Analysis of Financial Statements .....

Chapter
2

Analysis of Financial
Statements
Concept of Financial Analysis
Financial analysis is a process of evaluating relationship between component
parts of financial statement to obtain better understanding of a firm's
position and performance. It is an act of interpreting financial statement
(balance sheet, income statement, cash flow analysis, and statement of
retained earnings) with specific tools and purposes. There are various tools
and techniques to analyze the financial statements. Each of them is used
according the purpose for which the analysis is carried out. Some of
important tools are common size analysis, ratio analysis, Du Pont analysis,
analysis of sources and uses of funds, analysis of changes in financial
positions, analysis of retained earning and changes in equity.

Introduction of Financial Ratio Analysis

Computation of different ratios by taking different but related accounting
figures from balance sheet and income statement and interpretation of ratio
is known as ratio analysis. Hence, the financial ratio analysis is a tool of
measurement of financial strengths and weaknesses of the firm by properly
establishing the meaningful relationship between the two accounting figures
extracted from financial statements.

Types of Ratios
Financial ratios can be classified from different points of view. Here, in the
requirement of users such as short term creditors, long term creditors,
management, and investors of the ratios; they can be classified into the
following groups:
A. Liquidity Ratios
Liquidity ratios are the indicator of short-term solvency or financial strength
of the firm. They can be:
1. Current Ratio: Current ratio is also known as short-term solvency ratio or
working capital ratio. It reflects the short-term financial strength of the
business firm. It is calculated by dividing current assets by current liabilities:
2.....Managerial Finance
Current Ratio =
Where,
Current Assets: Current assets are those assets, which can be converted into
cash within a period of one year. Current assets include cash and bank
balances, inventories, prepaid expenses, sundry debtors, loans and advance,
short-term investments and marketable securities.
Current Liabilities: Current liabilities are those obligations, which are
payable within a period of one year. These comprise sundry creditors, bills
payable, outstanding and accrued expenses, income tax payable, etc.

2. Liquid or Quick Ratio or Acid Test Ratio: This ratio shows the
relationship between quick assets and current liabilities. It is calculated by
dividing total liquid or quick assets by total current liabilities:
Liquid or Quick Ratio =
Where,
Liquid or Quick Assets: Quick or liquid assets include all current assets items
except inventories and prepaid expenses. Therefore,
Liquid or Quick Assets = Current Assets – Inventories – Prepaid Expenses
3. Cash Ratio: A ratio between highly liquid assets and current liabilities is
known as cash ratio. It is calculated dividing highly liquid assets by total
current liabilities.
Cash Ratio =
Where,
Current Investments = Short term marketable securities

B. Debt Management Ratios

Debt management ratio is calculated to measure the long term financial
solvency of a firm.
Debt management ratios indicate the funds provided by owners and
creditors.
1. Debt Ratio: This ratio is the relation between total debt and total assets.
This ratio measures the extent to which borrowed funds support the assets of
the firm. It is computed by the following way:
Debt Ratio = =
Where,
Long term debt = Debentures, Bonds, Long term bank loan, Mortgage loan
2. Debt-Equity Ratio: This ratio shows the relationship between outsiders'
fund and shareholders' fund invested in the firm. This ratio helps to test the
long term financial position of the firm. It is calculated in this way:
Debt-Equity Ratio =
Where,
Shareholders equity = Common Stock + Preferred Stock + Reserve & Surplus
+ Retained Earning + Profit and loss A/C (Cr) – P/L A/C(Dr.) – Preliminary
expenses – discount on issue of shares and debentures etc.
3. Debt to Total Capital Ratio: This ratio is the relationship between long-
term debt and total capital employed by the firm. The total capital is also
 Analysis of Financial Statements .....3
regarded as permanent capital or capital employed or long term fund. It is
computed as:
Debt to Total Capital Ratio =
Where,
Total Capital = Shareholders equity + Long term debt
4. Times Interest Earned Ratio (TIE Ratio): This ratio is also known as
interest coverage ratio. This ratio judges the sufficiency of a firm’s income to
pay the interest by establishing the relationship between income before
interest and taxes (EBIT) and interest expenses. The ratio is calculated as
follows:
Times Interest Earned Ratio =
5. Fixed Charge Coverage Ratio: Fixed chare coverage ratio shows how
many times the earning before interest and tax covers all fixed financing
charges such as lease rentals and preference dividends. It is computed as
follows :
Fixed Charge Coverage Ratio =

C. Assets Management Ratios

Assets management ratios are based on the relationship between the level of
activity, represented by sales or cost of goods sold, and levels of different
assets. The following ratios are included in assets management ratios:
1. Inventory Turnover: Inventory turnover ratio measures how frequently
the firm's inventory turned into sales. This ratio is the number of times the
average stock held converts into sales.
Inventory Turnover Ratio =
Where,
Cost of good sold = Net sales – Gross Profit
Average Inventory =
If cost of goods sold and opening inventory are not given, Inventory
turnover ratio is calculated in this way:
Inventory Turnover Ratio =
2. Debtors Turnover Ratio: Debtors turnover ratio is also known as
receivable turnover ratio. This ratio indicates the number of times the
receivables rotate in a year. This ratio is calculated by using the following
formula:
Debtors Turnover Ratio =
Where,
Average Debtors =
If above information are not available, it is calculated in this way:
Debtors Turnover Ratio =
3. Days Sales Outstanding: Days sales outstanding (DSO) is also known as
average collection period or receivable conversion period or age of
receivables. This ratio represents the number of days worth of credit sales
that is locked in sundry debtors or receivables. It is computed as:
Days Sales Outstanding =
Or, Days Sales Outstanding =
4.....Managerial Finance
4. Fixed Assets Turnover Ratio: This ratio indicates the sufficiency of sales
in relation to the investment in fixed assets. This ratio also measures the
efficiency with which the firm is utilizing its investment in fixed assets. This
ratio is calculated in the following manner:
Fixed Assets Turnover Ratio =
Where,
Net fixed assets = Gross Fixed Assets – Depreciation
5. Total Assets Turnover Ratio: This ratio establishes the relationship
between net sales and total assets. It measures the firm's ability in generating
sales from the utilization of total assets. This ratio can be obtained by using
the following formula:
Total Assets Turnover Ratio =
Where,
Total Assets = Total Fixed Assets + Total Current Assets
6. Capital Employed Turnover Ratio: This ratio shows the relationship
between net sales and permanent capital used in the firm. It tests the
efficiency in utilizing the capital employed. The ratio can be computed as:
Capital Employed Turnover Ratio =
Where,
Capital employed = Shareholder's Equity + Long Term Debt
= Permanent Capital
= Total Assets or Liabilities & Equity – Current
Liabilities

D. Profitability Ratios
Profitability ratios are usually computed by relating it either with sales or
investment as listed below:
a. Profitability Ratios Related with Sales (Profit Margin Ratios)
These ratios show the relationship between profit and sales. The most
popular profit margin ratios are given below:
1. Gross Profit Margin: It is a ratio between gross profit and sales. Gross
profit margin is computed as:
Gross Profit Margin =
2. Net Profit Margin: It is a ratio between net profit and sales. Net profit
margin can be computed as:
Net Profit Margin =
b. Profitability Ratios Related with Investment (Rate of return ratios)
These ratios are related with the investment made by the firm. They can be
of following types:
1. Return on Total Assets (ROA): Return on total assets, is also called return
on investment, which is a ratio between net profit and total assets. This ratio
measures the rate of return earned by the firm as a whole for all its investors.
Return on total assets can be computed as follows:
Return on Total Assets =
2. Earning Power Ratio: Earning power ratio is a measure of business
performance, which is not affected by interest and tax. It is a ratio between
 Analysis of Financial Statements .....5
earning before interest and tax and total assets. Earning power ratio can be
computed as follows:
Earning Power Ratio =
3. Return on Equity (ROE): This ratio is also known as return on
shareholders' fund and return on net worth. It measures the relationship
between net profit after tax and shareholders' equity. Return on equity can
be computed as follows:
Return on Equity =

Market Value Ratios

These ratios indicate how the stock of the company is assessed in the capital
market. These ratios are the most comprehensive, measures of firm's
performance. Some of the important market value ratios are given below:
1. Price-Earning Ratio (P-E Ratio): This ratio indicates investor's judgment
or expectations about firm's performance. It is computed as:
Price Earning Ratio =
2. Market / Book Ratio: Market/book ratio is a ratio between market price
and book value of firm's stock and is computed as:
Market/Book Ratio =
Where,
Book value per share =
3. Earning Yield: It is the ratio between earning per share and market price
per share. It can be computed as follows:
Earning Yield =
4. Dividend Yield: Dividend yield is a ratio, which expresses the
relationship between dividend per share and market price per share. This
ratio is computed as:
Dividend Yield =
5. Dividend Payout Ratio: Dividend payout ratio is a ratio between
dividend per share and earning per share and is computed as:
Dividend Payout Ratio =
6. Retention Ratio: The ratio between retained earning per share and earning
price per share is called retention ratio. Retention ratio can be expressed as
follows:
Retention Ratio = (1 – Dividend Payout Ratio)
=

Common Size Statements

The common size analysis is a technique which analyzes the items of
financial statement on relative terms. This analysis indicates rising, falling or
constant efficiency in the business operation and provides a basis to compare
with the industry average or competitors.
The common size ratio for each item in the financial statement can be
calculated by using following equation:
Common size ratio =
Basically common size analysis is used to compare financial statement of
different size companies or of the same company over several periods. This
6.....Managerial Finance
analysis includes the analysis of common size statement. The common size
statement consists of common size balance sheet and income statement.
A. Common Size Balance Sheet
Balance sheet is one of the important parts of common size statements. In
this case, the common size balance sheet percentages show the relation of
each asset item to total assets and each liability and capital item to total
liabilities and capital. For example the common size ratio of receivable over
the total assets can be expressed as:
Common size ratio for receivable =

B. Common Size Income Statement

Common size income statement is especially useful in comparing the
performance for a particular year with that for another year.
For example the common size ratio of cost of goods sold over the sales can
be expressed as:
Common size ratio for cost of goods sold =

Index Analysis
Index analysis is an analysis of percentage financial statements where all
balance sheet and income statement items for a base year equal to 100
(percent) and subsequent financial statement items are expressed as
percentages of their values in the base year. The percentages can be related to
totals, such as total assets or total net sales or to some base year.

Percentage Change Analysis

Percentage change analysis can be used as a tool to analyze a firm's financial
statements. Under percentage change analysis, growth rates are calculated
for all balance sheet items and income statements items. This analysis points
out the change (increase or decrease) in accounting figures of different years.

Du Pont Analysis
The basic Du Pont analysis may be extended to explore the determinants of
the return on equity (ROE). It can be expressed as under:
ROE = ROA  Equity multiplier
= Profit margin  Total assets turnover  Equity multiplier
Where,
ROA = Net profit margin x Total assets turnover
Net Profit Margin =
Total assets turnover =
Equity Multiplier =
Or, =
Or, = 1 + Debt-equity ratio
Debt ratio =
Alternatively,
Debt ratio =
 Analysis of Financial Statements .....7

Comparative Ratios and 'Benchmarking'

Benchmarking is the process of comparing the ratio values of a particular
company with those of a smaller group of 'benchmark' companies. It does
not compare with the entire industry average. The benchmarking setup
makes it easy for the company management to see exactly where the
company stands relative to its competition.

Uses and importance of Financial Ratios

Financial ratios are important tools for analyzing the firm's financial
performance. The following are the uses and importance of the financial
ratios:
a. Useful in analysis of financial statement: Financial ratios are useful
for understanding the financial position of the business.
b. Express financial trend: Financial ratios give an exposure to the trends
of sales, costs, profit, dividend, etc. that helps users to make future
plans and policies.
c. Show changes: Financial ratio analysis helps to understand the changes
in the financial conditions of the business over the years.
d. Useful in planning: Financial ratio analysis helps in tabulation of
financial information of past years for analyzing the financial
performance that is used in financial planning and forecasting.
e. Facilitate in comparison: Financial ratio analysis provides information
for 'inter-firm comparison' as well as 'intra-firm comparison'. That is
helpful in deciding about the efficiency of the divisions in the past and
likely performance in the future.
f. Communicate strength and weakness: Financial ratios are of great
assistance in communicating strength and financial standing of the firm
as well as in locating weaknesses of the business. Management can then
pay attention to the weaknesses and take remedial measures to
overcome them.
g. Develop control mechanism: Financial ratio analysis compares
financial standing with past and can point out the deficiencies of the
business. So that corrective action can be taken accordingly.
h. Helpful in decision-making: Financial ratio analysis provides much
helpful information in developing various alternatives for decision-
making.
Limitations of Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. Though it is
accepted as an effective tool of financial analysis, it should be used
cautiously on account of the following limitations:
1. Difficulty: A single ratio in itself is not important. It would not be able
to convey anything.
2. Historical Data: Ratios are usually computed on the basis of historical
financial statements that provide information about past. Reliance on
past data to evaluate future without access to inside information will
surely be difficult to the external analysts.
8.....Managerial Finance
3. Price Level Change: As financial statements based on historical cost do
not reflect the true performance and financial position of the firm in
times of price level changes, ratio analysis cannot serve the purpose
well.
4. Conceptual Diversity: The difference in the definition of items in the
financial statements makes the interpretation of ratios difficult and may
provide different result.
5. Focus on Quantitative Part: Ratio analysis basically focuses on
quantitative analysis of the firm because it is numeric expression of
accounting / financial values that means it ignores qualitative analysis.
6. Dependent Analysis: The accuracy and correctness of ratios are totally
dependent upon the reliability of the data contained in financial
statements on the basis of which ratios are calculated. Ratios are only
the symptoms and require further interpretation.
 Analysis of Financial Statements .....9

PRACTICAL PROBLEMS
PROBLEM 1
Ace industries has current assets equal to Rs.3 million. The company's current ratio is
1.5, and its quick ratio is 1.0. What is the firm's level of current liabilities? What is the
firm's level of inventories?
Ans: Rs.2 million; Rs.1 million.

PROBLEM 2
(Days sales outstanding) Baker Brothers has a DSO of 40 days. The company's annual
sales are Rs.7,300,000. What is the level of its accounts receivable? Assume there are 365
days in a year.
Ans: Rs.800,000

PROBLEM 3
(Debt ratio) Bartley Barstools has an equity multiplier of 2.4. The company's assets are
financed with some combination of long-term debt and common equity. What is the
company's debt ratio?
58,33%
PROBLEM 4
Parker Phial Company has current assets of Rs.1 million an current liabilities Rs.600,000.
a. What is the company's current ratio?
b. What would be its current ratio if each of the following occurred, holding all other
things constant?
1. A machine costing Rs.100,000 is paid for with cash.
2. Inventories of Rs.120,000 are purchased and financed with trade credit.
3. Accounts payable of Rs.50,000 are paid off with cash.
4. Account receivable of Rs.75,000 are collected.
5. Long-term debt of Rs.200,000 is raised for investment in inventories
(Rs.100,000) and to pay down short-term borrowing (Rs.100,000).
( Ans: a. 1.67 times; b. 1.5 times, 1.56 times, 1.73 times, 1.67times, 2.2 times)

PROBLEM 5
(Liquidity ratios) The Petry Company has Rs.1,312,500 in current assets and Rs.525,000 in
current liabilities. Its initial inventory level is Rs.375,000 and it will raise funds as
additional notes payable and use them to increase inventory. How much can Petry's
short-term debt (notes payable) increase without pushing its current ratio below 2.0 ?
What will be the firm's quick ratio after Petry has raised the maximum amount of short-
term funds ? Ans: Rs. 262,500 , 1.19 times

PROBLEM 6
Ratio calculations) The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0,
an inventory turnover of 5 times, total current assets of Rs.8,10,000, and cash and
marketable securities of Rs.1,20,000 in 1995. If the cost of goods sold equaled 86 percent
of sales, what were Kretovich's annual sales and its DSO for 1995 ?
Ans: 37 days.
10.....Managerial Finance

PROBLEM 7
A Company has total annual sales (all credit) of Rs. 4,00,000 and a gross profit margin of
20 percent. Its current assets are Rs. 80,000; current liabilities, Rs. 60,000; inventories, Rs.
30,000; and cash, Rs. 10,000.
(a)How much average inventory should be carried if management wants the inventory
turnover to be 4 ?
(b)How rapidly (in how many days) must accounts receivable be collected if
management wants to have an average of Rs. 50,000 invested in receivables? (Assume
a 360-day year.)
Ans: a. Rs.80,000, b. 45 days
PROBLEM 8
Times interest earned ratio) H.R. Pickett Corporation has Rs.5,00,000 of debt outstanding,
and it pays and interest rate of 10 percent annually. Pickett's annual sales are Rs.2
million; its average tax rate is 20 percent; and its net profit margin on sales is 5 percent.
If the company does not maintain a TIE ratio of at least 5 times, its bank will refuse to
renew the loan, and bankruptcy will result. What is Pickett's TIE ratio ?
Ans: 3.5 times. Here, the TIE ratio of the corporation is 3.5 times, which is below the
standard TIE ratio (i.e. 5 times), so the bank will refuse to renew the loan and the
corporation will go under bankruptcy.

PROBLEM 9
Return on Equity) Midwest Packaging's ROE last year was only 3 percent, but its
management has developed a new operating plan designed to improve things. The new
plan calls for a total debt ratio of 60 percent, which will result in interest charges of
Rs.300 per year. Management projects an EBIT of Rs.1,000 on sales of Rs.10,000 and it
expects to have a total assets turnover ratio of 2.0. Under these conditions, the average
tax rate will be 30 percent. If the changes are made, what return on equity will Midwest
earn ? What is the ROA ?
Ans: 24.5%, 9.8%

PROBLEM 10
(Return on equity) Central City Construction Company, which is just being formed,
needs Rs.1 million of assets and it expects to have a basic earning power ratio of 20
percent. Central City will own no securities, so all of its income will be operating
income. If it chooses to, Central City can finance up to 50 percent of its assets with debt,
which will have an 8 percent interest rate. Assuming a 40 percent tax rate on all taxable
income, what is the difference between its expected ROE if Central City finances with 50
percent debt versus its expected ROE if it finances entirely with common stock?
Ans: The difference in ROE=19.2% – 12% = 7.2%

PROBLEM 11
(Market/book ratio) Jaster Jets has Rs. 10 billion in total assets. The right side of its
balance sheet consists of Rs. 1 billion in current liabilities, Rs. 3 billion in long-term debt,
and Rs. 6 billion in common equity. The company has 800 million shares of common
stock outstanding, and its stock price is Rs.32 per share. What is Jaster's market/book
ratio ?
Ans: 4.2667 times

PROBLEM 12
 Analysis of Financial Statements .....11
Debt Radio) K. Billingsworth & CO. had earnings per share of Rs. 4 last year, and it paid
a Rs.2 dividend. Total retained earnings increased by Rs. 12 million during the year,
while book value per share at year-end was Rs. 40. Billingsworth has no preferred stock,
and no new common stock was issued during the year. If Billingsworth's year-end debt
(which equals its total liabilities) was Rs. 120 million, what was the company's year-end
debt/assets ratio ? Ans: 33.33%

PROBLEM 13
Stella Stores, Inc., has sales of Rs. 6 million, a total asset turnover ratio of 6 for the year,
and net profits of Rs. 1,20,000.
(a) What is the company's return on assets or earning power ?
(b) The company is considering the installation of new point-of-sales cash registers
throughout its stores. This equipment is expected to increase efficiency in inventory
control, reduce clerical errors, and improve record keeping throughout the system. The
new equipment will increase the investment in assets by 20 percent and is expected to
increase the net profit margin from 2 percent to 3 percent. No change in sales is
expected. What is the effect of the new equipment on the return on assets ratio or
earning power ?
Ans: a. 12.%, b. 15%

PROBLEM 14
Cordillera Carson Company has the following balance sheet and income statement for
20X2 (in thousands):
Balance Sheet
Cash Rs. 400 Account payable Rs. 320
Accounts receivable 1,300 Accruals 260
Inventories 2,100 Short term loans 1,100
Current assets 3,800 Current liabilities Rs. 1,680
Long term debt 2,000
Net fixed assets 3,320 Net worth 3,440
Total assets Rs. 7,120 Total liabilities and net worth Rs. 7,120

Income Statement
Net sales (all credit) Rs. 12,680
Cost of goods sold 8,930
Gross profit Rs. 3,750
Selling, general and administration expenses 2,230
Interest expense 460
Profit before tax Rs. 1,060
Taxes 390
Profit after taxes Rs. 670
Notes: (i) Current period's depreciation is Rs. 480; (ii) Ending inventory for 20X1 was Rs.
1,800.
On the basis of this information, compute (a) the current ratio (b) the acid-test ratio (c)l
the average collection period, (d) the inventory turnover ratio, (e) the debt to net worth
ratio, (f) the long term debt to total capitalization ratio, (g) the gross profit margin, (h)
the net profit margin, and (i) the return on equity.
Ans: 2.26 times, 1.01 times, 37 days, 4.58 times, 1.07 times, 37%, 29.57%, 5.28%,
19.48%

PROBLEM 15
Balance sheet analysis) Complete the balance sheet and sales information in the table
that follows for Hoffimeister Industries using the following financial data :
12.....Managerial Finance
Debt ratio 50%
Quick ratio 0.80 
Total assets turnover : 1.5 
Days sales outstanding : 36 days
Gross profit margin on sales : (Sales - Cost of goods sold)/Sales 25%
Inventory turnover ratio : 5

Balance Sheet
Cash Accounts payable
Accounts receivable Long term debt 60,000
Inventories Common stock
Fixed assets Retained earnings 97,500
Total assets Rs.3,00,000 Total liabilities and equity
Sales Cost of goods sold

Ans: Cash 27,000; A R Rs. 45,000; Inventories Rs. 67,500; Fixed Assets Rs. 1,60,500; A.P.
Payable Rs. 90,000; Common Stock Rs. 52,500; Sales Rs. 4,50,000; Cost of goods sold
Rs. 3,37,500

PROBLEM 16
Complete the balance sheet and sales information (fill in the blanks) for the Goodrich
Company using the following financial data:
Debt/net worth = 1.5
Acid test ratio = 0.40
Total asset turnover = 1.5 times
Days' sales outstanding in accounts receivable: 20
Gross profit margin = 25%
Sales to inventory turnover = 5 times
Balance Sheet
Cash ________ Accounts payable _______
Account receivable ________ Common stock Rs.10,000
Inventories ________ Retained earnings Rs.20,000
Plant and equipment ________
Total assets ________ Total liabilities and capital _______
Sales ________ Cost of goods sold _______
Ans: Debt=Rs.45,000, TA&TL=Rs.75,000,Sales= Rs.112,500, AR=Rs.6,250,
Cash=Rs.11,750, Inventory=Rs.22,500, Plant=Rs.34,500, COGSRs.84,375

PROBLEM 17
Using the following information, complete the balance sheet.
Long term debt to net worth 0.5 to 1
Total asset turnover 2.5 times
Average collection period* 18 days
Inventory turnover 9 times
Gross profit margin 10%
Acid test ratio 1 to 1
*Assume a 360-day year and all sales on credit
Cash Rs. Notes and payables Rs. 1,00,000
Accounts receivable –––––– Long-term debt ––––––––
Inventory –––––– Common stock Rs. 1,00,000
Plant and equipment –––––– Retained earnings Rs. 1,00,000
Total assets Rs. Total liabilities and equity Rs.
 Analysis of Financial Statements .....13
Ans: Cash: Rs. 50,000; Accounts receivables: 50,000; Inventory: 1,00,000; Plant and
equipment: 2,00,000; Total assets: Rs. 4,00,000; Long-term debt: 1,00,000; Total liabilities
and equity: Rs. 400,000

PROBLEM 18
The following information is available on the Vanier Corporation. Assuming that sales
and production are steady throughout a 360-day year, complete the balance sheet and
income statement for Vanier Corporation.
Balance Sheet
as of December 31, 20 x 2 (in thousands)
Cash & marketable securities Rs. 500 Accounts payable Rs. 400
Accounts receivable ? Bank loan ?
Inventories ? Accruals 200
Current assets ? Current liabilities ?
Net fixed assets ? Long term debt 2,650
Common stock and retained earnings 3,750
Total assets ? Total liabilities and equity ?
Income Statement For 20X2 (in Thousands)
Credit sales Rs. 8,000
Cost of goods sold ?
Gross profit ?
Selling and administrative expenses ?
Interest expense 400
Profit before taxes ?
Taxes (44% rate) ?
Profit after taxes ?
Other Information
Current ratio 3 to 1
Depreciation Rs. 500
Net profit margin 7%
Total liabilities/shareholder's equity 1 to 1
Average collection period 45 days
Inventory turnover ratio 3 to 1

Ans: Current Assets Rs. 3,300; Net Fixed Assets Rs. 4,200; Current Liabilities Rs.
1,100; Total Assets Rs. 7,500; Net Income Rs. 560; Cost of goods sold Rs. 5,400

PROBLEM 19
Ratio analysis) The following data apply to A.L. Kaiser & Company (millions of
rupees) :
Cash and marketable securities Rs. 100.00
Fixed assets Rs. 283.50
Sales Rs. 1,000.00
Net income Rs. 50.00
Quick ratio 2.0 
Current ratio 3.0 
DSO 40.0 days
ROE 12%
Kaiser has no preferred stock- only common equity, current liabilities, and long-term
debt.
14.....Managerial Finance
a.Find Kaiser's (1) account receivable (A/R), (2) current liabilities. (3) current assets, (4)
total assets, (5) ROA, (6) common equity, and (7) long-term debt.
b.In Part a, you should have found Kaiser's accounts receivable (A/R) = Rs.111.1
million. If Kaiser could reduce its DSO from 40 days to 30 days while holding other
things constant, how much cash would it generate ? If this cash were use to buy back
common stock (at book value) and thus reduce the amount of common equity, how
would this affect (1) the ROE, (2) the ROA, and (3) the debt ratio ?
Ans: a. Rs.111.1 million., Rs.105.6 million, Rs.316.8 million, Rs.600.3 million, 8.33%,
Rs.416.7 million, Rs. 78 million; b. 12.86%, 8.74 %, 30.6%, 32%

PROBLEM 20
((Return on equity) Lloyd and Daughters has sales of Rs.200,000, a net income of
Rs.15,000, and the following balance sheet.

Cash Rs. 10,000 Account payable Rs. 30,000

Receivables 50,000 Other current liabilities 20,000
Inventories 150,000 Long term debt 50,000
Net fixed assets 90,000 Common equity 200,000
Total assets Rs. 300,000 Total liabilities and equity Rs. 300,000
a. The Company's new owner thinks that inventories are excessive and can be lowered
to the point where the current ratio is equal to the industry average, 2.5 , without
affecting either sales or net income. If inventories are sold off and not replaced so as to
reduce the current ratio to 2.5 , if the funds generated are used to reduce common
equity (stock can be repurchased at book value), and if no other changes occur, by how
much will the ROE change ?
b. Now suppose we wanted to take this problem and modify it for use on an exam,
that is, to create a new problem which you have not seen to test your knowledge of this
type of problem. How would your answer change if (1) We doubled all the rupee
amounts ? (2) We stated that the target current ratio was 3.0 ? (3) We said that the
company had 10,000 shares of stock outstanding, and we asked how much the change
in part a would increase EPS ? (4) What would your answer to (3) be if we changed the
original problem to state that the stock was selling for twice book value, so common
equity would not be reduced on a rupee-for-rupee basis ?

Ans: (a) 7.5%, 13.04%, 5.54% (b) (1) If all rupee amounts are doubled, the answer of part
(a) would remain constant due to the equal effect on both numerator and
denominator value. The change in ROE will remain constant at 5.54 percent. (2)
The ROE will increase by 3.21% (3) The EPS will increase by Rs. 1.11 (4) The
change in market price of common stock does not bring any change in EPS. So, if
market price of common stock becomes double of book value, it would not bring
change in EPS.

PROBLEM 21
(Ratio calculation) Assume you are given the following relationships for the Brauer
Corporation:
Sales/total assets = 1.5 x
 Analysis of Financial Statements .....15
Return on assets (ROA) = 3%
Return on equity (ROE) = 5%
Calculate Brauer's profit margin and debt ratio.
Ans: 2%, 40%

PROBLEM 22
(Du Pont Analysis) Keller Cosmetics maintains a profit margin of 5 percent and asset
turnover ratio of 3.
a. What is its ROA?
b. If its debt-equity ratio is 1.0, its interest payments and taxes are each
Rs.8,000 and EBIT is Rs.20,000, what is its ROE ?
Ans: 15%; 30%

PROBLEM 23
(Equity multiplier and return equity) Haselden Fried Chicken Company has a debt-
equity ratio of 1.10. Return on assets is 8.4 percent, and total equity is Rs.440,000. What
is the equity multiplier? Return on equity? Net income?
Ans: 2.10 times; 17.64%; Rs. 77,616

PROBLEM 24
Susan Doherty Designs has 1.64 million shares outstanding, shareholders' equity of
Rs.36.4 million, earning of Rs.4.7 million during the last 12 months during which it
paid dividends of Rs.1.1 million, and share price of Rs.59.
a. What is the price/earnings ratio?
b. What is the dividend yield?
c. What is the ratio of market to book value per share?
d. From this information, what can you say about the expected growth of the
company?
Ans: a. 20.56 times, b. 1.135%, c. 2.66 times,

PROBLEM 25
(Ratio analysis) Data for Bery Computer Company and its industry averages follow.
a. Calculate the indicated ratios for Bery.
b. Construct the Du Pont equation for both Bery and the industry.
c. Outline Bery's strengths and weaknesses as revealed by your analysis.
d. Suppose Bery had doubled its sales as well as its inventories, accounts
receivable, and common equity during 1995. 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.)

Bery Computer Company

Balance Sheet
as of December 31, 1998
Cash Rs. 77,500 Accounts payable Rs. 129,000
Receivables 336,000 Notes payable 84,000
Inventories 241,500 Other current liabilities 117,000
Total current assets Rs. 655,000 Total current liabilities Rs. 330, 000
16.....Managerial Finance
Net fixed assets 292,500 Long-term debt 256,500
Common equity 361,000
Total assets Rs. 947,500 Total liabilities and equity Rs. 947,500

Bery Computer Company

Income Statement
for Year Ended December 31, 1998
Sales Rs. 1,607,500
Cost of goods sold (1,353,000)
Gross profit (Rs 254,500)
Fixed operating expenses except depreciation (143,000)
Depreciation (41,500)
Earnings before interest and taxes (EBIT) Rs. 70,000
Interest (24,500)
Earnings before taxes (EBT) Rs. 45,500
Taxes (40%) (18,200)
Net income Rs. 27,300

Ratio Bery Industry Average

Current ratio - 2.0 
Days sales outstanding - 35 days
Inventory turnover - 5.6 
Total assets turnover - 3.0 
Profit margin on sales - 1.2 %
Return on assets - 3.6 %
Return on equity - 9%
Debt ratio - 60.0 %

Ans: a. 1.98 times, 75 days, 5.6 times, 1.7 times, 1.7 %, 2.9 %, 7.6 %, 61.9 %;

PROBLEM 24
(Ratio analysis) The Corrigan Corporation's forecasted 1999 financial statements follow,
along with some industry average ratio
a. Calculate Corrigan's 1999 forecasted ratios, compare them with the
industry average data, and comment briefly on Corrigan's projected strengths
and weaknesses.
b. What do you think would happen to Corrigan'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.

Corrigan Corporation: Forecasted

Balance Sheet as
of December 31, 1999
 Analysis of Financial Statements .....17

Cash Rs. 72,000

Accounts receivable 439,000
Inventories 894,000
Total current assets Rs. 1,405,000
land and building 238,000
Machinery 132,000
Other fixed assets 61,000
Total assets Rs. 1,836,000
Accounts and notes payable Rs. 432,000
Accruals 170,000
Total current liabilities Rs. 602,000
Long-term debt 404,290
Common stock 575,000
Retained earning 254,710
Total liabilities and equity Rs. 1,836,000

Corrigan Corporation: Forecasted

Income Statement
for 1999
Sales Rs. 4,290,000
Cost of goods sold (3,580,000)
Gross operating profit Rs. 710,000
General administrative and selling expenses (236,320)
Depreciation (159,000)
Miscellaneous (134,000)
Earnings before taxes (EBT) Rs. 180,680
Taxes (40%) (72,272)
Net income Rs. 108,408
Number of shares outstanding 23,000
Per Share Data
EPS Rs. 4.71
Cash dividends Rs. 0.95
PE ratio 5
Market price (average) Rs. 23.57

Industry Financial Ratios (1996)a

Quick ratio 1.0 
Current ratio 2.7 
Inventory turnoverb 5.8 
Days sales outstanding 32 days
Fixed assets turnoverb 13.0 
Total assets turnover 2.6 
Return on assets 9.1%
Return on equity 18.2%
Debt ratio 50.0%
Profit margin on sales 3.5%
18.....Managerial Finance
P/E ratio 6.0 
aIndustry average ratios have been constant
for the past four years.
bBased on year-end balance sheet figures
Ans: a. 85%, 2.33 times, 4.8 times, 37 days, 9.95 times, 2.34 times, 5.9%, 13.066%,
54.8%, 2.53%, 5 times b. To hold lower levels of inventory, it affects Inventory
turnover, total assets turnover, current ratio, debt ratio and it also affects the cost of
goods sold and profitability ratios.

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