Chapter 3 Problems 1. Dental Delights has two divisions. Division A has a profit of $200,000 on sales of $4,000,000. Division B is only able to make $30,000 on sales of $480,000. Based on the profit margins (returns on sales), which division is superior? 3-1. Solution: Dental Delights Division ADivision B [pic] Division B is superior 3. Bass Chemical, Inc. , is considering expanding into a new product line. Assets to support this expansion will cost $1,200,000. Bass estimates that it can generate $2 million in annual sales, with a 5 percent profit margin. What would net income and return on assets (investment) be for the year? -3. Solution:Bass Chemical, Inc. [pic] 4. Franklin Mint and Candy Shop can open a new store that will do an annual sales volume of $750,000. It will turn over its assets 2. 5 times per year. The profit margin on sales will be 6 percent. What would net income and return on assets (investment) be for the year? 3-4. Solution: Franklin Mint and Candy Shop [pic] 8. Sharpe Razor Company has total assets of $2,500,000 and current assets of $1,000,000. It turns over its fixed assets 5 times a year and has $700,000 of debt. Its return on sales is 3 percent. What is Sharpe’s return on stockholders’ equity? -8. Solution: Sharpe Razor Company total assets$2,500,000 – current assets 1,000,000 Fixed assets$1,500,000 [pic] total assets$2,500,000 –debt 700,000 Stockholders’ equity$1,800,000 [pic] [pic] 11. Acme Transportation Company has the following ratios compared to its industry for 2009. | |Acme Transportation |Industry | |Return on assets…………… | 9% | 6% | |Return on equity…………… |12% |24% |
Explain why the return-on-equity ratio is so much less favorable than the return-on-assets ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required. 3-11. Solution: Acme Transportation Company Acme Transportation has a lower debt/total assets ratio than the industry. For those who did a calculation, Acme’s debt to assets were 25% vs 75% for the industry. 14. Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3. 5 percent on each dollar of sales and turns over its assets 2. 5 times per year. It has $100,000 in current liabilities and $300,000 in long-term liabilities. . What is its return on stockholders’ equity? b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities. 3-14. Solution: Jerry Rice and Grain Stores a. [pic] [pic] [pic] 3-14. (Continued) b. The new level of sales will be: [pic] [pic] [pic] 25. Calloway Products has the following data. Industry information is also shown. Industry Data on Net YearNet IncomeTotal AssetsIncome/Total Assets 2006$360,000$3,000,00011% 007380,0003,400,0008 2008380,0003,800,0005 Industry Data on YearDebtTotal AssetsDebt/Total Assets 2006$1,600,000$3,000,00052% 20071,750,0003,400,00040 20081,900,0003,800,00031 As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of: a. Net income/Total assets? b. Debt/Total assets? 3-25. Solution: Calloway Products a. Net income/total assets |Year |Calloway Ratio |Industry Ratio | |2006 |12. % |11. 0% | |2007 |11. 18% |8. 0% | |2008 |10. 0% |5. 0% | Although the company has shown a declining return on assets since 2006, it has performed much better than the industry. Praise may be more appropriate than criticism. 3-25. (Continued) b. Debt/total assets Year |Calloway Ratio |Industry Ratio | |2006 |53. 33% |52. 0% | |2007 |51. 47% |40. 0% | |2008 |50. 0% |31. 0% |
While the company’s debt ratio is improving, it is not improving nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise. 26. Jodie Foster Care Homes, Inc. , shows the following data: YearNet IncomeTotal AssetsStockholders’ EquityTotal Debt 2005$118,000$1,900,000$ 700,000$1,200,000 2006131,0001,950,000950,0001,000,000 2007148,0002,010,0001,100,000910,000 2008175,7002,050,0001,420,000630,000 a. Compute the ratio of net income to total assets for each year and comment on the trend. b. Compute the ratio of net income to stockholders’ equity and comment on the trend.
Explain why there may be a difference in the trends between parts a and b. 3-26. Solution: Jodie Foster Care Homes, Inc. a. [pic] 2005 $118,000/$1,900,000 = 6. 21% 2006 $131,000/$1,950,000 = 6. 72% 2007 $148,000/$2,010,000 = 7. 36% 2008 $175,700/$2,050,000 = 8. 57% Comment: There is a strong upward movement in return on assets over the four year period. 3-26. (Continued) b. [pic] 2005 $118,000/$700,000= 16. 86% 2006 $131,000/$950,000= 13. 79% 2007 $148,000/$1,100,000= 13. 45% 2008 $175,700/$1,420,000= 12. 37% Comment: The return on stockholders’ equity ratio is going down each year.
The difference in trends between a and b is due to the larger portion of assets that are financed by stockholders’ equity as opposed to debt. Optional: This can be confirmed by computing total debt to total assets for each year. [pic] 200563. 2% 200651. 3% 200745. 3% 200830. 7% 31. The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in the balance sheet below. Total assets turnover 2. 4 times Cash to total assets 2. 0% Accounts receivable turnover 8. 0 times Inventory turnover10. 0 times Current ratio 2. 0 times Debt to total assets61. 0% GRIGGS CORPORATION
Balance Sheet 2008 AssetsLiabilities and Stockholders’ Equity Cash _____Current debt_____ Accounts receivable_____Long-term debt_____ Inventory_____ Total debt_____ Total current assets _____Equity_____ Fixed assets _____ Total assets _____ Total debt and stockholders’ equity_____ 3-31. Solution: Griggs Corporation Sales/total assets= 2. 4 times Total assets= $1,200,000/2. 4 Total assets= $500,000 Cash= 2% of total assets Cash= 2% ? $500,000 Cash= $10,000 Sales/accounts receivable= 8 times Accounts receivable= $1,200,000/8 Accounts receivable= $150,000 Sales/inventory= 10 times
Inventory= $1,200,000/10 Inventory= $120,000 3-31. (Continued) Fixed assets= Total assets – current assets Current asset= $10,000 + $150,000 + $120,000 = $280,000 Fixed assets= $500,000 – $280,000 = $220,000 Current assets/current debt= 2 Current debt= Current assets/2 Current debt= $280,000/2 Current debt= $140,000 Total debt/total assets= 61% Total debt= . 61 ? $500,000 Total debt= $305,000 Long-term debt= Total debt – current debt Long-term debt= $305,000 – 140,000 Long-term debt= $165,000 Equity= Total assets – total debt Equity= $500,000 – $305,000 Equity= $195,000 Griggs Corporation Balance Sheet 2008 Cash |$ 10,000 |Current debt |$140,000 | |A/R |150,000 |Long-term debt | 165,000 | |Inventory |$120,000 |Total debt |$305,000 | |Total current assets |280,000 | | | |Fixed assets | 220,000 |Equity | 195,000 | |Total assets |$500,000 |Total debt and |$500,000 | | | |stockholders’ | | | | |equity | | 35. Given the following financial statements for Jones Corporation and Smith Corporation: a. To which company would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering. b. In which one would you buy stock? Why? JONES CORPORATION | |Current Assets |Liabilities | |Cash |$ 20,000 |Accounts payable |$100,000 | |Accounts receivable |80,000 |Bonds payable (long-term) |80,000 | |Inventory |50,000 | | | |Long-Term Assets |Stockholders’ Equity | |Fixed assets |$500,000 |Common stock |$150,000 | |Less: Accumulated | (150,000) |Paid-in capital |70,000 | |depreciation | |Retained earnings |100,000 | |*Net fixed assets | 350,000 | | | |Total assets |$500,000 |Total liabilities and equity |$500,000 | Sales (on credit) |$1,250,000 | |Cost of goods sold | 750,000 | |Gross profit |500,000 | |†Selling and administrative expense |257,000 | |Less: Depreciation expense | 50,000 | |Operating profit |193,000 | |Interest expense | 8,000 | |Earnings before taxes |185,000 | |Tax expense | 92,500 | |Net income |$ 92,500 | *Use net fixed assets in computing fixed asset turnover. †Includes $7,000 in lease payments. | | |SMITH CORPORATION | |Current Assets |Liabilities | |Cash |$ 35,000 |Accounts payable |$ 75,000 | Marketable securities |7,500 |Bonds payable (long-term) |210,000 | |Accounts receivable |70,000 | | | |Inventory |75,000 | | | |Long-Term Assets |Stockholders’ Equity | |Fixed assets |$500,000 |Common stock |$ 75,000 | |Less: Accumulated |(250,000) |Paid-in capital |30,000 | |depreciation | |Retained earnings |47,500 | |*Net fixed assets | 250,000 | | | |Total assets |$437,500 | Total liabilities and equity |$437,500 | Sales (on credit) |$1,000,000 | |Cost of goods sold | 600,000 | |Gross profit |400,000 | |†Selling and administrative expense |224,000 | |Less: Depreciation expense | 50,000 | |Operating profit |126,000 | |Interest expense | 21,000 | |Earnings before taxes |105,000 | |Tax expense | 52,500 | |Net income |$ 52,500 | *Use net fixed assets in computing fixed asset turnover. †Includes $7,000 in lease payments. 3-35. Solution: Jones and Smith Comparison One way of analyzing the situation for each company is to compare the respective ratios for each on, examining those ratios which would be most important to a supplier or short-term lender and a stockholder. | |Jones Corp. |Smith Corp. | |Profit margin |7. 4% |5. 5% | |Return on assets (investments) |18. 5% |12. 00% | |Return on equity |28. 9% |34. 4% | |Receivable turnover |15. 63x |14. 29x | |Average collection period |23. 04 days |25. 2 days | |Inventory turnover |25x |13. 3x | |Fixed asset turnover |3. 7x |4x | |Total asset turnover |2. 5x |2. 29x | |Current ratio |1. 5x |2. 5x | |Quick ratio |1. 0x |1. 5x | |Debt to total assets |36% |65. 1% | |Times interest earned |24. 13x |6x | |Fixed charge coverage |13. 3x |4. 75x | |Fixed charge coverage calculation |(200/15) |(133/28) | a. Since suppliers and short-term lenders are most concerned with liquidity ratios, Smith Corporation would get the nod as having the best ratios in this category. One could argue, however, that Smith had benefited from having its debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios. 3-35. (Continued) b. Stockholders are most concerned with profitability. In this category, Jones has much better ratios than Smith.
Smith does have a higher return on equity than Jones, but this is due to its much larger use of debt. Its return on equity is higher than Jones’ because it has taken more financial risk. In terms of other ratios, Jones has its interest and fixed charges well covered and in general its long-term ratios and outlook are better than Smith’s. Jones has asset utilization ratios equal to or better than Smith and its lower liquidity ratios could reflect better short-term asset management, and that point was covered in part a. Note: Remember that to make actual financial decisions more than one year’s comparative data is usually required. Industry comparisons should also be made.