Chapter 3

DISCUSSION QUESTIONS

Question1: If we divide users of ratios into short-term lenders, long-term lenders, and shareholders,
which ratios would each group be most interested in, and for what reasons? (LO5)

Answer: Short-term Lenders would be mostly concerned with liquidity because their concern is with the
firm's ability to pay short-term obligations as they come due.

Long-term lenders - leverage since they are interested in how debt is related to total assets. They also
will examine profitability to ensure that interest payments can be made.

Shareholders - profitability, with secondary consideration given to debt utilization, liquidity, and other
ratios. As shareholders are the ultimate owners of the firm, their primary focus is on profits and the
returns on the investments.

Question 2: Inflation can have significant effects on income statements and balance sheets and,
therefore,
on the calculation of ratios. Discuss the possible impact of inflation on the following ratios and
explain the direction of the impact according to your assumptions. (LO6)
a. Return on investment
b. Inventory turnover
c. Capital asset turnover
d. Debt-to-assets ratio

Answer: a. Return on investment = Net income

Total assets

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

b. Inventory turnover = Sales or COGS

Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also
reflect "inflation-influenced" dollars and the net effect will be nil.

If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio
could be reported.

c. Capital asset turnover = Sales

Capital assets

Capital assets will be understated relative to sales and too high a ratio could be reported.
 d. Debt to total assets = Total debt
Total assets

Since both are based on historical costs, no major inflationary impact will take place in the ratio.
Assets are likely understated, however, causing ratio to be overstated.

Question3: Explain how the DuPont system of analysis breaks down ROA. Also explain how it breaks
down return on shareholders’ equity.

Answer: The return on assets is divided by the profit margin and asset turnover in the Du Pont system of
analysis.

ROA = Profit Margin × Asset Turnover

Net income = Net income × Sales

Total assets Sales Total assets

This allows us to evaluate the combined effect of asset turnover and profitability on the total return on
assets. Because it allows us to identify the sources of a firm's strengths and weaknesses, this study is quite
helpful. For instance, a business in the capital goods sector can have a high profit margin but a slow asset
turnover, whereas a company that processes food might have a low-profit margin but a quick asset
turnover.

The modified Du Pont formula shows:

ROE = ROA × Equity multiplier

Return on equity = Return on assets (investment) × Total assets

Equity
This suggests that return on assets, the debt-to-assets ratio, or a combination of the two may have an
impact on return on shareholders' equity. Analysts or investors should be particularly sensitive to a
high return on shareholders' equity that is influenced by large amounts of debt.

Question 4: What advantage does the fixed charge coverage ratio offer over simply using times interest
earned? (LO5)
Answer: The fixed charge coverage ratio measures the firm's ability to meet all fixed obligations rather
than interest payments alone, on the assumption that failure to meet any financial obligation will
endanger the position of the firm.

Question 5: How would our analysis of profitability ratios be distorted if we used income before taxes?
Income before interest and taxes?
Answer: In both instances, we would not reflect a very significant cost of doing business. But, one could
argue that, to the extent that differential tax rates of financing plans (and associated interest costs) did
not reflect the operating capability of the firm, omission of these changes could provide new insights

Question 6: Is there any validity in rule-of-thumb ratios for all corporations—for example, a current
ratio
of 2 to 1 or debt to assets of 50 percent? (LO3)

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

Question 7: Why is trend analysis helpful in analyzing ratios? What are the problems of trend analysis
when different bases of accounting are applied to different years? (LO4)

Answer: The ability to compare financial data across time and identify trends, tendencies, and
performance changes makes trend analysis useful when assessing ratios. It provides information about a
company's financial health and performance patterns by assisting in determining if ratios are getting
better, getting worse, or staying the same.
Nevertheless, issues occur when various accounting bases are used for various years. The trends may be
distorted by this irregularity in accounting practices, which also makes it difficult to evaluate the
company's financial success and position over time. It may result in false comparisons and inferences
regarding the performance trends and financial health of the organization.

Question 8: What effect will disinflation (after a high inflationary period) have on the reported income
of the firm?

Answer: After a time of strong inflation, disinflation usually has a favorable impact on a firm's reported
income. This is due to the possibility of exaggerated costs for items supplied and other expenses during
times of strong inflation, which lowers reported earnings. During a disinflation, prices stabilize or fall,
which lessens the effect of inflation on costs and raises the company's reported income.

Question 9: Why might disinflation prove to be favourable to financial assets?

Answer: Because earlier inflationary pressures may no longer have a significant impact on the dollar's
purchasing power. Lower inflation also means that investors' necessary return on financial assets will be
lower, which should result in a higher current valuation for future earnings or interest.

Question 10: Comparing the incomes of two companies can be very difficult even though they sell the
same products in equal volume. Why?

Answer: According to CPA Canada, the accounting profession accepts a wide range of financial reporting
methodologies. The implementation of IFRS (public firms) and ASPE (private firms) should result in more
accurate comparisons of statements among companies that follow the same accounting rules. Despite
the industry's efforts to provide uniform norms and practices, the reporting business still has a variety of
possibilities. Each item on the income statement and balance sheet must be carefully examined. Two
seemingly similar companies may have differing values for sales, R&D, unusual losses, and a variety of
other metrics.

PROBLEMS SOLVING QUESTIONS:

Question 4: Diet Health Foods Inc. has two divisions. Division A has a profit of $100,000 on sales of
$2,000,000. Division B is able to make only $25,000 on sales of $300,000. On the basis
of profit margin, which division is superior?

Answer: Diet Health Foods Inc.

Division A:
Profit margin = Net income / Sales
= $100,000 / $2,000,000 = 5%
Division B:
Profit margin = Net income / Sales
= $25,000 / $300,000 = 8.33%

Division B is superior in terms of profit margin with 8.33% against Division A's profit margin of
5.00%.

Question 8: Hugh Snore Bedding has assets of $400,000 and turns over its assets 1.5 times per year.
ROA is 12 percent. What is the firm’s profit margin?

Answer: Hugh Snore Bedding

Sales = Total assets × total asset turnover

= $400,000 × 1.5
= $600,000

Net income = Total assets × return on assets

= $400,000 × 12%
= $48,000
Profit margin = Net income / Sales
= $48,000 / $600,000
= 0.08
= 8.0%

Question 12: Global Healthcare Products has the following ratios compared to its industry for 20XX.
Global Healthcare Industry
Return on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2% 10%=
Return on assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18% 12%
Explain, with supporting calculations, why the return-on-assets ratio is so much more
favourable than the return-on-sales ratio, compared to the industry.

Answer: The Healthcare Globe has a higher asset turnover ratio over the Industry
ROA= Asset turnover * Profit margin
Asset turnover ratio= ROA divided by profit margin= 18%/2%=9*versus 12%/10%=1.2*

Question 16: Pony Express Company has $750,000 in assets and $300,000 of debt. The income for the
year
is $55,000.
a. Calculate the ROA.
b. Determine the return on shareholders’ equity.
c. If the asset turnover ratio is 2.2 times, what is the profit margin?

Answer:
a. ROA = $55,000/$750,000 = 0.733 = 7.3%
b. Equity Multipler = $750,000/$450,00 = 1.67
ROE = ROA * Equity Multipler = 7.3% * 1.67 = 12.22%
c. Sales = $750,00 * 2.2 = 1,650,000
Profit margin = %55,000/$1,650,000 =3.3%

Question 20: A firm has sales of $1.2 million, and 10 percent of the sales are for cash. The year-end
accounts receivable balance is $360,000. What is the average collection period?

Answer: A Firm

Average collection Period = Accounts receivable

Average daily credit sales
= $360,000
($1,200,000 * 90%)/365
= $360,000 = 122 days
$2,959

Question 24: Jim Kovacs Company makes supplies for schools. Sales in 20XX were $4,000,000. Assets
were as follows:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Net plant and equipment . . . . . . . . . . . . . . . . . . . . . . . 500,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000

a. Compute the following:

1. Accounts receivable turnover
2. Inventory turnover
3. Capital asset turnover
4. Total asset turnover

b. In 20XY, sales increased to $5,000,000 and the assets for that year were as follows:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Accounts receivable . . . . . . . . . . . . . 900,000
Inventory . . . . . . . . . . . . . . . . . . . . . . 975,000
Net plant and equipment . . . . . . . . . . 550,000
Total assets . . . . . . . . . . . . . . . . . . . . $2,525,000
Compute the same four ratios as in part a.
c. Indicate if there is an improvement or decline in total asset turnover, and based on the
other ratios, explain the reasons this development has taken place.
Answer:
A 1. Accounts receivable turnover = Sales/Accounts Receivable
=$4,000,000/ $800,000
=5x

2. Inventory turnover = Sales/Inventory

=$4,000,000/ $400,000
=10x

3. Fixed asset turnover = Sales/ (Net Plant & Equipment)

=$4,000,000/ $500,000
=8x

4. Total asset turnover = Sales/Total Assets

=$4,000,000/ $1,800,000
=2.22x

B 1. Accounts receivable turnover

=$5,000,000/ $900,000
=5.56x

2. Inventory turnover
=$5,000,000/ $975,000
=5.x

3. Fixed asset turnover

=$5,000,000/ $550,000
=9.09x

4. Total asset turnover

=$5,000,000/ $2,525,000
=1.98x

Question 28: Century Plaza Enterprises has three subsidiaries:

Grand Vista Bronte Caledon
Sales $16,000,000 $4,000,000 $8,000,000
Net income after tax 1,000,000 160,000 600,000
Assets 5,000,000 2,000,000 5,000,000
a. Which subsidiary has the lowest return on sales?
b. Which subsidiary has the highest ROA?
c. Calculate the ROA for the whole company.
d. If Century Plaza sells the $5,000,000 investment in Caledon and reinvests same amount in
Grand Vista at the same rate of ROA as currently in Grand Vista, calculate the new ROA
for the whole company.

Answer: Century Plaza Enterprises

A. Net income/Sales =Grand Vista/6.25% Bronte/4.0% Caledon/7.50%

The Bronte division has the lowest return on sales

B. Net income/total assets =Grand Vista/20.00% Bronte/8.00% Caledon/12.00%

The Grand Vista Has the highest Return on assets.

C. corporate net income =$1,000,00+$160,000+$600,000=$1,760,000

Corporate total assets=$5,000,000+$2,000,000+$5,000,000=$12,000,000
ROA=Net income/Total asseta=$1,760,000/$12,000,000=0.1467=14.67%

D. Return on the redeployed assests in Grand Vista

20%*$5,000,000=$1,000,000

Return on assests for the entire corporation

New corporation net income=$1,000,000+$160,000+$1,000,000=$2,160,000
ROA=Net income/Total assests=$2,160,000/$12,000,000=0.1800=18%

Question 32: The United World Corporation has three subsidiaries.

Computers Magazines Cable TV

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000,000 $4,000,000 $8,000,000
Net income (after taxes) . . . . . . . . . . . . . . . . . 1,000,000 160,000 600,000
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000 2,000,000 5,000,000
a. Which division has the lowest return on sales?
b. Which division has the highest ROA?
c. Compute the ROA for the entire corporation.
d. If the $5,000,000 investment in the cable TV division is sold and redeployed in the
computer subsidiary at the same rate of ROA currently achieved in the computer division,
what will be the new ROA for the entire corporation?

Answer:
a. Net income/ sales =
computers – 6.25%
Magazines - 4.0%
Cable tv - 7.5%
- magazines have the lowest return on sales

b. Net income/ total assets

Computers – 20%
Magazines – 8%
Cable tv – 12%
- computer division has highest ROA
c. Corporate income = 1.000.000 + 160,000 + 600,000 = 1,760,000
Corporate total assets = 5,000,000 + 2,000,000 + 5,000,000 = 12,000,000
ROA = $1,760,000 /$ 12,000,000 = 14.67%

d. Return on redeployed assets in computers:

20%  $5,000,000 = $1,000,000
Return on assets for the entire corporation:
New corporate net income = $1,000,000 + $160,000 + $1,000,000
= $2,160,000
ROA = 2,160,000/12,000,000 = 18%

Question 36. We are given the following information for Pettit Corporation.
Sales (credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 850,000
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . 700,000
Asset turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.25 times
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.50 times
Debt-to-assets ratio. . . . . . . . . . . . . . . . . . . . . . . 40%
Receivables turnover . . . . . . . . . . . . . . . . . . . . . . 6 times
Current assets are composed of cash, marketable securities, accounts receivable, and
inventory. Calculate the following balance sheet items:
a. Accounts receivable
b. Marketable securities
c. Capital assets
d. Long-term debt

Answer:
a. Accounts receivable = Sales/ receivables turnover
= $3,000,000/ 6× = $500,000

b. Current Assets = Current ratio * current liabilities

= 2.5 * $700,000 = $1,750,000

c. Capital assets = Total assets - current assets

Total assets = Sales/ asset turnover

= $3,000,000/ 1.25x
= $2,400,000

Capital assets = $2,400,000 - $1,750,000

= $650,000

d. Total debt = Debt to assets * total assets

= 40% * $2,400,000
= $960,000

Long-term debt = Total debt - current liabilities

= $960,000 - $700,000
= $260,000

Question 40: The financial statements for Jones Corporation and Smith Corporation are
shown below.
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 corporation would you buy shares? Why?

Answer: 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
Total current assets . . . . . . . . 150,000 Total liabilities 180,000
Long-Term Assets Shareholders’ Equity
Capital assets . . . . . . . . . . . . . . . 500,000 Common stock . . . . . . . . . . . . . . . . . . 220,000
Acc. amortization . . . . . . . . . 150,000 Retained earnings . . . . . . . . . . . . . . . . 100,000
Net capital assets . . . . . . . . . . . . 350,000

$500,000 $500,000

Sales (on credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,250,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Selling and administrative expense* . . . . . . . . . . . . . . . . . . . . 257,000
Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Earnings before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185,000
Tax expense (50%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92,500
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 92,500
*Includes $7,000 in lease payments.
Note: Jones Corporation has 75,000 shares outstanding.

SMITH CORPORATION
Current Assets Liabilities
Cash . . . . . . . . . . . . . . . . . . . . . . . $ 35,000 Accounts payable . . . . . . . . . . . . $ 75,000
Marketable securities . . . . . . . . . 7,500 Bonds payable @ 10%
Accounts receivable . . . . . . . . . . 70,000 (long-term) . . . . . . . . . . . . . . . . . 210,000
Inventory . . . . . . . . . . . . . . . . . . . 75,000
Total current assets . . . . . . . . . 187,500 Total liabilities . . . . . . . . . . . . . . 285,000
Long-Term Assets Shareholders’ Equity
Capital assets . . . . . . . . . . . . . . . . 500,000 Common stock . . . . . . . . . . . . . . 105,000
Acc. amortization . . . . . . . . . . 250,000 Retained earnings . . . . . . . . . . . . 47,500
Net capital assets . . . . . . . . . . . . . 250,000

$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
Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Earnings before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105,000
Tax expense (50%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,500
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 52,500

*Includes $7,000 in lease payments.Note: Smith Corporation has 75,000 shares outstanding.
Ans, One way of analysing the situation for each company is to compare the respective ratios for each
one,examing those ratios which would be most important to a supplier or short term lender and a
shareholder.

Jones Corporation Smith corporation

Profit margin 7.4% 5.25%

Return on assets investments 18.5% 12.0%

Return on equity 28.9% 34.4%
Receivable turnover 15.6% 14.3*
Average collection period 23.4days 25.6 days
Inventory turnover 15*or25* 8*or 13.3*
Inventory holding period 24.3 days 45.6 days
Accounts payable turnover 7.5* 8*
Accounts payable period 49 days 46 days
Capital asset turnover 3.57* 4*
Total, asset turnover 2.5* 2.28*
Current ratio 1.5* 2.5*
Quick ratio 1.0* 1.5*
Debt to total assets 36% 65%
Times interest earned 24.12* 6*
Fixed charge coveraged 13.33* 4.75*
Fixed charged calculation 200/15 133/28

a. Since suppliers and short-term lenders are particularly concerned with liquidity ratios,
Smith Corporation has the best ratios in this category.One may argue, however, that Smith
benefited from having debt that was predominantly long-term rather than short-
term.Nonetheless, it appears to have more favorable liquidity ratios.
b. Shareholders are primarily interested about profitability.In this category, Jones
Corporation has significantly better ratios than Smith Corporation.Smith Corporation has a
higher return on equity than Jones Corporation, but this is owing to its significantly greater
usage of debt.It has a better return on equity than Jones Corporation since it has taken on
more financial risk.In terms of other ratios, Jones Corporation's interest and fixed charges
are adequately covered, and its long-term ratios and prognosis are superior to Smith
Corporation's.Jones Corporation has asset utilization ratios that are similar to or better than
Smith Corporation, and its lender liquidity ratios may represent superior short-term asset
management, as was discussed in Part A.