Chapter 3 Problems 1. 3-1. 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? Solution: Dental Delights Division A Net Income Sales Division B $200,000 $30,000 5% 6.25% 4,000,000 $480,000 Division B is superior 3. 3-3. 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? Solution:Bass Chemical, Inc. Net income Sales profit margin $2,000,000 0.05 $100,000 Return on assets Net income (investment) Total assets $100,000 $1,200,000 8.33% S3-1 4. 3-4. 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? Solution: Franklin Mint and Candy Shop Net income Sales Profit Margin $750,000 0.06 $45,000 Assets Sales Total asset turnover $750,000 2.5 $300,000 Return on assets (invesment) Net income Total assets $45,000 $300,000 15% S3-2 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? 3-8. Solution: Sharpe Razor Company total assets – current assets Fixed assets $2,500,000 1,000,000 $1,500,000 Sales Fixed assets Fixed asset turnover $1,500,000 5 $7,500,000 total assets –debt Stockholders’ equity $2,500,000 700,000 $1,800,000 Net income = Sales profit margin = $7,500,000 3% = $225,000 Net income Stockholders' equity $225,000 12.5% $1,800,000 Return on stockholders' equity S3-3 11. Acme Transportation Company has the following ratios compared to its industry for 2009. Return on assets…………… Acme Transportation 9% Industry 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. S3-4 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. a. 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. Net income Sales profit margin $4,000,000 3.5% $140,000 Stockholders equity Total assets Total liabilities Total assets Sales/Total asset turnover $4,000,000/2.5 $1,600,000 Total liabilities Current liab ilities Long term liabilities $100,000 $300,000 $400,000 Stockholders' equity $1,600,000 $400,000 $1,200,000 Net income Stockholders' equity $140,000 11.67% $1,200,000 Return on stockholders' equity S3-5 3-14. (Continued) b. The new level of sales will be: Sales Total assets Total assets turnover $1,600,000 3 $4,800,000 Net income Sales Profit margin $4,800,000 3.5% $168,000 Return on stockholders' equity Net income Stockholders' equity $168,000 14% $1, 200,000 S3-6 25. Calloway Products has the following data. Industry information is also shown. Industry Data on Net Year Net Income 2006 2007 2008 Year 2006 2007 2008 Total Assets $360,000 380,000 380,000 Income/Total Assets $3,000,000 3,400,000 3,800,000 Debt $1,600,000 1,750,000 1,900,000 Total Assets $3,000,000 3,400,000 3,800,000 11% 8 5 Industry Data on Debt/Total Assets 52% 40 31 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 2006 2007 2008 Calloway Ratio 12.0% 11.18% 10.0% Industry Ratio 11.0% 8.0% 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. S3-7 3-25. (Continued) b. Debt/total assets Year 2006 2007 2008 Calloway Ratio 53.33% 51.47% 50.0% Industry Ratio 52.0% 40.0% 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: Year 2005 2006 2007 2008 a. b. Net Income $118,000 131,000 148,000 175,700 Total Assets $1,900,000 1,950,000 2,010,000 2,050,000 Stockholders’ Equity $ 700,000 950,000 1,100,000 1,420,000 Total Debt $1,200,000 1,000,000 910,000 630,000 Compute the ratio of net income to total assets for each year and comment on the trend. 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. Net income Total assets 2005 2006 2007 2008 $118,000/$1,900,000 = 6.21% $131,000/$1,950,000 = 6.72% $148,000/$2,010,000 = 7.36% $175,700/$2,050,000 = 8.57% Comment: There is a strong upward movement in return on assets over the four year period. S3-8 3-26. (Continued) Net income b. Stockholders' equity 2005 2006 2007 2008 $118,000/$700,000 $131,000/$950,000 $148,000/$1,100,000 $175,700/$1,420,000 = 16.86% = 13.79% = 13.45% = 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. Total debt Total assets 2005 2006 2007 2008 31. 63.2% 51.3% 45.3% 30.7% The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in the balance sheet below. Total assets turnover ................................... Cash to total assets ...................................... Accounts receivable turnover ..................... Inventory turnover ...................................... Current ratio ................................................ Debt to total assets ...................................... 2.4 times 2.0% 8.0 times 10.0 times 2.0 times 61.0% GRIGGS CORPORATION Balance Sheet 2008 Liabilities and Stockholders’ Equity Assets Cash .............................. Accounts receivable ...... Inventory ....................... _____ _____ _____ Current debt ............................................. _____ Long-term debt......................................... _____ Total debt ........................................... _____ S3-9 Total current assets _____ Fixed assets .................. _____ Total assets ................... _____ Equity ....................................................... _____ Total debt and stockholders’ equity 3-31. Solution: Griggs Corporation Sales/total assets Total assets Total assets = 2.4 times = $1,200,000/2.4 = $500,000 Cash Cash Cash = 2% of total assets = 2% × $500,000 = $10,000 Sales/accounts receivable Accounts receivable Accounts receivable = 8 times = $1,200,000/8 = $150,000 Sales/inventory Inventory Inventory = 10 times = $1,200,000/10 = $120,000 3-31. (Continued) Fixed assets Current asset Fixed assets = Total assets – current assets = $10,000 + $150,000 + $120,000 = $280,000 = $500,000 – $280,000 = $220,000 Current assets/current debt Current debt Current debt Current debt =2 = Current assets/2 = $280,000/2 = $140,000 Total debt/total assets Total debt Total debt = 61% = .61 × $500,000 = $305,000 Long-term debt Long-term debt = Total debt – current debt = $305,000 – 140,000 S3-10 _____ Long-term debt = $165,000 Equity Equity Equity = Total assets – total debt = $500,000 – $305,000 = $195,000 Griggs Corporation Balance Sheet 2008 Cash ..................... A/R ...................... Inventory ............. Total current assets Fixed assets ......... Total assets .......... 35. $ 10,000 Current debt .......... 150,000 Long-term debt ..... $120,000 Total debt .......... 280,000 220,000 Equity ................... $500,000 Total debt and stockholders’ equity $140,000 165,000 $305,000 195,000 $500,000 Given the following financial statements for Jones Corporation and Smith Corporation: a. b. To which company would you, as credit manager for a supplier, approve the extension of (shortterm) trade credit? Why? Compute all ratios before answering. In which one would you buy stock? Why? JONES CORPORATION Current Assets Cash ............................... $ 20,000 Accounts receivable ....... 80,000 Inventory ........................ 50,000 Liabilities Accounts payable ................... Bonds payable (long-term)..... $100,000 80,000 Long-Term Assets Fixed assets .................... $500,000 Less: Accumulated depreciation ............. (150,000) *Net fixed assets ........ 350,000 Total assets .............. $500,000 Stockholders’ Equity Common stock ....................... Paid-in capital ........................ Retained earnings ................... $150,000 70,000 100,000 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 S3-11 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 Cash ................................. $ 35,000 Marketable securities ...... 7,500 Accounts receivable ........ 70,000 Inventory ......................... 75,000 Liabilities Accounts payable .................. Bonds payable (long-term) .... $ 75,000 210,000 Long-Term Assets Fixed assets ..................... $500,000 Less: Accumulated depreciation ................ (250,000) *Net fixed assets ........... 250,000 Total assets ................. $437,500 Stockholders’ Equity Common stock....................... Paid-in capital ........................ Retained earnings .................. $ 75,000 30,000 47,500 Total liabilities and equity ... Sales (on credit) .......................................................... Cost of goods sold ...................................................... Gross profit ................................................................. †Selling and administrative expense ...................... Less: Depreciation expense .................................... Operating profit .......................................................... Interest expense .......................................................... Earnings before taxes .................................................. Tax expense ................................................................ Net income .................................................................. *Use net fixed assets in computing fixed asset turnover. †Includes $7,000 in lease payments. S3-12 $437,500 $1,000,000 600,000 400,000 224,000 50,000 126,000 21,000 105,000 52,500 $ 52,500 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. Profit margin Return on assets (investments) Return on equity Receivable turnover Average collection period Inventory turnover Fixed asset turnover Total asset turnover Current ratio Quick ratio Debt to total assets Times interest earned Fixed charge coverage Fixed charge coverage calculation Jones Corp. 7.4% 18.5% 28.9% 15.63x 23.04 days 25x 3.57x 2.5x 1.5x 1.0x 36% 24.13x 13.33x (200/15) Smith Corp. 5.25% 12.00% 34.4% 14.29x 25.2 days 13.3x 4x 2.29x 2.5x 1.5x 65.1% 6x 4.75x (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. S3-13 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. S3-14