Chapter 2 Revision Exercises + Solutions

Q1) Below is a selection of financial data for a given company:

a. Calculate the current and quick ratio at the end of each year. How has the company’s
short-term liquidity changed over this period?

b. Assuming a 365-day year for all calculations, compute the following:

(i) The collection period each year based on sales.

(ii) The inventory turnover and the payables period each year based on cost of goods
sold.
(iii) The days’ sales in cash each year.
(iv) The gross margin and profit margin each year.

c. What do these calculations suggest about the company’s performance?

Solution:
a. 
Year 1 Year 2
Current
ratio 9.70 2.80
Quick ratio 9.61 2.31

The firm’s short-run liquidity has deteriorated considerably, but from a high initial base.

b.
Year 1 Year 2
Collection period
(days) 28.3  28.1 
Inventory turnover (X) 38.5  4.7 
Payables period (days) 42.3  24.3 
919.3 243.7
Days’ sales in cash    
Gross margin 8% 25%
Profit margin −57% −88%

c. The company lost money in both years, more in the second year than the first. Cash flow from
operations is negative in both years—but has improved. Liquidity has fallen and the inventory
turnover is down sharply. The more than 10-fold increase in inventory suggests that Amberjack
was either wildly optimistic about potential sales or completely lost control of its inventory. A
third possibility is that the company is building inventory in anticipation of a major sales
increase next year. In any case, the inventory investment warrants close scrutiny. In general,
these numbers look like those of an unstable, startup operation.

Q2) Answer the following questions based on the information in the table. The tax rate is 40%
and all dollars are in millions. For simplicity, assume that the companies have no other liabilities
other than the debt shown next.

  Atlantic Corp. Pacific Corp.

EBIT $450 $   470
Debt (at 8%
interest) $290 $1,490
Equity $910 $   370

a. Calculate each company’s ROE, ROA, and ROIC.

b. Why is Pacific’s ROE so much higher than Atlantic’s? Does this mean Pacific is a better
company? Why or why not?
 c. Why is Atlantic’s ROA higher than Pacific’s? What does this tell you about the two
companies?
d. How do the two companies’ ROICs compare? What does this suggest about the two
companies?
Solution:
a.  
Atlantic Corp. Pacific Corp.
ROE 27.30% 70.12%
ROA 20.70% 13.95%
ROIC 22.50% 15.16%

ROE = NOI / Equity

Atlantic = (450 × 0.92 × 0.60) / 910 = 248.40 / 910 = 27.30%
Pacific = (470 × 0.92 × 0.60) / 370 = 259.44 / 370 = 70.12%

ROA = NOI / Assets = NOI / (Debt + Equity)

Atlantic = 248.40 / (290 + 910) = 248.40 / 1,200 = 20.70%
Pacific = 259.44 / (1,490 + 370) = 259.44 / 1,860 = 13.95%

ROIC = EBIT × (1 – T) / Capital = EBIT × (1 – T) / (Debt + Equity)

Atlantic = (450 × 0.60) / (290 + 910) = 22.50%
Pacific = (470 × 0.60) / (1,490 + 370) = 15.16%

b. Pacific’s higher ROE is a natural reflection of its higher financial leverage. It does
not mean that Pacific is the better company.

c. This is also due to Pacific’s higher leverage. ROA penalizes levered companies
by comparing the net income available to equity to the capital provided by
owners and creditors. It does not mean that Pacific is a worse company than Atlantic.

d. ROIC abstracts from differences in leverage to provide a direct comparison of the

earning power of the two companies’ assets. On this metric, Atlantic is the superior
performer, although both percentages are quite attractive. Before drawing any firm
conclusions, however, it is important to ask how the business risks faced by the
companies compare and whether the observed ratios reflect long-run capabilities or
transitory events.

Q3) The following are financial statements over the period 2014 through 2017 for a given
company.

a. Use these statements to calculate as many ratios as you can.

b. What insights do these ratios provide about R&E’s financial performance? What
problems, if any, does the company appear to have?
 Income Statements
  2014 2015 2016 2017
Net sales $11,190    $13,764  $16,104 $20,613
Cost of goods sold  9,400 11,699   13,688   17,727
Gross profit  1,790     2,065      2,416    2,886
Expenses:        
General, selling, and administrative
expenses  1,019     1,239     1,610    2,267
Net interest expense       100       103     110      90
Earnings before tax      671        723        696       529
Tax      302     325      313     238
Earnings after tax $     369   $  398 $     383 $  291

Balance Sheets
2014 2015 2016 2017
Assets
Current assets:
Cash and securities $     671   $     551 $    644 $  412
Accounts receivable   1,343     1,789    2,094    2,886
Inventories   1,119     1,376    1,932    2,267
Prepaid expenses     14      12      15   18
Total current assets   3,147     3,728    4,685    5,583
Net fixed assets        128               124            295         287 
Total assets $  3,275 $ 3,852 $ 4,980 $ 5,870
Liabilities and Owners’ Equity
Current liabilities:
Bank loan $   50   $   50 $   50  $      50
Accounts payable  1,007     1,443    2,426      3,212
Current portion long-term debt       60         50         50        100
Accrued wages        5       7     10        18 
Total current liabilities   1,122    1,550    2,536     3,380
Long-term debt      960       910       860        760
Common stock     150       150        150        150
Retained earnings     1,043   1,242  1,434  1,580
 Total liabilities and owners’ equity $  3,275 $ 3,852 $ 4,980 $ 5,870

Solution:

2014 2015 2016 2017

Profitability ratios:
Return on equity (%) 30.9 28.6 24.2 16.8
Return on assets (%) 11.3 10.3 7.7 5.0
Return on invested capital (%) 18.7 18.9 17.4 12.9
Profit margin (%) 3.3 2.9 2.4 1.4
Gross margin (%) 16.0 15.0 15.0 14.0

Turnover-control ratios:
Asset turnover (X) 3.4 3.6 3.2 3.5
Fixed-asset turnover (X) 87.4 111.0 54.6 71.8
Inventory turnover (X) 8.4 8.5 7.1 7.8
Collection period (days) 43.8 47.4 47.5 51.1
Days’ sales in cash (days) 21.9 14.6 14.6 7.3
Payables period (days) 39.1 45.0 64.7 66.1

2014 2015 2016 2017

Leverage and liquidity ratios:

Assets to equity (%) 274.5 276.7 314.4 339.3

Total liabilities to assets (%) 63.6 63.9 68.2 70.5
Total liabilities to equity (%) 174.5 176.7 214.4 239.3
Long-term debt to equity (%) 80.5 65.4 54.3 43.9
Times interest earned (X) 7.7 8.0 7.3 6.9
 Times burden covered (X) * 3.9 4.0 3.4
Current ratio (X) 2.8 2.4 1.8 1.7
Acid test (X) 1.8 1.5 1.1 1.0

* Would require current portion long-term debt from 2013 in order to calculate.

Q4) You are trying to prepare financial statements for a company, but seem to be missing its
balance sheet. You have the company’s income statement, which shows sales last year were
$420 million with a gross profit margin of 40%. You also know that credit sales equaled 75% of
the firm’s total revenues last year. In addition, the firm had a collection period of 55 days, a
payables period of 40 days, and an inventory turnover of 8 times based on cost of goods sold.
Calculate the company’s year-ending balance for accounts receivable, inventory, and accounts
payable.

Solution:
Q5) Given the following information, complete the balance sheet below:

Collection period 71 days

Days’ sales in cash 34 days
Current ratio 2.6
Inventory turnover 5 times
Liabilities to
assets 75%
Payables period 36 days

All sales are on credit. All calculations assume a 365-day year. Payables period is based on cost
of goods sold.

Assets
Current assets:  
Cash $1,100,000
Accounts receivable  
Inventory  1,900,000
Total current assets  
Net fixed assets        
Total assets 8,000,000
Liabilities and shareholders’
equity  
Current liabilities:  
Accounts payable  
Short-term debt        
Total current liabilities  
Long-term debt  
Shareholders’ equity        
Total liabilities and equity  

Solution:
Q6) In 2016, a company had $500 million of assets and $200 million of liabilities. EBIT were
$120 million, interest expense was $28 million, the tax rate was 40%, principal repayment
requirements were $24 million, and annual dividends were 30 cents per share on 20 million
shares outstanding.

a. Calculate the following:

i. Liabilities-to-equity ratio
ii. Times-interest-earned ratio
iii. Times burden covered

b. What percentage decline in earnings before interest and taxes could the company
have sustained before failing to cover:
i. Interest payment requirements?
ii. Principal and interest requirements?
iii. Principal, interest, and common dividend payments?

Solution:

a.
i. Liabilities-to-equity ratio = 200 / 300 = 0.67
ii. Times interest earned = EBIT/interest expense = 120 / 28 = 4.29
iii. Times burden covered = EBIT/ interest + [principal repayment / (1 – tax rate)]
 120
= 28+ 24
(1−0.4 )
= 1.76
b.
i. To fail to cover the existing interest payments, the times interest earned ratio has to fall below
one: (4.29 – 1) / 4.29 = 76.7%, or (120 – 28) / 120 = 76.7%
ii. To fail to cover the interest and sinking fund payment, the times burden covered ratio has to
fall to below one:
(1.76 – 1) / 1.76 = 43.2%
OR
24
[
120− 28+
(1−0.4) ]
÷ 120 = 43.3% (difference due to rounding.)

iii. To fail to cover interest, principal, and dividend payments we must further subtract the impact
24 +(0.3× 20)
{ [
of dividends on the EBIT: 120− 28+
1−0.4 ]}
÷ 120 = 35%
Q7) The following table presents selected 2016 annual income statement items and balance sheet
items for Toyota Motor and Apple. All dollars are in millions. Use the information to answer the
questions that follow.

  Toyota Apple
Sales $252,708 $ 215,369
Cost of goods sold   201,125    131,376
Accounts
receivable    83,027      29,299
Inventory    18,342        2,132
Accounts payable    48,570      59,321

a. Calculate and interpret the length of the operating cycle for Toyota and Apple.
b. Calculate and interpret the length of the cash conversion cycle for Toyota and Apple.
c. What are the advantages and disadvantages of Apple’s way of running operations
compared to Toyota’s way?

Solution:
a.
Days inventory outstanding = Inventory / (COGS / 365)
Toyota: 18,342 / (201,125 / 365) = 33.3 days
Apple: 2,132 / (131,376 / 365) = 5.9 days

Collection period = Accounts receivable / (Sales / 365)

Toyota: 83,027 / (252,708 / 365) = 119.9 days
Apple: 29,299 / (215,369 / 365) = 49.7 days

Operating cycle = Days inventory outstanding + Collection period

Toyota: 33.3 + 119.9 = 153.2 days
Apple: 5.9 + 49.7 = 55.6 days

On average, it takes Toyota 153 days from the time it acquires raw materials inventory until the
time it collects payment for its finished product. The comparable time for Apple is only 56 days.
b.

Payables period = Accounts payable / (COGS / 365)

Toyota: 48,570 / (201,125 / 365) = 88.1 days
Apple: 59,321 / (131,376 / 365) = 164.8 days

Cash conversion cycle = Operating cycle – Payables period

Toyota: 153.2 – 88.1 = 65.1 days
Apple: 55.6 – 164.8 = –109.2 days

On average, it takes Toyota 65 days from the time it pays for inventory until the time it collects
payment for its finished product. Toyota needs financing to cover this period of time from when
cash is paid out until it is received. The comparable number for Apple is negative 109 days,
meaning that, on average, it receives payment for finished product well before it pays for its
inventory.

c. Having a negative cash conversion cycle is rare, and it is a great financial advantage for Apple,
because it does not need financing to cover its inventory. In fact, Apple’s fast collection time and
slow payment time result in a source of financing for the company. However, the possible
disadvantages of having a short (or negative) cash conversion cycle are the risk of inventory
shortfalls from having too little inventory on hand, the risk of driving away customers from
demanding payment so quickly, and the risk of alienating suppliers from taking so long to pay
for goods.