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Cash $ Notes and payables $100,000

Accounts receivable Long-term debt
Inventory Common stock $100,000
Plant and equipment Retained earnings $100,000
Total assets Total liabilities and
$ shareholders’ equity $

4. Kedzie Kord Company had the following balance sheets and income statements over the
last three years (in thousands):

20X1 20X2 20X3

Cash $ 561 $ 387 $ 202
Receivables 1,963 2,870 4,051
Inventories 2,031 2,613 3,287
Current assets $ 4,555 $ 5,870 $ 7,540
Net fixed assets 2,581 4,430 4,364
Total assets $ 7,136 $10,300 $11,904
Payables $ 1,862 $ 2,944 $ 3,613
Accruals 301 516 587
Bank loan 250 900 1,050
Current liabilities $ 2,413 $ 4,360 $ 5,250
Long-term debt 500 1,000 950
Shareholder’s equity 4,223 4,940 5,704
Total liabilities and
shareholder’s equity $ 7,136 $10,300 $11,904
Sales $11,863 $14,952 $16,349
Cost of goods sold 8,537 11,124 12,016
Selling, general, and
administrative expenses 2,276 2,471 2,793
Interest 73 188 200
Profit before taxes $ 977 $ 1,169 $ 1,340
Taxes 390 452 576
Profit after taxes $ 587 $ 717 $ 764

Using common-size and index analysis, evaluate trends in the company’s financial condi-
tion and performance.

Problems
1. The data for various companies in the same industry are as follows:

COMPANY
A B C D E F
Sales (in millions) $10 $20 $8 $5 $12 $17
Total assets (in millions) 8 10 6 2.5 4 8
Net income (in millions) 0.7 2 0.8 0.5 1.5 1

Determine the total asset turnover, net profit margin, and earning power for each of the
companies.
2. Cordillera Carson Company has the following balance sheet and income statement for
20X2 (in thousands):

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BALANCE SHEET INCOME STATEMENT

Cash $ 400 Net sales (all credit) $12,680
Accounts receivable 1,300 Cost of goods sold 8,930
Inventories 2,100 Gross profit $ 3,750
Current assets $3,800 Selling, general, and
Net fixed assets 3,320 administration expenses 2,230
Total assets $7,120 Interest expense 460
Profit before taxes $ 1,060
Accounts payable $ 320 Taxes 390
Accruals 260 Profit after taxes $ 670
Short-term loans 1,100
Current liabilities $1,680
Long-term debt 2,000
Net worth 3,440
Total liabilities and net worth $7,120

Notes: (i) current period’s depreciation is $480; (ii) ending inventory for 20X1 was $1,800.

On the basis of this information, compute (a) the current ratio, (b) the acid-test ratio,
(c) the average collection period, (d) the inventory turnover ratio, (e) the debt-to-net-worth
ratio, (f ) the long-term debt-to-total-capitalization ratio, (g) the gross profit margin,
(h) the net profit margin, and (i) the return on equity.
3. Selected financial ratios for RMN, Incorporated, are as follows:

20X1 20X2 20X3

Current ratio 4.2 2.6 1.8
Acid-test ratio 2.1 1.0 0.6
Debt-to-total-assets 23% 33% 47%
Inventory turnover 8.7× 5.4× 3.5×
Average collection period 33 days 36 days 49 days
Total asset turnover 3.2× 2.6× 1.9×
Net profit margin 3.8% 2.5% 1.4%
Return on investment (ROI) 12.1% 6.5% 2.8%
Return on equity (ROE) 15.7% 9.7% 5.4%

a. Why did return on investment decline?

b. Was the increase in debt a result of greater current liabilities or of greater long-term
debt? Explain.
4. The following information is available on the Vanier Corporation:
BALANCE SHEET AS OF DECEMBER 31, 20X6 (in thousands)
Cash and marketable securities $500 Accounts payable $ 400
Accounts receivable ? Bank loan ?
Inventories ? Accruals 200
Current assets ? Current liabilities ?
Long-term debt 2,650
Net fixed assets ? Common stock and retained earnings 3,750
Total assets ? Total liabilities and equity ?

INCOME STATEMENT FOR 20X6 (in thousands)

Credit sales $8,000
Cost of goods sold ?
Gross profit ?
Selling and administrative expenses ?
Interest expense 400
Profit before taxes ?
Taxes (44% rate) ?
Profit after taxes ?

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OTHER INFORMATION
Current ratio 3 to 1
Depreciation $500
Net profit margin 7%
Total liabilities/shareholders’ equity 1 to 1
Average collection period 45 days
Inventory turnover ratio 3 to 1

Assuming that sales and production are steady throughout a 360-day year, complete the
balance sheet and income statement for Vanier Corporation.
5. A company has total annual sales (all credit) of $400,000 and a gross profit margin of
20 percent. Its current assets are $80,000; current liabilities, $60,000; inventories, $30,000;
and cash, $10,000.
a. How much average inventory should be carried if management wants the inventory
turnover to be 4?
b. How rapidly (in how many days) must accounts receivable be collected if management
wants to have an average of $50,000 invested in receivables? (Assume a 360-day year.)
6. Stoney Mason, Inc., has sales of $6 million, a total asset turnover ratio of 6 for the year, and
net profits of $120,000.
a. What is the company’s return on assets or earning power?
b. The company is considering the installation of new point-of-sales cash registers
throughout its stores. This equipment is expected to increase efficiency in inventory
control, reduce clerical errors, and improve record keeping throughout the system. The
new equipment will increase the investment in assets by 20 percent and is expected to
increase the net profit margin from 2 to 3 percent. No change in sales is expected. What
is the effect of the new equipment on the return on assets ratio or earning power?
7. The long-term debt section of the balance sheet of the Queen Anne’s Lace Corporation
appears as follows:

91/4% mortgage bonds $2,500,000

123/8% second mortgage bonds 1,500,000
101/4% debentures 1,000,000
141/2% subordinated debentures 1,000,000
$6,000,000

If the average earnings before interest and taxes of the company is $1.5 million and all debt
is long term, what is the overall interest coverage?
8. Tic-Tac Homes has had the following balance sheet statements the past four years (in
thousands):
20X1 20X2 20X3 20X4
Cash $ 214 $ 93 $ 42 $ 38
Receivables 1,213 1,569 1,846 2,562
Inventories 2,102 2,893 3,678 4,261
Net fixed assets 2,219 2,346 2,388 2,692
Total assets $5,748 $6,901 $7,954 $9,553
Accounts payable $1,131 $1,578 $1,848 $2,968
Notes payable 500 650 750 750
Accruals 656 861 1,289 1,743
Long-term debt 500 800 800 800
Common stock 200 200 200 200
Retained earnings 2,761 2,812 3,067 3,092
Total liabilities and
shareholders’ equity $5,748 $6,901 $7,954 $9,553

Using index analysis, what are the major problems in the company’s financial condition?

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9. US Republic Corporation balance sheet, December 31, 20X3

ASSETS LIABILITIES AND SHAREHOLDERS’ EQUITY

Cash $ 1,000,000 Notes payable, bank $ 4,000,000
Accounts receivable 5,000,000 Accounts payable 2,000,000
Inventory 7,000,000 Accrued wages and taxes 2,000,000
Fixed assets, net 17,000,000 Long-term debt 12,000,000
Preferred stock 4,000,000
Common stock 2,000,000
Retained earnings 4,000,000
Total liabilities and
Total assets $30,000,000 shareholders’ equity $30,000,000

US Republic Corporation statement of income and retained earnings,

year ended December 31, 20X3

Net sales
Credit $16,000,000
Cash 4,000,000
Total $20,000,000
Cost and Expenses
Cost of goods sold $12,000,000
Selling, general, and administrative expenses 2,200,000
Depreciation 1,400,000
Interest 1,200,000 $16,800,000
Net income before taxes $ 3,200,000
Taxes on income 1,200,000
Net income after taxes $ 2,000,000
Less: Dividends on preferred stock 240,000
Net income available to common shareholders $ 1,760,000
Add: Retained earnings at 1/1/X3 2,600,000
Subtotal $ 4,360,000
Less: Dividends paid on common stock 360,000
Retained earnings 12/31/X3 $ 4,000,000

a. Fill in the 20X3 column in the table that follows.

US Republic Corporation
INDUSTRY
RATIO 20X1 20X2 20X3 NORMS
1. Current ratio 250% 200% 225%
2. Acid-test ratio 100% 90% 110%
3. Receivable turnover 5.0× 4.5× 6.0×
4. Inventory turnover 4.0× 3.0× 4.0×
5. Long-term debt/total capitalization 35% 40% 33%
6. Gross profit margin 39% 41% 40%
7. Net profit margin 17% 15% 15%
8. Return on equity 15% 20% 20%
9. Return on investment 15% 12% 12%
10. Total asset turnover 0.9× 0.8× 1.0×
11. Interest coverage ratio 5.5× 4.5× 5.0×

b. Evaluate the position of the company using information from the table. Cite specific
ratio levels and trends as evidence.
c. Indicate which ratios would be of most interest to you and what your decision would
be in each of the following situations:
(i) US Republic wants to buy $500,000 worth of merchandise inventory from you,
with payment due in 90 days.
(ii) US Republic wants you, a large insurance company, to pay off its note at the bank
and assume it on a 10-year maturity basis at a current rate of 14 percent.

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(iii) There are 100,000 shares outstanding, and the stock is selling for $80 a share. The
company offers you 50,000 additional shares at this price.

Solutions to Self-Correction Problems

1. Present current ratio = $800/$500 = 1.60.
a. $700/$500 = 1.40. Current assets decline, and there is no change in current liabilities.
b. $900/$600 = 1.50. Current assets and current liabilities each increase by the same
amount.
c. $800/$500 = 1.60. Neither current assets nor current liabilities are affected.
d. $760/$540 = 1.41. Current assets decline, and current liabilities increase by the same
amount.
2. 20X1 20X2 20X3
Current ratio 1.19 1.25 1.20
Acid-test ratio 0.43 0.46 0.40
Average collection period 18 22 27
Inventory turnover 8.0 7.5 5.5
Total debt/equity 1.38 1.40 1.61
Long-term debt/total capitalization 0.33 0.32 0.32
Gross profit margin 0.200 0.163 0.132
Net profit margin 0.075 0.047 0.026
Total asset turnover 2.80 2.76 2.24
Return on assets 0.21 0.13 0.06

The company’s profitability has declined steadily over the period. As only $50,000 is added
to retained earnings, the company must be paying substantial dividends. Receivables are
growing at a slower rate, although the average collection period is still very reasonable rela-
tive to the terms given. Inventory turnover is slowing as well, indicating a relative buildup
in inventories. The increase in receivables and inventories, coupled with the fact that
shareholders’ equity has increased very little, has resulted in the total-debt-to-equity ratio
increasing to what would have to be regarded on an absolute basis as quite a high level.
The current and acid-test ratios have fluctuated, but the current ratio is not particularly
inspiring. The lack of deterioration in these ratios is clouded by the relative buildup in both
receivables and inventories, evidencing a deterioration in the liquidity of these two assets.
Both the gross profit and net profit margins have declined substantially. The relationship
between the two suggests that the company has reduced relative expenses in 20X3 in par-
ticular. The buildup in inventories and receivables has resulted in a decline in the asset
turnover ratio and this, coupled with the decline in profitability, has resulted in a sharp
decrease in the return on assets ratio.
Long-term debt Long-term debt
3. = 0.5 = Long-term debt = $100,000
Equity $200,000
Total liabilities and shareholders’ equity = $400,000
Total assets = $400,000
Sales Sales
= 2.5 = Sales = $1,000,000
Total assets $400,000

Cost of goods sold = (1 − Gross profit margin)(Sales)

= (0.9)($1,000,000) = $900,000
Cost of goods sold $900,000
= =9 Inventory = $100,000
Inventory Inventory

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