Financial Analysis-Sizing Up Firm Performance: Income Statement 2016 % of Sales Example Calculations

Chapter 4
Financial Analysis—Sizing Up Firm Performance
4-1. To create a common-size income statement for Patterson Printing Company, we need to express the
dollar amounts as proportions of sales. Transforming the dollar amounts into proportions allows us
to compare Patterson’s situation with other firms, even if those other firms have drastically higher
or lower sales than Patterson’s.
Expressing each dollar amount as a percentage of Patterson’s $30,000 in sales, we find:
Income Statement 2016 % of sales example calculations:

Revenues $30,000 100%
Cost of goods sold ($20,000) -67% = ($20,000)/$30,000
Gross profit $10,000 33%
Operating expenses ($8,000) -27%
Net operating income $2,000 7%
Interest expense ($900) -3%
Earnings before taxes $1,100 4%
Taxes ($400) -1%
Net income $700 2% = $700/$30,000
Patterson’s cost of goods sold represents 2/3 of its sales revenue, making it by far the most
important driver of Patterson’s profitability. Operating expenses are still a hefty 27%, however.
To create Patterson’s common-size balance sheet, we will again translate the relevant dollar
amounts by expressing them as proportions of a given whole. However, while we used sales (an
income statement total) as our reference figure for the income statement, here we will use total
assets (a balance sheet total). Thus for Patterson Printing Company, we divide all of the given
values by $33,000, which gives us the following:
78
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Solutions to End-of-Chapter Problems—Chapter 4 79
Balance Sheet 2016 % of TA example calculations:

Cash & Marketable Securities $500 2%
Accounts Receivable $6,000 18%
Inventories $9,500 29% = $9,500/$33,000
Total Current Assets $16,000 48%
Net Property Plant & Equipment $17,000 52% Net Prop
Total Assets $33,000 100%
Accounts Payable $7,200 22%

Short-term Debt $6,800 21%
Total Current Liabilities $14,000 42%
Long-term Liabilities $7,000 21%
Total Liabilities $21,000 64% = $21,000/$33,000
Total Owner's Equity $12,000 36%
Total Liabilities & Owner's Equity $33,000 100%
We will assess these common-size statements in the next problem.
4-2. To assess Patterson Printing Company’s situation, we can evaluate its relative proportions of
expenses and liabilities, using the common-size financials we created in Problem 4-1.
a. Cash represents a very small proportion of the firm’s total assets—only 2%. This could mean
that Patterson has inadequate liquidity. This is especially concerning since the firm’s current
liabilities equal 42% of assets—Patterson has lots of bills to pay soon, and very little cash on
hand. Even if all of its accounts receivable were to pay off immediately, it would still only have
20% of its assets in cash—less than its accounts payable. Most of the firm’s current assets
(about 60%) are tied up in inventory.
b. Patterson’s long-term debt is 21% of assets—the same as its short-term debt, and slightly less
than its accounts payable. Interest expenses are low—3% of sales. Patterson uses very little
long-term debt. Patterson is relying too heavily on short-term financing; this must be paid or
continually rolled over, exposing Patterson to interest rate risk and liquidity risk, i.e. having
insufficient liquidity to constantly meet required payments.
c. Patterson’s net income is 2% of sales. This is not a very high profit margin. (Of course, it may
be usual for Patterson’s industry—if Patterson Printing Company is in a very unattractive
industry!)
d. The majority of Patterson’s expenses come from COGS (67%) and operating expenses (27%).
Both items are cause for concern. Why does Patterson only have a 33% gross margin? This is
quite low and makes it difficult to be profitable if the company has significant operating
expenses. Secondly, why do operating costs eat up more than a quarter of the firm’s sales?
Based on these data, I would tell my boss:

 To change the firm’s financing mix, substituting some long-term debt for its short-term credit.
 To evaluate the firm’s inventory policies to see if it can reduce its investment there (e.g., just-in-
time delivery?).
 To reevaluate its credit policies—there is too much money tied up in A/R.
 To look for efficiencies in its operating procedures; operating expenses seem very high.
 To reduce cost of goods sold, by finding less expensive suppliers or by finding manufacturing
efficiencies in production.

80 Titman/Keown/Martin  Financial Management, Thirteenth Edition
 To consider increasing the price of products sold—the only ways to increase gross margin are to
drive down cost of goods sold or to increase price. The firm should explore both options.
The most urgent of the firm’s issues is its liquidity position—the firm is skating dangerously close
to not being able to pay its bills (if it’s not already there).
4-3. S&H will have net income of $780,000 next year, as found below:
next
Income Statement year % of sales notes
Revenues $15,000,000 100% $ given
Cost of goods sold ($9,000,000) 60% % given
Gross profit $6,000,000 40%
Operating expenses ($4,500,000) 30% % given
Net operating income $1,500,000 10%
Interest expense ($300,000) -2%
Earnings before taxes $1,200,000 8%
Taxes (@35%) ($420,000) -3% tax rate given
Net income $780,000 5%
We know that COGS and operating expenses total (60%  30%)  90% of revenues. The firm then
must pay interest expense of $300,000, and taxes at 35%. Thus we could also have found the NI
figure algebraically as follows:
net income  revenues  COGS  operating expenses  interest expense  taxes
 [revenues  COGS  operating expenses  interest expense]  (1  T)
 {revenues – [(60%)  (revenues)] – [(30%)  (revenues)] – $300,000}  (1  0.35)
 {[(10%)  (revenues)]  $300,000}  (0.65)
 {[(.10)  ($15M)]  $300,000}  (0.65)
 ($1.2M)  (0.65)
 $780,000.
4-4. Apex Fabricating, Inc. now has a current ratio of 2.5:
 current assets  10,381,800

current ratio     2.5.
 current liabilities  4,152,720
If the firm wants to use short-term debt (a current liability) to increase inventory (a current asset),
its current ratio will look like this:
10,381,800  new inventory
current ratio  
4,152,720  new short term debt

(where “inventory” means the incremental increase to inventory). Since the inventory amount and
the new short-term debt amount are the same, we can simplify this ratio:
10,381,800  x
current ratio 
4,152,720  x
Setting this equal to 2, then solving for x, we have:
10,381,800  x
2
4,152,720  x
x  $2,076,360.
4-5. If King Carpet reduces cash to $1,000,000, its new value of current assets will be:
new CA  old CA  change in CA
 (noncash CA  old cash) – cash spent
 ($9,000,000  $3,000,000)  $2,000,000  $10,000,000
This expression will calculate our new current asset value as none of the cash that King spent—a
reduction in CA—was used to buy new current assets.
We now need to find the current liability value after the change. $500,000 of the cash spent was on
trucks, which are a fixed asset. Only $1,500,000 was used to retire a short-term note—a reduction
in current liabilities. Thus, the new value is:
new CL  old CL  change in CL
 $6,000,000  $1,500,000  $4,500,000.
King’s new current ratio is therefore:
 current assets 
current ratio   
 current liabilities 
 $10 M 
 
 $4.5 M 
 2.22.
The firm’s current ratio has improved. The $2,000,000 decrease in CA was only a 16.67% decrease,
while the decrease in CL was 25%. Thus, since the numerator of the ratio fell by a smaller
percentage than did the denominator, the ratio increased.
4-6. Here is Campbell Industries’ current situation:
from Balance Sheet % of TA

accounts payable $500,000 7%
notes payable $250,000 4%
current liabilities $750,000 11%
long-tem debt $1,200,000 17%
total liabilities $1,950,000 28%
common equity $5,000,000 72%
total liabilities & equity $6,950,000 100%

a. Even though we weren’t given the firm’s total asset value, we know it’s the same as its total of
liabilities and equity, $6,950,000. Dividing each of the dollar amounts by this total asset figure
gives the percentages shown in the table above. Thus, we can see that Campbell finances 28% of
its assets with debt.
b. If Campbell were to purchase a new $1,000,000 warehouse (an asset) using long-term debt (a
liability), then both the numerator and the denominator of the debt ratio would rise by
$1,000,000. Here is how this would affect the firm’s debt ratio:
 total liabilities 
debt ratio   
 total assets 
 $1.95M  $1M 
 
 $6.95M  $1M 
 $2.95M 
 
 $7.95M 
 37.1%.
The firm now has a higher debt ratio. This is because the numerator—the debt—has risen by
51%, while the denominator—the assets—has risen by only 14%. Since the numerator rose
by a larger proportion than did the denominator, the ratio rises.
4-7. a. Times interest earned (TIE) is the ratio of EBIT (operating income) to interest expense.
Thus, for Karson, the current TIE is (using equation 4-7):
 EBIT 
TIE   
 int 
 $500,000 
 
 $200,000 
 2.5.
b. If Karson goes ahead with the new investment, it will increase its interest expenses by (10%) 
($1,000,000)  $100,000 and its net operating income by $400,000. Its new times interest earned
ratio will therefore be:
 $500,000  $400,000 
TIE   
 $200,000  $100,000 
 $900,000 
 
 $300,000 
 3.
This investment allows Karson to almost double its EBIT—increase it by 80%—while only
increasing its interest charges by 50%. Increasing the numerator of the times interest earned
ratio by so much more than the increase in the denominator causes the ratio to rise. After this
investment, Karson will have greater ability than before to meet its interest obligations, even
after increasing those obligations by half.

4-8. a. To determine Allen Corporation’s net operating income (EBIT) and net income, we start
with EBIT. Since the firm’s operating profit margin is 12%, we find EBIT using equation 4-11:
 EBIT 
operating profit margin   
 sales 
 EBIT 
0.12   
 $65M 
Rearranging, we find that EBIT  ($65,000,000)  (12%)  $7,800,000.
Now, to find net income, we must subtract interest expense and taxes. We are told that the
firm’s interest rate is 6%, but we’re only given total liabilities, not interest-bearing debt.
Assuming that all of the firm total liabilities bear interest (which is consistent with the explicit
hint given), we find interest expense of (6%)  ($20,000,000)  $1,200,000. Subtracting this from
EBIT gives us taxable income of $6,600,000; taxes on this amount at 35% total $2,310,000.
Thus, after paying its taxes, Allen Corporation will have net income of $4,290,000, as shown
below:
from Income Statement

Revenues $65,000,000
Net Operating Income $7,800,000
Interest expense ($1,200,000)
Earnings before taxes $6,600,000
Taxes (@35%) ($2,310,000)
Net income $4,290,000
b. Now, we evaluate this net income. Is Allen effectively using its assets to generate profits? Using
equation 4-13, we can calculate the firm’s operating return on assets (OROA):
 EBIT 
OROA   
 TA 
 $7.8 M 
 
 $42 M 
 18.6%.
Its return on equity, given by equation 4-14, is:
 NI 
ROE   
 E 
 $4.29 M 
 
 $42 M  $20 M 
 19.5%
(where we have found total equity as total assets less total liabilities).
While we don’t know anything about the risk of the Allen Corporation, the OROA and ROE
values suggest that the firm is using its assets effectively, generating a good return for its
shareholders.

4-9. a. Baryla’s gross profit margin is 40%, which tells us that
 gross profit 
0.40 =  
 sales 
(using equation 4-10). Since our sales are $100,000,000, we can now determine that gross profit
is ($100,000,000)  (0.40)  $40,000,000, so that cost of goods sold must be ($100,000,000 
$40,000,000)  $60,000,000. Since the firm wants to maintain an inventory turnover ratio of at
least 6.0, we can now find the maximum inventory level using equation 4-5 as:
 COGS 
inventory turnover   
 inventory 
 $60 M 
6 
 inventory 
The maximum inventory is then ($60,000,000/6)  $10,000,000. Any higher level of inventory
will cause the firm’s turnover ratio to fall below 6.0.
b. Since Baryla’s inventory includes $2,000,000 of unsalable items, the firm can have a maximum
of ($10,000,000  $2,000,000)  $8,000,000 in salable items. Thus, the inventory turnover for
good inventory cannot fall below ($60,000,000/$8,000,000)  7.5 if the firm wishes its overall
inventory turnover to remain at least 6.0.
4-10. a. Average collection period (ACP) is calculated as:
 A/R 
ACP   .
 annual credit sales/365 
If ALei wants its ACP to be 40 days, then we can solve for the maximum accounts receivable
(A/R) as follows:
 A/R 
40   ,
 $150,000,000/365 
so that the firm’s daily credit sales (the denominator of the ratio) equal $410,959. Multiplying
these daily credit sales by the average collection period, we find that ALei’s maximum accounts
receivable are ($410,959)  (40)  $16,438,356.
If the firm sells nearly $411,000 per day, and has, on average, 40 days’ worth of sales in
accounts receivable, it will have just over $16,000,000 in A/R. If the firm’s A/R is higher than
this, its average collection period (and its liquidity) will fall.
B. The firm currently has an ACP of 50 days, so it actually has more than $16,438,356 in A/R now:
It has (50)  ($410,959)  $20,547,945. If it wants to improve its ACP to 40 days, it must
therefore reduce its A/R by ($20,547,945  $16,438,356)  $4,109,589 (or 10 days’ worth of
sales!).

4-11. a. Given P.M. Postem’s sales, cost of goods sold, operating expenses, and tax rate, we can
create its income statement as follows:
last
Income Statement year notes
sales $400,000 given
cost of goods sold ($112,000) given
gross profit $288,000
operating expenses ($130,000) given
net operating income (EBIT) $158,000
interest expense $0 no interest-bearing debt
earnings before taxes (EBT) $158,000
taxes (@35%) ($55,300)
net income $102,700
b. The firm therefore was able to generate $102,700 in net income last year.
The firm’s operating profit margin is found using equation 4-11:
 EBIT 
operating profit margin   
 sales 
 $158,000 
OPM   
 $400,000 
 39.5%.
Thus, COGS and operating expenses consume (100%  39.5%)  60.5% of the firm’s revenues.
Note that we were given, but did not need, Postem’s shares outstanding, increase in retained
earnings, and dividend per share.
4-12. a. Given Callaway Lighting’s sales, cost of goods sold, operating expenses, and interest-
bearing debt information, we can construct its income statement as follows:
last
Income Statement year notes
sales $5,000,000 given
cost of goods sold ($4,500,000) given
gross profit $500,000
operating expenses ($130,000) given
net operating income (EBIT) $370,000
interest expense ($80,000) $1M in interest-bearing debt, at 8%
earnings before taxes (EBT) $290,000
taxes (@35%) ($101,500)
net income $188,500
Callaway was able to generate $188,500 in net income on sales of $5,000,000.

b. Callaway’s operating profit margin is ( EBIT
sales
) (from equation 4-11), so we have
($370,000/$5,000,000)  7.4%. Its net profit margin, ( sales ) , (from equation 4-12) will, as always,
NI
be lower, since this ratio incorporates not only operating costs, but also interest expense and
taxes. For Callaway, this is ($188,500/$5,000,000)  3.77%.
c. To evaluate whether Callaway can comfortably meet its interest obligations, we can use
equation 4-7 to calculate the times interest earned (TIE) ratio:
 EBIT 
TIE   
 int 
 $370,000 
 
 $80,000 
 4.63 times,
Callaway earns almost 5 times as much money from operations than it needs to meet its interest
payments. This is a comfortable cushion; Callaway does not appear to be using excessive
amounts of debt.
d. To find Callaway’s return on equity, ( common equity ), we need to find the amount of its common
NI
equity. We know that the firm increased its retained earnings by $40,000 for the year; this is
consistent with their having paid aggregate dividends of ($1.485/share)  (100,000 shares) 
$148,500, given that they generated net income of $188,500. The book value of the firm’s
common equity in the previous year was $900,000. Adding this initial value to the $40,000
increase in retained earnings gives us this year’s common equity, the denominator of the ROE
ratio.
 NI 
ROE   
 common equity 
 $188,500 
 .
 $40,000  last year's common.equity 
4-13. As shown in equation 4-14a, a firm’s equity multiplier is found as follows:
 1 
equity multiplier   
 1  debt ratio 
 1 
 .
1 total liabilities 
Since Garwryk’s debt ratio was given as 80%, its equity multiplier is simply ( 10.80
1
), or 5.
For a given level of assets, if the firm increases its debt financing, the debt ratio will increase.
This reduces the denominator in the equity multiplier ratio, resulting in an increase in the equity
multiplier. Thus, if Garwryk increased its debt ratio to 90%, its equity multiplier would rise
to ( 1 0.90
1
), or 10.

The equity multiplier accounts for a firm’s leverage—its use of debt. For a given level of total
assets, the more debt a firm uses, the less equity it uses. As the firm substitutes debt for equity, it
trades residual equity claims for relatively low, fixed financing costs (interest), potentially
magnifying the returns for the equity holders who are left. At some point, increases in the firm’s
debt ratio increase the risk of the firm’s default, i.e., bankruptcy, and interest rates increase
appreciably. When this occurs, equity holders drive the stock price down to reflect the increased
risk, thereby negating the benefits of increased debt.)
The chart below shows these relationships. As the debt ratio (measured on the x axis) rises, the
proportion of equity to total assets falls (of course), and the equity multiplier rises rapidly. This is
the effect of leverage—it magnifies returns to equity. This cuts both ways! It’s great when the firm
is doing well, but it increases shareholders’ pain when the firm does poorly—since debtholders
must be repaid in any case.
100% 25.00
90%
80% 20.00
70%
60% 15.00
50%
E/TA
equity multiplier
40% 10.00
30%
20% 5.00
10%
0% 0.00
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
debt ratio
4-14. We are given the following values for Triangular Chemicals:

total assets  $100,000,000
 NI 
ROE  40%   
 common.equity 
net profit margin  5%   NI 
 sales 
 
 
equity multiplier  2.5   1 
 .
 1  total.liabilities 
 total.assets 
Sales can be determined using the DuPont method for decomposition of ROE as follows:
ROE = (NI/Sales) × (Sales/Total Assets) × (Total Assets/Total Equity)
0.40 = 0.05 × (Sales/$100,000,000) × (2.5)
3.2 = (Sales/$100,000,000)
Sales = $320,000,000.

4-15. As with Problem 4-14, we are given a series of dollar amounts and ratios for our company, now
Dearborn Supplies, and we are asked to manipulate them to determine an implied value. Thus, to
find Dearborn’s debt ratio, we will proceed as we did above:
Total sales = $200,000,000
Total assets = $100,000,000
ROE = NI/Common equity
Net profit margin = 7.5% = NI/Sales

The company’s debt ratio can be determined using the DuPont method for decomposition of ROE
and the alternate expression for the equity multiplier as follows:
0.30 = 0.075 × ($200,000,000/$100,000,000) × (Equity multiplier)
2.0 = Equity multiplier.
 
 1 
Recall that the equity multiplier is    . = 2.0.
 1  total.liabilities 
 total.assets 
Thus, we have:
2.0 × [ 1 − (TL/TA)] = 1
2.0 − 2 (TL/TA) = 1
1 = 2 (TL/TA)
0.50 = 50% = (TL/TA) = debt ratio.
4-16. We are given the following values for Bryley, Inc.:

total assets  $100,000,000
total sales  $150,000,000
 NI 
net profit margin  5%   
 sales 
 1 
equity multiplier  3   .
total liabilities 
 1  total assets 
Bryley, Inc.’s ROE can be determined using the DuPont method as follows:
ROE = 0.05 × ($150,000,000/$100,000,000) × (3.0)
ROE = 0.225 = 22.5%.

4-17. If Rondoelea Products has $140,000,000 in sales and a net profit margin of 10% ([NI/sales]  10%),
then it must have net income of ($140,000,000)  (10%)  $14,000,000. This net income, of course,
if after taxes, so:
NI = EBT  (1  T)
$14,000,000  EBT  (1  0.30)  EBT  $20,000,000.
Now, since interest expense is 10% of the debt amount of $40,000,000, or $4,000,000, it must be
that EBIT  ($20,000,000  $4,000,000)  $24,000,000. Now we can find times interest earned:
 EBIT 
TIE   
 int 
 $24M 
 
 $4M 
 6 times.
last
from Income Statement year notes
sales $140,000,000 given
EBIT $24,000,000
interest expense ($4,000,000) $40 mil debt @10%
earnings before taxes (EBT) $20,000,000
taxes (@30%) ($6,000,000)
net income $14,000,000 10% net profit margin given
TIE = 6.00 EBIT/interest expense
18. a. Raconteurs, Inc.’s current ratio is (from equation 4-1):
 current assets   $110M 

current ratio       1.57.
 current liabilities   $70M 
Its acid test ratio, which subtracts inventory from the numerator, is:
 current assets-inventory 
acid-test ratio   
 current liabilities 
 $110M  $60M 
   0.71.
 $70M 
This is, of course, is lower than the current ratio, since its numerator is smaller.
b. Comparing Raconteurs’ ratios to the benchmark ratios, we see that the firm has a similar current
ratio, but a lower acid-test ratio. Raconteurs, therefore, has a higher investment in inventory than
its competitors have. The company is therefore less liquid than its competitors, and it should
evaluate its relatively high level of inventory.

4-19. Triangular Resources’ information is as follows:
net operating income (EBIT)  $5,000,000
 EBIT 
operating profit margin  20%   
 sales 
total asset turnover  1.5   sales  .

 TA 
 
We are asked to find total assets. Since TA is in the denominator of the total asset turnover (TATO),
using this ratio will be our last step. To find sales, the other input to the TATO ratio, we can use the
operating profit margin (OPM). Thus, we can use the following strategy:
1. OPM & EBIT  sales
2. sales & TATO  TA
Step 1:
 $5M 
OPM = 20%   sales 
 
 sales  $25,000,000.
Step 2:
 $25M 
TATO = 1.5   TA 
 
 TA  $16,666,667.
Thus, Triangular uses $16,666,667 in assets to generate 1.5 times that amount in sales, $25,000,000.
4-20. To evaluate Greene’s market-to-book ratio, we first must find both its price per share (the “market”
part) and its book value (BV) per share (the “book” part). Greene’s book value for all of its equity is
given as $750,500, and we are told that there are 50,000 shares outstanding. Thus, the BV per share
is ($750,500/50,000)  $15.01. To find price per share, we can use the P/E ratio:
P
price     EPS  (12.25)  ($3)  $36.75.
E
Now, we can see that Greene’s market-to-book is ($36.75/$15.01) = 2.45. The firm’s value is
estimated by the market to be almost 2 1/2 times larger than the accumulated historical investment
in the firm’s equity.
Investors are willing to pay more for a share of the firm than is suggested by their proportional
claim on the assets shown on the balance sheet. Why? Both because historical values are poor
estimates of current values (historical costs may be objective, but they do not represent current
reality), and because investors expect Greene’s earnings to grow over time through productive
employment of the firm’s assets.
4-21. a. As we did in Problem 4-20, we can use the P/E ratio to find price:
P
price     EPS  (20)  ($0.25)  $5.00.
E
Thus, if we expect that Larry’s Discount Tire Company would have a similar earnings multiplier
(P/E ratio) to that of comparable firms, then we would expect its price to be $5.00/share.

b. To find book value per share, we need the number of shares outstanding. Since the firm had net
income of $500,000, which translated into an earnings per share (or ( # shares
NI
) ) of $0.25, there
must be ($500,000/$0.25)  2,000,000 shares outstanding. Given the firm’s book value of equity
of $23,500,000, this implies a book value per share of ($23,500,000/2,000,000)  $11.75.
Larry’s market/book ratio is therefore $5.00/$11.75  0.426. The market values the firm less
highly—given its growth prospects—than would be indicated by its book value.
4-22. We are to find the market-to-book ratio for Lei Materials. Since we were given the stock price of
$50 (the “market” part), all we need to find is the firm’s book value per share.
We know that the firm’s total assets are $1billion. Total liabilities are the sum of current liabilities
($100,000,000) and long-term debt ($400,000,000), so total liabilities equal $500,000,000. Thus we
would find the firm’s book value of common equity as (TA  TL)  ($1,000,000,000 
$500,000,000)  $500,000,000, which, conveniently, is exactly what we were given.
Now we can find book value per share as ($500,000,000 equity book value/50,000,000 outstanding
price/share
shares)  $10/share. The firm’s market-to-book ratio is therefore ( BV/share )  ($50/$10)  5.0. The
market values Lei’s shares at 5 times their per-share book value.
4-23. This problem is similar to Problem 4-4, and we will follow a similar strategy. Mitchem Marble now
has a current ratio of 2.5:
 current assets   $2,500,000 
current ratio       2.5.
 current liabilities   current liabilities 
Since we know the firm’s current assets, this ratio implies that Mitchem’s current liabilities are now
$1,000,000.
If the firm wants to use a short-term line of credit (a current liability) to expand receivables and
inventory (current assets), its current ratio will look like this:
 $2,500,000  inventory  A/R 
current ratio   ,
 $1,000,000  new line of credit 
(where “inventory” and “A/R” mean the incremental increases to those accounts). Since the A/R
and inventory increments equal the new short-term debt amount, we can simplify this ratio:
 $2,500,000  x 
current ratio   .
 $1,000,000  x 
Setting this equal to 2, the firm’s minimum standard for this ratio, then solving for x, we have:
 $2,500,000  x 
2 
 $1,000,000  x 
2  ($1,000,000  x )  $2,500,000  x
$2,000,000  2  x  $2,500,000  x
x  $500,000.
Verifying, we see that:
 $2,500,000  $500,000 
 $1,000,000  $500,000 
 3,000,000 
   2.
 $1,500,000 

4-24. a. Since Advanced Autoparts (AAP) had current assets of $1,807,626,000 and current
liabilities of $1,364,994,000, its current ratio is:
 current assets   $1,807,626,000 

current ratio       1.32.
 current liabilities   $1,364,994,000 
AAP has current assets that are only 32% larger than its current liabilities.
b. If the firm wishes to increase its inventory (a current asset), financing the expansion with
accounts payable (a current liability), the current ratio will change. To determine the inventory
expansion that would leave the ratio at 1.2, we work as follows:
 $1,807,626,000  inventory 
 $1,364,994,000  A/P 
(where “inventory” and “A/P” mean the increments to those accounts). Since the A/P and
inventory increments are the same, we can simplify this ratio:
 $1,807,626,000  x 
current ratio   .
 $1,364,994,000  x 
Setting this equal to 1.2, the firm’s minimum standard for this ratio, then solving for x, we have:
 $1,807,626,000  x 
1.2   
 $1,364,994,000  x 
1.2 * ($1,364,994,000  x )  $1,807,626,000  x
$1,637,992,800  1.2 * x  $1,807,626,000  x
x  $848,166,000.
 $1,807,626,000  $848,166,000 
 $1,364,994,000  $848,166,000 
 $2,655,792,000 
 
 $2,213,160,000 
 1.2.
AAP can increase short-term borrowing by $848,166,000 to finance inventory, without
decreasing its current ratio below its target of 1.2.
c. If we now want to know how AAP could improve its ratio to 1.5 by simultaneously reducing
both its current assets and current liabilities, we manipulate the ratio just slightly differently:
 $1,807,626,000  x 
1.5   
 $1,364,994,000  x 
1.5* ($1,364,994,000  x )  $1,807,626,000  x
$2,047,491,000  1.5* x  $1,807,626,000  x
x  $479,730,000.


 $1,807,626,000  $479,730,000 
 $1,364,994,000  $479,730,000 
 $1,327,896,000 
 
 $885,264,000 
 1.5.
AAP would have to reduce its current assets and liabilities by almost $500,000,000 in order to
meet its more stringent target for its current ratio.
4-25. We are asked to find various ratios for the J.P. Robard Manufacturing Company. Some of these
ratios use only balance sheet data (the current ratio and the debt ratio); others use only income
statement values (times interest earned and operating profit margin); the rest use values from both
statements. Below, you will find the financial statement data and the relevant ratios.
this
Balance Sheet year BALANCE SHEET
cash $500,000 value calculation equation
accounts receivable $2,000,000 current ratio = 1.75 (current assets)/(current liabilities) 4-1
inventories $1,000,000 debt ratio = 0.5 (total debt)/(total assets) 4-6
Total Current Assets $3,500,000
net fixed assets $4,500,000
Total Assets $8,000,000
accounts payable $1,100,000

accrued expenses $600,000
short-term notes payable $300,000
Total Current Liabilities $2,000,000
long-term debt $2,000,000
Total Liabilities $4,000,000
Total Owner's Equity $4,000,000
Total Liabilities & Owner's Equity $8,000,000
Robard has almost twice as much in current assets as in current liabilities. Its quick ratio is slightly
lower, at ($2,500,000/$2,000,000)  1.25, telling us that Robard has 25% more in current assets
(excluding inventories) than in current debt. The firm uses a 50% debt mix overall, employing
equal proportions of debt and equity to finance its assets.
this
Income Statement year INCOME STATEMENT
Net sales (all credit) $8,000,000 value calculation equation
Cost of goods sold ($3,300,000) times interest earned = 4.63 (EBIT)/(interest expense) 4-7
Gross profit $4,700,000 operating profit margin = 0.21 (EBIT)/(sales) 4-11
Operating expenses (inc. depreciation) ($3,000,000)
Net Operating Income (EBIT) $1,700,000
Interest expense ($367,000)
Earnings before taxes $1,333,000
Taxes (@40%) ($533,200)
Net income $799,800
Looking at the firm’s income statement, we see that Robard generates 4.63 times as much EBIT as
it needs to make its interest payments. Its cost of goods sold and operating expenses represent 79%
of its sales revenue, leaving an operating profit margin of 21%.

The ratios below employ values from both financial statements:
BOTH
value calculation equation
inventory turnover = 3.30 (COGS)/(inventory) 4-5
total asset turnover = 1.00 (sales)/(total assets) 4-8
operating return on assets = 0.21 (EBIT)/(total assets) 4-13
average collection period = 91.25 (A/R)/(annual credit sales/365) 4-3
fixed asset turnover = 1.78 (sales)/(net plant & equipment) 4-9
return on equity = 0.20 (net income)/(common equity) 4-14
The firm turns its inventory 3.3 times per year. In contrast, fixed asset turnover is lower, at 1.78
times, reflecting the firm’s heavier reliance on fixed versus current assets (56% and 44% of total
assets, respectively). Its total asset turnover even less efficient: It employs $8,000,000 in total assets
to generate $8,000,000 in sales.
Since its total assets and sales are the same, its operating return on assets equals its operating profit
margin, 21%. Its return on equity is comparable, at 20%.
Given that Robard makes all of its sales on credit, it might want to evaluate its average collection
period of 91.25 days—3 months. We do not know if this is an outlier for Robard’s industry; perhaps
3 months is not overly long for a manufacturer of this type. Nonetheless, it might behoove the
company to explore changes that could speed its customers’ payments.
4-26. As in Problem 4-25, we are asked to calculate various ratios for a firm; these ratios use balance
sheet and income statement data. We are also asked to compare our firm, Carson Electronics, with
an industry leader, BGT Electronics. Using ratios will facilitate these comparisons, since ratios
allow us to express various quantities relative to other firm data, abstracting from the actual dollar
scale of the businesses.
We look first at the balance sheet ratios, the debt ratio, and the current ratio:
Balance Sheet CARSON BGT ELECTRONICS
cash $2,000,000 $1,500,000
accounts receivable $4,500,000 $6,000,000
inventories $1,500,000 $2,500,000
current assets $8,000,000 $10,000,000
net fixed assets $16,000,000 $25,000,000
Total Assets $24,000,000 $35,000,000
accounts payable $2,500,000 $5,000,000

accrued expenses $1,000,000 $1,500,000
short-term notes payable $3,500,000 $1,500,000
Total Current Liabilities $7,000,000 $8,000,000
long-term debt $8,000,000 $4,000,000
Total Liabilities $15,000,000 $12,000,000
Total Owner's Equity $9,000,000 $23,000,000
Total Liabilities & Owner's Equity $24,000,000 $35,000,000
BALANCE SHEET
CARSON BGT calculation equation
current ratio = 1.143 1.25 (current assets)/(current liabilities) 4-1
debt ratio = 0.625 0.343 (total debt)/(total assets) 4-6

For each ratio, the value that’s considered more desirable is boldfaced—here, both belong to BGT.
BGT has slightly better coverage of its short-term liabilities—having 25% more current assets than
it has current liabilities. The difference is not huge, however. The two firm’s quick ratios are almost
identical: 0.93 and 0.94, respectively (this ratio simply subtracts inventories from the numerator of
the current ratio). The firms therefore differ slightly in their investments in cash and A/R. Carson
has much more cash on hand than does BGT (8.3% of total assets, vs. 4.3% for BGT), but also has
a slightly larger investment in accounts receivable (18.75% vs. 17.14%). We will need to further
evaluate the latter number when we look at average collection period. However, given these current
asset values, we can’t say that Carson is really less liquid than BGT. Good news!
However, the news is not so good on the total debt front. Carson has a much higher debt ratio than
BGT. Carson finances 62.5% of its assets with debt, while BGT uses only 34.3% debt. (We will see
more implications of this when we consider times interest earned.) Carson’s higher leverage means
that its breakeven point is relatively higher, and that it is operating with more risk than is BGT.
There should be a magnifying effect on return on equity as a result; we’ll consider this below.
Now, let’s look at the income statement ratios:
Income Statement CARSON BGT ELECTRONICS

net sales (all credit) $48,000,000 $70,000,000
cost of goods sold ($36,000,000) ($42,000,000)
gross profit $12,000,000 $28,000,000
operating expenses ($8,000,000) ($12,000,000)
Net Operating Income (EBIT) $4,000,000 $16,000,000
Interest expense ($1,150,000) ($550,000)
Earnings before taxes $2,850,000 $15,450,000
Taxes (@40%) ($1,140,000) ($6,180,000)
Net income $1,710,000 $9,270,000
INCOME STATEMENT
times interest earned = 3.48 29.09 (EBIT)/(interest) 4-7
operating profit margin = 8.33% 22.86% (EBIT)/(sales) 4-11
As hinted at above, Carson’s times interest earned is much lower than BGT’s. Carson’s relatively
heavy use of debt means relatively high interest charges, so that the firm is able to cover those
charges fewer times with its EBIT. However, 3.48 times is not obviously a bad coverage ratio, and
perhaps BGT’s, at over 29 times, is exceptionally high. It would be interesting to look at the TIE for
a few other firms in their industry to better gauge the adequacy of Carson’s coverage.
However, there’s no denying that BGT’s operating profit margin is vastly better than Carson’s.
Why? Looking at relative operating expenses, Carson’s are 16.67% of sales, while BGT’s are
17.14%; this, then, cannot explain BGT’s superior performance. It must be the cost of goods sold.
Indeed, Carson’s COGS represent 75% of sales, while BGT’s are only 60% of sales. BGT’s
superior gross profit margin explains its superior operating profit margin.

Now, let’s look at the ratios that use data from both the balance sheet and the income statement:
BOTH
inventory turnover = 24.00 16.80 (COGS)/(inventory) 4-5
total asset turnover = 2.00 2.00 (sales)/(total assets) 4-8
operating return on assets = 16.67% 45.71% (EBIT)/(total assets) 4-13
average collection period = 34.22 31.29 (A/R)/(annual credit sales/365) 4-3
fixed asset turnover = 3.00 2.80 (sales)/(net plant & equipment) 4-9
return on equity = 19.00% 40.30% (net income)/(common equity) 4-14
The most salient of these ratios are the operating return on assets and the return on equity: BGT is
vastly better than Carson’s. Both firms have the same ratio of total assets to sales, but BGT is able
to generate 45.71% EBIT/TA, while Carson can only muster 16.67%. (We have already explained
this difference: BGT generates higher relative EBIT because its cost of goods sold is so much lower
than Carson’s.) BGT’s return on equity is higher than Carson’s, since BGT has higher EBIT and
lower interest charges; it therefore has higher relative net income (a net profit margin of 13.24%, vs.
Carson’s 3.56%). This is despite BGT’s higher proportion of equity to total assets (66% vs. 38%).
On other measures, Carson is doing better. It turns its inventory and fixed assets somewhat more
than BGT, but collects its A/R just a few days later than BGT.
Thus, we can identify Carson’s biggest problem: its cost of goods sold. BGT’s ability to keep its
COGS at 60% of sales translates into much higher profit margins than Carson can generate. I would
suggest that Carson’s management focus its attention on lowering the costs of its manufacturing
inputs or raising its prices to generate more revenue per unit.
4-27. a. The results for Blunt Industries are shown below. The values boldfaced for 2016 are
improvements over 2015.
industry
average 2015 2016 calculation equation
current ratio 2.00 1.84 0.90 (current assets)/(current liabilities) 4-1
acid-test ratio 0.80 0.78 0.24 (current assets - inventory)/(current liabilities) 4-2
average collection period 37.00 30.42 18.98 (A/R)/(annual credit sales/365) 4-3
inventory turnover 2.50 3.10 4.06 (COGS)/(inventory) 4-5
debt ratio 58.00% 0.50 0.61 (total debt)/(total assets) 4-6
times interest earned 3.80 3.15 4.67 (EBIT)/(interest) 4-7
operating profit margin 10.00% 9.60% 10.63% (EBIT)/(sales) 4-11
total asset turnover 1.14 1.33 2.05 (sales)/(total assets) 4-8
fixed asset turnover 1.40 2.42 3.50 (sales)/(net plant & equipment) 4-9
operating return on assets 11.40% 12.80% 21.79% (EBIT)/(total assets) 4-13
return on equity 9.50% 8.73% 22.13% (net income)/(common equity) 4-14
b. and d. We can evaluate Blunt’s relative performance by considering both the trend of the ratios
(2016 vs. 2015), and their comparisons to the industry average. We will use both of these
approaches for the firm’s liquidity, capital structure, asset management efficiency, and
profitability ratios.

LIQUIDITY
The liquidity ratios are the current ratio, acid-test ratio, average collection period, and accounts
receivable turnover.
Current ratio: Blunt’s current ratio has deteriorated over the last year. While its current assets
have stayed relatively stable (45% vs. 41% of total assets for 2015 and 2016, respectively), the
current liabilities have blown up in 2016, going from 24% of total assets to 46%. The firm’s
accounts payable have more than doubled, and short-term bank notes have almost tripled. The
firm now has a current ratio that is less than half of the industry average, suggesting
compromised liquidity.
Acid-test ratio: The acid-test ratio tells a similar bleak story. While the firm’s ratio was close to
the industry average in 2015, it has fallen to about ¼ of that value in 2016. Accounts receivable
has remained relatively stable over this period; inventory, however, rose from about 26% of
total assets to 30%. However, the real story here is cash and the huge swelling in current
liabilities in 2010: Cash fell from 8% of total assets to 0.3%. Blunt’s cash has disappeared,
and has dragged its acid-test ratio along with it. The firm is dangerously lacking in liquidity,
especially given current liabilities, which have increased 160% year/year.
Inventory turnover: Blunt’s inventory turnover is higher than the industry average, and has
increased significantly over the last year. The firm’s cost of goods sold more than doubled,
while inventory only increased by 63%. This is one bright spot for Blunt Industries.
Average collection period: Blunt’s ACP is improving from a level that was already better than
the industry average. The firm receives cash for its sales after about 19 days, while the industry
average is 37. The firm’s A/R has only increased by a third, even though its sales more than
doubled. This is an impressive result.
Thus the ratios involving income statement values look OK for Blunt, but its current asset and
current liability situations—especially its low cash—are troubling.
CAPITAL STRUCTURE
The firm’s relevant capital structure ratios are the debt ratio and the times interest earned ratio.
Debt ratio: The firm’s debt ratio has risen over the year, but is not much higher than the
industry average. While long-term debt has actually fallen (from 26% of total assets to 15%),
current liabilities have almost doubled as a percent of total assets. We have seen this already, in
the deterioration of the current ratio.
Times interest earned: The firm’s TIE has improved over the year, and is now higher than the
industry average. EBIT has risen as a percentage of sales, while interest charges (while rising in
absolute terms) have fallen relative to sales. Blunt Industries appears to have a comfortable
ability to generate cash to pay its interest charges.
ASSET MANAGEMENT EFFICIENCY
The relevant asset management efficiency ratios are total asset turnover and fixed asset turnover.
Total asset turnover: This ratio has improved over the period; it has been above the industry
average in both years. The firm’s sales more than doubled, but its assets only increased by 39%.
Blunt is demonstrating an ability to use its growing assets with increasing efficiency.
Fixed asset turnover: The story for fixed assets is similar: better than the industry norm in both
years, and improving. Blunt Industries supported its doubling in sales with only a 48% increase
in fixed assets.

PROFITABILITY
We will consider Blunt’s operating profit margin, operating return on assets, and return on equity.
Operating profit margin: Blunt is close to the industry average in both years, although its trend
is improving, and its 2016 results put it ahead of the industry. We’ve already seen that the firm’s
sales have more than doubled. Their operating costs have also increased, but not as much:
COGS and variable operating expenses have remained constant (at 60% and 10% of sales,
respectively); fixed cash operating expenses have decreased significantly (from 17% to13% of
sales); depreciation expenses have almost quadrupled ($6750 to $25,000) increasing from 3.6%
of sales to 6.3% of sales (we already saw that fixed assets increased). However, the drastic
increase in sales overwhelms the relatively smaller increases in costs, allowing EBIT to rise
from 9.6% to 10.6% of sales (an increase of 136%).
Operating return on assets: For both years, Blunt outperformed the industry on the measure,
and its performance was even better in 2016. We have already seen that Blunt increased its total
assets by only 39%, while doubling sales. It also improved its operating margin, increasing the
relative size of EBIT. EBIT is therefore a larger proportion of a much larger sales base; its ratio
to assets, which only increased modestly, therefore increased.
Return on equity: Blunt’s return on equity was slightly below the industry norm in 2015, but
was much higher in 2016. The firm increased its net income by over 170%, while increasing its
equity only 7%. (Liabilities, on the other hand, rose 70%.)
c. Finally, we consider Blunt’s 2016 market-value ratios. The firm has 5000 shares of common
stock, so that its earnings per share (net income/number of shares) equals ($16,703/5,000)  $3.34.
Its price-earnings ratio, (price/EPS), equals ($15/$3.34)  4.49. The market-to-book ratio depends
on the book value per share, (common equity/number of shares), or ($75,465/5,000)  $15.09.
The market-to-book ratio is therefore ($15/$15.09)  0.99. The P/E and market-to-book ratios
are very low—the firm’s shares are only selling for full book value, perhaps due to the perceived
risk given its low cash and liquidity position.
Given the values found above, Blunt Industries seems to be effectively managing its assets, with
the exception of its current assets. Its biggest problem here is its unsustainably low cash
position. The firm must take steps to become more liquid. It is already very effectively
managing its A/R and its inventories. It seems to have spent down its cash and increased short-
term notes payable to increase fixed assets, and used current liabilities to reduce long-term debt.
While this investment was effectively translated into sales, it has left the firm in a temporarily
awkward cash position. Its short-term liabilities have risen, but so has its times interest earned.
Nonetheless, the cash cushion is too small to protect the firm against even a minimal downturn.
Despite the poor cash position, it’s difficult to understand Blunt’s low price. Its performance is
improving and is better than its industry average in many categories of evaluation. If the firm
even managed to increase its earnings multiple (P/E) ratio to a historical norm for stocks in
general, 10 times, then it should be selling for $33.41. As mentioned above, perhaps its
dangerous liquidity position explains its poor stock price performance, as equity holders are
worried about the default potential.
4-28. a. R.M. Smithers’ total asset turnover is simply:
 sales 
TATO   
 $10M 
   2.
 $5M 
b. If the firm wants to increase this ratio to 3.5, leaving total assets the same, then sales
must increase to (TA)  (3.5)  ($5,000,000)  (3.5)  $17,500,000. This would be
an increase of ($17,500,000 $10,000,000)/($10,000,000)  75%, a huge increase.
c. The firm’s operating return on assets is:

 EBIT 
OROA   .
Since its operating profit margin, ( EBIT )
sales , is 10%, its EBIT must be 10% of sales, or (10%) 
($10,000,000)  $1,000,000. Its operating return on assets is therefore ($1,000,000/$5,000,000),

or 20%.
If, however, sales increase to $17,500,000 (giving the firm the total asset turnover goal of 3.5),
then its EBIT will be (10%)  ($17,500,000)  $1,750,000 (assuming the operating profit
margin remains at 10%). Its OROA in this case would be ($1,750,000/$5,000,000)  35%.
4-29. a. Brenmar’s average collection period is found as follows (using equation 4-3):
 A/R 
ACP   
 annual credit sales/365 
Since Brenmar makes 75% of its sales on credit, we can find the denominator for this ratio using
($9,000,000 total sales)  (75% credit sales)  $6,750,000. Now we can find the average collection
period as:
 $562,500 
ACP   
 $6,750,000 / 365 
 $562,500 
 
 $18,493 
 30.4 days.
b. In order to reduce its average collection period to 20 days, the firm will need to decrease its
level of accounts receivable. We can determine the new, lower level as:
 A/R 
20   
 $6,750,000/365 
A/R  20 * ($18,493)  $369,863,
a 34% decrease.
c. The company’s inventory turnover, or (COGS/inventory), is 9 times. In order to use this value to
find the firm’s inventory level, we need its cost of goods sold. Since the firm’s gross profit
margin is 30%, 70% (100%  30%) of its sales revenue must go to COGS. For a sales level of
$9,000,000, this implies a COGS of (70%)  ($9,000,000)  $6,300,000. We can now easily find
the firm’s inventory as follows:
 COGS 
inventory turnover   
 inventory 
 $6.3M 
9 
 inventory 
 inventory  $700,000.
We should be able to justify that with the other current asset information we were given. The
firm’s current assets are given as $1,500,000. It has cash and marketable securities of $100,000.
If the firm’s A/R is $562,500 and its inventory is $700,000, we have accounted for current assets
of $1,362,500. There is $137,500 of current assets unaccounted for—maybe prepaids?

4-30. a. The results for Pamplin, Inc. Industries are shown below. The values boldfaced for 2016
are improvements over 2015.
industry
average collection period 90.00 136.88 106.98 (A/R)/(annual credit sales/365) 4-3
inventory turnover 2.20 1.27 1.36 (COGS)/(inventory) 4-5
debt ratio 0.33 0.33 0.35 (total debt)/(total assets) 4-6
times interest earned 7.00 5.00 5.63 (EBIT)/(interest) 4-7
operating profit margin 20.00% 20.83% 24.83% (EBIT)/(sales) 4-11
total asset turnover 0.75 0.50 0.56 (sales)/(total assets) 4-8
fixed asset turnover 1.00 1.00 1.04 (sales)/(net plant & equipment) 4-9
return on equity 9.00% 7.50% 10.45% (net income)/(common equity) 4-14
We can evaluate Pamplin’s relative performance by considering both the trend of the ratios (2016
vs. 2015), and their comparisons to the industry average. We will use both of these approaches
for the firm’s liquidity, capital structure, asset management efficiency, and profitability ratios.
LIQUIDITY
The liquidity ratios are the current ratio, acid-test ratio, average collection period, and inventory
turnover.
Current ratio: Pamplin’s current ratio has deteriorated over the last year and is now below the
industry average. As a percentage of total assets, both cash and A/R have fallen, as has A/P.
However, the big story here is the addition of the note payable. Combined with the A/P, this
note brings Pamplin’s current liabilities up to 11.5% of total assets, from 8.33% in 2015.
Combined with the slight decrease in current assets (down to 46% of total assets, from 50%),
this implies a lower current ratio for the company.
Acid-test ratio: The acid-test ratio follows the same pattern: better than industry average in 2015;
worse in 2016. Given Pamplin’s decrease in cash, its A/R plus cash total has fallen from 27% of
assets to 22%. Inventories, as a percent of total assets, in the meantime, have grown a bit (up 1
percentage point). Thus Pamplin is holding less cash and A/R (in relative and absolute terms), and
has increased its current liabilities, all while generating more sales. Given how much lower its
liquidity looks relative to industry norms—at least on these two measures—Pamplin may want to
evaluate whether its ability to comfortably make its current liability payments is sufficient.
(We should note that the company does have an acid-test ratio of almost 2, which it may indeed
consider sufficient.)
Inventory turnover: Pamplin’s inventory turnover is better in 2016 than it was in 2015, but is still
below the industry average. While the firm’s COGS has remained fairly constant as a percentage
of sales, and inventory has increased as a percentage of assets, the increase in sales means that
COGS grew 21% over the period, while inventory grew only 13.6%. The larger increase in
COGS relative to inventory means that Pamplin’s inventory turnover has increased. However,
at 1.36 times, it is still well below the industry average of 2.2 times. The company may be carrying
too much stock in inventory, which would contribute to its relatively poor liquidity.
Average collection period: Pamplin’s ACP is better in 2016 than it was in 2015, but remains
higher than the industry average. The 2016 ratio was lower than 2015’s since A/R fell while
sales rose—two good outcomes that both worked to improve payment speeds. However, the
industry average is still more than 2 weeks faster than Pamplin’s, suggesting that there is more
work to be done here, especially given the deteriorating liquidity position.
Overall, Pamplin’s liquidity position needs improvement. It has taken on new short-term debt,
while reducing its cash cushion. It has too much money tied up in inventory and A/R. While the
situation is probably not dire, it is not ideal, either.

CAPITAL STRUCTURE
The firm’s relevant capital structure ratios are the debt ratio and the times interest earned ratio.
Debt ratio: The firm’s debt ratio has risen over the year, but is about the same as the industry
average. Total liabilities are up because of the new short-term borrowing. Assets have also risen,
but not by as large a percentage. The net result is a very slight increase in Pamplin’s debt ratio,
but nothing that’s concerning (beyond the liquidity issues discussed earlier).
Times interest earned: Pamplin’s TIE has improved in 2016 over 2015, but is still below the
industry average. 2016’s EBIT grew 44% over the period, and interest grew only 28%; thus the
improvement in TIE. However, the industry’s average of 7 times is still larger than Pamplin’s.
Should the company be concerned? Pamplin is generating a higher operating margin than
average, so it’s the interest charges which seem to be causing the variation with the industry.
At 5.63 times coverage, though, Pamplin’s debt does not seem excessive.
ASSET MANAGEMENT EFFICIENCY

The relevant asset management efficiency ratios are total asset turnover and fixed asset turnover.
Total asset turnover: This ratio has improved over the period, but is still below the industry
average. The firm has increased sales by almost 21%, by increasing assets by only about 8%.
However, the industry average is almost 50% higher than Pamplin’s, suggesting room for
improvement.
Fixed asset turnover: Here, Pamplin is not only improving, but is better—just barely—than
average. When increasing sales, the company increased its fixed assets by almost 17%. However,
since sales growth was even higher, the fixed asset turnover improved. The improvement leaves
the firm so close to average that Pamplin should not expect that there are no further efficiency
gains here.
PROFITABILITY
We will consider Pamplin’s operating profit margin and return on equity.
Operating profit margin: Pamplin’s ratio is improving, and has been better than the industry
average in both years. The firm’s sales increased about 21%, while EBIT increased 44%; the
(EBIT/sales) ratio therefore increased. The big story here is depreciation: The firm’s absolute
depreciation deduction actually fell, despite an increase in fixed assets. Thus the main difference
in 2016 came after gross profit—in depreciation expense.
Return on equity: Pamplin’s ROE has improved, and is now better than the industry average.
Net income increased by almost 50%. Thus the firm made a much higher profit relative to its
equity investment.
Given these values, Pamplin seems to be in good shape relative to its peers. Its primary area of
concern is its liquidity, but even here, the firm is not in dire straits.
4-31. a. Salco’s total asset turnover is (sales/total assets)  ($4,500,000/$2,000,000)  2.25.

(Equation 4-8)
Its operating profit margin is (EBIT/sales)  ($500,000/$4,500,000)  11.11%. (Equation 4-11)
Its operating return on assets is (EBIT/total assets)  ($500,000/$2,000,000)  0.25. (Equation 4-13)
b. If the firm goes ahead with its renovation, it will add $1,000,000 to fixed assets, raising total assets
to $3,000,000. If sales remain at $4,500,000, but the operating profit margin, (EBIT/sales), rises to
13%, then EBIT must rise to (13%)  ($4,500,000)  $585,000. The new operating return on
assets, (EBIT/total assets), must therefore be ($585,000/$3,000,000)  19.5%.
c. If the firm’s interest expense rises by $50,000, the new total interest will be $150,000. EBT now
becomes ($585,000  $150,000)  $435,000, which leaves $435,000  (1  0.35)  $282,750 in
net income (after taxes):

sales $4,500,000
net operating income (EBIT) $585,000 13% of sales (given)
Interest expense ($150,000)
EBT $435,000
Taxes (@35%) ($152,250)
net income $282,750
To determine ROE, we must compare this net income to the new common equity. Before the
renovation, Salco had $1,000,000 in equity. However, when the firm raised the new $1,000,000
for the plant, it got half of its money from equity, or $500,000. (This is because the firm wanted
to maintain its debt ratio of 50%, so that half of its new assets were financed with debt and the
other half with equity.) The new common equity value is $1,500,000, so that ROE 
(NI/common equity)  ($282,750/$1,500,000)  18.85%.
Before the renovation, Salco’s ROE was ($260,000/$1,000,000) = 26%. Thus the renovation has
eroded Salco’s ROE, as equity increased by 50% but NI only increased by 8.75%. What
happened? The investment did not increase sales, so the only potential benefit came from the
increased operating profit margin. However, since the increase in EBIT—to 13% of sales from
11% of sales—did not improve ROE, there must have been a problem after net operating
income. EBIT rose by $85,000; interest rose 50% ($50,000); taxes rose 8.75% ($12,250). Only
$22,750 of the improvement in EBIT makes it to the bottom line—not a great return on Salco’s
equityholders’ new investment of $500,000.
We can think of the new ROE as a weighted average: the first $1,000,000 in equity earned 26%,
but the $500,000 increment earned only ($22,750/$500,000)  4.55%. Thus after the renovation,
ROE is a weighted average of these two returns: [($22,750/$500,000)  ($500,000/$1,500,000)]
 [($260,000/$1,000,000)  ($1,000,000/$1,500,000)]  [(4.55%)  (1/3)]  [(26%)  (2/3)] 
18.85%. The marginal investment’s return of less than 5% is unlikely to be adequate
compensation for the firm’s new equity holders.
4-32. (Note that the correct values for cash for T. P. Jarmon Company are $15,000 and $14,000 for 2015
and 2016, respectively. The corrected balance sheets are shown below.)
Balance Sheet 2015 2016
cash $15,000 $14,000
marketable securities $6,000 $6,200
accounts receivable $42,000 $33,000
inventory $51,000 $84,000
prepaid rent $1,200 $1,100
current assets $115,200 $138,300
net plant & equipment $286,000 $270,000
total assets $401,200 $408,300
accounts payable $48,000 $57,000

notes payable $15,000 $13,000
accruals $6,000 $5,000
total current liabilities $69,000 $75,000
long-term debt $160,000 $150,000
total liabiliities $229,000 $225,000
total owners' equity $172,200 $183,300
total liabilities & owner's equity $401,200 $408,300

a. Here are the relevant ratios for T. P. Jarmon Company:
industry
debt ratio 0.50 0.57 0.55 (total debt)/(total assets) 4-6
times interest earned 10.00 8.00 (EB IT)/(interest expense) 4-7
average collection period 20.00 20.08 (A/R)/(annual credit sales/365) 4-3
inventory turnover 7.00 5.48 (COGS)/(inventory) 4-5
return on equity 12.00% 23.40% (net income)/(common equity) 4-14
operating return on assets 16.80% 19.59% (EBIT)/(total assets) 4-13
operating profit margin 14.00% 13.33% (EBIT)/(sales) 4-11
total asset turnover 1.20 1.47 (sales)/(total assets) 4-8
fixed asset turnover 1.80 2.22 (sales)/(net plant & equipment) 4-9
b. Jarmon wishes to open a line of credit for $80,000, using the credit line to finance inventory
(since the company can get good discounts for paying its suppliers quickly). A lender considering
such a credit request would want to make sure that Jarmon was sufficiently liquid to ensure
comfortable repayment of the loan obligations. He would therefore be very interested in
Jarmon’s liquidity ratios.
Jarmon’s current ratio is higher in 2016 than it was in 2015, and is slightly higher than the industry
average. However, its acid-test ratio is deteriorating, and is below average. These ratios together
imply that Jarmon has a substantial investment in inventory: In 2016, the ratio of inventory to total
assets rose to almost 21%, from about 13%. This is a large jump. Whether it’s very concerning
depends in part on how Jarmon is employing that inventory. However, the lower-than-average
inventory turnover suggests again that inventory is too high relative to sales.
Looking at the asset efficiency ratios, we see that both total asset and fixed asset turnover ratios
are significantly higher than average, with the fixed asset ratio slightly more so. The slightly
lower relative value for total assets may be another implication of Jarmon’s overinvestment in
inventory.
The firm’s accounts receivable has fallen as a percentage of total assets (from about 10.5% to 8%),
a good sign perhaps, but its average collection period is just about average. In sum, though, A/R
is probably not a concern for the lender.
A big concern, however, is the times interest earned ratio. Jarmon is already significantly below
the industry average on this coverage ratio. Its debt ratio is about 5 percentage points higher than
average (55% vs. 50%). Long-term debt is 37% of total assets, down from almost 40%; current
liabilities represent 18%, up from 17% of total assets. Again we see the emphasis on current
liabilities for the firm.
The firm’s average daily credit sales are over $1,600; the credit line the CFO wants therefore
represents almost 49 days’ worth of sales—almost two and a half times the average collection
period. Given the low TIE, the relatively high level of inventory, and the relatively high amount
of the credit line—enough to finance almost the entire value of inventory—I would suggest that
the lender ask Jarmon to justify more fully its loan request, and explain more carefully its
inventory level. Jarmon is probably an acceptable credit risk, but they need to provide more
information to convince me. The bank should also evaluate the amount of discounts Jarmon will
earn by using the loan to pay off accounts payable more quickly. How will these discounts
improve profitability?

4-33. We are asked to compare Dell to Apple, using the information given below. Is Apple more
valuable, since its stock price is so much higher?
2007
DELL APPLE
net income $3,572 $3,130
shares outstanding 2,300 869.16
EPS $1.55 $3.60
price $27.76 $133.64
P/E 17.91 37.11
BV of CE $4,129 $9,984
BV/share $1.80 $11.49
M/B 15.42 11.63
market cap $63,848 $116,155
Simply comparing price/share can be misleading as the price does not account for the number of
shares of equity outstanding. However, we can answer the question directly by calculating the
market capitalization, (price/share)  (# of shares outstanding). As we see above, using this measure
Apple is more valuable: The total of the firm’s equity is worth $116,155 million, while Dell is
worth only $64,848 million. This is true even though Apple has fewer shares (that’s the effect of the
much higher share price).
If we look at more standardized measures, we can abstract from size a bit and consider investment
potential. Apple’s P/E is much higher than Dell’s, and is much higher than the average 10–15 times
that we’ve observed for stocks over decades. Investors are clearly pricing in a lot of growth for
Apple. If Apple’s earnings ever disappoint and this multiple decreases, the stock will be severely
affected. Dell, on the other hand, has a P/E in the more usual range. $1 of Dell’s earnings costs an
investor $17.91; $1 of Apple’s earnings costs $37.11.
Oddly, this relationship reversed when we consider the market-to-book ratio: Now Dell’s ratio is
higher. Dell’s market price is over 15 times its book value per share, while Apple’s is only 11.63
times. Using this metric, Dell looks more expensive. Apple investors have invested much more per
share that Dell investors have: $11.49 vs. $1.80, respectively. Of course, there are fewer shares;
however, the aggregate book value of equity for Apple is more than twice that of Dell. This is
reflected in their relative returns on equity: Dell’s ROE is 86.5%; Apple’s is 31.4%.
The driver for the differences between Apple’s and Dell’s P/E and M/B ratios is the large difference
in number of shares. Dell’s P/E ratio is lower because its EPS is lower—and its EPS is lower
because its number of shares is higher, not because its total earnings are lower. Thus, we can’t look
at Dell’s lower P/E and pronounce it more reasonably priced—the P/E is lower because there are so
many shares outstanding. The market-to-book ratio tells the more accurate story here: At this time,
Dell’s stock is being priced more aggressively by the market. Thus, for investment potential,
perhaps this means that Dell is actually the more “valuable” company.

4-34. We have the following data for comparing Emerson Electric and General Electric:
2009
EMR GE
net income $2,170,000,000 $16,420,000,000
shares outstanding 787,658,802 10,662,337,662
EPS $2.76 $1.54
price $32.18 $13.11
P/E 11.68 8.51
BV of CE $8,608,000,000 $101,708,000,000
BV/share $10.929 $9.539
M/B 2.94 1.37
market cap $25,346,860,248 $139,783,246,749
ROE 25.21% 16.14%

Although Emerson’s stock price is much higher than GE’s, we can’t use this to determine the
companies’ relative pricing. GE has many more shares outstanding, and a much higher market
capitalization. Thus, to answer the question, we must compare the P/E and M/B ratios.
Unlike Problem 4-33, in this case we have a consistent story: Emerson’s P/E and M/B are higher than
GE’s. Investors are willing to pay almost $12 for $1 of Emerson’s earnings, but only about $8.50 for
$1 of GE’s earnings. Although Emerson’s book value per share is higher than GE’s, its market-to-
book is also higher, again reflecting investors’ confidence in Emerson. The worst financial crisis since
the Great Depression occurred in 2008, triggering a severe recession in late 2008 and throughout
2009. At that time, GE had a significant exposure to financial market turmoil through its large finance
operation GE Credit. The risk of this exposure is reflected in the market’s pricing of $1 of GE
earnings. In addition, Emerson’s ROE is much greater than GE’s; investors expected good earnings
growth and continued excellent performance, and priced the shares accordingly.
4-35.
$ millions NSM ADI TXN
revenue $1,640 $2,270 $11,320
gross margin 64.41% 58.83% 46.80%
operating margin 25.35% 20.09% 17.67%
net income $220.20 $349.78 $1,280
EPS $0.924 $1.225 $0.978
P/E 15.56 20.48 21.31
NSM ADI TXN

price $14.38 $25.09 $20.84
# shares 238,311,688 285,534,694 1,308,793,456
To determine whether Analog Devices or Texas Instruments is a better benchmark for National
Semiconductor, we need to specify what the benchmark is meant to achieve. Is it a measure of best
practices, an ideal against which we should gauge our firm’s performance? Or is it a representation
of what firms similar to ours are doing, so that we can see if we are far outside the norm?

Assuming it’s the latter, then it appears that Analog Devices is more like NSM. TXN is of a different
order of magnitude than the other two firms with regard to revenue and net income. Given the firm’s
vastly larger size, it is conceivable that TXN is involved in more types of businesses (is more
diversified) than are NSM and ADI, making TXN a poor proxy for NSM.
ADI is also closer to NSM in gross margin—both are significantly higher than TXN. This also may
suggest that TXN is operating in other, less profitable businesses, as it expanded in the past to
deploy earnings into new, lower-margin activities. The same is true for operating margin. On both
of these measures, not only is NSM more like ADI, it is also generating higher returns than either of
its competitors.
On EPS, NSM is actually closer to TXN. On P/E, it falls far below the other two firms. It will help
us to interpret these numbers if we look at each firm’s price and shares outstanding:
NSM ADI TXN

price $14.38 $25.09 $20.84
# shares 238,311,688 285,534,694 1,308,793,456
We can see that NSM’s P/E is relatively low because its price is relatively low. This is especially
noticeable since its earnings—the denominator of the ratio—are also low. Given NSM’s superior
gross and operating margins but poor relative net income, there must be something going on below
EBIT (too much interest?), and the firm is being punished for this.
Overall, it appears that ADI is the better benchmark for NSM—it’s closer in size and in current results.
4-36. Income Statements

Sears Holding (SHLD) Target Corp (TGT)
Period Ended 31-Jan-09 31-Jan-09
Cash & Cash Equivalents $864,000.00 $1,297,000.00

Accounts receivable 9,446,000.00 866,000.00
Inventories 6,705,000.00 8,795,000.00
Other Current Assets 473,000.00 458,000.00
Total Current Assets $17,488,000.00 $11,416,000.00
Long Term Investments 163,000.00
Property Plant & Equipment 25,756,000.00 8,091,000.00
Other Assets 699,000.00 5,835,000.00
Total assets $44,106,000.00 $25,342,000.00
Liabilities
Accounts Payable $7,366,000.00 $3,430,000.00
Short/Current Long Term Debt 1,262,000.00 787,000.00
Other Current Liabilities 1,884,000.00 4,295,000.00
Total Current Liabilities $10,512,000.00 $8,512,000.00
Long Term Debt 17,490,000.00 2,132,000.00
Other Long Term Liabilities 12,904,000.00 13,830,000.00
Total Liabilities $30,394,000.00 $15,962,000.00
Total Stockholder Equity $13,712,000.00 $9,380,000.00
Total Liabilities & Owner's Equity $44,106,000.00 $25,342,000.00
We will assume that all of both firms’ sales are credit sales (not true, undoubtedly).

We have used all of the ratios used in the H.J. Boswell example from Table 4.3 of the text. The
results are shown below. Values that are in bold are the better values for a given metric.
Sears Holding (SHLD) Target Corp (TGT)
Liquidity
Current ratio 1.66 1.34
Acid Test Ratio 1.03 0.31
Average collection period 73.72 4.87
Accounts Receivable Turnover 4.95 75.00
Inventory turnover 5.09 5.02
Asset Management Efficiency
Total asset turnover 1.06 2.56
Fixed asset turnover 1.82 8.03
Financial Leverage
Debt Ratio 0.69 0.63
Times Interest Earned 2.21 4.92
Profitability
Gross Profit Margin 27.05% 32.01%
Operating Profit margin 1.29% 6.78%
Net Profit Margin 0.71% 5.40%
Operating Return on Assets 1.36% 17.37%
Return on Equity 2.41% 37.40%
Target dominates Sears on many measures, although Sears has a better current ratio and acid-test
ratio. Moreover Target has a better ACP which may simply reflect the fact that Sears has a huge
credit operation relative to Target.
Both firms use similar amounts of leverage. Target, however, does a much better job covering its
interest expenses since it is more profitable with EBIT of $4.02 million vs. $602 million in EBIT
for Sears. Target’s times interest earned ratio is almost 5, compared to Sear’s times interest earned
ratio of 2.21.
All of Target’s profitability ratios are better than Sears, beginning with the gross profit margin.
These ratios should be of the most concern to the financial manager at Sears.

Financial Analysis-Sizing Up Firm Performance: Income Statement 2016 % of Sales Example Calculations

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Chapter 4

Financial Analysis—Sizing Up Firm Performance

Income Statement 2016 % of sales example calculations:

Balance Sheet 2016 % of TA example calculations:

Accounts Payable $7,200 22%

We will assess these common-size statements in the next problem.

Based on these data, I would tell my boss:

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4-4. Apex Fabricating, Inc. now has a current ratio of 2.5:

 current assets  10,381,800

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4-6. Here is Campbell Industries’ current situation:

from Balance Sheet % of TA

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from Income Statement

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4-10. a. Average collection period (ACP) is calculated as:

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Callaway was able to generate $188,500 in net income on sales of $5,000,000.

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4-13. As shown in equation 4-14a, a firm’s equity multiplier is found as follows:

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4-14. We are given the following values for Triangular Chemicals:

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Total sales = $200,000,000

Total assets = $100,000,000

ROE = NI/Common equity

Net profit margin = 7.5% = NI/Sales

4-16. We are given the following values for Bryley, Inc.:

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TIE = 6.00 EBIT/interest expense

18. a. Raconteurs, Inc.’s current ratio is (from equation 4-1):

 current assets   $110M 

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total asset turnover  1.5   sales  .

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 current assets   $1,807,626,000 

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Verifying, we see that:

accounts payable $1,100,000

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accounts payable $2,500,000 $5,000,000

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Income Statement CARSON BGT ELECTRONICS

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($10,000,000)  $1,000,000. Its operating return on assets is therefore ($1,000,000/$5,000,000),

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ASSET MANAGEMENT EFFICIENCY

4-31. a. Salco’s total asset turnover is (sales/total assets)  ($4,500,000/$2,000,000)  2.25.

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accounts payable $48,000 $57,000

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ROE 25.21% 16.14%

NSM ADI TXN

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