1
Critical Thinking Questions
4.1 What does it mean when a company’s return on assets (ROA) is equal to its return on
equity (ROE)?
When ROA equals ROE, it means that the firm does not use any leverage. For firms that
do use leverage, ROE will be higher than ROA.
4.2 Why is too much liquidity not a good thing?
Too much liquidity could mean that a firm is not putting its money to work as the
shareholders would want it to. It could mean that the firm’s managers are being too
conservative and investing in low-yield assets, or it could mean that the firm does not
have enough investment opportunities and is therefore hanging onto its cash. Recently,
several firms including Microsoft had several billions of dollars in cash on their books,
and, ultimately, Microsoft paid a special dividend to its shareholders. Too much liquidity
can also make it a takeover target for firms looking to utilize the debt capacity of the
liquid firm.
Analyzing Financial Statements
2
4.3 Inventory is excluded when the quick ratio or acid-test ratio is calculated because
inventory is the most difficult current asset to convert to cash without loss of value. What
types of inventory are likely to be most easily converted to cash?
For the quick ratio, one uses only the most liquid of all assets—that is, all current assets
less inventory, which is not very liquid relative to cash or receivables. While the current
ratio assumes that inventory could be sold at book value, the quick ratio assumes that
inventory has no value. Hence, this gives a more conservative estimate of a firm’s
liquidity than the current ratio, and gives a better estimate of the firm’s ability to meet its
short-term obligations.
4.4 What does a very high inventory turnover ratio signify?
This could mean a number of things, including that the firm is using up its inventory too
fast and is unable to meet the demand for its products, or it has priced its products too
low relative to its competitors, or worse, the firm is selling defective products that would
eventually be returned.
4.5 How would one explain a low receivables turnover ratio?
A low receivables turnover implies a high DSO. This could mean that the firm’s
customers are not paying on time, either because of an inefficient collection system or
because of a slowdown in their customers’ business or even in the entire economy.
3
4.6 What additional information does the fixed assets turnover ratio provide over the total
assets turnover ratio? For which industries does it carry greater significance?
The total assets turnover ratio measures the level of sales per dollar invested in total
assets. The higher the number, the more efficiently the management is using the firm’s
assets. Too high a number relative to its peers could imply that the firm is reaching its full
capacity and may require an additional investment in plant and equipment to generate
additional sales. The fixed asset turnover ratio can be utilized to break down the
performance of individual manufacturing facilities or a division. This ratio provides
significant information for manufacturing firms that are capital-intensive, while it will be
of much less significance for the service industry, where there is less reliance on plant
and equipment.
4.7 How does financial leverage help shareholders?
Financial leverage implies the use of debt capital in addition to the owners’ capital to
finance the firm. With the addition of debt, the owners’ capital can go a long way in
acquiring assets for the firm. Given that creditors only get the fixed-interest payments and
do not get any share of the gains from the company, the shareholders gain from the usage
of debt. This is called the leverage multiplier effect. As the company’s revenues grow,
shareholders get all the gain and the debt holders merely receive their interest payments.
4
4.8 Why do banks have a low ROA (relative to other industries) but a high ROE?
Banks have a very small equity base relative to firms in most other industries. Thus, they
are highly leveraged with borrowed funds. Since their equity base is small, this magnifies
the return on equity, but the return on assets is relatively small for the large asset base.
4.9 Why is the ROE a more appropriate proxy of wealth maximization for smaller firms
rather than for larger ones?
The basis on which any business or investment decisions are evaluated must include the
size, timing, and uncertainty in the future cash flows. ROE considers neither the risk of
the cash flows nor the size of the initial investment or future cash flows from that
investment. While the ROE and shareholder wealth are correlated, this is still a problem
in large, well-diversified companies with resources from multiple sources. Smaller firms
have fewer resources and sources and can better correlate their ROE to shareholder
wealth.
4.10 Why is it not enough for an analyst to look at just the short-term and long-term debt on a
firm’s balance sheet?
The amount of liabilities shown on a firm’s balance sheet is not the total obligation of a
firm in any given period. To get a true picture, one needs to look at the financial
footnotes that follow the financial statements. This is where you will be able to find the
5
amount of debt repayment that the firm is responsible for in the coming years. In
addition, off-balance sheet items could reflect certain future liabilities of the firm that do
not have to be reported on the balance sheet. One also should look for lease obligations of
the firm that are reported off the balance sheet but nevertheless remain a fixed obligation
that the firm has to meet with its cash flows. Thus, it is important for the analyst to look
beyond the short-term and long-term debt on the balance sheet to get a true measure of
the firm’s true financial commitments in any given period.
6
Questions and Problems
BASIC
4.1 Liquidity ratios: Explain why the quick ratio or acid-test ratio is a better measure of a
firm’s liquidity than the current ratio?
Solution:
The quick ratio is a better or more conservative measure of liquidity than the current
ratio. The difference in the measurement of the two is that for the quick ratio we exclude
the inventory in accounting of the short term assets. Thus the quick ratio is measured as:
sliabilitieCurreent
Inventory - assetsCurrent
ratio Quick =
This measure includes only the most liquid of the current assets and hence gives a better
measure of liquidity.
4.2 Liquidity ratios: Flying Penguins Corp. has total current assets of $11,845,175, current
liabilities of $5,311,020, and a quick ratio of 0.89. What is its level of inventory?
Solution:
Current assets = $11,845,175
Current liabilities = $5,311,020
Quick ratio = 0.89
7
$7,118,367=
∗−=
−=∗
−
=
=
)020,311,
5$89.0(175,845,11$Inventory
Inventory175,
845,11$020,311,4589.0
020,311,5$
Inventory175,
845,11$
89.
0
sliabilitieCurrent
Inventory - assetsCurrent
ratioQuick
4.3 Efficiency ratio: If Newton Manufacturers have an accounts receivable turnover of 4.8
times and net sales of $7,812,379, what is its level of receivables?
Solution:
Accounts receivable turnover = 4.8x
Net sales = $7,812,379
$1,627,579==
=
=
8.4
379,812,7
sreceivable Accounts
sreceivable Accounts
379,812,7
x8.4
sreceivable Accounts
salesNet
turnoversreceivable Accounts
4.4 Efficiency ratio: Bummel and Strand Corp. has a gross profit margin of 33.7 percent,
sales of $47,112,365, and inventories of $14,595,435. What is its inventory turnover
ratio?
Solution:
Gross profit margin = 33.7%
Sales = $ 47,112,365
8
Inventory = $14,595,435
498,235,31
)365,112,47337.0(365,112,47$sold goods of Cost
365,112,47
COGS365,112,47$
337.0
SalesNet
sold goods ofCost -salesNet
rgin Profit MaGross
=
∗−=
−
=
=
2.14x==
==
435,595,14
498,235,31
Ratio turnover Inventory
Inventory
sold goods ofCost
?atioTurnover R Inventory
4.5 Efficiency ratio: Sorenson Inc. has sales of $3,112,489, a gross profit margin of 23.1
percent, and inventory of $833,145. What are the company’s inventory turnover ratio and
days’ sales in inventory?
Solution:
Sales = $3,112,489
Gross profit margin = 23.1%
Inventory = $833,145
9
days 127.1
2.873x
=
==
=
==
=
∗−=
−
=
=
873.2
365
ratio turnover Inventory
365
inventory in sales s'Day
145,833$
504,393,2$
Inventory
sold goods of Cost
ratio turnover Inventory
504,393,2$
)489,112,3231.0(489,112,3sold goods of Cost
3,112,489
Sold Goods of Cost489,112,3
231.0
Sales
sold goods ofCost -Sales
marginprofit Gross
4.6 Leverage ratios: Breckenridge Ski Company has total assets of $422,235,811 and a debt
ratio of 29.5 percent. Calculate the company’s debt-to-equity ratio and the equity
multiplier.
Solution:
Total assets = $422,235,811
Debt ratio = 29.5%
10
42.
1
811,235,297$
811,235,422$
equity Total
assets Total
multiplier
Equity
42.0
274,676,297$
564,559,124$
ratioequity toDebt
47
$297,676,264$124,559,5-11$422,235,8
debt Total -assets Totalequity Total
64$124,559,50.29511
$422,235,8debt Total
=
==
==
==
=
=∗=
4.7 Leverage ratios: Norton Company has a debt-to-equity ratio of 1.65, ROA of 11.3
percent, and total equity of $1,322,796. What are the company’s equity multiplier, debt
ratio, and ROE?
Solution:
Debt-equity ratio = 1.65
ROA = 11.3%
Total equity = $1,322,796
494,505,3$
796,322,1$65.2
equity Total multiplier Equityassets Total
equiity Total
assets Total
multiplier Equity
1.651ratioequity Debt to1multiplier Equity
=
×=
×=
=
=
+=+=
2.65
111,396$
494,505,30.113assets TotalROAincome Net assets Total
income Net
ROA
=
×=×=
=
11
29.9%=== 796,322,1$
111,396$
Equity
income Net
ROE
0.623=−=
−==
65.2
1
1
multiplier Equity
1
1
assets Total
Equity
-1ratio Debt
4.8 DuPont equation: The Rangoon Timber Company has the following relationships:
Sales/Total assets = 2.23; ROA = 9.69%; ROE = 16.4%
What are Rangoon’s profit margin and debt ratio?
Solution:
Total assets turnover = 2.23
ROA = 9.69%
ROE = 16.4%
ROA = Profit margin x Total assets turnover
4.35%=
== 23.2
0969.0
turnoverassets Totoal
ROA
marginProfit
12
ROE = ROA x Equity multiplier
69.1
0969.0
164.0
ROA
ROE
multiplierEquity ===
0.41=−=
−=−=
69.1
1
1
multiplierEquity
1
1
assets Total
Equity
1 ratioDebt
4.9 Benchmark analysis: List the ways a company’s financial manager can benchmark their
own performance.
Solution:
Financial managers can benchmark their firm’s performance by collecting data in three
ways: through trend analysis, industry average analysis, and peer group analysis.
4.10 Benchmark analysis: Trademark Corp.’s financial manager collected the following
information for its peer group so that it can compare its own performance against that of
the peers.
Ratios
Trademark
Peer Group
DSO
33.5 days
27.9 days
13
Total assets turnover
2.3
3.7
Inventory turnover
1.8
2.8
Quick ratio
0.6
1.3
a. Explain how Trademark is doing relative to its peers.
b. How do the industry ratios help Trademark’s management?
Solution:
a. One can see that Trademark is not doing as well as its competitors. The turnover ratio
indicates that the firm either needs to increase its sales relative to its level of assets or
reduce its assets relative to its level of sales. In addition, the lower quick ratio indicates a
lower lever of liquidity, perhaps because of too much inventory. A reduction in the
inventory would help Trademark improve its performance to a level that is comparable to
its peer group.
b. Average industry ratios serve as benchmarks for the firm’s management to measure its
own performance. While no two firms are identical in any industry, the average ratios
across the industry are good target ratios for a firm.
4.11 Market-value ratios: Rockwell Jewelers has announced net earnings of $6,481,778 for
this year. The company has 2,543,800 shares outstanding, and the year-end stock price is
$54.21. What are the company’s earnings per share and P/E ratio?
14
Solution:
Net earnings = $6,481,778
Shares outstanding = 2,543,800
Year-end stock price = $54.21
$2.55=
=== 800,543,2
778,481,6$
goutstandin Shares
earningsNet
EPS shareper Earnings
times 21.26=
== 55.2$
21.54$
Earnings
Price
ratio earnings-Price
INTERMEDIATE
4.12 Liquidity ratios: Laurel Electronics has a quick ratio of 1.15, current liabilities of
$5,311,020, and inventories of $7,121,599. What is the firm’s current ratio?
Solution:
Quick ratio = 1.15
Current liabilities = $5,311,020
Inventory = $7,121,599
15
2$13,229,27assetsCurrent
599,121,7)
020,311,515.1(assets Current
$5,311,020
$7,121,599 -asset Current
15.1
$5,311,020
7,121,599 - assetsCurrent
sliabilitieCurrent
Inventory -asset Current
ratioQuick
=
+×
=
==
==
2.49=
== 020,311,5$
272,229,13$
sliabilitieCurrent
assetsCurrent
ratioCurrent
4.13 Efficiency ratio: Payton Corp. has total sales of $31,115,964, inventories of $4,412,933,
cash and equivalents of $2,469,050, and days’ sales outstanding of 39 days. If the firm’s
management want its DSO to be 30 days, by how much will the accounts receivable have
to change?
Solution:
Sales = $31,115,964; Inventory = $4,412,933
Cash = $2,469,050; DSO = 39 Days
44.719,324,3$ 365
964,115,31$39
365
salesNet DSO
sreceivable Accounts
salesNet
sreceivable 365 receivable untssales/AccoNet
365
turnoverreceivable Accounts
365
DSO
=
×
=
×
=
∗
=
==
Accounts
DSO
16
5$767,242.9-
$2,557,477-$3,324,719sreceivable
49.476,557,2$ 365
964,115,3130
365
salesNet DSO
s
receivable accounts New
Days 30 DSOTarget
=∆
=
×
=
×
=
=
Accounts
4.14 Efficiency ratio: Norwood Corp. currently has accounts receivable of $1,223,675 on net
sales of $6,216,900. What are its accounts receivable turnover ratio and days’ sales
outstanding?
Solution:
Accounts receivable = $1,223,675
Net sales = $6,216,900
times 5.08=
== 675,223,1$
900,216,6$
sreceivable Accounts
salesNet
turnoversreceivable Accounts
days 71.8=== 08.5
365
turnoverreceivable Accounts
365
DSO
4.15 Efficiency ratio: If Norwood Corp.’s management wants to reduce the DSO from that
calculated in the above problem to an industry average of 56.3 days and its net sales are
expected to decline by about 12 percent, what would be the new level of receivables?
17
Solution:
Target DSO = 56.3 days
New level of sales = $6,216,900 x 0.88 = $5,470,872
$843,863=
∗
=
∗
=
==
365
872
,470,53.56 365
salesNet DSO
receivable
receivable untssales/AccoNet
365
Days 56.3 DSO
Accounts
4.16 Coverage ratios: Nimitz Rental Company had depreciation expenses of $108,905,
interest expenses of $78,112, and an EBIT of $1,254,338 for the year ended June 30,
2008. What are the times interest earned and cash coverage ratios for this company?
Solution:
Depreciation = $108,905
Interest expenses = $78,112
EDIT = $1,254,338
times 16.1=
== 112,78$
338,254,1$
expenseInterest
EBIT
earnedinterest Times
18
times 17.5=
=
+
==
112
,78
243,363,1$
expenset Interes
onDepreciatiEBIT
expenseInterest
EBITDA
rates coverage
Cash
4.17 Leverage ratios: Conseco, Inc., has a debt ratio of 0.56. What are the company’s debt-to-
equity ratio and equity multiplier?
Solution:
Debt ratio = 0.56
1.27
2.27
==
=
+=
=
−
=
−
=
==
1-2.27
1-multiplierEquity ratioequity -to-Debt
equity) (Debt to1multiplier
56.01
1
assets Debt/Total1
1
assets /
1
Equity
assets Total
multiplierEquity
Equity
TotalEquity
4.18 Profitability ratios: Cisco Systems has total assets of $35.594 billion, total debt of
$9.678 billion, and net sales of $22.045 billion. Their net profit margin for the year was
20 percent, while the operating profit margin was 30 percent. What are Cisco’s net
income, EBIT ROA, ROA, and ROE?
Solution:
19
Total assets = $35.594 billion
Total debt = 9.678 billion
Net sales = $22.045 billion
Net profit margin = 20%
Operating profit margin = 30%
billion $4.409=
∗=
=
045.22$2.0incomeNet Sales
incomeNet
marginprofit Net
billion $6.613=
∗=
=
045.22$3.0BITE Sales
EBIT
marginprofit Operating
18.6%=== 594.35$
613.6$
assets Total
EBIT
ROAEBIT
12.4%=== 594.35$
409.4$
assets
Total
incomeNet
ROA
Total equity = Total assets – Total debt
= $35.594 - $9.678 = $25.916 billion
20
37.1
916.25$
594.35$
equity Total
assets Total
multiplierEquity
=
==
17% 1.37 0.124
EM ROA ROE
=×=
×=
4.19 Profitability ratios: Procter & Gamble reported the following information for year-end
2008. On net sales of $51.407 billion, the company earned a net income after taxes of
$6.481 billion. It had a cost of goods sold of $25.076 billion and an EBIT of $9.827
billion. What is the company’s (a) gross profit margin, (b) operating profit margin, and
(c) net profit margin?
Solution:
Net sales = $51.407 billion
Net income = $6.481 billion
Cost of goods sold = $25.076 billion
EBIT = $9.827 billion
(a)
51.2%=
−
=
=
407.51$
076.25$407.51$ salesNet
sold goods ofCost - salesNet
marginprofit Gross
(b)
19.1%=== 407.51$
827.9$
salesNet
EBIT
marginprofit Operating
21
(c)
12.6%=== 407.51$
481.6$
sales Net
incomeNet
marginprofit Net
4.20 Profitability ratios: Wal-Mart, Inc., has net income of $9,054,000 on net sales of
$256,329,812. The company has total assets of $104,912,112 and shareholders’ equity of
$43,623,445. Use the extended DuPont identity to find the return on assets and return on
equity for the firm.
Solution:
Net income = $9,054,000
Net sales = $256,329,812
Total assets = $104,912,112
Shareholder equity = $43,623,445
%53.3
812,329,256$
000,054,9$
salesNet
incomeNet
marginProfit ===
X44.2
112,912,104$
812,329,256$
assets Total
salesNet
turnover assets Total ===
8.63%=
×=
×=
44.20353.0
turnoverassets TotalmarginProfit assets on Return
22
20.75%=
×=
×=
×=
445,623,43$
112,912,104$
0863.0
equity Total
assets Total
0863.0
EMROAROE
4.21 Profitability ratios: Xtreme Sports Innovations has disclosed the following information:
EBIT = $25,664,300 Net income = $13,054,000 Net sales = $83,125,336
Total debt = $20,885,753 Total assets = $71,244,863
Compute the following ratios for this firm using the DuPont Identity—debt-to-equity
ratio, EBIT ROA, ROA, and ROE.
Solution:
EBIT = $25,664,300
Net income = $13,054,000
Net sales = $83,125,336
Total debt = $20,885,753
Total assets = $71, 244,863
23
1.41
0.411
ratioequity to1multiplieEquity
)753,885,20$863,244,71($
753.885,20$
debt) Total
-assets (Equity
Debt
equity-to-
=
+=
+=
=
−
=
==
Debt
r
Total
Debt
Debt
0.41
36.02%=
== 863,244,71$
300,664,25$
assets Total
EBIT
ROA EBIT
18.32%=
== 863,244,71$
000,054,13$
assets Total
income Net
ROA
25.9%=
×=
×=
41.11832.0
EMROAROE
4.22 Market-value ratios: Cisco Systems had net income of $4.401 billion and at year end
6.735 billion shares outstanding. Calculate the earnings per share for the company.
Solution:
Net income = $4.401 billion
Shares outstanding = $6.735 billion
24
$0.65=
== 735.6$
401.
4$
goutstandin Shares
incomeNet
shareper Earnings
4.23 Market-value ratios: Use the information for Cisco Systems in the last problem. In
addition, the company’s EBITDA was $6.834 billion and its share price was $22.36.
Compute the firm’s price-earnings ratio and the price-EBITDA ratio.
Solution:
EBITDA = $6.834 billion
Share price = $22.36
times 34.4== 65.0$
$22.36
ratio earnings- Price
$1.015== 735.6
$6.834
shareper EBITDA
times 22.04==− 015.1
$
$22.36
ratio EBITDA
Price
4.24 DuPont equation: Carter, Inc., a manufacturer of electrical supplies, has a ROE of 23.1
percent, a profit margin of 4.9 percent, and a total assets turnover ratio of 2.6 times. Its
peer group also has a ROE of 23.1 percent, but has outperformed Carter with a profit
25
margin of 5.3 percent and a total assets turnover ratio of 3.0 times. Explain how Carter
managed to achieve the same level of profitability as reflected by the ROE.
Solution:
Carter Inc: ROE = 23.1%, PM = 4.9%, TATO = 2.6x
1274.0
6.2049.0
TATO
PMROA
=
×=
×=
times 81.1
1274.0
231.0
EM
EMROA231.0ROE
==
×==
Peer Group: ROE = 23.1%, PM = 5.3%, TATO = 3 times
times45.1
3053.0
231.0
EM
EMTATOPM231.0ROE
=
×
=
××==
Carter matched its peer group’s ROE by using a higher degree of financial leverage as
indicated by its higher equity multiplier.
4.25 DuPont equation: Grossman Enterprises has an equity multiplier of 2.6 times, total
assets of $2,312,000, a ROE of 14.8 percent, and a total assets turnover of 2.8 times.
Calculate the firm’s sales and ROA.
26
Solution:
EM = 2.6x, TA = $2,312,000, ROE = 14.8%, TATO = 2.8x
$6,473,600=×=
=
=
000,312,2$8.2Sales
000,312,2$
Sales
8.2
assets Total
Sales
turnoverassets Total
231,889$
6.2
000,312,2$
Equity
Equity
000,312,2$
6.2
Equity
assets Total
EM
==
=
=
606,131$
231,889$148.0
EquityROENI
Equity
NI
ROE
=
×
=
×=
=
5.7%=== 000,312,2$
606,131$
assets Total
NI
ROA
27
Sample Test Problems
4.1 Morgan Sports Equipment Company has accounts payable of $1,221,669, cash of
$677,423, inventory of $2,312,478, accounts receivable of $845,113, and net working
capital of $2,297,945. What are the company’s current ratio and quick ratio?
Solution:
Current assets = $677,423 + $2,312,478 + $845,113 = $3,835,014
Net working capital = Current assets – Current liabilities
Current liabilities = Current assets – Net working capital
= $3,835,014 – $2,297,945 = $1,537,069
50.
069,537,1$
014,835,3$
sliabilitieCurrent
assetsCurrent
ratioCurrent
2=
==
0.99=
−
=
=
069,537,1$
478,312,2$014,835,3$ sliabilitieCurrent
Inventory - assetsCurrent
ratioQuick
4.2 Southwest Airlines, Inc., has total operating revenues of $6.53 million on total assets of
$11.337 million. Their property, plant, and equipment, including their ground equipment
and other assets, are listed at a historical cost of $11.921 million, while the accumulated
depreciation and amortization amount to $3.198 million. What are the airline’s total asset
turnover and fixed asset turnover ratios?
28
Solution:
Total assets = $11,337,000
Fixed assets = $11,921,000
Accumulated depreciation = $3,198,000
Net fixed assets = $11,921,000 – $3,198,000 = $8,723,000
Sales or operating revenues = $6,530,000
times 0.58=
== 337000,11$
000,530,6$
assets Total
Sales
ratio turnover assets Total
times 0 75.
000,723,8$
000,530,6$
assets Fixed
ratio turnover assets Fixed
=
== Sales
4.3 Haugen Enterprises has an equity multiplier of 2.5. What is the firm’s debt ratio?
Solution:
60% 0.60 0.4 - 1 ratio Debt
4.0
5.2
1
ratio Debt1
assets Debt/Total1
1
5.2
assets Total/Equity
1
Equity
assets Total
tiplierEquity Mul
===
==−
−
=
==
29
4.4 Centennial Chemical Corp. has a gross profit margin of 31.4 percent on revenues of
$13,144,680 and EBIT of $2,586,150. What are the company’s cost of goods sold and
operating profit margin?
Solution:
Revenues = $13,144,680
EBIT = $2,586,150
Gross profit margin = 31.4%
.48$9,017,250=
∗−=
−
=
=
)680,144,13314.0(680,144,13sold goods of Cost
13,144,680
sold goods of Cost680,144,13
314.0
Sales
sold goods ofCost -Sales
marginprofit Gross
19.7%=== 680,144,13$
150,586,2$
salesNet
EBIT
marginprofit Operating
4.5 National City Bank has 646,749,650 shares of common stock outstanding, and they are
currently priced at $37.55. If its net income is $2,780,955,000, what are its earnings per
share and price-earnings ratio?
Solution:
30
times 8.73
$4.30
==
=
==
=
30.4$
55.37$ EPS
price Share
ratio earnings- Price
650,749,
646
000,955,780,2$
goutstandin Shares
incomeNet
shareper Earnings
