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3 CHAPTER Evaluating A Firm s Financial Performance CHAPTER ORIENTATION Financial analysis can be defined as the process of assessing the financial condition of a firm. The principal analytical tool of the financial analyst is the financial ratio. In this chapter, we provide a set of key financial ratios and a discussion of their effective use. CHAPTER OUTLINE I II. III. Financial ratios help us identify some of the financial strengths and weaknesses of a company. The ratios give us a way of making meaningful comparisons of a firm s financial data at different points in time and with other firms. We could use ratios to answer the following important questions about a firm s operations. A. Question 1: How liquid is the firm? 1. The liquidity of a business is defined as its ability to meet maturing debt obligations. That is does or will the firm have the resources to pay the creditors when the debt comes due? There are two ways to approach the liquidity question. a. We can look at the firm s assets that are relatively liquid in nature and compare them to the amount of the debt coming due in the near term. We can look at how quickly the firm s liquid assets are being converted into cash. 2. b. B. Question 2: Is management generating adequate operating profits on the firm s assets? 1. 2. We want to know if the profits are sufficient relative to the assets being invested. We have several choices as to how we measure profits: gross profits, operating profits, or net income. Gross profits would not be acceptable because it does not include important information such as marketing and 30 distribution expenses. Net income includes the unwanted effects of the firm s financing policies. This leaves operating profits as our best choice in measuring the firm s operating profitability. Thus, the appropriate measure is the operating income return on investment (OIROI): OIROI = C. operating income total assets Question 3: How is the firm financing its assets? 1. 2. Here we are concerned with the mix of debt and equity capital the firm is using. Two primary ratios used to answer this question are the debt ratio and times interest earned. a. b. The debt ratio is the proportion of total debt to total assets. Times interest earned compares operating income to interest expense for a crude measure of the firm s capacity to service its debt. D. Question 4: Are the owners (stockholders) receiving an adequate return on their investment? 1. We want to know if the earnings available to the firm s owners, or common equity investors, are attractive when compared to the returns of owners of similar companies in the same industry. Return on equity (ROE) = net income common equity 2. 3. 4. We demonstrate the effect of using debt on net income through an example showing how the use of debt affects a firm s return on equity. Return on equity is presented as a function of: a. b. the operating income return on investment less the interest rate paid, and the amount of debt used in the capital structure relative to the equity. IV. An Integrative Approach to Ratio Analysis: The DuPont Analysis A. B. C. The DuPont analysis is another approach used to evaluate a firm s profitability and return on equity. Its graphic technique may be helpful in seeing how ratios relate to one another and the account balances. Return on Equity is a function of a firm s net profit margin, total asset turnover, and debt ratio. This list warns of the many pitfalls that may be encountered in computing and interpreting financial ratios. V. Limitations of Ratio Analysis A. 31 B. Ratio users should be aware of these concerns prior to making decisions based solely on ratio analysis. ANSWERS TO END-OF-CHAPTER QUESTIONS 3-1. In learning about ratios, we could simply study the different types or categories of ratios. These categories have conventionally been classified as follows: Liquidity ratios are used to measure the ability of a firm to pay its bills on time. Example ratios include the current ratio and acid-test ratio. Efficiency ratios reflect how effectively the firm has utilized its assets to generate sales. Examples of this type of ratio include accounts receivable turnover, inventory turnover, fixed asset turnover, and total asset turnover. Leverage ratios are used to measure the extent to which a firm has financed its assets with outside (non-owner) sources of funds. Example ratios include the debt ratio and times interest earned ratio. Profitability ratios serve as overall measures of the effectiveness of the firm s management relative to sales and/or to investment. Examples of profitability ratios include the net profit margin, return on total assets, operating profit margin, operating income return on investment, and return on common equity. Instead, we have chosen to cluster the ratios around important questions that may be addressed to some extent by certain ratios. These questions, along with the related ratios may be represented as follows: 1. How liquid is the firm? Current ratio Quick ratio Accounts receivable turnover (average collection period) Inventory turnover Is management generating adequate operating profits on the firm s assets? Operating income return on investment Operating profit margin Gross profit margin Asset turnover ratios, such as for total assets, accounts receivable, inventory, and fixed assets 2. 32 3. How is the firm financing its assets? Debt to total assets Debt to equity Times interest earned 4. Are the owners (stockholders) receiving an adequate return on their investment? Return on common equity In answering questions 2 through 4, we can see the linkage between operating activities and financing activities as they influence return on common equity. 3-2. The two sources of standards or norms used in performing ratio analysis consist of similar ratios for the firm being analyzed over a number of past operating periods, and similar ratios for firms which are in the same general industry or have similar product mix characteristics. The financial analyst can obtain norms from a variety of sources. Two of the most well known are the Dun & Bradstreet Industry Norms and Key Business Ratios and RMA s Annual Statement Studies. Industry norms often do not come from "representative" samples, and it is very difficult to categorize firms into industry groups. In addition, the industry norm is an average ratio which may not represent a desirable standard. Thus, industry averages only provide a "rough guide" to a firm s financial health. Liquidity is the ability to repay short-term debt. We measure liquidity by comparing the firm s liquid assets cash or assets that will be turned into cash in the operating cycle to the amount of short-term debt outstanding, which is the measurement provided by the current ratio and the quick, or acid-test, ratio. We can also measure liquidity by computing how quickly accounts receivables turn over (how long it takes to collect them on average) and how quickly inventories turn over. The more quickly these assets can be turned over, the more liquid the firm. Operating income return on investment is the amount of operating income produced relative to $1 of assets invested (total assets), while operating profit margin is the amount of operating income per $1 of sales. The first ratio measures the profitability on the firm s assets, while the latter measures the profitability on the sales. We can compute operating income return on investment (OIROI) as: Operating Income = Return on Invesment or as: Operating Income = Return on Investment Operating Profit Margin X Total Asset Turnover Operating Income Total Assets 3-3. 3-4. 3-5. 3-6. Thus, we see that OIROI is a function of how well we manage the income statement, as measured by the operating profit margin, and how well we manage the balance sheet (the firm s assets), as measured by the asset turnover ratio. 33 3-7. Gross profit margin measures a firm s pricing decisions and its ability to manage its cost of goods sold per dollar of sales. Operating profit margin is likewise a function of pricing and cost of goods sold, but also the amount of operating expenses (marketing expenses and general and administrative expenses) for every dollar of sales. Net profit margin builds on the above relationships, but then includes the firm s financing costs, such as interest expense. Thus, the gross profit margin measures the firm s pricing decisions and the ability to acquire or produce its product cheaply. The operating profit margin then adds the cost of distributing the product to the customer. Finally, the net profit margin adds the firm s financing decisions to the operating performance. Return on equity is equal to net income divided by the total equity. But knowing how to compute return on equity is not the same as understanding what decisions drive return on equity. It helps to know that return on equity is driven by the spread between operating income return on investment and the interest rate paid on the firm s debt. The greater the OIROI compared to the interest rate, the higher the return on equity will be. If OIROI is higher (lower) than the interest rate, as a firm increases its use of debt, return on equity will be higher (lower). 3-8. SOLUTIONS TO END-OF-CHAPTER PROBLEMS 3-1A. Cash Accounts Receivable * Inventory Current Assets Net Fixed Assets Total Assets * Based on 360 days. Current ratio Total asset turnover Gross profit margin Inventory turnover Average collection period Debt ratio Sales Cost of goods sold Total liabilities 6 1 15% 8 30 20% 2,100,000 1,785,000 420,000 201,875 175,000 223,125 600,000 1,500,000 2,100,000 Accounts Payable Long Term Debt Total Liabilities Common Equity Total Liability & Equity 100,000 320,000 420,000 1,680,000 2,100,000 3-2A. Mitchem's present current ratio of 2.5 to 1 in conjunction with its $2.5 million investment in current assets indicates that its current liabilities are presently $1 million. Letting x represent the additional borrowing against the firm's line of credit (which also 34 equals the addition to current assets) we can solve for that level of x which forces the firm's current ratio down to 2 to 1; i.e., 2 = ($2.5 million + x) / ($1.0 million + x) x = $0.5 million, or $500,000 3-3A. Instructor s Note: This is a very rudimentary "getting started" exercise. It requires no analysis beyond looking up the appropriate formula and plugging in the corresponding figures. Current ratio = Debt ratio = current assets current liabilities = = $3,500 $2,000 = = $1,700 $367 = = 1.75X .50 or 50% = 4.63X total debt total assets $4,000 $8,000 Times interest earned = Average collection period operating income interest expense = accounts receivable credit sales / 365 = $3,300 $1,000 $8,000 $4,500 = = = $8,000 $8,000 $2,000 = 91 days $8,000 / 365 = 3.3X Inventory turnover = cost of goods sold inventory = = net sales = fixed assets net sales total assets Fixed asset turnover Total asset turnover Gross profit margin = = = = 1.78X 1X .59 or 59% .21 or 21% gross profit net sales $4,700 $8,000 Operating profit margin = operating income net sales = $800 $4,000 $1,700 = $8,000 = Operating operating income income return = total assets on investment Return on net income = equity common equity = $1,700 $8,000 = .21 or 21% .20 or 20% or, we can calculate return on equity as: = Return on assets (1- debt ratio) = Total debt Net income 1 Total assets Total assets 35 = 800 (1 - .50 ) 8,000 = .20 or 20% 36 3-4A. a. b. Total Assets Turnover 3.5 = sales $5m $17.5m = sales = total assets $10m $5m = 2x Sales = Thus, the needed sales growth is $7.5 million ($17.5m - $10m), or an increase of 75%: $7.5m $10m c. For last year, Operating Income Return on Investment = = = operating profit margin 10% 20% X X total asset turnover 2.0 = 75% If sales grow by 75%, then for next year-end assuming a 10% operating profit margin: Operating Income Return on Investment = = = 3-5A. a. operating profit margin 10% 35% X X total asset turnover 3.5 Average Collection Accounts Receivable = Period Credit Sales/365 Avg Collection Period Avg Collection Period = = $562,500 (.75 x $9m)/365 30 days Note that the average collection period is based on credit sales, which are 75% of total firm sales. b. Average collection period = 20 = Accounts Receivable (.75 x $9m)/365 Solving for accounts receivable: Accounts receivable = $562,500 - $369,863 = $369,863 Thus, Brenmar would reduce its accounts receivable by $192,637. 37 c. Inventory Turnover 9 = = Cost of Goods Sold Inventories .70 x Sales Inventories .70 x $9m 9 = $700,000 Inventories = 3-6A. a. RATIO Liquidity: Current Ratio Acid-test (Quick) Ratio Average Collection Period Inventory Turnover Operating profitability: Operating Profit Margin Total Asset Turnover Average Collection Period Inventory Turnover Fixed Asset Turnover Financing: Debt Ratio Times Interest Earned 2002 6.0x 3.25x 137 days 1.27x 20.8% .5x 137 days 1.27x 1.00x 0.33 5.0x 2003 4.0x 1.92x 107 days 1.36x 24.8% .56x 107 days 1.36x 1.04x 0.35 5.63x 10.5% Industry Norm 5.0x 3.0x 90 days 2.2x 20.0% .75x 90 days 2.2x 1.00x 0.33 7.0x 9.0% Return on common stockholders investment: Return on Common Equity 7.5% b. Regarding the firm s liquidity in 2003, the current and acid-test (quick) ratios are both well below the industry averages and have decreased considerably from the prior year. Also, the average collection period and inventory turnover do not compare favorably against the industry averages, which suggests that accounts receivable and inventories are not of equal quality of these assets in other firms in the industry. So, we may reasonably conclude that Pamplin is less liquid than the average company in its industry. 38 c. In evaluating Pamplin s operating profitability relative to the average firm in the industry, we must first analyze the operating income return on investment (OIROI) both for Pamplin and the industry. From the information given, this computation may be made as follows: Operating income return on investment Industry: Pamplin 2002: Pamplin 2003: = Operating profit margin 20% 20.8% 24.8% X X X X Total asset turn over 0.75 = 15% 0.50 = 10.4% 0.56 = 13.9% Thus, given the low operating income return on investment for Pamplin relative to the industry, we must conclude that management is not doing an adequate job of generating operating profits on the firm s assets. However, they did improve between 2002 and 2003. The problem lies not with the operating profit margin, which addresses the operating costs and expenses relative to sales. Instead, the problem arises from Pamplin s management not using the firm s assets efficiently, as indicated by the low asset turnover ratios. Here the problem occurs in managing accounts receivable and inventories, where we see the low turnover ratios. The firm does appear to be using the fixed assets reasonably well note the satisfactory fixed assets turnover. d. Financing decisions A balance-sheet perspective: The debt ratio for Pamplin in 2003 is around 35%, an increase from 33% in 2002; that is, they finance slightly more than one-third of their assets with debt and a little less than two-thirds with common equity. Also, the average firm in the industry uses about the same amount of debt per dollar of assets as Pamplin. An income-statement perspective: Pamplin s times interest earned is below the industry norm 5.0 and 5.63 in 2002 and 2003, respectively, compared to 7.0 for the industry average. In thinking about why, we should remember that a company s times interest earned is affected by (1) the level of the firm s operating profitability (EBIT), (2) the amount of debt used, and (3) the interest rate. Items 2 and 3 determine the amount of interest paid by the company. Here is what we know about Pamplin: 1. The firm s operating income return on investment is below average, but improving. Thus, we would expect this fact to contribute to a lower, but also improving, times interest earned. The evidence is consistent with this thought. Pamplin uses about the same amount of debt as the average firm, which should mean that its times interest earned, all else equal, would be about the same as for the average firm. Thus, Pamplin s low times interest earned is not the consequence of using more debt. We do not have any information about Pamplin s interest rate, so we cannot make any observation about the effect of the interest rate. But 39 2. 3. we know if Pamplin is paying a higher interest rate than its competitors, such a situation would also be contributing to the problem. e. Pamplin has improved its return on common equity from 7.5% in 2002 to 10.5% in 2003, compared to an industry norm of 9%. The sharp improvement has come from a significant increase in the firm s operating income return on investment and a modest increase in the use of debt financing. It is also possible that the higher return on equity comes from Pamplin paying a lower interest rate on its debt, but we do not have enough information to know for certain. Nevertheless, Pamplin has enhanced the returns to its owners, but with a touch of additional financial risk (slightly higher debt ratio) in the process. Salco s total asset turnover, operating profit margin, and operating income return on investment. Total Asset Turnover = = = Operating Profit Margin = = = Operating Income Return on Investment = = = or = = = Sales Total Assets $4,500,000 $2,000,000 2.25 times Operating Income Sales $500,000 $4,500,000 11.11% Operating Income Total Assets $500,000 $2,000,000 25% Operating Income Sales x Sales Total Assets .1111 X 2.25 25% 3-7A. a. 40 b. The new operating income return on investment for Salco after the plant renovation: Operating Income Return on Investment = = = = Operating Income Sales .13 x $4,500,000 $3,000,000 x Sales Total Assets .13 x 1.5 19.5% c. Return earned on the common stockholders investment: Post-Renovation Analysis: Return on common equity Net Income Available = to Common Stockholders Common Equity = = $217,500 $1,000,000 + $500,000 14.5% Net income available to common stockholders following the renovation was calculated as follows: Operating Income (.13 x $4.5m) Less: Interest ($100,000 + $50,000) Earnings Before Taxes Less: Taxes (50%) Net Income Available to Common Stockholders The increase in Common equity was calculated as follows: Total assets purchased Less: Increase in debt ($1,500,000 - $1,000,000) Increase in equity to finance purchase $ 1,000,000 (500,000) $ 500,000 $ 585,000 (150,000) 435,000 (217,500) $ 217,500 The computation above is measuring the return on equity based on the beginning-of-the-year common equity. The equity would increase $217,500 by year end. 41 Pre-renovation Analysis: The pre-renovation rate of return on common equity is calculated as follows: Return on Common Equity = $200,000 $1,000,000 = 20% Comparative Analysis: A comparison of the two rates of return would argue that the renovation not be undertaken. However, since investments in fixed assets generally produce cash flows over many years, it is not appropriate to base decisions about their acquisition on a single year s ratios. There are additional problems with this approach to fixed asset decision making which we will discover when we discuss capital budgeting in a later chapter. Instructor s Note: To help convince those students who simply cannot accept the fact that the renovation may be worthwhile even though the return on common equity falls in the first year, we note that the existing plant is recorded on the firm s books at original cost less accounting depreciation. In a period of rising replacement costs, this means that the return on common equity of 20% without renovation may actually overstate the true return earned on a more realistic replacement cost common equity base. In addition, the issue is probably one of when to renovate (this year or next) rather than whether or not to renovate. That is, the existing facility may require renovation in the next two years to continue to operate. These considerations simply cannot be incorporated in the ratio analysis performed here. We find this a very useful point to make at this juncture of the course since industry practice still frequently involves use of rules of thumb and ratio guides to the analysis of capital expenditures. 3-8A. T.P. Jarmon Instructor s note: This problem serves to integrate the use of the DuPont analysis with financial ratios. The student is guided through a thorough analysis of a loan applicant that (on the surface) appears acceptable. However, an in-depth analysis reveals that the firm is not nearly so liquid as it first appears and has used a substantial amount of current debt to finance its assets. a. b. See the accompanying table. The most important ratios to consider in evaluating the firm s credit request relate to its liquidity and use of financial leverage. However, the credit analyst can also evaluate the firm s profitability ratios as a general indication as to how effective the firm s management has been in managing the resources available to it. This latter analysis would be useful in evaluating the prospects for a long and fruitful relationship with the new client. 42 c. The DuPont Analysis for Jarmon is shown in the graph on the next page. The earning power analysis provides an in-depth basis for analyzing Jarmon s only deficiency, that relating to its relatively large investment in inventories. However, even this potential weakness is largely overcome by the firm s strengths. The firm s return on assets and its return on owner capital (return on common equity) both compare well with the respective industry norms. Instructor s Note At this point, we usually note the one major deficiency of DuPont Analysis. This relates to the lack of any liquidity ratios. Thus, the analysis of earning power alone is not appropriate for credit analysis since no indicators of liquidity are calculated. This deficiency can, of course, be easily corrected by appending one or more liquidity ratios to the analysis. 43 Ratio Current Ratio Formula Calculation $138,300 $75,000 = 1.84 Industry Average 1.8 Acid-Test Ratio Current Assets - Inventory Current Liabilities $138,300 84,000 $75,000 $225,000 $408,300 = .55 = .72 .9 Debt Ratio $80,000 $10,000 43 Inventory Turnover Operating Income Return on Investment .5 =8 10 $33,000 $600,000 / 365 $460,000 $84,000 20.1 days 20 days 7 Accounts Receivable Credit Sales per Day = = 5.48 $80,000 = .196 $408,300 or 19.6% $80,000 = .133 $600,000 or 13.3% 16.8% 14% Ratio Formula Calculation $140,000 = .233 $600,000 or 23.3% $600,000 $408,300 $600,000 $270,000 = 1.47 Industry Average 25% 1.2 = 2.22 1.8 Return on Assets Net Income Total Assets Earnings Available to Common Stockholders Common Equity $42,900 = .1051 $408,300 or 10.51% $42,900 $183,300 6% 44 Return on Equity = .234 12% or 23.4% Return on Equity 23.4% Return on Assets 10.51% divided by Equity Total Assets 0.45 Net Profit Margin 7.15% multipled by Total Asset Turnover 1.47 Net Income $42,900 Sales $600,000 less divided by Sales $600,000 Sales $600,000 divided by Total Assets $408,300 Current Assets $138,300 Fixed Assets $270,000 Other Assets $0 Fixed Assets Turnover 2.22 Sales $600,000 Total costs and expenses $557,100 Cost of goods sold $460,000 Cash and Marketable Securites $20,200 Accounts Receivable $33,000 Fixed Assets $270,000 Cash operating expenses $30,000 Depreciation $30,000 Interest Expense $10,000 Taxes $27,100 Collection Period 20.08 days Inventory $84,000 Other Current Assets $1,100 Inventory Turnover 5.48 Daily Credit Accounts Sales Receivables divided by $33,000 $1,644 Cost of Goods Sold divided by $460,000 Inventory $84,000 45 3 9A. HiTech RATIO Liquidity: Current Ratio Acid-test (Quick) Ratio Average Collection Period Accounts Receivable Turnover Inventory Turnover Operating profitability: Operating Income Return on Investment Operating Profit Margin Total Asset Turnover Accounts Receivable Turnover Inventory Turnover Fixed Asset Turnover Financing: Debt Ratio Times Interest Earned Return on common stockholders investment: Return on Common Equity 2003 2.51 2.30 45.95 7.94 6.13 Industry Norm 2.01 1.66 72.64 5.02 4.42 23.2% 34.6% .67 7.94 6.13 2.51 .26 247.78 22.4% 9.0% 13.0% .69 5.02 4.42 2.27 .44 8.87 12.0% The above analysis of HiTech reveals a strong company in many areas. First, let s look at the liquidity question. How liquid is HiTech s balance sheet? The current ratio surpasses the industry, and when we subtract inventories in the acid test ratio, HiTech still surpasses the industry. It is the same with the inventory turnover ratio. This suggests that HiTech has a lower normal than inventory level. The receivable turnover and average collection period also reveal that HiTech controls this asset better than its competitors. These ratios tell us that HiTech s liquidity relies on assets other than inventory and receivables. When we review the balance sheet, this assumption is supported for we see that $11.8 million of the $17.8 million of HiTech s current assets is in cash and cash equivalents alone. We next turn to the profitability question. HiTech compares impressively on the OIROI and operating profit margin ratios. The OIROI ratio tells us that either HiTech must be doing a superior job at sales, expenses, or generating greater sales from a lower asset level. When we look at the total asset turnover, HiTech rates slightly lower than normal. HiTech is generating the same proportionate level of sales from the same level of assets as its competitors. We know that HiTech is doing a good job of turning over its current assets. The fixed asset turnover tells us that part of the problem is in the level of fixed assets that HiTech is maintaining. As we look at the balance sheet, we see that HiTech also maintains a high level of other investments . HiTech must be doing an excellent job at controlling costs, which is supported by the excellent operating profit margin ratio. We now look at the financing question. HiTech is maintaining a low level of debt as compared to the industry and is more than able to service its interest expense. This means that HiTech is financing its assets through equity. Let s look at the return that these owners are 46 receiving from their investment through the final ratio. HiTech also rates favorably on return on common equity, 22.4% as compared to the 12.0% industry average. 47 INTEGRATIVE PROBLEM 1. Blake International 1999 2000 2001 2002 2.22 1.35 58.63 6.23 3.73 0.08 0.38 0.04 1.85 18.64 0.69 2.30 0.04 2003 1.99 1.33 52.48 6.95 4.21 0.09 0.40 0.05 1.85 16.29 0.66 2.78 0.02 Current ratio 3.11 2.83 2.54 Acid-test ratio 1.64 1.78 1.56 Average collection period 53.16 62.00 56.29 Accounts receivable turnover 6.87 5.89 6.48 Inventory turnover 3.28 3.87 4.00 Operating income return on 0.22 0.15 0.16 investment Gross profit margin 0.40 0.39 0.38 Operating profit margin 0.10 0.08 0.08 Total asset turnover 2.10 1.95 2.07 Fixed asset turnover 18.13 18.81 23.21 Debt ratio 0.43 0.79 0.71 Times interest earned 14.00 6.31 4.31 Return on equity 0.18 0.36 0.27 Note: Above ratio calculations may be subject to rounding errors. Question #1 It is apparent that Blake s liquidity is decreasing over time, as the current and acid-test ratios indicate. However, the receivable turnover and average collection period stayed relatively constant while the inventory turnover actually increased. When we review the balance sheet, we note that the cash balance has actually increased while the receivable and inventory balances decreased, creating more liquidity within the total current assets, even though the net current asset balance decreased in total. The real problem lies with the increase in current liabilities over time in combination with the decrease in current assets. Question #2 Also of great concern is the decrease in operating profitability that is shown in the OIROI ratios over time. The problem does not seem to be in the cost of goods sold as indicated by the gross profit margin ratio. The problem appears in the operating profit margin having also decreased over time. Upon review of the income statement, we will see that while sales have decreased, the operating expenses have stayed the same. The total asset turnover and fixed asset turnover have also decreased, although not to the same degree. Blake has lowered the asset balances as sales have lowered, but still needs to work further to lower fixed assets, decrease expenses, and increase sales. Question #3 While sales and assets have decreased over time, the level of debt to equity has increased. As of 2003, 66% of Blake s assets are being financed through the use of debt. The company is quickly becoming over-leveraged and soon will lose its ability to pay interest as the times interest earned ratio shows. 48 Question #4 Return on common equity has declined, especially in the last two years. This can be the result of two factors, a lower rate of return or financing through less debt. As noted above, Blake has increased debt greatly over the last five years. As we have also noted, Blake s operating profitability has also decreased over the last few years as a result of decreasing sales and higher interest costs. We can safely assume that the decreasing return is the result of decreasing profits. Scott Corp. Current ratio Acid-test ratio Average collection period Accounts receivable turnover Inventory turnover 1999 1.85 1.28 80.75 4.52 4.45 2000 1.86 1.22 75.92 4.81 4.11 2001 2.05 1.33 69.69 5.24 4.01 2002 2.07 1.25 63.96 5.71 4.21 0.16 0.38 0.09 1.77 8.28 0.40 12.60 0.12 2003 2.26 1.43 64.71 5.64 4.42 0.16 0.40 0.10 1.67 6.93 0.36 16.41 0.14 Operating income return on 0.21 0.24 0.25 investment Gross profit margin 0.41 0.41 0.42 Operating profit margin 0.14 0.14 0.15 Total asset turnover 1.51 1.64 1.71 Fixed asset turnover 8.58 10.06 9.96 Debt ratio 0.37 0.38 0.41 Times interest earned 27.54 23.45 24.73 Return on equity 0.20 0.23 0.25 Note: Above ratio calculations may be subject to rounding errors. Question #1 Scott s liquidity increased over the last five years, despite its growth. While current liabilities increased, current assets grew by over 60%. This is reflected in the positive trend of the current ratio. Despite inventory growth of 90%, the acid-test ratio and inventory turnover both increased positively over time due to strong growth in other areas such as receivables and sales (which in turn impacted cost of goods sold on which the inventory turnover ratio is based). The receivable turnover ratio and average collection period also trended positively due to a slight increase in receivables as compared to an 84% increase in sales. Question #2 Operating profitability seems to have decreased slightly over the last five years. Upon review of the ratios in combination with the financial statements, this seems to be the result of two factors. One, operating expenses have grown disproportionately to sales over the years. Depreciation has grown due to the fixed asset growth, which is the second factor. The total asset turnover has increased as a result of the positive use of receivables and inventories. However, fixed assets have grown considerably, affecting both the OIROI and the fixed asset turnover. 49 Question #3 Upon initial review of the debt ratio, Scott seems to be successively financing its growth with the same proportion of debt over the last five years. However, Scott does need to be aware that the times interest earned is trending down due to the fact that the operating expenses have grown disproportionately. This will impact its ability to service debt over future years. Question #4 Scott has decreased its return on common equity especially in the last two years. Since Scott has not decreased its debt ratio, we must review the income statement for the explanation. Even though Scott has almost doubled its sales, net income has remained the same. This is the result of decreased operating profit margin and increased interest. The increased interest is either the result of increased debt or a higher cost of debt. 2. The differences in Scott s and Blake s financial performance are easy to find. Scott continues to be a thriving company while Blake seems to have many financial problems. Scott s sales have grown 84% while Blake s sales have decreased by 17%. However, they also have many similarities. Let s look at the differences and similarities by question. Liquidity Both Blake and Scott have done a good job of controlling their inventories and receivables. Both had positive trends in these areas. The difference is that Scott has considerable liquidity while Blake is losing this ability due to its increasing current liabilities. Profitability Both Scott and Blake are having problems with operating profitability. Their OIROI s have trended downward over time due to increasing operating expenses and increasing fixed assets as compared to sales. Financing The true differences appear in how Blake and Scott are financing their assets. While Scott s debt ratio has stayed the same, Blake has increased its debt ratio to 66%. This has significantly increased the risk to the financial health of Blake. While both Scott s and Blake s times interest earned have decreased due to increasing operating expenses, Blake is dangerously close to losing its ability to service its debt. Return on Investment Once again, Scott and Blake are more similar than different, except as to the severity of the amount. Scott and Blake have decreased their return on investment. Blake has increased its debt while Scott s stayed the same. Both have decreased their net income as compared to sales. This is the result of increased operating and interest costs, as gross profit margins have stayed the same. 50 Solutions for Set B 3-1B. Cash Accounts Receivable * Inventory Current Assets Net Fixed Assets Total Assets * Based on 360 days. Current ratio Total asset turnover Gross profit margin Inventory turnover Average collection period Debt ratio Sales Cost of goods sold Total liabilities 3 0.5 30% 10 45 30% 650,000 455,000 390,000 174,363 80,137 45,500 300,000 1,000,000 1,300,000 Accounts Payable Long Term Debt Total Liabilities Common Equity 100,000 290,000 390,000 910,000 Total Liability & Equity 1,300,000 3-2B. Allandale s present current ratio of 2.75 in conjunction with its $3.0 million investment in current assets indicates that its current liabilities are presently $1.09 million. Letting x represent the additional borrowing against the firm s line of credit (which also equals the addition to current assets), we can solve for that level of x which forces the firm s current ratio down to 2 to 1, i.e., 2 = ($3.0 million + x) / ($1.09 million + x) x = $.82 million 3-3B. Instructor s Note: This is a very rudimentary "getting started" exercise. It requires no analysis beyond looking up the appropriate formula and plugging in the corresponding figures. Current Ratio Debt Ratio = = = = = $3,500 $1,800 = = 1.94X $3,900 = .49 or 49% $8,000 $1,500 $367 = = 4.09X $1,500 $7,500 365 3.0X = 73 days Times Interest Earned Average Collection Period = Inventory Turnover = = $3,000 = $1,000 51 Fixed Asset Turnover = = Total Asset Turnover = Gross Profit Margin = = Operating Income = Net Sales $1,500 $8,000 = .19 or 19% Net Sales = Total Assets $7,500 = $4,500 $7,500 = $8,000 1.67X .94X .60 or 60% .20 or 20% $4,500 Gross Profits = = $7,500 Net Sales $1,500 = $7,500 == Return on Equity = = or, we can calculate return on equity as: = = = 3-4B. a. $680 $4,100 =.17 or 17% Return on assets (1- debt ratio) Total debt Net income 1 Total assets Total assets 680 (1 - .49 ) = 8,000 = = .17 or 17% Sales Total Assets $11m $6m = 1.83X Total Assets Turnover b. 2.5 Sales = = $15m Thus, the needed sales growth is $4 million ($15m - $11m) or an increase of 36%: = 36% 52 c. Last year, = = = X 6% 11% X 1.83 If sales grow by 36%, then for next year-end assuming a 6% operating profit margin: = = = Average Collection Period Avg Collection Period Avg Collection Period X 6% 15% X 2.5 3-5B. a. = = = $562,500 (.75 x $9.75m)/365 28.08 days Note that the average collection period is based on credit sales, which are 75% of total firm sales. b. = 20 = Accounts Receivable (.75 x $9.75m)/365 Accounts = Receivable Solving for accounts receivable: $400,685 Thus, Brenda Smith, Inc. would reduce its accounts receivable by $562,500 - $400,685 = c. Inventory Turnover 8 Inventories = = = = $914,062.50 $161,815 53 3-6B. a. RATIO Liquidity: Current Ratio Acid-test (Quick) Ratio Average Collection Period Inventory Turnover Operating profitability: Operating Income Return on Investment Operating Profit Margin Total Asset Turnover Average Collection Period Inventory Turnover Fixed Asset Turnover Financing: Debt Ratio Times Interest Earned 2002 5.00 2.70 131.40 1.22 2003 5.35 2.63 108.24 1.40 Industry Norm 5.00 3.00 90.00 2.20 12.24% 24.00% .51 131.40 1.22 1.04 34.69% 6.00 13.04% 22.76% .57 108.24 1.40 1.12 32.81% 5.50 9.53% 15.00% 20.00% .75 90.00 2.20 1.00 33.00% 7.00 13.43% Rate of return on common stockholders investment: Return on Common Equity 9.38% b. Regarding the firm s liquidity, the acid-test (quick) ratios are below the industry average and have decreased from the prior year. Also, the average collection period and inventory turnover are well below the industry averages, which suggests that inventories and receivables are not of equal quality of these assets in other firms in the industry. Since the current ratio is satisfactory, the problem apparently lies in the management of inventories and receivables. So, we may reasonably conclude that Chavez is less liquid than the average company in its industry because it has a greater investment in inventories and receivables than the industry average. 54 c. In evaluating Chavez s operating profitability relative to the average firm in the industry, we must first analyze the operating income return on investment (OIROI) both for Chavez and the industry. From the information given, this computation may be made as follows: = Industry: Chavez 2002: Chavez 2003: X 20.00% 24.00% 22.76% X X X 0.75 = 15.00% 0.51 = 12.24% 0.57 = 12.97% Thus, given the low operating income return on investment for Chavez relative to the industry, we must conclude that management is not doing an adequate job of generating operating profits on the firm s assets. However, they did improve between 2002 and 2003. The problem lies not with the operating profit margin, which addresses the operating costs and expenses relative to sales. Instead, the problem arises from Chavez s management not using the firm s assets efficiently, as indicated by the low asset turnover ratios. Here, the problem occurs in managing accounts receivable and inventories, where we see the low turnover ratios. The firm does appear to be using the fixed assets reasonably well note the satisfactory fixed assets turnover. d. Financing decisions A balance-sheet perspective: The debt ratio for Chavez in 2003 is around 33%, a decrease from 34.7% in 2002; that is, they finance about one-third of their assets with debt and a little more than two-thirds with common equity. The average firm in the industry uses about the same amount of debt per dollar of assets as Chavez. An income-statement perspective: Chavez s times interest earned is below the industry norm 6.0 and 5.5 in 2002 and 2003, respectively, compared to 7.0 for the industry average. In thinking about why, we should remember that a company s times interest earned is affected by (1) the level of the firm s operating profitability (EBIT), (2) the amount of debt used, and (3) the interest rate. Items 2 and 3 determine the amount of interest paid by the company. Here is what we know about Chavez: 1. The firm s operating profitability is below average, but improving. Thus, we would expect this fact to contribute to a lower times interest earned. The evidence is consistent with this thought. Chavez uses about the same amount of debt as the average firm, which should mean that its times interest earned, all else equal, would be about the same as for the average firm. Thus, Chavez s low times interest earned is not the consequence of using more debt. We do not have any information about Chavez s interest rate, so we cannot make any observation about the effect of the interest rate. But we know if Chavez is paying a higher interest rate than its competitors, such a situation would also be contributing to the problem. 55 2. 3. e. Chavez has improved its return on common equity from 9.38% in 2000 to 9.53% in 2001, compared to an industry norm of 13.43%. The improvement has come from an increase in the firm s operating income return on investment, despite a slight decrease in the use of debt financing. Thus, Chavez has enhanced the returns to its owners, and with a small decline of financial risk (slightly lower debt ratio) in the process. Mel s total asset turnover, operating profit margin, and operating income return on investment. Total Asset Turnover = = = Operating Profit Margin = = = Operating Income Return on Investment = $500,000 $5,000,000 10.00% Operating Income Total Assets $500,000 $2,000,000 25% X 10% X 2.50 = 25% $5,000,000 $2,000,000 2.50 times 3-7B. a. = = or b. = = The new operating income return on investment for Mel s after the plant renovation: = = = = x .13 X $5,000,000 $3,000,000 .13 X 1.67 21.67% 56 c. Return earned on the common stockholders investment: Post-Renovation Analysis: Return on Common Equity = = = Net Income Available to Common Stockholders Common Equity $306,000 $1,000,000 + $500,000 .204 = 20.4% Net income available to common stockholders following the renovation was calculated as follows: Operating Income (.13 x $5m) Less: Interest ($100,000 + $40,000) Earnings Before Taxes Less: Taxes (40%) Net Income Available to Common Stockholders The increase in Common equity was calculated as follows: Total assets purchased Less: Increase in debt ($1,500,000 - $1,000,000) Increase in equity to finance purchase $ 1,000,000 (500,000) $ 500,000 $ 650,000 (140,000) 510,000 (204,000) $ 306,000 The computation above is measuring the return on equity based on the beginning-of-the-year common equity. The equity would increase $217,500 by year end. Pre-renovation Analysis: The pre-renovation rate of return on common equity is calculated as follows: Return on Common Equity = $240,000 $1,000,000 = 24% 57 Comparative Analysis: A comparison of the two rates of return would argue that the renovation not be undertaken. However, since investments in fixed assets generally produce cash flows over many years, it is not appropriate to base decisions about their acquisition on a single year s ratios. There are additional problems with this approach to fixed asset decision making which we will discover when we discuss capital budgeting in a later chapter. Instructor s Note: To help convince those students who simply cannot accept the fact that the renovation may be worthwhile even though the return on common equity falls in the first year, we note that the existing plant is recorded on the firm s books at original cost less accounting depreciation. In a period of rising replacement costs, this means that the return on common equity of 24% without renovation may actually overstate the true return earned on a more realistic "replacement cost" common equity base. In addition, the issue is probably one of when to renovate (this year or next) rather than whether or not to renovate. That is, the existing facility may require renovation in the next two years to continue to operate. These considerations simply cannot be incorporated in the ratio analysis performed here. We find this a very useful point to make at this juncture of the course, since industry practice still frequently involves use of rules of thumb and ratio guides to the analysis of capital expenditures. 3-8B. a. b. See the accompanying table. The most important ratios to consider in evaluating the firm s credit request relate to its liquidity and use of financial leverage. However, the credit analyst can also evaluate the firm s profitability ratios as a general indication as to how effective the firm s management has been in managing the resources available to it. This latter analysis would be useful in evaluating the prospects for a long and fruitful relationship with the new client. 58 Ratio Formula Calculation $156,300 $73,000 Industry Average Current Ratio Current Assets Inventory Current Liabilities = 2.14 1.8 Acid-Test Ratio $156,300 93,000 = .87 $73,000 $223,000 $446,300 = .50 .9 Debt Ratio Operating Income Interest Expense .5 $120,000 $10,000 = 12 19.81 days 10 20 days 7 58 Inventory Turnover $38,000 $700,000 / 365 $500,000 $93,000 = = 5.38 Ratio Operating Income Return on Investment Formula Calculation $120,000 = .2689 $446,300 or 26.89% $120,000 $700,000 or = .171 Industry Average 16.8% 14% 17.1% 25% $200,000 = .2857 $700,000 or 28.57% $700,000 $446,300 $700,000 $290,000 Return on Assets Net Income Total Assets Earnings Available to Common Stockholders Common Equity $82,900 $446,300 or $82,900 $223,300 or = 1.57 1.2 59 Return on Equity = 2.41 1.8 = .1857 18.57% = .3712 6.0% 12% 37.12% Return on Equity 37.1% Return on Assets 18.57% divided by Equity Total Assets 0.50 Net Profit Margin 11.84% multipled by Total Asset Turnover 1.57 Net Income $82,900 Sales $700,000 less divided by Sales $700,000 Sales $700,000 divided by Total Assets $446,300 Current Assets $156,300 Fixed Assets $290,000 Other Assets $0 Fixed Assets Turnover 2.41 Sales $700,000 Total costs and expenses $617,100 Cost of goods sold $500,000 Cash and Marketable Securites $24,200 Accounts Receivable $38,000 Fixed Assets $290,000 Cash operating expenses $50,000 Depreciation $30,000 Interest Expense $10,000 Taxes $27,100 Collection Period 19.81 days Inventory $93,000 Other Current Assets $1,100 Inventory Turnover 5.38 Daily Credit Accounts Sales Receivables divided by $38,000 $1,918 Cost of Goods Sold divided by $500,000 Inventory $93,000 61 3-9B. Reynolds Computer RATIO 2003 Liquidity: Current Ratio 1.48 Acid-test (Quick) Ratio 1.40 Average Collection Period 38.69 Accounts Receivable Turnover 9.43 Inventory Turnover 50.87 Operating profitability: Operating Income Return on Investment 21.4% Operating Profit Margin 9.7% Total Asset Turnover 2.20 Accounts Receivable Turnover 9.43 Inventory Turnover 50.87 Fixed Asset Turnover 33.02 Financing: Debt Ratio .54 Times Interest Earned 72.26 Rate of return on common stockholders investment: Return on Common Equity 31.3% Norm 1.49 1.36 53.38 6.84 20.87 9.0% 6.0% 1.58 6.84 20.87 13.02 .47 14.79 13.0% Liquidity Based on the current and acid-test ratios, Reynolds Computer is performing as well as the industry average in the area of liquidity. At a detail level, Reynolds Computer is doing much better than average in managing both receivables and inventory. As you can observe, the acid-test ratio changes little from the current ratio. Based upon the small effect that inventory has on the current ratio, we might assume that Reynolds Computer is not holding a large amount of inventory. Upon review of the balance sheet, inventory only accounts for 5% of total current assets. Cash accounts for 54% of the total current assets making Reynolds Computer much more liquid than the current ratio indicates. Profitability Reynolds Computer seems to be doing an excellent job at operating profitability based on the OIROI ratio. Let s break down this ratio into its two components We have already ascertained that Reynolds Computer is managing its accounts receivable and inventory effectively. From the fixed asset ratio, Reynolds Computer is also managing a much lower amount of fixed assets as compared to sales than the industry. Overall, Reynolds Computer is generating more sales from every $1 of assets than its competitors. Reynolds Computer is also doing a good job at managing its income statement. The operating profit margin shows that Reynolds Computer is controlling costs efficiently. Both the asset turnover and profit margin contribute to Reynolds Computer s favorable operating profitability. Financing Reynolds Computer finances more of its assets through debt than its competitors. This involves more risk, but it can also provide higher returns as we will note in the next section. Reynolds Computer must be careful not to over-leverage itself. However, Reynolds Computer s times interest earned ratio indicates that Reynolds Computer can service its debt more easily than the average firm. Return on Investment- As noted above, Reynolds Computer finances more of its assets through debt than the industry average. With more debt and less equity, this will provide a higher return to its owners as long as the earned rate of return is higher than the cost of debt. Based on the high operating profitability and times interest earned ratios, we can assume this is the case. As a result, the common equity owners are receiving a higher return on their investment than the industry average. 62

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