978-0134083308 Chapter 7 Solution Manual Part 3

7.17 a. All of the following ratios for Otago Bay Marine Motors are based on the 2015 and 2016

financial statements (dollars in thousands) and are computed using the formulas in the chapter:

(1) Current ratio  Current assets/Current liabilities

(2) Total asset turnover Sales/Total assets

(3) Debt-equity ratio  Long-term debt/Stockholders’ equity

(4) Net profit margin  Net profit after taxes/Total revenues

(5) ROA  Net profit after taxes/Total assets

(6) ROE  Net profit after taxes/Stockholders’ equity

(7) EPS 

Net profit after taxes Preferred dividends

Number of common shares outstanding

–

2015

$32,032 $0

10,848

–

$2.95 per share=

2016

$35,442 $0

10,848

–

$3.27 per share=

Industry  $1.59

(8) P/E ratio  Shared price/EPS

120 Smart/Gitman/Joehnk • Fundamentals of Investing,Thirteenth Edition

(9) Dividend yield  Dividends per share/Market price per share

(10) Dividend payout ratio  Dividends per share/EPS

(11) Price-to-book-value ratio  Share price/Book value per share

Book value per share



Stockholders’ equity

Number of common shares outstanding

2015 BV



$181,704 $16.75

10,848 =

2016BV



$212,343 $19.57

10,848 =

Price-to-book value:

b. Based on the comparison to industry average ratios, the financial condition of Otago Bay Marine

Motors (OBMM) appears to be deteriorating. First, OBMM’s current ratio has declined 63%,

Also, the activity measure—total asset turnover—which was below the industry average last

year, has declined even further, suggesting that corporate resources are being poorly managed.

With respect to leverage, OBMM’s debt-equity ratio has grown to nearly twice the industry

average, indicating a need to control and reduce the amount of debt in the capital structure.

The market appears to reflect this deterioration in OBMM’s financial picture from 2015 to 2016.

Chapter 7 Analyzing Common Stocks 121

In summary, despite the relatively small percentage increases in net profit after taxes, Otago Bay

Marine Motors seems poorly managed. If left unchecked, OBMM’s financial condition will

7.18 a. For 2015

Profit margin 

Net earnings

Net sales



$20.20

$179.30

 11.27%

Asset turnover 

Net sales

Total assets



$179.30

$136.30

 1.32

Using profit margin and asset turnover to calculate ROA:

Net earnings Net sales

ROA Net sales Total assets

ROA 11.27% 1.32

14.88%

ROE ROA Equity multiplier

= ´

=

= ´

Where Equity multiplier  Total assets/Stockholders’ equity

 $136.3/$109.6

 1.24

ROE  14.88%  1.24

 18.45%

b. For 2016:

ROA  Profit margin Total asset turnover

ROE  ROA Equity multiplier

122 Smart/Gitman/Joehnk • Fundamentals of Investing,Thirteenth Edition

c. Between 2015 and 2016, Otago Bay Marine Motor’s ROA and ROE measures both deteriorated.

With respect to ROA, total assets have grown faster than net sales, thereby affecting total asset

The growth in total assets is also a main contributor to the decline in ROE, which is composed of

ROA multiplied by the equity multiplier. The higher equity multiplier reflects the fact that total

d. Generally, these changes from 2015 to 2016 do not appear fundamentally healthy for Otago Bay

Marine Motors. The increased total assets account, a large percentage of which was financed by

Solutions to Case Problems

Case 7.1 Some Financial Ratios Are Real Eye-Openers

The objective of this case is to have students calculate and interpret ratios as part of the fundamental

analysis of a firm.

1. All the ratios below for South Plains Chemical are computed according to the formulas in the chapter.

South Plains Chemical (dollars in thousands)

Liquidity

a. Net working capital Current assets – Current liabilities

b. Current ratio Currentassets/Currentliabilities

Activity

c. Receivables turnover Sales/Accounts receivable

d. Inventory turnover Sales/Inventory

e. Total asset turnover  Sales/Total assets

Leverage

Chapter 7 Analyzing Common Stocks 123

f . Debt-equity ratio Long-term debt/Stockholders’ equity

g. Times interest earned Earnings before interest and taxes/interest

Profitability

h. Net profit margin  Net profits after taxes/Sales

i. Return on total assets  Net profits after taxes/Total assets

j. Return on equity  Net profits after taxes/Stockholders’ equity

Common Stock Ratios

k. Earnings per share (Net profits after taxes – Preferred dividends)/

# of shares of common stock outstanding

l. Price/earnings ratio  Share price/EPS

m. Dividends per share  Total common dividends paid/

Common shares outstanding

n. Dividend yield  Dividends per share/Share price

o. Payout ratio  Dividends per share/EPS

p. Book value per share  Common equity/Common shares outstanding

q. Price-to-book value  Share price/Book value per share

2. Comparing the ratios computed in Question 1 to the latest industry averages, we find:

b. Activity. Here South Plains is weak; the low ratios inventory and total asset ratios suggest poor

d. Profitability. The results are mixed here. The firm has higher margins and higher ROE. The lower

124 Smart/Gitman/Joehnk • Fundamentals of Investing,Thirteenth Edition

e. Common stock. All the measures relative to dividends are low for this firm, yet its price/earnings

3. The firm seems to have good prospects for attractive returns but also has high risk. For Jack to

Case 7.2 Doris Looks at an Auto Issue

This case allows the student to experience the three steps of security analysis.

a. Other economic information that Doris might find helpful includes government fiscal policy (taxes,

spending, debt management); monetary policy (money supply growth, interest rates); consumer

spending and the investment plans of businesses;energy situation (oil imports, cost and availability of

b. 1. Auto imports. Trends in auto imports more clearly define potential growth for domestic

2. The relationship of the United Auto Workers (UAW) and the auto makers is an important part of

3. Interest rates. As mentioned above, automobiles are usually purchased with borrowed funds. The

4. The cost of gas. Since most cars need gasoline to run, it is very important to assess the course of

Note to the instructor: The situation can be more complex. For example, if the gas price is very

high, consumers will tend to get rid of their old gas guzzlers and buy small economy cars. Thus,

c. 1. Sales can be found from the total asset turnover ratio:

Chapter 7 Analyzing Common Stocks 125

TAT 

Sales

Total assets

From the case:

1.5

Sales

$25 billion

Solving for sales, we have:

2. Profits can be found from the net profit margin:

Net profit margin 

Net profits after taxes

Sales

From the case:

126 Smart/Gitman/Joehnk • Fundamentals of Investing,Thirteenth Edition