92 PART 2 Financial Tools

DuPont system of analysis is a diagnostic tool used to find the key areas respon-
sible for the firm’s financial performance. It enables the firm to break the return
on common equity into three components: profit on sales, efficiency of asset use,
and use of financial leverage.

Opener-in-Review
In the chapter opener you read about how financial analysts gave Abercrombie’s
stock a relatively positive outlook based on a current ratio of 2.79, a quick ratio
of 1.79, and a receivables collection period of 43 days. Based on what you
learned in this chapter, do you agree with the analysts’ assessment? Explain why
or why not.

Self-Test Problems (Solutions in Appendix)

LG 3 LG 4 LG 5 ST3–1 Ratio formulas and interpretations Without referring to the text, indicate for each
of the following ratios the formula for calculating it and the kinds of problems, if
any, the firm may have if that ratio is too high relative to the industry average. What
if the ratio is too low relative to the industry average? Create a table similar to the
one that follows and fill in the empty blocks.

Ratio Too High Too Low

Current ratio =
Inventory turnover =
Times interest earned =
Gross profit margin =
Return on total assets =
Price/earnings (P/E) ratio =

LG 3 LG 4 LG 5 ST3–2 Balance sheet completion using ratios Complete the 2012 balance sheet for O’Keefe
Industries using the information that follows it.

O’Keefe Industries Balance Sheet December 31, 2012

Assets Liabilities and Stockholders’ Equity

Cash $32,720 Accounts payable $120,000

Marketable securities 25,000 Notes payable ________
Accounts receivable _______ Accruals 20,000
Inventories _______ Total current liabilities ________
Total current assets _______ Long-term debt ________
Net fixed assets _______ Stockholders’ equity $600,000
Total assets $ Total liabilities and stockholders’ equity $
 CHAPTER 3 Financial Statements and Ratio Analysis 93

The following financial data for 2012 are also available:

1. Sales totaled $1,800,000.
2. The gross profit margin was 25%.
3. Inventory turnover was 6.0.
4. There are 365 days in the year.
5. The average collection period was 40 days.
6. The current ratio was 1.60.
7. The total asset turnover ratio was 1.20.
8. The debt ratio was 60%.

Warm-Up Exercises All problems are available in .

LG 1 E3–1 You are a summer intern at the office of a local tax preparer. To test your basic
knowledge of financial statements, your manager, who graduated from your alma
mater 2 years ago, gives you the following list of accounts and asks you to prepare a
simple income statement using those accounts.

Accounts ($000,000)

Depreciation 25
General and administrative expenses 22
Sales 345
Sales expenses 18
Cost of goods sold 255
Lease expense 4
Interest expense 3

a. Arrange the accounts into a well-labeled income statement. Make sure you label
and solve for gross profit, operating profit, and net profit before taxes.
b. Using a 35% tax rate, calculate taxes paid and net profit after taxes.
c. Assuming a dividend of $1.10 per share with 4.25 million shares outstanding,
calculate EPS and additions to retained earnings.

LG 1 E3–2 Explain why the income statement can also be called a “profit-and-loss statement.”
What exactly does the word balance mean in the title of the balance sheet? Why do
we balance the two halves?

LG 1 E3–3 Cooper Industries, Inc., began 2012 with retained earnings of $25.32 million.
During the year it paid four quarterly dividends of $0.35 per share to 2.75 million
common stockholders. Preferred stockholders, holding 500,000 shares, were paid
two semiannual dividends of $0.75 per share. The firm had a net profit after taxes
of $5.15 million. Prepare the statement of retained earnings for the year ended
December 31, 2012.

LG 3 E3–4 Bluestone Metals, Inc., is a metal fabrication firm that manufactures prefabricated
metal parts for customers in a variety of industries. The firm’s motto is “If you need
it, we can make it.” The CEO of Bluestone recently held a board meeting during
which he extolled the virtues of the corporation. The company, he stated confidently,
94 PART 2 Financial Tools

had the capability to build any product and could do so using a lean manufacturing
model. The firm would soon be profitable, claimed the CEO, because the company
used state-of-the-art technology to build a variety of products while keeping inven-
tory levels low. As a business press reporter, you have calculated some ratios to ana-
lyze the financial health of the firm. Bluestone’s current ratios and quick ratios for
the past 6 years are shown in the table below:

2007 2008 2009 2010 2011 2012

Current ratio 1.2 1.4 1.3 1.6 1.8 2.2

Quick ratio 1.1 1.3 1.2 0.8 0.6 0.4

What do you think of the CEO’s claim that the firm is lean and soon to be prof-
itable? (Hint: Is there a possible warning sign in the relationship between the two
ratios?)

LG 5 E3–5 If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72,
and a financial leverage multiplier of 1.43, what is its ROE? What is the advantage
to using the DuPont system to calculate ROE over the direct calculation of earnings
available for common stockholders divided by common stock equity?

Problems All problems are available in .

LG 1 P3–1 Reviewing basic financial statements The income statement for the year ended
December 31, 2012, the balance sheets for December 31, 2012 and 2011, and the
statement of retained earnings for the year ended December 31, 2012, for Technica,
Inc., are given below and on the following page. Briefly discuss the form and infor-
mational content of each of these statements.

Technica, Inc. Income Statement for the Year Ended

December 31, 2012

Sales revenue $600,000

Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $ 30,000
Depreciation expense 30,000
Total operating expense $ 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Earnings available for common stockholders $ 42,900

Earnings per share (EPS) $2.15

 CHAPTER 3 Financial Statements and Ratio Analysis 95

Technica, Inc. Balance Sheets

December 31
Assets 2012 2011

Cash $ 15,000 $ 16,000

Marketable securities 7,200 8,000
Accounts receivable 34,100 42,200
Inventories 82,000 50,000
Total current assets $138,300 $116,200
Land and buildings $150,000 $150,000
Machinery and equipment 200,000 190,000
Furniture and fixtures 54,000 50,000
Other 11,000 10,000
Total gross fixed assets $415,000 $400,000
Less: Accumulated depreciation 145,000 115,000
Net fixed assets $270,000 $285,000
Total assets $408,000 $401,200

Liabilities and Stockholders’ Equity

Accounts payable $ 57,000 $ 49,000

Notes payable 13,000 16,000
Accruals 5,000 6,000
Total current liabilities $ 75,000 $ 71,000
Long-term debt $150,000 $160,000
Common stock equity (shares outstanding:
19,500 in 2012 and 20,000 in 2011) $110,200 $120,000
Retained earnings 73,100 50,200
Total stockholders’ equity $183,300 $170,200
Total liabilities and stockholders’ equity $408,300 $401,200

Technica, Inc. Statement of Retained Earnings

for the Year Ended December 31, 2012

Retained earnings balance (January 1, 2012) $50,200

Plus: Net profits after taxes (for 2012) 42,900
Less: Cash dividends (paid during 2012) 20,000
Retained earnings balance (December 31, 2012) $73,100

LG 1 P3–2 Financial statement account identification Mark each of the accounts listed in the
following table as follows:
a. In column (1), indicate in which statement—income statement (IS) or balance
sheet (BS)—the account belongs.
b. In column (2), indicate whether the account is a current asset (CA), current lia-
bility (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue (R), or
stockholders’ equity (SE).
96 PART 2 Financial Tools

(1) (2)
Account name Statement Type of account

Accounts payable _______ _______

Accounts receivable _______ _______
Accruals _______ _______
Accumulated depreciation _______ _______
Administrative expense _______ _______
Buildings _______ _______
Cash _______ _______
Common stock (at par) _______ _______
Cost of goods sold _______ _______
Depreciation _______ _______
Equipment _______ _______
General expense _______ _______
Interest expense _______ _______
Inventories _______ _______
Land _______ _______
Long-term debts _______ _______
Machinery _______ _______
Marketable securities _______ _______
Notes payable _______ _______
Operating expense _______ _______
Paid-in capital in excess of par _______ _______
Preferred stock _______ _______
Preferred stock dividends _______ _______
Retained earnings _______ _______
Sales revenue _______ _______
Selling expense _______ _______
Taxes _______ _______
Vehicles _______ _______

LG 1 P3–3 Income statement preparation On December 31, 2012, Cathy Chen, a self-
employed certified public accountant (CPA), completed her first full year in business.
During the year, she billed $360,000 for her accounting services. She had two
employees, a bookkeeper and a clerical assistant. In addition to her monthly salary
of $8,000, Ms. Chen paid annual salaries of $48,000 and $36,000 to the book-
keeper and the clerical assistant, respectively. Employment taxes and benefit costs
for Ms. Chen and her employees totaled $34,600 for the year. Expenses for office
supplies, including postage, totaled $10,400 for the year. In addition, Ms. Chen
spent $17,000 during the year on tax-deductible travel and entertainment associated
with client visits and new business development. Lease payments for the office space
rented (a tax-deductible expense) were $2,700 per month. Depreciation expense on
the office furniture and fixtures was $15,600 for the year. During the year, Ms. Chen
paid interest of $15,000 on the $120,000 borrowed to start the business. She paid
an average tax rate of 30% during 2012.
a. Prepare an income statement for Cathy Chen, CPA, for the year ended
December 31, 2012.
b. Evaluate her 2012 financial performance.
 CHAPTER 3 Financial Statements and Ratio Analysis 97

Personal Finance Problem

LG 1 P3–4 Income statement preparation Adam and Arin Adams have collected their personal
income and expense information and have asked you to put together an income and
expense statement for the year ended December 31, 2012. The following informa-
tion is received from the Adams family.

Adam’s salary $45,000 Utilities $ 3,200

Arin’s salary 30,000 Groceries 2,200
Interest received 500 Medical 1,500
Dividends received 150 Property taxes 1,659
Auto insurance 600 Income tax, Social Security 13,000
Home insurance 750 Clothes and accessories 2,000
Auto loan payment 3,300 Gas and auto repair 2,100
Mortgage payment 14,000 Entertainment 2,000

a. Create a personal income and expense statement for the period ended
December 31, 2012. It should be similar to a corporate income statement.
b. Did the Adams family have a cash surplus or cash deficit?
c. If the result is a surplus, how can the Adams family use that surplus?

LG 1 P3–5 Calculation of EPS and retained earnings Philagem, Inc., ended 2012 with a net
profit before taxes of $218,000. The company is subject to a 40% tax rate and must
pay $32,000 in preferred stock dividends before distributing any earnings on the
85,000 shares of common stock currently outstanding.
a. Calculate Philagem’s 2012 earnings per share (EPS).
b. If the firm paid common stock dividends of $0.80 per share, how many dollars
would go to retained earnings?

LG 1 P3–6 Balance sheet preparation Use the appropriate items from the following list to pre-
pare in good form Owen Davis Company’s balance sheet at December 31, 2012.

Value ($000) at Value ($000) at

Item December 31, 2012 Item December 31, 2012

Accounts payable $ 220 Inventories $ 375

Accounts receivable 450 Land 100
Accruals 55 Long-term debts 420
Accumulated depreciation 265 Machinery 420
Buildings 225 Marketable securities 75
Cash 215 Notes payable 475
Common stock (at par) 90 Paid-in capital in excess
Cost of goods sold 2,500 of par 360
Depreciation expense 45 Preferred stock 100
Equipment 140 Retained earnings 210
Furniture and fixtures 170 Sales revenue 3,600
General expense 320 Vehicles 25
98 PART 2 Financial Tools

Personal Finance Problem

LG 1 P3–7 Balance sheet preparation Adam and Arin Adams have collected their personal
asset and liability information and have asked you to put together a balance sheet as
of December 31, 2012. The following information is received from the Adams family.

Cash $ 300 Retirement funds, IRA $ 2,000

Checking 3,000 2011 Sebring 15,000
Savings 1,200 2010 Jeep 8,000
IBM stock 2,000 Money market funds 1,200
Auto loan 8,000 Jewelry and artwork 3,000
Mortgage 100,000 Net worth 76,500
Medical bills payable 250 Household furnishings 4,200
Utility bills payable 150 Credit card balance 2,000
Real estate 150,000 Personal loan 3,000

a. Create a personal balance sheet as of December 31, 2012. It should be similar to

a corporate balance sheet.
b. What must the total assets of the Adams family be equal to by December 31, 2012?
c. What was their net working capital (NWC) for the year? (Hint: NWC is the dif-
ference between total liquid assets and total current liabilities.)

LG 1 P3–8 Impact of net income on a firm’s balance sheet Conrad Air, Inc., reported net
income of $1,365,000 for the year ended December 31, 2013. Show how Conrad’s
balance sheet would change from 2012 to 2013 depending on how Conrad “spent”
those earnings as described in the scenarios that appear below.

Conrad Air, Inc. Balance Sheet as of December 31, 2012

Assets Liabilities and Stockholders’ Equity

Cash $ 120,000 Accounts payable $ 70,000

Marketable securities 35,000 Short-term notes 55,000
Accounts receivable 45,000 Current liabilities $ 125,000
Inventories 130,000 Long-term debt 2,700,000
Current assets $ 330,000 Total liabilities $2,825,000
Equipment $2,970,000 Common stock $ 500,000
Buildings 1,600,000 Retained earnings 1,575,000
Fixed assets $4,570,000 Stockholders’ equity $2,075,000
Total assets $4,900,000 Total liabilities and equity $4,900,000

a. Conrad paid no dividends during the year and invested the funds in marketable
securities.
b. Conrad paid dividends totaling $500,000 and used the balance of the net income
to retire (pay off) long-term debt.
c. Conrad paid dividends totaling $500,000 and invested the balance of the net
income in building a new hangar.
d. Conrad paid out all $1,365,000 as dividends to its stockholders.
 CHAPTER 3 Financial Statements and Ratio Analysis 99

LG 1 P3–9 Initial sale price of common stock Beck Corporation has one issue of preferred
stock and one issue of common stock outstanding. Given Beck’s stockholders’ equity
account that follows, determine the original price per share at which the firm sold its
single issue of common stock.

Stockholders’ Equity ($000)

Preferred stock $ 125

Common stock ($0.75 par, 300,000
shares outstanding) 225
Paid-in capital in excess of par on
common stock 2,625
Retained earnings 900
Total stockholders’ equity $3,875

LG 1 P3–10 Statement of retained earnings Hayes Enterprises began 2012 with a retained earn-
ings balance of $928,000. During 2012, the firm earned $377,000 after taxes. From
this amount, preferred stockholders were paid $47,000 in dividends. At year-end
2012, the firm’s retained earnings totaled $1,048,000. The firm had 140,000 shares
of common stock outstanding during 2012.
a. Prepare a statement of retained earnings for the year ended December 31, 2012,
for Hayes Enterprises. (Note: Be sure to calculate and include the amount of cash
dividends paid in 2012.)
b. Calculate the firm’s 2012 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on common stock during
2012?

LG 1 P3–11 Changes in stockholders’ equity Listed are the equity sections of balance sheets for
years 2011 and 2012 as reported by Mountain Air Ski Resorts, Inc. The overall
value of stockholders’ equity has risen from $2,000,000 to $7,500,000. Use the
statements to discover how and why this happened.

Mountain Air Ski Resorts, Inc.

Balance Sheets (partial)

Stockholders’ equity 2011 2012

Common stock ($1.00 par)

Authorized—5,000,000 shares
Outstanding—1,500,000 shares 2012 $1,500,000
— 500,000 shares 2011 $ 500,000
Paid-in capital in excess of par 500,000 4,500,000
Retained earnings 1,000,000 1,500,000
Total stockholders’ equity $2,000,000 $7,500,000

The company paid total dividends of $200,000 during fiscal 2012.

a. What was Mountain Air’s net income for fiscal 2012?
b. How many new shares did the corporation issue and sell during the year?
c. At what average price per share did the new stock sold during 2012 sell?
d. At what price per share did Mountain Air’s original 500,000 shares sell?
100 PART 2 Financial Tools

LG 2 LG 3 P3–12 Ratio comparisons Robert Arias recently inherited a stock portfolio from his uncle.
Wishing to learn more about the companies in which he is now invested, Robert per-
LG 4 LG 5
forms a ratio analysis on each one and decides to compare them to each other. Some
of his ratios are listed below.

Island Burger Fink Roland

Ratio Electric Utility Heaven Software Motors

Current ratio 1.10 1.3 6.8 4.5

Quick ratio 0.90 0.82 5.2 3.7
Debt ratio 0.68 0.46 0.0 0.35
Net profit margin 6.2% 14.3% 28.5% 8.4%

Assuming that his uncle was a wise investor who assembled the portfolio with care,
Robert finds the wide differences in these ratios confusing. Help him out.
a. What problems might Robert encounter in comparing these companies to one
another on the basis of their ratios?
b. Why might the current and quick ratios for the electric utility and the fast-food
stock be so much lower than the same ratios for the other companies?
c. Why might it be all right for the electric utility to carry a large amount of debt,
but not the software company?
d. Why wouldn’t investors invest all of their money in software companies instead
of in less profitable companies? (Focus on risk and return.)

LG 3 P3–13 Liquidity management Bauman Company’s total current assets, total current liabil-
ities, and inventory for each of the past 4 years follow:

Item 2009 2010 2011 2012

Total current assets $16,950 $21,900 $22,500 $27,000

Total current liabilities 9,000 12,600 12,600 17,400
Inventory 6,000 6,900 6,900 7,200

a. Calculate the firm’s current and quick ratios for each year. Compare the resulting
time series for these measures of liquidity.
b. Comment on the firm’s liquidity over the 2009–2010 period.
c. If you were told that Bauman Company’s inventory turnover for each year in the
2009–2012 period and the industry averages were as follows, would this infor-
mation support or conflict with your evaluation in part b? Why?

Inventory turnover 2009 2010 2011 2012

Bauman Company 6.3 6.8 7.0 6.4

Industry average 10.6 11.2 10.8 11.0
 CHAPTER 3 Financial Statements and Ratio Analysis 101

Personal Finance Problem

LG 3 P3–14 Liquidity ratio Josh Smith has compiled some of his personal financial data in
order to determine his liquidity position. The data are as follows.

Account Amount

Cash $3,200
Marketable securities 1,000
Checking account 800
Credit card payables 1,200
Short-term notes payable 900

a. Calculate Josh’s liquidity ratio.

b. Several of Josh’s friends have told him that they have liquidity ratios of about
1.8. How would you analyze Josh’s liquidity relative to his friends?

LG 3 P3–15 Inventory management Wilkins Manufacturing has annual sales of $4 million and
a gross profit margin of 40%. Its end-of-quarter inventories are

Quarter Inventory

1 $ 400,000
2 800,000
3 1,200,000
4 200,000

a. Find the average quarterly inventory and use it to calculate the firm’s inventory
turnover and the average age of inventory.
b. Assuming that the company is in an industry with an average inventory turnover
of 2.0, how would you evaluate the activity of Wilkins’ inventory?

LG 3 P3–16 Accounts receivable management An evaluation of the books of Blair Supply,

which follows, gives the end-of-year accounts receivable balance, which is believed
to consist of amounts originating in the months indicated. The company had annual
sales of $2.4 million. The firm extends 30-day credit terms.

Month of origin Amounts receivable

July $ 3,875
August 2,000
September 34,025
October 15,100
November 52,000
December 193,000
Year-end accounts receivable $300,000

a. Use the year-end total to evaluate the firm’s collection system.

b. If 70% of the firm’s sales occur between July and December, would this affect the
validity of your conclusion in part a? Explain.
102 PART 2 Financial Tools

LG 3 P3–17 Interpreting liquidity and activity ratios The new owners of Bluegrass Natural
Foods, Inc., have hired you to help them diagnose and cure problems that the com-
pany has had in maintaining adequate liquidity. As a first step, you perform a liq-
uidity analysis. You then do an analysis of the company’s short-term activity ratios.
Your calculations and appropriate industry norms are listed.

Ratio Bluegrass Industry norm

Current ratio 4.5 4.0

Quick ratio 2.0 3.1
Inventory turnover 6.0 10.4
Average collection period 73 days 52 days
Average payment period 31 days 40 days

a. What recommendations relative to the amount and the handling of inventory

could you make to the new owners?
b. What recommendations relative to the amount and the handling of accounts
receivable could you make to the new owners?
c. What recommendations relative to the amount and the handling of accounts
payable could you make to the new owners?
d. What results, overall, would you hope your recommendations would achieve?
Why might your recommendations not be effective?

LG 4 P3–18 Debt analysis Springfield Bank is evaluating Creek Enterprises, which has
requested a $4,000,000 loan, to assess the firm’s financial leverage and financial
risk. On the basis of the debt ratios for Creek, along with the industry averages (see
top of page 103) and Creek’s recent financial statements (following), evaluate and
recommend appropriate action on the loan request.

Creek Enterprises Income Statement for the Year Ended December 31, 2012

Sales revenue $30,000,000

Less: Cost of goods sold 21,000,000
Gross profits $ 9,000,000
Less: Operating expenses
Selling expense $ 3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expense $ 6,000,000
Operating profits $ 3,000,000
Less: Interest expense 1,000,000
Net profits before taxes $ 2,000,000
Less: Taxes (rate = 40%) 800,000
Net profits after taxes $ 1,200,000
Less: Preferred stock dividends 100,000
Earnings available for common stockholders $ 1,100,000
 CHAPTER 3 Financial Statements and Ratio Analysis 103

Creek Enterprises Balance Sheet December 31, 2012 Industry averages

Assets Liabilities and Stockholders’ Equity Debt ratio 0.51

Times interest
Cash $ 1,000,000 Accounts payable $ 8,000,000 earned ratio 7.30
Marketable securities 3,000,000 Notes payable 8,000,000 Fixed-payment
Accounts receivable 12,000,000 Accruals 500,000 coverage ratio 1.85
Inventories 7,500,000 Total current liabilities $16,500,000
Total current assets $23,500,000 Long-term debt (includes
Land and buildings $11,000,000 financial leases)b $20,000,000
Machinery and equipment 20,500,000 Preferred stock (25,000
Furniture and fixtures 8,000,000 shares, $4 dividend) $ 2,500,000
Gross fixed assets (at cost)a $39,500,000 Common stock (1 million
Less: Accumulated depreciation 13,000,000 shares at $5 par) 5,000,000
Net fixed assets $26,500,000 Paid-in capital in excess of
Total assets $50,000,000 par value 4,000,000
Retained earnings 2,000,000
Total stockholders’ equity $13,500,000
Total liabilities and
stockholders’ equity $50,000,000
a
The firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of
the lease have yet to run.
b
Required annual principal payments are $800,000.

LG 5 P3–19 Common-size statement analysis A common-size income statement for Creek

Enterprises’ 2011 operations follows. Using the firm’s 2012 income statement pre-
sented in Problem 3–18, develop the 2012 common-size income statement and com-
pare it to the 2011 statement. Which areas require further analysis and investigation?

Creek Enterprises Common-Size Income Statement

for the Year Ended December 31, 2011

Sales revenue ($35,000,000) 100.0%

Less: Cost of goods sold 65.9
Gross profits 34.1%
Less: Operating expenses
Selling expense 12.7%
General and administrative expenses 6.3
Lease expense 0.6
Depreciation expense 3.6
Total operating expense 23.2
Operating profits 10.9%
Less: Interest expense 1.5
Net profits before taxes 9.4%
Less: Taxes (rate = 40%) 3.8
Net profits after taxes 5.6%
Less: Preferred stock dividends 0.1
Earnings available for common stockholders 5.5%
104 PART 2 Financial Tools

LG 4 LG 5 P3–20 The relationship between financial leverage and profitability Pelican Paper, Inc.,
and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Some
financial statement values for each company follow. Use them in a ratio analysis that
compares the firms’ financial leverage and profitability.

Item Pelican Paper, Inc. Timberland Forest, Inc.

Total assets $10,000,000 $10,000,000

Total equity (all common) 9,000,000 5,000,000
Total debt 1,000,000 5,000,000
Annual interest 100,000 500,000
Total sales 25,000,000 25,000,000
EBIT 6,250,000 6,250,000
Earnings available for
common stockholders 3,690,000 3,450,00

a. Calculate the following debt and coverage ratios for the two companies. Discuss
their financial risk and ability to cover the costs in relation to each other.
(1) Debt ratio
(2) Times interest earned ratio
b. Calculate the following profitability ratios for the two companies. Discuss their
profitability relative to each other.
(1) Operating profit margin
(2) Net profit margin
(3) Return on total assets
(4) Return on common equity
c. In what way has the larger debt of Timberland Forest made it more profitable
than Pelican Paper? What are the risks that Timberland’s investors undertake
when they choose to purchase its stock instead of Pelican’s?

LG 6 P3–21 Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in fiscal
year 2012. Some ratios for the company are listed below. Use this information to
determine the dollar values of various income statement and balance sheet accounts
as requested.

McDougal Printing, Inc.

Year Ended December 31, 2012

Sales $40,000,000
Gross profit margin 80%
Operating profit margin 35%
Net profit margin 8%
Return on total assets 16%
Return on common equity 20%
Total asset turnover 2
Average collection period 62.2 days
 CHAPTER 3 Financial Statements and Ratio Analysis 105

Calculate values for the following:

a. Gross profits
b. Cost of goods sold
c. Operating profits
d. Operating expenses
e. Earnings available for common stockholders
f. Total assets
g. Total common stock equity
h. Accounts receivable

LG 6 P3–22 Cross-sectional ratio analysis Use the financial statements below and on page 106
for Fox Manufacturing Company for the year ended December 31, 2012, along with
the industry average ratios below, to:
a. Prepare and interpret a complete ratio analysis of the firm’s 2012 operations.
b. Summarize your findings and make recommendations.

Fox Manufacturing Company Income Statement

for the Year Ended December 31, 2012

Sales revenue $600,000

Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $30,000
Depreciation expense 30,000
Total operating expense 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Net profits after taxes (earnings available
for common stockholders) $ 42,900

Earnings per share (EPS) $2.15

Ratio Industry average, 2012

Current ratio 2.35

Quick ratio 0.87
Inventory turnover a 4.55
Average collection perioda 35.8 days
Total asset turnover 1.09
Debt ratio 0.300
Times interest earned ratio 12.3
Gross profit margin 0.202
Operating profit margin 0.135
Net profit margin 0.091
Return on total assets (ROA) 0.099
Return on common equity (ROE) 0.167
Earnings per share (EPS) $3.10
a
Based on a 365-day year and on end-of-year figures.
106 PART 2 Financial Tools

Fox Manufacturing Company Balance Sheet

December 31, 2012
Assets

Cash $ 15,000
Marketable securities 7,200
Accounts receivable 34,100
Inventories 82,000
Total current assets $138,300
Net fixed assets 270,000
Total assets $408,300

Liabilities and Stockholders’ Equity

Accounts payable $ 57,000

Notes payable 13,000
Accruals 5,000
Total current liabilities $ 75,000
Long-term debt $150,000
Common stock equity (20,000 shares
outstanding) $110,200
Retained earnings 73,100
Total stockholders’ equity $183,300
Total liabilities and stockholders’ equity $408,300

LG 6 P3–23 Financial statement analysis The financial statements of Zach Industries for the
year ended December 31, 2012, follow.

Zach Industries Income Statement

for the Year Ended December 31, 2012

Sales revenue $160,000

Less: Cost of goods sold 106,000
Gross profits $ 54,000
Less: Operating expenses
Selling expense $ 16,000
General and administrative expenses 10,000
Lease expense 1,000
Depreciation expense 10,000
Total operating expense $ 37,000
Operating profits $ 17,000
Less: Interest expense 6,100
Net profits before taxes $ 10,900
Less: Taxes 4,360
Net profits after taxes $ 6,540
 CHAPTER 3 Financial Statements and Ratio Analysis 107

Zach Industries Balance Sheet December 31, 2012

Assets

Cash $ 500
Marketable securities 1,000
Accounts receivable 25,000
Inventories 45,500
Total current assets $ 72,000
Land $ 26,000
Buildings and equipment 90,000
Less: Accumulated depreciation 38,000
Net fixed assets $ 78,000
Total assets $150,000

Liabilities and Stockholders’ Equity

Accounts payable $ 22,000
Notes payable 47,000
Total current liabilities $ 69,000
Long-term debt 22,950
Common stocka 31,500
Retained earnings 26,550
Total liabilities and stockholders’ equity $150,000

a
The firm’s 3,000 outstanding shares of common stock closed 2012 at a price
of $25 per share.

a. Use the preceding financial statements to complete the following table. Assume
the industry averages given in the table are applicable for both 2011 and 2012.

Ratio Industry average Actual 2011 Actual 2012

Current ratio 1.80 1.84 ______

Quick ratio 0.70 0.78 ______
Inventory turnovera 2.50 2.59 ______
Average collection perioda 37.5 days 36.5 days ______
Debt ratio 65% 67% ______
Times interest earned ratio 3.8 4.0 ______
Gross profit margin 38% 40% ______
Net profit margin 3.5% 3.6% ______
Return on total assets 4.0% 4.0% ______
Return on common equity 9.5% 8.0% ______
Market/book ratio 1.1 1.2 ______
a
Based on a 365-day year and on end-of-year figures.

b. Analyze Zach Industries’ financial condition as it is related to (1) liquidity,

(2) activity, (3) debt, (4) profitability, and (5) market. Summarize the company’s
overall financial condition.
108 PART 2 Financial Tools

LG 6 P3–24 Integrative—Complete ratio analysis Given the following financial statements (fol-
lowing and on page 109), historical ratios, and industry averages, calculate Sterling
Company’s financial ratios for the most recent year. (Assume a 365-day year.)

Sterling Company Income Statement for the Year Ended December 31, 2012

Sales revenue $10,000,000

Less: Cost of goods sold 7,500,000
Gross profits $ 2,500,000
Less: Operating expenses
Selling expense $300,000
General and administrative expenses 650,000
Lease expense 50,000
Depreciation expense 200,000
Total operating expense $ 1,200,000
Operating profits $ 1,300,000
Less: Interest expense 200,000
Net profits before taxes $ 1,100,000
Less: Taxes (rate = 40%) 440,000
Net profits after taxes $ 660,000
Less: Preferred stock dividends 50,000
Earnings available for common stockholders $ 610,000

Earnings per share (EPS) $3.05

Sterling Company Balance Sheet December 31, 2012

Assets Liabilities and Stockholders’ Equity

Cash $ 200,000 Accounts payableb $ 900,000

Marketable securities 50,000 Notes payable 200,000
Accounts receivable 800,000 Accruals 100,000
Inventories 950,000 Total current liabilities $ 1,200,000
Total current assets $ 2,000,000 Long-term debt (includes
Gross fixed assets (at cost)a $12,000,000 financial leases)c $ 3,000,000
Less: Accumulated depreciation 3,000,000 Preferred stock (25,000 shares,
$2 dividend) $ 1,000,000
Net fixed assets $ 9,000,000
Other assets 1,000,000 Common stock (200,000
Total assets $12,000,000 shares at $3 par)d 600,000
Paid-in capital in excess of
par value 5,200,000
Retained earnings 1,000,000
Total stockholders’ equity $ 7,800,000
Total liabilities and
stockholders’ equity $12,000,000

a
The firm has an 8-year financial lease requiring annual beginning-of-year payments of $50,000. Five years of the lease have yet to run.
b
Annual credit purchases of $6,200,000 were made during the year.
c
The annual principal payment on the long-term debt is $100,000.
d
On December 31, 2012, the firm’s common stock closed at $39.50 per share.
 CHAPTER 3 Financial Statements and Ratio Analysis 109

Analyze its overall financial situation from both a cross-sectional and a time-series
viewpoint. Break your analysis into evaluations of the firm’s liquidity, activity, debt,
profitability, and market.

Historical and Industry Average Ratios for Sterling Company

Industry average,
Ratio Actual 2010 Actual 2011 2012

Current ratio 1.40 1.55 1.85

Quick ratio 1.00 0.92 1.05
Inventory turnover 9.52 9.21 8.60
Average collection period 45.6 days 36.9 days 35.5 days
Average payment period 59.3 days 61.6 days 46.4 days
Total asset turnover 0.74 0.80 0.74
Debt ratio 0.20 0.20 0.30
Times interest earned ratio 8.2 7.3 8.0
Fixed-payment coverage ratio 4.5 4.2 4.2
Gross profit margin 0.30 0.27 0.25
Operating profit margin 0.12 0.12 0.10
Net profit margin 0.062 0.062 0.053
Return on total assets (ROA) 0.045 0.050 0.040
Return on common equity (ROE) 0.061 0.067 0.066
Earnings per share (EPS) $1.75 $2.20 $1.50
Price/earnings (P/E) ratio 12.0 10.5 11.2
Market/book (M/B) ratio 1.20 1.05 1.10

LG 6 P3–25 DuPont system of analysis Use the following ratio information for Johnson
International and the industry averages for Johnson’s line of business to:
a. Construct the DuPont system of analysis for both Johnson and the industry.
b. Evaluate Johnson (and the industry) over the 3-year period.
c. Indicate in which areas Johnson requires further analysis. Why?

Johnson 2010 2011 2012

Financial leverage multiplier 1.75 1.75 1.85

Net profit margin 0.059 0.058 0.049
Total asset turnover 2.11 2.18 2.34

Industry Averages

Financial leverage multiplier 1.67 1.69 1.64

Net profit margin 0.054 0.047 0.041
Total asset turnover 2.05 2.13 2.15

LG 6 P3–26 Complete ratio analysis, recognizing significant differences Home Health, Inc., has
come to Jane Ross for a yearly financial checkup. As a first step, Jane has prepared a
complete set of ratios for fiscal years 2011 and 2012. She will use them to look for
significant changes in the company’s situation from one year to the next.
110 PART 2 Financial Tools

Home Health, Inc. Financial Ratios

Ratio 2011 2012

Current ratio 3.25 3.00

Quick ratio 2.50 2.20
Inventory turnover 12.80 10.30
Average collection period 42.6 days 31.4 days
Total asset turnover 1.40 2.00
Debt ratio 0.45 0.62
Times interest earned ratio 4.00 3.85
Gross profit margin 68% 65%
Operating profit margin 14% 16%
Net profit margin 8.3% 8.1%
Return on total assets 11.6% 16.2%
Return on common equity 21.1% 42.6%
Price/earnings ratio 10.7 9.8
Market/book ratio 1.40 1.25

a. To focus on the degree of change, calculate the year-to-year proportional change

by subtracting the year 2011 ratio from the year 2012 ratio, then dividing the
difference by the year 2011 ratio. Multiply the result by 100. Preserve the posi-
tive or negative sign. The result is the percentage change in the ratio from 2011
to 2012. Calculate the proportional change for the ratios shown here.
b. For any ratio that shows a year-to-year difference of 10% or more, state whether
the difference is in the company’s favor or not.
c. For the most significant changes (25% or more), look at the other ratios and cite
at least one other change that may have contributed to the change in the ratio
that you are discussing.

LG 1 P3–27 ETHICS PROBLEM Do some reading in periodicals and/or on the Internet to find
out more about the Sarbanes-Oxley Act’s provisions for companies. Select one of
those provisions, and indicate why you think financial statements will be more trust-
worthy if company financial executives implement this provision of SOX.

Spreadsheet Exercise
The income statement and balance sheet are the basic reports that a firm constructs for
use by management and for distribution to stockholders, regulatory bodies, and the
general public. They are the primary sources of historical financial information about
the firm. Dayton Products, Inc., is a moderate-sized manufacturer. The company’s
management has asked you to perform a detailed financial statement analysis of
the firm.
 CHAPTER 3 Financial Statements and Ratio Analysis 111

The income statements for the years ending December 31, 2012 and 2011,
respectively, are presented in the table below. (Note: Purchases of inventory during
2012 amounted to $109,865.)

Annual Income Statements (Values in millions)

For the year ended

December 31, 2012 December 31, 2011

Sales $178,909 $187,510

Cost of goods sold ? 111,631
Selling, general, and administrative expenses 12,356 12,900
Other tax expense 33,572 33,377
Depreciation and amortization 12,103 7,944
Other income (add to EBIT to arrive at EBT) 3,147 3,323
Interest expense 398 293
Income tax rate (average) 35.324% 37.945%
Dividends paid per share $1.47 $0.91
Basic EPS from total operations $1.71 $2.25

You also have the following balance sheet information as of December 31, 2012
and 2011, respectively.

Annual Balance Sheets (Values in millions)

December 31, 2012 December, 31, 2011

Cash and equivalents $ 7,229 $ 6,547

Receivables 21,163 19,549
Inventories 8,068 7,904
Other current assets 1,831 1,681
Property, plant, and equipment, gross 204,960 187,519
Accumulated depreciation and depletion 110,020 97,917
Other noncurrent assets 19,413 17,891
Accounts payable 13,792 22,862
Short-term debt payable 4,093 3,703
Other current liabilities 15,290 3,549
Long-term debt payable 6,655 7,099
Deferred income taxes 16,484 16,359
Other noncurrent liabilities 21,733 16,441
Retained earnings 74,597 73,161
Total common shares outstanding 6.7 billion 6.8 billion
112 PART 2 Financial Tools

TO DO
a. Create a spreadsheet similar to Table 3.1 to model the following:
(1) A multiple-step comparative income statement for Dayton, Inc., for the
periods ending December 31, 2012 and 2011. You must calculate the cost of
goods sold for the year 2012.
(2) A common-size income statement for Dayton, Inc., covering the years 2012
and 2011.
b. Create a spreadsheet similar to Table 3.2 to model the following:
(1) A detailed, comparative balance sheet for Dayton, Inc., for the years ended
December 31, 2012 and 2011.
(2) A common-size balance sheet for Dayton, Inc., covering the years 2012 and
2011.
c. Create a spreadsheet similar to Table 3.8 to perform the following analysis:
(1) Create a table that reflects both 2012 and 2011 operating ratios for Dayton,
Inc., segmented into (a) liquidity, (b) activity, (c) debt, (d) profitability, and
(e) market. Assume that the current market price for the stock is $90.
(2) Compare the 2012 ratios to the 2011 ratios. Indicate whether the results
“outperformed the prior year” or “underperformed relative to the prior
year.”

Visit www.myfinancelab.com for Chapter Case: Assessing Martin Manufacturing’s Current Financial
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