978-1259277160 Case Case 2

Unlock access to all the studying documents.

View Full Document

Chem-Med Company Case 2

Ratio Analysis

Purpose: The case allows the student to go into financial analyses in more depth than in possible with

end-of-chapter problems. In addition to computing a series of ratios, the student must consider industry

data and trends for the purpose of evaluating relative performance. The student must also make use of the

Du Pont system of analysis. Of special interest are the debt and performance covenants established by the

potential financier. Finally, the student is forced to identify the impact of extraordinary income on ratio

analysis and how it can distort one year’s performance.

Relation to Text: The case should follow Chapter 3.

Complexity: The case is moderately complex. It should require 1-1½ hours.

Solutions

1. Sales Growth = (Sales this year – Sales last year) / Sales last year

for 2015 $ 3,814 – $3,051 / $3,051 = + 25%

2. Net income growth = (Net income this year – Net income last year) / Net Income last year

for 2015 $1,150 – $ 766 / $ 766 = + 50%

According to Dr. Swan’s estimates net income growth will exceed sales growth in 2015, match sales

growth in 2016, then slack off and rebound in 2018. However, Dr. Swan’s figures are misleading: in

2016 they include $500,000 worth of extraordinary income expected to be received from the

settlement of the suit with Pharmacia. The astute analyst will realize that this amount should be

Aftertax effect of removing $500,000 from gross income = $500 x (1 – tax rate) = $500 x

(1 – .33) = – $335

of McGraw-Hill Education.

Failing to exclude the extraordinary amount has the effect of obscuring the “real” profitability ratios

3. Chem-Med’s current ratio = Current Assets / Current Liabilities:

Pharmacia had a current ratio in 2015 of 2.8, and the industry average was 2.4. Chem-Med, therefore,

in 2015 was slightly more liquid than the average company. This would probably be looked upon

favorably by someone considering loaning money to the company; however, the banker with whom

4. Chem-Med’s total debt to assets ratio = total liabilities / total assets

for 2015 = $ 614 / $ 4,491 = .137

The variation from year to year is small—no trend can be established, except, of course, that the ratio

remains nearly constant, indicating that Chem-Med is doing a good job in managing its debt. It was

doing especially well in 2015 compared to other companies in the industry, where the average debt to

5. Chem-Med’s average accounts receivable collection period = accounts receivable / sales per day

for 2015 = $ 564 / ($ 3,814/360) = 53 days

This is not a good sign. The average length of time that Chem-Med’s customers are taking to pay for

products they’ve bought is increasing steadily every year. If Chem-Med’s credit policy is, say, 2/10,

net 30, it is clear that very few customers are adhering to it, and the situation is getting worse. Not

6. Chem-Med’s return on equity ratio = net income / total equity for 2015 = $1,150 / $3,877 = 29.7%

Pharmacia’s ROE in 2015 was 29.7%, and the industry average was only 12.3%. A potential investor

in Chem-Med would be very pleased; Chem-Med is offering a handsome return that’s almost two and

of McGraw-Hill Education.

Note the drastic difference in the operation of the two companies, even though their ROEs are nearly

the same. Chem-Med makes relatively few sales (low asset turnover), but makes a lot of money on

each one (30%). Pharmacia is just the opposite: it makes a lot of sales, and only a little profit (7%) on

each one. Pharmacia’s ROE is also being propped up by greater use of debt than Chem-Med

of McGraw-Hill Education.