Part 2
Financial Tools
Chapters in This Part
Chapter 3
Financial Statements and Ratio Analysis
Chapter 4
Cash Flow and Financial Planning
Chapter 5
Time Value of Money
Integrative Case 2: Merit Enterprise Corp.
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Chapter 3
Financial Statements and Ratio Analysis
 Instructor’s Resources
Chapter Overview
This chapter examines the four key components of the stockholders’ report: the income statement, the balance
sheet, the statement of retained earnings, and the statement of cash flows. All major items on the income
statement and balance sheet are reviewed along with rules for consolidating foreign and domestic financial
statements (FASB No. 52). Next, the discussion turns to use of income-statement/balance-sheet figures to
assess a firm’s financial condition. Three types of comparative analysis are noted—cross-sectional, timeseries, and combined—and specific ratios for such analysis are presented for five perspectives on firm
condition—liquidity, activity, debt, profitability, and market. Each ratio is illustrated using the last public
financial statements of Whole Foods Market, Inc., just before it was acquired by Amazon. The meaning of
deviations of performance ratios from industry benchmarks (as well as differences across industries) is also
explored. The chapter ends with a complete (cross-sectional and time-series) ratio analysis of Whole Foods.
The DuPont system is integrated into the example to show how profit margin, sales volume, and leverage
interact to determine return on equity.
 Suggested Answer to Opener-in-Review
Students were told Kroger reported sales of $27.61 billion and cost of goods sold of $21.47 billion for the
quarter ending January 28, 2017 and then asked to calculate gross profit margin for the quarter.
Gross profit margin 
Sales  Cost of goods sold Gross profits
= [$27.61 – $21.47] / $27.61 = 22.2%

Sales
Sales
 Answers to Review Questions
3-1.
Generally accepted accounting principles (GAAP), the Financial Accounting Standards Board (FASB),
and the Public Company Accounting Oversight Board (PCAOB) all play significant roles in the
financial reporting of publicly traded firms. GAAP refers to the basic guidelines firms should use in
preparing and maintaining financial records and reports; these guidelines are authorized by the FASB—
the accounting profession’s rule-setting body. The PCAOB is a not-for-profit corporation that oversees
auditors of public corporations. Consistency in financial reporting and auditing practices/procedures
promotes investor confidence in the financial information firms release to the public.
3-2
The four major financial statements are the:

Income Statement, which summarizes firm operating results over a specified time period. It is a
“flow” document— demonstrating whether revenues over a month, quarter, or year exceed costs
with sufficient detail to explain profits or losses.

Balance Sheet, which summarizes firm financial condition at a given point in time. It is a “stock”
document— noting assets, liabilities and net financial position (owner’s stake) on a specific date in
detail sufficient to explain why that stake is large or small.
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Chapter 3
Financial Statements and Ratio Analysis
31

Statement of Retained Earnings, which reconciles net income earned during the year (and any cash
dividends paid) with the change in retained earnings from the beginning to the end of the year. It is
a condensed version of the statement of stockholders’ equity. Retained earnings are important not
as a source of surplus funds but rather because they represent reinvestment in the firm. The
statement of retained earnings highlights the reason for changes in the level of reinvestment.

The Statement of Cash Flows summarizes cash inflows and outflows experienced by a firm over a
specific period (like a month, quarter, or year). In general, inflows and outflows are grouped under
three headings: operating, investment, and financing. This statement is important to investors
because cash flows, unlike profits, can be used to meet ongoing firm obligations.
3-3
Notes to the Financial Statements offer important background details for firm financial statements.
Specifically, these notes explain how a firm’s accounting policies, procedures, calculations, and
transactions have affected specific line items, thereby making financial statements easier to interpret.
3-4
FASB Statement No. 52 governs rules for consolidating a firm’s foreign and domestic financial
statements. The statement requires U.S.-based companies to translate foreign-currency-denominated
assets and liabilities into U.S. dollars using the exchange rate on the last day of the fiscal year (current
rate). Income-statement items are treated similarly. Equity accounts, in contrast, are translated into
dollars using the exchange rate at the time of the parent’s equity investment (historical rate).
3-5
Current and prospective shareholders care about ratios bearing on expected cash flows and uncertainty
about those flows because risk and return drive stock price. Creditors, on the other hand, focus on ratios
gauging the firm’s short-term liquidity and ability to make scheduled interest and principal payments.
Management needs to track ratios related to both risk/return and debt service. Managers should focus
on maximizing shareholder wealth over the long term, but missing scheduled interest and principal
payments could cause bankruptcy and prevent the firm from living past the short term.
3-6
Cross-sectional analysis involves comparing performance ratios for different firms at a specific point in
time. Benchmarking is cross-sectional comparison of one firm’s performance ratios with those of a key
competitor, group of competitors, or the industry average. Time-series analysis, in contrast, looks at the
same firm’s performance over time (such as quarter-to-quarter or year-over-year).
3-7
An analyst should focus on significant differences between firm ratios and those of a designated peer
(competitor, group of competitors, or industry average), irrespective of whether the ratio is above or
below the benchmark. For example, above-normal inventory-turnover ratio could indicate highly
efficient inventory management or critically low inventory (and lost sales). When benchmarking, an
analyst should also examine multiple ratios for a complete picture of each aspect of firm condition.
3-8
Analyzing financial data from different points in the year could lead to inaccurate conclusions because
of seasonality. For example, many retailers post more sales in the fourth quarter than in the other three
combined because of Christmas. So, comparing sales in the second and fourth quarters for such firms
would make the second quarter look extraordinarily weak or the fourth quarter extraordinarily strong.
3-9
The current ratio is a better metric when current assets are all reasonably liquid while the quick ratio is
preferred if the firm operates with high levels of illiquid inventory.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
3-10 Most firms listed in Table 3.5 are large players in their industries; such firms typically rely on credit
lines with banks for emergency cash. Put another way, small firms “self-insure” against liquidity risk
with a high current ratio while large firms insure through bank credit. Whole Foods, as a
natural/organic grocery store with an upscale clientele, needs more liquidity than the typical grocery
store because of its recession vulnerability. During slowdowns, some Whole Foods’ customers switch
to traditional grocery stores to save money, so firm sales fall more than competitors. Banks frequently
reduce credit lines during recessions to minimize loan losses, so Whole Foods—although a national
chain—cannot rely its credit lines to stock fresh/organic products for remaining customers until the
economy improves. In short, like small firms, Whole Foods self-insures against liquidity risk.
3-11 Average collection period, or average age of accounts receivable, is useful in evaluating a firms credit
and collection policies. It equals accounts receivable divided by average daily sales. Interpreting the
ratio (in cross-section or time series analysis) requires context—specifically, what are the firm’s credit
policies, how do they compare with other firms, and have they changed over time? Average payment
period is accounts payable divided by average purchases per day. The difficulty in calculating this ratio
is that the denominator—average daily purchases—is not available in firm financial statements.
3-12 Financial leverage refers to a firm’s reliance on debt (or other types of fixed-cost financing such as
preferred stock) to fund ongoing operations. Financial leverage is important because greater reliance on
debt can improve returns to shareholders but at the cost of higher bankruptcy risk (i.e., a greater
likelihood a cash crunch will leave the firm unable to meet its obligations to creditors).
3-13 The debt and debt-to-equity ratios gauge firm indebtedness (leverage). Specifically, the debt ratio is
thepercentage of firm assets financed by debt, while the debt-to-equity ratio is the relative proportion of
debt and equity in the firm’s funding mix. Higher debt and debt-to-equity ratios correspond to greater
financial leverage. Coverage ratios measure ability to service debts and other fixed obligations.
Specifically, the times-interest-earned ratio captures the firm’s ability to pay interest on its debts, while
the fixed-payment-coverage ratio shows its capacity to meet a broader set of fixed obligations (such as
lease payments, principal payments on firm debt, and preferred stock dividends). For both coverage
ratios, higher values are preferred, indicating the firm is better able to honor fixed obligations.
3-14 The three profitability ratios found on a common-size income statement are (1) gross profit margin, (2)
operating profit margin, and (3) net profit margin. Gross margin is thepercentage of each sales dollar
remaining after the cost of goods sold is covered. Operating margin ispercentage of each sales dollar
remaining after deducting all firm costs/expenses except interest, taxes, and preferred stock dividends.
Net profit margin deducts all firm costs and expenses. For all three ratios, higher values are preferred.
3-15 Firms with high gross profit but low net profit margins have high large expenses other than the cost of
goods sold. For example, a firm with significant financial leverage will have high interest expense,
which will reduce its net profit margin relative to industry competitors that use little or no debt.
3-16 Return on assets (ROA) equals earnings available to common stockholders divided by total assets;
return on equity (ROE) is earnings divided by common stock equity. ROA and ROE have the same
numerator but different denominators. Firms with positive earnings and debt will have ROEs above
their ROAs. Only when assets are entirely financed by common stock will ROE equal ROA.
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Chapter 3
Financial Statements and Ratio Analysis
33
3-17 The price-earnings ratio (P/E) captures what investors will pay for a dollar of earnings while the
market/book (M/B) ratio shows market perception of firm value relative to the historical cost of assets.
Both ratios embody a forward-looking perspective in that their numerators reflect investor expectations
about future cash flows and the riskiness of those flows. Interpreting these ratios for a specific firm is
complicated by “backward-looking” denominators (i.e., earnings already posted for the P/E ratio and
historical cost of assets for the M/B ratio). Another issue with P/E ratios is the tendency of earnings to
plummet during recessions, which can boost the ratio to eye-popping levels.
3-18. Liquidity ratios measure firm capacity to meet current (short-term) financial commitments while
activity ratios capture how rapidly a firm can convert various accounts into cash or sales. Debt ratios
gauge a firm’s dependence on creditors to finance ongoing operations and ability to service these
obligations, and profitability ratios note a firm’s return with respect to sales, assets, or equity. Finally,
market ratios provide insight into investor perceptions of firm risk and return and risk. Creditors will be
more concerned with liquidity and debt ratios as these bear on the firm’s ability to meet its fixed
commitments.
3-19. The analyst should use a “level, peer, trend” approach for each of the five perspectives on firm
condition (liquidity, activity, debt, profitability, and market). “Level” means starting with computation
of multiple ratios for each of the five perspectives and then determining whether the ratios tell a
consistent story. If, for example, the current ratio is high (indicating strong liquidity), but the quick
ratio low, then the firm is carrying significant inventory. The next step should be ascertaining whether
that inventory can be sold with minimal losses in a cash crunch. “Peer” means comparing firm ratios
with key competitors or the industry average. “Trend” means extending those comparisons over time to
see longer-term patterns in each of the five areas and how these patterns compare with peer firms.
3-20 The DuPont system of analysis breaks firm return on equity (ROE) into three components: profitability
(net profit margin), asset efficiency (total-asset turnover), and leverage (the debt ratio). This breakdown
allows an analyst to isolate the impact of each factor on shareholder returns. For example, suppose firm
A posts a significantly higher ROE than firm B. The DuPont system will highlight the “big picture”
reasons for the difference. If the firms have similar profit margins and asset efficiency, but firm A has
higher leverage, then its higher ROE comes with greater risk of bankruptcy (and may not be a good
thing). If, however, the difference stems from firm A’s higher net profit margin, then higher ROE
reflects customer perception of firm A products as distinctive (and worth a significant mark-up).
 Suggested Answer to Global Focus Box:
More Countries Adopt International Financial Reporting Standards
What costs and benefits might be associated with a switch to IFRS in the United States?
The benefit is global standardization of accounting standards, which would allow American companies with
foreign operations (or foreign companies with American operations) to reduce financial-reporting costs by
using only one set of accounting policies/procedures—at least for operations in the 80+ countries now
adhering to IFRS. In theory, investors would also benefit from greater ease of comparing firm performance
across countries. The cost is a less rigorous standard. Many consider GAAP “the gold standard” and argue
movement to IFRS would lower the quality of financial reporting by U.S. firms. One reason U.S. financial
markets attract a large share of global savings is the greater transparency of American firms due to GAAP. If
U.S. reporting standards were weakened, American firms could face greater difficulty selling stocks and
bonds. A better approach to global standardization might be to bring the world in line with GAAP.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
 Suggested Answer to Focus on Ethics Box: Earnings Shenanigans
Logitech understated potential warranty expenses by assuming customers would submit defective-product
claims within one quarter—even though warranties extended for many years. Suppose instinct tells you the
assumption is reasonable and ethical because problems with electronic devices occur soon after purchase or
not at all. What evidence might you compile to challenge your instincts and satisfy auditors?
If assumptions about warranty expense are material (i.e., significantly affect earnings), the firm should
develop a warranty-expense policy grounded in historical experience and then apply that policy consistently
over time to a range of company products. (Put another way, auditors and SEC lawyers should be satisfied the
company did not just create a policy “on the fly” to inflate earnings artificially.) Specifically, the firm should
start by conducting extensive research on defective-product claims for a variety of its electronic devices. The
goal would be documenting patterns in the number and dollar volume of claims for all major products. Once
the database is built, differences across products can be investigated. If the number/dollar value of claims
differs significantly across devices, the next step is selecting products similar (and dissimilar) to the one for
which a warranty-expense policy is being developed. The firm should build a case by noting exactly why one
product is a good match but another product is not and then document defective-claim experience for
benchmark products. Ultimately, the firm will want a paper trail demonstrating a good-faith effort to develop
expense policies using an extensive historical database, not cherry-picked data. Auditors and SEC lawyers
will want to see evidence “peer” products were selected using the same reasonable, a consistent approach over
time, and that policies were developed based on consistent analysis of a historical database of firm products.
 Answers to Warm-Up Exercises
E3-1 Preparing income statements (LG 1) (Note that this solution assumes a 21% corporate tax rate as per the
Tax Cuts and Jobs Act. A previous version of this problem listed the tax rate as 35%).
Answer: a.
Income Statement ($000,000)
Sales revenue
Less: Cost of goods sold
Gross profits
Less: Operating expenses
Sales expense
General and administrative expenses
Lease expense
Depreciation expense
Total operating expense
Operating profits (EBIT)
Less: Interest expense
Net profit before taxes
$345.0
255.0
$90.0
$18.0
22.0
4.0
25.0
$69.0
$21.0
3.0
$18.0
b. Taxes = (Corporate tax rate)  (Net profits before taxes) = 0.21  $18 million = $3.78 million,
so net profit after taxes = $18 – $3.78 = $14.22 million. Under the old 35% corporate tax rate,
taxes paid would have been $6.3 million leaving after-tax profits of $11.7 million.
c. EPS = Net profits after taxes / Shares outstanding = $14.22 million / 4.25 million = $3.34
Addition to retained earnings = (Net profit after taxes) – (Total dividends paid)
Total dividends = (4.25 million)  ($1.10) = $4.675 million, so
Addition to retained earnings = $14.22 – $4.675 = $9.545 million.
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Chapter 3
Financial Statements and Ratio Analysis
35
Note that under the old corporate tax rate of 35% the answers would be:
EPS = $11.7 million ÷ 4.25 million = $2.60
Addition to retained earnings = $11.7 million - $4.675 million = $7.025 million
E3-2
Income statements and balance sheets (LG 1)
Answer: On income statements, calculations begin with sales revenue and end with net profits after taxes.
There is no guarantee a firm will be profitable. If net profits after taxes is positive, the firm earns a
profit; if negative, the firm suffers a loss. As for balance sheets, the fundamental equation of
accounting is: Total Assets = Total Liabilities + Owners’ Equity. This simply means creditors or
owners must supply the funds to purchase firm assets. The balance sheet demonstrates this
relationship by showing the value of assets must equal debt and equity claims on those assets.
E3-3
Answer:
Statement of retained earnings (LG 1)
Ocean Terminal Company, Ltd.
Statement of Retained Earnings ($000)
Year Ending December 31, 2019
Retained earnings balance (January 1, 2019)
Plus: Net profits after taxes (for 2019)
Less: Cash dividends (paid during 2019)
Preferred stock
Common stock
Total dividends paid
Retained earnings balance (December 31, 2019)
E3-4
$68,450
6,340
1,495
9,800
11,295
$63,495
Current ratios and quick ratios (LG 3)
Answer: As of now:
Current assets = £5 million
Current liabilities = £5million / 2.5 = £2 million
If they raise the inventory by £3 million and fund it by accounts payable, these accounts will
change to:
Current assets = £5 million + £3 million = £8 million
Current Liabilities = £2 million + £3 million = £5 million
The new current ratio will be = £8 million ÷ £5 million = 1.6
As the new current ratio is above the threshold limit stipulated by the bank, they can follow this
plan. To fund this increase in inventory without affecting the current ratio, they need to raise
capital through internal sources or long-term debt or by issuing additional equity.
E3-5
The DuPont System (LG 6)
Answer: Return on equity (ROE) = 6% × 1.5 × 1.2 = 10.8%. The DuPont system allows decomposition of
firm ROE into a profit-on-sales component (net profit margin), an efficiency-of-asset-use
component (total asset turnover), and a use-of-financial-leverage component (financial leverage
multiplier). Such a decomposition highlights each component’s role in determining firm ROE. For
example, these numbers used in the calculation of Geotherm Energy Ltd.’s ROE show how debt
finance “levers up” returns to shareholders. If the firm financed assets entirely with common
equity, the financial-leverage multiplier would be 1.0 (rather than 1.5), and ROE would be only
7.2% (rather than 10.8%). Decomposing ROE with the DuPont system also allows comparison of
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
the components with key competitors or the industry standard to see where the firm underperforms
and outperforms and to set parameters in order to define performance.
 Solutions to Problems
P3-1
Financial-statement account identification (LG 1; Basic)
a., b.
Account Name
Accounts payable
Accounts receivable
Accruals
Column 1 for (a)
Statement
BS
BS
BS
Column 2 for (b)
Type of Account
CL
CA
CL
Account Name
Accumulated depreciation
Administrative expense
Buildings
Cash
Common stock (at par)
Cost of goods sold
Depreciation
Equipment
General expense
Interest expense
Inventories
Land
Long-term debt
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
Column 1 for (a)
Statement
BS
IS
BS
BS
BS
IS
IS
BS
IS
IS
BS
BS
BS
BS
BS
BS
IS
BS
BS
IS
BS
IS
IS
IS
BS
Column 2 for (b)
Type of Account
FA*
E
FA
CA
SE
E
E
FA
E
E
CA
FA
LTD
FA
CA
CL
E
SE
SE
E
SE
R
E
E
FA
*
Not a fixed asset, but a charge against a fixed asset (and better known as a contra-asset).
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Chapter 3
P3-2
Financial Statements and Ratio Analysis
Income-statement preparation (LG 1; Intermediate)
a.
Cathy Chen, CPA – Income Statement
Year Ending December 31, 2019
Belle Florist — Income Statement
Year Ending December 31, 2019
Sales revenue
Less: Cost of goods sold
Gross Profit
Less: Operating expenses
Gas, electricity, and council tax
Lease payment
Salaries to employees
Depreciation expense
Overdraft charges
Total operating expense
Operating profits
Less: Taxes (25%)
Net profit after taxes
£280,000
80,000
£200,000
15,000
20,000
48,000
12,000
2,200
97,200
£102,800
25,700
£ 77,100
b. The financial performance of the business appears to be very good as they made a profit of
£77,100 on a total revenue of £280,000 (net profit margin of 27.54%). However, the assets
employed to generate these sales and profits need to be taken into account for a comprehensive
explanation of financial performance.
P3-3
Personal Finance Problem: Income-statement preparation (LG 1; Intermediate)
a. 2019 Personal Income and Expense Statement—Adam and Arin Adams
Income
Adam’s salary
Arin’s salary
Interest received
Dividends received
Total Income
$45,000
30,000
500
150
$75,650
Expenses
Mortgage payments
Utility expense
Groceries
Auto loan payment
Home insurance
Auto insurance
Medical expenses
Property taxes
Income tax and social security
Clothes and accessories
Gas and auto repair
Entertainment
Total Expenses
$14,000
3,200
2,200
3,300
750
600
1,500
1,659
13,000
2,000
2,100
2,000
$46,309
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
2019 Cash Surplus (Deficit)
$29,341
b. Income exceeds expenses, so the Adams have a cash surplus.
c. The cash surplus can be used for a variety of purposes. In the short term, the Adams could replace
their car, buy better furniture, or reduce their mortgage debt. Alternatively, they could put the
surplus in a bank deposit or money-market account as source of emergency liquidity or purchase
stocks and bonds as a long-term investment.
P3-4
Calculation of EPS and retained earnings (LG 1; Intermediate)
a.
Earnings per share:
Net profit before taxes
Less: Tax at 20%
Net profit after taxes
Less: Preferred stock dividends
Earnings available to common stockholders
€560,000
112,000
€448,000
50,000
€398,000
b. Addition to retained earnings:
100,000 shares  €1.20 = $120,000 common stock dividends
Earnings available to common shareholders
Less: Common stock dividends
Retained earnings
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€398,000
120,000
$278,000
Chapter 3
P3-5
Financial Statements and Ratio Analysis
Balance-sheet preparation (LG 1; Basic)
Mellark’s Baked Goods
Balance Sheet
December 31, 2019
Assets
Current assets
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Gross fixed assets
Land and buildings
Machinery and equipment
Furniture and fixtures
Vehicles
Total gross fixed assets
Less: Accumulated depreciation
Net fixed assets
Total assets
$215,000
75,000
450,000
375,000
$1,115,000
$325,000
560,000
170,000
25,000
$1,080,000
265,000
$ 815,000
$1,930,000
Liabilities and stockholders’ equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Total liabilities
$220,000
475,000
55,000
$750,000
420,000
$1,170,000
Stockholders’ equity
Preferred stock
Common stock (at par)
Paid-in capital in excess of par
Retained earnings
Total stockholders’ equity
$100,000
90,000
360,000
210,000
$760,000
Total liabilities and stockholders’ equity
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$1,930,000
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
P3-6
Effect of net income on a firm’s balance sheet (LG 1; Basic)
Account
a.
b.
c.
d.
P3-7
Beginning Value
Change
Ending Value
$35,000
$1,575,000
$2,700,000
$1,575,000
$1,600,000
$1,575,000
+$1,365,000
+$1,365,000
–$865,000
+$865,000
+$865,000
+$865,000
$1,400,000
$2,940,000
$1,835,000
$2,440,000
$2,465,000
$2,440,000
Marketable securities
Retained earnings
Long-term debt
Retained earnings
Buildings
Retained earnings
No net change in any accounts
Initial sale price of common stock (LG 1; Basic)
Total proceeds from original sale of common stock
= Par value of common stock + Paid-in capital in excess of par on common stock
= $250,000 + $2,376,000 = $2,626,000
Original issue price of common stock = Proceeds from original sale / Total shares =
$2,626,000/500,000 = $5.25 per share
P3-8
Statement of retained earnings (LG 1; Basic)
a. Common stock dividends = Net profits after taxes – Preferred dividends – ∆ Retained earnings
= $528,000 – $98,000 – ($1,324,000 – $1,151,000) = $257,000
Hayes Enterprises – Statement of Retained Earnings
Year Ending December 31, 2015
Retained earnings balance (January 1, 2015)
Plus: Net profits after taxes (for 2015)
Less: Cash dividends (paid during 2015)
Preferred stock
Common stock
Retained earnings (December 31, 2015)
$1,151,000
528,000
(98,000)
(257,000)
$1,324,000
b. Earnings available for common stockholders = Net profits after taxes – Preferred stock dividends
= $528,000 – $98,000 = $430,000
Earnings per share = Earnings available for common stockholders / Common shares outstanding
= $430,000 / 100,000 = $4.30
c. Cash dividend per share of common stock = Total cash dividends / common shares outstanding
= $257,000 (from part a) / 100,000 = $2.57
P3-9
Changes in stockholders’ equity (LG 1; Intermediate)
a. 2017 Net income = ∆ Retained earnings − Dividends paid = £1,200,000 − £600,000 + £300,000 =
£900,000
b. New shares issued = Outstanding shares in 2018 – Outstanding shares in 2017 = 2,000,000
c. 2018 Average price of newly issued common stock = (Change in share capital + Change in share
premium) / Shares issues = 800,000/2,000,000 = £0.40 per share
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Chapter 3
Financial Statements and Ratio Analysis
41
d. Original issue price (2015)
= Total Par Value + Paid-in Capital / Shares Outstanding
= [£1,000,000 + £400,000] / 10,000,000 = £0.14 per share
P3-10 Ratio comparisons (LG 2, LG 3, LG 4, and LG 5; Basic)
a. The companies listed operate in different industries, with wide-ranging differences in the business
model and operating structure, including the nature of the product delivered, amount of
plant/equipment needed for production, age of the industry, and degree of government regulation.
Hence, the ratios will be very different, making comparison difficult.
b. For a construction company, the current assets are mostly building supplies (or inventory) and
limited amount of cash with almost no trade receivables. The current liabilities are mostly trade
payables for their supplies which are organized to be delivered as and when required. This makes
their current ratio low.
Unlike a construction company, for a manufacturing company, current assets include substantial
amount of trade receivables as well. This makes their current ratio relatively higher.
c. The operating structure of a real estate firm will require borrowing large amounts of mortgage to
acquire real estate, using rental income to pay interest and principal, and keeping the surplus as
profit. As the value of fixed assets required to start such businesses is very high, and real estate
acts as good collateral for banks, it is normal for such companies to have a high debt to equity
ratio. On the other hand, a software firm requires very limited amount of capital assets—mostly IT
equipment—to start and run. It does not require large capital assets and hence large long-term
loans are not the norm for a software developer. Also, the software firm will have uncertain and
changing cash flows because of rapidly changing technology, intense competition, and consumer
fickleness, which can combine to make today’s “hot” software tomorrow’s white elephant.
d. Eddie will lose the benefits of reduced risk associated with diversification, if he places all his
money in one company from one industry. Although the software industry offers potentially high
profits and returns, it also carries significant uncertainty or risk associated with the profits.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
P3-11. Liquidity management (LG 3; Challenging)
a. Both Bauman’s liquidity ratios are falling over time as shown below.
Ratio
2016
2017
2018
2019
Current ratio
Quick ratio
1.88
1.22
1.74
1.19
1.79
1.24
1.55
1.14
b. Both ratios fall over the four-year period, indicating deterioration in Bauman’s liquidity position.
Because peer data are not given, it is not clear if this deterioration is industry-wide or only at
Bauman. The slide is more pronounced for the current ratio—between 2016 and 2019, the current
ratio tumbled 17.6% while the quick ratio slipped 6.5%. Inventory figures in calculation of the
current ratio but not the quick ratio. So the faster decline in the current ratio suggests inventories –
though rising in dollar terms—are declining as a percentage of Bauman’s current assets over time.
This trend may also be seen in the narrowing gap between the current and quick ratios. In short,
inventories are becoming a less important part of the liquidity picture.
c. Bauman’s inventory turnover ratio is only about 60% of the industry average, suggesting the firm
does a relatively poor job managing inventory. Put another way, Bauman carries more inventory
(on average) than its peers, relative to cost of goods sold. This is at odds with the finding in part b
that Bauman’s inventory is a shrinking part of current assets (and shrinking relative to current
liabilities).
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Chapter 3
Financial Statements and Ratio Analysis
43
P3-12. Personal finance: Liquidity ratio (LG 3; Basic)
a. Liquidity ratio = Total liquid assets / Total current debts
= (£3200 + £2200 + £1400) / (£1650 + £980) = £6800 / £2630 = 2.59
b. Jamie’s liquidity ratio exceeds 1.75, so he has more liquidity than his benchmark friends.
P3-13 Inventory management (LG 3; Intermediate)
Inventory-turnover ratio = Cost of goods sold / Inventories. So:
Firm
Loch
2017
3.85
2016
3.76
2015
3.84
Highland
2.44
2.38
2.39
Fell
4.10
3.84
3.86
The ratios are almost stable over the three-year period for each of the three companies. The values,
however, indicate that Fell Furniture is using its inventories in the most efficient manner, generating
sales of over 4 times its average inventory value, while Highland Furnishings is the most inefficient at
2.44 times its average inventory value. The turnover ratio for each company saw a dip in 2016, but
picked up again in 2017 (higher than its 2015 value).
P3-14. Accounts-receivable management (LG 3; Basic)
a. A good ratio for evaluating a firm’s collection system is average collection period
(= Accounts receivable  Average sales per day).
Average collection period 
$442,450
$442, 450

 50.47 days
$3,200,000 8,767.12
365
Speedy Manufacturing normally extends 30-day credit to customers, so an average collection
period over 20 days above 30 days suggests management should pay greater attention to accounts
receivable.
b.
Seasonality could explain the lower turnover and the high average collection period. End-of-year
accounts receivable ($442,450) might not be a good measure of the average accounts receivable
over the years, in which case average collection period is overstated. It also suggests the
November figure (0–30 days overdue) is not a cause for great concern. However, 16% of all
accounts receivable (those arising in July, August, and September) are 60 days or more overdue
and may be a sign of poor receivables collection management.
P3-15. Interpreting liquidity and activity ratios (LG 3; Intermediate)
a. Current ratio = Current assets / Current liabilities;
Quick ratio = [Current assets – Inventory] / Current liabilities;
Inventory-turnover ratio = Cost of goods sold / Inventories;
Average collection period = Accounts receivable / Average sales per day;
Average sales per day = Total sales / 365; and Total asset turnover = Sales / Total assets.
© 2019 Pearson Education, Ltd.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
So,
Firm
Almi
Current
Ratio
0.90
Quick
Ratio
0.74
Inventory
Turnover
13.92
Average
Collection
Period
27.05
Total
Asset
Turnover
0.53
Pemco
1.30
0.95
12.87
34.64
1.25
Harrison
0.75
0.50
11.40
58.38
1.27
b. Pemco has the highest current and quick ratios; thus, Pemco has the most liquidity.
c. Almi and Pemco have similar receivables collection periods; however, Harrison takes more than
58 days to collect its receivables from its debtors, making it the worst performer, with its
receivables collection period way higher than the other two.
d. Inventory turnover ratio indicates efficiency in managing inventory. Almi is the most efficient,
generating sales worth 13.92 times its average inventory; Harrison is the least efficient, generating
sales worth 11.40 times its average inventory. A company might have a very high inventory
turnover ratio, because it is very efficient at maintaining the correct amount of inventory
based on its current and forecasted sales, and have a low asset turnover because it might
have a high value of non-inventory assets like machines, and warehouses.
P3-16 Debt analysis (LG 4; Basic)
Ratio
Debt =
Calculation
Debt
Total assets
Times-interest-earned =
EBIT
Interest
Fixed-payment coverage
EBIT  Lease payment
=
Interest  Lease payments
+ {[(principal + preferred dividends)]
 [1 (1 – t)]}
$36,500,000
$50,000,000
$3,000,000
$1,000,000
Creek
Industry
0.73
0.51
3.00
7.30
1.37
1.85
$3,000,000  $200,000
$1,000,000  $200,000
+{[($800,000 + $100,000)]
 [1 (1 – 0.21)]}
Creek Enterprises finances a much larger percentage of assets with debt and has less ability to service
additional debt than the average firm in the industry, so the loan should be rejected. Note in the fixedpayment coverage ratio above, the original printing run of the book asked student to use a 40% tax
rate rather than the 21% enacted by the Tax Cuts and Jobs Act. Using 40% rather than 21% results in
a coverage ratio of 1.185.
P3-17 Profitability analysis (LG 4 and LG 5; Intermediate)
Gross profit margin = [Sales – Cost of goods sold] / Sales;
Net profit margin = Earnings available for common stockholders / Sales;
Return on Assets (ROA) = Earnings available for common stockholders / Total assets;
Return on Equity (ROE) = Earnings available for common stockholders / Common stock equity
© 2019 Pearson Education, Ltd.
Chapter 3
Financial Statements and Ratio Analysis
45
So,
Firm
Gold Drinks
Gross Profit
Margin
60.68%
Net Profit
Margin
13.43%
ROA
6.44%
ROE
24.39%
Tropical Fresh
55.08%
10.07%
8.53%
56.26%
Sun Supplies
59.94%
13.10%
8.61%
39.58%
It is difficult to pick one of these as the most profitable, because the four measures provide
different answers. Gold Drinks has the highest net profit, while Sun Supplies has the highest
return on equity.
b. ROE exceeds ROA because—while both ratios have the same numerator (earnings)—ROE has a
smaller denominator for all firms with some debt (If a firm has no debt, assets equal equity, so
ROE equals ROA). The ROE for each of these companies is higher than the ROA, indicating the
use of financial leverage to generate financial surplus for equity holders. However, the use of
financial leverage will also bring in additional financial risk, which is rewarded by higher surplus
for equity. Gold Drinks has the lowest percentage of debt amongst the three.
P3-18 Ratio analysis (LG 2, LG 3, and LG 4; Challenging)
2018
2019
Current Ratio
2.08
1.97
-5.2%
Worse
Quick Ratio
1.46
1.51
3.6%
Better
Average Collection Period
51.9
59.7
15.0%
Worse
Inventory Turnover Ratio
5.7
7.2
26.2%
Better
Asset Turnover Ratio
0.79
0.85
8.3%
Better
Debt Ratio
44.3%
45.7%
3.1%
Worse
Debt to Equity Ratio
89.5%
93.7%
4.7%
Worse
Times Interest Earned Ratio
3.33
4.49
34.8%
Better
Gross Profit Margin
33.3%
32.1%
-3.7%
Worse
Net Profit Margin
5.4%
7.2%
33.9%
Better
Return on Assets
4.2%
6.1%
44.5%
Better
Return on Equity
8.5%
12.6%
47.9%
Better
Debt
Activity
Liquidity
Ratio
Profitability
Better/Worse
(2018 to 2019)
%∆
From 2018 to 2019, Bartlett’s liquidity position weakened in that the current ratio deteriorated and
average collection period lengthened. One bright spot is that inventories, which can be relatively
illiquid, became a smaller percentage of current assets. Activity ratios unequivocally improved as
Bartlett turned over inventory faster and made more efficient use of assets. Bartlett’s debt ratio and
debt-to-equity ratio weakened as liabilities rose faster than assets or common equity. That said, the
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
key is ability to service debt, which strengthened considerably (as shown by the over one-third rise in
times-interest-earned). Finally, while cost of goods sold grew faster than sales, thereby causing a dip
in gross margin, overall profitability improved as Bartlett held operating expenses relatively steady.
As a result, both return on assets and equity rose considerably.
P3-19. Common-size statement analysis (LG 5)
Santa Enterprises
Common Size income statement
Years Ending December 31, 2016 and 2017
2016
2017
Sales revenue
100.00%
Less: Cost of goods sold
58.50%
Gross profits
41.50%
100.00%
62.90%
37.10%
Less: Operating expenses
Sales and marketing expenses
Lease payments
Depreciation expense
Total Operating expense
Operating profits
14.10%
5.50%
3.40%
23.00%
18.50%
9.52%
3.39%
16.13%
29.03%
8.06%
Less: Interest expense
Net Profit before taxes
Less: Taxes (Rate = 30%)
Net profit after taxes
3.50%
15.00%
3.00%
12.00%
3.87%
4.19%
0.84%
3.35%
Less: Preferred stock dividends
Retained profits
2.80%
9.20%
1.48%
1.87%
Items that needs further investigation:
1. Cost of goods sold has gone up from 58.5% to 62.90%, reducing gross profit from 41.5% to 37.10%.
2. Significant decrease in sales and marketing expense.
3. Depreciation expense has increased from 3.4% to 16.13%.
P3-20. The relationship between financial leverage and profitability (LG 4 and LG 5; Challenge)
total liabilities
total assets
$1,000,000
Debt ratio Pelican 
 0.10  10%
$10,000,000
$5,000,000
Debt ratio Timberland 
 0.50  50%
$10,000,000
a. (1) Debt ratio 
earning before interest and taxes
interest
$6,250,000
Times interest earned Pelican 
 62.5
$100,000
$6,250,000
Times interest earned Timberland 
 12.5
$500,000
(2) Times interest earned 
© 2019 Pearson Education, Ltd.
Chapter 3
Financial Statements and Ratio Analysis
47
Timberland has much more financial leverage and, consequently, greater debt service than does
Pelican, which will make Timberland’s earnings more volatile and expose its common-stock owners
to greater risk.
operating profit
sales
$6,250,000
Operating profit margin Pelican 
 0.25  25%
$25,000,000
$6,250,000
Operating profit margin Timberland 
 0.25  25%
$25,000,000
b. (1) Operating profit margin 
Earnings available for common stockholders
sales
$3,690,000
Net profit margin Pelican 
 0.1476  14.76%
$25,000,000
$3,450,000
Net profit margin Timberland 
 0.138  13.80%
$25,000,000
(2) Net profit margin 
Earnings available for common stockholders
total assets
$3,690,000
Return on total assetsPelican 
 0.369  36.9%
$10,000,000
$3,450,000
Return on total assetsTimberland 
 0.345  34.5%
$10,000,000
(3) Return on total assets 
(4) Return on common equity 
Earnings available for common stockholders
Common stock equity
$3,690,000
 0.41  41.0%
$9,000,000
$3,450,000
Return on common equity Timberland 
 0.69  69.0%
$5,000,000
Return on common equity Pelican 
Pelican is more profitable than Timberland, as shown by the higher operating profit margin, net profit
margin, and return on assets. However, Timberland’s return on common equity exceeds Pelican’s
because of Timberland’s greater leverage.
c. Pelican has a higher net profit margin because it uses less debt and, hence, has lower interest expense.
But Timberland has a higher ROE because of greater financial leverage. Put another way, Timberland
can spread its somewhat lower profits over a much smaller number of shareholders. That said, those
shareholders face higher risk. Specifically, Timberland’s greater reliance on debt means a higher
probability an unexpected fall in cash flows will cause bankruptcy.
P3-21. Analysis of Debt Ratios (LG 4; Intermediate)
a. Debt Ratio = Total Liabilities / Total Assets. For Carson, the debt ratio is
$16,906,300 / $27,668,200 = 61.10%, and for Boswell, the ratio is $819,901 / $1,242,487 =
65.98%.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
Times Interest Earned Ratio = Earnings Before Interest and Taxes / Interest.
The times interest earned ratio for Carson is 4,876,000/210,400 = 23.17.
The times interest earned ratio for Boswell = 76,585/47,149 = 1.62.
Debt ratios for the two companies are relatively similar. Carson has generated profits of over 23
times, to meet its interest payment obligation. Boswell has generated profits of only 1.62 times,
just enough to meet its interest payment obligation. Thus, Carson has a much larger ability to
cover interest expense with current cash flow, so lenders would probably view its position as
much less risky.
b. Interest Expense to Total Liability = Interest Expense / Total Liability.
Interest expense to total liability for Carson is 210,000/16,906,300 = 0.01244 or 1.244%.
Interest expense to total liability for For Boswell, 47,149 / 819,901 = 0.0575 or 5.75%.
On a theoretical basis, this ratio is trying to capture the overall cost of debt. Conceptually it is
similar to an interest rate—the ratio indicates how many dollars of interest a company must pay for
each dollar of liabilities on its books. For Carson, it is 1.244%, but for Boswell it is as high as
5.75%. The explanation for this high cost of debt for Boswell may lie in the fact that their
profitability and interest cover is much lower. In the eyes of lenders, this makes Boswell a riskier
borrower compared to Carson, thus resulting in the higher rates of interest
P3-22. Ratio proficiency (LG 6; Basic)
a.
Gross profit  sales  gross profit margin
Gross profit  $40,000,000  0.8  $32,000,000
b.
Cost of goods sold  sales  gross profit
Cost of goods sold  $40,000,000  $32,000,000  $8,000,000
c.
Operating profit  sales  operating profit margin
Operating profit  $40,000,000  0.35  $14,000,000
d.
Operating expenses  gross profit  operating profit
Operating expenses  $32,000,000  $14,000,000  $18,000,000
e.
Earnings available for common shareholders
 sales  net profit margin  $40,000,000  0.08  $3,200,000
g.
sales
$40,000,000

 $20,000,000
total asset turnover
2
earnings available for common shareholders
Total common equity 
ROE
$3,200,000
Total common equity 
 $16,000,000
0.20
h.
Accounts receivable  average collection period 
f.
Total assets 
Accounts receivable  62.2 days 
sales
365
$40,000,000
 62.2  $109,589.041  $6,816,438.36
365
© 2019 Pearson Education, Ltd.
Chapter 3
Financial Statements and Ratio Analysis
49
P3-23. Cross-sectional ratio analysis (LG 6; Intermediate)
a.
Ratio Analysis—Fox Manufacturing Company
Industry Average
Fox
2019
2019
Debt Ratios
Current ratio
Quick ratio
Activity Ratios
Inventory turnover
Average collection period
Total asset turnover
Debt Ratios
Debt ratio
Times interest earned
Profitability Ratios
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets
Return on common equity
Earnings per share
2.35
0.87
1.84
0.75
4.55 times
35.8 days
1.09
5.61 times
20.7 days
1.47
0.30
12.3
0.55
8.0
0.202
0.135
0.091
0.099
0.167
$3.10
0.233
0.133
0.072
0.105
0.234
$2.15
Liquidity: By both the current and quick ratios, Fox has a weaker liquidity position than the
industry.
Activity: Inventory and asset turnover ratios compare favorably with the industry. Further analysis
is necessary to determine whether Fox is truly in a weaker or stronger position than the industry.
Higher inventory turnover, for example, may be the product of excessively low inventory levels
(and resulting lost sales). Similarly, Fox’s shorter average collection period could be explained by
extremely efficient receivables management, an overly zealous credit department, or excessively
tight credit terms that reduce sales growth.
Debt: Fox uses more debt than the industry average, resulting in lower ability to cover interest with
current cash flow.
Profitability: Fox posted a higher gross profit margin than the industry, suggesting a higher sales
price or a lower cost of goods sold. Operating profit margin is in line with the industry, but net profit
margin is lower— indicating relatively high expenses other than cost of goods sold. The likely
explanation is interest expenses from Fox’s relatively high level of debt. On the bright side, Fox’s
use of leverage produced a superior return on equity (ROE).
b. Fox Manufacturing Company needs to improve its liquidity ratios and possibly reduce its debt load.
Fox uses more leverage than the industry and, therefore, has more financial risk. At the same
time, the firm’s leverage transforms relatively weak profitability into superior ROE.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
P3-24. Financial statement analysis (LG 6; Intermediate)
a.
Zach Industries—Ratio Analysis
Industry
Actual
Average
2018
Liquidity Ratios
Current ratio
Quick ratio
Activity Ratios
Inventory turnover
Average collection period
Debt Ratios
Debt ratio
Times interest earned
Profitability Ratios
Gross profit margin
Net profit margin
Return on total assets
Return on common equity
Market Ratio
Market/book ratio
Actual
2019
1.80
0.70
1.84
0.78
1.04
0.38
2.50
37.5 days
2.59
36.5 days
2.33
57 days
65%
3.8
67%
4.0
61.3%
2.8
38%
3.5%
4.0%
9.5%
40%
3.6%
4.0%
8.0%
34%
4.1%
4.4%
11.3%
1.1
1.2
1.3
b. Liquidity: Zach Industries’ liquidity position deteriorated from 2018 to 2019 and now compares
unfavorably with the industry average. The firm could have problems satisfying short-term
obligations as they come due.
Activity: Zach’s activity ratios deteriorated from 2018 to 2019. Indeed, the firm now turns
inventory over more slowly than peer firms. Similarly, average collection period lengthened by
nearly three weeks, and now also compares unfavorably with the industry average.
Debt: Zach Industries’ debt position has improved since 2018 and now compares favorably with
industry. That said, Zach Industries’ ability to service interest payments deteriorated – perhaps due
to the higher rates creditors demanded in the past because of the firm’s above average debt load. As a
result, Zach’s debt and debt service compare unfavorably with the industry average.
Profitability: Although Zach Industries’ gross margin is below the industry average (suggesting
a high cost of goods sold), net profit margin rose from 2018 to 2019 and now compares favorably
with industry. The high net margin translated into returns on assets and equity exceeding the
average for peer firms—indeed, ROE is all the more impressive given that Bartlett reduced
leverage absolutely and relative to the industry norm.
Market: Zach Industries’ market-to-book value rose from 2018 to 2019 and now compares even
more favorably to industry norm. This trend indicates investors have recently come to view firm
performance even more favorably than that of peer firms.
Overall, the firm maintains superior profitability at the risk of illiquidity. Investigation into the
management of accounts receivable and inventory is warranted.
© 2019 Pearson Education, Ltd.
Chapter 3
Financial Statements and Ratio Analysis
P3-25. Integrative—Complete ratio analysis (LG 6; Challenge)
a.
Sterling Company—Ratio Analysis
Ratio
(Given)
Actual
2017
(Given)
Actual
2018
Actual
2019
(Given)
Industry
2019
Liquidity
Current ratio
1.40
1.55
1.67
1.85
Quick ratio
1.00
0.92
0.88
1.05
Activity
Inventory turnover
9.52
9.21
7.89
8.60
45.6 days
36.9 days 29.2 days
35.5 days
59.3 days
0.74
61.6 days 53.0 days
0.80
0.83
46.4 days
0.74
Debt
Debt ratio
0.20
0.20
0.35
0.30
Times interest earned
8.2
7.3
6.5
8.0
4.5
4.2
4.051
4.2
0.30
0.27
0.25
0.25
0.12
0.062
0.12
0.062
0.13
0.082
0.10
0.053
0.045
0.050
0.068
0.040
0.061
0.067
0.120
0.066
$1.75
$2.20
$4.10
$1.50
12.0
10.5
9.63
11.2
1.20
1.05
1.16
1.10
Average collection
period
Average payment
period
Total asset turnover
Fixed-payment
coverage
Profitability
Gross profit margin
Operating profit
margin
Net profit margin
Return on total
assets
Return on common
Equity
Earnings per share
(EPS)
Market
Price/earnings
(P/E)
Market/book ratio
(M/B)
TS: Time Series
CS: Cross Sectional
TS: Improving
CS: Below Peer
TS: Deteriorating
CS: Below Peer
TS:
CS:
TS:
CS:
TS:
CS:
TS:
CS:
Deteriorating
Below Peer
Improving
Above Peer
Deteriorating
Above Peer
Improving
Above Peer
TS: Deteriorating
CS: Above Peer
TS: Deteriorating
CS: Poor
TS: Deteriorating
CS: Below Peer
TS: Deteriorating
CS: Equal to Peer
TS: Improving
CS: Above Peer
TS: Improving
CS: Above Peer
TS: Improving
CS: Above Peer
TS: Improving
CS: Above Peer
TS: Improving
CS: Above Peer
TS:
CS:
TS:
CS:
Falling
Below Peer
Steady
Above Peer
Note:
1. Principal payments are not given in the problem; this figure assumes such payments are zero.
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Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
Liquidity: Sterling’s overall liquidity position is weak compared with peer firms. The significant
(and growing) difference in the current and quick ratios suggests the firm is holding a significant
level of relatively illiquid inventory.
Activity: Sterling’s inventory turnover has deteriorated and currently lags the industry. At the
same time, the firm has made more efficient use of assets and now outperforms its peers. Sterling
has also significantly improved collections, both absolutely and relative to peer.
Debt: Sterling’s debt ratio has risen from 2017 and now exceeds the industry average. As a
consequence, times interest has deteriorated and now compares unfavorably with peer firms.
Profitability: Sterling’s gross margin, while in line with industry norms, has declined, probably
because of increases in the cost of goods sold. Operating and net profit margins have been stable
(or improving) at levels exceeding industry averages. Both ROA and the ROE have improved and
compare favorably with the industry. EPS has risen considerably since 2017, but the P/E ratio has
fallen, suggesting a lack of confidence in Sterling’s ability to match or exceed those earnings in
the future.
Market: The firm’s P/E ratio has been falling. Its market-to-book ratio—though somewhat
volatile—compare favorably with industry norms.
Overall, Sterling should work to improve inventory management and reduce debt load and
service. Other than these issues, the firm appears to be doing reasonably wellespecially in
generating returns on sales. Investors have generally endorsed this assessment, but somewhat
volatile market ratios do hint at some uncertainty about the firm’s ability to take needed action.
NOTE: The first printing of this textbook included a tax rate of 40% on the income statement.
The text has since been revised and now uses the 21% tax rate enacted as part of the Tax Cuts and
Jobs Act. The answer provided here uses that 21% tax rate. Students may obtain different answers
for the net profit margin, ROE, ROA, EPS, and P/E ratios if they are using a book with a 40% tax
rate.
P3-26. DuPont system of analysis (LG 6; Intermediate)
Net Profit Margin
Asset Turnover
ROA
ROE
Steve Steaks
8.14%
0.41
3.30%
10.74%
Barry Sizzle
10.80%
0.52
5.57%
56.62%
a. Barry Sizzle outperforms Steve Steaks in both net profit margin and asset turnover (i.e., Barry Sizzle
posted the higher figures).
b. Barry Sizzle outperforms Steve Steaks in both ROA and ROE (i.e., Barry Sizzle posted the higher figures).
© 2019 Pearson Education, Ltd.
Chapter 3
Financial Statements and Ratio Analysis
53
P3-27. Complete ratio analysis, recognizing significant differences (LG 6; Intermediate)
a.
Ratio
Current ratio
Quick ratio
Inventory turnover
Average collection period
Total asset turnover
Debt ratio
Times interest earned ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets
Return on common equity
Price/Earnings ratio
Market/book ratio
Dinnington Glass Company
2017
2018
4.45
3.52
15.4
35.4 days
1.8
0.38
5
52%
15%
11.20%
15.60%
22%
10.2
2.75
Proportional
Difference
-14.61%
-8.52%
-11.69%
-14.83%
+22.22%
+42.11%
-30.00%
-7.69%
+20.00%
+2.68%
+29.55%
+81.82%
-7.84%
-11.64%
3.8
3.22
13.6
30.15 days
2.2
0.54
3.5
48%
18%
11.50%
20.21%
40%
9.4
2.43
b.
Ratio
Proportional
Difference
Current ratio
Quick ratio
Inventory turnover
Average collection period
Total asset turnover
Debt ratio
Times interest earned ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on total assets
Return on common equity
Price/Earnings ratio
Market/book ratio
-14.61%
-8.52%
-11.69%
-15.17%
+22.22%
+42.11%
-30.00%
-7.69%
+20.00%
+2.68%
+29.55%
+81.82%
-7.84%
-11.64%
Home Health’s
Favor
No
No
No
Yes
Yes
No
No
No
Yes
Yes
Yes
Yes
No
No
c. The most obvious relationship is associated with the increase in the ROE value. The increase in
this ratio is connected with the increase in the ROA. The higher ROA is partially attributed to the
higher total asset turnover (as reflected in the DuPont model). This means that the efficient
utilization of assets to generate sales has increased the overall returns to shareholders
significantly. The ROE increase is also associated with the slightly higher level of debt as
captured by the higher debt ratio.
P3-28. Ethics problem (LG 1; Intermediate)
Answers will vary by article chosen, but in general, students will report that financial statements are
more trustworthy if company financial executives implement the provisions of Sarbanes-Oxley.
© 2019 Pearson Education, Ltd.
54
Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition
 Case
Case studies are available on www.pearson.com/mylab/finance.
Assessing Martin Manufacturing’s Current Financial Position
Martin Manufacturing Company is an integrative case study employing financial-analysis techniques. The
company is a capital-intensive firm that manages accounts receivable and inventory poorly. The industry
average inventory turnover can fluctuate from 10 to 100 depending on the market.
a.
Ratio calculations
Financial Ratio
Current ratio
Quick ratio
Inventory turnover (times)
Average collection period (days)
Total asset turnover (times)
Debt ratio
Times interest earned (times)
Gross profit margin
Net profit margin
Return on total assets
Return on equity
Ratio
$1,531,181  $616,000 = 2.5%
($1,531,181 – $700,625)  $616,000 = 1.3%
$3,704,000  $700,625 = 5.3%
$805,556  ($5,075,000  365) = 58.0
$5,075,000  $3,125,000 = 1.6
$1,781,250  $3,125,000 = 57%
$153,000  $93,000 = 1.6
$1,371,000  $5,075,000 = 27%
$33,000  $5,075,000 = 0.65%
$33,000  $3,125,000 = 1.1%
$33,000  $1,293,000 = 2.6%
Historical Ratios—Martin Manufacturing Company
Actual
Actual
Actual
2017
2018
2019
Current ratio
Quick ratio
Inventory turnover (times)
Average collection period (days)
Total asset turnover (times)
Debt ratio
Times interest earned
Gross profit margin
Net profit margin
Return on total assets
Return on equity
Price/earnings ratio
Market/book
b.
2019
1.7
1.0
5.2
50.7
1.5
45.8%
2.2
27.5%
1.04%
1.6%
3.0%
33.5
1.0
1.8
0.9
5.0
55.8
1.5
54.3%
1.9
28.0%
0.94%
1.4%
3.2%
38.7
1.1
2.5
1.3
5.3
58.0
1.6
57.0%
1.6
27.0%
0.65%
1.1%
2.6%
34.48
0.88
Industry
Average
1.5
1.2
10.2
46.0
2.0
24.5%
2.5
26.0%
1.14%
2.3%
3.1%
43.4
1.2
Liquidity: Martin’s liquidity has improved in recent years and now compares favorably with industry.
One potential concern is the significant difference between the current and quick ratio, implying the firm
has much of its liquidity tied up in inventory.
© 2019 Pearson Education, Ltd.
Chapter 3
Financial Statements and Ratio Analysis
55
Activity: Inventory turnover has been relatively stable but at a much lower level than the industry norm,
suggesting Martin is carrying too much inventory. The firm’s average collection period has risen and
now exceeds the industry average by nearly two weeks—both indications of collection problems. Total
asset turnover ratio has been stable, but again, at a lower level than the industry average, suggesting
inefficient use of existing assets.
Debt: The debt ratio has increased and now substantially exceeds the industry average. The times
interest ratio has also deteriorated and now falls considerably short of the industry norm. Both ratios
point to significant financial risk.
Profitability: Gross margin has been stable at a level just exceeding the industry average. Net profit
margin, however, has deteriorated markedly and now trails the industry average. Martin’s debt level and
service are the likely explanation for a strong gross but weak net margin.
Market: The market values Martin’s common stock at less than book value; in addition, the firm’s
market-to-book ratio compares unfavorably with peer firms. The market has also put a price on Martin
stock that is a lower multiple of earnings than the industry norm.
c.
Martin Manufacturing clearly has a problem managing inventory and generating sales appropriate for its
capital investment. The firm also carries substantial debt, which is further depressing profitability.
Investors are aware of these weaknesses and priced them accordingly, hence Martin’s weak market
ratios.
 Spreadsheet Exercise
Answer to Chapter 3’s Dayton, Inc., financial-statement spreadsheet problem are available on
www.pearson.com/mylab/finance.
 Group Exercise
Group exercises are available on www.pearson.com/mylab/finance.
This chapter’s exercise focuses on each group’s shadow firm. Groups are asked to obtain their firm’s latest 10-K
from the Securities and Exchange website (www.sec.gov) and then calculate/interpret basic performance
ratios as done in the text. The number of years for time-series analysis is up to the instructor. That said, fewer
years is advised the analysis can be performed using a single 10-K filing. The conclusion of this assignment is
calculation of the DuPont analysis for the shadow firm. This exercise shouldn’t require much assistance,
particularly if students made a good choice of firm in Chapter 1.
Modifications could include dropping intertemporal analysis and focusing solely on the most recent year.
Alternatively, groups could be asked to compare the ratios from their shadow firm with the ratios from
another firm within the same industry.
© 2019 Pearson Education, Ltd.