Listed are the 2015 financial statements for Garners’ Platoon Mental Health Care, Inc. Spread the balance sheet and income statement. Calculate the
financial ratios for the firm, including the internal and sustainable growth rates.
Using the DuPont system of analysis and the industry ratios reported, evaluate the performance of the firm.
GARNERS’ PLATOON MENTAL HEALTH CARE, INC.
Balance Sheet as of December 31, 2015 (in millions of dollars)
Assets Liabilities and Equity
Current assets: Current liabilities:
Cash and marketable securities $ 421 Accrued wages and taxes $ 316
Accounts receivable 1,109 Accounts payable 867
Inventory 1,760 Notes payable 872
Total $ 3,290 Total $ 2,055
Fixed assets: Long term debt: $ 3,090
Gross plant and equipment $ 5,812 Stockholders’ equity:
Less: Depreciation 840 Preferred stock (30 million
shares) $ 60
Net plant and equipment $ 4,972 Common stock and paid in
surplus (200 million shares) 637 Other long term assets 892 Retained earnings 3,312
Total $ 5,864 Total $ 4,009
Total assets $ 9,154 Total liabilities and equity $ 9,154
Net sales (all credit) $ 4,980
Less: Cost of goods sold 2,246
Gross profits $ 2,734
Less: Other operating expenses 125
Earnings before interest, taxes, depreciation, and amortization (EBITDA) $ 2,609
Less: Depreciation 200
Earnings before interest and taxes (EBIT) $ 2,409
Less: Interest 315
Earnings before taxes (EBT) $ 2,094
Less: Taxes 767
Net income $ 1,327
GARNERS’ PLATOON MENTAL HEALTH CARE, INC.
Income Statement for Year Ending December 31, 2015 (in millions of dollars)
(continued)
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Garners’ Platoon Mental
Health Care, Inc. Industry
Current ratio 2.00 times
Quick ratio 1.20 times
Cash ratio 0.25 times
Inventory turnover 2.50 times
Days’ sales in inventory 146.00 days
Average collection period 91.00 days
Average payment period 100.00 days
Fixed asset turnover 1.25 times
Sales to working capital 4.00 times
Total asset turnover 0.50 times
Capital intensity 2.00 times
Debt ratio 50.00%
Debt-to-equity 1.00 times
Equity multiplier 2.00 times
Times interest earned 7.25 times
Cash coverage 8.00 times
Profit margin 18.75%
Gross profit margin 49.16%
Operating profit margin 42.02%
Basic earnings power 19.90%
ROA 9.38%
ROE 18.75%
Dividend payout 35.00%
Market-to-book ratio 1.30 times
PE ratio 4.10 times
Less: Preferred stock dividends $ 60
Net income available to common stockholders $ 1,267
Less: Common stock dividends 395
Addition to retained earnings $ 872
Per (common) share data:
Earnings per share (EPS) $ 6.335
Dividends per share (DPS) $ 1.975
Book value per share (BVPS) $19.745
Market value (price) per share (MVPS) $26.850
3-1 The three most commonly used liquidity ratios are the current ratio, the quick (or acid-test) ratio, and the cash ratio.
3-2 The current ratio measures the dollars of current assets available to pay each dollar of current liabilities. The quick ratio measures the dollars of more liquid assets (cash and marketable securities and accounts receivable) available to pay each dollar of current liabilities. The cash ratio measures the dollars of cash and marketable securities available to pay each dollar of current liabilities
3-3 The more liquid assets a firm holds, the less likely it is that the firm will experience financial distress. Thus, the higher the liquidity ratios, the less liquidity risk a firm has. But liquid assets generate little, if any, profits for the firm. In contrast, fixed assets are illiquid, but generate revenue for the firm. Thus, extremely high levels of liquidity guard against liquidity crises but at the cost of lower returns on assets.
A N S W E R S T O T I M E O U T
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115 3-4 The major asset management ratios are the inventory turnover, the days’ sales in
inventory, the accounts receivable turnover, the average collection period (ACP), the accounts payable turnover, the average payment period (APP), the fixed asset turnover, the sales to working capital, the total asset turnover, and the capital intensity.
3-5 In general, a firm wants to produce a high level of sales per dollar of inven-tory. That is, it wants to turn inventory over as quickly as possible. However, if the inventory turnover ratio is extremely high and the days’ sales in inventory is extremely low, the firm may not be holding sufficient inventory to prevent run-ning out of the raw materials needed to keep the production process going.
In general, a firm wants to collect its accounts receivable as quickly as possible.
However, if the accounts receivable turnover ratio is extremely high and the ACP is extremely low, the firm’s accounts receivable policy may be so strict that cus-tomers prefer to do business with competing firms.
In general, a firm wants to pay for its purchases as slowly as possible. Thus, a high APP or a low accounts payable turnover is generally a sign of good manage-ment. However, if the APP is extremely high and the accounts payable turnover is extremely low, the firm may be abusing the credit terms that its raw materials suppliers offer. At some point, the firm’s suppliers may revoke its ability to buy raw materials on account and the firm will lose this source of free financing.
In general, high fixed asset turnover and sales to working capital are signs of good management. However, if either the fixed asset turnover or sales to work-ing capital is extremely high, the firm may be close to its maximum production capacity.
In general, the higher the total asset turnover and lower the capital intensity, the more efficient the overall asset management of the firm will be. However, as described above, inventory stockouts, capacity problems, or tight account receiv-ables policies can all lead to a high total asset turnover and may actually be signs of poor firm management.
3-6 Many of the ratios are mirror images of one another because one ratio might be the inverse of another ratio. For example, the inventory turnover ratio measures the number of times per year that inventory is turned over, while the days’ sales in inventory ratio measures the number of days that inventory is held before the final product is sold.
3-7 The major debt management ratios are the debt ratio, the debt-to-equity, the equity multiplier, the times interest earned, the fixed-charge coverage, and the cash coverage.
3-8 Low levels of debt will lead to a dilution of the return to stockholders due to a greater increased use of equity as well as not taking advantage of the tax deduct-ibility of interest expense. However, high levels of debt increase a firm’s potential for financial distress and even failure. If the firm has a bad year and cannot make its promised debt payments, debt holders can force the firm into bankruptcy.
3-9 In deciding the level of debt versus equity financing to hold on the balance sheet, managers must consider the trade-off between maximizing cash flows to the firm’s stockholders versus the risk of being unable to make promised debt pay-ments. When firms do well, financial leverage creates more cash flows to share with stockholders—it magnifies the return to the stockholders of the firm. This magnification is one reason that firm stockholders encourage the use of debt financing. However, financial leverage also increases the firm’s potential for financial distress and even failure. If the firm has a bad year and cannot make promised debt payments, debt holders can force the firm into bankruptcy. Thus, a firm’s current and potential debt holders (and even stockholders) look at equity financing as a safety cushion that can absorb fluctuations in the firm’s earnings and asset values and guarantee debt service payments.
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3-10 The major profitability ratios are the gross profit margin, operating profit margin, profit margin, the basic earnings power, the return on assets (ROA), the return on equity (ROE), and the dividend payout.
3-11 For all but the dividend payout, the higher the value of the ratio, the higher the profitability of the firm. But just as has been the case previously in this chapter, high profitability ratio levels may result from poor management in other areas of the firm as much as superior financial management.
3-12 Generally, a high ROE is considered to be a positive sign of firm performance.
However, if performance comes from a high degree of financial leverage, a high ROE can indicate a firm with an unacceptably high level of bankruptcy risk as well.
3-13 The major market value ratios are the market-to-book ratio and the price-earnings (or PE) ratio.
3-14 Generally, the higher the market-to-book and PE ratios, the better the firm’s performance. However, for value seeking investors, high market-to-book and PE firms indicate expensive companies. Further, higher PE ratios carry greater risk because investors are willing to pay higher prices today for a stock in anticipation of higher earnings in the future. These earnings may or may not materialize. Low-PE firms are generally companies with little expected growth or low earnings.
3-15 The price-earnings (or PE) ratio measures how much investors are willing to pay for each dollar the firm earns per share of its stock. PE ratios are often quoted in multiples—the number of dollars per share—which fund managers, investors, and analysts compare within industry classes. Managers and investors often use PE ratios to evaluate the relative financial performance of the firm’s stock.
3-16 The basic DuPont equation looks at ROA as the product of the profit margin and the total asset turnover ratios. The DuPont ROE equation looks at ROE as a prod-uct of the profit margin, the total asset turnover, and the equity multiplier.
3-17 This presentation of ROA and ROE allows managers, analysts, and investors to look at the return on assets and return on equity as a function of the net profit margin (profit per dollar of sales from the income statement), total asset turnover (efficiency in the use of assets from the balance sheet), and the equity multiplier (financial leverage from the balance sheet).
3-18 Managers, analysts, and investors can compute additional ratios by dividing all balance sheet amounts by total assets and all income statement amounts by net sales. These calculations, sometimes called “spreading the financial statements,”
yield what we call “common-size” financial statements that adjust for sizes.
3-19 The internal growth rate is the growth rate a firm can sustain if it uses only inter-nal financing—that is, retained earnings—to finance future growth. The reten-tion ratio represents the porreten-tion of net income that the firm reinvests as retained earnings. Since a firm either pays its net income as dividends to its stockholders or reinvests those funds as retained earnings, the dividend payout and the reten-tion ratios must always add to one. The sustainable growth rate is the maximum growth rate that can be achieved when managers finance asset growth with new debt and retained earnings.
3-20 A firm’s sustainable growth depends on four factors: (1) the profit margin (oper-ating efficiency), (2) the total asset turnover (efficiency in asset use), (3) financial leverage (the use of debt versus equity to finance assets), and (4) profit retention (reinvestment of net income into the firm rather than paying it out as dividends).
3-21 Time series analysis involves analyzing ratio trends over time, along with absolute ratio levels. It gives managers, analysts, and investors information about whether a firm’s financial condition is improving or deteriorating.
3-22 Cross-sectional analysis involves a comparison of one firm’s ratios relative to the ratios of other firms in the industry. Key to cross-sectional analysis is identifying similar firms in that they compete in the same markets, have similar asset sizes, and operate in a similar manner to the firm being analyzed.
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117 3-23 Analyzing ratio trends over time, along with absolute ratio levels, gives managers,
analysts, and investors information about whether a firm’s financial condition is improving or deteriorating. Cross-sectional analysis gives the manager a compari-son of one firm’s ratios relative to the ratios of other firms in the industry.
3-24 Data from financial statements should not be received without certain cautions.
These include: (1) Financial statement data are historical; historical data may not reflect future performance. (2) Firms use different accounting procedures.
(3) A firm’s cross-sectional competitors may often be located around the world;
financial statements for firms based outside the U.S. do not necessarily conform to GAAP. (4) Sales and expenses vary throughout the year. Managers, analysts, and investors need to note the timing of these fund flows when performing cross-sectional analysis. Similarly, firms end their fiscal years at different dates. Likewise, one-time events, such as a merger, may affect a firm’s financial performance.
(5) Large firms often have multiple divisions or business units engaged in different lines of business. (6) Firms often window dress their financial statements to make annual results look better. (7) Individual analysts may calculate ratios in modified forms.