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CHAPTER
4
Evaluation of Firm Performance
This chapter deals with financial ratio analyzing
using information contained in financial
statements. Financial ratios enable interested
parties to take the information contained in
financial statements and make relative
comparisons of firm performance over time and
also compare performance across different firms.
Financial ratios are statistical yardsticks that
relate two numbers generally taken from a firm’s
income statements and balance sheets. Financial
ratios fall into five categories: liquidity ratios,
asset management ratios, profitability ratios, and
market-based ratios.
Trend analysis introduces the element of time
into financial ratio analysis. It gives the analyst a
more dynamic view of the company’s situation
than a pure comparative financial ratio analysis
alone.
The relationship of the return on investment
(ROI) to margin and turnover can be used to
determine if one or both of the two is deficient in
contributing to the profitability of the firm.
Common-sized financial statements, which
express financial items in percentages, are
helpful in detecting and monitoring financial
trends.
To gain further insight into the relative financial
position of a firm, the analyst must compare the
financial ratios with industry averages. The more
diversified the firm, the more difficult it will be
to make such a comparison.
The Economic Value Added is a measure of
performance that compares the dollar return
generated by the firm to the return expected by
the investors in the various sources of capital
utilized by the firm.
Chapter Outline
I.
II.
Financial ratio analysis is used to measure the relative performance and creditworthiness of a
business entity. Some specific uses for ratio analysis include:
A.
Ratios are used as an analytical tool to assist management in identifying strengths and
weaknesses in the firm.
B.
Ratios are used as a monitoring device that may uncover problems in the firm’s
operations.
C.
Ratios are used internally by management for planning and for evaluating performance.
Financial ratios allow management to translate goals into operational objectives.
Successful financial ratio analysis requires that an analyst keep in mind the following points:
A.
Any discussion of financial ratios is likely to include only a representative sample of
49
50
III.
Contemporary Financial Management Fundamentals
B.
possible ratios
Financial ratios serve only as “flags” indicating potential areas of strength or weakness.
C.
Frequently a financial ratio must be dissected to discover its true meaning.
D.
A financial ratio is meaningful only when it is compared with some standard, such as an
industry ratio trend, a ratio trend for the specific firm being analyzed, or a stated
management objective.
E.
When financial ratios are used to compare one firm with another, it is important to
remember that differences in accounting techniques may result in substantial differences
in financial ratios.
A financial ratio is a relationship that indicates something about a firm's activities, such as the
ratio between the firm's current assets and current liabilities or between its accounts receivable and
annual sales. Financial ratios are frequently grouped into six types of ratios.
A.
Liquidity ratios indicate the ability of the firm to meet short-term financial obligations.
B.
Asset management ratios indicate how efficiently the firm is utilizing its resources.
C.
Financial leverage management ratios indicate the firm's capacity to meet its debt
obligations, both short-term and long-term.
D.
Profitability ratios measure the total effectiveness of management in generating profits on
sales, assets, and owners' investment.
E.
Market-based ratios measure the financial market's assessment of a company's
performance.
F.
The effective use of financial ratio analysis requires some experience and effort. There are
some basic approaches to financial ratio analysis, some basic interrelationships among
ratios, and sources of information that can enhance the analyst’s effectiveness. Two
common types of ratio analysis are, comparative and trend analysis.
1. Comparative analysis—The analyst compares the ratios of the firm to the industry
norms or other individual firms in the industry.
2. Trend analysis—This requires the analyst to examine the ratios of a firm for several
periods. This shows whether the firm’s financial condition is improving or
deteriorating over time.
IV.
The data for constructing ratios generally comes from a firm's balance sheet, income statement,
and statement of cash flows.
A.
Liquidity ratios:
Chapter 4/Evaluation of Firm Performance
Current ratio =
Quick (Acid test) ratio =
51
Current assets
Current liabilities
Current assets - Inventories
Current liabilities
The quick ratio can also be adjusted downward by removing accounts receivable over 90
days old from the numerator of the quick ratio.
B.
Asset Management Ratios:
Average collection period =
Inventory turnover =
Accounts receivable
Annual credit sales/365
Cost of sales
Average inventory
Fixed - asset turnover =
Sales
Net fixed assets
Total asset turnover =
C.
Sales
Total assets
Financial Leverage Management Ratios:
Debt ratio =
Total debt
Total assets
Debt - to - equity ratio =
Total debt
Total equity
Times interest earned =
Earnings before interest and taxes (EBIT)
Interest charges
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Contemporary Financial Management Fundamentals
Fixed charge coverage =
EBIT + Lease payments
Preferred dividends Before tax
Interest + Lease payments +
+
before tax
sinking fund
D.
Profitability Ratios:
Gross profit margin =
Net profit margin =
Sales - Cost of sales
Sales
Earnings after taxes (EAT)
Sales
Return on investment (ROI) =
Earnings after taxes (EAT)
Total assets
Return on stockholders equity =
E.
Market-Based Ratios
Market to book Ratio = P/B =
Market price per share
Book value per share
Price to earnings ratio = P/E =
F.
Earnings after taxes (EAT)
Stockholders equity
Market price per share
Current earnings per share
Market-to-Book Value or Pierce-to-Book Value (P/BV) Ratio:
Ma rket price per sh are
P / BV =
Bo ok va lue per sh are
V.
Analysis of profitability
A.
Return on Investment = Net Profit Margin x Total Asset Turnover.
ROI =
EAT
Sales
EAT

=
Sales Total assets
Total assets
Chapter 4/Evaluation of Firm Performance
53
B.
Dupont analysis—Dupont charts, such as the one in the textbook, present the major ratios
in a logical, organized fashion. This Dupont chart provides a good starting point for
analyzing the firm. For example, suppose a firm's return on stockholders' equity is
considered low. Is this because of a low ROI or a low equity multiplier (or both)? If the
ROI is too low, is this due to a low net profit margin or low total asset turnover (or both)?
If the net profit margin is low, which expenses are out of line?
C.
Return on Stockholders' Equity = Return on Investment x Equity Multiplier. (The equity
multiplier is the ratio of assets to equity).
Return on
stockholde rs =
equity
EAT
Sales

Sales
Total assets
x
Total assets
Stockholders
equity
Return on
stockholde rs =
Net profit Total asset Equity


margin
turnover multiplier
equity
D.
Computerized databases are available to assist in financial statement analysis. Standard
and Poors provides the Research Insight database, which contains balance sheet, income
statement, stock price and dividend information. Value Line provides financial
information on a large number of firms. Additional financial data may be access via the
Internet.
1.
2.
3.
4.
V.
www.yahoo.com
www.altavista.com
www.google.com
www.lycos.com
Even though ratios can provide valuable information, they can be misleading for a number of
reasons.
A.
Ratios are only as reliable as the accounting data on which they are based.
B.
Industry “average” ratios may not be very meaningful if there is significant dispersion in
the ratio for the industry.
C.
Industry classifications may be defined too broadly to make reliable comparative analysis
between a firm and a particular industry average.
D.
Financial ratios provide a historical assessment of performance, which may or may not be
a useful basis for making future projections.
54
Contemporary Financial Management Fundamentals
E.
VI.
A comparison of a firm’s ratios with industry norms provides a relative measure of
performance, not an absolute measure. For example, a firm’s profitability ratios may be
relatively better than its industry average, but on an absolute basis it may be poor
compared to the universe of firms.
A recent innovation in performance measurement is the economic value added.
A.
Economic Value Added (EVA) is a measure of operating performance that indicates how
successful the firm has been at increasing its MVA in a given year. EVA is defined as:
EVA = (EBIT)(I - T) - K  InvestedCapital
where
k = average cost of capital,
invested capital = amount of invested capital at the beginning of the year.
VII.
B.
A positive EVA signifies that management has generated earnings over and above what
the capital holders require.
C.
MVA is a cumulative measure of EVA since the invention of the firm.
Common-size statements are also helpful in financial analysis.
A.
A common-size balance sheet shows the firm’s assets and liabilities as a percentage of
total assets (rather than as dollar amounts).
B. A common-size income statement shows the firm’s income and expense items as a percentage
of net sales (rather than as dollar amounts).
VIII.
Sources of comparative financial data—The most popular sources of financial information for
business and industries are:
A.
Industry Norms and Key Business Ratios published by Dun and Bradstreet (D&B)
B.
Risk Management Association (RMA)
C.
Reports of the Federal Trade Commission (FTC) and the Securities and Exchange
Commission (SEC)
D.
Prentice-Hall’s Almanac of Business and Industrial Financial Ratios
E.
Financial Studies of Small Business from Financial Research Associates
F.
Moody’s or Standard and Poor’s Industrial, Financial, Transportation, and Over-theCounter manuals.
G.
Annual reports and 10K’s from corporations
H.
Trade associations and trade journals
Chapter 4/Evaluation of Firm Performance
I.
IX.
55
Publications of some commercial banks
Even though ratios can provide valuable information, they can be misleading for a number of
reasons.
A.
Ratios are only as reliable as the accounting data on which they are based.
B.
Industry “average” ratios may not be very meaningful if there is significant dispersion in
the ratio for the industry.
Industry classifications may be defined too broadly to make reliable comparative analysis
between a firm and a particular industry average.
C.
D.
Financial ratios provide a historical assessment of performance, which may or may not be
a useful basis for making future projections.
E.
A comparison of a firm’s ratios with industry norms provides a relative measure of
performance, not an absolute measure. Fore example, a firm’s profitability ratios may be
relatively better than its industry average, but on an absolute basis it may be poor
compared to the universe of firms.
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Contemporary Financial Management Fundamentals
Chapter Formulas:
1.
Liquidity ratios:
Current ratio =
Current assets
Current liabilities
Quick (Acid test) ratio =
2.
Asset Management Ratios:
Average collection period =
Inventory turnover =
Accounts receivable
Annual credit sales/365
Cost of sales
Average inventory
Fixed - asset turnover =
Total asset turnover =
3.
Current assets - Inventories
Current liabilities
Sales
Net fixed assets
Sales
Total assets
Financial Leverage Management Ratios:
Debt ratio =
Total debt
Total assets
Debt - to - equity ratio =
Total debt
Total equity
Times interest earned =
Earnings before interest and taxes (EBIT)
Interest charges
Fixed charge coverage =
EBIT + Lease payments
Preferred dividends Before tax
Interest + Lease payments +
+
before tax
sinking fund
Chapter 4/Evaluation of Firm Performance
Chapter Formulas:
4.
Profitability Ratios:
Gross profit margin =
Net profit margin =
Sales - Cost of sales
Sales
Earnings after taxes (EAT)
Sales
Return on investment (ROI) =
Earnings after taxes (EAT)
Total assets
Return on stockholders equity =
5.
Market-Based Ratios:
Market to book Ratio = P/B =
Market price per share
Book value per share
Price to earnings ratio = P/E =
6.
Market price per share
Book value per share
Return on Investment = Net Profit Margin x Total Asset Turnover:
ROI =
8.
Market price per share
Current earnings per share
Market-to-Book Value or Pierce-to-Book Value (PTBV) Ratio:
PIBV =
7.
Earnings after taxes (EAT)
Stockholders equity
EAT
Sales
EAT

=
Sales Total assets
Total assets
Economic Value Added (EVA):
EVA = (EBIT)(I - T) - K  InvestedCapital
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Contemporary Financial Management Fundamentals
True And False Questions
Agree with each of the statements or reject it and modify it so that it is acceptable.
1.
The current ratio will never exceed the quick ratio.
2.
Assuming a current ratio greater than one, the purchase of raw materials on credit decreases the
current ratio.
3.
The gross profit margin is greater than the net profit margin.
4.
The average collection period is found by dividing a firm's year-end accounts receivable by its
average daily credit sales.
5.
Because total assets exceed net fixed assets, the total asset turnover must exceed the fixed asset
turnover.
6.
A short average collection period is a sign of efficient accounts receivable management.
7.
The return on total equity equals the net profit margin times the total asset turnover.
8.
Free cash flow often is viewed as a better measure than earnings of the financial soundness of the
firm.
9.
The book value per share of common stock is determined by dividing the total common
stockholders’ equity for a firm by the number of shares outstanding.
10.
Firms with a current ratio below 2.0 are having liquidity problems.
11.
The basic rational for historical cost is that it is a measure of current value.
12.
Revenues increase net worth, while expenses decrease net worth.
13.
Leverage rations measure how efficiently the firm is employing its resources.
14.
No external sources of information are required to do a trend analysis.
15.
A firm’s ROI examines profit margin as it plays a major role in contributing to profitability.
Multiple Choice Questions
1.
______________ ratios measure the total effectiveness of management in generating profits on
sales, assets, and owners’ investment.
A.
Liquidity
B.
Asset management
C.
Financial leverage management
D.
Profitability
Chapter 4/Evaluation of Firm Performance
2.
59
E.
Market-based ratios
A common-size balance sheet shows a firm’s assets and liabilities, and shareholders’ equity as a
percentage of
A.
total sales.
B.
net income.
C.
total shareholders’ equity.
D.
total assets.
E.
total liabilities.
3.
In comparative analysis, the financial analyst compares the ratios of the firm
A.
for several reporting periods.
B.
to industry norms or other firms in the industry.
C.
to the firm’s ratios under ideal operating conditions.
D.
to the industry leader’s ratios.
E.
to governmental standards of acceptable accounting performance.
4.
To assess the ability of the firm to meet current financial obligations, a potential lender would most
likely be most concerned with the firm’s
A.
payout ratio.
B.
price-to-earnings ratio.
C.
average collection period.
D.
fixed charge coverage ratio.
E.
total asset turnover.
5.
If a firm’s net profit margin declines and the CEO wants to maintain the return on shareholder
equity, he must
A.
increase the firm’s utilization of assets.
B.
reduce the amount of debt in the firm’s capital structure.
C.
increase the firm’s total sales.
D.
increase the firm’s total shareholder equity.
E.
increase the firm’s average collection period.
6.
Financial ratios are used by management for ________________.
A.
analysis.
B.
analysis and monitoring.
C.
monitoring and planning.
D.
analysis, monitoring, and planning.
7.
_______________ is a measure of operating performance that indicates how successful the firm
has been at increasing its MVA in a given year.
A.
Economic value added (EVA)
B.
After-tax cash flow (ATCF)
C.
Earnings after taxes (EAT)
D.
Market value added (MVA)
E.
Earnings before interest and taxes (EBIT)
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Contemporary Financial Management Fundamentals
8.
Which of the following utilize financial ratio analysis?.
A.
credit managers
B.
unions
C.
security analysts
D.
bankers
E.
all of the above
9.
Which of the following is not an asset management ratio?
A.
average collection period
B.
inventory turnover ratio
C.
sales-to-inventory ratio
D.
fixed-asset turnover ratio
E.
total asset turnover ratio
10.
In general, the lower a firm’s risk, the higher its _______ ratio should be.
A.
market-to-book ratio
B.
average collection period
C.
PIE ratio
D.
debt ratio
E.
price to book ratio
11.
What are the primary sources of historical financial information about the firm?
A.
balance sheet
B.
income statement
C.
income statement and balance sheet
D.
sources and uses of funds
12. A ________ liability is one that arises automatically when a firm buys goods and services to produce
its product.
A.
spontaneous
B.
funded
C.
current
D.
long-term
13.
What is not included in a firm’s expenses?
A.
costs of goods sold
B.
depreciation
C.
interest expense
D.
dividends
14.
ROI can be viewed as a function of the net profit margin times
A.
sales.
B.
EAT.
C.
the total asset turnover.
D.
equity multiplier.
Chapter 4/Evaluation of Firm Performance
61
15.
If a significant portion of the assets of a firm has a market value ________ book value, the quality
of the firm’s balance sheet is reduced.
A.
equal to
B.
substantially below
C.
substantially above
D.
none of the above
16.
Profitability ratios measure how effectively a firm’s management is generating profits on _____.
A.
sales
B.
sales & total assets
C.
total assets and stockholders’ investment
D.
sales and stockholders’ investment
E.
sales, total assets, and stockholders’ investment
17.
Which of the following is not a profitability ratio?
A.
profitability ratio
B.
net profit margin ratio
C.
times interest earned ratio
D
return on investment ratio
E.
return on stockholders’ equity ratio
18.
The ratio of EBIT to total assets measures the ________ in a firm.
A.
stockholders’ equity rate of return
B.
operating profit rate of return
C.
profitability before considering the effects of financing decisions
D.
profitability after the cost of sales
E.
all of the above
19.
The gross profit margin ratio measures the ________ in a firm.
A.
stockholders’ equity rate of return
B.
operating profit rate of return
C.
profitability before considering the effects of financing decisions
D.
profitability after the cost of sales
E.
all of the above
20.
The ________ ratio analysis and the ________ analysis in combination provide the financial
analyst with a fairly clear picture of a firm’s performance.
A.
market-based; profitability
B.
liquidity; asset management
C.
financial leverage management; market-based
D.
liquidity; profitability
E.
comparative financial; trend
21.
Which of the following variable does ROI examine?
A.
EAT
B.
sales
C.
total assets
D.
all of the above
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Contemporary Financial Management Fundamentals
22.
Which of the following variable does return on stockholders’ equity examine?
A.
EAT, sales, EBIT, and total assets
B.
EAT, EBIT, total assets, and stockholders’ equity
C.
EBIT, total assets, sales, and stockholders’ equity
D.
EAT, sales, total assets, and stockholders’ equity
E.
EAT, total assets, total debt, and net fixed assets
23.
The ________ compares the dollar return generated by the firm to the return expected by the
investors of the capital invested by them in the firm.
A.
EBIT
B.
EVA
C.
ROI
D.
DuPont chart
E.
ROE
24.
_________ prepares a series of fourteen key business ratios for 800 different lines of businesses
based on SIC codes.
A.
RMA
B.
Dun and Bradstreet
C.
10K reports
D.
Quarterly Financial Reports for Manufacturing Companies
E.
Almanac of Business and Financial ratios
25.
__________ uses information from loan applications to compile sixteen ratios for over 250 lines
of business based on SIC codes.
A.
RMA
B.
Dun and Bradstreet
C.
10K reports
D.
Quarterly Financial Reports for Manufacturing Companies
E.
Almanac of Business and Financial ratios
Problems
1.
Please supply the missing figures:
(NPM)
Net Profit
Margin
(TAT)
Total Asset
Turnover
a.
20.0%
0.75
b.
____
2.00
c.
2.5%
d.
6.0%
(ROI)
Return on
Investment
____
Return on
Equity Stockholders'
Multiplier
Equity
1.00
____
8.0%
1.50
____
4.00
____
____
25.0%
____
9.0%
____
14.4%
Chapter 4/Evaluation of Firm Performance
2.
63
Find the sales of the Franklin Company using the following information:
Current ratio
Quick ratio
Current liabilities
Inventory turnover
Gross profit margin
2.0
1.6
$200,000
8.0
10%
3.
Minor Motors has a net profit margin of 3 percent, a total asset turnover of 2.2, and an equity
multiplier of 2.5. What is Minor's return on investment and return on stockholders' equity?
4.
Tom Putnam forecasts sales of $4,000,000 for his firm next year. If the firm maintains its average
collection period at 40 days and its inventory turnover at 8, what should be the firm's receivables
and inventory levels? The gross profit margin is 22 percent.
64
Contemporary Financial Management Fundamentals
5.
Joyce Tilleman is planning for a small distributing firm she will operate after graduation. Her best
guesses about several relevant financial variables are:
Sales
Gross profit margin
Average collection period (365 day year)
Inventory turnover
Minimum cash balance
Investment in fixtures and equipment
Long-term bank loan
Current ratio
All other required assets are to be leased
All sales are credit sales
$100,000
40%
97 days
4.0
$5,000
$10,000
$15,000
2.76
Complete the following pro forma balance sheet and indicate how much equity capital Joyce
must invest in her firm.
BALANCE SHEET
Cash
Accounts receivable
Inventory
TOTAL CURRENT
ASSETS
Long-term assets
TOTAL ASSETS
$
$
$_______
$
$_______
$
Accounts payable
Bank loan
$
$_______
TOTAL LIABILITIES
Stockholders' equity
TOTAL LIABILITIES
& EQUITY
$
$_______
$
Chapter 4/Evaluation of Firm Performance
6.
65
From the financial statements of the Jackson Products Company, please provide a common-size
balance sheet and common-size income statement.
JACKSON PRODUCTS COMPANY
Balance Sheet
December 31, 20X5
Cash and securities
Accounts receivable
Inventory
$ 240,000
320,000
1,040,000
Total current assets
$1,600,000
Net plant & equipment
800,000
Total assets
$ 2,400,000
Accounts payable
Notes payable
Other current
liabilities
Total current
liabilities
L-T debt (10%)
Common stock
Retained earnings
Total liabilities
and equity
$ 380,000
420,000
50,000
$ 850,000
$ 800,000
400,000
350,000
$ 2,400,000
INCOME STATEMENT
for the Year Ended December 31, 20X5
Net sales (all on credit)
Cost of sales
Gross profit
Selling, general, and administrative expenses
Earnings before interest and taxes
Interest:
Notes
$ 37,800
Long-term debt
80,000
Total interest charges
Earnings before tax
Federal income tax (40%)
Earnings after tax
$ 3,000,000
1,800,000
$ 1,200,000
860,000
$ 340,000
117,800
$ 222,200
88,880
$ 133,320
66
Contemporary Financial Management Fundamentals
The following data apply to problems 7 – 11.
Rich Corporation
Balance Sheet ($000)
12/31/05 and 12/31/06
2005
ASSETS
Cash
200
Accounts Receivable
310
Inventories
1,200
Total Current Assets
1,710
Plant and Equipment
900
Accumulated Depreciation
150
Net Fixed Assets
750
Total Assets
2,460
LIABILITIES AND STOCKHOLDER’S EQUITY
Accounts Payable
390
Notes Payable (8%)
340
Accruals
50
Total Current Liabilities
780
Long-Term Debt (9%)
900
Common Stock 10,000 Shares
200
Retained Earnings
580
Total Liabilities and Stockholders’ Equity
2,460
Sales
COGS
Gross Profit
Selling and Administrative Expenses
Interest Expense
Depreciation
EBT
Tax @ 40%
EAT
Market Price of Common Stock
EPS
7.
Rich Corporation
Income Statement ($000)
2005 and 2006
2005
2,700.00
1,620.00
1,080.00
774.00
108.20
40.00
157.80
63.12
94.68
94.70
9.47
Calculate the net worth of Rich Corporation.
2006
240.0
440.8
1,250.0
1,930.8
1,000.0
200.0
800.0
2730.8
400.0
400.0
50.0
850.0
1,000.0
200.0
680.8
2,730.8
2006
3,000.00
1,800.00
1,200.00
860.00
122.00
50.00
168.00
67.20
100.80
100.80
10.08
Chapter 4/Evaluation of Firm Performance
8.
What did Rich Corporation spend to increase plant and equipment in (2006)?
9.
If Rich Corporation has a cost of capital of 12%, what is the EVA for 2005?
10.
Calculate the key financial ratios for Rich Corporation (2005 and 2006).
67
68
Contemporary Financial Management Fundamentals
11.
Given the following industrial norms, what are Rich Corporation’s strengths and weaknesses?
Industrial Average
Liquidity:
Current Ratio
Acid Test Ratio
Activity:
Average Collection Period
Inventory Turnover
Fixed Asset Turnover
Total Asset Turnover
Leverage:
Debt Ratio
Times Interested Earned
Times Fixed Charges Earned
Profitability:
Debt-to-Equity Ratio
Net Margin
Return on Investment
Return on Equity
Earnings Per Share
Market-Based:
Price-to-Earnings Ratio
Market-to-Book Ratio
2.5
1.0
35
2.5
1.4
1.5
0.6
4.0
4.0
200%
4.0%
4.5%
17%
$12.00
12
1.5
Internet Exercises
The P/E ratio and dividend payout for the S&P 500 Index can be found at this Web site. Write a one-page
paper discussion your findings.
http://cpcug.org/user/invest/pepayout.html
The Value Point Analysis Model at this Web site gives you insight into evaluating a stocks risk with the
P/E ratio. Once you are at this Web site chick on VPA and do an analysis. Be prepared to discuss your
analysis in class.
http://www.eduvest.com/vparisk.html
The Motley Fool examines the importance of combining the P/E ratio with a company’s growth rate.
Check out this Web site and be ready to comment on the “Fool Ratio” examined here.
http://www.fool.com
Chapter 4/Evaluation of Firm Performance
69
Answers
True and False Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
The current ratio exceeds the quick ratio for all firms with an inventory.
True.
True.
True.
Because total assets exceed net fixed assets, the total asset turnover must be less than the fixed
asset turnover.
A short average collection period is not necessarily a sign of efficient accounts receivable
management. It could also result from overly strict credit terms that can reduce the firm's sales and
profitability.
The return on total assets equals the net profit margin times the total asset turnover.
True.
True.
The appropriate current ratio for a given firm can be substantially above or below 2.0 depending
on the industry and circumstances relevant to the specific firm.
Historical cost is not a measure of current value.
True.
Leverage ratios measure the degree to which a company is employing financial leverage.
True.
Margin and turnover both play a major role in contributing to profitability.
Multiple Choice Questions
1.
2.
3.
4.
5.
D
D
B
D
A
6.
7.
8.
9.
10.
D
A
E
C
C
11.
12.
13.
14.
15.
C
A
D
C
B
16.
17.
18.
19.
20.
E
C
B
D
E
21.
22.
23.
24.
25.
D
D
B
B
A
Problem Solutions
1.
a.
ROI = NPM x TAT = 20.0%(.75) = 15.0%
Return on Equity = ROI x Equity Multiplier = 15.0%(1.00) = 15.0%
b.
NPM = ROI/TAT = 8.0%/2.00 = 4%
Return on Equity = ROI x Equity Multiplier = 8%(1.5) = 12.0%
c.
ROI = NPM x TAT = 2.5%(4.00) = 10%
Equity Multiplier = Return on Equity/ROI =25%/10% = 2.50
d.
TAT = ROI/NPM = 9%/6% = 1.50
Equity Multiplier = Return on Equity/ROI = 14.4%/9% = 1.60
70
Contemporary Financial Management Fundamentals
2.
Current assets = 2.0(200,000) = $400,000
Current assets minus inventory = 1.6(200,000) = $320,000
Inventory = 400,000 - 320,000 = $80,000
Inventory Turnover = Sales / Inventory = 8.0 = sales/$80,000
Sales = $640,000
3.
Return on investment = Net profit margin x Total asset turnover
Return on investment = 3% x 2.2 = 6.6%
Return on stockholders' equity = Return on investment x Equity multiplier
Return on stockholders' equity = 6.6 % x 2.5 = 16.5%
4.
Accounts receivable = (40/365) 4,000,000 = $444,444
Cost of sales = (100%-gross profit margin) Sales
Cost of sales = 78% (4,000,000) = $3,120,000
Inventory = $3,120,000/8 = $390,000
5.
Cash = $5,000
Long-term assets = $10,000
Bank loan = $15,000
Accounts receivable = 100,000(97/365) = $26,575
Cost of sales = (100% - 40%)sales = (60%)100,000 = $60,000
Inventory = 60,000/4.0 = $15,000
Total current assets = 5,000 + 26,575 + 15,000 = $46,575
Total assets = 46,575 + 10,000 = $56,575
Current assets/current liabilities = 2.76
Accounts payable = current assets/2.76 = 46,575/2.76 = $16,875
Total liabilities = 16,875 + 15,000 = $31,875
Stockholders' equity = total assets - total liabilities = 56,575 - 31,875 = $24,700
BALANCE SHEET
Cash
Accounts receivable
Inventory
TOTAL
CURRENT ASSETS
Long-term assets
TOTAL
ASSETS
$ 5,000
26,575
15,000
$ 46,575
10,000
$ 56,575
Accounts payable
Bank loan
TOTAL
LIABILITIES
Stockholders' equity
TOTAL LIABILITIES
& EQUITY
Joyce must invest $24,700 of equity capital in her business.
$ 16,875
15,000
$ 31,875
24,700
$ 56,575
Chapter 4/Evaluation of Firm Performance
6.
JACKSON PRODUCTS COMPANY
Common-Size Balance Sheet
December 31, 20X5
Cash and Securities
Accounts Receivable
Inventory
Total current assets
Net plant and
equipment
Total assets
10.00%
13.33
43.33
66.67
33.33
100.00%
Accounts payable
Notes payable
Other current liabilities
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and
stockholders' equity
15.83%
17.50
2.08
35.42%
33.33
16.67
14.58
100.00%
JACKSON PRODUCTS COMPANY
Common-Size Income Statement
Net sales
Cost of sales
Gross profit
Selling, general, and administration expenses
Earnings before interest and taxes
Total interest charges
Earnings before tax
Federal income tax
Earnings after tax
7.
Net Worth = Total Assets – Total Liabilities
2005 $780 = $2,460 – $1680
2006 $880.0 = $2,730.8 – $1,850
8.
Increase in plant and equipment 2006 ($000):
Change in net fixed assets + depreciation 2006
(800 – 750) + (200 – 150) = $100
9.
EVA = (EBIT)(I - T) - K  InvestedCapital
= 266.0 (1-.40) - .12 x 295.20
= 148.13 in ($000)
= $148,130
100.00%
60.00
40.00%
28.67
11.33%
3.93
7.40%
2.96
4.44%
71
72
Contemporary Financial Management Fundamentals
10.
Key financial ratios:
Liquidity:
Current Ratio
Acid Test Ratio
Activity:
Average Collection Period
Inventory Turnover
Fixed Asset Turnover
Total Asset Turnover
Leverage:
Debt Ratio
Debt-to-Equity Ratio
Times Interested Earned
Times Fixed Charges Earned
Profitability:
Gross Profit Margin
Net Margin
Return on Investments
Return on Equity
Market-Based:
Price-to-Earnings ratio
11.
Industrial Average
2005
2006
2.5
1.0
2.19
0.65
2.27
0.80
35
2.5
1.4
1.5
41.3
1.35
3.60
1.10
52.9
1.44
3.75
1.10
0.6
200%
4.0
4.0
0.683
215.4%
2.46
2.46
0.677
210.0%
2.38
2.38
40%
4.0%
4.5%
17%
40%
3.5%
3.85%
12.1%
42%
3.36%
3.69%
11.4%
12
10
10
Most ratios are weak.
a. The current ration and acid test ratio are weak but moving towards the industrial average.
Investors like companies moving towards the industrial average and dislike companies moving
away from the average.
b. The debt ratio is close and moving closer to the industrial average.
c. Gross margin is equal to the industrial average.
d. Earnings per share are increasing and moving towards the industrial average.
e. P/E ratio is below the industry average, which is reflected in the lower ROI and ROE then the
industry average.
f. Market-to-book value is below average.