Fundamentals of Financial Management (MindTap Course List)
Fundamentals of Financial Management (MindTap Course List)
14th Edition
ISBN: 9781285867977
Author: Eugene F. Brigham, Joel F. Houston
Publisher: Cengage Learning
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Textbook Question
Chapter 4, Problem 23P

RATIO ANALYSIS Data for Barry Computer Co. and its industry averages follow.

  1. a. Calculate the indicated ratios for Barry.
  2. b. Construct the DuPont equation for both Barry and the industry.
  3. c. Outline Barry’s strengths and weaknesses as revealed by your analysis.
  4. d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and common equity during 2015. How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.)

Barry Computer Company: Balance Sheet as of December 31, 2015 (in Thousands)

Cash $ 77,500 Accounts payable $129,000
Receivables 336,000 Other current liabilities 117,000
Inventories 241,500 Notes payable to bank 84,000
Total current assets $655,000 Total current liabilities $330,000  
    Long-term debt 256,500
Net fixed assets 292,500 Common equity 361,000
Total assets $947,500 Total liabilities and equity $947,500

Barry Computer Company: Income Statement for Year Ended December 31, 2015 (in Thousands)

Sales $1,607,500
Cost of goods sold
Materials $717,000
Labor 453,000
Heat, light, and power 68,000
Indirect labor 113,000
Depreciation 41,500 1,392,500
Gross profit $215,000
Selling expenses 115,000
General and administrative expenses 30,000
Earnings before interest and taxes (EBIT) $70,000
Interest expense 24,500
Earnings before taxes (EBT) $45,500
Federal and state income taxes (40%) 18,200
Net income $27,300
Ratio Barry Industry Average
Current _____ 2.0×
Quick _____ 1.3×
Days sales outstandinga _____ 35 days
Inventory turnover _____ 6.7×
aCalculation is based on a 365-day year
Total assets turnover _____ 3.0×
Profit margin _____ 1.20%
ROA _____ 0
ROE _____ 9.00%
ROIC _____ 0
TIE _____ 3.0×
Debt/Total capital _____ 47.00%

(a)

Expert Solution
Check Mark
Summary Introduction

To determine: The indicated ratios.

Ratio Analysis

Ratio is used to compare two arithmetical figures. In case of the ratio analysis of the company the financial ratios are calculated. The financial ratio examines the performance of the company and is used in comparing with other same business. It indicates relationship of two or more parts of financial statements.

Explanation of Solution

Current Ratio

Current ratio is a part of liquidity ratio, which reflects the capability of the company to payback its short term debts. It is calculated based on the current assets and current liabilities that a company possesses in an accounting period.

Given,

Current asset is $655,000.

Current liabilities are $330,000.

The formula to calculate present current ratio is

Current Ratio=Current AssetsCurrent Liabilities

Substitute $655,000 for current ratio and $330,000 for current liabilities.

Current Ratio=$655,000$330,000=1.98times

Therefore, current ratio is 1.98 times.

Quick Ratio

It is also known as acid-test ratio which is used to determine the company’s capability to satisfy dues using only liquid assets. The less liquid assets inventory is excluded due to this it shows liquidity in better manner.

Given,

Current asset is $655,000.

Inventory is $241,500.

The formula of quick ratio is,

Quick Ratio=Current AssetsInventoryCurrent Liabilities

Substitute $655,000 for current assets, $330,000 for current liabilities and $241,500 for inventory.

Quick Ratio=$655,000$241,500$330,000=$413,500$330,000=1.25 times

Therefore, quick ratio is 1.25 times.

Days sales Outstanding

Days sales outstanding is used to measure days that a business usually requires to collects its receivable in average. It indicates account receivable of the firm and firm’s efficiency in collecting the account receivable.

Given,

Receivables are $336,000.

Annual sale is $1,607,500.

The formula to calculate Days sales outstanding is,

Days Sales Outstanding=Account ReceivableAnnual Sales/365=Account ReceivablesAnnual Sales×365

Substitute $336,000 for account receivables and $1,607,500 for annual sales.

Days Sales Outstanding=Account ReceivablesAnnual Sales×365=$336,000$1,607,500×365=76.29 days

Therefore, Days sales outstanding are 76.29 days.

Inventory Turnover Ratio

Inventory turnover reflects the number of times average inventory is converted into sales during a period. It is used to measure the efficiency of business operations.

Given,

Total sale is $1,607,500.

Total inventory is $241,500.

The formula of inventory turnover ratio is,

 Inventory Turnover Ratio=Total SalesTotal Inventory 

Substitute $1,607,500 for total sales and $241,500 for total inventory.

 Inventory Turnover Ratio=$1,607,500$241,500=6.66

Therefore, inventory turnover ratio is 6.66 times.

Total Assets Turnover Ratio

It indicates how effectively the asset of company is utilized. Total asset is the sum of current assets and fixed assets.

Given,

Total sales are $1,607,500.

Total assets are $947,500.

The formula of total assets turnover is,

Total Assets Turnover=Total SalesTotal Assets

Substitute $1,607,500 for total sales and $947,500 for total assets.

Total Assets Turnover=$1,607,500$947,500=1.70 times

Therefore, total assets turnover is 1.70 times.

Return on Assets

It is a profitability ratio. This ratio shows profit earning capability on per dollar of assets. It shows the percentage of net income on total assets. Higher the returns on assets better the profitability. Total assets include fixed as well as current assets.

Given,

Net income is$27,300.

Total assets are $947,500.

The formula of return on asset is,

ROA=Net IncomeTotal Value of Asset

Substitute $27,300 for net income and $947,500 for total value of assets.

ROA=$27,300$947,500=2.88%

Therefore, return on assets is 2.88%.

Return on Equity

Return on equity is the return from the equity. It is the ratio of net income and shareholders’ equity. This ratio measures the performance of the company and tells how well the company is performing. This ratio is used to compare own firm with competitors.

Given,

Net income is $27,300.

Common equity is $361,000.

The formula of return on equity is,

Return on Equity=Net IncomeCommon Equity×100

Substitute $27,300 for net income and $361,000 for common equity in above formula

Return on Equity=$27,300$361,000×100=7.56%

Therefore, return on equity is 7.56%.

Return on Invested Capital (ROIC)

It represent the amount of return earned by all investors and can be calculated by dividing total earnings available for investors to total invested capital.

Given,

Earnings before interest and tax (EBIT) are $70,000.

Tax rate is 40%.

Total debt is $340,500 (working note).

Total equity is $361,000.

The formula of ROIC is,

ROIC=EBIT(1Tax)Debt+Equity

Substitute $70,000 for EBIT, $340,500 for debt, 40% for tax and $361,000 for equity in above formula.

ROIC=$70,000(140%)340,500+$361,000=$42,000$701,500=5.99%

Therefore, Return on invested capital is 5.99%.

Working note:

Compute total debt.

Long term debt is $256,500.

Notes payable to bank is $84,000.

The total debt of the company is:

Total Debt=Long-term Debt+Notes Payable=$256,500+$84,000=$340,500

Times-Interest Earned Ratio

It is the type of solvency ratio which indicates the capability of business to repay interest and provide debt related services. It shows the relation between EBIT and long-term debt. It determines the debt servicing capacity of business keeping in view fixed interest on long-term debt.

Given,

EBIT is $70,000.

Interest expense is $24,500.

The formula to calculate times interest earned is,

Times Interest Earned=EBITInterest Expenses

Substitute $70,000 for EBIT and $24,500 for interest expense.

Times Interest Earned=$70,000$24,500=2.86%

Therefore, the Times Interest Earned ratio is 2.86%.

Debt/Total Capital

It is percentage of total capital which is financed by borrowed fund. Borrowed fund includes short and long term debts. Operating debt like account payable, accrual are not considered.

Given,

Total debt is $340,500 (working note).

Equity is $361,000

The formula of Debt/Total capital is,

Debt/Total Capital=Total DebtTotal Debt+Equity

Substitute $340,500 for total debt and $361,000 for equity.

Debt/Total Capital=$340,500$340,500+$361,000=$340,500$701,500=48.54%

Therefore, debt/total capital ratio is 48.54%.

Working notes:

Compute total debt.

Given,

Long term debt is $256,500.

Notes payable to bank is $84,000.

Calculation of total debt,

Total Debt=Long-term Debt+Notes Payable=$256,500+$84,000=$340,500

Therefore, total debt is $340,500.

(b)

Expert Solution
Check Mark
Summary Introduction

To construct: The Du Pont equation for both Company B and Industry.

Du Pont Equation

Among all ratios, return on equity is very common. It shows the value of the firm. Improvement in the ROE is considered as valued addition to the firm. ROE can be linked with other ratios. Analysis of such ratios will indicate proper reason for change in ROE. The combination is known as Du Pont equation which is shown below,

ROE =Net IncomeCommon Equity=Net IncomeTotal Assets×Total AssetsCommon Equity=Net IncomeSales×SalesTotal Assets×Total AssetsCommon Equity=Profit Margin× Total Assets Turnover Ratio×Equity Multiplier

Explanation of Solution

Determine the Du point relation

Company B

Given,

Net income of the company is$27,500.

Sales of the company are $1,607,500.

Total asset is $947,500.

Total common equity is $361,000.

The Du point relation of the company’s ratios is shown below:

ROE=Profit Margin× Total Assets Turnover Ratio×Equity Multiplier=Net IncomeSales×SalesTotal Assets×Total AssetsTotal Common Equity

Substitute $27,500 for the net income, $1,607,500 for sales, and $947,000 for total assets and $361,000 for the total common equity.

ROE=$27,500$1,607,500×$1,607,500$947,500×$947,500$361,000=1.70%×1.70times×2.62 times=7.56%

Therefore, the Du Pont equation of company is7.56%=1.70%×1.70times×2.62 times.

Industry

Given,

ROE of industry is 9%.

Profit margin is 1.20%.

Total assets turnover is 3.0 times.

Equity multiplier is 2.5 times (working note).

The DU Pont equation is,

ROE=Profit Margin× Total Assets Turnover Ratio×Equity Multiplier

Substitute 9% for ROE, 1.20 % for the profit margin, 3.0 times for the total assets turnover and 2.5 times for the equity multiplier in above formula.

9%=1.20%×3.0times×2.5%

Therefore the Du Pont equation of Industry is 9.0%=1.20%×3.0times×2.50times.

Working notes:

In case of industry, there is no equity multiplier. So, calculate equity multiplier.

Given,

Profit margin of the industry is 1.2%.

Return on equity is 9.0%.

Total assets turnover ratio is 3.0 times.

Calculation of equity multiplier,

ROE=Profit Margin× Total Assets Turnover Ratio×Equity Multiplier9.0%=1.2%×3.0 times×Equity MultiplierEquity Multiplier=9%3.60%Equity Multiplier=2.50times

Therefore, equity multiplier is 2.50 times.

(c)

Expert Solution
Check Mark
Summary Introduction

To outline: The strength and weakness of the company revealed by the analysis.

Explanation of Solution

The analysis shows the following data about the company.

RatiosCompanyIndustry
(a) Liquidity Ratio:  
Current1.98x2.0x
Quick1.25x1.3x
(b) Assets Management:  
Days sales outstanding76.29days35 days
Inventory turnover6.66x6.7x
Total assets turnover1.70x3.0x
(c) Debt Management:  
Total debt to capital48.54%47.0%
TIE2.86%3.0x
(d) Profitability:  
Profit margin1.70%1.20%
ROA2.88%3.60%
ROE7.56%9.0%
ROIC5.99%7.50%

Table (1)

  • Liquidity ratio shows the ability to pay back short term dues. The figures of the company are almost at par with industry’s average. The liquidity seems strong.
  • Assets management is the ability to utilize assets. The company weak in this respect. Total assets turnover is low. The inventory turnover of the company is half of the industry but the Days sales outstanding of the company is very high. Therefore, the company should improve collection from account receivables.
  • Debt management is the capability of the company to pay back its debts. Total debt/total capital of the company is higher than industry but TIE of the company is lower than industry.
  • Profit margin of the company is higher as compared to industry. ROA, ROE and ROIC are below the industry’s average.

Therefore, based on above given points, it can be said that the company liquidity is strong, assets management seems weak, the debt management is average and profitability can be considered strong.

(d)

Expert Solution
Check Mark
Summary Introduction

To identify: The effect in the ratio analysis of the company, supposing the company had doubled its sales as well as inventories, account receivables and common equity during 2015.

Answer to Problem 23P

If the company had doubled its sales, account receivables and inventory. The ratio analysis will be affected in the given way:

  • Liquidity Ratios: When the inventory and account receivables are doubled, then the current assets will increase. But there will be no change in current liability. The current assets will be improved and it will also improve the quick ratio. Therefore, it can be said the liquidity ratio will be improved.
  • Assets Management: There will be no change in days sales outstanding since both numerator and denominators are doubled. Inventory ratio will remain unchanged because both the numerator and denominators are doubled. The assets turnover will be little improved, as the sales will be doubled. The assets increases by little amount.
  • Total debt to capital: The equity will be doubled but debt will remain same. The proportion of debt to capital will be decreased. The solvency position of the company will be improved.
  • Profitability: Company already has better profit margin than industry. If there will be an increase in sale, the profit margin of the company. Hence, the profitability will be improved.

Explanation of Solution

If the account receivables and inventory will be doubled, the total assets of the company will be increased and it will affect the asset turnover ratio slightly because the sales are also being doubled. So, it can be said there will be little change in total assets ratio or can be unchanged also.

Therefore, if the sales, receivables, inventories and equities will be doubled, the liquidity, profitability and solvency will be improved but the assets utilization will remain same.

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Chapter 4 Solutions

Fundamentals of Financial Management (MindTap Course List)

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