Solutions Manual

CHAPTER 12

ANALYSIS OF FINANCIAL STATEMENTS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. 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 (stockholders) are interested primarily in profitability,
but they examine the other ratios to get information on the riskiness of
equity commitments. Credit analysts are more interested in the debt,
TIE, and EBITDA coverage ratios, as well as the profitability ratios.
Short-term creditors emphasize liquidity and look most carefully at the
current ratio.

2. 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 productscontracts written on paper and entered into between
the company and the insured. This question demonstrates that the
student should not take a routine approach to financial analysis but rather
should examine the business that he or she is analyzing.

3. 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.

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4. ROE is calculated as the return on assets multiplied by the equity

multiplier. The equity multiplier, defined as total assets divided by
common 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.

5. Return on investment relates to income earned on the capital invested in

the business firm. Unsatisfactory ROI could possibly lead to withdrawal
of capital provided by investors which could result to the demise of the
business.

6. Refer to pages 247, 248 and 252.

7. Example: If a company defers or postpones a regular maintenance and

repair activity with a view of reducing current years expenses. Such act
may in the long-run bring about unfavorable outcomes such as delays in
production, poor product quality, etc.

8. Liquidity is the firms ability to meet cash needs as they arise such as
payment of accounts payable, bank loans and operating expenses.
Liquidity is crucial to the firms survival because if the company is
unable to fulfill its obligations, operations could be disrupted that could
result to its closure.

9. Short-term lenders liquidity because their concern is with the firms

ability to pay short-term obligations as they come due.

Long-term lenders leverage because they are concerned with the

relationship of debt to total assets. They also will examine profitability to
insure that interest payments can be made.

Stockholders profitability because they are concerned with the

secondary consideration given to debt utilization, liquidity and other
ratios. Since stockholders are the ultimate owners of the firm, they are
primarily concerned with profits or the return on their investment.

10. If the accounts receivable turnover ratio is decreasing, accounts

receivable will be on the books for a longer period of time. This means
the average collection period will be increasing.

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11. The fixed charge coverage ratio measures the firms ability to meet all
fixed obligations rather that interest payments alone, on the assumption
that failure to meet any financial obligation will endanger the position of
the firm.

12. No rule-of-thumb ratio is valid for all corporations. There is simply too
much difference between industries or time periods in which ratios are
computed. Nevertheless, rules-of-thumb ratios do offer some initial
insight into the operations of the firm, and when used with caution by the
analyst can provide information.

13. a. Return on investment = Net income/Total assets

Inflation may cause net income to be overstated and total assets
to be understated. Too high a ratio could be reported.

b. Inventory turnover = Sales/Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO
accounting, inventory will also reflect inflation-influenced
pesos and the net effect will be nil. If the firm uses LIFO
accounting, inventory will be stated in old pesos and too high a
ratio could be reported.

c. Fixed asset turnover = Sales/Fixed assets

Fixed assets will be understated relative to sales and too high a
ratio could be reported.

d. Debt to total assets = Total debt/Total assets

Since both are based on historical costs, no major inflationary
impact will take place in the ratio.

14. Disinflation tends to lower reported earnings as inflation-induced income

is squeezed out of the firms income statement. This is particularly true
for firms in highly cyclical industries where prices tend to rise and fall
quickly.

15. Because it is possible that prior inflationary pressures will no longer

seriously impair the purchasing power of the peso. Lessening inflation
also means that the required return that investors demand on financial
assets will be going down, and with this lower demanded return, future
earnings or interest should receive a higher current evaluation.

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II. Problems

Problem 1 (Day Sales Outstanding)

DSO = 40 days; S = 7,300,000; AR = ?

AR AR
DSO = S 40 = 7,300,000
365 365

40 = AR/20,000 AR = (20,000) (40) = 800,000

Problem 2 (Debt Ratio)

A/E = 2.4; D/A = ?

D 1
= 1
A A/E
D 1
= 1
A 2.4
D
= 0.5833= 58.33%.
A

Problem 3 (Market/Book Ratio)

TA = 10,000,000,000; LT debt = 3,000,000,000

CL = 1,000,000,000; CE = 6,000,000,000
Share outstanding = 800,000,000; Stock price = 32; M/B = ?

6,000,000,000
Book Value = 800,000,000 = 7.50

32.00
MB = 7.50 = 4.2667

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AR
S
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 Analysis of Financial Statements Chapter 12

Problem 4 (Price/Earnings Ratio)

EPS = 2.00; BVPS = 20; M/B = 1.2; P/E = ?

M/B = 1.2
P/20 = 1.2
P = (20) ( 1.2)
P = 24.00

P/E = 24.00/2.00 = 12.0

Problem 5 (DuPont and ROE)

PM = 2%; EM = 2.0; Sales = 100,000,000; Assets = 50,000,000;

ROE = ?

ROE = PM x TATO x EM
= NI/S x S/TA x A/E
= 2% x 100,000,000/50,000,000 x 2
ROE = 8%

Problem 6 (DuPont and Net Income)

Step 1: Calculate total assets from information given.

Sales = 6,000,000
3.2 = Sales/TA
3.2 = 6,000,000/Assets
Assets = 6,000,000/3.2
Assets = 1,875,000

Step 2: Calculate net income. There is 50% debt and 50% equity, so,
Equity = 1,875,000 x 0.5 = 937,500.

ROE = NI/S x S/TA x TA/E

0.12 = NI/6,000,000 x 3.2 x 1,875,000/937,500
0.12 = 6.4NI/6,000,000
6.4NI = (60,000) (0.12)
NI = 720,000/6.4
NI = 112,500

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Problem 7 (Basic Earning Power)

ROA = 8%; NI = 600,000; TA = ?

ROA = NI/TA
8% = 600,000/TA
TA = 600,000/8%
TA = 7,500,000

To calculate BEP, we still need EBIT. To calculate EBIT, construct a

partial income statement.

EBIT 1,148,077 (225,000 + 923,077)

Interest 225,000 Given
EBT 923,077 (600,000/0.65)
Taxes (35%) 323,077
NI 600,000

BEP = EBIT/TA
= 1,148,077/7,500,000
= (0.1531)
BEP = 15.31%

Problem 8 (Ratio Calculations)

We are given ROA = 3% and Sales/Total assets = 1.5

From the DuPont equation:

ROA = Profit margin x Total assets turnover

3% = Profit margin (1.5)
Profit margin = 3%/1.5
Profit margin = 2%

We can also calculate the companys debt-to-assets 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:

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E NI E D E
= and =1 , so
A A NI A A
E 1
= 3%
A 0.05
E
= 60%.
A
D
=1 0.60= 0.40= 40%.
A

Alternatively, using the DuPont equation:

ROE = ROA x EM
5% = 3% x EM
EM = 5%/3% = 5/3 = TA/E

Take reciprocal: E/TA = 3/5 = 60%, therefore, D/A = 1 0.60 = 0.40 or

40%. Thus, the firms profit margin = 2% and its debt-to-assets ratio =
40%.

Problem 9 (Ratio Calculations)

TA = 12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?

EBIT
12,000,000,00 = 0.15 EBIT = 1,800,000,000
0
NI
12,000,000,00 = 0.05 NI = 600,000,000
0
Now use the income statement format to determine interest so you can
calculate the firms TIE ratio.
INT = EBIT EBT
EBIT 1,800,000,000 See above. = 1,800,000,000 1,000,000,000
INT 800,000,000
EBT 1,000,000,000 EBT = 600,000,000/0.6
Taxes (40%) 400,000,000
NI 600,000,000 See above.

TIE = EBIT/INT
= 1,800,000,000/800,000,000

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Chapter 12 Analysis of Financial Statements

TIE = 2.25
Problem 10 (Return on Equity)

ROE= Profit margin x TA turnover x Equity multiplier

= NI/Sales x Sales/TA x TA/Equity

Now we need to determine the inputs for the DuPont 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 N/A
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
Total asset turnover = 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 DuPont equation to determine ROE:

ROE = 462,000/10,000,000 x 10,000,000/5,000,000 x 2.5
ROE = 0.231 = 23.1%

Problem 11 (Current Ratio)

1,312,500
Present current ratio = 525,000 = 2.5

1,312,500 + NP
Minimum current ratio = = 2.0
525,000 + NP

1,312,500 + NP = 1,050,000 + 2NP

NP = 262,500

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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, and current liabilities will total 787,500.

Problem 12 (DSO and Accounts Receivable)

Step 1: Solve for current annual sales using the DSO equation:
55 = 750,000/ (Sales/365)
55Sales = 273,750,000
Sales = 273,750,000/55
Sales = 4,977,272.73

Step 2: If sales fall by 15%, the new sales level will be 4,977,272.73
(0.85) = 4,230,681.82. Again, using the DSO equation, solve
for the new accounts receivable figure as follows:

35 = AR/ (4,230,681.82/365)
35 = AR/11,590.91
AR= (11,590.91) (35)
AR= 405,681.82 405,682

Problem 13 (Balance Sheet Analysis)

1. Total debt = (0.50) (Total assets) = (0.50) (300,000) = 150,000

2. Accounts payable = Total debt Long-term debt

= 150,000 60,000
Accounts payable = 90,000

3. Common stock = Total liabilities and equity Debt Retained earnings

Common stock = 300,000 150,000 97,500 = 52,500

4. Sales = (1.5) (Total assets) = (1.5) (300,000) = 450,000

5. Inventories = Sales/5 = 450,000/5 = 90,000

6. Accounts receivable = (Sales/365) (DSO)

= (450,000/365) (36.5)
Accounts receivable = 45,000

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Chapter 12 Analysis of Financial Statements

7. Cash + Accounts receivable + Inventories = (1.8) (Accounts payable)

Cash + 45,000 + 90,000 = (1.8) (90,000)
Cash + 135,000 = 162,000
Cash = 27,000

8. Fixed assets = Total assets (Cash + Accounts receivable + Inventories)

Fixed assets = 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

Problem 14 (Ratio Analysis)

a. Amounts in thousands
Firm Industry
average
Current Current assets 655,000
= = = 1.98 2.0
ratio Current liabilities 330,000

Current assets 655,000

Quick ratio = Inventories = 241,500 = 1.25 1.3
Current liabilities 330,000

Accounts receivable 336,000 76.3

DSO = = = 35 days
Sales/365 4,404.11 days

Inventory Sales 1,607,500

= = = 6.66 6.7
turnover Inventories 241,500

T.A. Sales 1,607,500

= = = 1.70 3.0
turnover Total assets 947,500

Profit Net income 27,300

= = = 1.7% 1.2%
margin Sales 1,607,500

Net income 27,300

ROA = = = 2.9% 3.6%
Total assets 947,500

Net income 27,300

ROE = = = 7.6% 9.0%
Common equity 361,000

Total debt 586,500

Debt ratio = = = 61.9% 60.0%
Total assets 947,500

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b. For the firm;

947,500
ROE = PM x TA turnover x EM = 1.7% x 1.7 x 361,000 = 7.6%

For the industry, ROE = 1.2% x 3 x 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 firms days sales outstanding ratio 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 companys 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 average liquidity position and
financial leverage is similar to others in the industry.

d. If 2011 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 2011 ratios will be misled, and a return to normal conditions in
2012 could hurt the firms stock price.

Problem 15 (Ratio Analysis)

Ratio Analysis 2011 2010 Industry Average

Liquidity
Current ratio 2.33 2.11 2.7
Asset Management
Inventory turnover 4.74 4.47 7.0
Days sales outstanding 37.79 32.94 32
Fixed assets turnover 9.84 7.89 13.0
Total assets turnover 2.31 2.18 2.6
Profitability
Return on assets 1.00% 5.76% 9.1%
Return on equity 2.22% 11.47% 18.2%
Profit margin 0.43% 2.64% 3.5%

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Chapter 12 Analysis of Financial Statements

Debt Management
Debt-to-assets ratio 54.81% 49.81% 50.0%
Market Value
P/E ratio 15.43 5.65 6.0
Price/cash flow ratio 1.60 2.16 3.5

a. Mangos liquidity position has improved from 2010 to 2011; however, its
current ratio is still below the industry average of 2.7.

b. Mangos inventory turnover, fixed assets turnover, and total assets

turnover have improved from 2010 to 2011; however, they are still below
industry averages. The firm's days sales outstanding ratio has increased
from 2010 to 2011which is bad. In 2010, its DSO was close to the
industry average. In 2011, its DSO is somewhat higher. If the firm's
credit policy has not changed, it needs to look at its receivables and
determine whether it has any uncollectibles. If it does have uncollectible
receivables, this will make its current ratio look worse than what was
calculated above.

c. Mangos debt ratio has increased from 2010 to 2011, which is bad. In
2010, its debt ratio was right at the industry average, but in 2011 it is
higher than the industry average. Given its weak current and asset
management ratios, the firm should strengthen its balance sheet by
paying down liabilities.

d. Mangos profitability ratios have declined substantially from 2010 to

2011, and they are substantially below the industry averages. Mango
needs to reduce its costs, increase sales, or both.

e. Mangos P/E ratio has increased from 2010 to 2011, but only because its
net income has declined significantly from the prior year. Its P/CF ratio
has declined from the prior year and is well below the industry average.
These ratios reflect the same information as Corrigan's profitability
ratios. Corrigan needs to reduce costs to increase profit, lower its debt
ratio, increase sales, and improve its asset management.

f. ROE = PM TA Turnover Equity Multiplier

2011 2.22% 0.43% 2.31 2.21
2010 11.47% 2.64% 2.18 1.99
Industry Avg. 18.20% 3.50% 2.60 2.00

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Looking at the DuPont equation, Mango's profit margin is significantly

lower than the industry average and it has declined substantially from
2010 to 2011. The firm's total assets turnover has improved slightly from
2010 to 2011, but it's still below the industry average. The firm's equity
multiplier has increased from 2010 to 2011 and is higher than the
industry average. This indicates that the firm's debt ratio is increasing
and it is higher than the industry average.

Mango should increase its net income by reducing costs, lower its debt
ratio, and improve its asset management by either using less assets for
the same amount of sales or increase sales.

g. If Mango initiated cost-cutting measures, this would increase its net

income. This would improve its profitability ratios and market value
ratios. If Mango also reduced its levels of inventory, this would improve
its current ratioas this would reduce liabilities as well. This would
also improve its inventory turnover and total assets turnover ratio.
Reducing costs and lowering inventory would also improve its debt ratio.

Problem 16 (Profitability Ratios)

Esther Company

Sales 960,000
Assets = = = 400,000
Total asset turnover 2.4

Sales 960,000
Net income = = = 67,200
Profit margin 0.07

ROA(invest- Net income 67,200

= = = 16.80%
ment) Total assets 400,000

Problem 17 (Overall Ratio Analysis)

Bryan Corporation

a. Current Current assets 570,000

= = = 1.90
ratio Current liabilities 300,000

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Chapter 12 Analysis of Financial Statements

(Current assets
b. Quick ratio = Inventory) = 330,000 = 1.10
Profit margin 300,000

c. Debt to total Total debt 418,000

= = = 44%
assets Total assets 950,000

d. Asset Sales 3,040,000

= = = 3.20
turnover Total assets 950,000

Accounts
e. Average 280,000
receivable
collection = = (3,040,000 x 0.75)
Average daily
period 360 days
credit sales

280,000
= = 44.21 days
6,333 per day

Problem 18 (Profitability Ratios)

Alpha Industries

a. Total asset turnover x Profit margin = Return on total assets

1.4 x ? = 8.4%
Profit margin = 8.4%/1.4 = 6.0%

b. 12 x 7% = 8.4%

It did not change at all because the increase in profit margin made up for
the decrease in the asset turnover.

Problem 19 (DuPont System of Analysis)

King Company

Return on assets
a. Return on (investment) 12%
= =
equity (1 Debt /Assets) (1 0.40)

12%
= = 20%
0.60

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 Analysis of Financial Statements Chapter 12

b. The same as return on assets (12%).

Problem 20 (Average Collection Period)

Accounts
Average 180,000
receivable
collection = = (1,200,000 x 0.90)
Average daily
period 360 days
credit sales

180,000
= = 60 days
3,000 per day

Problem 21 (Average Daily Sales)

Charlie Corporation

Average daily Credit sales

=
credit sales 360

To determine credit sales, multiply accounts receivable by accounts

receivable turnover.

90,000 x 12 = 1,080,000

Average daily 1,080,000

= = 3,000
credit sales 360

Problem 22 (DuPont System of Analysis)

Jerry Company

a. Net income = Sales x Profit margin

= 4,000,000 x 3.5%
= 140,000

Stockholders equity = Total assets Total liabilities

Total assets = Sales /Total asset turnover

= 4,000,000/2.5
Total assets = 1,600,000

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Chapter 12 Analysis of Financial Statements

Total liabilities = Current liabilities + Long-term liabilities

= 100,000 + 300,000
Total liabilities = 400,000

Stockholders equity = 1,600,000 400,000

= 1,200,000

Return on Net income

140,000
stockholders = Stockholders = = 11.67%
1,200,000
equity equity

b. The value for sales will be:

Sales = Total assets x Total asset turnover

= 1,600,000 x 3
Sales = 4,800,000

Net income = Sales x Profit margin

= 4,800,00 x 3.5%
0
Net income = 168,000

Return on Net income

168,000
stockholders = Stockholders = = 14%
1,200,000
equity equity

Problem 23 (Analysis by Divisions)

Global Corporation

a. Medical supplies Heavy machinery Electronics

Net income/
sales 6.0% 3.8% 8.0%

The heavy machinery division has the lowest return on sales.

b. Medical supplies Heavy machinery Electronics

Net income/
Total assets 15.0% 2.375% 10.67%

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The medical supplies division has the highest return on assets.

c. Corporate net income 1,200,000 + 190,000 + 320,000

=
Corporate total assets 8,000,000 + 8,000,000 + 3,000,000

1,710,000
=
19,000,000

Return on assets = 9.0%

d. Return on redeployed assets in heavy machinery.

15% x 8,000,000 = 1,200,000

Corporate net income 1,200,000 + 1,200,000 + 320,000

=
Corporate total assets 19,000,000

2,720,000
=
19,000,000

Return on assets = 14.32%

Problem 24 (Using Ratios to Construct Financial Statements)

Inventory = 420,000/7
= 60,000

Current assets = 2 x 80,000

= 160,000

Accounts receivable = (420,000/360) x 36

= 42,000

Cash = 160,000 60,000 42,000

= 58,000

Current assets
Cash
58,000
Accounts receivable
42,000

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Chapter 12 Analysis of Financial Statements

Inventory
60,000
Total current assets 160,00
0

Problem 25 (Using Ratios to Construct Financial Statements)

Shannon Corporation

Sales/Total assets = 2.5 times

Total assets = 750,000/2.5 = 300,000

Cash = 2% of total assets

Cash = 2% x 300,000 = 6,000

Sales/Accounts receivable = 10 times

Accounts receivable = 750,000/10 = 75,000

Sales/Inventory = 15 times
Inventory = 750,000/15 = 50,000

Fixed assets = Total assets Current assets

Total current asset = 6,000 + 75,000 + 50,000 =
131,000
Fixed assets = 300,000 131,000 = 169,000

Current assets/current debt = 2

Current debt = Current assets/2 = 131,000/2 = 65,500

Total debt/total assets = 45%

Total debt = .45 x 300,000 = 135,000

Long-term debt = Total debt Current debt

Long-term debt = 135,000 65,500 = 69,500

Net worth = Total assets Total debt

Net worth = 300,000 135,000 = 165,000

Shannon Corporation
Balance Sheet as of December 31, 2011

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 Analysis of Financial Statements Chapter 12

Cash 6,000 Current debt 65,500

Accounts receivable 75,000 Long-term debt 69,500
Inventory 50,000 Total debt 135,000
Total current assets 131,000 Net worth 165,000
Fixed assets 169,000 Total debt and
Total assets 300,000 Stockholders equity 300,000
Problem 26 (Using Ratios to Determine Account Balances)

Cathy Corporation

a. Accounts receivable = Sales/Receivables turnover

= 3,000,000/6x = 500,000

b. Marketable securities = Current assets (Cash + Accounts

receivable + Inventory)

Current assets = Current ratio x Current liabilities

= 2.5 x 700,000 = 1,750,000

Marketable securities = 1,750,000 (150,000 + 500,000 +

850,000)
Marketable securities = 1,750,000 1,500,000 = 250,000

c. Fixed assets = Total assets Current assets

Total assets = Sales/Asset turnover

= 3,000,000/1.2x = 2,500,000

Fixed assets = 2,500,000 1,750,000 = 750,000

d. Long-term debt = Total debt Current liabilities

Total debt = Debt to assets x Total assets

= 40% x 2,500,000 = 1,000,00

Long-term debt = 1,000,000 700,000 = 300,000

Problem 27 (Using Ratios to Construct Financial Statements)

Ruby Inc.

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Chapter 12 Analysis of Financial Statements

Sales/Total assets = 2
Total assets = 20,000,000/2 = 10,000,000

Total debt/Total assets = 30%

Total debt = 10,000,000 x .3 = 3,000,000

Sales/Inventory = 5.0x
Inventory = 20,000,000/5x = 4,000,000

Average daily sales = 20,000,000/360 days

= 55,556 per day

Accounts receivable = 18 days x 55,556 = 1,000,000 (or)

= (20,000,000)/(360/18) = 1,000,000

Fixed assets = 20,000,000/5x = 4,000,000

Current assets = Total assets Fixed assets

= 10,000,000 4,000,000 = 6,000,000

Cash = Current assets Accounts receivable

Inventory
= 6,000,000 1,000,000 4,000,000
Cash = 1,000,000

Current liabilities = Current assets/3x

Current liabilities = 6,000,000/3 = 2,000,000

Long-term debt = Total debt Current debt

Long-term debt = 3,000,000 2,000,000 = 1,000,000

Equity = Total assets Total debt

Equity = 10,000,000 3,000,000 = 7,000,000

Ruby Inc.

Cash Current debt 2,000,000

1,000,000
Accounts receivable 1,000,000 Long-term debt 1,000,000
Inventory 4,000,000 Total debt 3,000,000
Total current assets 6,000,000

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 Analysis of Financial Statements Chapter 12

Fixed assets 4,000,000 Equity 7,000,000

Total assets 10,000,00 Total debt and equity 10,000,000
0

Problem 28 (Ratio Computation and Analysis)

One way of analyzing the situation for each company is to compare the
respective ratios for each one, examining those ratios which would be most
important to a supplier or short-term lender and a stockholder.

Black Corporation White Corporation

Profit margin 7.4% 5.25%
Return on assets 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 more concerned with liquidity
ratios, White Corporation would get the nod as having the best ratios in
this category. One could argue, however, that White had benefited from
having its debt primarily long term rather than short term. Nevertheless,
it appears to have better liquidity ratios.

b. Stockholders are most concerned with profitability. In this category,

Black Corporation has much better ratios than White Corporation. White
does have a higher return on equity than Black, but this is due to its much

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Chapter 12 Analysis of Financial Statements

larger use of debt. Its return on equity is higher than Blacks because it
has taken more financial risk. In terms of other ratios, Black has its
interest and fixed charges well covered and in general its long-term ratios
and outlook are better than White. Black has asset utilization ratios equal
to or better than White 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
years comparative data is usually required. Industry comparisons should
also be made.

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