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1.

Problem 6-7
Asset utilization ratios measure the efficiency with which the firm uses its assets to
generate sales revenue to reach a sufficient profitability level. Asset utilization ratios
measure how efficient a business is at using its assets to make money.
Asset turnover, total asset turnover, or asset turns is a financial ratio that measures
the efficiency of a company's use of its assets in generating sales revenue or sales
income to the company.

View all

The ratio measures the efficiency of how well a company uses assets to produce sales. A higher ratio is
favorable, as it indicates a more efficient use of assets. Conversely, a lower ratio indicates the company
is not using its assets as efficiently

Comparatively Lennox International is performing well because its total asset

turnover ratio over time remains higher than Tecumseh Products Company.
Similarly, Longterm asset turnonver ratio was higher in 22012 & 2013 but reduced
in 2014. However, ROA of Lennox Int. was always remains positive and higher
than Tecumseh where as Tecumseh ROA sharply decline in 2014 and 2015. Thus,
Lennox International performs much better the other one.

2. Lennox operating profit margin is higher because its sales opver the period
remains higher than Tecumseh Product Company.

Management compensation These days most of the businesses are run by professional managers who
are part of management team. This leads to separation of ownership and control which leads to conflict
between shareholders and managers. These professional managers are paid additional incentives apart
from regular monthly salaries. With better company's performance and growth of business managers
are paidh inhcentivhes ash compensathion or chrediting them fhor company's performhanceh.

Shareholder will be woried if the roiis unable to cover the cost of capital.

High initial costs incurred to set up the

new stores e.g. hiring more staff,

inventory purchases and capital

expenditure

? Costs will flow down to the net income

and reduce the distributable income to

shareholders

? More fixed capital is tied to the new

stores - more risk borne by the

shareholders

? Debt payer have claims before

shareholders in the event when company

become insolvent

? Higher debt ? Higher risk ? Higher IR

? reduce distributable income

to shareholders

Cannibalization of sales

(ROI)

? No stores will operate at potential level

? Revenue may increase but same store

sales is likely to decrease

Branding Issues (ROI)

? Additional staffing is needed with more

outlets

? Integration of new employees can take

time

? Mismanagement of employees may cause

company's branding to be tarnished

? E.g. Bad customer services may lead to

lost sales, deviation from core principle

1.2

? Avoid violation of debt covenants

? E.g. a loan agreement may use the firm’s

EBITDA as an affirmative covenant to

ensure the borrower’s ability to repay the

lender (e.g. minimum EBITDA)

? Manager might just focus on their target

bonus and manipulate their definition of

EBITDA without taking into

consideration of debt covenan

What if debt covenant was

breached?

? A penalty or fee charged

? An increase in the interest rate of the

bond or loan;

? An increase in the collateral;

? Termination of the debt agreement;h

demanding payment in full

Revenue = $50m
20% of Revenue = $10m
EBITDA = $20m
80% of EBITDA = $16m
 Target payout for Revenue = 70%
Target payout for EBITDA = 85% (Pro-rated)

Total Payout = (10 x 70%) + (24 x 85%) = $27.4m

70% 100% 140%

EBITDA 10 Million 30 Million 60 Million

Revenue 50 Million 100 Million 150 Million

% Target Payout
Threshold 70%
Target 100%
Maximum 140%

Measure of profits and mainly used to

EBITDAh

compare the financial health of a company,

without taking into consideration its capital
structure, taxes or different depreciation and
amortization assumptions a company may have.
Lower/avoid operating expenses to increase EBITDA
¡ Delay critics research or expenses for repair and maintenance

¡ Capitalize certain expenses as assets

¡ Subject to IAS 18 and FRS 116

¡ Decrease provisions

H Potential acceleration of

earnings during bad years and recording less revenue during good yearsHHHHHHH

Manipulating Inventory Valuation

(COGS)

COGS Ending Inventory

LIFO Highest Lowest

FIFO Lowest Highest

¡ Prefer FIFO since the resulting COGS is

lower, which will cause a higher EBITDA

HH

HH

Increase in Debt and LiabilitiesH

H• Debt fell from $25,743 to $1,993

• Interest expenses will be lower

• Since pre-tax income considers interest expenses, a fall in interest expense will be favourable to
the management

6-1

1. Which company has shown the strongest sales growth over the past three

years?

Based of the information provided in the table above it is safe to

assume that Kroger co. has shown the strongest sales growth over

the past three years because of the of a more positive annual sales

growth rate.

2. Which company was the most profitable in its most recent fiscal year? - What

was the source of that superior profitability—a profit margin advantage or better

turnover?

With the average ROA taken into account for the 3 companies, it can

be concluded with the information provided that Kroger co. had the

most average growth from year one.

1.Current Ration i.e (Current Assets/ Current Liabilities) reflected the liquidity of the
organizations.

Cash conversion cycle presents the time needed for the organization in between
procurement of raw material and receiving the moneys from its buyer.

Since Ross store has the least current ration i.e. 1.36, we might say that it owns least liquid
assets at present.
but the ratio is above 1 then we might say that the organization owns enough current assets
to satisfy its current obligation. To support the same quick ratio analysis is required.

2. Occupancy Cost includes costs related to occupying a space including; rent, real estate
taxes, personal property taxes, insurance on building and contents, depreciation, and
amortization expenses.
if the same related to cost of goods sold included in Cost of Goods sold then more
weightage would be assigned to the Days inventory held, as an additional day will be costly
to the organization.

3. Ross store's 2.2 days accounts receivable outstanding is result of its practice of selling
goods on credit.
4.Aerostale & the GAP having 0 day accounts receivable is result of its policy of only cash
sale.

1. Return on Assets (ROA) = net income/Average total assets

For 2016:

For 2017: Net income = $900.4 million

Average total assets = ($14,327 + $15,223.5)/2

= $14,775.25 million

ROA = $900.4 million/$14,775.25 million

= 6.1%

For 2017:

Net income = $1,380.6

Average total assets = ($15,223.5 + $15,841.3)/2

= $15,532.4million

ROA = $1,380.6 million/$15,532.4 million

= 8.9%
For 2018:

Net income = $2,481.1

Average total assets = ($15,841.3 + $17,920.6)/2

= $16,880.95 million

ROA = $2,481.1million/$16,880.95 million

= 14.7%

2. Return on Assets = Net profit margin*Asset turnover ratio

Net profit margin = net profit/net sales revenue

Asset turnover ratio = net sales revenue/average total assets

For 2016:

Net profit margin = $900.4 million/$16,208.1 million

= 5.56%

Asset turnover ratio = $16,208.1 million/$15,223.5 million

= 1.065
ROA = 0.0556*1.065

= 5.92%

For 2017:

Net profit margin = $1,380.6 million/$20,252.4 million

= 6.82%

Asset turnover ratio = $20,252.4 million/$15,841.3 million

= 1.28

ROA = 0.0682*1.28

= 8.73%

For 2018:

Net profit margin = $2,481.1 million/$25,067.3million

= 9.9%

Asset turnover ratio = $25,067.3 million/$17,920.6 million

= 1.40
ROA = 0.099*1.4

= 13.86

3. Yes, the profitability has changed over the three years. In 2016, the net profit margin was

. 5.56%, which increased to 6.82%. In 2018, the net profit margin came to be 9.9%. The profitability has
shown an increasing trend over the three years.

4. Return on Equity (ROE) = Net income/Average Equity

For 2016:

Net income = $900.4 million

Average equity = ($7,849.9 + $8,254.7)/2

= $8,052.3 million

ROE = $900.4 million/$8,052.3 million

= 11.182%

For 2017:

Net income = $1,380.6

Average total equity= ($8,254.7 + $9,084.8)/2

= $8,669.75 million

ROE = $1,380.6 million/$8,669.75 million

= $15.92%

For 2018:

Net income = $2,481.1

Average equity = ($9,084.8+ $10,202.0)/2

= $9,643.4 million

ROE = $2,481.1million/$9,643.4 million

= 25.73%