Study Guide Chapter 4

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  • 1. CHAPTER 4 Evaluationof FirmPerformance This chapter deals with financial ratio analyzing The relationship of the return on investment using information contained in financial (ROI) to margin and turnover can be used to statements. Financial ratios enable interested determine if one or both of the two is deficient parties to take the information contained in in contributing to the profitability of the firm. financial statements and make relative Common-sized financial statements, which comparisons of firm performance over time and express financial items in percentages, are also compare performance across different firms. helpful in detecting and monitoring financial Financial ratios are statistical yardsticks that trends. relate two numbers generally taken from a To gain further insight into the relative financial firm’s income statements and balance sheets. position of a firm, the analyst must compare the Financial ratios fall into five categories: financial ratios with industry averages. The liquidity ratios, asset management ratios, more diversified the firm, the more difficult it profitability ratios, and market-based ratios. will be to make such a comparison. Trend analysis introduces the element of time The Economic Value Added is a measure of into financial ratio analysis. It gives the analyst performance that compares the dollar return a more dynamic view of the company’s situation generated by the firm to the return expected by than a pure comparative financial ratio analysis the investors in the various sources of capital alone. utilized by the firm. Chapter Outline I. Financial ratio analysis is used to measure the relative performance and creditworthiness of a business entity. Some specific uses for ratio analysis include: A. Ratios are used as an analytical tool to assist management in identifying strengths and weaknesses in the firm. B. Ratios are used as a monitoring device that may uncover problems in the firm’s operations. C. Ratios are used internally by management for planning and for evaluating performance. Financial ratios allow management to translate goals into operational objectives. II. Successful financial ratio analysis requires that an analyst keep in mind the following points: A. Any discussion of financial ratios is likely to include only a representative sample of 49
  • 2. 50 Contemporary Financial Management Fundamentals possible ratios B. Financial ratios serve only as “flags” indicating potential areas of strength or weakness. C. Frequently a financial ratio must be dissected to discover its true meaning. D. A financial ratio is meaningful only when it is compared with some standard, such as an industry ratio trend, a ratio trend for the specific firm being analyzed, or a stated management objective. E. When financial ratios are used to compare one firm with another, it is important to remember that differences in accounting techniques may result in substantial differences in financial ratios. III. A financial ratio is a relationship that indicates something about a firm's activities, such as the ratio between the firm's current assets and current liabilities or between its accounts receivable and annual sales. Financial ratios are frequently grouped into six types of ratios. A. Liquidity ratios indicate the ability of the firm to meet short-term financial obligations. B. Asset management ratios indicate how efficiently the firm is utilizing its resources. C. Financial leverage management ratios indicate the firm's capacity to meet its debt obligations, both short-term and long-term. D. Profitability ratios measure the total effectiveness of management in generating profits on sales, assets, and owners' investment. E. Market-based ratios measure the financial market's assessment of a company's performance. F. The effective use of financial ratio analysis requires some experience and effort. There are some basic approaches to financial ratio analysis, some basic interrelationships among ratios, and sources of information that can enhance the analyst’s effectiveness. Two common types of ratio analysis are, comparative and trend analysis. 1. Comparative analysis—The analyst compares the ratios of the firm to the industry norms or other individual firms in the industry. 2. Trend analysis—This requires the analyst to examine the ratios of a firm for several periods. This shows whether the firm’s financial condition is improving or deteriorating over time. IV. The data for constructing ratios generally comes from a firm's balance sheet, income statement, and statement of cash flows. A. Liquidity ratios: Current assets Current ratio = Current liabilities
  • 3. Chapter 4/Evaluation of Firm Performance 51 Current assets - Inventories Quick (Acid test) ratio = Current liabilities The quick ratio can also be adjusted downward by removing accounts receivable over 90 days old from the numerator of the quick ratio. B. Asset Management Ratios: Accounts receivable Average collection period = Annual credit sales/365 Cost of sales Inventory turnover = Average inventory Sales Fixed - asset turnover = Net fixed assets Sales Total asset turnover = Total assets C. Financial Leverage Management Ratios: Total debt Debt ratio = Total assets Total debt Debt - to - equity ratio = Total equity Earnings before interest and taxes (EBIT) Times interest earned = Interest charges Fixed charge coverage = EBIT + Lease payments Preferred dividends Before tax Interest + Lease payments + + before tax sinking fund D. Profitability Ratios:
  • 4. 52 Contemporary Financial Management Fundamentals Sales - Cost of sales Gross profit margin = Sales Earnings after taxes (EAT) Net profit margin = Sales Earnings after taxes (EAT) Return on investment (ROI) = Total assets Earnings after taxes (EAT) Return on stockholders equity = Stockholders equity E. Market-Based Ratios Market price per share Market to book Ratio = P/B = Book value per share Market price per share Price to earnings ratio = P/E = Current earnings per share F. Market-to-Book Value or Pierce-to-Book Value (P/BV) Ratio: Market price per share P / BV = Book value per share V. Analysis of profitability A. Return on Investment = Net Profit Margin x Total Asset Turnover. EAT Sales EAT ROI = × = Sales Total assets Total assets B. Dupont analysis—Dupont charts, such as the one in the textbook, present the major ratios in a logical, organized fashion. This Dupont chart provides a good starting point for analyzing the firm. For example, suppose a firm's return on stockholders' equity is considered low. Is this because of a low ROI or a low equity multiplier (or both)? If the ROI is too low, is this due to a low net profit margin or low total asset turnover (or both)? If the net profit margin is low, which expenses are out of line? C. Return on Stockholders' Equity = Return on Investment x Equity Multiplier. (The equity multiplier is the ratio of assets to equity).
  • 5. Chapter 4/Evaluation of Firm Performance 53 Return on EAT Sales Total assets stockholders = × x Sales Total assets Stockholders equity equity Return on Net profit Total asset Equity stockholders = × × margin turnover multiplier equity D. Computerized databases are available to assist in financial statement analysis. Standard and Poors provides the Research Insight database, which contains balance sheet, income statement, stock price and dividend information. Value Line provides financial information on a large number of firms. Additional financial data may be access via the Internet. 1. www.yahoo.com 2. www.altavista.com 3. www.google.com 4. www.lycos.com V. Even though ratios can provide valuable information, they can be misleading for a number of reasons. A. Ratios are only as reliable as the accounting data on which they are based. B. Industry “average” ratios may not be very meaningful if there is significant dispersion in the ratio for the industry. C. Industry classifications may be defined too broadly to make reliable comparative analysis between a firm and a particular industry average. D. Financial ratios provide a historical assessment of performance, which may or may not be a useful basis for making future projections. E. A comparison of a firm’s ratios with industry norms provides a relative measure of performance, not an absolute measure. For example, a firm’s profitability ratios may be relatively better than its industry average, but on an absolute basis it may be poor compared to the universe of firms. VI. A recent innovation in performance measurement is the economic value added. A. Economic Value Added (EVA) is a measure of operating performance that indicates how successful the firm has been at increasing its MVA in a given year. EVA is defined as:
  • 6. 54 Contemporary Financial Management Fundamentals EVA = (EBIT)(I - T) - K × InvestedCapital where k = average cost of capital, invested capital = amount of invested capital at the beginning of the year. B. A positive EVA signifies that management has generated earnings over and above what the capital holders require. C. MVA is a cumulative measure of EVA since the invention of the firm. VII. Common-size statements are also helpful in financial analysis. A. A common-size balance sheet shows the firm’s assets and liabilities as a percentage of total assets (rather than as dollar amounts). B. A common-size income statement shows the firm’s income and expense items as a percentage of net sales (rather than as dollar amounts). VIII. Sources of comparative financial data—The most popular sources of financial information for business and industries are: A. Industry Norms and Key Business Ratios published by Dun and Bradstreet (D&B) B. Risk Management Association (RMA) C. Reports of the Federal Trade Commission (FTC) and the Securities and Exchange Commission (SEC) D. Prentice-Hall’s Almanac of Business and Industrial Financial Ratios E. Financial Studies of Small Business from Financial Research Associates F. Moody’s or Standard and Poor’s Industrial, Financial, Transportation, and Over-the- Counter manuals. G. Annual reports and 10K’s from corporations H. Trade associations and trade journals I. Publications of some commercial banks IX. Even though ratios can provide valuable information, they can be misleading for a number of reasons. A. Ratios are only as reliable as the accounting data on which they are based. B. Industry “average” ratios may not be very meaningful if there is significant dispersion in the ratio for the industry. C. Industry classifications may be defined too broadly to make reliable comparative analysis between a firm and a particular industry average. D. Financial ratios provide a historical assessment of performance, which may or may not
  • 7. Chapter 4/Evaluation of Firm Performance 55 be a useful basis for making future projections. E. A comparison of a firm’s ratios with industry norms provides a relative measure of performance, not an absolute measure. Fore example, a firm’s profitability ratios may be relatively better than its industry average, but on an absolute basis it may be poor compared to the universe of firms.
  • 8. 56 Contemporary Financial Management Fundamentals Chapter Formulas: 1. Liquidity ratios: Current assets Current ratio = Current liabilities Chapter Formulas: Current assets - Inventories Quick (Acid test) ratio = Current liabilities 4. Profitability Ratios: 2. Asset Management Ratios: Sales - Cost of sales Gross profit margin = Accounts receivable Average collection period = Sales Annual credit sales/365 Earnings after taxes (EAT) Net profit margin = Cost of Sales sales Inventory turnover = Average inventory Earnings after taxes (EAT) Return on investment (ROI) = Sales Total assets Fixed - asset turnover = Net fixed assets Earnings after taxes (EAT) Return on stockholders equity = Sales Stockholders equity Total asset turnover = Total assets 5. Market-Based Ratios: 3. Financial Leverage Management Ratios: Market price per share Market to book Ratio = P/B = Total debt Book value per share Debt ratio = Total assets Market price per share Price to earnings ratio = P/E = debt TotalCurrent earnings per share Debt - to - equity ratio = Total equity 6. Market-to-Book Value or Pierce-to-Book Value (PTBV) Ratio: Earnings before interest and taxes (EBIT) Times interest earned per share Market price = PIBV = Interest charges Book value per share 7. Fixed charge coverage = Return on Investment = Net Profit Margin x Total Asset Turnover: EAT Sales EAT ROI = × EBIT + Lease payments = Sales Total assets Total assets Preferred dividends Before tax Interest + Lease payments + + 8. Economic Value Added (EVA): before tax sinking fund EVA = (EBIT)(I - T) - K × InvestedCapital
  • 9. Chapter 4/Evaluation of Firm Performance 57 True And False Questions Agree with each of the statements or reject it and modify it so that it is acceptable. 1. The current ratio will never exceed the quick ratio. 2. Assuming a current ratio greater than one, the purchase of raw materials on credit decreases the current ratio.
  • 10. 58 Contemporary Financial Management Fundamentals 3. The gross profit margin is greater than the net profit margin. 4. The average collection period is found by dividing a firm's year-end accounts receivable by its average daily credit sales. 5. Because total assets exceed net fixed assets, the total asset turnover must exceed the fixed asset turnover. 6. A short average collection period is a sign of efficient accounts receivable management. 7. The return on total equity equals the net profit margin times the total asset turnover. 8. Free cash flow often is viewed as a better measure than earnings of the financial soundness of the firm. 9. The book value per share of common stock is determined by dividing the total common stockholders’ equity for a firm by the number of shares outstanding. 10. Firms with a current ratio below 2.0 are having liquidity problems. 11. The basic rational for historical cost is that it is a measure of current value. 12. Revenues increase net worth, while expenses decrease net worth. 13. Leverage rations measure how efficiently the firm is employing its resources. 14. No external sources of information are required to do a trend analysis. 15. A firm’s ROI examines profit margin as it plays a major role in contributing to profitability. Multiple Choice Questions 1. ______________ ratios measure the total effectiveness of management in generating profits on sales, assets, and owners’ investment. A. Liquidity B. Asset management C. Financial leverage management D. Profitability E. Market-based ratios 2. A common-size balance sheet shows a firm’s assets and liabilities, and shareholders’ equity as a percentage of A. total sales. B. net income. C. total shareholders’ equity. D. total assets. E. total liabilities. 3. In comparative analysis, the financial analyst compares the ratios of the firm A. for several reporting periods. B. to industry norms or other firms in the industry.
  • 11. Chapter 4/Evaluation of Firm Performance 59 C. to the firm’s ratios under ideal operating conditions. D. to the industry leader’s ratios. E. to governmental standards of acceptable accounting performance. 4. To assess the ability of the firm to meet current financial obligations, a potential lender would most likely be most concerned with the firm’s A. payout ratio. B. price-to-earnings ratio. C. average collection period. D. fixed charge coverage ratio. E. total asset turnover. 5. If a firm’s net profit margin declines and the CEO wants to maintain the return on shareholder equity, he must A. increase the firm’s utilization of assets. B. reduce the amount of debt in the firm’s capital structure. C. increase the firm’s total sales. D. increase the firm’s total shareholder equity. E. increase the firm’s average collection period. 6. Financial ratios are used by management for ________________. A. analysis. B. analysis and monitoring. C. monitoring and planning. D. analysis, monitoring, and planning. 7. _______________ is a measure of operating performance that indicates how successful the firm has been at increasing its MVA in a given year. A. Economic value added (EVA) B. After-tax cash flow (ATCF) C. Earnings after taxes (EAT) D. Market value added (MVA) E. Earnings before interest and taxes (EBIT) 8. Which of the following utilize financial ratio analysis?. A. credit managers B. unions C. security analysts D. bankers E. all of the above 9. Which of the following is not an asset management ratio? A. average collection period B. inventory turnover ratio C. sales-to-inventory ratio D. fixed-asset turnover ratio E. total asset turnover ratio
  • 12. 60 Contemporary Financial Management Fundamentals 10. In general, the lower a firm’s risk, the higher its _______ ratio should be. A. market-to-book ratio B. average collection period C. PIE ratio D. debt ratio E. price to book ratio 11. What are the primary sources of historical financial information about the firm? A. balance sheet B. income statement C. income statement and balance sheet D. sources and uses of funds 12. A ________ liability is one that arises automatically when a firm buys goods and services to produce its product. A. spontaneous B. funded C. current D. long-term 13. What is not included in a firm’s expenses? A. costs of goods sold B. depreciation C. interest expense D. dividends 14. ROI can be viewed as a function of the net profit margin times A. sales. B. EAT. C. the total asset turnover. D. equity multiplier. 15. If a significant portion of the assets of a firm has a market value ________ book value, the quality of the firm’s balance sheet is reduced. A. equal to B. substantially below C. substantially above D. none of the above 16. Profitability ratios measure how effectively a firm’s management is generating profits on _____. A. sales B. sales & total assets C. total assets and stockholders’ investment D. sales and stockholders’ investment E. sales, total assets, and stockholders’ investment 17. Which of the following is not a profitability ratio?
  • 13. Chapter 4/Evaluation of Firm Performance 61 A. profitability ratio B. net profit margin ratio C. times interest earned ratio D return on investment ratio E. return on stockholders’ equity ratio 18. The ratio of EBIT to total assets measures the ________ in a firm. A. stockholders’ equity rate of return B. operating profit rate of return C. profitability before considering the effects of financing decisions D. profitability after the cost of sales E. all of the above 19. The gross profit margin ratio measures the ________ in a firm. A. stockholders’ equity rate of return B. operating profit rate of return C. profitability before considering the effects of financing decisions D. profitability after the cost of sales E. all of the above 20. The ________ ratio analysis and the ________ analysis in combination provide the financial analyst with a fairly clear picture of a firm’s performance. A. market-based; profitability B. liquidity; asset management C. financial leverage management; market-based D. liquidity; profitability E. comparative financial; trend 21. Which of the following variable does ROI examine? A. EAT B. sales C. total assets D. all of the above 22. Which of the following variable does return on stockholders’ equity examine? A. EAT, sales, EBIT, and total assets B. EAT, EBIT, total assets, and stockholders’ equity C. EBIT, total assets, sales, and stockholders’ equity D. EAT, sales, total assets, and stockholders’ equity E. EAT, total assets, total debt, and net fixed assets 23. The ________ compares the dollar return generated by the firm to the return expected by the investors of the capital invested by them in the firm. A. EBIT B. EVA C. ROI D. DuPont chart E. ROE 24. _________ prepares a series of fourteen key business ratios for 800 different lines of businesses based on SIC codes.
  • 14. 62 Contemporary Financial Management Fundamentals A. RMA B. Dun and Bradstreet C. 10K reports D. Quarterly Financial Reports for Manufacturing Companies E. Almanac of Business and Financial ratios 25. __________ uses information from loan applications to compile sixteen ratios for over 250 lines of business based on SIC codes. A. RMA B. Dun and Bradstreet C. 10K reports D. Quarterly Financial Reports for Manufacturing Companies E. Almanac of Business and Financial ratios Problems 1. Please supply the missing figures: (NPM) (TAT) (ROI) Return on Net Profit Total Asset Return on Equity Stockholders' Margin Turnover Investment Multiplier Equity a. 20.0% 0.75 ____ 1.00 ____ b. ____ 2.00 8.0% 1.50 ____ c. 2.5% 4.00 ____ ____ 25.0% d. 6.0% ____ 9.0% ____ 14.4% 2. Find the sales of the Franklin Company using the following information: Current ratio 2.0 Quick ratio 1.6 Current liabilities $200,000 Inventory turnover 8.0 Gross profit margin 10% 3. Minor Motors has a net profit margin of 3 percent, a total asset turnover of 2.2, and an equity multiplier of 2.5. What is Minor's return on investment and return on stockholders' equity?
  • 15. Chapter 4/Evaluation of Firm Performance 63 4. Tom Putnam forecasts sales of $4,000,000 for his firm next year. If the firm maintains its average collection period at 40 days and its inventory turnover at 8, what should be the firm's receivables and inventory levels? The gross profit margin is 22 percent. 5. Joyce Tilleman is planning for a small distributing firm she will operate after graduation. Her best guesses about several relevant financial variables are: Sales $100,000 Gross profit margin 40% Average collection period (365 day year) 97 days Inventory turnover 4.0 Minimum cash balance $5,000 Investment in fixtures and equipment $10,000 Long-term bank loan $15,000 Current ratio 2.76 All other required assets are to be leased All sales are credit sales Complete the following pro forma balance sheet and indicate how much equity capital Joyce must invest in her firm. BALANCE SHEET Cash $ Accounts payable $ Accounts receivable $ Bank loan $_______
  • 16. 64 Contemporary Financial Management Fundamentals Inventory $_______ TOTAL CURRENT TOTAL LIABILITIES $ ASSETS $ Stockholders' equity $_______ Long-term assets $_______ TOTAL LIABILITIES TOTAL ASSETS $ & EQUITY $
  • 17. Chapter 4/Evaluation of Firm Performance 65 6. From the financial statements of the Jackson Products Company, please provide a common-size balance sheet and common-size income statement. JACKSON PRODUCTS COMPANY Balance Sheet December 31, 20X5 Cash and securities $ 240,000 Accounts payable $ 380,000 Accounts receivable 320,000 Notes payable 420,000 Inventory 1,040,000 Other current liabilities 50,000 Total current assets $1,600,000 Total current liabilities $ 850,000 Net plant & equipment 800,000 L-T debt (10%) $ 800,000 Total assets $ 2,400,000 Common stock 400,000 Retained earnings 350,000 Total liabilities and equity $ 2,400,000 INCOME STATEMENT for the Year Ended December 31, 20X5 Net sales (all on credit) $ 3,000,000 Cost of sales 1,800,000 Gross profit $ 1,200,000 Selling, general, and administrative expenses 860,000 Earnings before interest and taxes $ 340,000 Interest: Notes $ 37,800 Long-term debt 80,000 Total interest charges 117,800 Earnings before tax $ 222,200 Federal income tax (40%) 88,880 Earnings after tax $ 133,320
  • 18. 66 Contemporary Financial Management Fundamentals The following data apply to problems 7 – 11. Rich Corporation Balance Sheet ($000) 12/31/05 and 12/31/06 2005 2006 ASSETS Cash 200 240.0 Accounts Receivable 310 440.8 Inventories 1,200 1,250.0 Total Current Assets 1,710 1,930.8 Plant and Equipment 900 1,000.0 Accumulated Depreciation 150 200.0 Net Fixed Assets 750 800.0 Total Assets 2,460 2730.8 LIABILITIES AND STOCKHOLDER’S EQUITY Accounts Payable 390 400.0 Notes Payable (8%) 340 400.0 Accruals 50 50.0 Total Current Liabilities 780 850.0 Long-Term Debt (9%) 900 1,000.0 Common Stock 10,000 Shares 200 200.0 Retained Earnings 580 680.8 Total Liabilities and Stockholders’ Equity 2,460 2,730.8 Rich Corporation Income Statement ($000) 2005 and 2006 2005 2006 Sales 2,700.00 3,000.00 COGS 1,620.00 1,800.00 Gross Profit 1,080.00 1,200.00 Selling and Administrative Expenses 774.00 860.00 Interest Expense 108.20 122.00 Depreciation 40.00 50.00 EBT 157.80 168.00 Tax @ 40% 63.12 67.20 EAT 94.68 100.80 Market Price of Common Stock 94.70 100.80 EPS 9.47 10.08 7. Calculate the net worth of Rich Corporation. 8. What did Rich Corporation spend to increase plant and equipment in (2006)?
  • 19. Chapter 4/Evaluation of Firm Performance 67 9. If Rich Corporation has a cost of capital of 12%, what is the EVA for 2005? 10. Calculate the key financial ratios for Rich Corporation (2005 and 2006). 11. Given the following industrial norms, what are Rich Corporation’s strengths and weaknesses? Industrial Average Liquidity:
  • 20. 68 Contemporary Financial Management Fundamentals Current Ratio 2.5 Acid Test Ratio 1.0 Activity: Average Collection Period 35 Inventory Turnover 2.5 Fixed Asset Turnover 1.4 Total Asset Turnover 1.5 Leverage: Debt Ratio 0.6 Times Interested Earned 4.0 Times Fixed Charges Earned 4.0 Profitability: Debt-to-Equity Ratio 200% Net Margin 4.0% Return on Investment 4.5% Return on Equity 17% Earnings Per Share $12.00 Market-Based: Price-to-Earnings Ratio 12 Market-to-Book Ratio 1.5 Internet Exercises The P/E ratio and dividend payout for the S&P 500 Index can be found at this Web site. Write a one- page paper discussion your findings. http://cpcug.org/user/invest/pepayout.html The Value Point Analysis Model at this Web site gives you insight into evaluating a stocks risk with the P/E ratio. Once you are at this Web site chick on VPA and do an analysis. Be prepared to discuss your analysis in class. http://www.eduvest.com/vparisk.html The Motley Fool examines the importance of combining the P/E ratio with a company’s growth rate. Check out this Web site and be ready to comment on the “Fool Ratio” examined here. http://www.fool.com Answers True and False Questions 1. The current ratio exceeds the quick ratio for all firms with an inventory. 2. True. 3. True.
  • 21. Chapter 4/Evaluation of Firm Performance 69 4. True. 5. Because total assets exceed net fixed assets, the total asset turnover must be less than the fixed asset turnover. 6. A short average collection period is not necessarily a sign of efficient accounts receivable management. It could also result from overly strict credit terms that can reduce the firm's sales and profitability. 7. The return on total assets equals the net profit margin times the total asset turnover. 8. True. 9. True. 10. The appropriate current ratio for a given firm can be substantially above or below 2.0 depending on the industry and circumstances relevant to the specific firm. 11. Historical cost is not a measure of current value. 12. True. 13. Leverage ratios measure the degree to which a company is employing financial leverage. 14. True. 15. Margin and turnover both play a major role in contributing to profitability. Multiple Choice Questions 1. D 6. D 11. C 16. E 21. D 2. D 7. A 12. A 17. C 22. D 3. B 8. E 13. D 18. B 23. B 4. D 9. C 14. C 19. D 24. B 5. A 10. C 15. B 20. E 25. A Problem Solutions 1. a. ROI = NPM x TAT = 20.0%(.75) = 15.0% Return on Equity = ROI x Equity Multiplier = 15.0%(1.00) = 15.0% b. NPM = ROI/TAT = 8.0%/2.00 = 4% Return on Equity = ROI x Equity Multiplier = 8%(1.5) = 12.0% c. ROI = NPM x TAT = 2.5%(4.00) = 10% Equity Multiplier = Return on Equity/ROI =25%/10% = 2.50 d. TAT = ROI/NPM = 9%/6% = 1.50 Equity Multiplier = Return on Equity/ROI = 14.4%/9% = 1.60 2. Current assets = 2.0(200,000) = $400,000 Current assets minus inventory = 1.6(200,000) = $320,000 Inventory = 400,000 - 320,000 = $80,000 Inventory Turnover = Sales / Inventory = 8.0 = sales/$80,000 Sales = $640,000 3. Return on investment = Net profit margin x Total asset turnover Return on investment = 3% x 2.2 = 6.6% Return on stockholders' equity = Return on investment x Equity multiplier
  • 22. 70 Contemporary Financial Management Fundamentals Return on stockholders' equity = 6.6 % x 2.5 = 16.5% 4. Accounts receivable = (40/365) 4,000,000 = $444,444 Cost of sales = (100%-gross profit margin) Sales Cost of sales = 78% (4,000,000) = $3,120,000 Inventory = $3,120,000/8 = $390,000 5. Cash = $5,000 Long-term assets = $10,000 Bank loan = $15,000 Accounts receivable = 100,000(97/365) = $26,575 Cost of sales = (100% - 40%)sales = (60%)100,000 = $60,000 Inventory = 60,000/4.0 = $15,000 Total current assets = 5,000 + 26,575 + 15,000 = $46,575 Total assets = 46,575 + 10,000 = $56,575 Current assets/current liabilities = 2.76 Accounts payable = current assets/2.76 = 46,575/2.76 = $16,875 Total liabilities = 16,875 + 15,000 = $31,875 Stockholders' equity = total assets - total liabilities = 56,575 - 31,875 = $24,700 BALANCE SHEET Cash $ 5,000 Accounts payable $ 16,875 Accounts receivable 26,575 Bank loan 15,000 Inventory 15,000 TOTAL TOTAL CURRENT ASSETS $ 46,575 LIABILITIES $ 31,875 Long-term assets 10,000 Stockholders' equity 24,700 TOTAL TOTAL LIABILITIES ASSETS $ 56,575 & EQUITY $ 56,575 Joyce must invest $24,700 of equity capital in her business. 6. JACKSON PRODUCTS COMPANY Common-Size Balance Sheet December 31, 20X5 Cash and Securities 10.00% Accounts payable 15.83% Accounts Receivable 13.33 Notes payable 17.50 Inventory 43.33 Other current liabilities 2.08 Total current assets 66.67 Total current liabilities 35.42% Net plant and Long-term debt 33.33 equipment 33.33 Common stock 16.67 Total assets 100.00% Retained earnings 14.58
  • 23. Chapter 4/Evaluation of Firm Performance 71 Total liabilities and stockholders' equity 100.00% JACKSON PRODUCTS COMPANY Common-Size Income Statement Net sales 100.00% Cost of sales 60.00 Gross profit 40.00% Selling, general, and administration expenses 28.67 Earnings before interest and taxes 11.33% Total interest charges 3.93 Earnings before tax 7.40% Federal income tax 2.96 Earnings after tax 4.44% 7. Net Worth = Total Assets – Total Liabilities 2005 $780 = $2,460 – $1680 2006 $880.0 = $2,730.8 – $1,850 8. Increase in plant and equipment 2006 ($000): Change in net fixed assets + depreciation 2006 (800 – 750) + (200 – 150) = $100 9. EVA = (EBIT)(I - T) - K × InvestedCapital = 266.0 (1-.40) - .12 x 295.20 = 148.13 in ($000) = $148,130 10. Key financial ratios: Industrial Average 2005 2006 Liquidity: Current Ratio 2.5 2.19 2.27 Acid Test Ratio 1.0 0.65 0.80 Activity: Average Collection Period 35 41.3 52.9 Inventory Turnover 2.5 1.35 1.44 Fixed Asset Turnover 1.4 3.60 3.75 Total Asset Turnover 1.5 1.10 1.10 Leverage: Debt Ratio 0.6 0.683 0.677 Debt-to-Equity Ratio 200% 215.4% 210.0%
  • 24. 72 Contemporary Financial Management Fundamentals Times Interested Earned 4.0 2.46 2.38 Times Fixed Charges Earned 4.0 2.46 2.38 Profitability: Gross Profit Margin 40% 40% 42% Net Margin 4.0% 3.5% 3.36% Return on Investments 4.5% 3.85% 3.69% Return on Equity 17% 12.1% 11.4% Market-Based: Price-to-Earnings ratio 12 10 10 11. Most ratios are weak. a. The current ration and acid test ratio are weak but moving towards the industrial average. Investors like companies moving towards the industrial average and dislike companies moving away from the average. b. The debt ratio is close and moving closer to the industrial average. c. Gross margin is equal to the industrial average. d. Earnings per share are increasing and moving towards the industrial average. e. P/E ratio is below the industry average, which is reflected in the lower ROI and ROE then the industry average. f. Market-to-book value is below average.