Essay 1 - DuPont Analysis and Leverage

This study unit contains 3 essays, each with a unique scenario and multiple relevant
questions.

Suggested
Scenario Question
Time
1 1-7 30 minutes

All questions are required.

Calculations in support of numerical answers must be presented. Credit will not be

awarded for numerical answers for which there are no supporting calculations.

Firms employ different strategies in the pursuit of profit, with successful strategies often
dictated by the type of industries and markets in which the firms operate. Listed below
are selected entries from the financial reports of two firms (labeled “A” and “B”).
Firm A (in € millions)
Income Statements Items Balance Sheet Items
Net sales 120 Assets 273
Cost of goods sold 48 Liabilities 200
Selling, general and admin. expenses 18 Shareholders’ equity 73
Depreciation 6
Interest expense 23
Taxes 8
Firm B (in € millions)
Income Statements Items Balance Sheet Items
Net sales 74 Assets 168
Cost of goods sold 25 Liabilities 84
Selling, general and admin. expenses 11 Shareholders’ equity 84
Depreciation 2
Interest expense 10
Taxes 7
The DuPont approach provides a useful way to compare the financial performance of
firms.
A. What are two advantages of using the DuPont approach?

A. Calculate return on equity for both firms using the DuPont formula.

A. Calculate each firm’s debt to equity ratio.

A. Discuss how the use of leverage affects the financial risk of the firms.

A. Discuss why the use of higher levels of financial leverage may be

appropriate for some firms but too risky for others.

A. One firm uses a higher degree of financial leverage, and yet their return
on equity is similar to that of the other firm. Discuss the other factors
that impact return on equity with respect to Firms A and B.

A. Identify two limitations of financial ratio analysis.

Essay 2 - Ratio Analysis

This study unit contains 3 essays, each with a unique scenario and multiple relevant
questions.

Suggested
Scenario Question
Time
1 1-3 30 minutes

All questions are required.

Calculations in support of numerical answers must be presented. Credit will not be

awarded for numerical answers for which there are no supporting calculations.

Easecom Company is a manufacturer of highly specialized products for networking

video-conferencing equipment. Production of specialized units is, to a large extent,
performed under contract, with standard units manufactured to marketing projections.
Maintenance of customer equipment is an important area of customer satisfaction. With
the recent downturn in the computer industry, the video-conferencing equipment
segment has suffered, causing a slide in Easecom’s performance. Easecom’s income
statement for the fiscal year ended October 31, Year 1, is presented below.
Easecom Company
Income Statement
For the Year Ended October 31, Year 1
($000 omitted)
Net sales:
Equipment $6,000
Maintenance contracts 1,800
Total net sales $7,800
Expenses:
Cost of goods sold $4,600
Customer maintenance 1,000
Selling expense 600
Administrative expense 900
Interest expense 150
Total expenses $7,250
Income before income taxes $ 550
Income taxes 220
Net income $ 330
Easecom’s return on sales before interest and taxes was 9% in Fiscal Year 1, while the
industry average was 12%. Easecom’s total asset turnover was three times, and its
return on average assets before interest and taxes was 27%, both well below the
industry average. In order to improve performance and raise these ratios near to, or
above, industry averages, Bill Hunt, Easecom’s president, established the following
goals for Fiscal Year 2:
• Return on sales before interest and taxes 11%
• Total asset turnover 4 times
• Return on average assets before interest and taxes 35%
To achieve Hunt’s goals, Easecom’s management team took into consideration the
growing international video-conferencing market and proposed the following actions for
Fiscal Year 2:
• Increase equipment sales prices by 10%.

• Increase the cost of each unit sold by 3% for needed technology and quality improvements, and
increased variable costs.

• Increase maintenance inventory by $250,000 at the beginning of the year and add two
maintenance technicians at a total cost of $130,000 to cover wages and related travel expenses.
These revisions are intended to improve customer service and response time. The increased
inventory will be financed at an annual interest rate of 12%; no other borrowings or loan
reductions are contemplated during Fiscal Year 2. All other assets will be held to Fiscal Year 1
levels.

• Increase selling expenses by $250,000 but hold administrative expenses at Year 1 levels.

• The effective rate for Year 2 federal and state taxes is expected to be 40%, the same as Year 1.

It is expected that these actions will increase equipment unit sales by 6%, with a
corresponding 6% growth in maintenance contracts.
A. Prepare a pro forma income statement for Easecom Company for the
fiscal year ending October 31, Year 2, on the assumption that the
proposed actions are implemented as planned and that the increased
sales objectives will be met. (All numbers should be rounded to the
nearest thousand, i.e., $000 omitted.)

A. Calculate the following ratios for Easecom Company for Fiscal Year 2
and determine whether Bill Hunt’s goals will be achieved:
a. Return on sales before interest and taxes
b. Total asset turnover
c. Return on average assets before interest and taxes

A. Discuss the limitations and difficulties that can be encountered in using

ratio analysis, particularly when making comparisons to industry
averages.
Essay 3 - Ratios and Financing\

This study unit contains 3 essays, each with a unique scenario and multiple relevant
questions.

Suggested
Scenario Question
Time
1 1-4 30 minutes

All questions are required.

Calculations in support of numerical answers must be presented. Credit will not be

awarded for numerical answers for which there are no supporting calculations.

Warford Corporation was formed 5 years ago through a public subscription of common
stock. Lucinda Street, who owns 15% of the common stock, was one of the organizers
of Warford and is its current president. The company has been successful but is
currently experiencing a shortage of funds. On June 10, Street approached the Bell
National Bank, asking for a 12-month extension on two $30,000 notes, which are due
on June 30, Year 5, and September 30, Year 5. Another note of $7,000 is due on
December 31, Year 5, but she expects no difficulty in paying this note on its due date.
Street explained that Warford’s cash flow problems are due primarily to the company’s
desire to finance a $300,000 plant expansion over the next 2 fiscal years through
internally generated funds.
The Commercial Loan Officer of Bell National Bank requested financial reports for the
last 2 fiscal years. These reports are reproduced below.
Warford Corporation
Income Statement
For the Fiscal Years Ended March 31
Year 4 Year 5
Sales $2,700,000 $3,000,000
Cost of goods sold* 1,720,000 1,902,500
Gross margin $ 980,000 $1,097,500
Operating expenses 780,000 845,000
Net income before taxes $ 200,000 $ 252,500
Income taxes (40%) 80,000 101,000
Income after taxes $ 120,000 $ 151,500
*Depreciation charges on the plant and equipment of $100,000 and $102,500
for fiscal years ended March 31, Year 4 and Year 5, respectively, are included
in cost of goods sold.
Warford Corporation
 Statement of Financial Position
March 31
Year 4 Year 5
Assets:
Cash $ 12,500 $ 16,400
Notes receivable 104,000 112,000
Accounts receivable (net) 68,500 81,600
Inventories (at cost) 50,000 80,000
Plant and equipment (net of depreciation) 646,000 680,000
Total assets** $881,000 $970,000
Liabilities and Owners’ Equity:
Accounts payable $ 72,000 $ 69,000
Notes payable 54,500 67,000
Accrued liabilities 6,000 9,000
Common stock (60,000 shares, $10 par) 600,000 600,000
Retained earnings*** 148,500 225,000
Total liabilities and owners’ equity $881,000 $970,000
**Total assets at the end of Year 4 was the same as at the end of Year 3.
***Cash dividends were paid at the rate of $1.00 per share in fiscal Year 4 and
$1.25 per share in fiscal Year 5.

A. Calculate the following items for Warford Corporation:

a. Current ratio for fiscal Year 4 and Year 5.
b. Acid-test (quick) ratio for fiscal Year 4 and Year 5.
c. Percentage change in sales, cost of goods sold, gross margin,
and net income after taxes from fiscal Year 4 to Year 5.

A. Identify and explain what other financial reports and/or financial

analyses might be helpful to the commercial loan officer of Bell National
Bank in evaluating Street’s request for a time extension on Warford’s
notes.

A. Assume that the percentage changes experienced in fiscal year Year 5

as compared with fiscal year Year 4 for sales, cost of goods sold, and
gross margin will be repeated in each of the next 2 years. Show the
calculations necessary to determine whether Warford’s desire to finance
the plant expansion from internally generated funds is realistic.
A. Should Bell National Bank grant the extension on Warford’s notes
considering Street’s statement about financing the plant expansion
through internally generated funds? Explain your answer.