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
Net Income $200,000 $30,000
 5%  6.25%
Sales 4,000,000 $480,000
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.

Net income  Sales  profit margin

 $2,000,000  0.05

 $100,000

Return on assets  Net income

(investment) Total assets
$100,000

$1,200,000
 8.33%

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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
Net income  Sales  Profit Margin

 $750,000  0.06

 $45,000

Sales
Assets 
Total asset turnover
$750,000

2.5
 $300,000

Net income
Return on assets (invesment) 
Total assets
$45,000

$300,000
 15%

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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
Sales  Fixed assets  Fixed asset turnover 
$1,500,000  5  $7,500,000

total assets $2,500,000

–debt 700,000
Stockholders’ equity $1,800,000
Net income = Sales  profit margin =
$7,500,000  3% = $225,000

Net income
Return on stockholders' equity 
Stockholders' equity
$225,000
  12.5%
$1,800,000

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11. Acme Transportation Company has the following ratios compared to its industry
for 2009.

Acme
Transportation Industry
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.

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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
Net income  Sales  profit margin
 $4,000,000  3.5%
 $140,000

Stockholders equity  Total assets  Total liabilities

a. Total assets  Sales/Total asset turnover
 $4,000,000/2.5
 $1,600,000

Total liabilities  Current liabilities  Long  term liabilities

 $100,000  $300,000
 $400,000

Stockholders' equity  $1,600,000  $400,000  $1,200,000

Net income
Return on stockholders' equity 
Stockholders' equity
$140,000
  11.67%
$1,200,000

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3-14. (Continued)
b. The new level of sales will be:
Sales  Total assets  Total assets turnover
 $1,600,000  3
 $4,800,000

Net income  Sales  Profit margin

 $4,800,000  3.5%
 $168,000

Net income
Return on stockholders' equity 
Stockholders' equity
$168,000
  14%
$1,200,000

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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 Ratio

2006 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.

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3-25. (Continued)
b. Debt/total assets

Year Calloway Ratio Industry Ratio

2006 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.
Net income
a.
Total assets
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.

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3-26. (Continued)
Net income
b.
Stockholders' equity
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.
Total debt
Total assets
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........................................... _____
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 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
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 Long-term debt = $165,000
Equity = Total assets – total debt
Equity = $500,000 – $305,000
Equity = $195,000
Griggs Corporation
Balance Sheet 2008
Cash..................... $ 10,000 Current debt.......... $140,000
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 $500,000
stockholders’
equity

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 CORPORATION
Current 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 Paid-in capital 70,000
depreciation............. ................................................ 100,000
(150,000 Retained earnings
) ................................................
*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
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 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 CORPORATION
Current 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 Paid-in capital........................ 30,000
depreciation Retained earnings.................. 47,500
....................................... (250,000)
*Net fixed assets 250,000
.......................................
Total assets Total liabilities and equity...
.................................... $437,500 $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.

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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 (200/15) (133/28)
calculation

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.

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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.

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