclude that management is not doing an adequate job
of generating operating profits on the firm’s assets. However, they did improve
between 2002 and 2003. The problem lies not with the operating profit margin,
which addresses the operating costs and expenses relative to sales. Instead, the
problem arises from Chavez’s management not using the firm’s assets efficiently,
as indicated by the low asset turnover ratios. Here, the problem occurs in
managing accounts receivable and inventories, where we see the low turnover
ratios. The firm does appear to be using the fixed assets reasonably well—note
the satisfactory fixed assets turnover.
d. Financing decisions
A balance-sheet perspective:
The debt ratio for Chavez in 2003 is around 33%, a decrease from 34.7% in
2002; that is, they finance about one-third of their assets with debt and a little
more than two-thirds with common equity. The average firm in the industry uses
about the same amount of debt per dollar of assets as Chavez.
An income-statement perspective:
Chavez’s times interest earned is below the industry norm—6.0 and 5.5 in 2002
and 2003, respectively, compared to 7.0 for the industry average. In thinking
about why, we should remember that a company’s times interest earned is
affected by (1) the level of the firm’s operating profitability (EBIT), (2) the
amount of debt used, and (3) the interest rate. Items 2 and 3 determine the
amount of interest paid by the company. Here is what we know about Chavez:
1. The firm’s operating profitability is below average, but improving. Thus,
we would expect this fact to contribute to a lower times interest earned.
The evidence is consistent with this thought.
2. Chavez uses about the same amount of debt as the average firm, which
should mean that its times interest earned, all else equal, would be about
the same as for the average firm. Thus, Chavez’s low times interest
earned is not the consequence of using more debt.
3. We do not have any information about Chavez’s interest rate, so we
cannot make any observation about the effect of the interest rate. But
we know if Chavez is paying a higher interest rate than its competitors,
such a situation would also be contributing to the problem.

54
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.
Total Asset Turnover =
$5,000,000
=
$2,000,000

= 2.50 times
Operating Profit Margin =
$500,000
=
$5,000,000

= 10.00%
Operating Income Operating Income
Return on Investment = Total Assets

$500,000
=
$2,000,000

= 25%
or = X
= 10% X 2.50 = 25%
b. The new operating income return on investment for Mel’s after the plant
renovation:
= x
$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 Stockholders
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

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

Current Assets  Inventory $156,300  93,000


Acid-Test Ratio = .87 .9
Current Liabilities $73,000

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

Operating Income $120,000


= 12 10
Interest Expense $10,000
58

$38,000 19.81 20
= days days
$700,000 / 365

$500,000
Inventory Turnover = 5.38 7
$93,000
Industry
Ratio Formula Calculation Average

Operating Income $120,000


= .2689 16.8%
Return on Investment $446,300
or 26.89%

$120,000
= .171 14%
$700,000
or 17.1%

$200,000
= .2857 25%
$700,000
or 28.57%

$700,000
= 1.57 1.2
$446,300
59

$700,000
= 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
$82,900
Return on Equity Common Stockholders = .3712 12%
$223,300
Common Equity
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 Fixed
$24,200
$38,000 Sales
$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