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%
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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.
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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