Chapter 03: Financial Analysis
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?
Short-term lenders—Liquidity ratios because their concern is with the firm’s
ability to pay short-term obligations as they come due.
Long-term lenders—Leverage ratios because they are concerned with the
relationship of debt to total assets. They also will examine profitability to insure
that interest payments can be made.
Stockholders—Profitability ratios, with secondary consideration given to debt
utilization, liquidity, and other ratios. Since stockholders are the ultimate
owners of the firm, they are primarily concerned with profits or the return on
their investment.
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.
The Du Pont system of analysis breaks out the return on assets between the
profit margin and asset turnover.
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:
Chapter 03: Financial Analysis
Haines Corp.
20X1 20X2
Cost of goods sold $2,130,000 $2,850,000
Sales 3, 230, 000 3,370, 000
It is decreasing profitability.
Selling & admin. expense $298, 000 $227,000
Sales 3, 230,000 3,370,000
It is increasing profitability.
Interest expense $47, 200 $51,600
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
=
=
Chapter 03: Financial Analysis
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
OR
Return
Return on equity
=
=−
=−
=
==
=on assets (investment)
(1 Debt/Assets)
$1,400,000
Debt/Assets 70%
$2,000,000
10% 10%
Return on equity 33%
(1 .70) .30
−
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−
3-8. (Continued)
c.
Sales Total assets Total assets turnover
=
of debt. Its return on sales is 8 percent. What is its return on stockholders’ equity?
Chapter 03: Financial Analysis
Network Communications
Total assets $1,500,000
Chapter 03: Financial Analysis
Net income
Return on stockholders’ equity Stockholders’ equity
$215,100 16.57%
$1, 298,370.37
=
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