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P3-20. The relationship between financial leverage and profitability (LG 4 and LG 5; Challenge)
a. (1)
(2)
Timberland has much more financial leverage and, consequently, greater debt service than does
b. (1)
(2)
(3)
(4)
Pelican is more profitable than Timberland, as shown by the higher operating profit margin, net
c. Pelican has a higher net profit margin because it uses less debt and, hence, has lower interest
expense. But Timberland has a higher ROE because of greater financial leverage. Put another way,
P3-21. Analysis of Debt Ratios (LG 4; Intermediate)
a. Debt Ratio = Total Liabilities / Total Assets. For Estée Lauder, the debt ratio is
Debt ratios for the two companies are relatively similar, but Estée Lauder has a much larger
a. Interest expense divided by total liabilities is conceptually similar to an interest rate—the ratio
indicates how many dollars of interest a company must pay for each dollar of liabilities on its
There are two possible explanations for this pattern. The most important is the companies have
different mixes of interest-bearing and non-interest-bearing liabilities. In fact, Estée Lauder’s
a much smaller company than Estée Lauder, so its interest-bearing debts probably carry a
P3-22. Ratio proficiency (LG 6; Basic)
a.
b.
c.
P3-23. Cross-sectional ratio analysis (LG 6; Intermediate)
a.
Ratio Analysis—Fox Manufacturing Company
Industry
Average
2019
Fox
2019
Debt Ratios
Current ratio 2.35 1.84
Quick ratio 0.87 0.75
Profitability Ratios
Gross profit margin 0.202 0.233
Operating profit margin 0.135 0.133
Liquidity: By both the current and quick ratios, Fox has a weaker liquidity position than the
industry.
Activity: Inventory and asset turnover ratios compare favorably with the industry. Further
Debt: Fox uses more debt than the industry average, resulting in lower ability to cover interest
with current cash flow.
Profitability: Fox posted a higher gross profit margin than the industry, suggesting a higher sales
price or a lower cost of goods sold. Operating profit margin is in line with the industry, but net
b. Fox Manufacturing Company needs to improve its liquidity ratios and possibly reduce its debt
P3-24. Financial statement analysis (LG 6; Intermediate)
a.
Zach Industries—Ratio Analysis
Industry
Average
Actual
2018
Actual
2019
Liquidity Ratios
Current ratio 1.80 1.84 1.04
Quick ratio 0.70 0.78 0.38
Activity Ratios
Inventory turnover 2.50 2.59 2.33
Return on total assets 4.0% 4.0% 4.4%
Return on common
9.5% 8.0% 11.3%
b. Liquidity: Zach Industries’ liquidity position deteriorated from 2018 to 2019 and now compares
obligations as they come due.
Activity: Zach’s activity ratios deteriorated from 2018 to 2019. Indeed, the firm now turns
nearly three weeks, and now also compares unfavorably with the industry average.
Debt: Zach Industries’ debt position has improved since 2018 and now compares favorably
with industry. That said, Zach Industries’ ability to service interest payments deteriorated –
Profitability: Although Zach Industries’ gross margin is below the industry average
(suggesting a high cost of goods sold), net profit margin rose from 2018 to 2019 and now
Market: Zach Industries’ market-to-book value rose from 2018 to 2019 and now compares
even more favorably to industry norm. This trend indicates investors have recently come to
P3-25. Integrative—Complete ratio analysis (LG 6; Challenge)
a.
Sterling Company—Ratio Analysis
(Given)
Actual
(Given)
Actual Actual
(Given)
Industry TS: Time Series
Ratio 2017 2018 2019 2019 CS: Cross Sectional
Liquidity
Current ratio 1.40 1.55 1.67 1.85 TS: Improving
CS: Below Peer
days
Average payment TS: Deteriorating
period 59.3 days 61.6 days 53.0
days
46.4 days CS: Above Peer
Profitability
Gross profit margin 0.30 0.27 0.25 0.25 TS: Deteriorating
CS: Equal to Peer
Operating profit TS: Improving
margin 0.12 0.12 0.13 0.10 CS: Above Peer
Return on common TS: Improving
Equity 0.061 0.067 0.120 0.066 CS: Above Peer
Earnings per share TS: Improving
(EPS) $1.75 $2.20 $4.10 $1.50 CS: Above Peer
Market
Note:
1. Principal payments are not given in the problem; this figure assumes such payments are zero.
Liquidity: Sterling’s overall liquidity position is weak compared with peer firms. The
Activity: Sterling’s inventory turnover has deteriorated and currently lags the industry. At the
Profitability: Sterling’s gross margin, while in line with industry norms, has declined,
probably because of increases in the cost of goods sold. Operating and net profit margins have
been stable (or improving) at levels exceeding industry averages. Both ROA and the ROE have
Market: The firm’s P/E ratio has been falling. Its market-to-book ratio—though somewhat
volatile—compare favorably with industry norms.
Overall, Sterling should work to improve inventory management and reduce debt load and
service. Other than these issues, the firm appears to be doing reasonably wellespecially in
P3-26. DuPont system of analysis (LG 6; Intermediate)
a. Net profit margin = Earnings Available to Common Stockholders / Sales
= $13,333 / $163,786 = 8.1% for ATT
Verizon outperforms AT&T in both net profit margin and asset turnover (i.e., Verizon posted
the higher figures).
b. Return on assets (ROA) = Earnings Available to Common Stockholders / Total assets
= $13,333 / $403,821 = 3.3% for ATT
Verizon outperforms AT&T in both ROA and ROE (i.e., Verizon posted the higher figures).
P3-27. Complete ratio analysis, recognizing significant differences (LG 6; Intermediate)
a.
Home Health, Inc.
Ratio 2018 2019 Difference
Proportional
Difference
Current ratio 3.25 3.00 – 0.25 – 7.69%
Quick ratio 2.50 2.20 – 0.30 – 12.00%
Inventory turnover 12.80 10.30 – 2.50 – 19.53%
Average collection period 42.6 days 31.4 days – 11.2 days – 26.29%
Total asset turnover 1.40 2.00 + 0.60 +42.86%
Debt ratio 0.45 0.62 + 0.17 + 37.78%
b.
Ratio
Proportional
Difference
Home Health’s
Favor
Quick ratio – 12.00% No
Inventory turnover – 19.53% No
Average collection period – 26.29% Yes
c. The most obvious relationship is associated with the increase in the ROE value. The increase in
this ratio is connected with the increase in the ROA. The higher ROA is partially attributed to
P3-28. Ethics problem (LG 1; Intermediate)
Answers will vary by article chosen, but in general, students will report that financial statements are
more trustworthy if company financial executives implement the provisions of Sarbanes-Oxley.
Case
Case studies are available on www.pearson.com/mylab/finance.
Assessing Martin Manufacturing’s Current Financial Position
Martin Manufacturing Company is an integrative case study employing financial-analysis techniques. The
company is a capital-intensive firm that manages accounts receivable and inventory poorly. The industry
average inventory turnover can fluctuate from 10 to 100 depending on the market.
a.Ratio calculations
Financial Ratio 2019
Current ratio $1,531,181 $616,000 = 2.5%
Quick ratio ($1,531,181 – $700,625) $616,000 = 1.3%
Inventory turnover (times) $3,704,000 $700,625 = 5.3%
Average collection period (days) $805,556 ($5,075,000 365) = 58.0
Historical Ratios—Martin Manufacturing Company
Ratio
Actual
2017
Actual
2018
Actual
2019
Industry
Average
Current ratio 1.7 1.8 2.5 1.5
Quick ratio 1.0 0.9 1.3 1.2
Inventory turnover (times) 5.2 5.0 5.3 10.2
Average collection period
(days)
50.7 55.8 58.0 46.0
Total asset turnover (times) 1.5 1.5 1.6 2.0
b.Liquidity: Martin’s liquidity has improved in recent years and now compares favorably with
Activity: Inventory turnover has been relatively stable but at a much lower level than the industry
norm, suggesting Martin is carrying too much inventory. The firm’s average collection period has risen
Debt: The debt ratio has increased and now substantially exceeds the industry average. The times
Profitability: Gross margin has been stable at a level just exceeding the industry average. Net profit
Market: The market values Martin’s common stock at less than book value; in addition, the firm’s
market-to-book ratio compares unfavorably with peer firms. The market has also put a price on Martin
c.Martin Manufacturing clearly has a problem managing inventory and generating sales appropriate for
ratios.
Spreadsheet Exercise
Answer to Chapter 3’s Dayton, Inc., financial-statement spreadsheet problem are available on
www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.pearson.com/mylab/finance .
This chapter’s exercise focuses on each group’s shadow firm. Groups are asked to obtain their firm’s latest
10-K from the Securities and Exchange website (www.sec.gov) and then calculate/interpret basic
Modifications could include dropping intertemporal analysis and focusing solely on the most recent year.
