Chapter 4, Problem 24P

### Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

Chapter
Section

### Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

# DUPONT ANALYSIS A firm has been experiencing low profitability in recent years. Perform an analysis of the firm’s financial position using the DuPont equation. The firm has no lease payments but has a $2 million sinking fund payment on its debt. The most recent industry average ratios and the firm’s financial statements are as follows:Industry Average Ratios Current ratio 3× Fixed assets turnover 6× Debt-to-capital ratio 20% Total assets turnover 3× Times interest earned 7× Profit margin 3% EBITDA coverage 9× Return on total assets 9% Inventory turnover 10× Return on common equity 12.86% Days sales outstandinga 24 days Return on invested capital 11.50% aCalculation is based on a 365-day year.Balance Sheet as of December 31, 2015 (Millions of Dollars) Cash and equivalents$78 Accounts payable $45 Accounts receivable 6600% Other current liabilities 11 Inventories 159 Notes payable 2900% Total current assets$303 Total current liabilities $85 Long-term debt 5000.00% Total liabilities$135 Gross fixed assets 225 Common stock 114 Less depreciation 78 Retained earnings 201 Net fixed assets 147 Total stockholders’ equity $315 Total assets 450 Total liabilities and equity$450 Income Statement for Year Ended December 31, 2015 (Millions of Dollars) Net sales $795.0 Cost of goods sold 660.0 Gross profit$135.0 Selling expenses 73.5 EBITDA $61.5 Depreciation expense 12.0 Earnings before interest and taxes (EBIT)$ 49.5 Interest expense 4.5 Earnings before taxes (EBT) $45.0 Taxes (40%) 18.0 Net income$ 27.0 a. Calculate the ratios you think would be useful in this analysis.b. Construct a DuPont equation, and compare the company’s ratios to the industry average ratios.c. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?d. Which specific accounts seem to be most out of line relative to other firms in the industry?e. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis? How might you correct for such potential problems?

a.

Summary Introduction

To determine: The ratios that would be useful in this analysis.

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 ratios examine the performance of the company and are used in comparing with other same business. It indicates relationship of two or more parts of financial statements.

Explanation

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 assets are $303. Current liabilities are$85.

The formula to calculate current ratio is,

Current Ratio=Current AssetsCurrent Liabilities

Substitute $303 for current assets and$85 for current liabilities.

Current Ratio=$303$85=3.56times

Therefore, current ratio is 3.56 times.

Fixed Assets Turnover Ratio:

It reflects the efficiency of company to utilize fixed asset to increase sale.

Given,

Sales are $795. Net fixed assets are$147.

The formula to calculate fixed assets turnover is,

Fixed Assets Turnover=Total Sales Net Fixed Assets

Substitute $795 for total sales and$`147 for fixed assets in above formula.

Fixed Assets Turnover=$795$147=5.40 times

Therefore, fixed assets turnover is 5.40 times.

Debt-to-CapitalRatio:

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 $79 (working note). Equity is$315 (working note).

The formula of Debt-to-capital ratio is,

Debt-to-Capital Ratio=Total DebtDebt+Equity×100

Substitute $79 for total debt and$315for equity in above formula.

Debt-to-Capital Ratio=$79$79+$315×100=$79$394×100=20.05% Therefore, debt-to-capital ratio is 20.05%. Working notes: Compute total debt. Given, Long term debt is$50.

Notes payable is $29. Calculation of total debt of the company, Total Debt=Long-term Debt+Notes Payable=$50+$29=$79 (1)

Therefore, total debt is $79. Compute the total value of the common equity. Given, Common stock is$114.

Retained earnings are $201. Formula to calculate common equity is, Common Equity=Common Stock+Retained Earnings Substitute$114 for common stock and $201 for retained earnings Common Equity=$114+$201=$315 (2)

Therefore common equity is $315. 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 is$795

Total assets are $450. Formula to calculate total assets turnover is, Total Assets Turnover=Total SalesTotal Assets Substitute$795 for total sales and $450 for total assets. Total Assets Turnover=$795$450=1.76 times Therefore, total assets turnover is 1.76 times. 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. Given, Earnings before interest and tax (EBIT)are$49.5.

Interest expense is $4.5. Formula to calculate times interest earned is, Times Interest Earned=EBITInterest Expenses Substitute$49.5 for EBIT and $4.5 for interest expense. Times Interest Earned=$49.5$4.5=11% Therefore, the times interest earned ratio is 11%. Profit Margin Profit margin is the ratio net income of the company and total sales. It is one of the profitability ratios. Given, Net income is$27.

Sales are $795. Formula to calculate profit ratio is, Profit Ratio=Net IncomeSales×100 Substitute$27 for net income and \$795 for sales in above formula

b.

Summary Introduction

To determine: DuPont equation and comparison of company’s ratio with industry average ratio.

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

c.

Summary Introduction

To identify: The income statement or balance sheet accounts figures looks to be primarily responsible for low profits or not.

d.

Summary Introduction

To identify: The particular accounts that seems to be most out of line relative to other firms in the same industry.

(e)

Summary Introduction

To identify: The validity of the ratio analysis if the firm had pronounced seasonal sales pattern or if the sales increases rapidly during the year and the way of correcting potential problems.

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