Chapter 3
Problems
1. Dental Delights has two divisions. Division A has a profit of $200,000 on sales of $4,000,000. Division B is only able to make $30,000 on sales of $480,000. Based on the profit margins (returns on sales), which division is superior?
3-1. Solution:
Dental Delights
Division A Division B
Division B is superior
3. Bass Chemical, Inc., is considering expanding into a new product line. Assets to support this expansion will cost $1,200,000. Bass estimates that it can generate $2 million in annual sales, with a 5 percent profit margin. What would net income and return on assets (investment) be for the year?
3-3. Solution:Bass Chemical, Inc.
4. Franklin Mint and Candy Shop can open a new store that will do an annual sales volume of $750,000. It will turn over its assets 2.5 times per year. The profit margin on sales will be
6 percent. What would net income and return on assets (investment) be for the year?
3-4. Solution:
Franklin Mint and Candy Shop
8. Sharpe Razor Company has total assets of $2,500,000 and current assets of $1,000,000. It turns over its fixed assets 5 times a year and has $700,000 of debt. Its return on sales is
3 percent. What is Sharpe’s return on stockholders’ equity?
3-8. Solution:
Sharpe Razor Company
total assets $2,500,000
– current assets 1,000,000
Fixed assets $1,500,000
total assets $2,500,000
–debt 700,000
Stockholders’ equity $1,800,000
11. Acme Transportation Company has the following ratios compared to its industry
for 2009.
Return on assets…………… / 9% / 6%
Return on equity…………… / 12% / 24%
Explain why the return-on-equity ratio is so much less favorable than the return-on-assets ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required.
3-11. Solution:
Acme Transportation Company
Acme Transportation has a lower debt/total assets ratio than the industry.
For those who did a calculation, Acme’s debt to assets were
25% vs 75% for the industry.
14. Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3.5 percent on each dollar of sales and turns over its assets 2.5 times per year. It has $100,000 in current liabilities and $300,000 in long-term liabilities.
a. What is its return on stockholders’ equity?
b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities.
3-14. Solution:
Jerry Rice and Grain Stores
a.
3-14. (Continued)
b. The new level of sales will be:
25. Calloway Products has the following data. Industry information is also shown.
Industry Data on Net Year Net Income Total Assets Income/Total Assets
2006 $360,000 $3,000,000 11%
2007 380,000 3,400,000 8
2008 380,000 3,800,000 5
Industry Data on
Year Debt Total Assets Debt/Total Assets
2006 $1,600,000 $3,000,000 52%
2007 1,750,000 3,400,000 40
2008 1,900,000 3,800,000 31
As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of:
a. Net income/Total assets?
b. Debt/Total assets?
3-25. Solution:
Calloway Products
a. Net income/total assets
Year / Calloway Ratio / Industry Ratio2006 / 12.0% / 11.0%
2007 / 11.18% / 8.0%
2008 / 10.0% / 5.0%
Although the company has shown a declining return on assets since 2006, it has performed much better than the industry. Praise may be more appropriate than criticism.
3-25. (Continued)
b. Debt/total assets
Year / Calloway Ratio / Industry Ratio2006 / 53.33% / 52.0%
2007 / 51.47% / 40.0%
2008 / 50.0% / 31.0%
While the company’s debt ratio is improving, it is not improving nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise.
26. Jodie Foster Care Homes, Inc., shows the following data:
Year Net Income Total Assets Stockholders’ Equity Total Debt
2005 $118,000 $1,900,000 $ 700,000 $1,200,000
2006 131,000 1,950,000 950,000 1,000,000
2007 148,000 2,010,000 1,100,000 910,000
2008 175,700 2,050,000 1,420,000 630,000
a. Compute the ratio of net income to total assets for each year and comment on the trend.
b. Compute the ratio of net income to stockholders’ equity and comment on the trend. Explain why there may be a difference in the trends between parts a and b.
3-26. Solution:
Jodie Foster Care Homes, Inc.
a.
2005 $118,000/$1,900,000 = 6.21%
2006 $131,000/$1,950,000 = 6.72%
2007 $148,000/$2,010,000 = 7.36%
2008 $175,700/$2,050,000 = 8.57%
Comment: There is a strong upward movement in return on assets over the four year period.
3-26. (Continued)
b.
2005 $118,000/$700,000 = 16.86%
2006 $131,000/$950,000 = 13.79%
2007 $148,000/$1,100,000 = 13.45%
2008 $175,700/$1,420,000 = 12.37%
Comment: The return on stockholders’ equity ratio is going down each year. The difference in trends between a and b is due to the larger portion of assets that are financed by stockholders’ equity as opposed to debt.
Optional: This can be confirmed by computing total debt to total assets for each year.
2005 63.2%
2006 51.3%
2007 45.3%
2008 30.7%
31. The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in the balance sheet below.
Total assets turnover 2.4 times
Cash to total assets 2.0%
Accounts receivable turnover 8.0 times
Inventory turnover 10.0 times
Current ratio 2.0 times
Debt to total assets 61.0%
GRIGGS CORPORATION
Balance Sheet 2008
Assets Liabilities and Stockholders’ Equity
Cash _____ Current debt _____
Accounts receivable _____ Long-term debt _____
Inventory _____ Total debt _____
Total current assets _____ Equity _____
Fixed assets _____
Total assets _____ Total debt and stockholders’ equity _____
3-31. Solution:
Griggs Corporation
Sales/total assets = 2.4 times
Total assets = $1,200,000/2.4
Total assets = $500,000
Cash = 2% of total assets
Cash = 2% × $500,000
Cash = $10,000
Sales/accounts receivable = 8 times
Accounts receivable = $1,200,000/8
Accounts receivable = $150,000
Sales/inventory = 10 times
Inventory = $1,200,000/10
Inventory = $120,000
3-31. (Continued)
Fixed assets = Total assets – current assets
Current asset = $10,000 + $150,000 +
$120,000 = $280,000
Fixed assets = $500,000 – $280,000
= $220,000
Current assets/current debt = 2
Current debt = Current assets/2
Current debt = $280,000/2
Current debt = $140,000
Total debt/total assets = 61%
Total debt = .61 × $500,000
Total debt = $305,000
Long-term debt = Total debt – current debt
Long-term debt = $305,000 – 140,000
Long-term debt = $165,000
Equity = Total assets – total debt
Equity = $500,000 – $305,000
Equity = $195,000
Griggs Corporation
Balance Sheet 2008
A/R / 150,000 / Long-term debt / 165,000
Inventory / $120,000 / Total debt / $305,000
Total current assets / 280,000
Fixed assets / 220,000 / Equity / 195,000
Total assets / $500,000 / Total debt and
stockholders’
equity / $500,000
35. Given the following financial statements for Jones Corporation and Smith Corporation:
a. To which company would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering.
b. In which one would you buy stock? Why?
JONES CORPORATIONCurrent Assets / Liabilities
Cash / $ 20,000 / Accounts payable / $100,000
Accounts receivable / 80,000 / Bonds payable (long-term) / 80,000
Inventory / 50,000
Long-Term Assets / Stockholders’ Equity
Fixed assets / $500,000 / Common stock / $150,000
Less: Accumulated
depreciation / (150,000) / Paid-in capital
Retained earnings / 70,000
100,000
*Net fixed assets / 350,000
Total assets / $500,000 / Total liabilities and equity / $500,000
Sales (on credit) / $1,250,000
Cost of goods sold / 750,000
Gross profit / 500,000
†Selling and administrative expense / 257,000
Less: Depreciation expense / 50,000
Operating profit / 193,000
Interest expense / 8,000
Earnings before taxes / 185,000
Tax expense / 92,500
Net income / $ 92,500
*Use net fixed assets in computing fixed asset turnover.
†Includes $7,000 in lease payments.
SMITH CORPORATIONCurrent Assets / Liabilities
Cash / $ 35,000 / Accounts payable / $ 75,000
Marketable securities / 7,500 / Bonds payable (long-term) / 210,000
Accounts receivable / 70,000
Inventory / 75,000
Long-Term Assets / Stockholders’ Equity
Fixed assets / $500,000 / Common stock / $ 75,000
Less: Accumulated
depreciation / (250,000) / Paid-in capital
Retained earnings / 30,000
47,500
*Net fixed assets / 250,000
Total assets / $437,500 / Total liabilities and equity / $437,500
Sales (on credit) / $1,000,000
Cost of goods sold / 600,000
Gross profit / 400,000
†Selling and administrative expense / 224,000
Less: Depreciation expense / 50,000
Operating profit / 126,000
Interest expense / 21,000
Earnings before taxes / 105,000
Tax expense / 52,500
Net income / $ 52,500
*Use net fixed assets in computing fixed asset turnover.
†Includes $7,000 in lease payments.
3-35. Solution:
Jones and Smith Comparison
One way of analyzing the situation for each company is to compare the respective ratios for each on, examining those ratios which would be most important to a supplier or short-term lender and a stockholder.
Jones Corp. / Smith Corp.Profit margin / 7.4% / 5.25%
Return on assets (investments) / 18.5% / 12.00%
Return on equity / 28.9% / 34.4%
Receivable turnover / 15.63x / 14.29x
Average collection period / 23.04 days / 25.2 days
Inventory turnover / 25x / 13.3x
Fixed asset turnover / 3.57x / 4x
Total asset turnover / 2.5x / 2.29x
Current ratio / 1.5x / 2.5x
Quick ratio / 1.0x / 1.5x
Debt to total assets / 36% / 65.1%
Times interest earned / 24.13x / 6x
Fixed charge coverage / 13.33x / 4.75x
Fixed charge coverage calculation / (200/15) / (133/28)
a. Since suppliers and short-term lenders are most concerned with liquidity ratios, Smith Corporation would get the nod as having the best ratios in this category. One could argue, however, that Smith had benefited from having its debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios.
3-35. (Continued)
b. Stockholders are most concerned with profitability. In this category, Jones has much better ratios than Smith. Smith does have a higher return on equity than Jones, but this is due to its much larger use of debt. Its return on equity is higher than Jones’ because it has taken more financial risk. In terms of other ratios, Jones has its interest and fixed charges well covered and in general its long-term ratios and outlook are better than Smith’s. Jones has asset utilization ratios equal to or better than Smith and its lower liquidity ratios could reflect better short-term asset management, and that point was covered in part a.
Note: Remember that to make actual financial decisions more than one year’s comparative data is usually required. Industry comparisons should also be made.
S3-1