TEST BANK RATIO ANALYSIS

Question 11.2.1:
Minden Co has current assets that consist of cash: $20,000, receivables: $70,000 and inventory:
$90,000. Current liabilities are $75,000. The current ratio is:

a) 2.4:1; (($20,000+$70,000+$90,000)/$75,000=2.4)
b) 2.2:1;
c) 2.0:1;
d) 1.8:1:
e) none of the above.

Question 11.2.2:
Minden Co has current assets that consist of cash: $20,000, receivables: $70,000 and inventory:
$90,000. Current liabilities are $75,000. The quick ratio is:

a) 1.7:1:
b) 1.2:1: (($20,000+$70,000)/$75,000=1.2:1)
c) 1.0:1;
d) 0.8:1
e) none of the above.

Question 11.2.3:
Minden Co has current assets that consist of cash: $20,000, receivables: $70,000 and inventory:
$90,000. Current liabilities are $75,000. On the basis of the current ratio and the quick ratio,
Minden Co is:

a) highly illiquid;
b) somewhat illiquid;
c) adequately liquid; (CR>2:1, QR>1:1)
d) excessively liquid;
e) none of the above.

Question 11.2.4:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. Their return on sales is:

a) 8.0%;
b) 10.0%; ($50,000/$500,000=10%)
c) 12.5%;
d) 16.0%;
e) 20.0%.

Question 11.2.5:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. Their return on assets
is:

a) 8.0%;
b) 10.0%;
c) 12.5%; ($50,000/($125,000+$275,000)=12.5%)
d) 16.0%;
e) 20.0%.

Question 11.2.6:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. Their return on equity
is:

a) 8.0%;
b) 10.0%;
c) 12.5%;
d) 16.0%; (($50,000-$10,000-$20,000)/$125,000) = 16%)
e) 20.0%.

Question 11.2.7:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. Their return on equity
in comparison to their return on assets is:

a) roa is higher than roe because of leverage;

b) roa is lower than roe because of leverage;
c) roa is the same as roe;
d) they are both related to the return on sales;
e) none of the above.

Question 11.2.8:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. Their debt to assets
ratio is:

a) 50.00%;
b) 65.00%;
c) 68.75%; ($275,000/($275,000+$125,000)=68.75%)
d) 220.00%;
e) none of the above.

Question 11.2.9:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. On the basis of the debt
to equity ratio, Minded would be considered to have:

a) too much debt, making it a risky company to invest in;

($275,000/$125,000 = 220% (>100% is risky))
b) just enough debt;
c) too little debt, making it a risky company to invest in;
d) too little debt, making it a low profitability investment;
e) none of the above.
f)
Question 11.2.10:
Minden Co has sales of $500,000, operating profit of $50,000, interest expense of $10,000, tax
expense of $20,000, total equity of $125,000 and total debt of $275,000. The debt carries
interest @ 5% per annum. The interest cover ratio is:

a) 5X;
b) 3X; (($50,000-$20,000)/$10,000=3X)
c) 2X;
d) 1.5X;
e) none of the above.

Question 11.2.11:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. Their receivables turnover ratio was:

a) 10.2X;
b) 9.4X;
c) 7.1X; ($500,000/$70,000=7.1X)
d) 5.6X;
e) none of the above.

Question 11.2.12:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. Their inventory holding period (to the nearest day) was:

a) 66 days; ($90,000*365/$500,000=66 days)

b) 51 days;
c) 46 days;
d) 32 days;
e) none of the above.
Question 11.2.13:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. If Minded changed to a policy of just-in-time inventory
management, their inventory turnover ratio would:

a) decrease;
b) stay the same;
c) increase; (with zero inventory, t/o ratio is infinitely high)
d) there is insufficient information;
e) none of the above.

Question 11.2.14:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. Their total asset turnover ratio is:

a) 1.00X;
b) 1.25X; (($500,000/($180,000+$400,000-$220,000)=1.25X)
c) 1.500X;
d) 2.3X;
e) none of the above.

Question 11.2.15:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. a dividend of $10,000 was paid to the common shareholders.
There are 1,000 shares in issue. Their earnings per share are:

a) $1:
b) $2;
c) $10;
d) $20; ($20,000/1,000 shares = $20 per share)
e) none of the above.

Question 11.2.16:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. a dividend of $10,000 was paid to the common shareholders.
There are 1,000 shares in issue. Their dividend cover ratio is:

a) 5X;
 b) 3X;
c) 2.5X;
d) 2X; (($50,000-$20,000-$10,000)/$10,000=2X)
e) none of the above.

Question 11.2.17:
Minden Co has current assets of $180,000 (cash: $20,000, accounts receivable: $70,000,
inventory: $90,000), and long-term assets that had cost $400,000, with accumulated depreciation
to date of $180,000. Sales were $500,000, and operating profit was $50,000. Tax was $20,00
and interest paid was $10,000. a dividend of $10,000 was paid to the common shareholders.
There are 1,000 shares in issue, and the share price is $240 per share. The price to earnings ratio
is:

a) 24X;
b) 12X; ($240/$20 EPS = 12X)
c) 10X;
d) 8X;
e) none of the above.

1) Pepsi Corporation’s current ratio is 0.5, while Coke Company’s current ratio is 1.5. Both
firms want to “window dress” their coming end-of-year financial statements. As part of their
window dressing strategy, each firm will double its current liabilities by adding short-term debt
and placing the funds obtained in the cash. Which of the statements below best describes the
actual results of these transactions account?
a. The transactions will have no effect on the current ratios.
b. The current ratios of both firms will be increased.
c. The current ratios of both firms will be decreased.
d. Only Pepsi Corporation’s current ratio will be increased.
e. Only Coke Company’s current ratio will be increased.

2) Stennett Corp.’s CFO has proposed that the company issue new debt and use the proceeds
to buy back common stock. Which of the following are likely to occur if this proposal is
adopted? (Assume that the proposal would have no effect on the company’s operating income.)
a. Return on assets (ROA) will decline.
b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.
e. None of the statements from above are correct.

3) Company J and Company K each recently reported the same earnings per share (EPS).
Company J’s stock, however, trades at a higher price. Which of the following statements is most
correct?
a. Company J must have a higher P/E ratio.
b. Company J must have a higher market to book ratio.
c. Company J must be riskier.
d. Company J must have fewer growth opportunities.
e. All of the statements above are correct.

4) Strack Housewares Supplies Inc. has $2 billion in total assets. The other side of its
balance sheet consists of $0.2 billion in current liabilities, $0.6 billion in long-term debt, and
$1.2 billion in common equity. The company has 300 million shares of common stock
outstanding, and its stock is $20 per share. What is Strack’s market-to-book ratio?
a. 1.25
b. 2.65
c. 3.15
d. 4.40
e. 5.00

5) Perry Technologies Inc. had the following financial information for the past year:
. Inventory turnover = 8.0.
. Quick ratio = 1.5.
. Sales = $860,000.
. Current ratio = 1.75.

What were Perry’s current liabilities?

a. $430,000
b. $500,000
c. $107,500
d. $ 61,429
e. $573,333

6) Shepherd Enterprises has an ROE of 15 percent, a debt ratio of 40 percent, and a profit
margin of 5 percent. The company’s total assets equal $800 million. What are the company’s
sales? (Assume that the company has no preferred stock.

a. $1,440,000,000
b. $2,400,000,000
c. $ 120,000,000
d. $ 360,000,000
e. $ 960,000,000

7) Tapley Dental Supply Company has the following data:

Net income: $240 Sales: $10,000 Total assets: $6,000
Debt ratio: 75% TIE ratio: 2.0 Current ratio: 1.2
BEP ratio: 13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to $300,
without affecting sales or the balance sheet (the additional profits will be paid out as
dividends), by how much would its ROE increase?

a. 3.00%
b. 3.50%
c. 4.00%
d. 4.25%
e. 5.50%
8) A company had the following balance sheet and income statement information:

Balance sheet:
Cash $ 20
A/R 1,000
Inventories 5,000
Total C.A. $ 6,020 Debt $ 4,000
Net F.A. 2,980 Equity 5,000
Total Assets $ 9,000 Total claims $ 9,000

Income statement:
Sales $10,000
Cost of goods sold 9,200
EBIT $ 800
Interest (10%) 400
EBT $ 400
Taxes (40%) 160
Net Income $ 240

The industry average inventory turnover is 5. You think you can change your inventory
control system so as to cause your turnover to equal the industry average, and this change
is expected to have no effect on either sales or cost of goods sold. The cash generated
from reducing inventories will be used to buy tax-exempt securities which have a 7
percent rate of return. What will your profit margin be after the change in inventories is
reflected in the income statement?

a. 2.1%
b. 2.4%
c. 4.5%
d. 5.3%
e. 6.7%

9) The Meryl Corporation's common stock is currently selling at a P/E ratio of 10. If the
firm has 100 shares of common stock outstanding, a return on equity of 20 percent, and a
debt ratio of 60 percent, what is its return on total assets (ROA)?

a. 8.0%
b. 10.0%
c. 12.0%
 d. 16.7%
e. 20.0%

10) Collins Company had the following partial balance sheet and complete annual income
statement:

Partial Balance Sheet:

Cash $ 20
A/R 1,000
Inventories 2,000
Total current assets $ 3,020
Net fixed assets 2,980
Total assets $ 6,000

Income Statement:
Sales $10,000
Cost of goods sold 9,200
EBIT $ 800
Interest (10%) 400
EBT $ 400
Taxes (40%) 160
Net Income $ 240

The industry average DSO is 30 (based on a 360-day year). Collins plans to change its
credit policy so as to cause its DSO to equal the industry average, and this change is
expected to have no effect on either sales or cost of goods sold. If the cash generated
from reducing receivables is used to retire debt (which was outstanding all last year and
which has a 10 percent interest rate), what will Collins' debt ratio (Total debt/Total assets)
be after the change in DSO is reflected in the balance sheet?

a. 33.33%
b. 45.28%
c. 52.75%
d. 60.00%
e. 65.71%

Ch 3 (13ed) Analysis of Fin Statements Prob Set

Answers
1. D
2. D
3. A
4. E
5. A
6. A
7. C
8. C
9. A
10. E

FIN638
Assignment 2

Due Date: October 29

Chapter 10:

1. All else being equal, which of the following will increase a company’s current ratio?

a. An increase in accounts receivable.

b. An increase in accounts payable.
c. An increase in net fixed assets.
d. Statements a and b are correct.

2. Stennett Corp.’s CFO has proposed that the company issue new debt and use the proceeds
to buy back common stock. Which of the following are likely to occur if this proposal is adopted?
(Assume that the proposal would have no effect on the company’s operating income.)

a. Return on assets (ROA) will decline.

b. The Depreciation will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.

3. Bedford Hotels and Breezewood Hotels both have $100 million in total assets and a 10
percent return on assets (ROA). Each company has a 40 percent tax rate. Bedford,
however, has a higher debt ratio and higher interest expense. Which of the following
statements is most correct?

a. The two companies have the same return on equity (ROE).

b. Bedford has a higher return on equity (ROE).
c. Bedford has a lower level of operating income (EBIT).
d. Statements a and b are correct.
4. Company J and Company K each recently reported the same earnings per share (EPS).
Company J’s stock, however, trades at a higher price. Which of the following statements is
most correct?
 a. Company J must have a higher P/E ratio.
b. Company J must have a higher market to book ratio.
c. Company J must be riskier.
d. Company J must have fewer growth opportunities.
5. As a short-term creditor concerned with a company’s ability to meet its financial obligation to
you, which one of the following combinations of ratios would you most likely prefer?

Current Debt
ratio TIE ratio

a. 0.8 1.3 0.3

b. 1.2 1.2 0.8
c. 1.7 1.2 0.8
d. 2.0 1.3 0.55 *

6. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent. The
company recently reported that its basic earning power (BEP) ratio was 15 percent and its return
on assets (ROA) was 9 percent. What was the company’s interest expense?

a. $ 0
b. $ 2,000,000
c. $ 6,000,000
d. $15,000,000

7. Culver Inc. has earnings before interest and taxes (EBIT )of $300. The company’s times
interest earned ratio is 7.00. Calculate the company’s interest charges.

a. $42.86
b. $50.00
c. $40.00
d. $60.00

8. A fire has destroyed a large percentage of the financial records of the Carter Company. You have
the task of piecing together information in order to release a financial report. You have found the
return on equity to be 18 percent. If sales were $4 million, the debt ratio was 0.40, and total
liabilities were $2 million, what would be the return on assets (ROA)?

a. 10.80%
b. 0.80%
c. 1.25%
d. 12.60%

9. A firm that has an equity multiplier of 4.0 will have a debt ratio of

a. 4.00
b. 3.00
c. 1.00
d. 0.75
USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

You are provided with the following information for a company.

Sales 35000
Receivables 750
COGS 20000
Inventory 3000
Payables 1500

10. Calculate DSO (days sales outstanding) ratio

a) 7.83
b) 8.4
c) 55.1
d) 36.7

11. Calculate the inventory turnover ratio

a) 27.23
b) 13.3
c) 55.43
d) 11.67

You are provided with the following information about MaxCorp.

Net sales 5000

Total Assets 3000
Depreciation 260
Net Income 600
Long term Debt 2000
Equity 2160

12. Calculate the return on equity (ROE)

 a) 20.4%
b) 17.8%
c) 22.4%
d) 27.8%

1.)

The inventory turnover and current ratio are related. The combination of a high current ratio and
a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-
average inventory level and/or that part of the inventory is obsolete or damaged.

a. True
b. False

2.)

Since the ROA measures the firm's effective utilization of assets (without considering how these
assets are financed), two firms with the same EBIT must have the same ROA.

a. True
b. False

3.)

Suppose firms follow similar financing policies, face similar risks, have equal access to capital,
and operate in competitive product and capital markets. Under these conditions, then firms that
have high profit margins will tend to have high asset turnover ratios, and firms with low profit
margins will tend to have low turnover ratios.

a. True
b. False

4.)

One problem with ratio analysis is that relationships can be manipulated. For example, if our
current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to
build up our cash account would cause the current ratio to increase.

a. True
b. False

5.)
Companies HD and LD are both profitable, and they have the same total assets (TA), Sales (S),
return on assets (ROA), and profit margin (PM). However, Company HD has the higher debt
ratio. Which of the following statements is CORRECT?

a. Company HD has a lower total assets turnover than Company LD.

b. Company HD has a lower equity multiplier than Company LD.
c. Company HD has a higher fixed assets turnover than Company B.
d. Company HD has a higher ROE than Company LD.
e. Company HD has a lower operating income (EBIT) than Company LD.

6.)

A firm wants to strengthen its financial position. Which of the following actions would increase
its quick ratio?

a. Offer price reductions along with generous credit terms that would (1) enable the firm to
sell some of its excess inventory and (2)lead to an increase in accounts receivable.
b. Issue new common stock and use the proceeds to increase inventories.
c. Speed up the collection of receivables and use the cash generated to increase inventories.
d. Use some of its cash to purchase additional inventories.
e. Issue new common stock and use the proceeds to acquire additional fixed assets.

7.)

Other things held constant, which of the following alternatives would increase a company’s cash
flow for the current year?

a. Increase the number of years over which fixed assets are depreciated for tax purposes.
b. Pay down the accounts payables.
c. Reduce the days’ sales outstanding (DSO) without affecting sales or operating costs.
d. Pay workers more frequently to decrease the accrued wages balance.
e. Reduce the inventory turnover ratio without affecting sales or operating costs.

8.)

Pace Corp.'s assets are $625,000, and its total debt outstanding is $185,000. The new CFO
wants to employ a debt ratio of 55%. How much debt must the company add or subtract to
achieve the target debt ratio?

a. $158,750
b. $166,688
c. $175,022
d. $183,773
e. $192,962

9.)
Bonner Corp.'s sales last year were $415,000, and its year-end total assets were $355,000. The
average firm in the industry has a total assets turnover ratio (TATO) of 2.4. Bonner's new CFO
believes the firm has excess assets that can be sold so as to bring the TATO down to the industry
average without affecting sales. By how much must the assets be reduced to bring the TATO to
the industry average, holding sales constant?

a. $164,330
b. $172,979
c. $182,083
d. $191,188
e. $200,747
10.)

LeCompte Corp. has $312,900 of assets, and it uses only common equity capital (zero debt). Its
sales for the last year were $620,000, and its net income after taxes was $24,655. Stockholders
recently voted in a new management team that has promised to lower costs and get the return on
equity up to 15%. What profit margin would LeCompte need in order to achieve the 15% ROE,
holding everything else constant?

a. 7.57%
b. 7.95%
c. 8.35%
d. 8.76%
e. 9.20%

11.)

Last year Urbana Corp. had $197,500 of assets, $307,500 of sales, $19,575 of net income, and a
debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will enable
it to reduce costs and thus raise net income to $33,000. Assets, sales, and the debt ratio would
not be affected. By how much would the cost reduction improve the ROE?

a. 9.32%
b. 9.82%
c. 10.33%
d. 10.88%
e. 11.42%

12.)

Last year Vaughn Corp. had sales of $315,000 and a net income of $17,832, and its year-end
assets were $210,000. The firm's total-debt-to-total-assets ratio was 42.5%. Based on the Du
Pont equation, what was Vaughn's ROE?

a. 14.77%
 b. 15.51%
c. 16.28%
d. 17.10%
e. 17.95%

13.)

Last year Central Chemicals had sales of $205,000, assets of $127,500, a profit margin of 5.3%,
and an equity multiplier of 1.2. The CFO believes that the company could reduce its assets by
$21,000 without affecting either sales or costs. Had it reduced its assets in this amount, and had
the debt ratio, sales, and costs remained constant, by how much would the ROE have changed?

a. 1.81%
b. 2.02%
c. 2.22%
d. 2.44%
e. 2.68%
14.)

Last year Altman Corp. had $205,000 of assets, $303,500 of sales, $18,250 of net income, and a
debt-to-total-assets ratio of 41%. The new CFO believes the firm has excessive fixed assets and
inventory that could be sold, enabling it to reduce its total assets to $152,500. Sales, costs, and net
income would not be affected, and the firm would maintain the 41% debt ratio. By how much
would the reduction in assets improve the ROE?

a. 4.69%
b. 4.93%
c. 5.19%
d. 5.45%
e. 5.73%

15.)

Muscarella Inc. has the following balance sheet and income statement data:

Cash $ 14,000 Accounts payable $ 42,000

Receivables 70,000 Other current liabilities 28,000
Inventories 210,000 Total CL $ 70,000
Total CA $294,000 Long-term debt 70,000
Net fixed assets 126,000 Common equity 280,000
Total assets $420,000 Total liab. and equity $420,000
Sales $280,000
Net income $ 21,000
 The new CFO thinks that inventories are excessive and could be lowered sufficiently to
cause the current ratio to equal the industry average, 2.70, without affecting either sales or
net income. Assuming that inventories are sold off and not replaced to get the current ratio
to the target level, and that the funds generated are used to buy back common stock at
book value, by how much would the ROE change?

a. 4.28%
b. 4.50%
c. 4.73%
d. 4.96%
e. 5.21%

16.)

Last year Swensen Corp. had sales of $303,225, operating costs of $267,500, and year-end assets
of $195,000. The debt-to-total-assets ratio was 27%, the interest rate on the debt was 8.2%, and
the firm's tax rate was 37%. The new CFO wants to see how the ROE would have been affected
if the firm had used a 45% debt ratio. Assume that sales and total assets would not be affected,
and that the interest rate and tax rate would both remain constant. By how much would the ROE
change in response to the change in the capital structure?

a. 2.08%
b. 2.32%
c. 2.57%
d. 2.86%
e. 3.14%
Solutions

1.) a
2.) b
3.) b
4.) b
5.) d
6.) a
7.) c
8.) a
9.) c
10.) a
11.) d
12.) a
13.) b
14.) c
15.) b
16.) d
LG1-LG5 1. Classify each of the following ratios according to a ratio category (liquidity ratio, asset
management ratio, debt management ratio, profitability ratio, or market value ratio).

a. Current ratio – liquidity ratio

b. Inventory turnover ratio – asset management ratio
c. Return on assets – profitability ratio
d. Accounts payable period – asset management ratio
e. Times interest earned – debt management ratio
f. Capital intensity ratio – asset management ratio
g. Equity multiplier – debt management ratio
h. Basic earnings power ratio – profitability ratio

LG1 2. For each of the actions listed below, determine what would happen to the current ratio. Assume
nothing else on the balance sheet changes and that net working capital is positive.

a. Accounts receivable are paid in cash – Current ratio does not change
b. Notes payable are paid off with cash – Current ratio increases
c. Inventory is sold on account – Current ratio does not change
d. Inventory is purchased on account– Current ratio decreases
e. Accrued wages and taxes increase – Current ratio decrease
f. Long-term debt is paid with cash – Current ratio decreases
g. Cash from a short-term bank loan is received – Current ratio decreases

LG1-LG5 3. Explain the meaning and significance of the following ratios

a. Quick ratio - Inventories are generally the least liquid of a firm’s current assets. Further,
inventory is the current asset for which book values are the least reliable measures of market
value. In practical terms, what this means is that if the firm must sell inventory to pay upcoming
bills, the firm is most likely to have to discount inventory items in order to liquidate them, and so
therefore they are the assets on which losses are most likely to occur. Therefore, the quick (or
acid-test) ratio measures a firm’s ability to pay off short-term obligations without relying on
inventory sales. The quick ratio measures the dollars of more liquid assets (cash and marketable
securities and accounts receivable) available to pay each dollar of current liabilities.

b. Average collection period - The average collection period (ACP) measures the number of days
accounts receivable are held before the firm collects cash from the sale. In general, a firm wants to
produce a high level of sales per dollar of accounts receivable, i.e., it wants to collect its accounts
receivable as quickly as possible to reduce any cost of financing inventories and accounts receivable,
including interest expense on liabilities used to finance inventories and accounts receivable, and
defaults associated with accounts receivable.

c. Return on equity - Return on equity (ROE) measures the return on the common stockholders’
investment in the assets of the firm. ROE is the net income earned per dollar of common
stockholders’ equity. The value of a firm’s ROE is affected not only by net income, but also by the
amount of financial leverage or debt that firm uses.
 d. Days’ sales in inventory - . The days’ sales in inventory ratio measures the number of days that
inventory is held before the final product is sold. In general, a firm wants to produce a high level of
sales per dollar of inventory, that is, it wants to turn inventory over (from raw materials to finished
goods to sold goods) as quickly as possible. A high level of sales per dollar of inventory implies
reduced warehousing, monitoring, insurance, and any other costs of servicing the inventory. So, a
high inventory turnover ratio or a low days’ sales in inventory is a sign of good management.

e. Debt ratio - The debt ratio measures the percentage of total assets financed with debt. The
debt-to-equity ratio measures the dollars of debt financing used for every dollar of equity
financing. The equity multiplier ratio measures the dollars of assets on the balance sheet for
every dollar of equity financing. As you might suspect, all three measures are related. So, the
lower the debt, debt-to-equity, or equity multiplier ratios, the less debt and more equity the firm
uses to finance its assets (i.e., the bigger the firm’s equity cushion).

f. Profit margin - The profit margin is the percent of sales left after all firm expenses are paid.

g. Accounts payable turnover - The accounts payable turnover ratio measures the dollar cost of goods
sold per dollar of accounts payable. In general, a firm wants to pay for its purchases as slowly as
possible. The more slowly it can pay for its supply purchases, the less the firm will need other costly
sources of financing such as notes payable or long-term debt. Thus, a high APP or a low accounts
payable turnover ratio is generally a sign of good management.

h. Market-to-book ratio - The market-to-book ratio compares the market (current) value of the firm’s
equity to their historical costs. In general, the higher the market-to-book ratio, the better the firm.

LG2 4. A firm has an average collection period of 10 days. The industry average ACP is 25 days. Is this a
good or poor sign about the management of the firm’s accounts receivable?

If the ACP is extremely low, the firm’s accounts receivable policy may be so strict that customers
prefer to do business with competing firms. Firms offer accounts receivable terms as an incentive to
get customers to buy products from their firm rather than a competing firm. By offering firm
customers the accounts receivable privilege, management allows customers to buy (more) now and
pay later. Without this incentive, that is, if managers require customers to pay for their purchases very
quickly, customers may chose to buy the goods from the firm’s competitors who offer better credit
terms. So extremely low ACP levels may be a sign of bad firm management.

LG3 5. A firm has a debt ratio of 20%. The industry average debt ratio is 65%. Is this a good or poor sign
about the management of the firm’s financial leverage?

When a firm issues debt to finance its assets, it gives the debtholders first claim to a fixed
amount of its cash flows. Stockholders are entitled to any residual cash flows―those left after
debtholders are paid. When a firm does well, financial leverage increases the reward to
shareholders since the amount of cash flows promised to debtholders is constant and capped. So
when firms do well, financial leverage creates more cash flows to share with stockholders—it
magnifies the return to the stockholders of the firm. This magnification is one reason that firm
 stockholders encourage the use of debt financing. However, financial leverage also increases the
firm’s potential for financial distress and even failure. If the firm has a bad year and can not
make promised debt payments, debtholders can force the firm into bankruptcy. Thus, a firm’s
current and potential debtholders (and even stockholders) look at equity financing as a safety
cushion that can absorb fluctuations in the firm’s earnings and asset values and guarantee debt
service payments. Clearly, the larger the fluctuations or variability of a firm’s cash flows, the
greater the need for an equity cushion. Managers’ choice of capital structure―the amount of debt
versus equity to issue―affects the firm’s viability as a long-term entity. In deciding the level of
debt versus equity financing to hold on the balance sheet, managers must consider the trade-off
between maximizing cash flows to the firm’s stockholders versus the risk of being unable to
make promised debt payments.

LG4 6. A firm has an ROE of 20%. The industry average ROE is 12%. Is this a good or poor sign about
the management of the firm?

Generally, a high ROE is considered to be a positive sign of firm performance. However, if

performance comes from a high degree of financial leverage, a high ROE can indicate a firm
with an unacceptably high level of bankruptcy risk as well.

LG6 7. Why is the DuPont system of analysis an important tool when evaluating firm performance?

Many of the ratios discussed in the chapter are interrelated. So a change in one ratio may well affect
the value of several ratios. Often these interrelations can help evaluate firm performance. Managers
and investors often perform a detailed analysis of ROA (Return on Assets) and ROE (Return on
Equity) using the DuPont analysis system. Popularized by the DuPont Corporation, the DuPont
analysis system uses the balance sheet and income statement to break the ROA and ROE ratios into
component pieces.

LG6 8. A firm has an ROE of 10%. The industry average ROE is 15%. How can the DuPont system of
analysis help the firm’s managers identify the reasons for this difference?

The basic DuPont equation looks at the firm’s overall profitability as a function of the profit the
firm earns per dollar of sales (operating efficiency) and the dollar of sales produced per dollar of
assets on the balance sheet (efficiency in asset use). With this tool, managers can see the reason
for any changes in ROA in more detail. For example, if ROA increases, the DuPont equation
may show that the net profit margin was constant, but the total asset turnover (efficiency in using
assets) increased, or that total asset turnover remained constant, but profit margins (operating
efficiency) increased. Managers can then break down operating efficiency and efficiency in asset
use further using the ratios described above to more specifically identify the reasons for an ROA
change.

LG6 9. What is the difference between the internal growth rate and the sustainable growth rate?

The internal growth rate is the growth rate a firm can sustain if it uses only internal financing—that
is, retained earnings—to finance future growth. A problem arises when a firm relies only on internal
financing to support asset growth: Through time, its debt ratio will fall because as asset values grow,
 total debt stays constant—only retained earnings finance asset growth. If total debt remains constant,
as assets grow the debt ratio decreases. As we noted above shareholders often become disgruntled if,
as the firm grows, a decreasing debt ratio (increasing equity financing) dilutes their return. So as
firms grow, managers must often try to maintain a debt ratio that they view as optimal. In this case,
managers finance asset growth with new debt and retained earnings. The maximum growth rate that
can be achieved this way is the sustainable growth rate.

LG7 10. What is the difference between time series analysis and cross-sectional analysis?

Time series analysis evaluates the performance of the firm over time. Cross-sectional analysis
evaluates the performance of the firm against one or more companies in the same industry.

LG7 11. What information does time series and cross-sectional analysis provide for firm managers,
analysts, and investors?

Analyzing ratio trends over time, along with absolute ratio levels, gives managers, analysts, and
investors information about whether a firm’s financial condition is improving or deteriorating.
For example, ratio analysis may reveal that the days’ sales in inventory is increasing. This
suggests that inventories, relative to the sales they support, are not being used as well as they
were in the past. If this increase is the result of a deliberate policy to increase inventories to offer
customers a wider choice and if it results in higher future sales volumes or increased margins that
more than compensate for increased capital tied up in inventory, the increased relative size of the
inventories is good for the firm. Managers and investors should be concerned, on the other hand,
if increased inventories result from declining sales but steady purchases of supplies and
production.

Looking at one firm’s financial ratios, even through time, give managers, analysts, and investors only
a limited picture of firm performance. Ratio analysis almost always includes a comparison of one
firm’s ratios relative to the ratios of other firms in the industry, or cross-sectional analysis. Key to
cross-sectional analysis is identifying similar firms in that they compete in the same markets, have
similar assets sizes, and operate in a similar manner to the firm being analyzed. Since no two firms
are identical, obtaining such a comparison group is no easy task. Thus, the choice of companies to use
in cross-sectional analysis is at best subjective.

LG8 12. Why is it important to know a firm’s accounting rules before making any conclusions about
its performance from ratios analysis?

Firms use different accounting procedures. For example, inventory methods can vary. One firm
may use FIFO (first-in, first-out), transferring inventory at the first purchase price, while another
uses LIFO (last-in, first-out), transferring inventory at the last purchase price. Likewise, the
depreciation method used to value a firm’s fixed assets over time may vary across firms. One
firm may use straight-line depreciation while another may use an accelerated depreciation
method (e.g., MACRS). Particularly when reviewing cross-sectional ratios, differences in
accounting rules can affect balance sheet values and financial ratios. It is important to know
which accounting rules the firms under consideration are using before making any conclusions
about its performance from ratio analysis.
LG8 13. What does it mean when a firm window dresses its financial statements?

Firms often window dress their financial statements to make annual results look better. For example,
to improve liquidity ratios calculated with year-end balance sheets, firms often delay payments for
raw materials, equipment, loans, etc. to build up their liquid accounts and thus their liquidity ratios. If
possible, it is often more accurate to use other than year-end financial statements to conduct
performance analysis.

Problems

Basic 3-1 Liquidity Ratios You are evaluating the balance sheet for Goodman’s Bees Corporation. From the
Problems balance sheet you find the following balances: Cash and marketable securities = $400,000, Accounts
receivable = $1,200,000, Inventory = $2,100,000, Accrued wages and taxes = $500,000,
LG1 Accounts payable = $800,000, and Notes payable = $600,000. Calculate Goodman Bee’s Current
ratio, Quick ratio, and Cash ratio.

$400,000 + $1,200,000 + $2,100,000

Current ratio = ———————————————— = 1.9474 times
$500,000 + $800,000 + $600,000

$400,000 + $1,200,000 + $2,100,000 - $2,100,000

Quick ratio (acid-test ratio) = —————————————————————— = 0.84211
times
$500,000 + $800,000 + $600,000
$400,000
Cash ratio = —————————————— = 0.21053 times
$500,000 + $800,000 + $600,000

LG1 3-2 Liquidity Ratios The top part of Ramakrishnan Inc,’s 2008 and 2009 balance sheets is listed
below (in millions of dollars).

Current assets: 2008 2009 Current liabilities: 2008 2009

Cash and marketable Accrued wages and
securities $ 15 $ 20 taxes $ 18 $ 19

Accounts receivable 75 84 Accounts payable 45 51

Inventory 110 121 Notes payable 40
45
Total $200 $225 Total $103 $115

Calculate Ramakrishnan Inc.’s Current ratio, Quick ratio, and Cash ratio for 2008 and 2009.

2008 2009

$200m. $225m.
 Current ratio = ——— = 1.9417 times ———— = 1.9565
times
$103m. $115m.

$200m. - $110m. $225m. - $121m.

Quick ratio (acid-test ratio) = ——————— = 0.8738 times ———————— = 0.90435
times
$103m. $115m.

$15m. $20m.
Cash ratio = ———— = 0.14563 times —————— = 0.17391 times
$103m. $115m.

LG2 3-3 Asset Management Ratios Tater and Pepper Corp. reported sales for 2008 of $23 million. Tater
and Pepper listed $5.6 million of inventory on its balance sheet. Calculate Tater and Pepper’s 2008
EBIT. Using a 365 day year, how many days did Tater and Pepper’s inventory stay on the premises?
How many times per year did Tater and Pepper’s inventory turn over?

$5.6m. x 365
Days’ sales in inventory = —————— = 88.8696 days
$23m.

$23m.
Inventory turnover ratio = ———— = 4.1071 days
$5.6m.

LG2 3-4 Asset Management Ratios Mr. Husker’s Tuxedos, Corp. ended the year 2008 with an average
collection period of 32 days. The firm’s credit sales for 2008 were $33 million. What is the year-end
2008 balance in accounts receivable for Mr. Husker’s Tuxedos?

Accounts receivable x 365

Average collection period (ACP) = ——————————— = 32 days
$33m.

=> Accounts receivable = 32 days x $33 m./365 = $2.89m.

LG3 3-5 Debt Management Ratios Tiggie’s Dog Toys, Inc. reported a debt-to-equity ratio of 1.75 times
at the end of 2008. If the firm’s total debt at year-end was $25 million, how much equity does
Tiggie’s have?

Total debt $25 m.

Debt-to-equity ratio = ————— = 1.75 = ————— => Total equity = $25m./1.75 =
14.29m.
Total equity Total equity
LG3 3-6 Debt Management Ratios You are considering a stock investment in one of two firms
(LotsofDebt, Inc. and LotsofEquity, Inc.), both of which operate in the same industry. LotsofDebt,
Inc. finances its $25 million in assets with $24 million in debt and $1 million in equity. LotsofEquity,
Inc. finances its $25 million in assets with $1 million in debt and $24 million in equity. Calculate the
debt ratio, equity multiplier, and debt-to-equity ratio for the two firms.

LotsofDebt Lotsof Equity

$24m. $1m
Debt ratio = ——— = 96.00% ——— = 4.00%
$25m. $25m

$25m. $25m.
Equity multiplier ratio = ——— = 25 times ——— = 1.042 times
$1m. $24m.

$24m. $1m.
Debt-to-equity ratio = ——— = 24 times ——— = .042 times
$1m. $24m.

LG4 3-7 Profitability Ratios Maggie’s Skunk Removal, Corp.’s 2008 income statement listed net sales =
$12.5 million, EBIT = $5.6 million, net income available to common stockholders = $3.2 million, and
common stock dividends = $1.2 million. The 2008 year-end balance sheet listed total assets = $52.5
million, and common stockholders equity = $21 million with 2 million shares outstanding. Calculate
the profit margin, basic earnings power ratio, ROA, ROE, and dividend payout ratio.

$3.2m. - $1.2m.
Profit margin = ——————— = 16.00%
$12.5m.
$5.6m.
Basic earnings power ratio (BEP) = ——— = 10.67%
$52.5m.

$3.2m.
Return on assets (ROA) = ——— = 6.095%
$52.5m.

$3.2m.
Return on equity (ROE) = ——— = 15.24%
$21m.

$1.2m.
Dividend payout ratio = ——— = 37.50%
$3.2m.

LG4 3-8 Profitability Ratios In 2008, Jake’s Jamming Music, Inc. announced an ROA of 8.56%, ROE of
14.5%, and profit margin of 20.5%. The firm had total assets of $16.5 million at year-end 2008.
 Calculate the 2008 values of net income available to common stockholders’, common stockholders’
equity, and net sales for Jake’s Jamming Music, Inc.

Net income available to common stockholders

Return on assets (ROA) = 0.0856 = ———————————————————
$16.5m.

=> Net income available to common stockholders = 0.0856 x $16.5 m. = $1,412,400

$1,412,400
Return on equity (ROE) = 0.145 = ————————————
Common stockholders’ equity

=> Common stockholders’ equity = $1,412,400/0.145 = $9,740,690

$1,412,400
Profit margin = 0.205 = ————— => Sales = $1,412,400/0.205 = $6,889,756
Sales

LG5 3-9 Market Value Ratios You are considering an investment in Roxie’s Bed & Breakfast, Corp.
During the last year the firm’s income statement listed addition to retained earnings = $4.8 million
and common stock dividends = $2.2 million. Roxie’s year-end balance sheet shows common
stockholders’ equity = $35 million with 10 million shares of common stock outstanding. The
common stock’s market price per share = $9.00. What is Roxie’s Bed & Breakfast’s book value per
share and earnings per share? Calculate the market-to-book ratio and PE ratio.

Book value per share = $35m./10m. = $3.50 per share

Earnings per share = ($4.8m. + $2.2m.)/10m. = $0.70 per share

$9.00
Market-to-book ratio = ——— = 2.57 times
$3.50

$9.00
Price-earnings (PE) ratio = ——— = 12.86 times
$0.70

LG5 3-10 Market Value Ratios Gambit Golf’s market-to-book ratio is currently 2.5 times and PE ratio is
6.75 times. If Gambit Golf’s common stock is currently selling at $12.50 per share, what is the book
value per share and earnings per share?
$12.50
Market-to-book ratio = 2.50 = ————————— => Book value per share =
$12.50/2.50 = $5.00
 Book value per share

$12.50
Price-earnings (PE) ratio = 6.75 times = ————————— => Earnings per share =
$12.50/6.75 = $1.85
Earnings per share

LG6 3-11 DuPont Analysis If Silas 4-Wheeler, Inc. has an ROE = 18%, equity multiplier = 2, a profit
margin of 18.75%, what is the total asset turnover ratio and the capital intensity ratio?

ROE = .18 = .1875x Total asset turnover x 2 => Total asset turnover = .18/(.1875 x 2) = 48.00%
Capital intensity ratio = 1/48% = 2.083333 times

LG6 3-12 DuPont Analysis Last year Hassan’s Madhatter, Inc. had an ROA of 7.5%, a profit margin of
12%, and sales of $10 million. Calculate Hassan’s Madhatter’s total assets.

ROA = 0.075 = .12 x ($10m./Total assets) => Total assets = .12 x $10m./.075 = $16m.

LG6 3-13 Internal Growth Rate Last year Lakesha’s Lounge Furniture Corporation had an ROA of 7.5%
and a dividend payout ratio of 25%. What is the internal growth rate?

0.075 x (1 - .25)
Internal growth rate = ————————— = 8.11%
(1 - 0.075) x (1 - .25)

LG6 3-14 Sustainable Growth Rate Last year Lakesha’s Lounge Furniture Corporation had an ROE of
12.5% and a dividend payout ratio of 20% What is the sustainable growth rate?

0.125 x (1 - .20)
Sustainable growth rate = ————————— = 9.14%
(1- 0.125) x (1 - .20)

Intermediate 3-15 Liquidity Ratios Brenda’s Bar and Grill has current liabilities of $15 million. Cash makes up 10
percent of the current assets and accounts receivable makes up another 40 percent of current assets.
Problems Brenda’s current ratio = 2.1 times. Calculate the value of inventory listed on the firm’s balance sheet.
LG1
Current ratio = 2.1 = Current assets/$15m. => Current assets = 2.1 x $15m. = $31.5m.
Cash = 0.10 x $31.5m. = $3.15m.
Accounts receivable = 0.40 x $31.5m. = $12.6m.
=> Inventory = $31.5m. - $3.15m. - $12.6m. = $15.75m.

LG1-LG2 3-16 Liquidity and Asset Management Ratios Mandesa, Inc. has current liabilities = $5 million,
current ratio = 2 times, inventory turnover ratio = 12 times, average collection period = 30 days, and
sales = $40 million. Calculate the value of cash and marketable securities.

Current assets
 Current ratio = 2 times = ———————— => Current assets = 2 x $5m. = $10m.
$5m.

$40m.
Inventory turnover ratio = 12 times = ———— => Inventory = $40m./12 = $3,333,333
Inventory

Accounts receivable x 365

Average collection period (ACP) = 30 days = ———————————
$40m.

=> Accounts receivable = 30 x $40m./365 = $3,287,671

=> Cash and marketable securities = $10m. - $3,333,333 - $3,287,671 = $3,378,96

LG2 3-17 Asset Management and Profitability Ratios You have the following information on Els’
Putters, Inc.: sales to
LG4 working capital = 4.6 times, profit margin = 20%, net income available to common stockholders = $5
million, and current liabilities = $6 million. What is the firm’s balance of current assets?

Profit margin = .2 = $5m./Sales => Sales = $5m./.2 = $25m

Sales/(Current assets – Current liabilities) = 4.6 = $25m./(Current assets - $6m.)
=> Current assets = ($25m./4.6) + 6m. = $11.43m.

LG2 3-18 Asset Management and Debt Management Ratios Use the following information to complete
the balance sheet
LG3 below. Sales = $5.2 million, capital intensity ratio = 2.10 times, debt ratio = 55%, and fixed asset
turnover ratio = 1.2 times.

Step 1: Capital intensity ratio = 2.10 = Total assets/$5.2m. => Total assets = 2.1 x $5.2m. = $10.92m.
and Total liabilities and equity = $10.92m.

Step 2: Debt ratio = .55 = Total debt/$10.92m. => Total debt = .55 x $10.92m. = $6.006m.

Step 3: Total equity = $10.92m. - $6.006m. = $4.914m.

Step 4: Fixed asset turnover = 1.2 = $5.2m./Fixed assets => Fixed assets = $5.2m./1.2 = $4.333m.

Step 5: Current assets = $10.922m. - $4.333m. = $6.587m.

Assets Liabilities and Equity

Current assets Step 5 $6.587m. Total liabilities Step 2 $____$6.006m._____

Fixed assets Step 4 $4.333m. Total equity Step 3 ____$4.914m._____

 Total assets Step 1 $ __$10.92m.___ Total liabilities and equity
$____$10.92m.____

LG3 3-19 Debt Management Ratios Tiggie’s Dog Toys, Inc. reported a debt to equity ratio of 1.75 times
at the end of 2008. If the firm’s total assets at year-end were $25 million, how much of their assets are
financed with debt and how much with equity?

Debt to equity = 1.75 = Total debt/Total equity = Total debt/(Total assets – Total debt)
1.75 = Total debt/($25m. – Total debt) => 1.75 x ($25m. – Total debt) = Total debt
=> (1.75 x $25m.) – (1.75 x Total debt) = Total debt => $43.75m. = 2.75 x Total debt
=> Total debt = $43.75m./2.75 = $15.91m.
=> Total equity = $25m. - $15.91m. = $9.09m.

LG3 3-20 Debt Management Ratios Calculate the times interest earned ratio for LaTonya’s Flop Shops,
Inc. using the following information. Sales = $1 million, cost of goods sold = $600,000, depreciation
expense = $100,000, addition to retained earnings = $97,500, dividends per share = $1, tax rate =
30%, and number of shares of common stock outstanding = 60,000. LaTonaya’s Flop Shops has no
preferred stock outstanding.

Net sales (all credit) $1,000,000

Less: Cost of goods sold 600,000
Gross profits step 4. $400,000

Less: Depreciation 100,000

Earnings before interest and taxes (EBIT) step 5. $300,000
Less: Interest step 6. $75,000
Earnings before taxes (EBT) step 3. $225,000
Less: Taxes
Net income step 2. $157,500

Less: Common stock dividends step 1. $60,000

Addition to retained earnings $97,500

Step 1. Common stock dividends = $1 x 60,000 = $60,000

Step 2. Net income = Common stock dividends + Addition to retained earnings = $60,000 + $97,500
= $157,500

Step 3. EBT (1 – tax rate) = Net income => EBT = Net income/(1 – tax rate) = $157,500/(1-.3)
= $225,000

Step 4. Gross profits = Net sales – Cost of goods sold = $1,000,000 – $600,000 = $400,000

Step 5. Gross profits – Depreciation = EBIT = $400,000 - $100,000 = $300,000

Step 6. EBIT – Interest = EBT => Interest = EBIT - EBT = $300,000 - $225,000 = $75,000
 => Times interest earned = $300,000/$75,000 = 4.00 times

LG2 3-21 Profitability and Asset Management Ratios You are thinking of investing in Nikki T’s, Inc.
You have only the
LG4 following information on the firm at year-end 2008: net income = $250,000, total debt = $2.5 million,
debt ratio = 55%. What is Nikki T’s ROE for 2008?

Debt ratio = .55 = $2.5m./Total assets => Total assets = $2.5m/.55 = $4.545m.
=> Total equity = $4.545m. - $2.5m. = $2.045m.
=> ROE = $250,000/$2.045m. = 12.22%

LG4 3-22 Profitability Ratios Rick’s Travel Service has asked you to help piece together financial
information on the firm for the most current year. Managers give you the following information: sales
= $4.8 million, total debt = $1.5 million, debt ratio = 40%, ROE = 18%. Using this information,
calculate Rick’s ROA.

Debt ratio = .40 = $1.5m./Total assets => Total assets = $1.5m./.4 = $3.75m.
=> Total equity = $3.75m. - $1.5m. = $2.25m.
=> ROE = .18 = Net income/$2.25m. => Net income = .18 x $2.25m. = $405,000
=> ROA = $405,000/$3.75m. = 10.8%

LG5 3-23 Market Value Ratios Leonatti Labs’ year-end price on its common stock is $35. The firm has
total assets of $50 million, the debt ratio is 65%, no preferred stock, and there are 3 million shares of
common stock outstanding. Calculate the market-to-book ratio for Leonatti Labs.

Debt ratio = .65 = Total debt/$50m. => Total debt = .65 x $50m. = $32.5m.
=> Total equity = $50m. - $32.5m. = $17.5m.
=> Book value of equity = $17.5m./3/m. = $5.83333 per share
=> Market to book ratio = $35/$5.83333 = 6 times

LG5 3-24 Market Value Ratios Leonatti Labs’ year-end price on its common stock is $15. The firm has a
profit margin of 8%, total assets of $25 million, a total asset turnover ratio of 0.75, no preferred stock,
and there are 3 million shares of common stock outstanding. Calculate the PE ratio for Leonatti
Labs.

Total asset turnover = .75 = Sales/$25m. => Sales = $25m. x .75 = $18.75m.
=> Profit margin = .08 = Net income/$18.75m. => Net income = .08 x $18.75m. = $1.5m
=> EPS = $1.5m./3m. = $0.50 per share
=> PE ratio = $15/$0.50 = 30 times

LG6 3-25 DuPont Analysis Last year, Stumble-on-Inn, Inc. reported an ROE = 18%. The firm’s debt ratio
was 55%, sales were $15 million, and the capital intensity ratio was 1.25 times. Calculate the net
income for Stumble-on-Inn last year.

Capital intensity ratio = 1.25 = Total assets/$15. => Total assets = 1.25 x $15m. = $18.75m.
=> Debt ratio = .55 = Total debt/$18.75m. => Total debt = .55 x $18.75m. = $10.3125m.
 => Total equity = $18.75m. - $10.3125m. = $8.4375m.
=> ROE = .18 = Net income/$8.4375m. => Net income = .18 x $8.4375m. = $1,518,750

LG6 3-26 DuPont Analysis You are considering investing in Nuran Security Services. You have been
able to locate the following information on the firm: total assets = $16 million, accounts receivable =
$2.2 million, ACP = 25 days, net income = $2.5 million, and debt-to-equity ratio = 1.2 times.
Calculate the ROE for the firm.

Debt-to-equity = 1.2 = Total debt/Total equity = Total debt/(Total assets – Total debt)
1.2 = Total debt/(16m. – Total debt) => (1.2 x 16m.) – 1.2 x Total debt = Total debt
=> 19.2m. = 2.2 x Total debt => Total debt = 19.2m./2.2 = $8.727m.
=> Total equity = $19.2m. - $8.727. = $7.273m.
=> ROE = $2.5m./$7.273m. = 34.375%

LG6 3-27 Internal Growth Rate Dogs R Us reported a profit margin of 10.5%, total asset turnover ratio
of 0.75 times, debt-to-equity ratio of 0.80 times, net income of $500,000, and dividends paid to
common stockholders of $200,000. The firm has no preferred stock outstanding. What is Dogs R Us’
internal growth rate?

ROA = Profit Margin x Total asset turnover = 10.5% x 0.75 = 7.875%

RR = ($500,000 - $200,000)/$500,000 = .60

ROA x RR 0.07875 x .60

Internal growth rate = —————— = ——————— = 8.548%
(1-ROA) x RR (1 - 0.07875) x .60

1. Which of the following is considered a profitability measure?

a. Days sales in inventory

b. Fixed asset turnover
c. Price-earnings ratio
d. Cash coverage ratio
e. Return on Assets

2. Firm A has a Return on Equity (ROE) equal to 24%, while firm B has an ROE of 15% during
the same year. Both firms have a total debt ratio (D/V) equal to 0.8. Firm A has an asset
turnover ratio of 0.9, while firm B has an asset turnover ratio equal to 0.4. From this we know
that

a. Firm A has a higher profit margin than firm B

b. Firm B has a higher profit margin than firm A
c. Firm A and B have the same profit margin
d. Firm A has a higher equity multiplier than firm B
e. You need more information to say anything about the firm's profit margin
3. If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to 1.1,
what is the firm's Net Working Capital?

a. $0
b. $100
c. $200
d. $1,000
e. $1,200

4. To measure a firm's solvency as completely as possible, we need to consider

a. The firm's relative proportion of debt and equity in its capital structure
b. The firm's capital structure and the liquidity of its current assets
c. The firm's ability to use Net Working Capital to pay off its current liabilities
d. The firms leverage and its ability to make interest payments on its long-term debt
e. The firm leverage and its ability to turn its assets over into sales

ANSWERS:

Answer 1: e
Answer 2: b (Profit margin of firm A=5.33% and for firm B=7.5% - use Du Pont Identity)
Answer 3: CA/CL=1.2 and (CA-100)/CL=1.1 => solve and find CL=1,000 and CA=1,200=>
answer c
Answer: d

Conceptual

23. The equity multiplier can be expressed as 1 – (Debt/Assets).

a. True b. False

24. A high current ratio is always a good indication of a well-managed liquidity position.

a. True b. False

25. International Appliances Inc. has a current ratio of 0.5. Which of the following actions
would improve (increase) this ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Sell some of the existing inventory at cost.
26. Refer to Self-Test Question 25. Assume that International Appliances has a current ratio
of 1.2. Now, which of the following actions would improve (increase) this ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Use cash to pay for some fixed assets.

SELF-TEST PROBLEMS

1. Info Technics Inc. has an equity multiplier of 2.75. The company’s assets are financed
with some combination of long-term debt and common equity. What is the company’s
debt ratio?

a. 25.00% b. 36.36% c. 52.48% d. 63.64% e.

75.00%

2. Refer to Self-Test Problem 1. What is the company’s common equity ratio?

a. 25.00% b. 36.36% c. 52.48% d. 63.64% e.

75.00%

3. Cutler Enterprises has current assets equal to $4.5 million. The company’s current ratio
is 1.25. What is the firm’s level of current liabilities (in millions)?

a. $0.8 b. $1.8 c. $2.4 d. $2.9 e. $3.6

4. Jericho Motors has $4 billion in total assets. The other side of its balance sheet consists
of $0.4 billion in current liabilities, $1.2 billion in long-term debt, and $2.4 billion in
common equity. The company has 500 million shares of common stock outstanding, and
its stock price is $25 per share. What is Jericho’s market-to-book ratio?

a. 2.00 b. 4.27 c. 5.21 d. 3.57 e. 1.42

5. Taylor Toys Inc. has $6 billion in assets, and its tax rate is 35 percent. The company’s
basic earning power (BEP) is 10 percent, and its return on assets (ROA) is 2.5 percent.
What is Taylor’s times-interest-earned (TIE) ratio?
 a. 1.625 b. 2.000 c. 2.433 d. 2.750 e. 3.000

12. Lewis Inc. has sales of $2 million per year, all of which are credit sales. Its days sales
outstanding is 42 days. What is its average accounts receivable balance? Assume a 365-
day year.

a. $230,137 b. $266,667 c. $333,333 d. $350,000 e.

$366,750

13. Southeast Jewelers Inc. sells only on credit. Its days sales outstanding is 73 days, and its
average accounts receivable balance is $500,000. What are its sales for the year?
Assume a 365-day year.

a. $1,500,000 b. $2,500,000 c. $2,000,000 d. $2,750,000

e. $3,000,000

14. A firm has total interest charges of $20,000 per year, sales of $2 million, a tax rate of 40
percent, and a profit margin of 6 percent. What is the firm’s times-interest-earned ratio?

a. 10 b. 11 c. 12 d. 13 e. 14

15. Refer to Self-Test Problem 14. What is the firm’s TIE, if its profit margin decreases to
3 percent and its interest charges double to $40,000 per year?

a. 3.0 b. 2.5 c. 3.5 d. 4.2 e. 3.7

16. Wilson Watercrafts Company has $12 billion in total assets. The company’s basic earning
power (BEP) is 15 percent, and its times-interest-earned ratio is 4.0. Wilson’s depreciation
and amortization expense totals $1.28 billion. It has $0.8 billion in lease payments and
$0.4 billion must go towards principal payments on outstanding loans and long-term debt.
What is Wilson’s EBITDA coverage ratio?

a. 1.00 b. 1.33 c. 1.50 d. 2.10 e. 2.35

17. A fire has destroyed many of the financial records at Anderson Associates. You are
assigned to piece together information to prepare a financial report. You have found that
the firm’s return on equity is 12 percent and its debt ratio is 0.40. What is its return on
assets?

a. 4.90% b. 5.35% c. 6.60% d. 7.20% e. 8.40%

18. Refer to Self-Test Problem 17. What is the firm’s debt ratio if its ROE is 15 percent and
its ROA is 10 percent?
 a. 67% b. 50% c. 25% d. 33% e. 45%

19. Rowe and Company has a debt ratio of 0.50, a total assets turnover of 0.25, and a profit
margin of 10 percent. The president is unhappy with the current return on equity, and he
thinks it could be doubled. This could be accomplished (1) by increasing the profit
margin to 14 percent and (2) by increasing debt utilization. Total assets turnover will not
change. What new debt ratio, along with the 14 percent profit margin, is required to
double the return on equity?

a. 0.55 b. 0.60 c. 0.65 d. 0.70 e. 0.75

20. Altman Corporation has $1,000,000 of debt outstanding, and it pays an interest rate of 12
percent annually. Altman’s annual sales are $4 million, its federal-plus-state tax rate is 40
percent, and its net profit margin on sales is 10 percent. If the company does not
maintain a TIE ratio of at least 5 times, its bank will refuse to renew the loan, and
bankruptcy will result. What is Altman’s TIE ratio?

a. 9.33 b. 4.44 c. 2.50 d. 4.00 e. 6.56

21. Refer to Self-Test Problem 20. What is the maximum amount Altman’s EBIT could
decrease and its bank still renew its loan?

a. $186,667 b. $45,432 c. $66,767 d. $47,898 e.

$143,925

22. Pinkerton Packaging’s ROE last year was 2.5 percent, but its management has developed
a new operating plan designed to improve things. The new plan calls for a total debt ratio
of 50 percent, which will result in interest charges of $240 per year. Management
projects an EBIT of $800 on sales of $8,000, and it expects to have a total assets turnover
ratio of 1.6. Under these conditions, the federal-plus-state tax rate will be 40 percent. If
the changes are made, what return on equity will Pinkerton earn?

a. 2.50% b. 13.44% c. 13.00% d. 14.02% e.

14.57%

(The following financial statement applies to the next three Self-Test Problems.)

Baker Corporation Balance Sheet

December 31, 2002

Cash and marketable securities $ 50 Accounts payable $ 250

Accounts receivable 200 Accrued liabilities 250
Inventory 250 Notes payable 500
Total current assets $ 500 Total current liabilities $1,000
Net fixed assets 1,500 Long-term debt 250
Common stock 400
 Retained earnings 350
Total assets $2,000 Total liabilities and equity $2,000

23. What is Baker Corporation’s current ratio as of December 31, 2002?

a. 0.35 b. 0.65 c. 0.50 d. 0.25 e. 0.75

24. If Baker uses $50 of cash to pay off $50 of its accounts payable, what is its new current
ratio after this action?

a. 0.47 b. 0.44 c. 0.54 d. 0.33 e. 0.62

25. If Baker uses its $50 cash balance to pay off $50 of its long-term debt, what will be its
new current ratio?

a. 0.35 b. 0.50 c. 0.55 d. 0.60 e. 0.45

28. Dauten Enterprises is just being formed. It will need $2 million of assets, and it expects
to have an EBIT of $400,000. Dauten will own no securities, so all of its income will be
operating income. If it chooses to, Dauten can finance up to 50 percent of its assets with
debt that will have a 9 percent interest rate. Dauten has no other liabilities. Assuming a
40 percent federal-plus-state tax rate on all taxable income, what is the difference
between the expected ROE if Dauten finances with 50 percent debt versus the expected
ROE if it finances entirely with common stock?

a. 7.2% b. 6.6% c. 6.0% d. 5.8% e. 9.0%

29. Helen’s Fashion Designs recently reported net income of $3,500,000. The company has
700,000 shares of common stock, and it currently trades at $25 a share. The company
continues to expand and anticipates that one year from now its net income will be
$4,500,000. Over the next year the company also anticipates issuing an additional
100,000 shares of stock, so that one year from now the company will have 800,000 shares
of common stock. Assuming the company’s price/earnings ratio remains at its current
level, what will be the company’s stock price one year from now?

a. $25.25 b. $27.50 c. $28.125 d. $31.00 e. $33.00

30. Henderson Chemical Company has $5 million in sales. Its ROE is 10 percent and its
total assets turnover is 2.5. The company is 60 percent equity financed. What is the
company’s net income?

a. $95,750 b. $105,300 c. $110,250 d. $120,000 e.

$145,000

31. Bradberry Bolts Inc. recently reported the following information:

Net income $750,000

ROA 6%
 Interest expense $210,000

The company’s tax rate is 35 percent. What is the company’s basic earning power
(BEP)?

a. 7.25% b. 8.33% c. 9.45% d. 10.00% e. 10.91%

ANSWERS TO SELF-TEST QUESTIONS

 1. liquidity; current 14. benchmarking
2. receivable; cash 15. managers; credit analysts; stock
3. leverage analysts
4. total debt; total assets 16. fixed assets turnover
5. times-interest-earned 17. total assets turnover
6. profitability 18. balance sheet; income statement
7. profit margin 19. EBITDA coverage
8. price/earnings 20. basic earning power
9. market; book 21. equal
10. trend; industry 22. price/cash flow
11. Extended Du Pont Equation
12. margin; total assets
13. trend
SOLUTIONS TO SELF-TEST PROBLEMS

1. d. 2.75 = A/E
E/A = 1/2.75
E/A = 36.36%.

D/A = 1 – E/A
= 1 – 36.36%
= 63.64%.

2. b. From Self-Test Problem #1 above, E/A = 36.36%.

3. e. CA = $4.5 million; CA/CL = 1.25.

$4.5/CL = 1.25
1.25(CL) = $4.5
CL = $3.6 million.

4. c. TA = $4,000,000,000; CL = $400,000,000; LT debt = $1,200,000,000; CE = $2,400,000,000;

Shares outstanding = 500,000,000; P0 = $25; M/B = ?

$2,400,000,000
500,000,000
Book value = = $4.80.

$25.00
$4.80
M/B = = 5.2083  5.21.

5. a. TA = $6,000,000,000; T = 35%; EBIT/TA = 10%; ROA = 2.5%; TIE = ?

EBIT
$6,000,000,000
= 0.10
EBIT = $600,000,000.

NI
$6,000,000,000
= 0.025
NI = $150,000,000.

Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.
INT = EBIT – EBT
EBIT $600,000,000 See above. = $600,000,000 –
$230,769,231
 INT 369,230,769
EBT $230,769,231EBT = $150,000,000/0.65
Taxes (35%) 80,769,231
NI $150,000,000 See above.

TIE = EBIT/INT
= $600,000,000/$369,230,769
= 1.625.

Current assets $1,070

Current ratio = = = 1.44.
Current liabilitie s $745
6. c.

Sales $2,400
Inventory turnover = = = 3.84.
Inventory $625
7. a.

Sales $2,400
Fixed assets turnover = = = 2.00.
Net fixed assets $1,200

Sales $2,400
Total assets turnover = = = 1.06.
Total assets $2,270

Accounts receivable $245

DSO = = = 37.26 days .
Sales/ 365 $2,400 / 365

8. d. Debt ratio = Total debt/Total assets = $1,165/$2,270 = 0.51 = 51%.

TIE ratio = EBIT/Interest = $175/$35 = 5.00.

Net income $84

Profit margin = = = 0.0350 = 3.50%.
Sales $2,400
9. b.

Net income $84

ROA = = = 0.0370 = 3.70%.
Total assets $2,270
Net income $84
ROE    0.0760  7.60%.
Common equity $1,105
 EBIT $175
BEP    0.0771  7.71%.
Total assets $2,270

Net income $84,000

EPS = = = $8.40.
Number of shares outstanding 10,000
10. e.

Price $40.00
EPS $8.40
P/E ratio = = = 4.76.

Net income  Depreciati on $84,000  $80,000

Number of shares outstandin g 10,000
Cash flow/share = = = $16.40.

$40.00
$16.40
Price/cash flow = = 2.44.

Market price $40(10,000)

Market/ Book value = = = 0.36.
Book value $1,105,000

11. d. ROE = Profit margin × Total assets turnover × Equity multiplier

$84 $2,400 $2,270
  = 0.035  1.057  2.054
$2,400 $2,270 $1,105
=
= 0.0760 = 7.60%.

Accounts receivable
Sales/ 365
12. a. DSO =
AR
$2,000,000 / 365
42 days =
AR = $230,137.

13. b. DSO = Accounts receivable/(Sales/365)

73 days = $500,000/(Sales/365)
73(Sales/365) = $500,000
Sales = $2,500,000.
14. b. Net income = $2,000,000(0.06) = $120,000.

Earnings before taxes = $120,000/(1 – 0.4) = $200,000.

EBIT = $200,000 + $20,000 = $220,000.

TIE = EBIT/Interest = $220,000/$20,000 = 11.

15. c. Net income = $2,000,000(0.03) = $60,000.

Earnings before taxes = $60,000/(1 – 0.4) = $100,000.

EBIT = $100,000 + $40,000 = $140,000.

TIE = EBIT/Interest = $140,000/$40,000 = 3.5.

16. e. TA = $12,000,000,000; EBIT/TA = 15%; TIE = 4; DA = $1,280,000,000; Lease payments =

$800,000,000; Principal payments = $400,000,000; EBITDA coverage = ?

EBIT/$12,000,000,000 = 0.15
EBIT = $1,800,000,000.

4 = EBIT/INT
4 = $1,800,000,000/INT
INT = $450,000,000.

EB
ITDA = EBIT + DA
= $1,800,000,000 + $1,280,000,000
= $3,080,000,000.

EBITDA  Lease payments

INT  Princ. pmts  Lease pmts
EBITDA coverage ratio =
$3,080,000,000  $800,000,000
$450,000,000  $400,000,000  $800,000,000
=
$3,880,000,000
$1,650,000,000
= = 2.3515  2.35.

17. d. If Total debt/Total assets = 0.40, then Total equity/Total assets = 0.60, and the equity
multiplier (Assets/Equity) = 1/0.60 = 1.667.
 NI NI A
E A E
= 
ROE = ROA × EM
12% = ROA × 1.667
ROA = 7.20%.

18. d. ROE = ROA × Equity multiplier

15% = 10% × TA/Equity
1.5 = TA/Equity.

Equity/TA = 1/1.5 = 0.67.

Debt/TA = 1 – Equity/TA = 1 – 0.67 = 0.33 = 33%.

19. c. If Total debt/Total assets = 0.50, then Total equity/Total assets = 0.50 and the equity
multiplier (Assets/Equity) = 1/0.50 = 2.0.

ROE = PM × Total assets turnover × EM.

Before: ROE = 10% × 0.25 × 2.00 = 5.00%.

After: 10.00% = 14% × 0.25 × EM; thus EM = 2.8571.

Assets
Equity
Equity multiplier =
1
Equity/ Assets
2.8571 =
0.35 = Equity/Assets.

Debt/TA = 1 – Equity/TA = 100% – 35% = 65%.

20. e. TIE = EBIT/Interest, so find EBIT and Interest.

Interest = $1,000,000(0.12) = $120,000.

Net income = $4,000,000(0.10) = $400,000.

Pre-tax income = $400,000/(1 – T) = $400,000/0.6 = $666,667.

EBIT = $666,667 + $120,000 = $786,667.

TIE = $786,667/$120,000 = 6.56×.

21. a. TIE = EBIT/INT
5 = EBIT/$120,000
 EBIT = $600,000.

From Self-Test Problem #20, EBIT = $786,667, so EBIT could decrease by $786,667 –
$600,000 = $186,667.

22. b. ROE = Profit margin × Total assets turnover × Equity multiplier

= NI/Sales × Sales/TA × TA/Equity.

Now we need to determine the inputs for the 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) $8,000

Cost NA
EBIT (given) $ 800
Interest (given) 240
EBT $ 560
Taxes (40%) 224
Net income $ 336

Now we can use some ratios to get some more data:

Total assets turnover = S/TA = 1.6 (given).

D/A = 50%, so E/A = 50%, and therefore TA/E = 1/(E/A) = 1/0.5 = 2.00.

Now we can complete the Extended Du Pont Equation to determine ROE:

ROE = $336/$8,000  1.6  2.0 = 13.44%.

23. c. Baker Corporation’s current ratio equals Current assets/Current liabilities = $500/$1,000
= 0.50.
24. a. Baker Corporation’s new current ratio equals ($500 – $50)/($1,000 – $50) = $450/$950 =
0.47.

25. e. Only the current assets balance is affected by this action. Baker’s new current ratio =
($500 – $50)/$1,000 = $450/$1,000 = 0.45.

26. d. Whitney’s BEP ratio equals EBIT/Total assets = $300/$750 = 40%.

Whitney’s ROA equals Net income/Total assets = $165/$750 = 22%.

27. b. Cotner’s BEP ratio equals EBIT/Total assets = $300/$1,250 = 24%.

Cotner’s ROA equals Net income/Total assets = $160/$1,250 = 12.8%.

28. b. Known data: Total assets = $2,000,000; EBIT = $400,000; kd = 9%, T = 40%.

D/A = 0.5 = 50%, so Equity = 0.5($2,000,000) = $1,000,000.

D/A = 0% D/A = 50%

EBIT $400,000 $400,000
Interest 0 90,000*
Taxable income $400,000 $310,000
Taxes (40%) 160,000 124,000
Net income (NI) $240,000 $186,000

*If D/A = 50%, then half of assets are financed by debt, so Debt = 0.5($2,000,000) =
$1,000,000. At a 9 percent interest rate, INT = 0.09($1,000,000) = $90,000.

For D/A = 0%, ROE = NI/Equity = $240,000/$2,000,000 = 12%. For D/A = 50%, ROE
= $186,000/$1,000,000 = 18.6%. Difference = 18.6% – 12.0% = 6.6%.

29. c. The current EPS is $3,500,000/700,000 shares or $5.00. The current P/E ratio is then
$25/$5 = 5.00. The new number of shares outstanding will be 800,000. Thus, the new EPS
= $4,500,000/800,000 = $5.625. If the shares are selling for 5 times EPS, then they must be
selling for $5.625(5) = $28.125.

30. d. Step 1: Calculate total assets from information given.

Sales = $5 million.

2.5 = Sales/TA
$5,000,000
Assets
2.5 =
Assets = $2,000,000.
Step 2: Calculate net income.
There is 40% debt and 60% equity, so Equity = $2,000,000  0.6 = $1,200,000.

ROE = NI/S  S/TA  TA/E

0.10 = NI/$5,000,000  2.5  $2,000,000/$1,200,000
4.1667( NI)
$5,000,000
0.10 =
$500,000 = 4.1667(NI)
$120,000 = NI.

31. e. Given ROA = 6% and net income of $750,000, then total assets must be $12,500,000.
 NI
TA
ROA =
$750,000
TA
6% =
TA = $12,500,000.

To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement:

EBIT $1,363,846($210,000 + $1,153,846)

Interest 210,000 (Given)
EBT $1,153,846 $750,000/0.65
Taxes (35%) 403,846
NI $ 750,000

EBIT
TA
BEP =
$1,363,846
$12,500,000
=
= 0.1091 = 10.91%.