4-17
24. To reduce the risk inherent in ______________________________ a company should strive for a high
proportion of variable costs in its cost structure.
25. Firms that have either convertible securities or stock options or warrants outstanding have
__________________________________________________.
26. EPS is an ambiguous measure of profitability because it reflects operating performance in the
numerator and ________________________________________ in the denominator.
27. Operating income is negative in an amount equal to _________________________ when revenues are
zero.
28. Firms and industries characterized by heavy fixed capacity costs and lengthy periods required to add
new capacity operate under a(n) ___________________________________.
1. Below is financial information for two restaurant retailers. Popper’s Company operates an innovative
retail bakery-cafe business and franchising business. At the end 2010, Popper’s had 132 company–
owned and 346 franchise-operated bakery-cafes. Popper’s located most of their unique bakery-cafe
concept stores in suburban, strip mall, and regional mall locations. As a first mover in this concept, the
company operates in 32 states. Simmer Corporation began operations five years earlier than Popper’s
and purchases and roasts whole bean coffees and sells them, along with numerous coffee drinks and
related products at over 2,900 Company-operated retail stores.
Selected Data for Popper’s Company and Simmer Corporation
(amounts in millions)
Simmer Popper’s
Net Sales
4-18
Sales Simmer $5,000 Popper’s 300
$4,076 $278
Cost of Goods Sold 1,686 97
Interest Expense 0 0
Net Income 268 22
Average Inventory 303 4
Average Fixed Assets 2,163 130
Required:
a. Compute the Inventory turnover, fixed asset turnover, and accounts receivable turnover.
b. Describe the likely reasons for the difference in the accounts receivable turnover and the
inventory turnover
ANS:
The differences between the two companies accounts receivable turnover can be explained by
2. Sensitron and Douglas Tools manufacture and market power tools and accessories. Sensitron targets
customers in the professional contractor market, while Douglas Tools focuses on home users and
professionals. Selected financial data for the companies appears below.
Sensitron 2010 2009 2008
Sales $2,109,100 $2,095,700 $2,175,700
Average Accounts Receivable 564,500 608,650 631,072
Change in Sales from previous year 0.64% -3.68% 11.83%
Douglas Tools 2010 2009 2008
Sales $4,394,000 $4,245,600 $4,474,900
Average Accounts Receivable 718,800 745,850 803,150
Change in Sales from previous year 3.50% -5.12% 0.59%
Required:
1. Calculate the accounts receivable turnover ratio for each firm for year 2010, 2009, 2008.
2. Suggest reasons for the differences in the accounts receivable turnover ratios for these two firms.
ANS:
1.
2010 2009 2008
A/R Turnover—
Sensitron $2,109,100 / 564,500 =3.74 $2,095,700 / 608, 650
2.
3. Sensitron and Douglas Tools manufacture and market power tools and accessories. Sensitron targets
customers in the professional contractor market, while Douglas Tools focuses on home users and
professionals. Both firms use the same cost flow assumption for valuing inventories and cost of goods
sold. Selected financial data for the companies appears below.
Sensitron 2010 2009 2008
Cost of Goods Sold $1,144,200 $1,134,100 $1,169,400
Average Inventory 372,550 397,050 436,870
Change in Sales from previous year 0.64% -3.68% 11.83%
Douglas Tools 2010 2009 2008
Cost of Goods Sold $2,876,100 $2,846,600 $2,889,000
Average Inventory 730,550 778,100 797,500
Change in Sales from previous year 3.50% -5.12% 0.59%
Required:
1. Calculate the inventory turnover ratio for each firm for year 2010, 2009, and 2008.
2. Suggest reasons for the differences in the Inventory turnover ratios for these two firms.
ANS:
1.
2010 2009 2008
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
2.
4. Linda’s Clothing is a retailer of contemporary women’s clothing. Selected financial information for
Linda’s appears below:
2011 2010 2009 2008
Net Income $ 56,759 $ 31,150 $ 15,375 $14,750
Total Assets at year-end $381,500 $246,250 $145,490 $71,268
Weighted Average number of shares
Outstanding 84,215 80,546 77,965 75,888
Total Liabilities at year-end 205,967 119,657 60,522 17,623
Common Stockholders’ Equity at year-end $175,533 $126,593 $ 84,968 $53,645
Interest Expense 165 195 258 368
Required:
a. Compute the rate of return on assets for the years 2009-2011. Linda’s has an effective tax rate of
35%.
b. Compute the rate of return on common shareholders’ equity for the years 2009-2011.
c. Compute basic earnings per share for the years 2009-2011.
d. Interpret the changes in ROA versus ROCE and EPS over the three-year period.
ANS:
d. As Linda’s Clothing begins to finance more of its assets with liabilities the gap between ROA
and ROCE increases. The company is extremely profitable and all ratios are increasing. As the
5. Explain the difference between a simple and complex capital structure as the terms are used in the
calculation of EPS.
ANS:
A simple capital structure consists only of common stock and includes no potentially dilutive
6. Discuss the economic characteristics of firms that have the following mix of profit margin and asset
turnover. In addition provide an example of an industry that would have the relevant profit margin
asset turnover mix:
A. High profit margin and low asset turnover.
B. Low profit margin and high asset turnover
ANS:
1. Firms and industries characterized by heavy fixed capacity costs and lengthy periods required to
add new capacity operate under a capacity constraint. There is an upper limit on the size of assets
7. Below is financial information for two sporting goods retailers. Extreme Sports Company operates a
retail business and franchising business. At the end 2011, Extreme Sports had 263 Company-owned
and 120 franchise-operated retail stores. Extreme’s stores are located in suburban, strip mall and
regional mall locations, the company operates in 32 states. All Sports Corporation sells sporting goods
and related products at over 2,500 Company-operated retail stores.
Selected Data for All Sports and Extreme Sports
(amounts in millions)
All Sports Extreme Sports
Sales $5,320 $1,344
Cost of Goods Sold 3,897 887
Interest Expense 138 43
Net Income 212 33
Average Accounts Receivable 114 18
Average Inventory 998 286
Average Fixed Assets 1,163 130
Average Total Assets 2,472 662
Average Tax Rate 40% 40%
Calculate the following ratios for All Sports and Extreme Sports:
a. Return on assets
b. Profit margin for ROA
c. Assets turnover
d. Accounts receivable turnover
e. Inventory turnover
f. Fixed asset turnover
ANS:
4-22
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
PROBLEM
1. Grundig Technologies is a manufacturer. Below are the company’s two most recent balance sheets and
its most recent income statement. Use this information to answer the following questions:
a. Calculate the rate of return on assets (ROA) for 2011. Disaggregate ROA into the profit margin
for ROA and total assets turnover components.
b. Calculate the rate of return on common stockholders’ equity (ROCE) for 2011. Disaggregate
ROCE into the profit margin for ROCE, total assets turnover and capital structure leverage
components.
c. Did financial leverage work to the advantage of the common shareholders during 2011? Explain.
Grundig Technologies
Balance Sheet
As of December 31
ASSETS 2011 2010
Cash $ 69,000 $ 22,000
Accounts Receivable 82,000 66,000
Supplies 15,000 19,000
Inventories 180,000 189,000
Land 75,000 110,000
Equipment 260,000 200,000
Accumulated Deprec.-EQ. (69,000) (42,000)
TOTAL ASSETS $612,000 $564,000
LIABILITIES
Accounts Payable $ 34,000 $ 47,000
Unearned Rent 15,000 19,000
Bonds Payable 150,000 200,000
Stockholders’ Equity
Common Stock( $1 Par Value) 214,000 164,000
Retained Earnings 199,000 134,000
TOTAL LIABILITIES AND EQUITY $612,000 $564,000
Grundig Technologies
Income Statement
For the year ended December 31, 2011
Sales $560,000
Cost of Goods Sold ($320,000)
Gross Profit $240,000
4-23
General and Administrative Expense ($38,000)
Selling Expense ($27,000)
Interest Expense ($17,000)
Income before Income taxes $158,000
Income Tax Expense (35%) ($55,300)
Net Income $102,700
ANS:
2. Use the following information about Sanibel Corporation to calculate the following ratios for 2011
(assume an effective tax rate of 35%):
a. Return on Assets
b. Profit margin for ROA
c. Assets Turnover
d. Return on Common Shareholders’ Equity
e. Profit Margin for ROCE
f. Accounts Receivable Turnover
g. Inventory Turnover
h. Fixed Asset Turnover
Sanibel Corporation
Balance Sheet
As of December 31, 2011 2010
Assets:
Cash and cash equivalents $ 712,300 $ 425,000
Accounts Receivable 408,000 106,250
Inventory 510,000 612,000
Current Assets 1,630,300 1,143,250
Equipment 714,000 654,500
Less: Accumulated depreciation (238,000) (119,000)
Land 425,000 170,000
Total assets $2,531,300 $1,848,750
Liabilities
Accounts Payable $ 297,500 $ 382,500
Accrued Salaries Payable 93,500 136,000
Rent Expense Payable 37,400 17,000
Income Tax Payable 117,300 68,000
4-24
Current Liabilities 545,700 603,500
Long-term note payable 850,000 510,000
Total Liabilities 1,395,700 1,113,500
Stockholders’ Equity:
Common stock 714,000 510,000
Retained earnings 421,600 225,250
Total liabilities and stockholders’ equity $2,531,300 $1,848,750
Sanibel Corporation
Income Statement
For the year ended December 31, 2011
Revenues $2,499,000
Cost of goods sold (1,428,000)
Gross Profit 1,071,000
Operating Expenses
Depreciation expense (112,000)
Salary expense (233,600)
Insurance Expense (40,000)
Rent Expense (160,000)
Interest Expense (67,200)
Total Operating Expenses (612,800)
Income from Operations 458,200
Income Tax Expense (160,370)
Net income $ 297,830
ANS:
a. Return on Assets—297,830 + 67,200 ( 1-.35) / $2,190,025 = 15.6%
b. Profit margin for ROA—$341,510 / $2,499,000 = 13.7%
3. The following balance sheets and income statements are for Net Devices Inc., a manufacturer of small
electronic devices, including calculators, personal digital assistants and mp3 players. Use the
information to calculate the following information:
a. Compute the rate of return on assets for Net Devices for both 2011 and 2010. Disaggregate the
rate of return on assets into the profit margin on ROA and asset turnover components. The income tax
rate is 35%.
b. Calculate the accounts receivable turnover ratio for Net Devices for 2011 and 2010. All of the
company’s sales were made on account.
c. Calculate the inventory turnover ratio for Net Devices for 2011 and 2010.
d. Calculate the fixed assets turnover ratio for Net Devices for 2011 and 2010.
e. Calculate the rate of return on common shareholders’ equity for Net Devices for 2011 and 2010.
The amount of preferred dividends paid each year appears after the income statement. Calculate profit
margin for ROCE.
f. Determine Net Devices capital structure leverage for 2011 and 2010.
g. Calculate Net Devices earnings per share for 2011 and 2010.
ASSETS (in thousands)
Fiscal year end 2011 2010 2009
Cash $ 875,650 $ 571,250 $ 154,230
Marketable securities 6,560 0 0
Receivables 771,580 775,250 902,000
Inventories 1,320,150 1,254,600 1,418,500
Other current assets 249,000 231,200 229,900
Total current assets 3,222,940 2,832,300 2,704,630
Property, plant & equipment 1,118,750 1,100,300 1,122,400
Intangibles 263,050 241,000 215,600
Deposits & other assets 184,500 168,250 168,900
Total assets $4,789,240 $4,341,850 $4,211,530
LIABILITIES (in thousands)
Fiscal year end 2011 2010 2009
Accounts payable $1,178,540 $1,061,100 $1,138,250
Current long term debt 18,100 316,500 150,900
Accrued expenses 664,100 615,900 585,400
Income taxes payable 138,900 108,400 38,200
Other current liabilities 0 0 0
Total current liabilities 1,999,640 2,101,900 1,912,750
Long term debt 478,250 378,400 599,630
Other long term liabilities 13,350 0 0
Total liabilities 2,491,240 2,480,300 2,512,380
Preferred stock 850,000 850,000 550,000
Common stock net 4,000 3,950 3,800
Additional Paid-in Capital 869,000 758,000 689,500
4-26
Retained earnings 1,430,500 1,055,000 1,245,050
Treasury stock (855,500) (805,400) (789,200)
Shareholders’ equity 2,298,000 1,861,550 1,699,150
Total Liab. & Equity $4,789,240 $4,341,850 $4,211,530
INCOME STATEMENT (in thousands)
Fiscal year end 2011 2010
Net sales $11,455,500 $11,082,100
Cost of Goods Sold (8,026,450) (7,940,065)
Gross profit 3,429,050 3,142,035
Selling, general & admin. Exp. (1,836,400) (1,789,200)
Income before deprec. & amort. 1,592,650 1,352,835
Depreciation & amortization (785,250) (757,250)
Interest expense (46,195) (43,340)
Income before tax 761,205 552,245
Provision for income taxes (157,725) (112,290)
Minority interest — —
Net income $ 603,480 $ 439,955
ADDITIONAL INFORMATION
Outstanding shares 308,515,000 303,095,000
Preferred Dividends—Total $85,000,000 $85,000,000
ANS:
Return on Assets 13.88% 10.95%
Accounts Receivable Turnover 14.81 13.21
a. Return on Assets:
4-27
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Assets Turnover:
b. Accounts Receivable Turnover:
d. Fixed Assets Turnover:
e. ROCE:
4. Discuss how the following three elements of risk help us understand return on assets differs across
firms and changes over time:
1. Operating leverage
2. Cyclicality of sales
3. Product life cycle
ANS:
1. Firms with high levels of operating leverage experience greater variability in their ROAs than
2. The cyclicality of sales represents how the sales of certain goods and services are sensitive to
conditions in the economy. Companies with cyclical products do well when the economy is in an
3. As products move through their life cycles, their ROAs should move from being negative during
the introduction period and become positive during the growth period. ROA should reach a peak
5. Examine the four following conditions involving inventory turnover. Discuss what economic factors
might be leading to the condition and whether it suggests positive or negative future economic
conditions.
Condition A: Increasing cost of goods sold to sales percentage, coupled with an increasing
inventory turnover. Condition B: Decreasing cost of goods sold to sales
percentage, coupled with a decreasing inventory turnover.
Condition C: Increasing cost of goods sold to sales percentage, coupled with a decreasing
inventory turnover. Condition D: Decreasing cost of goods sold to sales
percentage, coupled with an increasing inventory turnover.
ANS:
Condition A: Increasing cost of goods sold to sales percentage, coupled with an increasing
proportion of its products instead of outsourcing, thereby capturing more of the gross margin but
requiring the firm to carry raw materials and work-in-process inventories.
necessitating price reductions to move goods. Despite price reductions, inventory builds up.
increased inventory turnover. Firm implements a just–in–time inventory system, reducing storage costs,
product obsolescence, and the amount of inventory held.
6. Carridine Company reported net income of $1,903 on revenues of $55,618 for Year 4. Interest expense
totaled $459, and preferred dividends totaled $13.5. Average total assets for Year 4 were $17,500. The
income tax rate is 40 percent. Average preferred shareholders’ equity totaled $250, and average
common shareholders’ equity totaled $7,500. Assume that all the following amounts are in thousands.
REQUIRED:
a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and assets
turnover components.
b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE, assets
turnover, and capital leverage ratio components.
c. Calculate the amount of net income to common shareholders derived from the
excess return on creditors’ capital, the excess return on preferred shareholders’ capital,
and the return on common shareholders’ capital.
ANS:
a. Rate of Return on Assets: [$1,903 + (1 – .40)($459)]/$17,500 = 12.4%
b. Rate of Return on Common Shareholders’ Equity: ($1,903 – $13.5)/$7,500 = 25.2%
c. Average total liabilities equal $9,750 (= $17,500 – $250 – $7,500). Carridine Company earned
7. Freedom Company reported net income for 2010 of $2,031 million on sales of $25,600 million.
Interest expense for 2010 was $235 million, and minority interest was $344 million for 2010. The
income tax rate is 40 percent. Total assets were $10,800 million at the beginning of 2010 and $14,874
million at the end of 2010. Compute the rate of ROA for 2010 and disaggregate
ROA into profit margin for ROA and asset turnover components.
ANS:
Rate of Return = Profit Margin Assets
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
21.2% = 10.6% 2.0
8. Rattigan Industries reported net income (amounts in thousands) for Year 4 of $60,615 on sales of
$1,560,235. It declared preferred dividends of $22,100. Preferred shareholders’
equity totaled $265,750 at both the beginning and end of Year 4. Common shareholders’ equity totaled
$298,150 at the beginning of Year 4 and $365,000 at the end of Year
4. Rattigan had no minority interest in its equity. Total assets were $1,440,000 at the beginning of Year
4 and $1,550,000 at the end of Year 4.
ANS:
Rate of Return on Common Shareholders’ Equity:
9. Krane, Inc. reported net income (amounts in thousands) of $619,700 for Year 4.Included in net income
was income tax expense of $10,400. During the year the company paid the preferred shareholders
$9,000 in dividends. The weighted average of common shares outstanding during Year 4 was 468,810
shares. Krane Inc., subtracted interest expense net of tax saving on convertible debt of $4,820. If the
convertible debt had been converted into common stock, it would have increased the weighted average
common shares outstanding by 20,905 shares. Krane, Inc. has outstanding stock options that, if
exercised, would increase the weighted average of common shares outstanding by 7,335 shares.
REQUIRED:
Compute basic and diluted earnings per share for Year 4, showing supporting computations.
ANS:
10. Raleigh Manufacturing reported net income (amounts in millions) of $1,166 on sales of $5,520 during
Year 4. Interest expense totaled $75. The income tax rate was 30 percent. Average total assets were
$7,135, and average common shareholders’ equity was $3,405. The firm did not have preferred stock
outstanding or minority interest in its equity.
REQUIRED:
4-31
a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and assets
turnover components.
b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE, assets
turnover, and capital structure leverage ratio components.
c. Calculate the amount of net income to common shareholders derived from the
excess return on creditors’ capital and the amount from the return on common
shareholders’ capital.
ANS:
a. Rate of Return on Assets: [$1,166 + (1 – .30)($75)]/$7,135 = 17.1%
b. Rate of Return on Common Shareholders’ Equity: $1,166/$3,405 = 34.2%
c. Average total liabilities equal $3,730 (= $7,135 – $3,405). Raleigh earned $637.8 (= .171 x $3,730)
on assets financed by liabilities, while the liabilities cost $52.5 [= (1 – .30)($75)].
11. Below are three relationships that are important to the determination of profitability. Assume assets
were $22,900,000 on Dec. 31, 2008.
1. Operating leverage = Earnings before interest but after taxes
Average assets.
2. Financial structure leverage = Net income available to common shareholders
Earnings before interest but after taxes
3. ROCE = ROA Common earnings leverage Financial structure leverage
REQUIRED:
Compute the operating leverage, financial structure leverage, and ROCE (rounded to two places).
Then use these relationships to analyze how the profitability of X-Mart changed over the three year
period below. What does the company need to do to reverse this trend? What are the risks of your
strategy?
As of Dec. 31 2009 2010 2011
ROA 0.10 0.10 0.08
Assets $27,500,000 $23,000,000 $27,600,000
Net income available to common shareholders $67,250,000 $68,960,210 $70,910,840
Earnings after taxes but before interest $25,000,000 $24,541,000 $24,794,000
4-32
ANS:
ROCE has deteriorated somewhat over the three years in question. The drop in 2011 is due to the
decline in ROA that was not accompanied by the increased use of financial leverage. Had the company
Common earnings leverage 0.99 0.97 0.98