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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 52 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. 56 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 57 58 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) 60 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 62 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.