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ExERCISES AND PRoBlEmS
P2.1 Cisco Systems, Inc.: Review the time-series of various rates of return and rates of return components for
Cisco Systems, Inc. in Exhibit P2.1. (Cisco manufactures and sells networking and communications products worldwide. It sells its products and services through its direct sales force, distributors, and retail partners.)
a. Discuss the change in the return on assets during this period using its components.
b. Discuss the change in the return on equity during this period using its components.
c. Why are the unlevered and levered profit margins the same in all years, whereas the leverage ratios (as measured by total assets to common equity) are not equal to each other in any year?
ExHIbIt P2.1 Rates of Return and Components for Cisco Systems, Inc.
CISCO Systems, Inc. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Return on assets . . . 30.0% 33.9% 23.1% 18.8% 17.7% 11.2% −3.0% 5.2% 9.6% 13.7% Return on equity. . . 37.8% 43.5% 29.5% 23.7% 22.3% 14.0% −3.8% 6.8% 12.6% 18.4% Unlevered profit margin . . . 21.3% 22.3% 16.3% 16.0% 17.2% 14.1% −4.5% 10.0% 19.0% 22.5% Levered profit margin . . . 21.3% 22.3% 16.3% 16.0% 17.2% 14.1% −4.5% 10.0% 19.0% 22.5% Revenue to average total assets . . 1.41 1.52 1.42 1.18 1.03 0.80 0.65 0.52 0.50 0.61 Total assets to common equity . . . 1.26 1.28 1.28 1.26 1.26 1.25 1.27 1.31 1.32 1.35
P2.2 The Sherwin-Williams Company: Review the time-series of various rates of return and rates of return com-
ponents for the Sherwin-Williams Company in Exhibit P2.2. (Sherwin-Williams manufactures, distributes, and sells coatings and related products in North America and South America. It operates four segments: paint stores, consumer, automotive finishes, and international coatings.)
a. Discuss the change in the return on assets in the time-series using its components.
b. Discuss the change in the return on equity in the time-series using its components.
c. Why does the return on equity increase much more than the return on assets during this time period?
d. Why is the return on equity less than the return on assets in Year 6?
ExHIbIt P2.2 Rates of Return and Components for the Sherwin-Williams Company
Sherwin-Williams Company Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Return on assets . . . 9.9% 9.5% 8.8% 7.8% 8.4% 1.4% 8.1% 9.5% 10.0% 10.6% Return on equity. . . 17.7% 17.5% 17.4% 16.5% 17.8% 1.0% 17.8% 22.0% 23.7% 25.3% ROE to ROA . . . 1.80 1.84 1.97 2.10 2.11 0.74 2.21 2.31 2.37 2.39 Unlevered profit margin . . . 6.2% 5.9% 6.3% 6.4% 6.8% 1.0% 5.9% 6.5% 6.6% 6.9% Levered profit margin . . . 6.1% 5.5% 5.3% 5.5% 6.1% 0.3% 5.2% 6.0% 6.1% 6.4% Revenue to average total assets . . 1.60 1.61 1.39 1.22 1.23 1.34 1.37 1.47 1.52 1.54 Total assets to common equity . . . 1.81 1.97 2.35 2.45 2.38 2.46 2.49 2.50 2.54 2.56
P2.3 Dell Inc.: Review the time-series of various working capital management ratios for Dell Inc. (formerly Dell
Computer Corporation) in Exhibit P2.3. (Dell designs, develops, manufactures, and sells computer systems and services around the world.)
a. Discuss the change in Dell’s current and quick ratios over the time-series. Is this change “good” or “bad” for Dell? In other words, should Dell try to reverse the trend in its time-series of current and quick ratios?
b. Using Dell’s component ratios, discuss the change in Dell’s trade cash cycle over the time-series.
ExHIbIt P2.3 Working Capital Management Ratios for Dell Inc.
Dell Inc. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Current assets to current
liabilities . . . 2.1 1.7 1.5 1.7 1.5 1.5 1.1 1.0 1.0 1.2 Quick ratio . . . 1.5 1.4 1.2 1.5 1.3 1.3 0.8 0.8 0.8 1.0 Days of sales held in inventory. . . . 31.4 20.5 9.3 6.6 6.1 5.7 4.9 6.4 7.8 5.4 Accounts receivable
collection period . . . 43.6 38.3 35.4 39.7 37.3 31.9 30.2 25.0 27.4 29.9 Accounts payable payment
period . . . 38.5 46.8 51.4 52.4 54.1 56.6 67.5 68.9 72.2 74.7 Trade cash cycle. . . 36.5 12.0 −6.8 −6.1 −10.8 −19.0 −32.4 −37.5 −37.0 −39.5
P2.4 Water Pik Technologies, Inc.: Review the time-series of various working capital management ratios for
Water Pik Technologies, Inc. in Exhibit P2.4. (Water Pik designs, manufactures, and sells personal health care products, swimming pool products, and water heating systems.)
a. Discuss the change in Water Pik’s current and quick ratios over the time-series. Is this change “good” or “bad” for Water Pik? In other words, should Water Pik try to reverse the trend in its time-series of current and quick ratios?
b. Using Water Pik’s component ratios, discuss the change in Water Pik’s trade cash cycle over the time-series.
ExHIbIt P2.4 Working Capital Management Ratios for Water Pik Technologies, Inc.
Water Pik technologies, Inc. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Current assets to current liabilities. . . 1.8 1.8 2.1 2.3 2.4 2.0 Quick ratio . . . 1.1 1.1 1.4 1.4 1.5 1.1 Days of sales held in inventory. . . 55.8 59.2 67.7 69.3 69.6 91.2 Accounts receivable collection period . . . 74.5 74.0 88.2 98.9 98.4 104.6 Accounts payable payment period . . . 55.4 51.3 49.0 43.9 41.3 52.6 Trade cash cycle. . . 74.9 81.9 106.9 124.3 126.7 143.3
P2.5 Samsonite Corporation: Review the time-series of various financial leverage and coverage ratios for Sam-
sonite Corporation in Exhibit P2.5. (Samsonite designs, develops, manufactures, and sells luggage and travel- related consumer products.)
a. Discuss the change in Samsonite’s financial leverage and coverage ratios over the time-series.
b. Using its financial leverage and coverage ratios, discuss what you know about its common equity.
c. Which is larger—interest expense or preferred stock dividends—for each year in the time series? (Assume that an income tax rate of zero was used to measure the financial ratios.)
ExHIbIt P2.5 Financial Leverage and Coverage Ratios for Samsonite Corporation
Samsonite Corporation Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
Total debt to total assets . . . 0.5 0.5 0.3 0.8 0.8 0.8 0.9 0.7 0.7 Preferred stock to total assets . . . 0.0 0.0 0.0 0.3 0.4 0.4 0.5 0.6 0.3 Total debt to common equity . . . 12.7 10.8 0.9 NMF NMF NMF NMF NMF NMF Preferred stock to common equity. . . 0.0 0.0 0.0 NMF NMF NMF NMF NMF NMF EBIT coverage (interest only) . . . −0.2 0.7 3.6 0.5 1.1 1.2 0.9 1.5 1.7 EBIT coverage
(interest + preferred stock dividends) . . . −0.2 0.7 3.6 0.4 0.7 0.7 0.5 0.8 1.0
"NMF" = not a meaningful figure
P2.6 Use the financial statements in Exhibit P2.6 to calculate the return on assets, return on equity, and their respec- tive top-level components (unlevered profit margin, asset utilization, earnings leverage factor, and financial leverage factor) for the Jake and Luke Schnall Company for Year 10. In addition, for each of the events described below, recalculate the return on assets, return on equity, and their respective components assuming the event occurred at the end of Year 9. Assume that the company distributes an annual dividend to common shareholders equal to net income minus any dividends distributed to preferred stockholders.
a. The company issues additional debt at its current interest rate to fund capital expenditures and raise the working capital necessary to grow the company by 50 percent in 2010; the new investment will earn an ROA equal to the company’s current ROA.
b. Same information as part (a) except the company issues additional preferred stock instead of debt.
c. Same information as part (a) except the company issues additional common stock instead of debt.
d. The company issues additional debt at its current interest rate to repurchase 10 percent of the company’s common stock at a price equal to two times its book value.
e. The company refinances all of its existing debt and issues debt in a highly levered transaction. Its new interest rate is 2 percent higher than its previous interest rate. It used the cash proceeds from the debt issu- ance to repurchase 55 percent of the company’s common stock at a price equal to two times its book value.
f. The company issues additional common stock to repurchase all of the existing debt and preferred stock at book value with no taxable gains or losses on the debt.
g. The company sells 20 percent of its business (operating assets and liabilities) at book value with no tax- able gain or loss. The sale of the business reduces the company’s revenue and all operating expenses by 10 percent. The company uses the cash flow from the sale to redeem debt at book value with no taxable gains or losses on the debt.
h. The company sells 20 percent of its business (operating assets and liabilities) at book value with no tax- able gain or loss. The sale of the business reduces the company’s revenue and all operating expenses by 10 percent. The company uses the cash flow from the sale to repurchase some of the company’s common stock.
ExHIbIt P2.6 Financial Statements for the Jake and Luke Schnall Company
Income Statement ($ in millions) Rate Year 10
Operating revenue . . . $ 5,000 Operating expenses . . . 1,750 Operating income (EBIT) . . . $ 3,250 Interest expense. . . 7.0% 263 Income before income tax expense (EBT) . . . $ 2,988 Income tax expense (benefit) . . . 40.0% 1,195 Net income . . . $ 1,793
Common Equity balance Rate Year 10
Beginning balance . . . $ 4,875 Net income . . . 1,793 Preferred stock dividends . . . 8.0% −150 Dividends . . . −1,643 Ending balance. . . $ 4,875
balance Sheet ($ in millions) Year 9 Year 10
Total current assets . . . $ 2,500 $ 2,500 Property, plant, and equipment, net. . . 10,000 10,000 Total assets with excess assets . . . $12,500 $12,500 Total current liabilities. . . $ 2,000 $ 2,000 Total debt . . . 3,750 3,750 Total liabilities . . . $ 5,750 $ 5,750 Preferred stock. . . $ 1,875 $ 1,875 Common stock (equity) . . . 4,875 4,875 Total stockholders’ equity . . . $ 6,750 $ 6,750 Total liabilities and stockholders’ equity. . . $12,500 $12,500
P2.7 Exhibit P2.7 presents certain rates of return, profit margins, and other information on the Nate and Evelyn Z’s Furniture Company. Using the information in the exhibit, complete the partial financial statements and calculate the missing financial ratios (shown as “?-#”) in Exhibit P2.7. (All financial ratios using balance sheet numbers were calculated using Year 12 ending balances instead of average balances.)
ExHIbIt P2.7 Nate and Evelyn Z’s Furniture Company
Income Statement ($ in millions) Year 12 Financial Ratios Year 12
Operating revenue . . . $30,000 Return on assets . . . 17.5% Operating expenses . . . ?-1 Return on investment. . . 19.4%
Operating income (EBIT) . . . ?-2 Return on equity. . . ?-13
Interest expense. . . ?-3 Unlevered profit margin . . . 14.0% Income before income tax expense (EBT) . . . ?-4 Total asset utilization (turnover) . . . ?-14
Income tax expense (benefit) . . . ?-5 Levered profit margin (to common) . . . 10.8% Net income . . . ?-6 Financial leverage factor . . . 2.938 balance Sheet ($ in millions) Year 12 Other Information Year 12 Total assets with excess assets . . . ?-7 Constant income tax rate . . . 30.0% Preferred stock dividend rate . . . 9.0% Total current liabilities. . . ?-8 Change in preferred stock at end of Year 12 . . . . $1,000 Total debt . . . ?-9 Preferred stock dividends . . . $432
Preferred stock. . . ?-10
Common stock (equity) . . . ?-11
P2.8 You are an analyst and have certain rates of return, profit margins, and other information on the Jeff, Matt, and Mike Associates Company. Using the information in the exhibit, complete the partial financial statements and calculate the missing financial ratios (shown as “?-#”) in Exhibit P2.8. The company had no purchases or other additions to Intangible Assets. (All financial ratios using balance sheet numbers are calculated using Year 7 ending balances instead of average balances. The company had no sales or retirements of property, plant, and equipment or intangible assets. Essentially all of the company’s property, plant, and equipment is depreciable. All changes in financing occur at the end of the fiscal year.)
ExHIbIt P2.8 Financial Statements for Jeff, Matt and Mike Associates
Income Statement ($ in millions) Year 7 Other Information Year 7
Operating revenue . . . ?-1 Income tax rate . . . 30.0% Preferred stock dividend rate . . . 9.0% Change in preferred stock . . . $ 1,000 Retained earnings—beginning balance . . . $ 4,400 Inventory purchases . . . $12,400 Capital expenditures (PPEQ) . . . $15,000 Beginning of year balance—intangible assets . . . $ 2,500 Common dividends . . . $ 3,014
Cost of goods sold. . . ?-2
Selling, general and administrative . . . ?-3
Depreciation and amortization (All) . . . ?-4
Operating income (EBIT) . . . ?-5
Interest expense. . . ?-6
Income before income tax expense (EBT) . . . ?-7
Income tax expense (benefit) . . . ?-8
Net income . . . ?-9
balance Sheet ($ in millions) Year 7 Financial Ratios (based on Ending balances) Year 7 Cash . . . ?-10 Cost of goods sold expense ratio . . . 28.571% Selling, general and administrative expense ratio . . . 33.333% Total liabilities to total assets . . . 0.546 EBITDA to interest . . . 8.000 EBITDA to fixed charges . . . 4.776 Quick (asset test) ratio . . . 1.531 Days of inventory held . . . 133.833 Accounts receivable collection period . . . 32.776 Trade cash cycle. . . 103.028 Provision for bad debts ratio . . . 4.546% Depreciable life of gross plant . . . 12.500 Depreciable life of net plant . . . 8.500 PPEQ investment (CAPEX) to revenues . . . 35.714% PPEQ investment (CAPEX) to depreciation . . . 2.500 Earnings per share (EPS)—basic . . . $4.375 Shares outstanding for basic EPS . . . 984.0 Accounts receivable . . . ?-11
Inventory. . . ?-12
Current assets . . . ?-13
Property, plant and equipment—gross (PPEQ) . . . ?-14
Accumulated depreciation . . . ?-15
Property, plant and equipment—net . . . ?-16
Intangible assets . . . ?-17
Total assets with excess assets . . . ?-18
Accounts payable. . . ?-19
Accruals . . . ?-20
Total current liabilities. . . $ 3,070 Total debt . . . ?-21 Total liabilities . . . ?-22 Preferred stock . . . ?-23 Common stock—paid-in-capital . . . ?-24 Retained earnings . . . ?-25 Shareholders’ equity . . . ?-26
Total liabilities and stockholders’ equity. . . ?-27
P2.9 Main Street Restaurant Group: A young analyst was asked to measure the return on assets and return on
equity for the operations of the Main Street Restaurant Group by using the abbreviated balance sheets and income statements that appear in Exhibit P2.9. (The company operates TGI Friday’s and other restaurants.) Based on this information, the analyst calculated the rates of return using the following formulas
Return on Assets5Net Income1112Average Tax Rate23Interest Expense Average Total Assets
Return on Equity5 Net Income Average Common Equity
a. Comment on the formulas the analyst used to measure the rates of return on the company’s operations shown in the exhibit.
b. Using the information in the exhibit, correctly calculate the return on assets and return on equity for the company’s operations, for each year for which you have data available.
c. Calculate the components of the correctly calculated return on assets and return on equity for each year for which you have data available.
ExHIbIt P2.9 Abbreviated Balance Sheets and Income Statements for the Main Street Restaurant Group Main Street Restaurant Group
balance Sheet (Abbreviated) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Current assets . . . $ 8.56 $ 13.20 $ 15.82 $ 12.55 $ 9.83 $ 10.04 Plant, property & equip (net). . . 58.00 63.85 65.23 71.27 68.13 66.45 Other assets . . . 19.96 31.20 31.42 28.58 28.25 26.69 Total assets. . . $ 86.52 $108.25 $112.47 $112.40 $106.21 $103.18
Total current liabilities. . . $ 25.22 $ 20.89 $ 23.81 $ 27.58 $ 26.80 $ 29.74 Long term debt. . . 31.51 44.40 47.23 52.00 47.87 42.23 Other liabilities . . . 2.41 2.47 1.22 3.21 2.44 1.92 Total liabilities . . . $ 59.14 $ 67.76 $ 72.26 $ 82.79 $ 77.11 $ 73.89 Common stock. . . $ 44.20 $ 53.63 $ 53.66 $ 53.94 $ 54.95 $ 54.95 Retained earnings . . . –16.82 –13.14 –13.45 –24.33 –25.85 –25.66 Treasury stock . . . 0.00 0.00 0.00 0.00 0.00 0.00 Common equity (total) . . . $ 27.38 $ 40.49 $ 40.21 $ 29.61 $ 29.10 $ 29.29 Liabilities and shareholders’ equity . . . $ 86.52 $108.25 $112.47 $112.40 $106.21 $103.18
Debt in current liabilities . . . $ 1.83 $ 2.01 $ 3.01 $ 3.50 $ 3.82 $ 3.85 Average income tax rate. . . 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% Closing stock price. . . $ 3.25 $ 3.03 $ 4.94 $ 2.12 $ 2.86 $ 1.60 Common dividends . . . $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.00 $ 0.00
Main Street Restaurant Group
Income Statement (Abbreviated) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Sales (net). . . $141.16 $187.15 $214.26 $229.15 $227.49 $224.75 Cost of goods sold. . . 121.29 161.65 184.86 194.79 200.79 199.75 Gross profit. . . $ 19.87 $ 25.50 $ 29.40 $ 34.36 $ 26.70 $ 25.00 Selling, general, & admin expenses . . . 9.93 11.15 11.20 12.39 10.08 9.52 Depreciation, depletion, & amortiz . . . 5.65 8.49 9.68 8.36 8.99 8.87 Operating income. . . $ 4.29 $ 5.86 $ 8.52 $ 13.61 $ 7.63 $ 6.61 Interest expense. . . 2.60 3.62 3.83 3.90 4.52 3.97 Minority interest in income . . . 0.00 0.00 0.00 0.00 0.00 0.00 Non-operating income (expenses) . . . –0.49 1.69 –3.45 –7.99 –2.08 –1.69 Pretax income . . . $ 1.20 $ 3.93 $ 1.24 $ 1.72 $ 1.03 $ 0.95 Income taxes . . . 0.42 1.38 0.43 0.60 0.36 0.33 Income before extraordinary items & discontinued oper . . . $ 0.78 $ 2.55 $ 0.81 $ 1.12 $ 0.67 $ 0.62 Extraordinary items and discontinued operations . . . –0.17 –0.02 0.00 0.00 0.00 0.00 Net income . . . $ 0.61 $ 2.53 $ 0.81 $ 1.12 $ 0.67 $ 0.62