Chapter 4

Analysis of Financial Statements

ANSWERS TO END-OF-CHAPTER QUESTIONS

3-1 The emphasis of the various types of analysts is by no means uniform

nor should it be. Management is interested in all types of ratios for
two reasons. First, the ratios point out weaknesses that should be
strengthened; second, management recognizes that the other parties are
interested in all the ratios and that financial appearances must be
kept up if the firm is to be regarded highly by creditors and equity
investors. Equity investors are interested primarily in profitability,
but they examine the other ratios to get information on the riskiness
of equity commitments. Long-term creditors are more interested in the
debt, TIE, and EBITDA coverage ratios, as well as the profitability
ratios. Short-term creditors emphasize liquidity and look most
carefully at the current ratio.

3-2 The inventory turnover ratio is important to a grocery store because of

the much larger inventory required and because some of that inventory
is perishable. An insurance company would have no inventory to speak
of since its line of business is selling insurance policies or other
similar financial products--contracts written on paper and entered into
between the company and the insured. This question demonstrates that
the student should not take a routine approach to financial analysis
but rather should examine the business that he or she is analyzing.

3-3 Given that sales have not changed, a decrease in the total assets
turnover means that the company’s assets have increased. Also, the
fact that the fixed assets turnover ratio remained constant implies
that the company increased its current assets. Since the company’s
current ratio increased, and yet, its cash and marketable securities
and DSO are unchanged means that the company has increased its
inventories.

3-4 Differences in the amounts of assets necessary to generate a dollar of

sales cause asset turnover ratios to vary among industries. For
example, a steel company needs a greater number of dollars in assets to

Answers and Solutions: 3 - 1

 produce a dollar in sales than does a grocery store chain. Also,
profit margins and turnover ratios may vary due to differences in the
amount of expenses incurred to produce sales. For example, one would
expect a grocery store chain to spend more per dollar of sales than
does a steel company. Often, a large turnover will be associated with
a low profit margin, and vice versa.

3-5 Inflation will cause earnings to increase, even if there is no increase

in sales volume. Yet, the book value of the assets that produced the
sales and the annual depreciation expense remain at historic values and
do not reflect the actual cost of replacing those assets. Thus, ratios
that compare current flows with historic values become distorted over
time. For example, ROA will increase even though those assets are
generating the same sales volume.
When comparing different companies, the age of the assets will
greatly affect the ratios. Companies with assets that were purchased
earlier will reflect lower asset values than those that purchased
assets later at inflated prices. Two firms with similar physical
assets and sales could have significantly different ROAs. Under
inflation, ratios will also reflect differences in the way firms treat
inventories. As can be seen, inflation affects both income statement
and balance sheet items.

3-6 ROE, using the Du Pont equation, is the return on assets multiplied by the
equity multiplier. The equity multiplier, defined as total assets divided
by owners’ equity, is a measure of debt utilization; the more debt a firm
uses, the lower its equity, and the higher the equity multiplier. Thus,
using more debt will increase the equity multiplier, resulting in a higher
ROE.

3-7 a. Cash, receivables, and inventories, as well as current liabilities,

vary over the year for firms with seasonal sales patterns.
Therefore, those ratios that examine balance sheet figures will vary
unless averages (monthly ones are best) are used.

b. Common equity is determined at a point in time, say December 31,

2002. Profits are earned over time, say during 2002. If a firm is
growing rapidly, year-end equity will be much larger than beginning-
of-year equity, so the calculated rate of return on equity will be
different depending on whether end-of-year, beginning-of-year, or
average common equity is used as the denominator. Average common
equity is conceptually the best figure to use. In public utility
rate cases, people are reported to have deliberately used end-of-
year or beginning-of-year equity to make returns on equity appear
excessive or inadequate. Similar problems can arise when a firm is
being evaluated.

3-8 Firms within the same industry may employ different accounting
techniques that make it difficult to compare financial ratios. More
fundamentally, comparisons may be misleading if firms in the same
industry differ in their other investments. For example, comparing

Answers and Solutions: 3 - 2

 Pepsico and Coca-Cola may be misleading because apart from their soft
drink business, Pepsi also owns other businesses, such as Frito-Lay.

3-9 Total Effect

Current Current on Net
Assets Ratio Income
a. Cash is acquired through issuance of
additional common stock. + + 0

b. Merchandise is sold for cash. + + +

c. Federal income tax due for the previous

year is paid. - + 0

d. A fixed asset is sold for less than

book value. + + -

Answers and Solutions: 3 - 3

 Total Effect
Current Current on Net
Assets Ratio Income
e. A fixed asset is sold for more than
book value. + + +

f. Merchandise is sold on credit. + + +

g. Payment is made to trade creditors for

previous purchases. - + 0

h. A cash dividend is declared and paid. - - 0

i. Cash is obtained through short-term bank

loans. + - 0

j. Short-term notes receivable are sold at

a discount. - - -

k. Marketable securities are sold below cost. - - -

l. Advances are made to employees. 0 0 0

m. Current operating expenses are paid. - - -

n. Short-term promissory notes are issued to

trade creditors in exchange for past due
accounts payable. 0 0 0

o. 10-year notes are issued to pay off

accounts payable. 0 + 0

p. A fully depreciated asset is retired. 0 0 0

q. Accounts receivable are collected. 0 0 0

r. Equipment is purchased with short-term

notes. 0 - 0

s. Merchandise is purchased on credit. + - 0

t. The estimated taxes payable are increased. 0 - -

3-10 EVA is calculated as EBIT(1 - T) - (WACC)(Total Investor-Supplied

Operating Capital). ROE is calculated as NI/Equity. As long as a
company invests in projects with returns greater than their costs of
capital, the projects are profitable and should be accepted. Likewise,
EVA will be increased. Consequently, the firm’s projects this year may
have lower ROEs, but the costs of capital could be lower too. Also,
ROE doesn’t consider the size of an investment. A very small
investment with a high ROE will not add much to shareholder wealth, as
will a more substantial investment with an ROE that’s still greater
than the project’s cost of capital.

Answers and Solutions: 3 - 4

 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

3-1 DSO = 40 days; S = $7,300,000; AR = ?

AR
DSO =
S
365
AR
40 =
$7,300,000/365
40 = AR/$20,000
AR = $800,000.

3-2 A/E = 2.4; D/A = ?

 
D  1
= 1 - 
A  A

 E
= 1 -
D 1 

A  2.4
D
.
= 0.5833 = 58.33%.
A

3-3 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; TA/E = ?

ROA = NI/A; PM = NI/S; ROE = NI/E.

ROA = PM  S/TA
NI/A = NI/S  S/TA
10% = 2%  S/TA
S/TA = 5.

ROE = PM  S/TA  TA/E

NI/E = NI/S  S/TA  TA/E
15% = 2%  5  TA/E
15% = 10%  TA/E
TA/E = 1.5.

3-4 TA = $10,000,000,000; CL = $1,000,000,000; LT debt = $3,000,000,000; CE

= $6,000,000,000; Shares outstanding = 800,000,000; P0 = $32; M/B = ?

$6,000,000,000
Book value = = $7.50.
800,000,000

Answers and Solutions: 3 - 5

 $32.00
M/B = = 4.2667.
$7.50

3-5 TA = $12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?

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

NI
= 0.05
$12,000,000,000
NI = $600,000,000.

Now use the income statement format to determine interest so you can
calculate the firm’s TIE ratio.

EBIT $1,800,000,000 See above. INT = EBIT – EBT

INT 800,000,000 = $1,800,000,000 -
EBT $1,000,000,000
$1,000,000,000 EBT = $600,000,000/0.6
Taxes (40%) 400,000,000
NI $ 600,000,000 See above.

TIE = EBIT/INT
= $1,800,000,000/$800,000,000
= 2.25.

3-6 We are given ROA = 3% and Sales/Total assets = 1.5.

From Du Pont equation: ROA = Profit margin  Total assets turnover

3% = Profit margin(1.5)
Profit margin = 3%/1.5 = 2%.

We can also calculate the company’s debt ratio in a similar manner,

given the facts of the problem. We are given ROA(NI/A) and ROE(NI/E);
if we use the reciprocal of ROE we have the following equation:

E NI E D E
=  and = 1 - , so
A A NI A A
E 1
= 3% 
A 0.05
E
= 60% .
A
D
= 1 - 0.60 = 0.40 = 40% .
A

Answers and Solutions: 3 - 6

 Alternatively,

ROE = ROA  EM
5% = 3%  EM
EM = 5%/3% = 5/3 = TA/E.

Take reciprocal:

E/TA = 3/5 = 60%;

therefore, D/A = 1 - 0.60 = 0.40 = 40%.

Thus, the firm’s profit margin = 2% and its debt ratio = 40%.

$1,312,500
3-7 Present current ratio = = 2.5.
$525,000

$1,312,500 + NP
Minimum current ratio = = 2.0.
$525,000 + NP

$1,312,500 + NP = $1,050,000 + 2NP

NP = $262,500.

Short-term debt can increase by a maximum of $262,500 without violating

a 2 to 1 current ratio, assuming that the entire increase in notes
payable is used to increase current assets. Since we assumed that the
additional funds would be used to increase inventory, the inventory
account will increase to $637,500 and current assets will total
$1,575,000.

3-8 TIE = EBIT/INT, so find EBIT and INT.

Interest = $500,000  0.1 = $50,000.

Net income = $2,000,000  0.05 = $100,000.

Pre-tax income (EBT) = $100,000/(1 - T) = $100,000/0.7 = $142,857.
EBIT = EBT + Interest = $142,857 + $50,000 = $192,857.

TIE = $192,857/$50,000 = 3.86.

3-9 TA = $30,000,000,000; EBIT/TA = 20%; TIE = 8; DA = $3,200,000,000;

Lease payments = $2,000,000,000; Principal payments = $1,000,000,000;
EBITDA coverage = ?

EBIT/$30,000,000,000 = 0.2
EBIT = $6,000,000,000.

Answers and Solutions: 3 - 7

 8 = EBIT/INT
8 = $6,000,000,000/INT
INT = $750,000,000.

EBITDA = EBIT + DA
= $6,000,000,000 + $3,200,000,000
= $9,200,000,000.

EBITDA  Lease payments

EBITDA coverage ratio =
INT  Princ. pmts  Lease pmts
$9,200,000,000  $2,000,000,000
=
$750,000,000  $1,000,000,000  $2,000,000,000
$11,200,000,000
= = 2.9867.
$3,750,000,000

3-10 ROE = Profit margin  TA 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) $10,000,000

- Cost na
EBIT (given) $ 1,000,000
- INT (given) 300,000
EBT $ 700,000
- Taxes (34%) 238,000
NI $ 462,000

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

Total assets turnover = 2 = S/TA; TA = S/2 = $10,000,000/2 =
$5,000,000.

D/A = 60%; so E/A = 40%; and, therefore,

Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5.

Now we can complete the Du Pont equation to determine ROE:

ROE = $462,000/$10,000,000  $10,000,000/$5,000,000  2.5 = 0.231 =
23.1%.

Answers and Solutions: 3 - 8

3-11 Known data:

TA = $1,000,000; kd = 8%; T = 40%; BEP = 0.2 = EBIT/Total assets, so

EBIT = 0.2($1,000,000) = $200,000; D/A = 0.5 = 50%, so Equity =
$500,000.

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

EBIT $200,000 $200,000
Interest 0 40,000*
EBT $200,000 $160,000
Tax (40%) 80,000 64,000
NI $120,000 $ 96,000

NI $120,000 $96,000
ROE = = = 12% = 19.2%
Equity $1,000,000 $500,000
Difference in ROE = 19.2% - 12.0% = 7.2%.

*If D/A = 50%, then half of the assets are financed by debt, so Debt =
$500,000. At an 8 percent interest rate, INT = $40,000.

3-12 Statement a is correct. Refer to the solution setup for Problem 3-11
and think about it this way: (1) Adding assets will not affect common
equity if the assets are financed with debt. (2) Adding assets will
cause expected EBIT to increase by the amount EBIT = BEP(added assets).
(3) Interest expense will increase by the amount kd(added assets). (4)
Pre-tax income will rise by the amount (added assets)(BEP - kd).
Assuming BEP > kd, if pre-tax income increases so will net income. (5)
If expected net income increases but common equity is held constant,
then the expected ROE will also increase. Note that if k d > BEP, then
adding assets financed by debt would lower net income and thus the ROE.
Therefore, Statement a is true--if assets financed by debt are added,
and if the expected BEP on those assets exceeds the cost of debt, then
the firm’s ROE will increase.
Statements b, c, and d are false, because the BEP ratio uses EBIT,
which is calculated before the effects of taxes or interest charges are
felt. Of course, Statement e is also false.

3-13 a. Currently, ROE is ROE1 = $15,000/$200,000 = 7.5%.

The current ratio will be set such that 2.5 = CA/CL. CL is
$50,000, and it will not change, so we can solve to find the new
level of current assets: CA = 2.5(CL) = 2.5($50,000) = $125,000.
This is the level of current assets that will produce a current
ratio of 2.5.
At present, current assets amount to $210,000, so they can be
reduced by $210,000 - $125,000 = $85,000. If the $85,000 generated
is used to retire common equity, then the new common equity balance
will be $200,000 - $85,000 = $115,000.
Assuming that net income is unchanged, the new ROE will be ROE2 =
$15,000/$115,000 = 13.04%. Therefore, ROE will increase by 13.04% -
7.50% = 5.54%.

Answers and Solutions: 3 - 9

 b. 1. Doubling the dollar amounts would not affect the answer; it would
still be 5.54%.
2. Common equity would increase by $25,000 from the Part a scenario,
which would mean a new ROE of $15,000/$140,000 = 10.71%, which
would mean a difference of 10.71% - 7.50% = 3.21%.

3. An inventory turnover of 2 would mean inventories of $100,000,

down $50,000 from the current level. That would mean an ROE of
$15,000/$150,000 = 10.00%, so the change in ROE would be 10.00% -
7.5% = 2.5%.

4. If the company had 10,000 shares outstanding, then its EPS would be
$15,000/10,000 = $1.50. The stock has a book value of
$200,000/10,000 = $20, so the shares retired would be $85,000/$20 =
4,250, leaving 10,000 - 4,250 = 5,750 shares. The new EPS would be
$15,000/5,750 = $2.6087, so the increase in EPS would be $2.6087 -
$1.50 = $1.1087, which is a 73.91 percent increase, the same as the
increase in ROE.

5. If the stock was selling for twice book value, or 2  $20 = $40,
then only half as many shares could be retired ($85,000/$40 =
2,125), so the remaining shares would be 10,000 - 2,125 = 7,875,
and the new EPS would be $15,000/7,875 = $1.9048, for an increase
of $1.9048 - $1.5000 = $0.4048.

c. We could have started with lower inventory and higher accounts

receivable, then had you calculate the DSO, then move to a lower DSO
that would require a reduction in receivables, and then determine
the effects on ROE and EPS under different conditions. Similarly,
we could have focused on fixed assets and the FA turnover ratio. In
any of these cases, we could have had you use the funds generated to
retire debt, which would have lowered interest charges and
consequently increased net income and EPS.
If we had to increase assets, then we would have had to finance
this increase by adding either debt or equity, which would have
lowered ROE and EPS, other things held constant.
Finally, note that we could have asked some conceptual questions
about the problem, either as a part of the problem or without any
reference to the problem. For example, “If funds are generated by
reducing assets, and if those funds are used to retire common stock,
will EPS and/or ROE be affected by whether or not the stock sells
above, at, or below book value?”

3-14 TA = $7,500,000,000; EBIT/TA = 10%; TIE = 2.5; DA = $1,250,000,000; Lease

payments = $775,000,000; Principal payments = $500,000,000; EBITDA coverage
= ?

EBIT/$7,500,000,000 = 0.10
EBIT = $750,000,000.

Answers and Solutions: 3 - 10

2.5 = EBIT/INT
2.5 = $750,000,000/INT
INT = $300,000,000.

Answers and Solutions: 3 - 11

 EBITDA = EBIT + DA
= $750,000,000 + $1,250,000,000
= $2,000,000,000.

EBITDA  Lease payments

EBITDA coverage ratio =
INT  Princ. pmts  Lease pmts
$2,000,000,000  $775,000,000
=
$300,000,000  $500,000,000  $775,000,000
$2,775,000,000
= = 1.7619  1.76.
$1,575,000,000

3-15 TA = $5,000,000,000; T = 40%; EBIT/TA = 10%; ROA = 5%; TIE ?

EBIT
 0.10
$5,000,000,000
EBIT  $500,000,000.

NI
 0.05
$5,000,000,000
NI  $250,000,000.

Now use the income statement format to determine interest so you can
calculate the firm’s TIE ratio.

EBIT $500,000,000 See above. INT = EBIT – EBT

INT 83,333,333 = $500,000,000 - $416,666,667
EBT $416,666,667 EBT = $250,000,000/0.6
Taxes (40%) 166,666,667
NI $250,000,000 See above.

TIE = EBIT/INT
= $500,000,000/$83,333,333
= 6.0.

3-16 Total market value = $3,750,000,000(1.9) = $7,125,000,000.

Market value per share = $7,125,000,000/50,000,000 = $142.50.

Alternative solution:
Book value per share = $3,750,000,000/50,000,000 = $75.
Market value per share = $75(1.9) = $142.50.

3-17 Step 1: Solve for current annual sales using the DSO equation:
55 = $750,000/(Sales/365)
55Sales = $273,750,000
Sales = $4,977,272.73.

Answers and Solutions: 3 - 12

 Step 2: If sales fall by 15%, the new sales level will be
$4,977,272.73(0.85) = $4,230,681.82. Again, using the DSO
equation, solve for the new accounts receivable figure as
follows:
35 = AR/($4,230,681.82/365)
35 = AR/$11,590.91
AR = $405,681.82  $405,682.

3-18 The current EPS is $2,000,000/500,000 shares or $4.00. The current P/E
ratio is then $40/$4 = 10.00. The new number of shares outstanding will
be 650,000. Thus, the new EPS = $3,250,000/650,000 = $5.00. If the shares
are selling for 10 times EPS, then they must be selling for $5.00(10) =
$50.

3-19 Step 1: Calculate total assets from information given.

Sales = $6 million.

3.2 = Sales/TA
$6,000,000
3.2 =
Assets
Assets = $1,875,000.

Step 2: Calculate net income.

There is 50% debt and 50% equity, so Equity = $1,875,000  0.5 =
$937,500.

ROE = NI/S  S/TA  TA/E

0.12 = NI/$6,000,000  3.2  $1,875,000/$937,500
6.4NI
0.12 =
$6,000,000
$720,000 = 6.4NI
$112,500 = NI.

3-20 Given ROA = 8% and net income of $600,000, total assets must be $7,500,000.

NI
ROA =
TA
$600,000
8% =
TA
TA = $7,500,000.

To calculate BEP, we still need EBIT. To calculate EBIT construct a

partial income statement:

EBIT $1,148,077 ($225,000 + $923,077)

Interest 225,000 (Given)
EBT $ 923,077 $600,000/0.65
Taxes (35%) 323,077

Answers and Solutions: 3 - 13

 NI $ 600,000

EBIT
BEP =
TA
$1,148,077
=
$7,500,000
= 0.1531 = 15.31%.

3-21 1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.

2. Accounts payable = Debt – Long-term debt = $150,000 - $60,000

= $90,000.

Total liabilities
3. Common stock = and equity - Debt - Retained earnings
= $300,000 - $150,000 - $97,500 = $52,500.

4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.

5. Inventories = Sales/5 = $450,000/5 = $90,000.

6. Accounts receivable = (Sales/365)(DSO) = ($450,000/365)(36.5)

= $45,000.

7. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable)

Cash + $45,000 + $90,000 = (1.8)($90,000)
Cash + $135,000 = $162,000
Cash = $27,000.

8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)

Fixed assets = $300,000 - ($27,000 + $45,000 + $90,000)
Fixed assets = $138,000.

9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) =

$337,500.

Answers and Solutions: 3 - 14

3-22 a. (Dollar amounts in thousands.)
Industry
Firm Average

Current assets $655,000

= = 1.98 2.0
Current liabilities $330,000

Accounts receivable $336,000

DSO = = = 76.3 days 35 days
Sales/365 $4,404.11

Sales $1,607,500
= = 6.66 6.7
Inventories $241,500

Sales $1,607,500
= = 1.70 3.0
Total assets $947,500

Net income $27,300

= = 1.7% 1.2%
Sales $1,607,500

Net income $27,300

= = 2.9% 3.6%
Total assets $947,500

Net income $27,300

= = 7.6% 9.0%
Common equity $361,000

Total debt $586,500

= = 61.9% 60.0%
Total assets $947,500

b. For the firm,

$947,500
ROE = PM  T.A. turnover  EM = 1.7%  1.7  = 7.6%.
$361,000
For the industry, ROE = 1.2%  3  2.5 = 9%.

Note: To find the industry ratio of assets to common equity,

recognize that 1 - (total debt/total assets) = common equity/total
assets. So, common equity/total assets = 40%, and 1/0.40 = 2.5 =
total assets/common equity.

c. The firm’s days sales outstanding is more than twice as long as the
industry average, indicating that the firm should tighten credit or
enforce a more stringent collection policy. The total assets turnover
ratio is well below the industry average so sales should be increased,
assets decreased, or both. While the company’s profit margin is higher
than the industry average, its other profitability ratios are low
compared to the industry--net income should be higher given the amount
of equity and assets. However, the company seems to be in an average
liquidity position and financial leverage is similar to others in the
industry.

Answers and Solutions: 3 - 15

 d. If 2002 represents a period of supernormal growth for the firm,
ratios based on this year will be distorted and a comparison between
them and industry averages will have little meaning. Potential
investors who look only at 2002 ratios will be misled, and a return
to normal conditions in 2003 could hurt the firm’s stock price.

3-23 a.
Industry
Firm
Average

Current assets $303

Current ratio = = = 2.73 2
Current liabilities $111

Debt to Debt $135

total assets = = = 30.00%
Total assets $450
30.00%

Times interest EBIT $49.5

earned = = = 11 7
Interest $4.5

EBITDA EBITDA  Lease pymts $61.5

coverage = = = 9.46 9
Princ. Lease $6.5
INT  pymts  pymts

Inventory Sales $795

turnover = = = 5 10
Inventories $159

Accounts receivable $66

DSO = = = 30.3 days 24
Sales/365 $795/365
days

F.A. Sales $795

Turnover = = = 5.41 6
Net fixed assets $147

T.A. Sales $795

Turnover = = = 1.77 3
Total assets $450

Net income $27

Profit margin = = = 3.40%
Sales $795
3.00%

Return on Net income $27

total assets = Total assets
=
$450
= 6.00%
9.00%

Answers and Solutions: 3 - 16

 Return on
common equity = ROA  EM = 6%  1.4286 = 8.57%
12.90%

Alternatively,

Net income $27

ROE = = = 8.57%  8.6%.
Equity $315

Answers and Solutions: 3 - 17

b. ROE = Profit margin  Total assets turnover  Equity multiplier

Net income Sales Total assets

=  
Sales Total assets Common equity

$27 $795 $450

=   = 3.4%  1.77  1.4286 = 8.6%.
$795 $450 $315

Firm Industry Comment

Profit margin 3.4% 3.0% Good
Total assets turnover 1.77 3.0 Poor
Equity multiplier 1.4286 1.43* O.K.

D E
* 1 - =
TA TA
1 – 0.30 = 0.7
TA 1
EM = = = 1.43.
E 0.7

Alternatively, EM = ROE/ROA = 12.9%/9% = 1.43.

c. Analysis of the Du Pont equation and the set of ratios shows that
the turnover ratio of sales to assets is quite low. Either sales
should be increased at the present level of assets, or the current
level of assets should be decreased to be more in line with current
sales.

d. The comparison of inventory turnover ratios shows that other firms

in the industry seem to be getting along with about half as much
inventory per unit of sales as the firm. If the company’s inventory
could be reduced, this would generate funds that could be used to
retire debt, thus reducing interest charges and improving profits,
and strengthening the debt position. There might also be some
excess investment in fixed assets, perhaps indicative of excess
capacity, as shown by a slightly lower-than-average fixed assets
turnover ratio. However, this is not nearly as clear-cut as the
overinvestment in inventory.

e. If the firm had a sharp seasonal sales pattern, or if it grew

rapidly during the year, many ratios might be distorted. Ratios
involving cash, receivables, inventories, and current liabilities,
as well as those based on sales, profits, and common equity, could
be biased. It is possible to correct for such problems by using
average rather than end-of-period figures.

Answers and Solutions: 3 - 18

3-24 a. Here are the firm’s base case ratios and other data as compared to
the industry:

Firm Industry Comment

Current 2.3 2.7 Weak
Inventory turnover 4.8 7.0 Poor
Days sales outstanding 37.4 days 32.0 days Poor
Fixed assets turnover 10.0 13.0 Poor
Total assets turnover 2.3 2.6 Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.1 18.2 Bad
Debt ratio 54.8 50.0 High
Profit margin on sales 2.5 3.5 Bad
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio 5.0 6.0 Poor
P/CF ratio 2.0 3.5 Poor
M/B ratio 0.65 n.a. --

The firm appears to be badly managed--all of its ratios are worse than
the industry averages, and the result is low earnings, a low P/E, a low
stock price, and a low M/B ratio. The company needs to do something to
improve.

b. A decrease in the inventory level would improve the inventory turnover,

total assets turnover, and ROA, all of which are too low. It would
have some impact on the current ratio, but it is difficult to say
precisely how that ratio would be affected. If the lower inventory
level allowed the company to reduce its current liabilities, then the
current ratio would improve. The lower cost of goods sold would
improve all of the profitability ratios and, if dividends were not
increased, would lower the debt ratio through increased retained
earnings. All of this should lead to a higher market/book ratio, a
higher stock price, a higher price/earnings ratio, and a higher
price/cash flow ratio.

Answers and Solutions: 3 - 19

Answers and Solutions: 3 - 20