140 Part 2 Fundamental Concepts in Financial Management

4-8 Why is it sometimes misleading to compare a company’s financial ratios with those of other
firms that operate in the same industry?

4-9 Suppose you were comparing a discount merchandiser with a high-end merchandiser.
Suppose further that both companies had identical ROEs. If you applied the DuPont
equation to both firms, would you expect the three components to be the same for each
company? If not, explain what balance sheet and income statement items might lead to the
component differences.

4-10 Refer to an online finance source such as Yahoo! Finance or Google Finance to look up the
P/E ratios for Alphabet Inc. (the parent company of Google), and Macy’s. Which company
has the higher P/E ratio? What factors could explain this?

4-11 Differentiate between ROE and ROIC.

4-12 Indicate the effects of the transactions listed in the following table on total current assets,
current ratio, and net income. Use (1) to indicate an increase, (2) to indicate a decrease,
and (0) to indicate either no effect or an indeterminate effect. Be prepared to state any
necessary assumptions and assume an initial current ratio of more than 1.0. (Note: A good
accounting background is necessary to answer some of these questions; if yours is not
strong, answer the questions you can.)

Total Effect
Current Current on Net
Assets Ratio Income
a. Cash is acquired through issuance of additional
common stock. _____ _____ _____
b. Merchandise is sold for cash. _____ _____ _____
c. Federal income tax due for the previous year is paid. _____ _____ _____
d. A fixed asset is sold for less than book value. _____ _____ _____
e. A fixed asset is sold for more than book value. _____ _____ _____
f. Merchandise is sold on credit. _____ _____ _____
g. Payment is made to trade creditors for previous purchases. _____ _____ _____
h. A cash dividend is declared and paid. _____ _____ _____
i. Cash is obtained through short-term bank loans. _____ _____ _____
j. Short-term notes receivable are sold at a discount. _____ _____ _____
k. Marketable securities are sold below cost. _____ _____ _____
l. Advances are made to employees. _____ _____ _____
m. Current operating expenses are paid. _____ _____ _____
n. Short-term promissory notes are issued to trade creditors
in exchange for past due accounts payable. _____ _____ _____
o. 10-year notes are issued to pay off accounts payable. _____ _____ _____
p. A fully depreciated asset is retired. _____ _____ _____
q. Accounts receivable are collected. _____ _____ _____
r. Equipment is purchased with short-term notes. _____ _____ _____
s. Merchandise is purchased on credit. _____ _____ _____
t. The estimated taxes payable are increased. _____ _____ _____

Problems

Easy Problems 4-1 DAYS SALES OUTSTANDING Baxley Brothers has a DSO of 23 days, and its annual sales
1-6 are $3,650,000. What is its accounts receivable balance? Assume that it uses a 365-day year.

4-2 DEBT TO CAPITAL RATIO Kaye’s Kitchenware has a market/book ratio equal to 1. Its
stock price is $12 per share and it has 4.8 million shares outstanding. The firm’s total

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 Chapter 4 Analysis of Financial Statements 141

capital is $110 million and it finances with only debt and common equity. What is its
debt-to-capital ratio?

4-3 DuPONT ANALYSIS Henderson’s Hardware has an ROA of 11%, a 6% profit margin, and
an ROE of 23%. What is its total assets turnover? What is its equity multiplier?

4-4 MARKET/BOOK AND EV/EBITDA RATIOS Edelman Engines has $17 billion in total
assets—of which cash and equivalents total $100 million. Its balance sheet shows
$1.7 billion in current liabilities—of which the notes payable balance totals $1 billion.
The firm also has $10.2 billion in long-term debt and $5.1 billion in common equity. It
has 300 million shares of common stock outstanding, and its stock price is $20 per share.
The firm’s EBITDA totals $1.368 billion. Assume the firm’s debt is priced at par, so the
market value of its debt equals its book value. What are Edelman’s market/book and
its EV/EBITDA ratios?

4-5 PRICE/EARNINGS RATIO A company has an EPS of $2.40, a book value per share of $21.84,
and a market/book ratio of 2.73. What is its P/E ratio?

4-6 DuPONT AND ROE A firm has a profit margin of 3% and an equity multiplier of 1.9. Its
sales are $150 million, and it has total assets of $60 million. What is its ROE?

Intermediate 4-7 ROE AND ROIC Baker Industries’s net income is $24,000, its interest expense is $5,000, and
Problems its tax rate is 25%. Its notes payable equals $27,000, long-term debt equals $75,000, and com-
7-19 mon equity equals $250,000. The firm finances with only debt and common equity, so it has
no preferred stock. What are the firm’s ROE and ROIC?

4-8 DuPONT AND NET INCOME Precious Metal Mining has $17 million in sales, its ROE is 17%,
and its total assets turnover is 3.23. Common equity on the firm’s balance sheet is 50% of
its total assets. What is its net income?

4-9 BEP, ROE, AND ROIC Broward Manufacturing recently reported the following information:

Net income $615,000

ROA 10%
Interest expense $202,950
Accounts payable and accruals $950,000

Broward’s tax rate is 25%. Broward finances with only debt and common equity, so it has
no preferred stock. 40% of its total invested capital is debt, and 60% of its total invested
capital is common equity. Calculate its basic earning power (BEP), its return on equity
(ROE), and its return on invested capital (ROIC).
4-10 M/B, SHARE PRICE, AND EV/EBITDA You are given the following information: Stockholders’
equity as reported on the firm’s balance sheet 5 $6.5 billion, price ∕ earnings ratio 5 9, com-
mon shares outstanding 5 180 million, and market/book ratio 5 2.0. The firm’s market
value of total debt is $7 billion, the firm has cash and equivalents totaling $250 million, and
the firm’s EBITDA equals $2 billion. What is the price of a share of the company’s common
stock? What is the firm’s EV/EBITDA?

4-11 RATIO CALCULATIONS Assume the following relationships for the Caulder Corp.:

Sales/Total assets 1.33

Return on assets (ROA) 4.0%
Return on equity (ROE) 8.0%

Calculate Caulder’s profit margin and debt-to-capital ratio assuming the firm uses only
debt and common equity, so total assets equal total invested capital.
4-12 RATIO CALCULATIONS Thomson Trucking has $12 billion in assets, and its tax rate is 25%.
Its basic earning power (BEP) ratio is 10%, and its return on assets (ROA) is 5.25%. What is
its times-interest-earned (TIE) ratio?

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142 Part 2 Fundamental Concepts in Financial Management

4-13 TIE AND ROIC RATIOS The W.C. Pruett Corp. has $600,000 of interest-bearing debt out-
standing, and it pays an annual interest rate of 7%. In addition, it has $600,000 of com-
mon equity on its balance sheet. It finances with only debt and common equity, so it
has no preferred stock. Its annual sales are $2.7 million, its average tax rate is 25%, and
its profit margin is 7%. What are its TIE ratio and its return on invested capital (ROIC)?

4-14 RETURN ON EQUITY Pacific Packaging’s ROE last year was only 5%, but its management
has developed a new operating plan that calls for a debt-to-capital ratio of 40%, which will
result in annual interest charges of $561,000. The firm has no plans to use preferred stock,
and total assets equal total invested capital. Management projects an EBIT of $1,870,000 on
sales of $17,000,000, and it expects to have a total assets turnover ratio of 2.1. Under these
conditions, the tax rate will be 25%. If the changes are made, what will be the company’s
return on equity?

4-15 RETURN ON EQUITY AND QUICK RATIO Lloyd Inc. has sales of $200,000, a net income of
$15,000, and the following balance sheet:

Cash $ 10,000 Accounts payable $ 30,000

Receivables 50,000 Notes payable to bank 20,000
Inventories 150,000 Total current liabilities $ 50,000
Total current assets $ 210,000 Long-term debt 50,000
Net fixed assets 90,000 Common equity 200,000
Total assets $ 300,000 Total liabilities and equity $300,000

The new owner thinks that inventories are excessive and can be lowered to the point where
the current ratio is equal to the industry average, 2.53, without affecting sales or net income. If
inventories are sold and not replaced (thus reducing the current ratio to 2.53), if the funds gener-
ated are used to reduce common equity (stock can be repurchased at book value), and if no other
changes occur, by how much will the ROE change? What will be the firm’s new quick ratio?

4-16 RETURN ON EQUITY Commonwealth Construction (CC) needs $3 million of assets to get
started, and it expects to have a basic earning power ratio of 35%. CC will own no securi-
ties, all of its income will be operating income. If it so chooses, CC can finance up to 30%
of its assets with debt, which will have an 8% interest rate. If it chooses to use debt, the
firm will finance using only debt and common equity, so no preferred stock will be used.
Assuming a 25% tax rate on taxable income, what is the difference between CC’s expected
ROE if it finances these assets with 30% debt versus its expected ROE if it finances these
assets entirely with common stock?

4-17 CONCEPTUAL: RETURN ON EQUITY Which of the following statements is most correct?
(Hint: Work Problem 4-16 before answering 4-17, and consider the solution setup for 4-16
as you think about 4-17.)

a. If a firm’s expected basic earning power (BEP) is constant for all of its assets and
exceeds the interest rate on its debt, adding assets and financing them with debt will
raise the firm’s expected return on common equity (ROE).
b. The higher a firm’s tax rate, the lower its BEP ratio, other things held constant.
c. The higher the interest rate on a firm’s debt, the lower its BEP ratio, other things held
constant.
d. The higher a firm’s debt ratio, the lower its BEP ratio, other things held constant.
e. Statement a is false, but statements b, c, and d are true.

4-18 TIE RATIO MPI Incorporated has $6 billion in assets, and its tax rate is 25%. Its basic earn-
ing power (BEP) ratio is 11%, and its return on assets (ROA) is 6%. What is MPI’s times-
interest-earned (TIE) ratio?

4-19 CURRENT RATIO The Stewart Company has $2,392,500 in current assets and $1,076,625 in
current liabilities. Its initial inventory level is $526,350, and it will raise funds as additional
notes payable and use them to increase inventory. How much can its short-term debt (notes
payable) increase without pushing its current ratio below 2.0?

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 Chapter 4 Analysis of Financial Statements 143

Challenging 4-20 DSO AND ACCOUNTS RECEIVABLE Ingraham Inc. currently has $205,000 in accounts
Problems receivable, and its days sales outstanding (DSO) is 71 days. It wants to reduce its DSO
20–24 to 20 days by pressuring more of its customers to pay their bills on time. If this policy is
adopted, the company’s average sales will fall by 15%. What will be the level of accounts
receivable following the change? Assume a 365-day year.

4-21 P/E AND STOCK PRICE Ferrell Inc. recently reported net income of $8 million. It has
540,000 shares of common stock, which currently trades at $21 a share. Ferrell continues to
expand and anticipates that 1 year from now its net income will be $13.2 million. Over the
next year, it also anticipates issuing an additional 81,000 shares of stock so that 1 year from
now it will have 621,000 shares of common stock. Assuming Ferrell’s price/earnings ratio
remains at its current level, what will be its stock price 1 year from now?

4-22 BALANCE SHEET ANALYSIS Complete the balance sheet and sales information using the
following financial data:

Total assets turnover: 1.53

Days sales outstanding: 36.5 daysa
Inventory turnover ratio: 3.753
Fixed assets turnover: 3.03
Current ratio: 2.03
Gross profit margin on sales: (Sales 2 Cost of goods sold) ∕ Sales 5 25%
a
Calculation is based on a 365-day year.

Balance Sheet
Cash Current liabilities
Accounts receivable Long-term debt 60,000
Inventories Common stock
Fixed assets Retained earnings 97,500
Total assets $300,000 Total liabilities and equity

Sales Cost of goods sold

4-23 RATIO ANALYSIS Data for Barry Computer Co. and its industry averages follow. The
firm’s debt is priced at par, so the market value of its debt equals its book value. Since
dollars are in thousands, the number of shares is shown in thousands too.

a. Calculate the indicated ratios for Barry.

b. Construct the DuPont equation for both Barry and the industry.
c. Outline Barry’s strengths and weaknesses as revealed by your analysis.
d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and
common equity during 2021. How would that information affect the validity of your
ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if
averages are not used. No calculations are needed.)

Barry Computer Company:

Balance Sheet as of December 31, 2021 (in thousands)
Cash $ 77,500 Accounts payable $129,000
Receivables 336,000 Other current liabilities 117,000
Inventories 241,500 Notes payable to bank 84,000
Total current assets $ 655,000 Total current liabilities $330,000
Long-term debt 256,500
Net fixed assets 292,500 Common equity (36,100 shares) 361,000
Total assets $ 947,500 Total liabilities and equity $947,500

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144 Part 2 Fundamental Concepts in Financial Management

Barry Computer Company: Income Statement for Year Ended

December 31, 2021 (in thousands)
Sales $ 1,607,500
Cost of goods sold
Materials $717,000
Labor 453,000
Heat, light, and power 68,000
Indirect labor 113,000 1,351,000
Gross profit $ 256,500
Selling expenses 115,000
General and administrative expenses 30,000
Depreciation 41,500
Earnings before interest and taxes (EBIT) $ 70,000
Interest expense 21,000
Earnings before taxes (EBT) $ 49,000
Federal and state income taxes (25%) 12,250
Net income $ 36,750

Earnings per share $ 1.018

Price per share on December 31, 2021 $ 12.00

Ratio Barry Industry Average

Current _____ 2.03
Quick _____ 1.33
Days sales outstandinga _____ 35 days
Inventory turnover _____ 5.73
Total assets turnover _____ 3.03
Profit margin _____ 1.6%
ROA _____ 4.8%
ROE _____ 12.1%
ROIC _____ 9.4%
TIE _____ 3.53
Debt/Total capital _____ 47.0%
M/B _____ 4.223
P/E _____ 13.27
EV/EBITDA _____ 9.14
a
Calculation is based on a 365-day year.

4-24 DuPONT ANALYSIS A firm has been experiencing low profitability in recent years. Perform
an analysis of the firm’s financial position using the DuPont equation. The firm has no lease
payments but has a $2 million sinking fund payment on its debt. The most recent industry
average ratios and the firm’s financial statements are as follows:
Industry Average Ratios
Current ratio 33 Fixed assets turnover 63
Debt-to-capital ratio 20% Total assets turnover 33
Times interest earned 73 Profit margin 3.75%
EBITDA coverage 93 Return on total assets 11.25%
Inventory turnover 83 Return on common equity 16.10%
Days sales outstanding a
24 days Return on invested capital 14.40%
a
Calculation is based on a 365-day year.

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 Chapter 4 Analysis of Financial Statements 145

Balance Sheet as of December 31, 2021 (millions of dollars)

Cash and equivalents $ 78 Accounts payable $ 45
Accounts receivable 66 Other current liabilities 11
Inventories 159 Notes payable 29
Total current assets $303 Total current liabilities $ 85
Long-term debt 50
Total liabilities $135
Gross fixed assets 225 Common stock 114
Less depreciation 78 Retained earnings 201
Net fixed assets $147 Total stockholders’ equity $315
Total assets $450 Total liabilities and equity $450

Income Statement for Year Ended December 31, 2021 (millions of dollars)
Net sales $ 795.00
Cost of goods sold 660.00
Gross profit $ 135.00
Selling expenses 73.50
EBITDA $ 61.50
Depreciation expense 12.00
Earnings before interest and taxes (EBIT) $ 49.50
Interest expense 4.50
Earnings before taxes (EBT) $ 45.00
Taxes (25%) 11.25
Net income $ 33.75

a. Calculate the ratios you think would be useful in this analysis.

b. Construct a DuPont equation, and compare the company’s ratios to the industry ave-
rage ratios.
c. Do the balance sheet accounts or the income statement figures seem to be primarily
responsible for the low profits?
d. Which specific accounts seem to be most out of line relative to other firms in the industry?
e. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the
year, how might that affect the validity of your ratio analysis? How might you correct
for such potential problems?

Comprehensive/Spreadsheet Problem

4-25 RATIO ANALYSIS The Corrigan Corporation’s 2020 and 2021 financial statements follow,
along with some industry average ratios. Corrigan is exempt from the interest deduction
limitation because its average gross revenues for the prior 3 years was less than $25 million.
So 100% of its interest expense is deductible.
a. Assess Corrigan’s liquidity position, and determine how it compares with peers and
how the liquidity position has changed over time.
b. Assess Corrigan’s asset management position, and determine how it compares with
peers and how its asset management efficiency has changed over time.
c. Assess Corrigan’s debt management position, and determine how it compares with
peers and how its debt management has changed over time.
d. Assess Corrigan’s profitability ratios, and determine how they compare with peers
and how its profitability position has changed over time.
e. Assess Corrigan’s market value ratios, and determine how its valuation compares with
peers and how it has changed over time. Assume the firm’s debt is priced at par, so
the market value of its debt equals its book value.

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