CHAPTER 12
ANALYSIS OF FINANCIAL STATEMENTS
SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS I. Questions1. The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity commitments. Credit analysts are more interested in the debt, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio.
2. The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial products—contracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing.
3. Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit margin, and vice versa.
4. ROE is calculated as the return on assets multiplied by the equity multiplier. The equity multiplier, defined as total assets divided by common equity, is a measure of debt utilization; the more debt a firm uses, the lower its equity, and the higher the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher ROE.
5. Return on investment relates to income earned on the capital invested in the business firm. Unsatisfactory ROI could possibly lead to withdrawal of capital provided by investors which could result to the demise of the business.
6. Refer to pages 247, 248 and 252.
7. Example: If a company defers or postpones a regular maintenance and repair activity with a view of reducing current year’s expenses. Such act may in the long-run bring about unfavorable outcomes such as delays in production, poor product quality, etc.
8. Liquidity is the firm’s ability to meet cash needs as they arise such as payment of accounts payable, bank loans and operating expenses. Liquidity is crucial to the firm’s survival because if the company is unable to fulfill its obligations, operations could be disrupted that could result to its closure.
9. Short-term lenders – liquidity because their concern is with the firm’s ability to pay short-term obligations as they come due.
Long-term lenders – leverage because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made.
Stockholders – profitability because they are concerned with the secondary consideration given to debt utilization, liquidity and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment. 10. If the accounts receivable turnover ratio is decreasing, accounts
receivable will be on the books for a longer period of time. This means the average collection period will be increasing.
11. The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather that interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.
12. No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information.
13. a. Return on investment = Net income/Total assets
Inflation may cause net income to be overstated and total assets to be understated. Too high a ratio could be reported.
b. Inventory turnover = Sales/Inventory
Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect “inflation-influenced” pesos and the net effect will be nil. If the firm uses LIFO accounting, inventory will be stated in old pesos and too high a ratio could be reported.
c. Fixed asset turnover = Sales/Fixed assets
Fixed assets will be understated relative to sales and too high a ratio could be reported.
d. Debt to total assets = Total debt/Total assets
Since both are based on historical costs, no major inflationary impact will take place in the ratio.
14. Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm’s income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly.
15. Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the peso. Lessening inflation also means that the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current evaluation.
II. Problems
Problem 1 (Day Sales Outstanding) DSO = 40 days; S = ₱7,300,000; AR = ?
40 = AR/ 20,000 AR = ( 20,000) (40) = ₱ ₱ ₱800,000 Problem 2 (Debt Ratio)
A/E = 2.4; D/A = ? 58.33%. = 0.5833 = A D 2.4 1 1 = A D A/E 1 1 = A D
Problem 3 (Market/Book Ratio)
TA = 10,000,000,000; LT debt = 3,000,000,000₱ ₱ CL = 1,000,000,000; CE = 6,000,000,000₱ ₱
Share outstanding = 800,000,000; Stock price = 32; M/B = ?₱
12-4 AR S 365 DSO = ₱7,300,000AR 365 40 = AR Book Value = ₱6,000,000,000800,000,000 = 7.50₱ MB = ₱₱32.007.50 = 4.2667
Problem 4 (Price/Earnings Ratio) EPS = ₱2.00; BVPS = ₱20; M/B = 1.2; P/E = ? M/B = 1.2× P/₱20 = 1.2× P = ( 20) (₱ 1.2×) P = ₱24.00 P/E = ₱24.00/₱2.00 = 12.0 Problem 5 (DuPont and ROE)
PM = 2%; EM = 2.0; Sales = ₱100,000,000; Assets = ₱50,000,000; ROE = ?
ROE = PM x TATO x EM = NI/S x S/TA x A/E
= 2% x ₱100,000,000/₱50,000,000 x 2 ROE = 8%
Problem 6 (DuPont and Net Income)
Step 1: Calculate total assets from information given. Sales = 6,000,000₱
3.2 × = Sales/TA
3.2 × = 6,000,000/Assets₱ Assets = 6,000,000/3.2 ₱ × Assets = 1,875,000₱
Step 2: Calculate net income. There is 50% debt and 50% equity, so, Equity = 1,875,000 ₱ x 0.5 = 937,500.₱
ROE = NI/S x S/TA x TA/E
0.12 = NI/ 6,000,000 ₱ x 3.2 x 1,875,000/ 937,500₱ ₱ 0.12 = 6.4NI/ 6,000,000₱
6.4NI = ( 60,000) (0.12)₱ NI = 720,000/6.4₱ NI = 112,500₱
Problem 7 (Basic Earning Power) ROA = 8%; NI = 600,000; TA = ?₱ ROA = NI/TA 8% = 600,000/TA₱ TA = 600,000/8%₱ TA = 7,500,000₱
To calculate BEP, we still need EBIT. To calculate EBIT, construct a partial income statement.
EBIT ₱1,148,077 ( 225,000 + 923,077)₱ ₱ Interest 225,000 Given EBT 923,077 ( 600,000/0.65)₱ Taxes (35%) 323,077 NI 600,000₱ BEP = EBIT/TA = 1,148,077/ 7,500,000₱ ₱ = (0.1531) BEP = 15.31%
Problem 8 (Ratio Calculations)
We are given ROA = 3% and Sales/Total assets = 1.5 From the DuPont equation:
ROA = Profit margin x Total assets turnover 3% = Profit margin (1.5)
Profit margin = 3%/1.5 Profit margin = 2%
We can also calculate the company’s debt-to-assets ratio in a similar manner, given the facts of the problem. We are given ROA (NI/A) and ROE (NI/E); if we use the reciprocal of ROE we have the following equation:
40%. = 0.40 = 0.60 1 = A D . 60% = A E 0.05 1 3% = A E so , A E 1 = A D and NI E A NI = A E
Alternatively, using the DuPont equation: ROE = ROA x EM
5% = 3% x EM
EM = 5%/3% = 5/3 = TA/E
Take reciprocal: E/TA = 3/5 = 60%, therefore, D/A = 1 – 0.60 = 0.40 or 40%. Thus, the firm’s profit margin = 2% and its debt-to-assets ratio = 40%.
Problem 9 (Ratio Calculations)
TA = 12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?₱
Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.
EBIT ₱1,800,000,000 See above.
INT 800,000,000 EBT ₱1,000,000,000 EBT = 600,000,000/0.6₱ Taxes (40%) 400,000,000 NI ₱ 600,000,000 See above. TIE = EBIT/INT = 1,800,000,000/ 800,000,000₱ ₱
INT = EBIT – EBT
= 1,800,000,000 – ₱ ₱1,000,000,000 EBIT ₱12,000,000,00 0 = 0.15 EBIT = 1,800,000,000₱ NI ₱12,000,000,00 0 = 0.05 NI = 600,000,000₱
TIE = 2.25×
Problem 10 (Return on Equity)
ROE= Profit margin x TA turnover x Equity multiplier = NI/Sales x Sales/TA x TA/Equity
Now we need to determine the inputs for the DuPont equation from the data that were given. On the left we set up an income statement, and we put numbers in it on the right:
Sales (given) ₱10,000,000 – Cost N/A EBIT (given) ₱ 1,000,000 – INT (given) 300,000 EBT ₱ 700,000 – Taxes (34%) 238,000 NI ₱ 462,000
Now we can use some ratios to get some more data:
Total assets turnover = 2 = S/TA; TA = S/2 = 10,000,000/2₱ Total asset turnover = 5,000,000₱ D/A = 60%; so E/A = 40%; and, therefore,
Equity multiplier = TA/E = 1/ (E/A) = 1/0.4 = 2.5
Now we can complete the DuPont equation to determine ROE: ROE = 462,000/ 10,000,000 ₱ ₱ x 10,000,000/ 5,000,000 ₱ ₱ x 2.5 ROE = 0.231 = 23.1%
Problem 11 (Current Ratio)
Present current ratio = = 2.5
Minimum current ratio = = 2.0
1,312,500 + NP ₱ = 1,050,000 + 2NP₱ NP = 262,500₱ 1,312,500 ₱ 525,000 ₱ 1,312,500 + NP ₱ 525,000 + NP ₱
Short-term debt can increase by a maximum of 262,500 without₱ violating a 2 to 1 current ratio, assuming that the entire increase in notes payable is used to increase current assets. Since we assumed that the additional funds would be used to increase inventory, the inventory account will increase to 637,500 and current assets will total₱
1,575,000, and current liabilities will total 787,500.
₱ ₱
Problem 12 (DSO and Accounts Receivable)
Step 1: Solve for current annual sales using the DSO equation: 55 = 750,000/ (Sales/365)₱
55Sales = 273,750,000₱ Sales = 273,750,000/55₱ Sales = 4,977,272.73₱
Step 2: If sales fall by 15%, the new sales level will be 4,977,272.73₱ (0.85) = 4,230,681.82. Again, using the DSO equation, solve₱ for the new accounts receivable figure as follows:
35 = AR/ ( 4,230,681.82/365)₱ 35 = AR/ 11,590.91₱
AR= ( 11,590.91) (35)₱ AR= 405,681.82 ₱ 405,682₱ Problem 13 (Balance Sheet Analysis)
1. Total debt = (0.50) (Total assets) = (0.50) (₱300,000) = ₱ 150,000 2. Accounts payable = Total debt – Long-term debt
= ₱150,000 – ₱60,000 Accounts payable = ₱ 90,000
3. Common stock = Total liabilities and equity – Debt – Retained earnings Common stock = ₱300,000 – ₱150,000 – ₱97,500 = ₱ 52,500
4. Sales = (1.5) (Total assets) = (1.5) (₱300,000) = ₱ 450,000 5. Inventories = Sales/5 = ₱450,000/5 = ₱ 90,000
6. Accounts receivable = (Sales/365) (DSO) = (₱450,000/365) (36.5) Accounts receivable = ₱ 45,000
7. Cash + Accounts receivable + Inventories = (1.8) (Accounts payable) Cash + ₱45,000 + ₱90,000 = (1.8) (₱90,000)
Cash + ₱135,000 = ₱162,000 Cash = 27,000₱
8. Fixed assets = Total assets – (Cash + Accounts receivable + Inventories) Fixed assets = ₱300,000 – (₱27,000 + ₱45,000 + ₱90,000) = ₱ 138,000
9. Cost of goods sold = (Sales) (1 – 0.25) = (₱450,000) (0.75) = ₱ 337,500 Problem 14 (Ratio Analysis)
a. Amounts in thousands
Firm Industry average Current
ratio = Current liabilitiesCurrent assets =
₱655,000 330,000 ₱ = 1.98 2.0 Quick ratio = Current assets − Inventories Current liabilities = ₱655,000 − 241,500 ₱ 330,000 ₱ = 1.25 1.3 DSO = Accounts receivableSales/365 = ₱₱336,0004,404.11 = days76.3 35 days Inventory
turnover = InventoriesSales = ₱1,607,500₱241,500 = 6.66 6.7 T.A.
turnover = Total assetsSales =
₱1,607,500 947,500
₱ = 1.70 3.0 Profit
margin = Net incomeSales =
₱27,300 1,607,500
₱ = 1.7% 1.2%
ROA = Total assets Net income = ₱₱27,300947,500 = 2.9% 3.6% ROE = Common equityNet income = ₱₱27,300361,000 = 7.6% 9.0% Debt ratio = Total assetsTotal debt = ₱586,500₱947,500 = 61.9% 60.0%
b. For the firm;
ROE = PM x TA turnover x EM = 1.7% x 1.7 x For the industry, ROE = 1.2% x 3 x 2.5 = 9%
Note: To find the industry ratio of assets to common equity, recognize that 1 – (Total debt/Total assets) = Common equity/Total assets. So, Common equity/Total assets = 40%, and 1/0.40 = 2.5 = Total assets/Common equity.
c. The firm’s days sales outstanding ratio is more than twice as long as the industry average, indicating that the firm should tighten credit or enforce a more stringent collection policy. The total assets turnover ratio is well below the industry average so sales should be increased, assets decreased or both. While the company’s profit margin is higher than the industry average, its other profitability ratios are low compared to the industry – net income should be higher given the amount of equity and assets. However, the company seems to be in average liquidity position and financial leverage is similar to others in the industry.
d. If 2011 represents a period of supernormal growth for the firm, ratios based on this year will be distorted and a comparison between them and industry averages will have little meaning. Potential investors who look only at 2011 ratios will be misled, and a return to normal conditions in 2012 could hurt the firm’s stock price.
Problem 15 (Ratio Analysis)
Ratio Analysis 2011 2010 Industry Average
Liquidity
Current ratio 2.33 2.11 2.7
Asset Management
Inventory turnover 4.74 4.47 7.0
Days sales outstanding 37.79 32.94 32
Fixed assets turnover 9.84 7.89 13.0
Total assets turnover 2.31 2.18 2.6
Profitability Return on assets 1.00% 5.76% 9.1% Return on equity 2.22% 11.47% 18.2% Profit margin 0.43% 2.64% 3.5% ₱947,500 ₱361,000 = 7.6%
Debt Management
Debt-to-assets ratio 54.81% 49.81% 50.0% Market Value
P/E ratio 15.43 5.65 6.0
Price/cash flow ratio 1.60 2.16 3.5
a. Mango’s liquidity position has improved from 2010 to 2011; however, its current ratio is still below the industry average of 2.7.
b. Mango’s inventory turnover, fixed assets turnover, and total assets turnover have improved from 2010 to 2011; however, they are still below industry averages. The firm's days sales outstanding ratio has increased from 2010 to 2011—which is bad. In 2010, its DSO was close to the industry average. In 2011, its DSO is somewhat higher. If the firm's credit policy has not changed, it needs to look at its receivables and determine whether it has any uncollectibles. If it does have uncollectible receivables, this will make its current ratio look worse than what was calculated above.
c. Mango’s debt ratio has increased from 2010 to 2011, which is bad. In 2010, its debt ratio was right at the industry average, but in 2011 it is higher than the industry average. Given its weak current and asset management ratios, the firm should strengthen its balance sheet by paying down liabilities.
d. Mango’s profitability ratios have declined substantially from 2010 to 2011, and they are substantially below the industry averages. Mango needs to reduce its costs, increase sales, or both.
e. Mango’s P/E ratio has increased from 2010 to 2011, but only because its net income has declined significantly from the prior year. Its P/CF ratio has declined from the prior year and is well below the industry average. These ratios reflect the same information as Corrigan's profitability ratios. Corrigan needs to reduce costs to increase profit, lower its debt ratio, increase sales, and improve its asset management.
f. ROE = PM × TA Turnover × Equity Multiplier
2011 2.22% 0.43% 2.31 2.21
2010 11.47% 2.64% 2.18 1.99
Looking at the DuPont equation, Mango's profit margin is significantly lower than the industry average and it has declined substantially from 2010 to 2011. The firm's total assets turnover has improved slightly from 2010 to 2011, but it's still below the industry average. The firm's equity multiplier has increased from 2010 to 2011 and is higher than the industry average. This indicates that the firm's debt ratio is increasing and it is higher than the industry average.
Mango should increase its net income by reducing costs, lower its debt ratio, and improve its asset management by either using less assets for the same amount of sales or increase sales.
g. If Mango initiated cost-cutting measures, this would increase its net income. This would improve its profitability ratios and market value ratios. If Mango also reduced its levels of inventory, this would improve its current ratio—as this would reduce liabilities as well. This would also improve its inventory turnover and total assets turnover ratio. Reducing costs and lowering inventory would also improve its debt ratio. Problem 16 (Profitability Ratios)
Esther Company
Assets = Sales
Total asset turnover =
₱960,000
2.4 = ₱400,000
Net income = Sales
Profit margin = ₱960,000 0.07 = ₱67,200 ROA(invest-ment) = Net income Total assets = ₱ 67,200 400,000 ₱ = 16.80%
Problem 17 (Overall Ratio Analysis)
Bryan Corporation a. Current
b. Quick ratio = (Current assets −Inventory) Profit margin = ₱330,000 300,000 ₱ = 1.10 c. Debt to total assets = Total debt Total assets = ₱ 418,000₱950,000 = 44% d. Asset turnover = Sales Total assets = ₱ 3,040,000₱ 950,000 = 3.20 e. Average collection period = Accounts receivable Average daily credit sales = ₱ 280,000 ( 3,040,000 ₱ x 0.75) 360 days = ₱6,333 per day₱ 280,000 = 44.21 days Problem 18 (Profitability Ratios)
Alpha Industries
a. Total asset turnover x Profit margin = Return on total assets
1.4 x ? = 8.4%
Profit margin = 8.4%/1.4 = 6.0%
b. 12 x 7% = 8.4%
It did not change at all because the increase in profit margin made up for the decrease in the asset turnover.
Problem 19 (DuPont System of Analysis) King Company a. Return on equity = Return on assets (investment) (1 – Debt /Assets) = 12% (1 – 0.40) = 12% 0.60 = 20%
b. The same as return on assets (12%). Problem 20 (Average Collection Period)
Average collection period = Accounts receivable Average daily credit sales = ₱ 180,000 ( 1,200,000 ₱ x 0.90) 360 days = ₱3,000 per day₱ 180,000 = 60 days
Problem 21 (Average Daily Sales)
Charlie Corporation Average daily
credit sales =
Credit sales 360
To determine credit sales, multiply accounts receivable by accounts receivable turnover. 90,000 ₱ x 12 = 1,080,000₱ Average daily credit sales = 1,080,000 ₱ 360 = ₱3,000
Problem 22 (DuPont System of Analysis) Jerry Company
a. Net income = Sales x Profit margin = ₱4,000,000 x 3.5%
= ₱140,000
Stockholders’ equity = Total assets − Total liabilities Total assets = Sales /Total asset turnover
= ₱4,000,000/2.5 Total assets = ₱1,600,000
Total liabilities = Current liabilities + Long-term liabilities = ₱100,000 + 300,000₱ Total liabilities = ₱400,000 Stockholders’ equity = ₱1,600,000 − ₱400,000 = ₱1,200,000 Return on stockholders’ equity = Net income Stockholders’ equity = ₱ 140,000 1,200,000 ₱ = 11.67%
b. The value for sales will be:
Sales = Total assets x Total asset turnover = ₱1,600,000 x 3
Sales = ₱4,800,000
Net income = Sales x Profit margin = ₱4,800,00 0 x 3.5% Net income = ₱168,000 Return on stockholders’ equity = Net income Stockholders’ equity = ₱₱ 168,0001,200,000 = 14% Problem 23 (Analysis by Divisions)
Global Corporation
a. Medical supplies Heavy machinery Electronics Net income/
sales 6.0% 3.8% 8.0%
The heavy machinery division has the lowest return on sales.
b. Medical supplies Heavy machinery Electronics Net income/
The medical supplies division has the highest return on assets. c. Corporate net income
= ₱1,200,000 + 190,000 + 320,000₱ ₱ Corporate total assets ₱8,000,000 + 8,000,000 + 3,000,000₱ ₱
= ₱₱ 1,710,00019,000,000 Return on assets = 9.0%
d. Return on redeployed assets in heavy machinery. 15% x 8,000,000 = 1,200,000₱ ₱ Corporate net income
= ₱1,200,000 + 1,200,000 + 320,000₱ ₱ Corporate total assets 19,000,000₱
= ₱₱ 2,720,00019,000,000 Return on assets = 14.32%
Problem 24 (Using Ratios to Construct Financial Statements) Inventory = ₱420,000/7 = ₱60,000 Current assets = ₱ x 80,0002 ₱ = ₱160,000 Accounts receivable = ( 420,000/360) ₱ x 36 = ₱42,000 Cash = ₱160,000 − 60,000 − 42,000₱ ₱ = ₱58,000 Current assets Cash ₱ 58,000 Accounts receivable ₱ 42,000
Inventory ₱ 60,000 Total current assets ₱160,00
0
Problem 25 (Using Ratios to Construct Financial Statements) Shannon Corporation
Sales/Total assets = 2.5 times
Total assets = ₱750,000/2.5 = ₱300,000
Cash = 2% of total assets
Cash = 2% x 300,000 = ₱ ₱6,000
Sales/Accounts receivable = 10 times
Accounts receivable = ₱750,000/10 = ₱75,000
Sales/Inventory = 15 times
Inventory = ₱750,000/15 = ₱50,000
Fixed assets = Total assets − Current assets
Total current asset = ₱6,000 + ₱75,000 + ₱50,000 = 131,000
₱
Fixed assets = ₱300,000 − 131,000 = ₱ ₱169,000 Current assets/current debt = 2
Current debt = Current assets/2 = 131,000/2 = ₱ ₱65,500 Total debt/total assets = 45%
Total debt = .45 x 300,000 = ₱ ₱135,000 Long-term debt = Total debt − Current debt Long-term debt = ₱135,000 − 65,500 = ₱ ₱69,500 Net worth = Total assets − Total debt
Net worth = ₱300,000 − 135,000 = ₱ ₱165,000 Shannon Corporation
Cash ₱ 6,000 Current debt ₱65,500 Accounts receivable 75,000 Long-term debt 69,500
Inventory 50,000 Total debt 135,000
Total current assets 131,000 Net worth 165,000 Fixed assets 169,000 Total debt and
Total assets ₱300,000 Stockholders’ equity ₱300,000 Problem 26 (Using Ratios to Determine Account Balances)
Cathy Corporation
a. Accounts receivable = Sales/Receivables turnover = ₱3,000,000/6x = ₱500,000 b. Marketable securities = Current assets − (Cash + Accounts
receivable + Inventory)
Current assets = Current ratio x Current liabilities = 2.5 x 700,000 = 1,750,000₱ ₱
Marketable securities = ₱1,750,000 − ( 150,000 + 500,000 + ₱ ₱ 850,000)
₱
Marketable securities = ₱1,750,000 − 1,500,000 = ₱ ₱250,000 c. Fixed assets = Total assets − Current assets
Total assets = Sales/Asset turnover
= ₱3,000,000/1.2x = ₱2,500,000 Fixed assets = ₱2,500,000 − 1,750,000 = ₱ ₱750,000 d. Long-term debt = Total debt − Current liabilities
Total debt = Debt to assets x Total assets = 40% x 2,500,000 = ₱ ₱1,000,00 Long-term debt = ₱1,000,000 − 700,000 = ₱ ₱300,000 Problem 27 (Using Ratios to Construct Financial Statements)
Sales/Total assets = 2
Total assets = ₱20,000,000/2 = ₱10,000,000 Total debt/Total assets = 30%
Total debt = ₱10,000,000 x .3 = 3,000,000₱
Sales/Inventory = 5.0x
Inventory = ₱20,000,000/5x = ₱4,000,000
Average daily sales = ₱20,000,000/360 days = ₱55,556 per day
Accounts receivable = 18 days x 55,556 = ₱ ₱1,000,000 (or) = ( 20,000,000)/(360/18) = ₱ ₱1,000,000 Fixed assets = ₱20,000,000/5x = ₱4,000,000
Current assets = Total assets − Fixed assets
= ₱10,000,000 − 4,000,000 = ₱ ₱6,000,000
Cash = Current assets − Accounts receivable −
Inventory
= ₱6,000,000 − 1,000,000 − 4,000,000₱ ₱
Cash = ₱1,000,000
Current liabilities = Current assets/3x
Current liabilities = ₱6,000,000/3 = ₱2,000,000 Long-term debt = Total debt − Current debt
Long-term debt = ₱3,000,000 − 2,000,000 = ₱ ₱1,000,000
Equity = Total assets − Total debt
Equity = ₱10,000,000 − 3,000,000 = ₱ ₱7,000,000 Ruby Inc.
Cash ₱
1,000,000
Current debt ₱ 2,000,000 Accounts receivable 1,000,000 Long-term debt 1,000,000
Inventory 4,000,000 Total debt 3,000,000
Fixed assets 4,000,000 Equity 7,000,000
Total assets ₱10,000,00
0
Total debt and equity ₱10,000,000
Problem 28 (Ratio Computation and Analysis)
One way of analyzing the situation for each company is to compare the respective ratios for each one, examining those ratios which would be most important to a supplier or short-term lender and a stockholder.
Black Corporation White Corporation
Profit margin 7.4% 5.25%
Return on assets 18.5% 12.00%
Return on equity 28.9% 34.4%
Receivable turnover 15.63x 14.29x
Average collection period 23.04 days 25.2 days
Inventory turnover 25x 13.3x
Fixed asset turnover 3.57x 4x
Total asset turnover 2.5x 2.29x
Current ratio 1.5x 2.5x
Quick ratio 1.0x 1.5x
Debt to total assets 36% 65.1%
Times interest earned 24.13x 6x
Fixed charge coverage 13.33x 4.75x
Fixed charge coverage
calculation (200/15) (133/28)
a. Since suppliers and short-term lenders are more concerned with liquidity ratios, White Corporation would get the nod as having the best ratios in this category. One could argue, however, that White had benefited from having its debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios.
b. Stockholders are most concerned with profitability. In this category, Black Corporation has much better ratios than White Corporation. White does have a higher return on equity than Black, but this is due to its much
larger use of debt. Its return on equity is higher than Blacks’ because it has taken more financial risk. In terms of other ratios, Black has its interest and fixed charges well covered and in general its long-term ratios and outlook are better than White. Black has asset utilization ratios equal to or better than White 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.
