Chap 3 Problem Solutions

Chapter 3
Analysis of Financial Statements

ANSWERS TO END-OF-CHAPTER QUESTIONS
3-1 a. A liquidity ratio is a ratio that shows the relationship of a firm’s

cash and other current assets to its current liabilities. The
current ratio is found by dividing current assets by current
liabilities. It indicates the extent to which current liabilities
are covered by those assets expected to be converted to cash in the
near future. The quick, or acid test, ratio is found by taking
current assets less inventories and then dividing by current
liabilities.
b. Asset management ratios are a set of ratios which measure how

effectively a firm is managing its assets. The inventory turnover
ratio is sales divided by inventories. Days sales outstanding is
used to appraise accounts receivable and indicates the length of time
the firm must wait after making a sale before receiving cash. It is
found by dividing receivables by average sales per day. The fixed
assets turnover ratio measures how effectively the firm uses its
plant and equipment. It is the ratio of sales to net fixed assets.
Total assets turnover ratio measures the turnover of all the firm’s
assets; it is calculated by dividing sales by total assets. The
operating capital requirement ratio measures the amount of capital
needed to support sales. It is calculated by dividing operating
capital by sales.
c. Financial leverage ratios measure the use of debt financing. The

debt ratio is the ratio of total debt to total assets, it measures
the percentage of funds provided by creditors. The times-interest-
earned ratio is determined by dividing earnings before interest and
taxes by the interest charges. This ratio measures the extent to
which operating income can decline before the firm is unable to meet
its annual interest costs. The fixed charge coverage ratio is
similar to the times-interest-earned ratio, but it recognizes that
many firms lease assets and also must make sinking fund payments. It
is found by adding EBIT and lease payments then dividing this total
by interest charges, lease payments, and sinking fund payments over
one minus the tax rate.
d. Profitability ratios are a group of ratios which show the combined

effects of liquidity, asset management, and debt on operations. The
operating profit margin after taxes measures the amount of operating
profit that is generated by sales. It is defined as NOPAT divided by
sales. The profit margin on sales, calculated by dividing net income
by sales, gives the profit per dollar of sales. Basic earning power
is calculated by dividing EBIT by total assets. This ratio shows the
raw earning power of the firm’s assets, before the influence of taxes
The Dryden Press Learning Objectives: 3 - 1

and leverage. Return on total assets is the ratio of net income to
total assets. Return on common equity is found by dividing net
income into common equity.
e. Market value ratios relate the firm’s stock price to its earnings and
book value per share. The price/earnings ratio is calculated by
dividing price per share by earnings per share--this shows how much
investors are willing to pay per dollar of reported profits. Market-
to-book ratio is simply the market price per share divided by the
book value per share. Book value per share is common equity divided
by the number of shares outstanding.
f. Trend analysis is an analysis of a firm’s financial ratios over time.

It is used to estimate the likelihood of improvement or deterioration
in its financial situation. Comparative ratio analysis is when a
firm compares its ratios to other leading companies in the same
industry. This technique is also known as benchmarking.
g. The Du Pont chart is a chart designed to show the relationships among

return on investment, asset turnover, the profit margin, and
leverage. The Du Pont equation is a formula which shows that the
rate of return on assets can be found as the product of the profit
margin times the total assets turnover.
h. Window dressing is a technique employed by firms to make their

financial statements look better than they really are. Seasonal
factors can distort ratio analysis. At certain times of the year a
firm may have excessive inventories in preparation of a “season” of
high demand. Therefore an inventory turnover ratio taken at this
time as opposed to after the season will be radically distorted.
3-2 The emphasis of the various types of analysts is by no means uniform nor
should it be. Management is interested in all types of ratios for two
reasons. First, the ratios point out weaknesses that should be
strengthened; second, management recognizes that the other parties are
interested in all the ratios and that financial appearances must be kept
up if the firm is to be regarded highly by creditors and equity
investors. Equity investors are interested primarily in profitability,
but they examine the other ratios to get information on the riskiness of
equity commitments. Long-term creditors are more interested in the
debt ratio, TIE, and fixed-charge coverage ratios, as well as the
profitability ratios. Short-term creditors emphasize liquidity and
look most carefully at the liquidity ratios.
3-3 The inventory turnover ratio is important to a grocery store because of

the much larger inventory required and because some of that inventory is
perishable. An insurance company would have no inventory to speak of
since its line of business is selling insurance policies or other
similar financial products--contracts written on paper and entered into
between the company and the insured. This question demonstrates the
fact that the student should not take a routine approach to financial
Learning Objectives: 3 - 2 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
analysis but rather should examine the particular business he or she is
dealing with.
3-4 Given that sales have not changed, a decrease in the total assets
turnover means that the company's assets have increased. Also, the fact
that the fixed assets turnover ratio remained constant implies that the
company increased its current assets. Since the company's current ratio
increased, and yet, its quick ratio is unchanged means that the company
has increased its inventories.
3-5 Differences in the amounts of assets necessary to generate a dollar of

sales cause asset turnover ratios to vary among industries. For
example, a steel company needs a greater number of dollars in assets to
produce a dollar in sales than does a grocery store chain. Also, profit
margins and turnover ratios may vary due to differences in the amount of
expenses incurred to produce sales. For example, one would expect a
grocery store chain to spend more per dollar of sales than does a steel
company. Often, a large turnover will be associated with a low profit
margin, and vice versa.
3-6 Inflation will cause earnings to increase, even if there is no increase

in sales volume. Yet, the book value of the assets that produced the
sales and the annual depreciation expense remain at historic values and
do not reflect the actual cost of replacing those assets. Thus, ratios
that compare current flows with historic values become distorted over
time. For example, ROA will increase even though those assets are
generating the same sales volume.
When comparing different companies, the age of the assets will
greatly affect the ratios. Companies whose assets were purchased
earlier will reflect lower asset values than those that purchased the
assets later at inflated prices. Two firms with similar physical assets
and sales could have significantly different ROAs. Under inflation,
ratios will also reflect differences in the way firms treat inventories.
As can be seen, inflation affects both income statement and balance
sheet items.
3-7 ROE, using the Du Pont equation, is the return on assets multiplied by
the equity multiplier. The equity multiplier, defined as total assets
divided by owners' equity, is a measure of debt utilization; the more
debt a firm uses, the lower its equity, and the higher the equity
multiplier. Thus, using more debt will increase the equity multiplier,
resulting in a higher ROE.
3-8 a. Cash, receivables, and inventories, as well as current liabilities,

vary over the year for firms with seasonal sales patterns.
Therefore, those ratios that examine balance sheet figures will vary
unless averages (monthly ones are best) are used.
b. Common equity is determined at a point in time, say December 31,

1998. Profits are earned over time, say during 1998. If a firm is
growing rapidly, year-end equity will be much larger than beginning-
of-year equity, so the calculated rate of return on equity will be

different depending on whether end-of-year, beginning-of-year, or
average common equity is used as the denominator. Average common
equity is conceptually the best figure to use. In public utility
rate cases, people are reported to have deliberately used end-of-year
or beginning-of-year equity to make returns on equity appear exces-
sive or inadequate. Similar problems can arise when a firm is being
evaluated.
3-9 Firms within the same industry may employ different accounting
techniques which make it difficult to compare financial ratios. More
fundamentally, comparisons may be misleading if firms in the same
industry differ in their other investments. For example, comparing
Pepsico and Coca-Cola may be misleading because apart from their soft
drink business, Pepsi also owns other businesses such as Frito-Lay,
Pizza Hut, Taco Bell, and KFC.
3-10 Total Effect

Current Current on Net
Assets Ratio Income
a. Cash is acquired through issuance of
additional common stock. + + 0
b. Merchandise is sold for cash. + + +
c. Federal income tax due for the previous

year is paid. ─ + 0
d. A fixed asset is sold for less than

book value. + + ─
e. A fixed asset is sold for more than

book value. + + +
f. Merchandise is sold on credit. + + +
g. Payment is made to trade creditors for

previous purchases. ─ + 0
h. A cash dividend is declared and paid. ─ ─ 0
i. Cash is obtained through short-term bank

loans. + ─ 0
j. Short-term notes receivable are sold at

a discount. ─ ─ ─
k. Marketable securities are sold below cost. ─ ─ ─
l. Advances are made to employees. 0 0 0
m. Current operating expenses are paid. ─ ─ ─
Learning Objectives: 3 - 4 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
n. Short-term promissory notes are issued to
trade creditors in exchange for past due
accounts payable. 0 0 0
Total Effect
Current Current on Net
Assets Ratio Income
o. Ten-year notes are issued to pay off
accounts payable. 0 + 0
p. A fully depreciated asset is retired. 0 0 0
q. Accounts receivable are collected. 0 0 0
r. Equipment is purchased with short-term

notes. 0 ─ 0
s. Merchandise is purchased on credit. + ─ 0
t. The estimated taxes payable are increased. 0 ─ ─

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Install Equation Editor and double-

3-1 CA = $3,000,000; click here to view equation. = 1.5;
click here to view equation. = 1.0;
CL = ?; I = ?

click here to view equation.

3-2 DSO = 40 days; ADS = $20,000; AR = ?

3-3 A/E = 2.4; D/A = ?

3-4 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; A/E = ?

ROA = NI/A; PM = NI/S; ROE = NI/E
ROA = PM  S/TA
NI/A = NI/S  S/TA
10% = 2%  S/TA
S/TA = 5.
ROE = PM  S/TA  TA/E

NI/E = NI/S  S/TA  TA/E
15% = 2%  5  TA/E
15% = 10%  TA/E
TA/E = 1.5.
3-5 We are given ROA = 3% and Sales/Total assets = 1.5.
From Du Pont equation: ROA = Profit margin  Total assets turnover

3% = Profit margin (1.5)
Profit margin = 3%/1.5 = 2%.
We can also calculate the company's debt ratio in a similar manner,

given the facts of the problem. We are given ROA(NI/A) and ROE(NI/E);
if we use the reciprocal of ROE we have the following equation:

Alternatively,
ROE = ROA  EM
5% = 3%  EM
EM = 5%/3% = 5/3 = TA/E.
Take reciprocal:
E/TA = 3/5 = 60%;

therefore,
D/A = 1 - 0.60 = 0.40 = 40%.
Thus, the firm's profit margin = 2% and its debt ratio = 40%.

3-6 Present current ratio = click here to view equation. = 2.5.

Minimum current ratio = click here to view equation. = 2.0.
$1,312,500 + ΔNP = $1,050,000 + 2ΔNP

ΔNP = $262,500.
Short-term debt can increase by a maximum of $262,500 without violating

a 2 to 1 current ratio, assuming that the entire increase in notes
payable is used to increase current assets. Since we assumed that the
additional funds would be used to increase inventory, the inventory
account will increase to $637,500, and current assets will total
$1,575,000.
Quick ratio = ($1,575,000 - $637,500)/$787,500 = $937,500/$787,500 =

1.19.
Install Equation Editor and double- Install Equation Editor and double-
3-7 1. click here to view equation. = 3.0 click here to view equation. = 3.0
Current liabilities = $270,000.
2. click here to view equation. = 1.4 click here to view equation. = 1.4
Inventories = $432,000.

3. click here to view equation.
$810,000 = $120,000 + Accounts receivable + $432,000

Accounts receivable = $258,000.
4. click here to view equation. = 6.0 click here to view equation. = 6.0
Sales = $2,592,000.
5. DSO = click here to view equation. = click here to view equation. = 36 days.
3-8 TIE = EBIT/INT, so find EBIT and INT.

Interest = $500,000  0.1 = $50,000.
Net income = $2,000,000  0.05 = $100,000.
Pre-tax income = $100,000/(1 - T) = $100,000/0.7 = $142,857.
EBIT = $142,857 + $50,000 = $192,857.

TIE = $192,857/$50,000 = 3.86.
3-9 ROE = Profit margin  TA turnover  Equity multiplier

= NI/Sales  Sales/TA  TA/Equity.
Now we need to determine the inputs for the equation from the data that
were given. On the left we set up an income statement, and we put
numbers in it on the right:
Sales (given) $10,000,000

Cost na
EBIT (given) $ 1,000,000
INT (given) 300,000
EBT $ 700,000
Taxes (34%) 238,000
NI $ 462,000
Now we can use some ratios to get some more data:

Total assets turnover = 2 = S/TA; TA = S/2 = $10,000,000/2 = $5,000,000.
D/A = 60%; so E/A = 40%; and, therefore,

Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5.
Now we can complete the Du Pont equation to determine ROE:

ROE = $462,000/$10,000,000  $10,000,000/$5,000,000  2.5 = 0.231 =
23.1%.
3-10 Known data:
TA = $1,000,000
BEP = 0.2 = EBIT/Total assets, so EBIT = 0.2($1,000,000) = $200,000.
kd = 8%
T = 40%
D/A = 0.5 = 50%, so Equity = $500,000.
D/A = 0% D/A = 50%

EBIT $200,000 $200,000
Interest 0 40,000*
EBT $200,000 $160,000
Tax (40%) 80,000 64,000
NI $120,000 $ 96,000
ROE = click here to view equation. = click here to view equation. = 12%;
click here to view equation. = 19.2%.
Difference in ROE = 19.2% - 12.0% = 7.2%.
*If D/A = 50%, then half of assets are financed by debt, so Debt =
$500,000. At an 8% interest rate, INT = $40,000.
3-11 Statement a is correct. Refer to the solution setup for Problem 3-10
and think about it this way: (1) Adding assets will not affect common
equity if the assets are financed with debt. (2) Adding assets will
cause expected EBIT to increase by the amount EBIT = BEP(added assets).
(3) Interest expense will increase by the amount k d(added assets). (4)
Pre-tax income will rise by the amount (added assets)(BEP - k d).
Assuming BEP > kd, if pre-tax income increases so will net income. (5)
If expected net income increases but common equity is held constant,
then the expected ROE will also increase. Note that if kd > BEP, then
adding assets financed by debt would lower net income and thus the ROE.
Therefore, Statement a is true--if assets financed by debt are added,
and if the expected BEP on those assets exceeds the cost of debt, then
the firm's ROE will increase.
Statements b and c are false, because the BEP ratio uses EBIT, which
is calculated before the effects of taxes or interest charges are felt,
and d is false unless kd > BEP. Of course, Statement e is also false.
3-12 a. Currently, ROE is ROE1 = $15,000/$200,000 = 7.5%.

The current ratio will be set such that 2.5 = CA/CL. CL is
$50,000, and it will not change, so we can solve to find the new
level of current assets: CA = 2.5(CL) = 2.5($50,000) = $125,000.
This is the level of current assets that will produce a current ratio
of 2.5.
At present, current assets amount to $210,000, so they can be
reduced by $210,000 - $125,000 = $85,000. If the $85,000 generated
is used to retire common equity, then the new common equity balance
will be $200,000 - $85,000 = $115,000.
Assuming that net income is unchanged, the new ROE will be ROE 2 =
$15,000/$115,000 = 13.04%. Therefore, ROE will increase by 13.04% -
7.50% = 5.54%.
b. 1. Doubling the dollar amounts would not affect the answer; it would
still be 5.54%.
2. Common equity would increase by $25,000 from the Part a scenario,

which would mean a new ROE of $15,000/$140,000 = 10.71%, which
would mean a difference of 10.71% - 7.50% = 3.21%.
3. An inventory turnover of 2 would mean inventories of $100,000,

down $50,000 from the current level. That would mean an ROE of
$15,000/$150,000 = 10.00%, so the change in ROE would be 10.00% -
7.5% = 2.5%.
4. If the company had 10,000 shares outstanding, then its EPS would
be $15,000/10,000 = $1.50. The stock has a book value of
$200,000/10,000 = $20, so the shares retired would be $85,000/$20
= 4,250, leaving 10,000 - 4,250 = 5,750 shares. The new EPS would
be $15,000/5,750 = $2.6087, so the increase in EPS would be
$2.6087 - $1.50 = $1.1087, which is a 73.91% increase, the same as
the increase in ROE.
5. If the stock was selling for twice book value, or 2  $20 = $40,
then only half as many shares could be retired ($85,000/$40 =
2,125), so the remaining shares would be 10,000 - 2,125 = 7,875,
and the new EPS would be $15,000/7,875 = $1.9048, for an increase
of $1.9048 - $1.5000 = $0.4048.
c. We could have started with lower inventory and higher accounts

receivable, then had you calculate the DSO, then move to a lower DSO
which would require a reduction in receivables, and then determine
the effects on ROE and EPS under different conditions. Similarly, we
could have focused on fixed assets and the FA turnover ratio. In any
of these cases, we could have had you use the funds generated to
retire debt, which would have lowered interest charges and
consequently increased net income and EPS.
If we had to increase assets, then we would have had to finance
this increase by adding either debt or equity, which would have
lowered ROE and EPS, other things held constant.
Finally, note that we could have asked some conceptual questions
about the problem, either as a part of the problem or without any
reference to the problem. For example, "If funds are generated by
reducing assets, and if those funds are used to retire common stock,
will EPS and/or ROE be affected by whether or not the stock sells
above, at, or below book value?"
3-13 a. (Dollar amounts in thousands.)
Industry
Firm Average
click here to view equation. = click here to view equation. =
1.98 2.0
DSO = click here to view equation. = click here to view equation. = 75
days 35 days
click here to view equation. = click here to view equation.
= 6.66 6.7
= 5.50 12.1
= 1.70 3.0
43.6% 24.0%
2.6% 1.7%
= 1.7% 1.2%
Industry
Firm Average
= 2.9% 3.6%
= 7.6% 9.0%
= 61.9% 60.0%
b. For the firm,

ROE = PM  T.A. turnover  EM = 1.7%  1.7  click here to view equation.
= 7.6%.
For the industry, ROE = 1.2%  3  2.5 = 9%.
Note: To find the industry ratio of assets to common equity,

recognize that 1 - (total debt/total assets) = common equity/total
assets. So, common equity/total assets = 40%, and 1/0.40 = 2.5 =
total assets/common equity.
c. The firm's days sales outstanding is more than twice as long as the
industry average, indicating that the firm should tighten credit or
enforce a more stringent collection policy. The total assets
turnover ratio is well below the industry average so sales should be
increased, assets decreased, or both. While the company's profit
margin is higher than the industry average, its other profitability
ratios are low compared to the industry--net income should be higher
given the amount of equity and assets. However, the company seems to
be in an average liquidity position and financial leverage is similar
to others in the industry.
d. If 1998 represents a period of supernormal growth for the firm,

ratios based on this year will be distorted and a comparison between
them and industry averages will have little meaning. Potential
investors who look only at 1998 ratios will be misled, and a return
to normal conditions in 1999 could hurt the firm's stock price.
3-14 1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.
2. Accounts payable = Debt - Long-term debt = $150,000 - $60,000

= $90,000

3. Common stock = click here to view equation. - Debt - Retained earnings
= $300,000 - $150,000 - $97,500 = $52,500.
4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.
5. Inventory = Sales/5 = $450,000/5 = $90,000.
6. Accounts receivable = (Sales/360)(DSO) = ($450,000/360)(36)

= $45,000.
7. Cash + Accounts receivable = (0.80)(Accounts payable)

Cash + $45,000 = (0.80)($90,000)
Cash = $72,000 - $45,000 = $27,000.
8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)

= $300,000 - ($27,000 + $45,000 + $90,000) = $138,000.
9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500.
3-15 a. (Dollar amounts in millions.) Industry

Firm Average

Current ratio = click here to view equation. =
click here to view equation. = 2.73 2
click here to view equation. = 30% 30%
click here to view equation. = 11 7
click here to view equation. = 5 10
DSO = click here to view equation. = click here to view equation.
= 30 days 24 days

Profit margin = click here to view equation. =
click here to view equation. = 3.40% 3%
click here to view equation. = 6.00% 9%
click here to view equation. = ROA  EM = 6%  1.43 = 8.58%
12.9%
Alternatively,
ROE = click here to view equation. = click here to view equation. = 8.6%.
b. ROE = Profit margin  Total assets turnover  Equity multiplier
= click here to view equation.  click here to view equation. 
= click here to view equation.  click here to view equation. 
click here to view equation. = 3.4%  1.77  1.43 = 8.6%.
Firm Industry Comment
Profit margin 3.4% 3.0% Good
Total assets turnover 1.77 3.0 Poor
Equity multiplier 1.43 1.43* Good

* click here to view equation.
Alternatively, EM = ROE/ROA = 12.9%/9% = 1.43.
c. Analysis of the Du Pont equation and the set of ratios shows that the
turnover ratio of sales to assets is quite low. Either sales should
be increased at the present level of assets, or the current level of
assets should be decreased to be more in line with current sales.
Thus, the problem appears to be in the balance sheet accounts.
d. The comparison of inventory turnover ratios shows that other firms in

the industry seem to be getting along with about half as much
inventory per unit of sales as the firm. If the company's inventory
could be reduced, this would generate funds that could be used to
retire debt, thus reducing interest charges and improving profits,
and strengthening the debt position. There might also be some excess
investment in fixed assets, perhaps indicative of excess capacity, as
shown by a slightly lower-than-average fixed assets turnover ratio.
However, this is not nearly as clear-cut as the overinvestment in
inventory.
e. If the firm had a sharp seasonal sales pattern, or if it grew rapidly

during the year, many ratios might be distorted. Ratios involving
cash, receivables, inventories, and current liabilities, as well as
those based on sales, profits, and common equity, could be biased.
It is possible to correct for such problems by using average rather
than end-of-period figures.
3-16 a. Here are the firm's base case ratios and other data as compared to
the industry:
Firm Industry Comment

Quick 0.8 1.0 Weak
Current 2.3 2.7 Weak
Inventory turnover 4.8 7.0 Poor
Days sales outstanding 37 days 32 days Poor
Fixed assets turnover 10.0 13.0 Poor
Total assets turnover 2.3 2.6 Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.1 18.2 Bad
Debt ratio 54.8 50.0 High
Profit margin on sales 2.5 3.5 Bad
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio 5.0 6.0 Poor
M/B ratio 0.65 n.a. --
The firm appears to be badly managed--all of its ratios are worse

than the industry averages, and the result is low earnings, a low
P/E, a low stock price, and a low M/B ratio. The company needs to do
something to improve.
b. A decrease in the inventory level would improve the inventory

turnover, total assets turnover, and ROA, all of which are too low.
It would have some impact on the current ratio, but it is difficult
to say precisely how that ratio would be affected. If the lower
inventory level allowed the company to reduce its current
liabilities, then the current ratio would improve. The lower cost of
goods sold would improve all of the profitability ratios and, if
dividends were not increased, would lower the debt ratio through
increased retained earnings. All of this should lead to a higher
market/book ratio and a higher stock price.
SOLUTION TO SPREADSHEET PROBLEM
3-17 a. The revised data and ratios are shown below:
INPUT DATA: KEY OUTPUT:
1999 Firm Industry

Cash $ 84,527 Quick 1.2 1.0
A/R 395,000 Current 3.0 2.7
Inventories 700,000 Inv. turn. 6.1 7.0
Land and bldg. 238,000 DSO 33 32
Machinery 132,000 F.A.turn. 8.3 13.0
Other F.A. 150,000 T.A.turn. 2.5 2.6
ROA 10.5% 9.1%
Accts. & notes pay. $ 275,000 ROE 19.9% 18.2%
Accruals 120,000 TD/TA 47.0% 50.0%
Long-term debt 404,290 PM 4.2% 3.5%
Common stock 575,000 EPS $7.78 n.a.
Retained earnings 325,237 Stock Price $46.68 n.a.
P/E ratio 6.0 6.0
Total assets $1,699,527 M/B 1.19 n.a.
Total claims $1,699,527
Income statement
Sales $4,290,000
Cost of G.S. 3,450,000
Adm. & sales exp. 248,775
Depreciation 159,000
Misc. 134,000
Net income $ 178,935
P/E ratio 6
No. of shares 23,000
Cash dividend $ 0.95
Under these new conditions, the company looks much better. Its turnover ratios
are still low, but its ROA and ROE are above the industry average; its estimated
P/E ratio is better, and its stock price is anticipated to double. There is still room
for improvement, but the company is in much better shape.
Solution to Spreadsheet Problem: 3 - 16 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
b. The financial statements and ratios for the scenario in which the cost of goods
sold decreases by an additional $125,000 are shown below. As you can see, the
profit ratios are quite high and the stock price has risen to $66.24.
1999 Firm Industry

Cash $ 159,527 Quick 1.4 1.0
A/R 395,000 Current 3.2 2.7
Other F.A. 150,000 T.A.turn. 2.4 2.6
ROA 14.3% 9.1%
Accruals 120,000 TD/TA 45.0% 50.0%
P/E ratio 6.0 6.0
Income statement
Sales $4,290,000
Cost of G.S. 3,325,000
Misc. 134,000
P/E ratio 6
The Dryden Press items and derived items copyright © 1999 by The Dryden Press Solution to Spreadsheet Problem: 3 - 17
c. The financial statements and ratios for the scenario in which the cost of goods
sold increases by $125,000 over the revised estimate are shown below. As you
can see, profits would decline sharply. The ROE would drop to 12.6%, EPS would
fall to $4.52, the stock price would drop to $27.11, and the M/B ratio would be
only 0.76.
1999 Firm Industry

Cash $ 9,527 Quick 1.0 1.0
A/R 395,000 Current 2.8 2.7
Other F.A. 150,000 T.A.turn. 2.6 2.6
ROA 6.4% 9.1%
Accruals 120,000 TD/TA 49.2% 50.0%
P/E ratio 6.0 6.0
Income statement
Sales $4,290,000
Cost of G.S. 3,575,000
Misc. 134,000
P/E ratio 6
d. Computer models allow us to analyze quickly the impact of operating and

financial decisions on the firm's overall performance. A firm can analyze its
financial ratios under different scenarios to see what might happen if a decision,
such as the purchase of a new asset, did not produce the expected results. This
gives the managers some idea about what might happen under the best and
worst cases and helps them to make better decisions.
Solution to Spreadsheet Problem: 3 - 18 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
MINI CASE
The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 3 - 19
THE DONNA
FIRST PARTJAMISON
OF THE WAS
CASE, BROUGHT IN CHAPTER
PRESENTED IN AS ASSISTANT TO THE
2, DISCUSSED FRED CAMPO,
SITUATION
COMPUTRON'S
THAT COMPUTRON CHAIRMAN,
INDUSTRIESWHO
WAS HAD THE TASK
IN AFTER OF GETTING
AN EXPANSION THE COMPANY
PROGRAM. THUS BACK
FAR,
INTO
SALESA HAVE
SOUNDNOT FINANCIAL
BEEN UP TO POSITION. COMPUTRON'S
THE FORECASTED 1997
LEVEL, COSTS AND
HAVE 1998
BEEN BALANCE
HIGHER THAN
SHEETS AND INCOME
WERE PROJECTED, AND ASTATEMENTS, TOGETHER
LARGE LOSS OCCURRED WITH RATHER
IN 1998, PROJECTIONS
THAN THEFOR 1999,
EXPECTED
ARE SHOWN
PROFIT. AS IN THE FOLLOWING
A RESULT, TABLES.
ITS MANAGERS, ALSO, THE
DIRECTORS, TABLES SHOW
AND INVESTORS THE 1997
ARE CONCERNED
AND 1998
ABOUT THEFINANCIAL RATIOS, ALONG WITH INDUSTRY AVERAGE DATA. THE 1999
FIRM'S SURVIVAL.
PROJECTED FINANCIAL STATEMENT DATA REPRESENT JAMISON'S AND CAMPO'S
BEST GUESS FOR 1999 RESULTS, ASSUMING THAT SOME NEW FINANCING IS
ARRANGED TO GET THE COMPANY "OVER THE HUMP."
JAMISON EXAMINED MONTHLY DATA FOR 1998 (NOT GIVEN IN THE CASE),
AND SHE DETECTED AN IMPROVING PATTERN DURING THE YEAR. MONTHLY
SALES WERE RISING, COSTS WERE FALLING, AND LARGE LOSSES IN THE EARLY
MONTHS HAD TURNED TO A SMALL PROFIT BY DECEMBER. THUS, THE ANNUAL
DATA LOOKED SOMEWHAT WORSE THAN FINAL MONTHLY DATA. ALSO, IT
APPEARS TO BE TAKING LONGER FOR THE ADVERTISING PROGRAM TO GET THE
MESSAGE ACROSS, FOR THE NEW SALES OFFICES TO GENERATE SALES, AND FOR
THE NEW MANUFACTURING FACILITIES TO OPERATE EFFICIENTLY. IN OTHER
WORDS, THE LAGS BETWEEN SPENDING MONEY AND DERIVING BENEFITS WERE
LONGER THAN COMPUTRON'S MANAGERS HAD ANTICIPATED. FOR THESE
REASONS, JAMISON AND CAMPO SEE HOPE FOR THE COMPANY--PROVIDED IT CAN
SURVIVE IN THE SHORT RUN.
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 NO
ANSWERS.
BALANCE SHEETS
1999E 1998 1997

ASSETS
CASH $ 14,000 $ 7,282 $ 9,000
SHORT-TERM INVESTMENTS 71,632 0 48,600
ACCOUNTS RECEIVABLE 878,000 632,160 351,200
INVENTORIES 1,716,480 1,287,360 715,200
TOTAL CURRENT ASSETS $2,680,112 $1,926,802 $1,124,000
GROSS FIXED ASSETS 1,197,160 1,202,950 491,000
LESS ACCUMULATED DEPRECIATION 380,120 263,160 146,200
NET FIXED ASSETS $ 817,040 $ 939,790 $ 344,800
TOTAL ASSETS $3,497,152 $2,866,592 $1,468,800
Mini Case: 3 - 20 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
LIABILITIES AND EQUITY
ACCOUNTS PAYABLE $ 436,800 $ 524,160 $ 145,600
NOTES PAYABLE 600,000 720,000 200,000
ACCRUALS 408,000 489,600 136,000
TOTAL CURRENT LIABILITIES $1,444,800 $1,733,760 $ 481,600
LONG-TERM DEBT 500,000 1,000,000 323,432
COMMON STOCK 1,680,936 460,000 460,000
RETAINED EARNINGS (128,584) (327,168) 203,768
TOTAL EQUITY $1,552,352 $ 132,832 $ 663,768
TOTAL LIABILITIES AND EQUITY $3,497,152 $2,866,592 $1,468,800
NOTE: "E" INDICATES ESTIMATED. THE 1999 DATA ARE FORECASTS.
INCOME STATEMENTS
1999E 1998 1997

SALES $7,035,600 $5,834,400 $3,432,000
COST OF GOODS SOLD 5,728,000 5,728,000 2,864,000
OTHER EXPENSES 680,000 680,000 340,000
DEPRECIATION 116,960 116,960 18,900
TOTAL OPERATING COSTS $6,524,960 $6,524,960 $3,222,900
EBIT $ 510,640 ($ 690,560) $ 209,100
INTEREST EXPENSE 88,000 176,000 62,500
EBT $ 422,640 ($ 866,560) $ 146,600
TAXES (40%) 169,056 (346,624) 58,640
NET INCOME $ 253,584 ($ 519,936) $ 87,960
EPS $1.014 ($5.199) $0.880

DPS $0.220 $0.110 $0.220
BOOK VALUE PER SHARE $6.209 $1.328 $6.638
STOCK PRICE $12.17 $2.25 $8.50
SHARES OUTSTANDING 250,000 100,000 100,000
TAX RATE 40.00% 40.00% 40.00%
LEASE PAYMENTS 40,000 40,000 40,000
SINKING FUND PAYMENTS 0 0 0
RATIO ANALYSIS
INDUSTRY
1999E 1998 1997 AVERAGE
CURRENT 1.1 2.3 2.7
QUICK 0.4 0.8 1.0
INVENTORY TURNOVER 4.5 4.8 6.1
DAYS SALES OUTSTANDING (DSO) 39.0 36.8 32.0
FIXED ASSETS TURNOVER 6.2 10.0 7.0
TOTAL ASSETS TURNOVER 2.0 2.3 2.6
OPERATING CAPITAL REQUIREMENT 31.8%33.2% 29.5%
DEBT RATIO 95.4% 54.8% 50.0%
TIE -3.9 3.3 6.2
FIXED CHARGE COVERAGE -3.0 2.4 5.1
OPERATING PROFIT MARGIN AFTER TAXES -7.1% 3.7% 4.4%
PROFIT MARGIN -8.9% 2.6% 3.5%
BASIC EARNING POWER -24.1% 14.2% 19.1%
ROA -18.1% 6.0% 9.1%
ROE -391.4% 13.3% 18.2%
PRICE/EARNINGS -0.4 9.7 14.2
MARKET/BOOK 1.7 1.3 2.4
BOOK VALUE PER SHARE $1.33 $6.64 N.A.
A. WHY ARE RATIOS USEFUL? WHAT ARE THE FIVE MAJOR
CATEGORIES OF RATIOS?
ANSWER:RATIOS ARE USED BY MANAGERS TO HELP IMPROVE THE FIRM'S PERFORMANCE,

BY LENDERS TO HELP EVALUATE THE FIRM'S LIKELIHOOD OF REPAYING DEBTS,
AND BY STOCKHOLDERS TO HELP FORECAST FUTURE EARNINGS AND DIVIDENDS.
THE FIVE MAJOR CATEGORIES OF RATIOS ARE: LIQUIDITY, ASSET MANAGEMENT,
DEBT MANAGEMENT, PROFITABILITY, AND MARKET VALUE.
B. CALCULATE THE 1999 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 1997, 1998, AND AS
PROJECTED FOR 1999? WE OFTEN THINK OF RATIOS AS BEING USEFUL (1) TO
MANAGERS TO HELP RUN THE BUSINESS, (2) TO BANKERS FOR CREDIT
ANALYSIS, AND (3) TO STOCKHOLDERS FOR STOCK VALUATION. WOULD THESE
DIFFERENT TYPES OF ANALYSTS HAVE AN EQUAL INTEREST IN THE LIQUIDITY
RATIOS?
ANSWER:CURRENT RATIO99 = CURRENT ASSETS/CURRENT LIABILITIES

= $2,680,112/$1,444,800 = 1.86.
QUICK RATIO99 = (CURRENT ASSETS - INVENTORY)/CURRENT LIABILITIES

= ($2,680,112 - $1,716,480)/$1,444,800 = 0.667.
THE COMPANY'S CURRENT AND QUICK RATIOS ARE LOW RELATIVE TO ITS
1997 CURRENT AND QUICK RATIOS; HOWEVER, THEY HAVE IMPROVED FROM
THEIR 1998 LEVELS. BOTH RATIOS ARE WELL BELOW THE INDUSTRY AVERAGE,
HOWEVER.
C. CALCULATE THE 1999 INVENTORY TURNOVER, DAYS SALES

OUTSTANDING (DSO), FIXED ASSETS TURNOVER, OPERATING CAPITAL
REQUIREMENT, AND TOTAL ASSETS TURNOVER. HOW DOES COMPUTRON'S
UTILIZATION OF ASSETS STACK UP AGAINST OTHER FIRMS IN ITS INDUSTRY?
ANSWER:INVENTORY TURNOVER 99 = SALES/INVENTORY
= $7,035,600/$1,716,480 = 4.10.
DSO99 = RECEIVABLES/(SALES/360)
= $878,000/($7,035,600/360) = 44.9 DAYS.
FIXED ASSETS TURNOVER 99 = SALES/NET FIXED ASSETS

= $7,035,600/$817,040 = 8.61.

Install EquationCAPITAL
OPERATING Editor and double-
= click here to view equation. +
= ($14,000 + $878,000 + $1,716,480 - $436,800 -

$408,000) + $817,040
= $2,580,720.
OPERATING CAPITAL REQUIREMENT 99 = OPERATING CAPITAL/SALES

= $2,580,720/$7,035,600 = 36.7%.
TOTAL ASSETS TURNOVER 99 = SALES/TOTAL ASSETS

= $7,035,600/$3,497,152 = 2.01.
THE FIRM'S INVENTORY TURNOVER RATIO HAS BEEN STEADILY DECLINING,

WHILE ITS DAYS SALES OUTSTANDING HAS BEEN STEADILY INCREASING. WHILE
THE FIRM'S FIXED ASSETS TURNOVER RATIO IS BELOW ITS 1997 LEVEL, IT IS
ABOVE THE 1998 LEVEL. THE FIRM'S TOTAL ASSETS TURNOVER RATIO IS BELOW
ITS 1997 LEVEL AND JUST SLIGHTLY BELOW ITS 1998 LEVEL.
THE FIRM'S INVENTORY TURNOVER AND TOTAL ASSETS TURNOVER ARE
BELOW THE INDUSTRY AVERAGE. THE FIRM'S DAYS SALES OUTSTANDING IS
ABOVE THE INDUSTRY AVERAGE (WHICH IS BAD); HOWEVER, THE FIRM'S FIXED
ASSETS TURNOVER IS ABOVE THE INDUSTRY AVERAGE. (THIS MIGHT BE DUE TO
THE FACT THAT COMPUTRON IS AN OLDER FIRM THAN MOST OTHER FIRMS IN
THE INDUSTRY, IN WHICH CASE, ITS FIXED ASSETS ARE OLDER AND THUS HAVE
BEEN DEPRECIATED MORE, OR THAT COMPUTRON'S COST OF FIXED ASSETS
WERE LOWER THAN MOST FIRMS IN THE INDUSTRY.) THE FIRM’S OPERATING
CAPITAL REQUIREMENT RATIO IS HIGHER THAN THE INDUSTRY AVERAGE,
INDICATING THAT COMPUTRON REQUIRES MORE DOLLARS OF CAPITAL TO
GENERATE A DOLLAR OF SALES THAN THE AVERAGE FIRM IN THE INDUSTRY.
D. CALCULATE THE 1999 DEBT, TIMES-INTEREST-EARNED, AND FIXED
CHARGE COVERAGE RATIOS. HOW DOES COMPUTRON COMPARE WITH THE
INDUSTRY WITH RESPECT TO FINANCIAL LEVERAGE? WHAT CAN YOU
CONCLUDE FROM THESE RATIOS?
ANSWER:DEBT RATIO99 = TOTAL DEBT/TOTAL ASSETS

= ($1,444,800 + $500,000)/$3,497,152 = 55.61%.
TIE99 = EBIT/INTEREST = $510,640/$88,000 = 5.80.
FCC99 = (EBIT + LEASE PAYMENT)/((INTEREST + LEASE PAYMENT

+ (SINKING FUND PAYMENT/(1 - T))
= ($510,640 + $40,000)/($88,000 + $40,000) = 4.30.
THE FIRM'S DEBT RATIO IS MUCH IMPROVED FROM 1998, BUT IT IS STILL
ABOVE ITS 1997 LEVEL AND THE INDUSTRY AVERAGE. THE FIRM'S TIE AND FIXED
CHARGE RATIOS ARE MUCH IMPROVED FROM THEIR 1997 AND 1998 LEVELS, BUT
E. CALCULATE THE 1999 OPERATING PROFIT MARGIN AFTER TAXES,

PROFIT MARGIN, BASIC EARNING POWER (BEP), RETURN ON ASSETS (ROA),
AND RETURN ON EQUITY (ROE). WHAT CAN YOU SAY ABOUT THESE RATIOS?
THEY ARE STILL BELOW THE INDUSTRY AVERAGE.
ANSWER:OPERATING PROFIT MARGIN AFTER-TAX99 = NOPAT/SALES = $306,384/$7,035,600

= 4.4%.
PROFIT MARGIN99 = NET INCOME/SALES = $253,584/$7,035,600 = 3.6%.
BASIC EARNING POWER 99 = EBIT/TOTAL ASSETS = $510,460/$3,497,152 =

14.6%.
ROA99 = NET INCOME/TOTAL ASSETS = $253,584/$3,497,152 = 7.25%.
ROE99 = NET INCOME/COMMON EQUITY = $253,584/$1,552,352 = 16.34%.
THE FIRM’S OPERATING PROFIT MARGIN AFTER TAXES IS JUST ABOVE THE
INDUSTRY AVERAGE. THE FIRM'S PROFIT MARGIN IS ABOVE 1997 AND 1998
LEVELS AND IS JUST SLIGHTLY ABOVE THE INDUSTRY AVERAGE. THE BASIC
EARNING POWER, ROA, AND ROE RATIOS ARE ABOVE BOTH 1997 AND 1998
LEVELS, BUT BELOW THE INDUSTRY AVERAGE DUE TO POOR ASSET UTILIZATION.
F. CALCULATE THE 1999 PRICE/EARNINGS RATIO AND MARKET/BOOK

RATIO. DO THESE RATIOS INDICATE THAT INVESTORS ARE EXPECTED TO HAVE
A HIGH OR LOW OPINION OF THE COMPANY?
ANSWER:EPS = NET INCOME/SHARES OUTSTANDING = $253,584/250,000 = $1.0143.
PRICE/EARNINGS 99 = PRICE PER SHARE/EARNINGS PER SHARE

= $12.17/$1.0143 = 12.0.
CHECK: PRICE = EPS  P/E = $1.0143(12) = $12.17.
BVPS = COMMON EQUITY/SHARES OUTSTANDING = $1,552,352/250,000 =

$6.21.
MARKET/BOOK = MARKET PRICE PER SHARE/BOOK VALUE PER SHARE

= $12.17/$6.21 = 1.96.
BOTH THE P/E RATIO AND BVPS ARE ABOVE THE 1997 AND 1998 LEVELS BUT
BELOW THE INDUSTRY AVERAGE.
G. USE THE EXTENDED DU PONT EQUATION TO PROVIDE A SUMMARY

AND OVERVIEW OF COMPUTRON'S FINANCIAL CONDITION AS PROJECTED FOR
1999. WHAT ARE THE FIRM'S MAJOR STRENGTHS AND WEAKNESSES?
ANSWER: Install Equation Editor and double- Install Equation Editor and double-
DU PONT EQUATION = click
here to view equation.  click here to view equation.
 click here to view equation.
= 3.6%  2.01  1/(1 - 0.5561) = 16.3%.
STRENGTHS: THE FIRM'S FIXED ASSETS TURNOVER WAS ABOVE THE INDUSTRY
AVERAGE. HOWEVER, IF THE FIRM'S ASSETS WERE OLDER THAN OTHER FIRMS
IN ITS INDUSTRY THIS COULD POSSIBLY ACCOUNT FOR THE HIGHER RATIO.
(COMPUTRON'S FIXED ASSETS WOULD HAVE A LOWER HISTORICAL COST AND
WOULD HAVE BEEN DEPRECIATED FOR LONGER PERIODS OF TIME.) THE FIRM'S
PROFIT MARGIN IS SLIGHTLY ABOVE THE INDUSTRY AVERAGE, DESPITE ITS
HIGHER DEBT RATIO. THIS WOULD INDICATE THAT THE FIRM HAS KEPT COSTS
DOWN, BUT, AGAIN, THIS COULD BE RELATED TO LOWER DEPRECIATION COSTS.
WEAKNESSES: THE FIRM'S LIQUIDITY RATIOS ARE LOW; MOST OF ITS ASSET
MANAGEMENT RATIOS ARE POOR (EXCEPT FIXED ASSETS TURNOVER); ITS DEBT
MANAGEMENT RATIOS ARE POOR, MOST OF ITS PROFITABILITY RATIOS ARE LOW
(EXCEPT PROFIT MARGIN); AND ITS MARKET VALUE RATIOS ARE LOW.
H. USE THE FOLLOWING SIMPLIFIED 1999 BALANCE SHEET TO SHOW,

IN GENERAL TERMS, HOW AN IMPROVEMENT IN THE DSO WOULD TEND TO
AFFECT THE STOCK PRICE. FOR EXAMPLE, IF THE COMPANY COULD IMPROVE
ITS COLLECTION PROCEDURES AND THEREBY LOWER ITS DSO FROM 44.9 DAYS
TO THE 32-DAY INDUSTRY AVERAGE WITHOUT AFFECTING SALES, HOW WOULD
THAT CHANGE "RIPPLE THROUGH" THE FINANCIAL STATEMENTS (SHOWN IN
THOUSANDS BELOW) AND INFLUENCE THE STOCK PRICE?
ACCOUNTS RECEIVABLE $ 878 DEBT $1,945

OTHER CURRENT ASSETS 1,802
NET FIXED ASSETS 817 EQUITY 1,552
LIABILITIES
TOTAL ASSETS $3,497 PLUS EQUITY $3,497
ANSWER:SALES PER DAY = $7,035,600/360 = $19,543.
ACCOUNTS RECEIVABLE UNDER NEW POLICY = $19,543 X 32 DAYS

= $625,376.
FREED CASH = OLD A/R - NEW A/R = $878,000 - $625,376 = $252,624.
I. DOES IT APPEAR THAT INVENTORIES COULD BE ADJUSTED, AND, IF
SO, HOW SHOULD THAT ADJUSTMENT AFFECT COMPUTRON'S PROFITABILITY
AND STOCK PRICE.
ANSWER:THE INVENTORY TURNOVER RATIO IS LOW. IT APPEARS THAT THE FIRM EITHER
HAS EXCESSIVE INVENTORY OR SOME OF THE INVENTORY IS OBSOLETE. IF
INVENTORY WERE REDUCED, THIS WOULD IMPROVE THE LIQUIDITY RATIOS, THE
INVENTORY AND TOTAL ASSETS TURNOVER, AND THE DEBT RATIO, WHICH
SHOULD IMPROVE THE FIRM'S STOCK PRICE AND PROFITABILITY.
J. IN 1998, THE COMPANY PAID ITS SUPPLIERS MUCH LATER THAN

THE DUE DATES, AND IT WAS NOT MAINTAINING FINANCIAL RATIOS AT LEVELS
CALLED FOR IN ITS BANK LOAN AGREEMENTS. THEREFORE, SUPPLIERS COULD
CUT THE COMPANY OFF, AND ITS BANK COULD REFUSE TO RENEW THE LOAN
WHEN IT COMES DUE IN 90 DAYS. ON THE BASIS OF DATA PROVIDED, WOULD
YOU, AS A CREDIT MANAGER, CONTINUE TO SELL TO COMPUTRON ON CREDIT?
(YOU COULD DEMAND CASH ON DELIVERY, THAT IS, SELL ON TERMS OF COD,
BUT THAT MIGHT CAUSE COMPUTRON TO STOP BUYING FROM YOUR COMPANY.)
SIMILARLY, IF YOU WERE THE BANK LOAN OFFICER, WOULD YOU RECOMMEND
RENEWING THE LOAN OR DEMAND ITS REPAYMENT? WOULD YOUR ACTIONS BE
INFLUENCED IF, IN EARLY 1999, COMPUTRON SHOWED YOU ITS 1999
PROJECTIONS PLUS PROOF THAT IT WAS GOING TO RAISE OVER $1.2 MILLION
OF NEW EQUITY CAPITAL?
ANSWER:WHILE THE FIRM'S RATIOS BASED ON THE PROJECTED DATA APPEAR TO BE

IMPROVING, THE FIRM'S LIQUIDITY RATIOS ARE LOW. AS A CREDIT MANAGER, I
WOULD NOT CONTINUE TO EXTEND CREDIT TO THE FIRM UNDER ITS CURRENT
ARRANGEMENT, PARTICULARLY IF I DIDN'T HAVE ANY EXCESS CAPACITY. TERMS
OF COD MIGHT BE A LITTLE HARSH AND MIGHT PUSH THE FIRM INTO
BANKRUPTCY. LIKEWISE, IF THE BANK DEMANDED REPAYMENT THIS COULD ALSO
FORCE THE FIRM INTO BANKRUPTCY.
CREDITORS' ACTIONS WOULD DEFINITELY BE INFLUENCED BY AN INFUSION OF
EQUITY CAPITAL IN THE FIRM. THIS WOULD LOWER THE FIRM'S DEBT RATIO AND
CREDITORS' RISK EXPOSURE.
K. IN HINDSIGHT, WHAT SHOULD COMPUTRON HAVE DONE BACK IN
1997?
ANSWER:BEFORE THE COMPANY TOOK ON ITS EXPANSION PLANS, IT SHOULD HAVE DONE
AN EXTENSIVE RATIO ANALYSIS TO DETERMINE THE EFFECTS OF ITS PROPOSED
EXPANSION ON THE FIRM'S OPERATIONS. HAD THE RATIO ANALYSIS BEEN
CONDUCTED, THE COMPANY WOULD HAVE "GOTTEN ITS HOUSE IN ORDER"
BEFORE UNDERGOING THE EXPANSION.
L. WHAT ARE SOME POTENTIAL PROBLEMS AND LIMITATIONS OF

FINANCIAL RATIO ANALYSIS?
ANSWER:SOME POTENTIAL PROBLEMS ARE LISTED BELOW:
1. COMPARISON WITH INDUSTRY AVERAGES IS DIFFICULT IF THE FIRM OPERATES

MANY DIFFERENT DIVISIONS.
2. DIFFERENT OPERATING AND ACCOUNTING PRACTICES DISTORT

COMPARISONS.
3. SOMETIMES HARD TO TELL IF A RATIO IS "GOOD" OR "BAD."
4. DIFFICULT TO TELL WHETHER COMPANY IS, ON BALANCE, IN A STRONG OR

WEAK POSITION.
5. "AVERAGE" PERFORMANCE IS NOT NECESSARILY GOOD.
6. SEASONAL FACTORS CAN DISTORT RATIOS.
7. "WINDOW DRESSING" TECHNIQUES CAN MAKE STATEMENTS AND RATIOS

LOOK BETTER.
M. WHAT ARE SOME QUALITATIVE FACTORS ANALYSTS SHOULD
CONSIDER WHEN EVALUATING A COMPANY'S LIKELY FUTURE FINANCIAL
PERFORMANCE?
ANSWER:TOP ANALYSTS RECOGNIZE THAT CERTAIN QUALITATIVE FACTORS MUST BE

CONSIDERED WHEN EVALUATING A COMPANY. THESE FACTORS, AS SUMMARIZED
BY THE AMERICAN ASSOCIATION OF INDIVIDUAL INVESTORS (AAII), ARE AS
FOLLOWS:
1. ARE THE COMPANY'S REVENUES TIED TO ONE KEY CUSTOMER?
2. TO WHAT EXTENT ARE THE COMPANY'S REVENUES TIED TO ONE KEY

PRODUCT?
3. TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER?
4. WHAT PERCENTAGE OF THE COMPANY'S BUSINESS IS GENERATED OVERSEAS?
5. COMPETITION
6. FUTURE PROSPECTS
7. LEGAL AND REGULATORY ENVIRONMENT

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Chapter 3

Analysis of Financial Statements

3-1 a. A liquidity ratio is a ratio that shows the relationship of a firm’s

b. Asset management ratios are a set of ratios which measure how

c. Financial leverage ratios measure the use of debt financing. The

d. Profitability ratios are a group of ratios which show the combined

The Dryden Press Learning Objectives: 3 - 1

f. Trend analysis is an analysis of a firm’s financial ratios over time.

g. The Du Pont chart is a chart designed to show the relationships among

h. Window dressing is a technique employed by firms to make their

3-3 The inventory turnover ratio is important to a grocery store because of

3-5 Differences in the amounts of assets necessary to generate a dollar of

3-6 Inflation will cause earnings to increase, even if there is no increase

3-8 a. Cash, receivables, and inventories, as well as current liabilities,

b. Common equity is determined at a point in time, say December 31,

The Dryden Press Learning Objectives: 3 - 3

3-10 Total Effect

b. Merchandise is sold for cash. + + +

c. Federal income tax due for the previous

d. A fixed asset is sold for less than

e. A fixed asset is sold for more than

f. Merchandise is sold on credit. + + +

g. Payment is made to trade creditors for

h. A cash dividend is declared and paid. ─ ─ 0

i. Cash is obtained through short-term bank

j. Short-term notes receivable are sold at

k. Marketable securities are sold below cost. ─ ─ ─

l. Advances are made to employees. 0 0 0

m. Current operating expenses are paid. ─ ─ ─

p. A fully depreciated asset is retired. 0 0 0

q. Accounts receivable are collected. 0 0 0

r. Equipment is purchased with short-term

s. Merchandise is purchased on credit. + ─ 0

t. The estimated taxes payable are increased. 0 ─ ─

The Dryden Press Learning Objectives: 3 - 5

Install Equation Editor and double-

Install Equation Editor and double-

Install Equation Editor and double-

3-2 DSO = 40 days; ADS = $20,000; AR = ?

Install Equation Editor and double-

3-3 A/E = 2.4; D/A = ?

Install Equation Editor and double-

3-4 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; A/E = ?

ROE = PM  S/TA  TA/E

3-5 We are given ROA = 3% and Sales/Total assets = 1.5.

From Du Pont equation: ROA = Profit margin  Total assets turnover

We can also calculate the company's debt ratio in a similar manner,

Install Equation Editor and double-

E/TA = 3/5 = 60%;

Install Equation Editor and double-

Install Equation Editor and double-

$1,312,500 + ΔNP = $1,050,000 + 2ΔNP

Short-term debt can increase by a maximum of $262,500 without violating

Quick ratio = ($1,575,000 - $637,500)/$787,500 = $937,500/$787,500 =

Current liabilities = $270,000.

Install Equation Editor and double-

$810,000 = $120,000 + Accounts receivable + $432,000

3-8 TIE = EBIT/INT, so find EBIT and INT.

EBIT = $142,857 + $50,000 = $192,857.

3-9 ROE = Profit margin  TA turnover  Equity multiplier