Chapter 3

Discussion Questions
3-1.

If we divide users of ratios into short-term lenders, long-term lenders, and

stockholders, in which ratios would each group be most interested, and for what
reasons?
Short-term lendersliquidity ratios because their concern is with the firms
ability to pay short-term obligations as they come due.
Long-term lendersleverage ratios because they are concerned with the
relationship of debt to total assets. They also will examine profitability to insure
that interest payments can be made.
Stockholdersprofitability ratios, with secondary consideration given to debt
utilization, liquidity, and other ratios. Since stockholders are the ultimate
owners of the firm, they are primarily concerned with profits or the return on
their investment.

3-2.

Explain how the Du Pont system of analysis breaks down return on assets. Also
explain how it breaks down return on stockholders equity.
The Du Pont system of analysis breaks out the return on assets between the
profit margin and asset turnover.
Return on Assets
Net income

Total assets

=
Net income

Sales

Profit Margin

Asset Turnover

Sales
Total assets

In this fashion, we can assess the joint impact of profitability and asset turnover
on the overall return on assets. This is a particularly useful analysis because we
can determine the source of strength and weakness for a given firm. For example,
a company in the capital goods industry may have a high profit margin and a
low asset turnover, while a food processing firm may suffer from low profit
margins, but enjoy a rapid turnover of assets.
The modified form of the Du Pont formula shows:
Returnonequity =

Returnonassets investment
1 Debt/Assets

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This indicates that return on stockholders equity may be influenced by return

on assets, the debt-to-assets ratio or a combination of both. Analysts or
investors should be particularly sensitive to a high return on stockholders
equity that is influenced by large amounts of debt.
3-3.

If the accounts receivable turnover ratio is decreasing, what will be happening

to the average collection period?
If the accounts receivable turnover ratio is decreasing, accounts receivable will
be on the books for a longer period of time. This means the average collection
period will be increasing.

3-4.

What advantage does the fixed charge coverage ratio offer over simply using
times interest earned?
The fixed charge coverage ratio measures the firms 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.

3-5.

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?
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.

3-6.

Why is trend analysis helpful in analyzing ratios?

Trend analysis allows us to compare the present with the past and evaluate our
progress through time. A profit margin of 5 percent may be particularly
impressive if it has been running only 3 percent in the last ten years. Trend
analysis must also be compared to industry patterns of change.

3-7.

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 based
on your assumptions.
a.
b.
c.
d.

Return on investment.
Inventory turnover.
Fixed asset turnover.
Debt-to-assets ratio.

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a. Return on investment

Net income
Total assets

Inflation may cause net income to be overstated and total assets to be

understated causing an artificially high ratio that is misleading.
Sales

b. Inventory turnover 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. Fixed asset turnover

Sales
Fixed assets

Fixed assets will be understated relative to their replacement cost and 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.
3-8.

What effect will disinflation following a highly inflationary period have on the
reported income of the firm?
Disinflation tends to lower reported earnings as inflation-induced income is
squeezed out of the firms income statement. This is particularly true for firms
in highly cyclical industries where prices tend to rise and fall quickly.

3-9.

Why might disinflation prove to be favorable to financial assets?

Because it is possible that prior inflationary pressures will no longer seriously
impair the purchasing power of the dollar, lessening inflation also means that
the required return that investors demand on financial assets will be going
down, and with this lower demanded return, future earnings or interest should
receive a higher current evaluation.

S3-3

3-10.

Comparisons of income can be very difficult for two companies even though
they sell the same products in equal volume. Why?
There are many different methods of financial reporting accepted by the
accounting profession as promulgated by the Financial Accounting Standards
Board. Though the industry has continually tried to provide uniform guidelines
and procedures, many options remain open to the reporting firm. Every item on
the income statement and balance sheet must be given careful attention. Two
apparently similar firms may show different values for sales, research and
development, extraordinary losses, and many other items.

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Chapter 3
Problems
1.

3-1.

Dental Delights has two divisions. Division A has a profit of $200,000 on sales of
$4,000,000. Division B is only able to make $30,000 on sales of $480,000. Based on the
profit margins (returns on sales), which division is superior?

Solution:
Dental Delights
Division A
Net Income
Sales

Division B

$200,000
$30,000
5%
6.25%
4,000,000
$480,000

Division B is superior

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2.

3-2.

Griffey Junior Wear, Inc., has $800,000 in assets and $200,000 of debt. It reports net
income of $100,000.
a.
What is the return on assets?
b.
What is the return on stockholders equity?

Solution:
Griffey Junior Wear
a.

Return on assets (investment) =

Net income
Total assets

$100,000
12.5%
$800,000
b.

Return on equity

Net income
Stockholders' equity

Stockholders' equity total assets total debt

$800,000 $200,000 $600,000
Net income
$100,000

16.67%
Stockholder's equity $600,000
Return on equity

Debt/Assets

Return on equity

Return on assets (investment)

(1 Debt/Assets)
$200,000
25%
$800,000
12.5%
(1 .25)

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12.5%
16.67%
.75

3.

3-3.

Bass Chemical, Inc., is considering expanding into a new product line. Assets to support
this expansion will cost $1,200,000. Bass estimates that it can generate $2 million in annual
sales, with a 5 percent profit margin. What would net income and return on assets
(investment) be for the year?

Solution:
Bass Chemical, Inc.
Net income Sales profit margin
$2,000,000 0.05
$100,000
Return on assets Net income
(investment)
Total assets

$100,000
$1,200,000

8.33%

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4.

3-4.

Franklin Mint and Candy Shop can open a new store that will do an annual sales volume of
$750,000. It will turn over its assets 2.5 times per year. The profit margin on sales will be
6 percent. What would net income and return on assets (investment) be for the year?

Solution:
Franklin Mint and Candy Shop
Net income Sales Profit Margin
$750,000 0.06
$45,000
Assets

Sales
Total asset turnover
$750,000
2.5

$300,000
Return on assets (invesment)

Net income
Total assets
$45,000
$300,000

15%

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5.

3-5.

Hugh Snore Bedding, Inc., has assets of $400,000 and turns over its assets 1.5 times per
year. Return on assets is 12 percent. What is its profit margin (return on sales)?

Solution:
Hugh Snore Bedding, Inc.
Sales Assets total asset turnover
$400,000 1.5%
$600,000
Net income Assets Return on assets
$48,000 $400,000 12%
Net income
$48,000 / $600,000 8%
Sales

6.

One-Size-Fits-All Casket Co.s income statement for 2008 is as follows:

Sales.......................................................................................$3,000,000
Cost of goods sold.................................................................. 2,100,000
Gross profit............................................................................ 900,000
Selling and administrative expense........................................ 450,000
Operating profit...................................................................... 450,000
Interest expense......................................................................
75,000
Income before taxes............................................................... 375,000
Taxes (30%)........................................................................... 112,500
Income after taxes.................................................................. $262,500
a. Compute the profit margin for 2008.
b. Assume in 2009, sales increase by 10 percent and cost of goods sold increases by 25%.
The firm is able to keep all other expenses the same. Once again, assume a tax rate of
30 percent on income before taxes. What are income after taxes and the profit margin
for 2009?

S3-9

3-6.

Solution:
One Size-Fits-All Casket Co.
a. Profit margin for 2008
Net Income
$262,500

8.75%
Sales
$3,000,000
b. Sales............................................................. $3,300,000*
Cost of goods sold........................................ 2,625,000**
Gross profit..................................................
675,000
Selling and administrative expense..............
450,000
Operating profit............................................
225,000
Interest expense............................................
75,000
Income before taxes.....................................
150,000
Taxes (30%).................................................
45,000
Income after taxes (2008).............................
$105,000
* $3,000,000 1.10 = $3,300,000
** $2,100,000 1.25 = $2,625,000
Profit Margin for 2009
Net Income
$105,000

3.18%
Sales
$3,300,000

S3-10

7.

3-7.

Easter Egg and Poultry Company has $2,000,000 in assets and $1,400,000 of debt. It
reports net income of $200,000.
a. What is the firms return on assets?
b. What is its return on stockholders equity?
c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin
(return on sales)?

Solution:
Easter Egg and Poultry Company
a.

Return on assets (investment)

Net income
Total assets

$200,000
10%
$2,000,000
Net income
Stockholders' equity
Stockholders' equity total assets total debt
$2,000,000 $1,400,000
$600,000
Return on equity

Net income
$200,000

33%
Stockholders' equity $600,000
b.

OR
Return on equity
Debt/Assets
Return on equity

Return on assets (investment)

(1 Debt/Assets)
$1,400,000
70%
$2,000,000
10%
(1 .70)

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10%
33%
.30

3-7. (Continued)
Sales total assets total assets turnover
$2,000,000 2.5
c.

$5,000,000
Profit margin

8.

Net income
$200,000

4%
Sales
$5,000,000

Sharpe Razor Company has total assets of $2,500,000 and current assets of $1,000,000. It
turns over its fixed assets 5 times a year and has $700,000 of debt. Its return on sales is
3 percent. What is Sharpes return on stockholders equity?

3-8. Solution:
Sharpe Razor Company
total assets
current assets
Fixed assets

$2,500,000
1,000,000
$1,500,000

Sales Fixed assets Fixed asset turnover

$1,500,000 5 $7,500,000
total assets
debt
Stockholders equity

$2,500,000
700,000
$1,800,000

Net income = Sales profit margin =

$7,500,000 3% = $225,000
Net income
Stockholders' equity
$225,000

12.5%
$1,800,000

Return on stockholders' equity

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9.

3-9.

Baker Oats had an asset turnover of 1.6 times per year.

a.
If the return on total assets (investment) was 11.2 percent, what was Bakers profit
margin?
b.
The following year, on the same level of assets, Bakers assets turnover declined to
1.4 times and its profit margin was 8 percent. How did the return on total assets
change from that of the previous year?

Solution:
Baker Oats
a.

Total asset turnover Profit Margin = Return on Total assets

1.6 ? = 11.2%
Profit margin =

b. 1.4

11.2%
7.0%
1.6

8% = 11.2%

It did not change at all because the increase in profit margin made
up for the decrease in the asset turnover.

S3-13

10.

Global Healthcare Products has the following ratios compared to its industry for 2008.

Return on sales..
Return on assets

Global
Healthcare
2%
18%

Industry
10%
12%

Explain why the return-on-assets ratio is so much more favorable than the return-on-sales
ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that
is required.

3-10. Solution:
Global Healthcare Products
Global Healthcare Products has a higher asset turnover ratio than
the industry.
Return on Assets
=Asset Turnover
Return on Sales
18% 12%
vs
2% 10%
9 vs1.2

S3-14

11.

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

Return on assets
Return on equity

Acme
Transportation
9%
12%

Industry
6%
24%

Explain why the return-on-equity ratio is so much less favorable than the return-on-assets
ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that
is required.

3-11. Solution:
Acme Transportation Company
Acme Transportation has a lower debt/total assets ratio than the industry.
For those who did a calculation, Acmes debt to assets were
25% vs 75% for the industry.

S3-15

12.

Gates Appliances has a return-on-assets (investment) ratio of 8 percent.

a.
If the debt-to-total-assets ratio is 40 percent, what is the return on equity?
b.
If the firm had no debt, what would the return-on-equity ratio be?

3-12. Solution:
Gates Appliances
Return on equity

a.

Return on assets (investment)

(1 Debt/Assets)

8%
(1 0.40)

8%
0.60

13.33%
b. The same as return on assets (8%).

S3-16

13.

Using the Du Pont method, evaluate the effects of the following relationships for the
Butters Corporation.
a. Butters Corporation has a profit margin of 7 percent and its return on assets
(investment) is 25.2 percent. What is its assets turnover?
b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the
firms return on equity be?
c. What would happen to return on equity if the debt-to-total-assets ratio decreased to
35 percent?

3-13. Solution:
Butters Corporation
Profit margin Total asset turnover Return on asset (investment)
7%

?
25.2%

a.

Total asset turnover

25.2%
7%

3.6x

Return on equity

b.

Return on assets (investment)

(1 Debt/Assets)

25.2%
(1 0.50)

25.2%
0.50

50.40%

S3-17

3-13. (Continued)
Return on equity

c.

Return on assets (investment)

(1 Debt/Assets)

25.2%
(1 .35)

25.2%
0.65

38.77%

S3-18

14.

Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3.5 percent on
each dollar of sales and turns over its assets 2.5 times per year. It has $100,000 in current
liabilities and $300,000 in long-term liabilities.
a. What is its return on stockholders equity?
b. If the asset base remains the same as computed in part a, but total asset turnover goes
up to 3, what will be the new return on stockholders equity? Assume that the profit
margin stays the same as do current and long-term liabilities.

3-14. Solution:
Jerry Rice and Grain Stores
Net income Sales profit margin
$4,000,000 3.5%
$140,000

a.

Stockholders equity Total assets Total liabilities

Total assets Sales/Total asset turnover
$4,000,000/2.5
$1,600,000
Total liabilities Current liabilities Long term liabilities
$100,000 $300,000
$400,000

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

Net income
Stockholders' equity
$140,000

11.67%
$1,200,000

Return on stockholders' equity

S3-19

3-14. (Continued)
b. The new level of sales will be:
Sales Total assets Total assets turnover
$1,600,000 3
$4,800,000
Net income Sales Profit margin
$4,800,000 3.5%
$168,000
Return on stockholders' equity

15.

Net income
Stockholders' equity
$168,000
14%
$1,200,000

Assume the following data for Interactive Technology and Silicon Software.

Net income..
Sales
Total assets..
Total debt.
Stockholders equity.

Interactive
Technology (IT)
$ 15,000
150,000
160,000
60,000
100,000

Silicon
Software (SS)
$ 50,000
1,000,000
400,000
240,000
160,000

a. Compute return on stockholders equity for both firms using ratio 3a in the text. Which
firm has the higher return?
b. Compute the following additional ratios for both firms.
Net income/Sales
Net income/Total assets
Sales/Total assets
Debt/Total assets
c. Discuss the factors from part b that added or detracted from one firm having a higher
return on stockholders equity than the other firm as computed in part a.

3-15. Solution

S3-20

Interactive Technology and Silicon Software

a.

Interactive
Technology (IT)

Silicon
Software (SS)

Net income
$15,000
$50,000

15%
31.25%
Stockholders' equity $100,000
$160,000
Silicon Software (SS) has a much higher return on stockholders
equity than Interactive Technology (IT).

S3-21

3-15. (Continued)
b.

Interactive
Technology (IT)
Net income
Sales
Net income
Total assets
Sales
Total assets
Debt
Total assets

Silicon
Software (SS)

$15,000
$150,000
$15,000

$160,000
$150,000

$160,000
$60,000

$160,000

10%
9.37%
.937x
37.5%

$50,000
5%
$1,000,000
$50,000
12.5%
$400,000
$1,000,000
2.5x
$400,000
$240,000
60%
$400,000

c. As previously indicated, Silicon Software (SS) has a substantially

higher return on stockholders equity than Interactive Technology
(IT). The reason is certainly not to be found on return on the sales
dollar where Interactive Technology has a higher return than
Silicon Software (10% vs. 5%).
However, Silicon Software has a higher return than Interactive
Technology on total assets (12.5% versus 9.37%). The reason is
clearly to be found in total asset turnover, which strongly favors
Silicon Software over Interactive Technology (2.5x versus .937x).
This factor alone leads to the higher return on total assets.

S3-22

16.

A firm has sales of $3 million, and 10 percent of the sales are for cash. The year-end
accounts receivable balance is $285,000. What is the average collection period?
(Use a 360-day year.)

3-16. Solution:
Accounts receivable
Average daily credit sales
($3,000,000 90%)
$285,000 /
360 days
$285,000

$7,500 per day

38 days

Average collection period

17.

Martin Electronics has an accounts receivable turnover equal to 15 times. If accounts

receivable are equal to $80,000, what is the value for average daily credit sales?

3.17. Solution:
Martin Electronics
Average daily credit sales

Credit sales
360

To determine credit sales, multiply accounts receivable by

accounts receivable turnover.
$80,000 15 $1,200,000
Average daily credit sales

$1,200,000
$3,333
360

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18.

Perez Corporation has the following financial data for the years 2007 and 2008:
2007
$8,000,000
6,000,000
800,000

Sales
Cost of goods sold
Inventory..

2008
$10,000,000
9,000,000
1,000,000

a. Compute inventory turnover based on ratio number 6, Sales/Inventory, for each year.
b. Compute inventory turnover based on an alternative calculation that is used by many
financial analysts, Cost of goods sold/Inventory, for each year.
c. What conclusions can you draw from part a and part b?

3-18. Solution:
Perez Corporation
2007

2008

a.

Sales
$8,000,000
$10,000,000

10x
10x
Inventory
8,00,000
1,000,000

b.

Cost of goods sold $6,000,000

$9,000,000

7.5x
9x
Inventory
800,000
1,000,000

c. Based on the sales to inventory ratio, the turnover has

remained constant at 10x. However, based on the cost of
goods sold to inventory ratio, it has improved from
7.5x to 9x.
The latter ratio may be providing a false picture of
improvement in this example simply because cost of goods
sold has gone up as percentage of sales (from 75 percent to
90 percent). Inventory is not really turning over any faster.

S3-24

19.

The Speed-O Company makes scooters for kids. Sales in 2008 were $8,000,000. Assets
were as follows:
Cash.
$200,000
Accounts receivable. 1,600,000
Inventory..
800,000
Net plant and equipment.. 1,000,000
Total assets $3,600,000
a. Compute the following:
1. Accounts receivable turnover
2. Inventory turnover
3. Fixed asset turnover
4. Total asset turnover
b. In 2009, sales increased to $10,000,000 and the assets for that year were as follows:
Cash...
$200,000
Accounts receivable..
1,800,000
Inventory...
2,200,000
Net plant and equipment...
1,050,000
Total assets.. $5,250,000
Once again, compute the four ratios listed in 19a.
c.

Indicate if there is an improvement or decline in total asset turnover, and based on the
other ratios, indicate why this development has taken place.

S3-25

3-19. Solution:
Speed-O Company
a. 1. Accounts receivable turnover = Sales/Accounts
Receivable
$8,000,000
5x
1,600,000
2. Inventory turnover = Sales/Inventory
$8,000,000
10 x
800,000
3. Fixed asset turnover = Sales/(Net Plant & Equipment)
$8,000,000
8x
1,000,000
4. Total asset turnover = Sales/Total Assets
$8,000,000
2.22 x
3,600,000
b. 1. Accounts receivable turnover
$10,000,000
5.56 x
1,800,000
2. Inventory turnover
$10,000,000
4.55 x
2,200,000

S3-26

3-19. (Continued)
3. Fixed asset turnover
$10,000,000
9.52 x
1,050,000
4. Total asset turnover
$10,000,000
1.90 x
5,250,000
c. There is a decline in total asset turnover from 2.22 to 1.90.
This development has taken place because of the slowdown in
inventory turnover (10x down to 4.55x). The other two ratios
are slightly improved.

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20.

The balance sheet for Stud Clothiers is shown below. Sales for the year were $2,400,000,
with 90 percent of sales sold on credit.
STUD CLOTHIERS
Balance Sheet 200X
Liabilities and Equity
$ 60,000 Accounts payable.. $ 220,000
240,000 Accrued taxes
30,000
350,000 Bonds payable
150,00
(long-term)
0
410,000 Common stock..
80,000
Paid-in capital
200,000
Retained earnings..
380,000
$1,060,000
Total liabilities and equity $1,060,000

Assets
Cash
Accounts receivable...
Inventory
Plant and equipment...
Total assets...

Compute the following ratios:

a.
b.
c.
d.
e.

Current ratio.
Quick ratio.
Debt-to-total-assets ratio.
Asset turnover.
Average collection period.

3-20. Solution:
Stud Clothiers
Current ratio
a.

Current assets
Current liabilities
$650,000
$250,000

2.6x

S3-28

3-20. (Continued)
Quick ratio

b.

(Current assets inventory)

Current liabilities

$650,000 $350,000
$250,000

$300,000
$250,000

1.2x
Debt to total assets

Total debt
Total assets

$400,000
$1,060,000

c.

37.74%
Asset turnover

Sales
Total assets

$2,400,000
$1,060,000

d.

2.26x
Average collection period
e.
$240,000 /

Accounts receivable
Average daily credit sales

($2,400,000 0.90)
$240,000

40 days
360 days
$6,000 per day

S3-29

21.

Neeley Office Supplies income statement is given below.

a.
What is the times interest earned ratio?
b.
What would be the fixed charge coverage ratio?
NEELEY OFFICE SUPPLIES
Sales..............................................................................
Cost of goods sold.........................................................
Gross profit...................................................................
Fixed charges (other than interest)................................
Income before interest and taxes...................................
Interest...........................................................................
Income before taxes......................................................
Taxes.............................................................................
Income after taxes.........................................................

$200,000
115,000
85,000
25,000
60,000
15,000
45,000
15,300
$ 29,700

3-21. Solution:
Neeley Office Supplies
Timesinterestedearned
a.

Incomebeforeinterestandtaxes
Interest
$60,000
15,000

4x
Fixed charge coverage

b.

Income before fixed charges and taxes

Fixed charges

$60,000 25,000
$15,000 25,000

$85,000
$40,000

2.125x

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22.

Using the income statement for Times Mirror and Glass Co., compute the following ratios:
a.
The interest coverage.
b.
The fixed charge coverage.
The total assets for this company equal $80,000. Set up the equation for the Du Pont
system of ratio analysis, and compute c, d, and e.
c.
d.
e.

Profit margin.
Total asset turnover.
Return on assets (investment).
TIMES MIRROR AND GLASS COMPANY
Sales..............................................................................
Less: Cost of goods sold.........................................
Gross profit...................................................................
Less: Selling and administrative expense...............
Less: Lease expense................................................
Operating profit*...........................................................
Less: Interest expense.............................................
Earnings before taxes....................................................
Less: Taxes (30%)...................................................
Earnings after taxes.......................................................
*Equals income before interest and taxes.

$126,000
93,000
$ 33,000
11,000
4,000
$ 18,000
3,000
$ 15,000
4,500
$ 10,500

3-22. Solution:
Times Mirror and Glass Co.
Times interest earned
a.

Income before interest and taxes

Interest
$18,000
$3,000

6x

S3-31

3-22. (Continued)
Fixed charge coverage

b.

Income before fixed charges and taxes

Fixed charges

$18,000 4,000
$3,000 $4,000

$22,000
$7,000

3.14x

ProfitMargin
c.

NetIncome
Sales
$10,500
$126,000

8.33%
Total asset turnover
d.

Sales
Total assets
$126,000
$80,000

1.575x
Return on assets (investments)
e.

Net income
Sales

Sales
Total assets

8.33% 1.575x
13.12%

S3-32

23.

A firm has net income before interest and taxes of $120,000 and interest expense of
$24,000.
a.
What is the times interest earned ratio?
b.
If the firms lease payments are $40,000, what is the fixed charge coverage?

3-23. Solution:
Times interest earned
a.

Income before interest and taxes

Interest

120,000 / $24,000
5x
Fixed charge converage

b.

IBIT + Before tax fixed charges

Interest + Fixed charges
$120,000 $40,000
$24,000 $40,000

2.5x

S3-33

24.

In January 1999, the Status Quo Company was formed. Total assets were $500,000, of
which $300,000 consisted of depreciable fixed assets. Status Quo uses straight-line
depreciation, and in 1999 it estimated its fixed assets to have useful lives of 10 years.
Aftertax income has been $26,000 per year each of the last 10 years. Other assets have not
changed since 1999.
a.
Compute return on assets at year-end for 1999, 2001, 2004, 2006, and 2008.
(Use $26,000 in the numerator for each year.)
b.
To what do you attribute the phenomenon shown in part a?
c.
Now assume income increased by 10 percent each year. What effect would this have
on your above answers? Merely comment.

3-24. Solution:
Status Quo Company
a.

Return on assets (investment) = Income after taxes/Total

assets.
The return on assets for Status Quo will increase over time as
the assets depreciate and the denominator gets smaller. Fixed
assets at the beginning of 1995 equal $300,000 with a ten-year
life which means the depreciation expense will be $30,000
per year. Book values at year-end are as follows:
1999 = $270,000;
2001 = $210,000;
2004 = $120,000;
2006 = $ 60,000;
2008 = -0Return on assets (investment) =

Income after taxes

Current assets + Fixed assets

1999 = $26,000/$470,000 = 5.53%

2001 = $26,000/$410,000 = 6.34%
2004 = $26,000/$320,000 = 8.13%
2006 = $26,000/$260,000 = 10.00%
2008 = $26,000/$200,000 = 13.00%

S3-34

3-24. (Continued)
b. The increasing return on assets over time is due solely to the
fact that annual depreciation charges reduce the amount of
investment. The increasing return is in no way due to
operations.
Financial analysts should be aware of the effect of overall
asset age on the return-on-investment ratio and be able to
search elsewhere for indications of operating efficiency when
ROI is very high or very low.
c.

As income rises, return on assets will be higher than in part

(b) and would indicate an increase in return partially from
more profitable operations.

S3-35

25.

Calloway Products has the following data. Industry information is also shown.

Year
2006
2007
2008

Net Income
$360,000
380,000
380,000

Year
2006
2007
2008

Debt
$1,600,000
1,750,000
1,900,000

Total Assets
$3,000,000
3,400,000
3,800,000

Industry Data on Net

Income/Total Assets
11%
8
5

Total Assets
$3,000,000
3,400,000
3,800,000

Industry Data on
Debt/Total Assets
52%
40
31

As an industry analyst comparing the firm to the industry, are you likely to praise or
criticize the firm in terms of:
a.
Net income/Total assets?
b.
Debt/Total assets?

3-25. Solution:
Calloway Products
a. Net income/total assets
Year
2006
2007
2008

Calloway Ratio
12.0%
11.18%
10.0%

Industry Ratio
11.0%
8.0%
5.0%

Although the company has shown a declining return on assets

since 2006, it has performed much better than the industry.
Praise may be more appropriate than criticism.

S3-36

3-25. (Continued)
b. Debt/total assets
Year
2006
2007
2008

Calloway Ratio
53.33%
51.47%
50.0%

Industry Ratio
52.0%
40.0%
31.0%

While the companys debt ratio is improving, it is not

improving nearly as rapidly as the industry ratio. Criticism
may be more appropriate than praise.
26.

Jodie Foster Care Homes, Inc., shows the following data:

Year
2005
2006
2007
2008
a.
b.

Net Income
$118,000
131,000
148,000
175,700

Total Assets
$1,900,000
1,950,000
2,010,000
2,050,000

Stockholders Equity
$ 700,000
950,000
1,100,000
1,420,000

Total Debt
$1,200,000
1,000,000
910,000
630,000

Compute the ratio of net income to total assets for each year and comment on the trend.
Compute the ratio of net income to stockholders equity and comment on the trend.
Explain why there may be a difference in the trends between parts a and b.

3-26. Solution:
Jodie Foster Care Homes, Inc.
a.

Net income
Total assets
2005
2006
2007
2008

$118,000/$1,900,000 = 6.21%
$131,000/$1,950,000 = 6.72%
$148,000/$2,010,000 = 7.36%
$175,700/$2,050,000 = 8.57%

Comment: There is a strong upward movement in return on

assets over the four year period.
S3-37

3-26. (Continued)
Net income
b.
Stockholders' equity
2005
2006
2007
2008

$118,000/$700,000
$131,000/$950,000
$148,000/$1,100,000
$175,700/$1,420,000

= 16.86%
= 13.79%
= 13.45%
= 12.37%

Comment: The return on stockholders equity ratio is going

down each year. The difference in trends between a and b is
due to the larger portion of assets that are financed by
stockholders equity as opposed to debt.
Optional: This can be confirmed by computing total debt to
total assets for each year.
Total debt
Total assets
2005
2006
2007
2008

63.2%
51.3%
45.3%
30.7%

S3-38

27.

The United World Corporation has three subsidiaries.

Sales.......................................
Net income (after taxes).........
Assets.....................................

Computers

Magazines

Cable TV

$16,000,000
1,000,000
5,000,000

$4,000,000
160,000
2,000,000

$8,000,000
600,000
5,000,000

a.
b.
c.
d.

Which division has the lowest return on sales?

Which division has the highest return on assets?
Compute the return on assets for the entire corporation.
If the $5,000,000 investment in the cable TV division is sold off and redeployed in
the computer division at the same rate of return on assets currently achieved in the
computer division, what will be the new return on assets for the entire corporation?

3-27. Solution:
United World Corporation
a.

b.

Computers Magazines Cable TV

6.25%
4.00%
7.50%
The magazine division has the lowest return on sales.
Net income/sales

Computers Magazines Cable TV

20.0%
8.00%
12.00%
The computer division has the highest return on assets.
Net income/total assets

Corporate net income

$1,000,000 $160,000 $600,000

Corporate total assets $5,000,000 $2,000,000 $5,000,000

c.

$1,760,000
$12,000,000

14.67%

S3-39

3-27. (Continued)
d. Return on redeployed assets in computers.
20% $5,000,000 = $1,000,000
Return on assets for the entire corporation:
Corporate net income $1,000,000 $160,000 $1,000,000

Corporate total asset

$12,000,000

$2,160,000
$12,000,000

18%

S3-40

28.

Omni Technology Holding Company has the following three affiliates:

Sales.................................
Net income (after taxes)...
Assets...............................
Stockholders equity.........
a.
b.
c.
d.
e.
f.
g.

Software

Personal
Computers

Foreign
Operations

$40,000,000
2,000,000
5,000,000
4,000,000

$60,000,000
2,000,000
25,000,000
10,000,000

$100,000,000
8,000,000
60,000,000
50,000,000

Which affiliate has the highest return on sales?

Which affiliate has the lowest return on assets?
Which affiliate has the highest total asset turnover?
Which affiliate has the highest return on stockholders equity?
Which affiliate has the highest debt ratio? (Assets minus stockholders equity
equals debt.)
Returning to question b, explain why the software affiliate has the highest return on
total assets.
Returning to question d, explain why the personal computer affiliate has a higher
return on stockholders equity than the foreign operations affiliate even though it has
a lower return on total assets.

3-28. Solution:
Omni Technology Holding Company
a.

Net income/sales

Personal
Foreign
Software Computers Operations
5.0%
3.3%
8.0%

The foreign operation affiliate has the highest return on sales.

Personal
Foreign
b. Net income/total assets Software Computers Operations
40.0%
8.0%
13.3%
The personal computer affiliate has the lowest return on
assets

S3-41

3-28. (Continued)
c.

Sales/total assets

Software
8.0x

Personal
Foreign
Computers Operations
2.4x
1.7x

The software affiliate has the highest return on total asset

turnover.
Personal

Foreign

20.0%

16.0%

d. Net income/
Software Computers Operations
Stockholders equity
50.0%

The Software affiliate has the highest return on stockholders

equity.

e.

Debt/total assets

Personal Foreign
Software Computers Operations
20.0%
60.0%
16.7%

The personal computer affiliate has the highest debt/total

assets ratio.
f.

This is because of its high total turnover ratio of 8.0x times in

part c.

g. This is because the personal computer affiliate has a higher

debt ratio (60.0%) than the foreign operations affiliate
(16.7%).

S3-42

29.

Bard Corporation shows the following income statement. The firm uses FIFO inventory
accounting.
BARD CORPORATION
Income Statement for 2008
Sales.....................................................................
Cost of goods sold................................................
Gross profit..........................................................
Selling and administrative expense......................
Depreciation.........................................................
Operating profit....................................................
Taxes (30%).........................................................
Aftertax income...................................................
a.

b.
c.

$200,000 (10,000 units at $20)

100,000 (10,000 units at $10)
100,000
10,000
20,000
70,000
21,000
$ 49,000

Assume in 2009 the same 10,000-unit volume is maintained, but that the sales price
increases by 10 percent. Because of FIFO inventory policy, old inventory will still be
charged off at $10 per unit. Also assume that selling and administrative expense will
be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent.
Compute aftertax income for 2009.
In part a, by what percent did aftertax income increase as a result of a 10 percent
increase in the sales price? Explain why this impact occurred.
Now assume that in 2010 the volume remains constant at 10,000 units, but the sales
price decreases by 15 percent from its year 2009 level. Also, because of FIFO
inventory policy, cost of goods sold reflects the inflationary conditions of the prior
year and is $11 per unit. Further, assume selling and administrative expense will be 5
percent of sales and depreciation will be unchanged. The tax rate is 30 percent.
Compute the aftertax income.

3-29. Solution:
Bard Corporation
a.

2009
Sales................................
Cost of goods sold..........
Gross profit...................
Selling and adm. expense
Depreciation...................
Operating profit............
Taxes (30%)....................
After tax income...........
S3-43

$220,000 (10,000 units at $22)

100,000 (10,000 units at $10)
$120,000
11,000 (5% of sales)
20,000
$ 89,000
$ 26,700
$ 62,300

3-29. (Continued)
b. Gain in aftertax income
2009
2008
Increase

$62,300
49,000
$13,300

Increase
$13,300

27.14%
Base value (2008) $49,000
Aftertax income increased much more than sales because of
FIFO inventory policy (in this case, the cost of old inventory
did not go up at all), and because of historical cost
depreciation (which did not change).
c.

2010
Sales................................
Cost of goods sold..........
Gross profit...................
Selling and adm. expense
Depreciation...................
Operating profit............
Taxes (30%)....................
After tax income...........
*$22 0.85 = $18.70

$187,000 (10,000 units at $18.70*)

110,000 (10,000 units at $11.00)
$ 77,000
9,350 (5% of sales)
20,000
$ 47,650
$ 14,295
$ 33,355

The low profits indicate the effect of inflation followed by

disinflation.

S3-44

30.

Construct the current assets section of the balance sheet from the following data. (Use cash
as a plug figure after computing the other values.)
Yearly sales (credit).....................................................................
Inventory turnover.......................................................................
Current liabilities.........................................................................
Current ratio.................................................................................
Average collection period............................................................
Current assets:
Cash......................................................................... $______
Accounts receivable................................................
______
Inventory.................................................................
______
Total current assets...............................................
______

$720,000
6 times
$105,000
2
35 days

3-30. Solution:
Inventory
Account rec.
Current assets
Cash
Cash................................
Accounts receivable.......
Inventory........................
Total current assets

= $720,000/6
= $120,000
= ($720,000/360) 35
= $70,000
= 2 $105,000
= $210,000
= $210,000 $120,000 $70,000
= $ 20,000
$ 20,000
70,000
120,000
$210,000

S3-45

31.

The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in
the balance sheet below.
Total assets turnover...................................
Cash to total assets......................................
Accounts receivable turnover.....................
Inventory turnover......................................
Current ratio................................................
Debt to total assets......................................

2.4 times
2.0%
8.0 times
10.0 times
2.0 times
61.0%

GRIGGS CORPORATION
Balance Sheet 2008
Assets
Cash ..............................
Accounts receivable......
Inventory.......................
Total current assets .
Fixed assets ..................
Total assets ...................

Liabilities and Stockholders Equity

_____
_____
_____
_____
_____
_____

Current debt.............................................
Long-term debt.........................................
Total debt............................................
Equity.......................................................

_____
_____
_____
_____

Total debt and stockholders equity

_____

3-31. Solution:
Griggs Corporation
Sales/total assets
Total assets
Total assets

= 2.4 times
= $1,200,000/2.4
= $500,000

Cash
Cash
Cash

= 2% of total assets
= 2% $500,000
= $10,000

Sales/accounts receivable
Accounts receivable
Accounts receivable

= 8 times
= $1,200,000/8
= $150,000

Sales/inventory
Inventory
Inventory

= 10 times
= $1,200,000/10
= $120,000

S3-46

3-31. (Continued)
Fixed assets
Current asset

= Total assets current assets

= $10,000 + $150,000 +
$120,000 = $280,000
= $500,000 $280,000
= $220,000

Fixed assets
Current assets/current debt
Current debt
Current debt
Current debt

=2
= Current assets/2
= $280,000/2
= $140,000

Total debt/total assets

Total debt
Total debt

= 61%
= .61 $500,000
= $305,000

Long-term debt
Long-term debt
Long-term debt

= Total debt current debt

= $305,000 140,000
= $165,000

Equity
Equity
Equity

= Total assets total debt

= $500,000 $305,000
= $195,000
Griggs Corporation
Balance Sheet 2008

Cash.....................
A/R.......................
Inventory..............
Total current
assets
Fixed assets..........
Total assets...........

$ 10,000 Current debt..........

150,000 Long-term debt.....
$120,000 Total debt...........
280,000
220,000 Equity....................
$500,000 Total debt and
stockholders
equity

S3-47

$140,000
165,000
$305,000
195,000
$500,000

32.

We are given the following information for the Coleman Machine Tools Corporation.
Sales (credit).......................................................................
Cash.....................................................................................
Inventory.............................................................................
Current liabilities................................................................
Asset turnover.....................................................................
Current ratio........................................................................
Debt-to-assets ratio.............................................................
Receivables turnover...........................................................

$7,200,000
300,000
2,150,000
1,400,000
1.20 times
2.50 times
40%
8 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.
Fixed assets.
d.
Long-term debt.

3-32. Solution:
Coleman Machine Corporation
a. Accounts receivable

= Sales/Receivable turnover
= $7,200,000/8x
= $900,000

b. Marketable securities = Current assets (cash +

accounts rec. + inventory)
Current Assets

= Current ratio Current liabilities

= 2.5 $1,400,000
= $3,500,000

Marketable securities = $3,500,000 ($300,000 +

$900,000 + $2,150,000)
= $3,500,000 $3,350,000
= $150,000

S3-48

3-32. (Continued)
c. Fixed assets
Total assets

Fixed assets
d. Long-term debt
Total debt

Long-term debt

= Total assets Current assets

= Sales/Asset turnover
= $7,200,000/1.20x
= $6,000,000
= $6,000,000 $3,500,000
= $2,500,000
= Total debt current liabilities
= Debt to assets total assets
= 40% $6,000,000
= $2,400,000
= $2,400,000 $1,400,000
= $1,000,000

S3-49

33.

The following data are from Sharon Stone and Gravel, Inc., financial statements. The firm
manufactures home decorative material. Sales (all credit) were $60 million for 2008.
Sales to total assets.........................................
Total debt to total assets.................................
Current ratio...................................................
Inventory turnover.........................................
Average collection period..............................
Fixed asset turnover.......................................

3.0 times
40%
2.0 times
10.0 times
18.0 days
7.5 times

Fill in the balance sheet:

Cash.....................................
..............................._____t_
Accounts receivable............
Inventory.............................
Total current assets........
Fixed assets.........................
Total assets....................

______

Current debt..........................................

______
______
______
______
______

Long-term debt......................................
Total debt.........................................
Equity....................................................

______
______
______

Total debt and stockholders equity

______

3-33. Solution:
Sharon Stone and Gravel, Inc.
Sales/total assets
Total assets
Total assets

= 3.0x
= $60 million/3.0
= $20 million

Total debt/total asset

Total assets
Total assets

= 40%
= $20 million x .4
= $8 million

Sales/inventory
Inventory
Inventory
Average daily sales

= 10.0x
= $60 million/10.0x
= $6 million
= $60 million/360 days
= $166,667 per day
= 18 days $166,667
= $3 million (or)

Accounts receivable

S3-50

3-33. (Continued)
Accounts receivable =

$60 million
$3,000,000
360
18

Fixed assets

= $60 million/7.5x
= $8 million

Cash

= Total assets inventory

accounts receivable fixed assets
= $20 million $6 million $3 million
$8 million
= $3 million

Current assets

= Cash + accounts receivable + inventory

= $3 million + $3 million + $6 million
= $12 million

Current debt

= Current assets/2
= $12 million/2
= $6 million

Long-term debt

= Total debt current debt

= $8 million $6 million
= $2 million

Equity

= Total assets total debt

= $20 million $8 million
= $12 million

S3-51

3-33. (Continued)
Cash................. $ 3.0 million Current
debt.............
Accounts
Long-term
receivable..... $ 3.0
debt.............
Inventory......... $ 6.0
Total debt.......
Total current
Equity.............
assets............ $12.0
Fixed assets..... $ 8.0
Total assets..... $20.0 million Total debt and
equity...........

S3-52

$ 6.0 million
$ 2.0
$ 8.0
$12.0
$20.0 million

34.

Using the financial statements for the Goodyear Calendar Company, calculate the 13 basic
ratios found in the chapter.
GOODYEAR CALENDAR COMPANY
Balance Sheet
December 31, 2008
Assets
Current assets:
Cash
....................................................................................................
Marketable securities
....................................................................................................
Accounts receivable (net)
....................................................................................................
Inventory
....................................................................................................
Total current assets
.................................................................................................
Investments........................................................................................
Plant and equipment..........................................................................
Less: Accumulated depreciation
....................................................................................................
Net plant and equipment
.................................................................................................
Total assets........................................................................................

$ 40,000
30,000
120,000
180,000
$370,000
40,000
450,000
(100,000)
350,000
$760,000

GOODYEAR CALENDAR COMPANY

Liabilities and Stockholders Equity
Current liabilities:
Accounts payable
....................................................................................................
Notes payable
....................................................................................................
Accrued taxes
....................................................................................................
Total current liabilities
.................................................................................................
Long-term liabilities:
Bonds payable
....................................................................................................
Total liabilities
.................................................................................................
Stockholders equity..........................................................................
Preferred stock, $100 par value
....................................................................................................
Common stock, $1 par value
....................................................................................................
Capital paid in excess of par
S3-53

$ 90,000
10,000
10,000
110,000
170,000
280,000
90,000
60,000
230,000

....................................................................................................
Retained earnings
....................................................................................................
Total stockholders equity
.................................................................................................
Total liabilities and stockholders equity...........................................

S3-54

100,000
480,000
$760,000

GOODYEAR CALENDAR COMPANY

Income Statement
For the Year Ending December 31, 2008
Sales (on credit).................................................................................
Less: Cost of goods sold
....................................................................................................
Gross profit........................................................................................
Less: Selling and administrative expenses
....................................................................................................
Operating profit (EBIT)....................................................................
Less: Interest expense
....................................................................................................
Earnings before taxes (EBT).............................................................
Less: Taxes
....................................................................................................
Earnings after taxes (EAT)................................................................
*Includes $10,000 in lease payments.

$2,000,000
1,300,000
700,000
400,000*
300,000
20,000
280,000
112,000
$ 168,000

3-34. Solution:
Goodyear Calendar Company
Profitability ratios
Profit margin = $168,000/$2,000,000 = 8.40%
Return on assets (investment) = $168,000/$760,000 = 22.1%
Return on equity = $168,000/$480,000 = 35%
Assets utilization ratios
Receivable turnover = $2,000,000/$120,000 = 16.66x
Average collection period = $120,000/$5,555 = 21.6 days
Inventory turnover = $2,000,000/$180,000 = 11.11x
Fixed asset turnover = $2,000,000/$350,000 = 5.71x
Total asset turnover = $2,000,000/$760,000 = 2.63x
Liquidity ratio
Current ratio = $370,000/$110,000 = 3.36x
Quick ratio = $190,000/$110,000 = 1.72x
Debt utilization ratios
Debt to total assets = $280,000/$760,000 = 36.84%
Times interest earned = $300,000/$20,000 = 15x
Fixed charge coverage = $310,000/$30,000 = 10.33x
S3-55

35.

Given the following financial statements for Jones Corporation and Smith Corporation:
a.
To which company would you, as credit manager for a supplier, approve the
extension of (short-term) trade credit? Why? Compute all ratios before answering.
b.
In which one would you buy stock? Why?
JONES CORPORATION
Current Assets
Cash................................ $ 20,000
Accounts receivable.......
80,000
Inventory........................
50,000

Liabilities
Accounts payable...................
Bonds payable (long-term).....

Long-Term Assets
Fixed assets.................... $500,000
Less: Accumulated
depreciation.............
(150,000
)
*Net fixed assets........
350,000
Total assets..............
$500,000

Stockholders Equity
Common stock.......................
Paid-in capital
................................................
Retained earnings
................................................
Total liabilities and equity

$100,000
80,000

$150,000
70,000
100,000

$500,000

Sales (on credit).......................................................................................

$1,250,000
Cost of goods sold....................................................................................
750,000
Gross profit..............................................................................................
500,000
Selling and administrative expense.....................................................
257,000
Less: Depreciation expense...................................................................
50,000
Operating profit........................................................................................
193,000
Interest expense........................................................................................
8,000
Earnings before taxes...............................................................................
185,000
Tax expense..............................................................................................
92,500
Net income...............................................................................................
$ 92,500
*Use net fixed assets in computing fixed asset turnover.
Includes $7,000 in lease payments.

S3-56

SMITH CORPORATION
Current Assets
Cash................................. $ 35,000
Marketable securities......
7,500
Accounts receivable........
70,000
Inventory.........................
75,000

Liabilities
Accounts payable..................
Bonds payable (long-term)....

$ 75,000
210,000

Long-Term Assets
Fixed assets..................... $500,000
Less: Accumulated
depreciation
....................................... (250,000)
*Net fixed assets
250,000
.......................................
Total assets
.................................... $437,500

Stockholders Equity
Common stock.......................
Paid-in capital........................
Retained earnings..................

$ 75,000
30,000
47,500

Total liabilities and equity...

$437,500

Sales (on credit)..........................................................

Cost of goods sold.......................................................
Gross profit.................................................................
Selling and administrative expense.......................
Less: Depreciation expense.....................................
Operating profit...........................................................
Interest expense...........................................................
Earnings before taxes..................................................
Tax expense.................................................................
Net income..................................................................
*Use net fixed assets in computing fixed asset turnover.
Includes $7,000 in lease payments.

S3-57

$1,000,000
600,000
400,000
224,000
50,000
126,000
21,000
105,000
52,500
$ 52,500

3-35. Solution:
Jones and Smith Comparison
One way of analyzing the situation for each company is to compare the
respective ratios for each on, examining those ratios which would be
most important to a supplier or short-term lender and a stockholder.
Profit margin
Return on assets (investments)
Return on equity
Receivable turnover
Average collection period
Inventory turnover
Fixed asset turnover
Total asset turnover
Current ratio
Quick ratio
Debt to total assets
Times interest earned
Fixed charge coverage
Fixed charge coverage
calculation

Jones Corp.
7.4%
18.5%
28.9%
15.63x
23.04 days
25x
3.57x
2.5x
1.5x
1.0x
36%
24.13x
13.33x
(200/15)

Smith Corp.
5.25%
12.00%
34.4%
14.29x
25.2 days
13.3x
4x
2.29x
2.5x
1.5x
65.1%
6x
4.75x
(133/28)

a. Since suppliers and short-term lenders are most concerned with

liquidity ratios, Smith Corporation would get the nod as having the
best ratios in this category. One could argue, however, that Smith
had benefited from having its debt primarily long term rather than
short term. Nevertheless, it appears to have better liquidity ratios.

S3-58

3-35. (Continued)
b. Stockholders are most concerned with profitability. In this
category, Jones has much better ratios than Smith. Smith does have
a higher return on equity than Jones, but this is due to its much
larger use of debt. Its return on equity is higher than Jones because
it has taken more financial risk. In terms of other ratios, Jones has
its interest and fixed charges well covered and in general its longterm ratios and outlook are better than Smiths. Jones has asset
utilization ratios equal to or better than Smith and its lower
liquidity ratios could reflect better short-term asset management,
and that point was covered in part a.
Note: Remember that to make actual financial decisions more than one
years comparative data is usually required. Industry comparisons
should also be made.

S3-59

COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Al Thomas has recently been approached by his brother-in-law, Robert Watson, with a proposal
to buy a 20 percent interest in Watson Leisure Time Sporting Goods. The company manufactures
golf clubs, baseball bats, basketball goals, and other similar items.
Mr. Watson is quick to point out the increase in sales over the last three years as indicated in
the income statement, Exhibit 1. The annual growth rate is 20 percent. A balance sheet for a
similar time period is shown in Exhibit 2, and selected industry ratios are presented in Exhibit 3.
Note the industry growth rate in sales is only approximately 10 percent per year.
There was a steady real growth of 2 to 3 percent in gross domestic product during the period
under study. The rate of inflation was in the 3 to 4 percent range.
The stock in the corporation has become available due to the ill health of a current
stockholder, who needs cash. The issue here is not to determine the exact price for the stock, but
rather whether Watson Leisure Time Sporting Goods represents an attractive investment
situation. Although Mr. Thomas has a primary interest in the profitability ratios, he will take a
close look at all the ratios. He has no fast and firm rules about required return on investment, but
rather wishes to analyze the overall condition of the firm. The firm does not currently pay a cash
dividend, and return to the investor must come from selling the stock in the future. After doing a
thorough analysis (including ratios for each year and comparisons to the industry), what
comments and recommendations do you offer to Mr. Thomas?

S3-60

Comprehensive Problem 1. (Continued)

Exhibit 1
WATSON LEISURE TIME SPORTING GOODS
Income Statement
200X
200Y
Sales (all on credit)....................................... $1,500,000
$1,800,000
Cost of goods sold........................................
950,000
1,120,000
Gross profit...................................................
550,000
680,000
Selling and administrative expense*............
380,000
490,000
Operating profit............................................
170,000
190,000
Interest expense............................................
30,000
40,000
Net income before taxes...............................
140,000
150,000
Taxes.............................................................
46,120
48,720
Net income.................................................... $ 93,880
$ 101,280
Shares............................................................
40,000
40,000
Earnings per share........................................
$2.35
$2.53
*Includes $20,000 in lease payments for each year.

200Z
$2,160,000
1,300,000
860,000
590,000
270,000
85,000
185,000
64,850
$ 120,150
46,000
$2.61

Exhibit 2
WATSON LEISURE TIME SPORTING GOODS
Balance Sheet
200X
200Y
Assets
Cash.............................................................. $ 20,000
$ 30,000
Marketable securities....................................
30,000
35,000
Accounts receivable......................................
150,000
230,000
Inventory.......................................................
250,000
285,000
Total current assets..................................
450,000
580,000
Net plant and equipment...............................
550,000
720,000
Total assets.................................................... $1,000,000
$1,300,000
Liabilities and Stockholders Equity
Accounts payable.......................................... $ 100,000
$ 225,000
Notes payable (bank)....................................
100,000
100,000
Total current liabilities............................
200,000
325,000
Long-term liabilities.....................................
250,000
331,120
Total liabilities.........................................
450,000
656,120
Common stock ($10 par)..............................
400,000
400,000
Capital paid in excess of par.........................
50,000
50,000
Retained earnings.........................................
100,000
193,880
Total stockholders equity.......................
550,000
643,880
Total liabilities and stockholders equity...... $1,000,000
$1,300,000

S3-61

200Z
$

20,000
50,000
330,000
325,000
725,000
1,169,000
$1,894,000
$ 200,000
300,000
500,000
550,740
1,050,740
460,000
80,000
303,260
843,260
$1,894,000

Comprehensive Problem 1 (Continued)

Exhibit 3
Selected Industry Ratios
200X

200Y

200Z

Growth in sales.............................................

9.98%

10.02%

Profit margin.................................................

5.75%

5.80%

5.81%

Return on assets (investment).......................

8.22%

8.24%

8.48%

Return on equity...........................................

13.26%

13.62%

14.16%

Receivable turnover......................................

10x

Average collection period.............................

36 days

Inventory turnover........................................

9.5x

10.1x

37.9 days

35.6 days

5.71x

5.62x

5.84x

Fixed asset turnover......................................

2.75x

2.66x

2.20x

Total asset turnover.......................................

1.43x

1.42x

1.46x

Current ratio..................................................

2.10x

2.08x

2.15x

Quick ratio....................................................

1.05x

1.02x

1.10x

Debt to total assets........................................

38%

39.5%

Times interest earned....................................

5.00x

5.20x

5.26x

Fixed charge coverage..................................

3.85x

3.95x

3.97x

9.7%

9.8%

Growth in EPS..............................................

S3-62

40.1%

CP 3-1.

Solution:
Watson Leisure Time Sporting Goods
200X

Growth in sales

(Company)
(Industry)
Profit margin
(Company)
(Industry)
Return on assets
(Company)
(Industry)
Return on equity
(Company)
(Industry)
Receivable turnover (Company)
(Industry)
Average collection (Company)
period
(Industry)
Inventory turnover (Company)
(Industry)
Fixed asset turnover (Company)
(Industry)
Total asset turnover (Company)
(Industry)
Current ratio
(Company)
(Industry)
Quick ratio
(Company)
(Industry)
Debt to total assets (Company)
(Industry)
Times interest
(Company)
earned
(Industry)
Fixed charge
(Company)
coverage
(Industry)
Growth in E.P.S.
(Company)
(Industry)

6.26%
5.75%
9.39%
8.22%
17.07%
13.26%
10.0x
10.0x
36 days
36 days
6.0x
5.71x
2.73x
2.75x
1.50x
1.43x
2.25x
2.10x
1.00x
1.05x
45.0%
38.0%
5.67x
5.0x
3.80x
3.85x
------S3-63

200Y
20%
9.98%
5.63%
5.80%
7.79%
8.24%
15.73%
13.62%
7.83x
9.5x
46.0 days
37.9 days
6.32x
5.62x
2.50x
2.66x
1.38x
1.42x
1.78x
2.08x
.91x
1.02x
50.47%
39.50%
4.75x
5.20x
3.50x
3.95x
7.7%
9.7%

200Z
20%
10.02%
5.56%
5.81%
6.34%
8.48%
14.25%
14.16%
6.55x
10.1x
55.0 days
35.6 days
6.65x
5.84x
1.85x
2.20x
1.14x
1.44x
1.45x
2.15x
0.80x
1.10x
55.48%
40.10%
3.18x
5.26x
2.76x
3.97x
3.2%
9.8%

CP 3-1. (Continued)
Discussion of Ratios
While Watson Leisure Time Sporting Goods is expanding its sales much
more rapidly than others in the industry, there are some clear
deficiencies in their performance. These can be seen in terms of a trend
analysis over time as well as a comparative analysis with industry data.
In terms of profitability, the profit margin is declining over time. This is
surprising in light of the 44 percent increase in sales over two years
(20 percent per year). There obviously are no economies of scale for this
firm. Higher selling and administrative costs and interest expense appear
to be causing the problem. The return-on-asset ratio starts out in 200X
above the industry average (9.39 percent versus 8.22 percent) and ends
up well below it (6.34 percent versus 8.48 percent) in 200Z. The decline
of 3.05 percent for return on assets at Watson Sporting Goods is serious,
and can be attributed to the previously mentioned declining profit
margin as well as a slowing total asset turnover (going from 1.5X to
1.14X).
Return on equity is higher than the industry ratio, but in a downtrend.
It is superior to the industry average for one reason: the firm has a
heavier debt position than the industry. Lower returns on assets are
translated into higher returns on equity because of the firms high debt.
The previously mentioned slower turnover of assets can be analyzed
through the turnover ratios. A very real problem can be found in
accounts receivable where turnover has gone from 10X to 6.55X.
This can also be stated in terms of an average collection period that has
increased from 36 days to 55 days. While inventory turnover has been
and remains superior to the industry, the same cannot be said for fixed
asset turnover. A decline from 2.73X to 1.85X was caused by an increase
in 112.5 percent in fixed assets (representing $619,000).
We can summarize the discussion of the turnover ratios by saying that
despite a 44 percent increase in sales, assets grew even more rapidly
causing a decline in total asset turnover from 1.50X to 1.14X.
S3-64

CP 3-1. (Continued)
The liquidity ratios also are not encouraging. Both the current and quick
ratios are falling against a stable industry norm of approximately two
and one respectively.
The debt to total assets ratio is particularly noticeable in regard to
industry comparisons. Watson Sporting Goods has gone from being
seven percent over the industry average to 15.38 percent above the norm
(55.48 percent versus 40.1 percent). Their heavy debt position is clearly
out of line with their competitors. Their downtrend in times interest
earned and fixed charge coverage confirms the heavy debt burden on the
company.
Finally, we see that the firm has a slower growth rate in earnings per
share than the industry. This is a function of less rapid growth in
earnings as well as an increase in shares outstanding (with the sale of
6,000 shares in 200Z). Once again, we see that the rapid growth in sales
is not being translated down into significant earnings gains. This is true
in spite of the fact that there is a very stable economic environment.
It does not appear that this is an attractive investment opportunity.
Optional Discussion:
Although the student was not specifically asked to address the issue, the
instructor may wish to comment on the shares that were sold in 200Z.
Looking at the capital section of the balance sheet, it appears that 6,000
shares were sold for a total value of $90,000.
$60,000
30,000
$90,000

increase in par value

increase in capital paid in excess of par
total value of 6,000 shares

S3-65

CP 3-1. (Continued)
The $90,000 proceeds indicates the 6,000 shares were sold at an average
price of $15.00 each. The $15.00 represents a fairly low multiplier of
200Z earnings of $2.61. The price/earnings ratio is 5.75X. Book value
per share (including the new shares) is $18.33 ($843,260/46,000), so
once again the price of $15 is fairly modest (81.8 percent of book value).
If Mr. Thomas were to purchase 20 percent of the shares outstanding at
$15 per share, the total cost would be:
92,000
$15

shares (20 percent of 46,000)

price per share

$138,000
He would probably have difficulty justifying such an investment based
on the performance of the firm. There are no dividend payouts, so return
to the investor would have to come in the form of capital appreciation if
and when he was able to resell the shares. The prospects, at this point,
would not appear to justify the purchase. This is particularly true when
one considers that Mr. Thomas would be buying a minority interest
(20%) and would not have control of the firm.

S3-66

Comprehensive Problem 2
Sun Microsystems is a leading supplier of computer related products, including servers,
workstations, storage devices, and network switches.
In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G.
McNealy offered the following remarks:
Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still,
we finished with revenue growth of 16 percentand thats significant. We believe its a
good indication that Sun continued to pull away from the pack and gain market share. For
that, we owe a debt of gratitude to our employees worldwide, who aggressively brought
costs downeven as they continued to bring exciting new products to market.
The statement would not appear to be telling you enough. For example, McNealy says the
year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can
delve further by examining the income statement in Exhibit 1. Also, for additional analysis of
other factors, consolidated balance sheet(s) are presented in Exhibit 2.
1.
2.
3.

Referring to Exhibit 1, compute the annual percentage change in net income per common
share-diluted (2nd numerical line from the bottom) for 19981999, 19992000, and
20002001.
Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years.
Begin with 1998.
What is the major reason for the change in the answer for question 2 between 2000 and
2001? To answer this question for each of the two years, take the ratio of the major income
statement accounts (which follow Exhibit 1 on the next page) to net revenues (sales).
Cost of sales
Research and development
Selling, general and administrative expense
Provision for income tax

S3-67

Comprehensive Problem 2 (Continued)

Exhibit 1
SUN MICROSYSTEMS, INC.
Summary Consolidated Statement of Income (in millions)
2001
Dollars
Net revenues.......................................... $18,250
Costs and expenses:
Cost of sales
10,041
...............................................................
Research and development
2,016
...............................................................
Selling, general and
4,54
administrative
4
...................................................
Goodwill amortization
261
...............................................................
In-process research and
7
development
7
...................................................
Total costs and expenses....................... 16,939

2000
Dollars
$15,721

1999
Dollars
$11,806

1998
Dollars
$9,862

7,549

5,670

4,713

1,630

1,280

1,029

4,07
2

3,19
6

2,82
6

65

19

1
2

12
1

17
6

13,328

10,286

8,748

Operating income.................................. 1,311

Gain (loss) on strategic investments.....
(90)
Interest income, net...............................
363
Litigation settlement.............................

Income before taxes.............................. 1,584

Provision for income taxes....................
603
Cumulative effect of change in
accounting principle, net
(54)
.......................................................
Net income............................................ $ 927

2,393
208
170

2,771
917

1,520

85

1,605
575

1,114

48

1,162
407

$ 1,854

$ 1,030

$ 755

0.31

$ 0.24

3,282

3,180

Net income per common share

diluted
.......................................................
Shares used in the calculation of net
income per common share
diluted
.......................................................

0.27

3,417

0.55

3,379

4.

Compute return on stockholders equity for 2000 and 2001 using data from Exhibits 1 and 2.

5.

Analyze your results to question 4 more completely by computing ratios 1, 2a, 2b, and 3b
(all from this chapter) for 2000 and 2001. Actually the answer to ratio 1 can be found as
part of the answer to question 2, but it is helpful to look at it again.
S3-68

What do you think was the main contributing factor to the change in return on stockholders
equity between 2000 and 2001? Think in terms of the Du Pont system of analysis.

S3-69

Comprehensive Problem 2 (Continued)

6.

The average stock prices for each of the four years shown in Exhibit 1 were as follows:
1998
1999
2000
2001

11
16
28
9

Exhibit 2
SUN MICROSYSTEMS, INC.
Consolidated Balance Sheets (in millions)
2001
Assets
Current assets:
Cash and cash equivalents...................................................................
$ 1,472
Short-term investments....................................................................... 387
Accounts receivable, net of allowances of $410 in 2001
and $534 in 2000
2,955
...............................................................................................
Inventories...........................................................................................1,049
Deferred tax assets..............................................................................1,102
Prepaids and other current assets........................................................ 969
Total current assets
7,934
..................................................................................................
Property, plant and equipment, net...........................................................2,697
Long-term Investments............................................................................4,677
Goodwill, net of accumulated amortization of $349 in 2001
2,04
and $88 in 2000...................................................................................
1
Other assets, net....................................................................................... 832
$18,181

S3-70

2000
$ 1,849
626
2,690
557
673
482
6,877
2,095
4,496
163
521
$14,152

Comprehensive Problem 2 (Continued)

Liabilities and Stockholders Equity
Current liabilities:
Short-term borrowings........................................................................
$
3
Accounts payable................................................................................1,050
Accrued payroll-related liabilities....................................................... 488
Accrued liabilities and other...............................................................1,374
Deferred revenues and customer deposits...........................................1,827
Warranty reserve.................................................................................. 314
Income taxes payable.......................................................................... 90
Total current liabilities
5,146
..................................................................................................
Deferred income taxes.............................................................................. 744
Long-term debt and other obligations......................................................1,705
Total debt
$ 7,595
...................................................................................................
Commitments and contingencies
Stockholders equity:
Preferred stock, $0.001 par value, 10 shares authorized
(1 share which has been designated as Series A Preferred
participating stock); no shares issued and outstanding

..................................................................................................
Common stock and additional paid-in-capital, $0.00067 par
value, 7,200 shares authorized; issued: 3,536 shares in 2001
and 3,495 shares in 2000
6,238
..................................................................................................
Treasury stock, at cost: 288 shares in 2001 and 301
shares in 2000
.................................................................................................. (2,435)
Deferred equity compensation............................................................ (73)
Retained earnings................................................................................6,885
Accumulated other comprehensive income (loss)............................... (29)
Total stockholders equity
10,586
..................................................................................................
$18,181

7
924
751
1,155
1,289
211
209
4,546

577
1,720
$ 6,843

2,728

(1,438)
(15)
5,959
75
7,309
$14,152

a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown
above and divide by net income per common stock-dilution from Exhibit 1.
b. Why do you think the P/E has changed from its 2000 level to its 2001 level? A brief
review of P/E ratios can be found under the topic of Price-Earnings Ratio Applied to
Earnings per Share in Chapter 2.
7.

The book values per share for the same four years discussed in the preceding question were:
1998
1999
2000

$1.18
$1.55
$2.29
S3-71

2001

$3.26

a. Compute the ratio of price to book value for each year.

b. Is there any dramatic shift in the ratios worthy of note?

S3-72

CP 3-2.

Solution
Sun Microsystems, Inc.

1. Percentage change in net income per common share-diluted

1999
1998

$ .31
$ .24
$ .07
+29.2%

2000
1999

$ .55
$ .31
$ .24
+77.4%

2001
2000

$ .27
$ .55
$.28
50.9%

2. Profit margin
1998
Net income $755
=
Net revenues 9,862
7.66%

1999

2000

2001

$1,030
11,806

$1,854
15,721

$927
18, 250

8.72%

11.79% 5.08%

3. Percent of net revenue

2000
Net revenues
Cost of sales
Research and
development
S, G, and A
Provision for
income taxes

$15,721
7,549

2001
48.02%

$18,250
10,041

55.02%

1,630
4,072

10.37
25.90

2,016
4,544

11.05
24.90

917

5.83

603

3.30

The main problem between 2000 and 2001 was the increase in cost
of sales as a percentage of net revenue (48.02% to 55.02%).

S3-73

CP 3-2. (Continued)
4. Return on stockholders equity

Net income Stockholders' equity

5.
1.

Net income
Net revenues (sales)

Net income
2.a. Total assets
2.b.

3.b.

Net income
Sales

Sales
Total assets

2000

2001

$1,854
7,309

$ 927
10,586

25.37%

8.76%

2000

2001

11.79%

5.08%

13.1%

5.10%

11.79% 1.11 5.08% 1.00

Return on assets
1 Debt/Assets)

13.09%

5.08%

13.09%
1 .484

5.08%
1 .418

25.37%

8.73%

The main contributing factor to the decline in the return on

stockholders equity (25.37% to 8.73%) was the decline in the
profit margin (11.79% vs. 5.08%). The decrease in asset turnover
(1.11 to 1.00) made a small contribution to the decline as did the
decline in the debt ratio (48.4% to 41.8%).

S3-74

CP 3-2. (Continued)
6.a. P/E = Stock price/net income per common share-diluted (EPS)
1998

1999

2000

2001

Shares prices
EPS

$11.25
.24

$16.75
.31

$28.50
.55

$9.50
.27

P/E

46.9

51.8

35.2

54.0

b. The sharp decline in performance caused investors to pay a lower

multiple for the stock.
7.a. Price to book value = Stock price/book value
1998

1999

2000

2001

Shares prices
Book value

$11.25
1.18

$16.75
1.55

$28.50
2.29

$9.50
3.26

P/BV

9.53

12.45

2.91

10.81

b. Once again, the sharp fall off in price to book value between 2000
and 2001 can be attributed to the decline in performance (and the
impact on the stock prices). Book value was going up, but the ratio
declined sharply due to the declining stock prices.

S3-75