Chapter 3
Financial Analysis
Discussion Questions
3-1. If we divide users of ratios into short-term lenders, long-term lenders, and
stockholders, in which ratios would each group be most interested, and for what
reasons?
Long-term lenders—Leverage ratios because they are concerned with the
Stockholders—Profitability ratios, with secondary consideration given to debt
3-2. Explain how the Du Pont system of analysis breaks down return on assets. Also
explain how it breaks down return on stockholders’ equity.
Return on assets = Profit margin ×Asset turnover
assets Total
Sales
Sales
incomeNet
assets Total
incomeNet
In this fashion, we can assess the joint impact of profitability and asset turnover
on the overall return on assets. This is a particularly useful analysis because we
can determine the source of strength and weakness for a given firm. For example,
a company in the capital goods industry may have a high profit margin and a
low asset turnover, while a food processing firm may suffer from low profit
margins, but enjoy a rapid turnover of assets.
The modified form of the Du Pont formula shows:
( )
( )
Return on assets investment
Return on equity = 1 Debt/Assets–
This indicates that return on stockholders’ equity may be influenced by return
3-3. If the accounts receivable turnover ratio is decreasing, what will be happening
to the average collection period?
3-4. What advantage does the fixed charge coverage ratio offer over simply using
times interest earned?
The fixed charge coverage ratio measures the firm’s ability to meet all fixed
3-5. Is there any validity in rule-of-thumb ratios for all corporations (for example, a
current ratio of 2 to 1 or debt to assets of 50 percent)?
No rule-of-thumb ratio is valid for all corporations. There is simply too much
3-6. Why is trend analysis helpful in analyzing ratios?
Trend analysis allows us to compare the present with the past and evaluate our
3-7. Inflation can have significant effects on income statements and balance sheets,
and therefore on the calculation of ratios. Discuss the possible impact of
inflation on the following ratios, and explain the direction of the impact based
on your assumptions.
a. Return on investment.
b. Inventory turnover.
c. Fixed asset turnover.
d. Debt-to-assets ratio.
a.
assets Total
incomeNet
investmenton Return
b.
Inventory
Sales
turnoverInventory
Inflation may cause sales to be overstated. If the firm uses FIFO accounting,
c.
assets Fixed
Sales
overasset turn Fixed
d.
assets Total
debt Total
assets totalDebt to
3-8. What effect will disinflation following a highly inflationary period have on the
reported income of the firm?
3-9. Why might disinflation prove to be favorable to financial assets?
Because it is possible that prior inflationary pressures will no longer seriously
impair the purchasing power of the dollar, lessening inflation also means that
3-10. Comparisons of income can be very difficult for two companies even though
they sell the same products in equal volume. Why?
There are many different methods of financial reporting accepted by the
accounting profession as promulgated by the Financial Accounting Standards
Chapter 3
Problems
1. Profitability ratios (LO2) Low Carb Diet Supplement Inc. has two divisions. Division A
has a profit of $156,000 on sales of $2,010,000. Division B is able to make only $28,800
on sales of $329,000. Based on the profit margins (returns on sales), which division is
superior?
3-1. Solution:
Low Carb Diet Supplements
Division A Division B
Net income $156,000 $28,800
7.76% 8.75%
Sales 2,010,000 $329,000
= =
Division B is superior.
2. Profitability ratios (LO2) Database Systems is considering expansion into a new product
3-2. Solution:
Database Systems
Net income = Sales profit margin
= $1,410,000 0.08
= $112,800
´
´
Return on assets Net income
(investment) Total assets
$112,800
$380,000
29.7%
=
=
=
3. Profitability ratios (LO2) Polly Esther Dress Shops Inc. can open a new store that will do
an annual sales volume of $837,900. It will turn over its assets 1.9 times per year. The
3-3. Solution:
Polly Esther Dress Shops Inc.
Sales
Assets Total asset turnover
$837,900 $441,000
1.9
Net income Sales Profit Margin
$837,900 0.08 = $67,032
Net income
Return on assets (investment) Total assets
$67,032 15.2%
$441,000
=
= =
= ´
= ´
=
= =
4. Profitability ratios (LO2) Billy’s Crystal Stores Inc. has assets of $5,960,000 and turns
over its assets 1.9 times per year. Return on assets is 8 percent. What is the firm’s profit
margin (return on sales)?
3-4. Solution:
Billy’s Crystal Stores Inc.
Sales Assets total asset turnover
$11,324,000 $5,960,000 1.9
$476,800 $5,960,000 8%
Net income $476,800/$11,324,000 = 4.21%
Sales
= ´
= ´
= ´
=
5. Profitability ratios (LO2) Elizabeth Tailors Inc. has assets of $8,940,000 and turns over its
assets 1.9 times per year. Return on assets is 13.5 percent. What is the firm’s profit margin
(returns on sales)?
3-5. Solution:
Elizabeth Tailors Inc.
Sales Assets Total asset turnover
$16,986,000 $8,940,000 1.9
Net income Assets Return on assets
$1,206,900 $8,940,000 13.5%
Net income $1,206,900 / $16,986,000 7.11%
Sales
= ´
= ´
= ´
= ´
= =
6. Profitability ratios (LO2) Dr. Zhivàgo Diagnostics Corp. income statements for 20X1 are
as follows:
Sales……………………………………………………………………………$2,790,000
Cost of goods sold………………………………………………………… 1,790,000
a. Compute the profit margin for 20X1.
b. Assume that in 20X2, sales increase by 10 percent and cost of goods sold increases by
20 percent. The firm is able to keep all other expenses the same. Assume a tax rate of
30 percent on income before taxes. What is income after taxes and the profit margin for
20X2?
3-6. Solution:
Dr. Zhivàgo Diagnostics
a. Profit margin for 20X1
Net income $450,240 16.14%
Sales $2,790,000
= =
b. Sales…………………………………………………… $3,069,000*
Cost of goods sold………………………………… 2,148,000**
3-6. (Continued)
* $2,790,000 × 1.10 = $3,069,000
Operating profit 802,000 293,000
Interest expense 47,200 51,600
For each year, compute the following and indicate whether it is increasing or decreasing
profitability in 20X2 as indicated by the ratio.
a. Cost of goods sold to sales.
b. Selling and administrative expense to sales.
c. Interest expenses to sales.
3-7. Solution:
Haines Corp.
20X1 20X2
a.
Cost of goods sold $2,130,000 $2,850,000
65.9% 84.6%
Sales 3, 230,000 3,370,000
= =
It is decreasing profitability.
b.
Selling & admin. expense $298,000 $227,000
9.2% 6.7%
Sales 3, 230,000 3,370,000
= =
It is increasing profitability.
c.
Interest expense $47, 200 $51,600
1.5% 1.5%
Sales 3, 230,000 3,370,000
= =
It is not changing profitability.
8. Profitability ratios (LO2) Easter Egg and Poultry Company has $2,000,000 in assets and
$1,400,000 of debt. It reports net income of $200,000.
a. What is the firm’s return on assets?
b. What is its return on stockholders’ equity?
c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin
(return on sales)?
3-8. Solution:
Easter Egg and Poultry Company
a.
Net income
Return on assets (investment) Total assets
$200,000 10%
$2,000,000
=
=
b.
Net income
Return on equity Stockholders’ equity
Stockholders’ equity Total assets Total debt
$2,000,000 $1,400,000
$600,000
Net income $200,000 33%
Stockholders’ equity $600,000
=
= –
= –
=
= =
3-8. (Continued)
c.
Sales Total assets Total assets turnover
$2,000,000 2.5
$5,000,000
Net income $200,000
Profit margin 4%
Sales $5,000,000
= ´
= ´
=
= = =
9. Profitability ratios (LO2) Network Communications has total assets of $1,500,000 and
current assets of $612,000. It turns over its fixed assets three times a year. It has $319,000
of debt. Its return on sales is 8 percent. What is its return on stockholders’ equity?