Textbook Cases

Case Problem 7.1 Some Financial Ratios Are Real Eye-Openers

1. LG 5

2. LG 6

Jack Arnold is a resident of Lubbock, Texas, where he is a prosperous rancher and businessman. He has also built up a sizable portfolio of common stock, which, he believes, is due to the fact that he thoroughly evaluates each stock he invests in. As Jack says, “You can’t be too careful about these things! Anytime I plan to invest in a stock, you can bet I’m going to learn as much as I can about the company.” Jack prefers to compute his own ratios even though he could easily obtain analytical reports from his broker at no cost. (In fact, Bob Smith, his broker, has been volunteering such services for years.)

Recently Jack has been keeping an eye on a small chemical stock. The firm, South Plains Chemical Company, is big in the fertilizer business—which is something Jack knows a lot about. Not long ago, he received a copy of the firm’s latest financial statements (summarized here) and decided to take a closer look at the company.

Cash	$ 1,250
Accounts receivable	$ 8,000	Current liabilities	$10,000
Inventory	$12,000	Long-term debt	$ 8,000
Current assets	$21,250	Stockholders’ equity	$12,000
Fixed and other assets	$ 8,750	Total liabilities and
Total assets	$30,000	stockholders’ equity	$30,000
South Plains Chemical Company Balance Sheet ($ thousands)
Sales	$50,000
Cost of goods sold	$25,000
Operating expenses	$15,000
Operating profit	$10,000
Interest expense	$ 2,500
Taxes	$ 2,500
Net profit	$ 5,000
Dividends paid to common stockholders ($ in thousands)	$ 1,250
Number of common shares outstanding	5 million
Recent market price of the common stock	$ 25
South Plains Chemical Company Income Statement ($ thousands)

Questions

a. Using the South Plains Chemical Company figures, compute the following ratios.

	Latest Industry Averages		Latest Industry Averages
Liquidity		Profitability
a. Net working capital	N/A	h. Net profit margin	8.5%
b. Current ratio	1.95	i. Return on assets	22.5%
Activity		j. ROE	32.2%
c. Receivables turnover	5.95	Common-Stock Ratios
d. Inventory turnover	4.50	k. Earnings per share	$2.00
e. Total asset turnover	2.65	l. Price-to-earnings ratio	20.0
Leverage		m. Dividends per share	$1.00
f. Debt-equity ratio	0.45	n. Dividend yield	2.5%
g. Times interest earned	6.75	o. Payout ratio	50.0%
		p. Book value per share	$6.25
		q. Price-to-book-value ratio	6.4

b. Compare the company ratios you prepared to the industry figures given in part a. What are the company’s strengths? What are its weaknesses?

c. What is your overall assessment of South Plains Chemical? Do you think Jack should continue with his evaluation of the stock? Explain.