meaning, The identical principles and calculations apply to compa nies of any size—very small businesses as well as larger companies. MAPAX Manufacturing Corp. manufactures two product lines, stoves and furnaces, both sold to the residential and commercial mar. kets, The company also stocks a variety of resale accessories, some of which must be slightly modified to meet customer specifications, The stove and furnace business is a stable but growing industry. Although susceptible to both economic and industry cycles, its historical swings have been shallow, seldom more than 5 percent in either direction, FIGURES 311 and 3.2 show MAPAXS balance sheets and income statements (respectively) for the years Year 1, Year 2, and Year 3. FIGURE3.1_ MAPAX Manufacturing Corp. Balance Sheet As of December 31, Year 1, Year 2, Year 3 (in dollars) Cash 622,852 ‘Accounts receivable 1,364,344 | 1.392.188| 1.406.250 inventory 2,721,250 | 3.125.000 | 3,696,263 Propaid expenses 5,000 5.000 5,000 Total curont assets 4713-446 | 4643873] 5.048513 Buildings 2,000,000 2,000,000 Machinery & equipment 6,000,000 8,000,000 Delivery tucks 50,000 50,000, ‘Total ined assets 8,050,000 | 91 10050,000 Less: Accumulated depreciation (2,200,000) _(2.668,000)| (3,200,000) Net fixed assets §,850,000 | 6,482,000 | 6,850,000 Other assats 100,000 | 100,000 100,000 Total Assets 10.665.406) 11.225,678| 11908519 Bank nate payable 500,000 | 250,000 200,000 ‘Accounts payable 500.140 [666.559 775.814 ‘Accrued expenses 200,000,| 200.000 200,000 Other current liabilities 50,000 50,000) 80,000, Total current liabilities 1,300.440 [7.166.650] 7.228.614 Long-term debt 4,400,000} 4,200,000| 4,000,000 Mortgage loan 1,150,000 | 7.075.000 1,000,000 Total Liabilities 6,980,440 6441559 / 6,225,614 Common stock 100,000 100,000 100,000 Retained earings—beginning 270119 | 3,683,006 | 4684,320 Profits) 981,567 [1.001313 968,579 Aetained earnings—ending 3,683,008 | 4684320| 6.672.899 ‘Total Net Worth 3,783,008 | 4,784,320] 6,772,890 ‘Total Liabilities and Net Worth 10,663,448 | 11,225.79 11,990,613, en as rvmnyenny rmancra! Statements NGURE 3.2 MAPAX Manufacturing Corp. Statement of Income For the Years Ended December 31, Year 1, Year 2, Year 3(in dollars) 10914750 11137500 11,250,009 5.588.952 5702400 5,760,009 849430866785 B75. 579 Overhead 70373 708877 _747347 Total cost of sales 710960 7294081 7382-967 Gross profit 377379 3903409 apse Porcent of sales 346% 5% 34.4% Operating expenses Seling expenses 584768 $9672 608.909 ‘Administrative expense 520297 530.915.541.759 Other expenses 20,000 20,000 20,000 Depreciation 468,000 32000 _s85.009 Total operating expenses 1593084 1679837 755,659 NNetincome before interest andtaxes 2180705 2.163.772 211,48 Percent of sales 200% 19.4% 18.8% Interest 548,750 517,000 [Net income before taxes 1618022 1,594,493 Taxes 613708 605.904 Netincome 1001313“ 988.57g Percent of sales 90% 88% Profitability Ratios Profitability ratios indicate a company’s ability to earn a satisfac. tory return on sales, total assets, and invested capital. Of course, you must define “satisfactory” to meet your objectives, Every company ig different, and it would be wrong to assume that a company that earns a 10 percent return on sales is outperforming one thal earns a 5 per. cent return, or that a company with an 80 percent gross profit rar. gin is run more efficiently than one turning a 30 percent gross profit ‘Comparison with industry standards or with companies of similar size in similar businesses is the only reasonable way to interpret the values derived from profitability ratios. Ed‘Two profitability ratios common company’s earnings potential are ly used to measure the trend of, 3 Gross profit margin as.a percent of sales Net income as a percent of sales These ratios can normall i « ly be read direct! ments without additional analysis. Obviously cate improvements in operating expense cont reverse condition indicate: Percent and 9 percent, respectively percent, ly, are very respectal turing companies in stable, mature industes Hea a ‘ot so good and indicates that something negative may Le heen '© MAPAX' cost structure or market position: ” Gross profit to sales 345% 345% Netinonersaes “ggg tag be happening Three other fit ler profitability ratios measure the income) a company earns on invested capital aa + Return on owner's equity * Return on investment * Return on total assets In the MAPAX example, these ratios were Return on owners’ equity mono 259% Beuunenivesman idee wasoninwen) fea SS TR Am on investment (unadjusted for taxes on interest) 179% n tur an tl assets (austed or tares on intrest) 120% bi nn mon total asses unadjusted for taxes ninterest) 16.2% 141% 139. Financ ni nancial analysts will probably argue for the next two hundred years about which of thes of 2 rat ye ios yields the most accurate picture of ly from financial state increasing ratios indi- : : ol pricing, product Iso competitive advantage—all pstivesigns wean ee « follows: The arguments ran 1+ Hor returit on owners’ equity: "The only true measure of a company {show much it returns to its owners. '* For return on investment: The true measure of a company is how inuch it returns to all investors, both debt holders and equity investors. * For return on assets: The true measure of a company is the effi- ciency of its management, which can be measured only by the returns generated on assets employed. argument has merit, and which ratio is appropriate in a given situation is related to the capital structure of a company and the purpose of the analysis. ‘Although the return on owners’ equity ratio is straightforward, the return on investment ratios and return on assets ratios war- rant an explanation. The theory behind return on investment is that long-term debt represents as valid an investment as common shares. Therefore, by definition, the term investment as used in these ratios represents the sum of the average outstanding balances of long-term debt and the average stockholder investment. Furthermore, since debt is included in the ratio’s denominator, interest expense must be added back to net income to arrive at the numerator. Arguments pérsist about the merits of adding back inter- est expense adjusted for the tax effect or total interest. The answer can only be a matter of personal choite. The final point to clarify is that practically speaking, only interest on long-term debt should be used. Theoretically, short-term interest should be included; however, since it is virtually impossible to obtain average interest expense for short-term debt, most calculations ignore the minor distortion caused by excluding it. The return on assets ratio, sometimes referred to as the asset utilization ratio or assets employed ratio, uses average total assets as a denominator, on the theory that assets must be employed during the entire period to generate the income for the period. In addition, the same argument over using interest that has or has not been adjusted for the tax effect for the numerator applies here as in the return on investment calculation