LECTURE 2

CONCEPT REVIEW AD CRITICAL THINKING QUESTIONS

3. Current Ratio [LO2] Explain what it means for a fi rm to have a current ratio equal to
.50. Would the fi rm be better off if the current ratio were 1.50? What if it were 15.0?
Explain your answers.

Answer
A current ratio of 0.50 means that the firm has twice as much in current liabilities as
it does in current assets; the firm potentially has poor liquidity. If pressed by its
short-term creditors and suppliers for immediate payment, the firm might have a
difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50%
more current assets than it does current liabilities. This probably represents an
improvement in liquidity; short-term obligations can generally be met completely
with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any
excess funds sitting in current assets generally earn little or no return. These excess
funds might be put to better use by investing in productive long-term assets or
distributing the funds to shareholders.

4. Financial Ratios [LO2] Fully explain the kind of information the following financial
ratios provide about a firm:
a. Quick ratio. f. Times interest earned ratio.
b. Cash ratio. g. Profit margin.
c. Total asset turnover. h. Return on assets.
d. Equity multiplier. i. Return on equity.
e. Long-term debt ratio. j. Price–earnings ratio.

Answer
a. Quick ratio provides a measure of the short-term liquidity of the firm, after
removing the effects of inventory, generally the least liquid of the firm’s current
assets.
b. Cash ratio represents the ability of the firm to completely pay off its current
liabilities with its most liquid asset (cash).
c. Total asset turnover measures how much in sales is generated by each dollar of
firm assets.
d. Equity multiplier represents the degree of leverage for an equity investor of the
firm; it measures the dollar worth of firm assets each equity dollar has a claim to.
e. Long-term debt ratio measures the percentage of total firm capitalization funded
by long-term debt.
 f. Times interest earned ratio provides a relative measure of how well the firm’s
operating earnings can cover current interest obligations.
g. Profit margin is the accounting measure of bottom-line profit per dollar of sales.
h. Return on assets is a measure of bottom-line profit per dollar of total assets.
i. Return on equity is a measure of bottom-line profit per dollar of equity.
j. Price-earnings ratio reflects how much value per share the market places on a
dollar of accounting earnings for a firm.

5. Standardized Financial Statements [ LO1] What types of information do common-

size financial statements reveal about the fi rm? What is the best use for these common-
size statements? What purpose do common–base year statements have? When would you
use them?

Answer
Common size financial statements express all balance sheet accounts as a percentage
of total assets and all income statement accounts as a percentage of total sales. Using
these percentage values rather than nominal dollar values facilitates comparisons
between firms of different size or business type. Common-base year financial
statements express each account as a ratio between their current year nominal dollar
value and some reference year nominal dollar value. Using these ratios allows the
total growth trend in the accounts to be measured.

7. Du Pont Identity [LO3] Why is the Du Pont identity a valuable tool for analyzing the
performance of a fi rm? Discuss the types of information it reveals compared to ROE
considered by itself.

Answer
Return on equity is probably the most important accounting ratio that measures the
bottom-line performance of the firm with respect to the equity shareholders. The Du
Pont identity emphasizes the role of a firm’s profitability, asset utilization efficiency,
and financial leverage in achieving an ROE figure. For example, a firm with ROE of
20% would seem to be doing well, but this figure may be misleading if it were
marginally profitable (low profit margin) and highly levered (high equity multiplier).
If the firm’s margins were to erode slightly, the ROE would be heavily impacted.

QUESTION AND PROBLEM

1. Calculating Liquidity Ratios [LO2] SDJ, Inc., has net working capital of $2,710,
current liabilities of $3,950, and inventory of $3,420. What is the current ratio?
What is the quick ratio?

Solution

Using the formula for NWC, we get:

NWC = CA – CL
CA = CL + NWC = $3,950 + 2,710 = $6,660
 So, the current ratio is:
Current ratio = CA / CL = $6,660/$3,950 = 1.69 times

And the quick ratio is:

Quick ratio = (CA – Inventory) / CL = ($6,660– $3,420) / $3,950 = 0.82 times

2. Calculating Profitability Ratios [LO2] Diamond Eyes, Inc., has sales of $18 million,
total assets of $15.6 million, and total debt of $6.3 million. If the profit margin is 8 percent,
what is net income? What is ROA? What is ROE?

Solution
We need to find net income first. So:
Profit margin = Net income / Sales
Net income = Sales(Profit margin)
Net income = ($18,000,000)(0.08) = $1,440,000

ROA = Net income / TA = $1,440,000 / $15,600,000 = .0923 or 9.23%

To find ROE, we need to find total equity.

TE = $15,600,000 – 6,300,000 = $9,300,000

ROE = Net income / TE = 1,440,000 / $9,300,000 = .1548 or 15.48%

3. Calculating the Average Collection Period [LO2] Boom Lay Corp. has a current
accounts receivable balance of $327,815. Credit sales for the year just ended were
$4,238,720. What is the receivables turnover? The days’ sales in receivables? How long did
it take on average for credit customers to pay off their accounts during the
past year?

Solution
Receivables turnover = Sales / Receivables
Receivables turnover = $4,238,720 / $327,815 = 12.93 times

Days’ sales in receivables = 365 days / Receivables turnover = 365 / 12.93 = 28.23
days

The average collection period for an outstanding accounts receivable balance was
28.23 days.

4. Calculating Inventory Turnover [LO2] The Cape Corporation has ending inventory of
$483,167, and cost of goods sold for the year just ended was $4,285,131. What is the
inventory turnover? The days’ sales in inventory? How long on average did a unit of
inventory sit on the shelf before it was sold?

Solution
Inventory turnover = COGS / Inventory
Inventory turnover = $4,285,131 / $483,167 = 8.87 times
 Days’ sales in inventory = 365 days / Inventory turnover = 365 / 8.87 = 41.15 days

On average, a unit of inventory sat on the shelf 41.15 days before it was sold.

5. Calculating Leverage Ratios [LO2] Perry, Inc., has a total debt ratio of .46. What is its
debt–equity ratio? What is its equity multiplier?

Solution
Total debt ratio = 0.46 = TD / TA

Substituting total debt plus total equity for total assets, we get:

0.46 = TD / (TD + TE)

Solving this equation yields:

0.46(TE) = 0.54(TD)

Debt/equity ratio = TD / TE = 0.46 / 0.54 = 0.85

Equity multiplier = 1 + D/E = 1.85

6. Calculating Market Value Ratios [LO2] That Wich Corp. had additions to retained
earnings for the year just ended of $375,000. The firm paid out $175,000 in cash dividends,
and it has ending total equity of $4.8 million. If the company currently has 145,000 shares
of common stock outstanding, what are earnings per share? Dividends per share? Book
value per share? If the stock currently sells for $79 per share, what is the market-to-book
ratio? The price–earnings ratio? If the company had sales of $4.7 million, what is the
price–sales ratio?

Solution
Net income = Addition to RE + Dividends = $375,000 + 175,000 = $550,000

Earnings per share = NI / Shares = $550,000 / 145,000 = $3.79 per share

Dividends per share = Dividends / Shares = $175,000 /145,000 = $1.21 per share

Book value per share = TE / Shares = $4,800,000 / 145,000 = $33.10 per share

Market-to-book ratio = Share price / BVPS = $79 / $33.10 = 2.39 times

P/E ratio = Share price / EPS = $79 / $3.79 = 20.84 times

Sales per share = Sales / Shares = $4,700,000 / 145,000 = $32.41

P/S ratio = Share price / Sales per share = $79 / $32.41 = 2.44 times
7. DuPont Identity [LO4] If Roten Rooters, Inc., has an equity multiplier of 1.45, total
asset turnover of 1.80, and a profit margin of 5.5 percent, what is its ROE?

Solution
ROE = (PM)(TAT)(EM)
ROE = (.055)(1.8)(1.45) = .1436 or 14.36%

8. DuPont Identity [LO4] Kindle Fire Prevention Corp. has a profit margin of 4.6 percent,
total asset turnover of 2.3, and ROE of 19.14 percent. What is this firm’s debt–equity ratio?

Solution
ROE = (PM)(TAT)(EM)
0.1914 = (.046)(2.3)(EM)
EM=1.81
(D+E)/E=1.81
D=0.81E
D/E=0.81

9. Sources and Uses of Cash [LO4] Based only on the following information for Shinoda
Corp., did cash go up or down? By how much? Classify each event as a source or use of
cash.
Decrease in inventory: $430
Decrease in accounts payable: 165
Increase in notes payable: 150
Increase in accounts receivable: 180

Solution

Decrease in inventory is a source of cash

Decrease in accounts payable is a use of cash
Increase in notes payable is a source of cash
Increase in accounts receivable is a use of cash
Changes in cash = sources – uses = $430 – 165 + 150 – 180 = $235
Cash increased by $235

10. Calculating Average Payables Period [LO2] Tortoise, Inc., had a cost of goods sold
of $43,821. At the end of the year, the accounts payable balance was $7,843. How long on
average did it take the company to pay off its suppliers during the year? What might a
large value for this ratio imply?

Solution
Payables turnover = COGS / Accounts payable
Payables turnover = $43,821 / $7,843 = 5.59 times

Days’ sales in payables = 365 days / Payables turnover

Days’ sales in payables = 365 / 5.59 = 63.69 days
 The company left its bills to suppliers outstanding for 63.69 days on average. A large
value for this ratio could imply that either (1) the company is having liquidity
problems, making it difficult to pay off its short-term obligations, or (2) that the
company has successfully negotiated lenient credit terms from its suppliers.

11. Enterprise Value–EBITDA Multiple [LO2] The market value of the equity of
Thompson, Inc., is $580,000. The balance sheet shows $35,000 in cash and $190,000 in
debt, while the income statement has EBIT of $91,000 and a total of $135,000 in
depreciation and amortization. What is the enterprise value–EBITDA multiple for this
company?

Solution
Enterprise value = market value of stock + book value of liabilities – Cash
= $580,000 + $190,000 - $35,000 =$735,000
EBTTDA =$91,000 + $135,000 =$226,000
Enterprise value-EBITDA multiple = $735,000 : $226,000 = 3.25times

12. Equity Multiplier and Return on Equity [LO3] Isolation Company has a debt–ratio
of .80. Return on assets is 7.9 percent, and total equity is $480,000. What is the equity
multiplier? Return on equity? Net income?

The equity multiplier is:

EM = 1 + D/E
EM = 1 + 0.80 = 1.80

One formula to calculate return on equity is:

ROE = (ROA)(EM)
ROE = .079(1.80) = .1422 or 14.22%
ROE can also be calculated as:

ROE = NI / TE

So, net income is:

NI = ROE(TE)
NI = (.1422)($480,000) = $68,256