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# Ratio Analysis

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EXERCISE 14-7 Selected Financial Ratios for Common Stockholders (LO2)

Recent financial statements for the Madison Corporation, a company that sells drilling equipment, are given below:

Balance Sheet
June 30
Assets
Current Assets:
Cash \$21, 000
Accounts receivable, net 160,000
Merchandise inventory 300,000
Prepaid expenses 9,000
Total current assets 490,000
Property and equipment, net 810,000
Total assets \$1,300,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities \$200,000
Bond payable, 10% 300,000
Total liabilities 500,000
Stockholders' equity:
Common stock, \$5 par value \$100,000
Retained earnings 700,000
Total stockholders' equity 800,000
Total liabilities and stockholders' equity \$1,300,000

Income Statement
For the Year Ended June 30
Sales \$2,100,000
Cost of goods sold 1,260,000
Gross margin 840,000
Net operating income 180,000
Interest expense 30,000
Net income before taxes 150,000
Income taxes (30%) 45,000
Net income \$105,000

In addition to the data in these statements, assume that Madison Corporation paid dividends of \$3.15 per share during the year. Also assume that the company's common stock had a market price of \$63 per share on June 30 and there is was no change in the number of outstanding shares of common stock during the fiscal year.

Required:
Compute the following financial ratios:

1. Earnings per share.
2. Dividend payout ratio.
3. Dividend yield ratio.
4. Price-earnings ratio.

EXERCISE 14-8 Selected Financial Ratios for Common Stockholders (LO2)

Refer to the financial statements for Madison Corporation above. Assets at the beginning of the year totaled \$1,100,000, and the stockholders' equity totaled \$725,000.

Required:
Compute the following financial ratios:

1. Return of total assets.
2. Return on common stockholders' equity.
3. Was financial leverage positive or negative for the year? Explain.

PROBLEM 14-11A Interpretation of Financial Ratios (LO1, LO2, LO3)

Shannon Michaels is interested in the stock of Acelicom, a company that sells building materials to the construction industry. Before purchasing the stock, Shannon would like your help in analyzing the following data:

Year 3 Year 2 Year 1
Sales trend 132 118 108
Current ratio 2.7 2.4 2.3
Acid-test (quick) ratio 0.6 0.8 1.0
Accounts receivable turnover 9.8 10.7 12.8
Inventory turnover 6.4 7.8 8.4
Dividend yield 7.4% 6.8% 5.7%
Dividend payout ratio 42% 52% 62%
Return on total assets 12.8% 11.5% 9.8%
Return on common stockholders' equity 15.1% 10.5% 8.6%
Dividends paid per share* \$1.40 \$1.40 \$1.40
*There have been no changes in common stock outstanding over the three-year period.

Shannon would like answers to a number of questions about the trend of events in Acelicom over the last three years. His questions are:

a. Is it becoming easier for the company to pay its bills as they come due?
b. Are customers paying their accounts at least as fast now as they were in Year 1?
c. Is the total of accounts receivable increasing, decreasing, or remaining constant?
d. Is the level of inventory increasing, decreasing, or remaining constant?
e. Is the market price of the company's stock going up or down?
f. Are the earnings per share increasing or decreasing?
g. Is the price-earnings ration going up or down?
h. Is the company employing financial leverage to the advantage of the common stockholders?

Required:
Answer each of Shannon's questions and explain how you arrived at you answer.

PROBLEM 14-12A Common-Size Statements and Financial Ratios for Creditors (LO1, LO3, LO4)

Vicki Newport organized Newport Industries 10 years ago to produce and sell several electronic devices on which she had secured patents. Although the company has been fairly profitable, it is now experiencing a severe cash shortage. For this reason, it is requesting a \$500,000 long-term loan from San Juan Bank, \$80,000 or which will be used to bolster the Cash account and \$420,000 of which will be used to modernize equipment. The company's financial statements for the two most recent years follow:

Newport Industries
Comparative Balance Sheet
This Year Last Year
Assets
Current Assets:
Cash \$60,000 \$140,000
Marketable Securities 0 30,000
Accounts receivable, net 470,000 290,000
Inventory 940,000 590,000
Prepaid expenses 35,000 40,000
Total current assets 1,505,000 1,090,000
Property and equipment, net 1,410,000 1,300,000
Total assets \$2,915,000 \$2,390,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities \$703,000 \$371,000
Bond payable, 12% 500,000 500,000
Total liabilities 1,203,000 871,000
Stockholders' equity:
Preferred stock, \$25 par, 8% 300,000 300,000
Common stock, \$10 par value 550,000 550,000
Retained earnings 862,000 669,000
Total stockholders' equity 1,712,000 1,519,000
Total liabilities and stockholders' equity \$2,915,000 \$2,390,000

Newport Industry
Comparative Income Statement and Reconciliation
This Year Last Year
Sales \$4,960,000 \$4,380,000
Cost of goods sold 3,839,000 3,470,000
Gross margin 1,121,000 910,000
Selling and administrative expenses 651,000 550,000
Net operating income 470,000 360,000
Interest expense 60,000 60,000
Net income before taxes 410,000 300,000
Income taxes (30%) 123,000 90,000
Net income 287,000 210,000
Dividends paid:
Preferred dividends 24,000 24,000
Common dividends 70,000 60,000
Total dividends paid 94,000 84,000
Net income retained 193,000 126,000
Retained earnings, beginning of year 669,000 543,000
Retained earnings, end of year \$862,000 \$669,000

During the past year, the company introduced several new product lines and raised the selling prices on a number of old product lines in order to improve its profit margin. The company also hired a new sales manager, who has expanded sales into several new territories. Sales terms are 2/10, n/30. All sales are on account. The following ratios are typical of companies in this industry:

Current ratio 2.5
Acid-test (quick) ration 1.3
Average collection period 17 days
Average sale period 60 days
Debt-to-equity ratio 0.90
Times interest earned 6.0
Return on total assets 13%
Price-earnings ratio 12

Required:
1. To assist the San Juan Bank in making a decision about the loan, compute the following ratios for both this year and last year:
a. The amount of working capital.
b. The current ratio.
c. The acid-test (quick) ratio
d. The average collection period. (The accounts receivable at the beginning of last year totaled \$240,000.)
e. The average sale period. (The inventory at the beginning of last year totaled \$490,000.)
f. The debt-to-equity ratio.
g. The times interest earned.

2. For both this year and last year:
a. Present the balance sheet in common-size format.
b. Present the income statement in common-size format down through net-income.

3. Comment on the results of your analysis in (1) and (2) above and make a recommendation as to whether or not the loan should be approved.

PROBLEM 14-13A Financial Ratios for Common Stockholders (LO2)

Refer to the financial statements and other data in problem 14-12A. Assume that you are an account executive for a large brokerage house and that one of your clients has asked for a recommendation about the possible purchase of Newport Industry stock. You are not acquainted with the stock and for this reason wish to do some analytical work before making a recommendation.

Required:
1. You decide first to assess the well being of the common shareholders. For both this year and last year compute:
a. The earnings per share. There has been no change in preferred or common stock over the last two years.
b. The dividend yield ratio for common stock. The company's stock is currently selling for \$38 per share; last year it sold for \$35 per share.
c. The dividend payout ratio for common stock.
d. The price-earnings ratio. How do investors regard Newport Industry as compared to other companies in the industry? Explain.
e. The book value per share of common stock. Does the difference between market value and book value suggest that the stock is overpriced? Explain.

2. You decide next to assess the company's rate of return. Compute the following for both this year and last year:
a. The return on total assets. (Total assets at the beginning of last year were \$2,230,000.)
b. The return on common stockholders' equity. (Stockholders' equity at the beginning of last year was \$1,418,000.)
c. Is the company's financial leverage positive or negative? Explain.

3. Would you recommend that you client purchase shares of Newport Industry stock? Explain.

ETHICS CHALLENGE (LO3, LO4)

Mountain Aerosport was founded by Jurgen Prinz to produce a ski he had designed for doing aerial tricks. Up to this point, Jurgen has financed the company with his own savings and with cash generated by his business. However, Jurgen now faces a cash crisis. In the year just ended, an acute shortage of a vital tungsten steel alloy developed just as the company was beginning production for the Christmas season. Jurgen had been assured by his suppliers that the steel would be delivered in time to make Christmas shipments, but the suppliers had been unable to fully deliver on this promise. As a consequence, Mountain Aerosport had large stocks of unfinished skis at the end of the year and had been unable to fill all of the orders that had come from retailers for the Christmas season. Consequently, sales are below expectations for the year, and Jurgen does not have enough cash to pay his creditors.
Well before the accounts payable were due, Jurgen visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Jurgen that there should not be any problem getting a loan to pay off his accounts payable - providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income was at least four times the interest on the proposed loan. Jurgen promised to return later with a copy of his financial statements.
Jurgen would like to apply for a \$120 thousand six-month loan bearing an interest rate of 10% per year. The unaudited financial reports of the company appear below.

Mountain Aerosport
Comparative Balance Sheet
As of December 31
(in thousands of dollars)
This Year Last Year
Assets
Current Assets:
Cash \$105 \$225
Accounts receivable, net 75 60
Inventory 240 150
Prepaid expenses 15 18
Total current assets 435 453
Property and equipment, net 405 270
Total assets \$840 \$723
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable \$231 \$135
Accrued payables 15 15
Total current liabilities 246 150
Long-term liabilities 0 0
Total liabilities 246 150
Stockholders' equity:
Common stock and additional paid-in capital 150 150
Retained earnings 444 423
Total stockholders' equity 594 573
Total liabilities and stockholders' equity \$840 \$723

Mountain Aerosport
Income Statement
For the Year Ended December 31, This Year
(in thousands of dollars)
Sales (all on account) \$630
Cost of goods sold 435
Gross margin 195
Selling expenses 63
Total selling and administrative expenses 165
Net operating income 30
Interest expense 0
Net income before taxes 30
Income taxes (30%) 9
Net income \$21

Required:
1. On the basis of the above unaudited financial statements and the statement made by the loan officer, would the company qualify for the loan?
2. Last year Jurgen purchased and installed new, more efficient equipment to replace an older heat-treating furnace. Jurgen had originally planned to sell the old equipment but found that it is still needed whenever the heat-treating process is a bottleneck. When Jurgen discussed his cash flow problems with his brother-in-law, he suggested to Jurgen that the old equipment be sold or at least reclassified as inventory on the balance sheet since it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of \$68 thousand. The bank does not require audited financial statements. What advise would you give to Jurgen concerning the machine?

#### Solution Preview

EXERCISE 14-7 Selected Financial Ratios for Common Stockholders (LO2)

Recent financial statements for the Madison Corporation, a company that sells drilling equipment, are given below:

Balance Sheet
June 30
Assets
Current Assets:
Cash \$21, 000
Accounts receivable, net 160,000
Merchandise inventory 300,000
Prepaid expenses 9,000
Total current assets 490,000
Property and equipment, net 810,000
Total assets \$1,300,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities \$200,000
Bond payable, 10% 300,000
Total liabilities 500,000
Stockholders' equity:
Common stock, \$5 par value \$100,000
Retained earnings 700,000
Total stockholders' equity 800,000
Total liabilities and stockholders' equity \$1,300,000

Income Statement
For the Year Ended June 30
Sales \$2,100,000
Cost of goods sold 1,260,000
Gross margin 840,000
Net operating income 180,000
Interest expense 30,000
Net income before taxes 150,000
Income taxes (30%) 45,000
Net income \$105,000

In addition to the data in these statements, assume that Madison Corporation paid dividends of \$3.15 per share during the year. Also assume that the company's common stock had a market price of \$63 per share on June 30 and there is was no change in the number of outstanding shares of common stock during the fiscal year.

Required:
Compute the following financial ratios:

1. Earnings per share.
EPS = Net Income/Number of common shares outstanding
Since the common stock value is 100,000 and the par value is \$5, the number of shares is 100,000/5 = 20,000
EPS = 105,000/20,000 = \$5.25

2. Dividend payout ratio.

Dividend payout ratio = Dividend per share / Earnings per share = 3.15/5.25 = 60%

3. Dividend yield ratio.

Dividend yield ratio = Dividend per share/Market price
= 3.15/63 = 5%

4. Price-earnings ratio.

Price - Earnings = Market Price/EPS = 63/5.25 = 12 times

EXERCISE 14-8 Selected Financial Ratios for Common Stockholders (LO2)

Refer to the financial statements for Madison Corporation above. Assets at the beginning of the year totaled \$1,100,000, and the stockholders' equity totaled \$725,000.

Required:
Compute the following financial ratios:

1. Return of total assets.

Return on total assets = (Net Income + Interest Expense X (1-tax rate)/Average total assets
= (105,000 + 30,000 X (1-0.3))/((,100,000+1,300,000)/2)
=126,000/1,200,000 = 10.5%

2. Return on common stockholders' equity.

Return on Equity = (Net Income - Preferred dividends)/Average equity
=105,000/((725,000+800,000)/2) = 13.8%

3. Was financial leverage positive or negative for the year? Explain.

Financial leverage refers to the use of debt and the increase in return on equity as compared to return on assets. Financial leverage is positive if the ROE > ROA. In this case the financial leverage was positive since the ROE is greater than ROA.

PROBLEM 14-11A Interpretation of Financial Ratios (LO1, LO2, LO3)

Shannon Michaels is interested in the stock of Acelicom, a company that sells building materials to the construction industry. Before purchasing the stock, Shannon would like your help in analyzing the following data:

Year 3 Year 2 Year 1
Sales trend 132 118 108
Current ratio 2.7 2.4 2.3
Acid-test (quick) ratio 0.6 0.8 1.0
Accounts receivable turnover 9.8 10.7 12.8
Inventory turnover 6.4 7.8 8.4
Dividend yield 7.4% 6.8% 5.7%
Dividend payout ratio 42% 52% 62%
Return on total assets 12.8% 11.5% 9.8%
Return on common stockholders' equity 15.1% 10.5% 8.6%
Dividends paid per share* \$1.40 \$1.40 \$1.40
*There have been no changes in common stock outstanding over the three-year period.

Shannon would like answers to a number of questions about the trend of events in Acelicom over the last three years. His questions are:

a. Is it becoming easier for the company to pay its bills as they come due?

No it is not becoming easier to pay the bills. The reason is the increase in current ratio and the decrease in quick ratio. An increase in current ratio coupled with the decrease in receivables and inventory turnover indicates that the firm is converting assets in cash at a slower rate and so would find difficult to pay its bills.

b. Are customers paying their accounts at least as fast now as they were in Year 1?

The decrease in accounts receivable turnover implies that the customers are paying their accounts more slowly in year 3 as compared to year 1.

c. Is the total of accounts receivable increasing, decreasing, or remaining constant?

The total of accounts receivable is increasing. The reason is that sales are increasing and the accounts receivable turnover is decreasing. The average collection period is increasing and that combined with higher sales would imply that the total of accounts receivable is increasing.

d. Is the level of inventory increasing, decreasing, or remaining constant?

The level of inventory is possibly increasing. The inventory turnover is down indicating that inventory is there for more number of days. The sales have increased and assuming that the gross margin is the same, the cost of goods sold would have increased. With the number of days rising, the inventory value would increase.

e. Is the market price of the company's stock going up or down?

An increasing dividend yield with a constant dividend per share amount indicates that the market price of the stock is going down.

f. Are the earnings per share increasing or decreasing?

The earnings per share is increasing. The reason is the decrease in dividend payout ratio. Dividend payout ratio = DPS/EPS and since the DPS is constant and so for the ratio to decrease, the EPS has to increase

g. Is the ...

#### Solution Summary

The solution explains the calculation of various ratios

\$2.19