Questions (1) (3-2) (33) 4) (3-5) (3-4) (ST-1) Debs Ratio Chapter 3: Analysis of Financial Statements 111 return on equity. The firm’s management can use the Du Pont system to analyze ways of improving performance. Benchmarking is the process of comparing a particular company with a group of similar successful companies. Ratio analysis has limitations, but when used with care and judgment it can be very helpful, Define each of the following terms: e f. & Liquidity ratios: current ratio; quick, or acid test, ratio, Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed assets turnover ratio; total assets turnover ratio Financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; coverage ratio Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on total assets (ROA); return on common equity (ROF) ‘Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; marke book (M/B) ratio; book value per share ‘Trend analysis; comparative ratio analysis; benchmarking Du Pont equation; window dressing; seasonal effects on ratios Financial ratio analysis is conducted by managers, equity investors, long-term cred- itors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios? Over the past year, M. D. Ryngaert & Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio. However, the company’s sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes? Profit margins and turnover ratios vary from one industry to another. What differ- ences would you expect to find between a grocery chain such as Safeway and a steel company? Think particularly about the turnover ratios, the profit margin, and the Du Pont equation. How might (a) seasonal factors and (b) different growth rates distort a comparative ratio analysis? Give some examples. ITow might these problems be alleviated? Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry? Set-Test Problems Argent Corporation had earnings per share of $4 last year, and it paid a $2 divi- dend. Total retained earnings increased by $12 million during the year, and book value per share at year-end was $40. Argent has no preferred stock, and no new common stock was issued during the year. If Argent’s year-end debt (which equals its total liabilities) was $120 million, what was the company’s year-end debt/assets ratio?112. Pare 1: Fundamental Concepts of Corporate Finance (st-2) Ratio Analy Problems Ene Prowinus 1-5, (8-1) Days Sales Outstanding (3-2) Debt Ratio (3-3) MorkeriBook Ratio (3-4) Price/Eamnings Reno (3-5) ROE betnwsma Proouens 10 (3-6) Dy Poot Analysis (3-7) Current end Quick Retios ‘The following data apply to Jacobus and Associates (millions of dollars): Cash and marketable securities $100.00 Fixed assets S. 283.50 Sales $1,000.00 Net income S$ 50.00 Quick ratio 2.0 Current ratio 3.0 DSO 40.55 days ROE 12% Jacobus has no preferred stock—only common equity, current liabilities, and long- term debt a. Find Jacobus's (1) accounts receivable, (2) current liabilities, (3) current assets, @ total assets, (5) ROA, (6) common equity, and (7) long-term debr. b. In part a, you should have found Jacobus’s accounts receivable = $111.1 million. If Jacobus could reduce its DSO from 40.55 days to 30.4 days while holding other things constant, how much cash would it generate? If this cash were used to buy back common stock (at book value), thus reducing the amount of common equity, how would this affect (1) the ROE, (2) the ROA, and (3) the ratio of total debt to total assets? en exis ee Greene Sisters has a DSO of 20 days. ‘The company’s average daily sales are $20,000. ‘What is the level of its accounts receivable? Assume there are 365 days in a year. ‘Vigo Vacations has an equity multiplier ofS. The company’s assets are financed with some combination of long-term debt and common equity. What is the company’s debt ratio? ‘Winston Washers’s stock price is $75 per share. Winston has $10 billion in total as- sets. Its balance sheet shows $1 billion in current liabilities, $3 billion in long-term debt, and $6 billion in common equity. It has 800 million shares of common stock outstanding. What is Winston's market/book ratio? A company has an EPS of $1.50, a cash flow per share of $3.00, and a price/cash flow ratio of 8.0, What is its P/E ratio? Needham Pharmaceuticals has a profit margin of 3% and an equity multiplier of 2.0. Tes sales are $100 million and it has total assets of $50 million. What is its ROE? Donaldson & Son has an ROA of 10%, a 2% profit margin, and a return on equity equal to 15%. What is the company’s total assets turnover? What is the firm’s equity multiplier? Ace Industries has current assets equal to $3 million. ‘The company’s current ratio is 15, and its quick ratio is 1.0, What is the firm’s level of current liabilities? What is the firm’s level of inventories?(8-8) Profit Margin and Debt Ratio 3-9) ‘Current and Quick Rotios (3-10) Times interest-Eomned Ratio Crnuercne Prosins ata (3-41) Bolance sheer Anolyss (3-42) Comprehensive Ratio Coleuierons (3-43) Comprehensive Ratio ‘Analysis Chapter 3: Analysis of Financial Statements 113 Assume you are given the following relationships for the Clayton Corporation: Sales/total assets Ls Return on assets (ROA) 3% Return on equity (ROE) 5% Calculate Clayton’s profit margin and debt ratio. ‘The Nelson Company has $1,312,500 in current assets and $525,000 in current liabili- ties, Its intial inventory level is $375,000, and it will raise funds as additional notes pay- able and use them to increase inventory. How much can Nelson’s short-term debt (notes payable) increase without pushing its current ratio below 2.0? What will be the firm's quick ratio after Nelson has raised the maximum amount of short-term funds? ‘The Manor Corporation has $500,000 of debt outstanding, and it pays an interest rate of 10% annually: Manor’s annual sales are $2 million, its average tax rate is 30%, and its net profit margin on sales is 5%. If the company does not maintain a ‘TIE ratio of at least $ to 1, then its bank will refuse to renew the loan and bank- ruptcy will result. What is Manor's TIE ratio? Complete the balance sheet and sales information in the table that follows for Hoff- meister Industries using the following financial data: Debt ratio: 50% Quick ratio: 0.80 ‘Total assets turnover: 1.5 Days sales outstanding: 36.5 days" Gross profit margin on sales: (Sales ~ Cost of goods sold)/Sales = 25% Inventory turnover ratio: 5.0 *Caleulation is based om a 565-day year Balance Sheet Cash Accounts payable Accounts receivable Long-term debt Inventories ‘Common stock Fixed assets Retained earnings Total assets Total liabilities and equity Sales Cost of goods sold ‘The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, an inventory turnover of 6 times, total current assets of $810,000, and cash and marketable securities of $120,000. What were Kretovich’s annual sales and its DSO? Assume a 365-day year. Data for Morton Chip Company and its industry averages follow. aoee Calculate the indicated ratios for Morton. Construct the extended Du Pont equation for both Morton and the industry. Outline Morton’s strengths and weaknesses as revealed by your analysis. Suppose Morton had doubled its sales as well as its inventories, accounts receiv- able, and common equity during 2010, How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.)114. Pare 1: Fundamental Concepts of Corporate Finance (3-14) Comprehensive Ratio ‘Analysis Morton Chip Company: Balance Sheet as of December 34, 2010 (Thousands of Dollars) Cash $77,500 Accounts payable $129,000 Receivables 336,000 Notes payable 84,000 Inventories 241,500 Other current liabilities 117,000 Total current assets $655,000 ‘Total current liabilities 5330,000, Net fixed assets 292,500 Long-term debt 256,500 Common equity 361,000 Total assets $997,500 Total liabilities and equity $947,500 Morton Chip Company: Income Statement for Year Ended December 34, 2010 (Thousands of Dollars) Sales Cost of goods sold Selling, general, and administrative expenses Earnings before interest and taxes (EBIT) Interest expense Earnings before taxes (EBT) Federal and state income taxes (40%) Net income Ratio Morton Current assets/Current liabilities Days sales outstanding? Sales/Inventory Sales/Fixed assets Sales/Total assets Net income/Sales Net income/Toral assets Net income/Common equity Total debt/Total assets “Calculation is based on a 65-day year, $1,607,500 1,392,500 145,000 5” 70,000 24,500 545,500 18,200 Industry Average ‘The Jimenez Corporation's forecasted 2011 financial statements follow, along with some industry average ratios a, Calculate Jimenez's 2011 forecasted ratios, compare them with the industry average data, and comment briefly on Jimene?’s projected strengths and weaknesses. b. What do you think would happen to Jimenez’s ratios if the company initiated cost-cutting measures that allowed it to hold lower levels of inventory and substantially decreased the cost of goods sold? No calculations are necessary: Think about which ratios would be affected by changes in these two accounts.Chapter 3: Analysis of Financial Statements 115 Jimenez Corporation: Forecasted Balance Sheet as of December 34, 2014 Assets Cash Accounts receivable Inventories ‘Total current assets Fixed assets ‘Total assets Liabilities and Equity Accounts and notes payable Accruals ‘Total current liabilities Long-term debt ‘Common stock Retained earnings ‘Total liabilities and equity $72,000 439,000 894,000 57,405,000 431,000 51,836,000 $ 432,000 70,000 ¥ 602,000 404,290 575,000 254,710 $1,836,000 Jimenez Corporation: Forecasted Income Statement for 2014 Sales $4,290,000 Cost of goods sold 3,580,000 Selling, general, and administrative expenses 370,320 Depreciation 159,000 Earnings before taxes (EBT) 5 180,680 ‘Taxes (40%) mn Net income 108,408 Per Share Data EPS $471 Cash dividends per share $095 PIE ratio 5 ‘Market price (average) $2357 Number of shares outstanding 23,000 Industry Financial Ratios (2010)" Quick ratio 10 Current ratio 27 Inventory turnover” 7.0 Days sales outstanding® 32 days Fixed assets turnover” 13.0 ‘Total assets turnover” 26 Return on assets 9.1% Return on equity 18.2% Debt ratio 50.0% Profit margin on sales 3.5% P/E ratio 60 Price/Cash flow ratio 3S “Industy average ratios have ben constant forthe past 4 years “aed on yoarsnd balance shox gu “Cacti isbased 0 8 365day yee116. Pare 1: Fundamental Concepts of Corporate Finance ‘SPREADSHEET PROBLEM (3-15) Build o Medel: Ratio ‘Analysis * Start with the partial model in the file Cb03 PIS Build a Model.xls from the textbook’s Web site. Joshua & White (J&W) Technologies’s financial statements are also shown below. Answer the following questions. (Note: Industry average ratios are provided in (Ch03 P15 Build a Model.xls.) Has J&W’s liquidity position improved or worsened? Explain Haas J&W's ability to manage its assets improved or worsened? Explain. How has J&W’s profitability changed during the last year? Perform an extended Du Pont analysis for J&W for 2009 and 2010. What do these results tell you? €. Perform a common size analysis. What has happened to the composition (that is, percentage in each category) of assets and liabilities? £ Perform a percentage change analysis. What does this tell you about the change in profitability and asset utilization? Joshua & White Technologies: December 34 Balance Sheets (Thousands of Dollars) Liabilities Assets 2010 2009 & Equity 2010 2009 Cash and cash equivalents $ 21,000 $ 20,000 Accounts payable $ 33,600 $ 32,000 Short-term investments 3,759 3,240 Accruals 12,600 12,000 Accounts receivable 52,500 48,000 Notes payable 19.929 __ 6,480 ‘Total current Inventories 84,000 __ 56,000 liabilities $ 66,129 $ 50,480 ‘Total current Long-term assets $161,259 $127,240 debt 67,662 _58,320 Net fixed assets 218,400 _200,000 Total liabilities $133,791 $108,800 ‘Total assets $379,659 $327,240 Common stock 183,793 178,440 a Retained carnings 62,075 ‘Total common equity $245,868 $218,440 ‘Total liabilities & equity $379,659 $327,240 Joshua & White Technologies December 34 Income Statements (Thousands of Dollars) 2010 2009 Sales $420,000 $400,000 Expenses excluding depr. & amort. 327,600 320,000 EBITDA ¥ 92,400 $80,000 Depreciation and amortization 19,660 18,000 EBIT, $72,740 $62,000Chapter 3: Analysis of Financial Statements 117 2010 Interest expense EBT 367,000, ‘axes (40%) 26,800 Net income Common dividends $18,125 $17,262 Other Data 2010 2009 Year-end stock price S 90.00 $ 96.00 Number of shares (Thousands) 4,052 4,000 Lease payment (Thousands of Dollars) $20,000 $20,000 Sinking fund payment (Thousands of Dollars) s 0 a) Use the Thomson ONE—Business Schoo! Eltion online detabase to work this chapters questions ANALYSIS OF ForD’S FINANCIAL STATEMENTS WITH THOMSON ONE—Business ScHOOL EDITION Use Thomson ONE to analyze Ford Motor Company. Enter Ford's ticker symbol (F) and select GO. By selecting the tab at the top labeled Financials, you can find Ford's key financial statements for the past several years. At the Financials screen cn the second line of tabs, select the Fundamental Ratios tab. If you then select the Database Ratios from the pull-down menu, you can select either annual or quarterly ratios. ‘Under annual ratios, there is an in-depth summary of Ford’s various ratios over the past three years. Click on the Peers tab (on the first line of tabs) near the top of the screen for a summary of financial information for Ford and a few of its peers. If you click on the Peer Sets tab (second line of tabs), you can modify the list of peer firms. The default setup is “Peers set by SIC Code.” To obtain a comparison of many of the key ratios presented in the text, just click on Financials (second line of tabs) and select Key Fi nancial Ratios from the drop-down menu. Thomson ONE—BSE Discussion Questions 1, What has happened to Ford’s liquidity position over the past 3 years? How does Ford’s liquidity compare with its peers? (Hint: You may use both the peer key fi- nancial ratios and liquidity comparison to answer this question.) 2. Take a look at Ford’s inventory tumover ratio. How does this ratio compare with its peers? Have there been any interesting changes over time in this mea- sure? Do you consider Ford’s inventory management to be a strength or a weakness? 3. Construct a simple Du Pont analysis for Ford and its peers. What are Ford’s strengths and weaknesses relative to its competitors?18. Pare 1: Fundamental Concepts of Corporate Finance ‘The first part of the case, presented in Chapter 2, discussed the situation of Computron In- dustries after an expansion program. A large loss occurred in 2010, rather than the expected. profit. As a result, its managers, directors, and investors are concerned about the firm's survival Donna Jamison was brought in as assistant to Fred Campo, Computron’s chairman, who had the taik of getting the company back into a sound financial position. Computron’s 2009 and 2010 balance sheets and income statements, together with projections for 2011, are shown, in the following tables. ‘The tables also show the 2009 and 2010 financial ratios, along with in- dustry average data. ‘The 2011 projected financial statement data represent Jamison’s and Campo’s best guess for 2011 results, assuming that some new financing is arranged to get the company “over the hump.” Balance Sheets 2009 2010 2011F, Assets Cash, $9,000 $7282 S$ 14,000 ‘Short-term investments 48,600 20,000 71,632 Accounts receivable 351,200 632,160 878,000 Inventories 715,200, 1,287,360 1,716,480 Total current assets $7,124,000 $1,946,802 $2,680,112 Gross fixed assets 491,000 1,202,950 1,220,000 Less: Accumulated depreciation 146,200 263,160, Net fixed assets 344,800 939,790 Total assets 1,468,800 $2,886,5 Liabilities and Equity Accounts payable $145,600 $324,000 $359,800 Notes payable 200,000 720,000 300,000 Accruals 136,000 284,960 Total current liabilities 581,600 37,328,960 ‘51,039,800 Long-term debt 323,432 1,000,000 500,000 ‘Common stock (100,000 shares) 460,000 460,000 1,680,936 Retained earnings 203,768, 97,632 Total equity 5 663,768 $357,632 “Total liabilities and equity $51,468,800 $2,886,592 Note: “E” denotes “estimated”; the 2011 data are forecasts. Jamison must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or mo answers. a. Why are ratios useful? What three groups use ratio analysis and for what reasons? b. Calculate the 2011 current and quick ratios based on the projected balance sheet and income statement data, What can you say about the company’s liquidity position in 2009, 2010, and as projected for 2011? We often think of ratios as being useful (1) to managers to help ran the business, (2) to bankers for eredit analysis, and () to stock- holders for stock valuation. Would these different types of analysts have an equal inter- ‘st in the liquidity ratios? € Calculate the 2011 inventory turnover, days sales outstanding (DSO), fixed assets turn- over, and total assets turnover. How does Computron’s utilization of assets stack up against that of other firms in its industry?Chapter 3: Analysis of Financial Statements 119 Income Statements 092K Sales $3,432,000 85,834,400 ‘$7,035,600 Cost of goods sold 2,864,000 4:980,000 5,800,000 Other expenses 340,000 720,000 612,960, Depreciation 18,900 116,960 120,000 “Total operating costs $3,222,900 155,816,960 36,532,960 EBIT $209,100 SA 502,640 Interest expense 62,500 176,000 80,000 EBT. 5 146,600 158,560) 5 422,640, ‘Taxes (40%) 58,640 63,424) 169,056 Net income 7, F 95.136) 5 Other Data Stock price S850 S 6.00 say Shares outstanding 100,000, 100,000 20,000 EPS $0880 (S 0.951) S101 DPS $ 0.220 0.110 0.220 ‘Tax rate 40% 40% 40% Book value per share S 6.638 S 5576 Ss 7.909 Lease payments $40,000 $40,000 S 40,000 Note: “E" denotes “estimated”; the 2011 data are forecasts. Ratio Analysis Industry 2009 20102011 Average Carrent 23 15 27 Quick os os 10 Inventory tumnover 48 45 61 Days sales outstanding 373 396 320 Fixed assets turnover 100 62 70 ‘Total assets turnover 23 20 2s Debt ratio 548% 80.7% 50.0% TE 33 ol 62 EBITDA coverage 26 08 8.0 Profit margin 26% — -1.6% 3.6% Basic earning power 142% 0.6% 17.8% ROA 60% = 3.3% 9.0% ROE, 133% 171% 17.9% Price/Rarnings (P/E) 97 63 162 Price/Cash flow 80 278 76 Market/Book 1B ra 29 Note: “E" denotes “estimated.” 4. Calculate the 2011 debs, times-interest-earned, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios? €. Calculate the 2011 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROF). What ean you say about these ratios? £ Calculate the 2011 price/earnings ratio, price/eash flow ratio, and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?120 Part 1: Fundamental Concepts of Corporate Finance & Perform a common size analysis and percentage change analysis. What do these analyses tell you about Computron? h, Use the extended Du Pont equation to provide a summary and overview of Compr tron’s financial condition as projected for 2011, What are the firm's major strengths and weaknesses? i, What are some potential problems and limitations of financial ratio analysis? j. What are some qualitative factors that analysts should consider when evaluating 3 company’s likely furure financial performance? 7 Telenor ‘The following cases from Textchoice, Cengage Learning’s online library, cover many of the concepts discssed im this chapter and are available at http://www textcboice2.com. Klein-Brigham Series: Case 35, “Mark X Company (A),” which illustrates the use of ratio analysis in the evaluation of a firms existing and potential financial positions; Case 36, “Garden State Container Corporation,” ‘which is similar in content to Case 35; Case SI, “Safe Packaging Corporation,” which updates Case 36; Case 68, “Sweet Dreams Inc,” which also upslates Case 36, and Case 71, "Swan-Davis, Tne,” which illustrates how financial analysis—based on both historical statements and forecasted, statements—is used for internal management and lending decisions.