Is owner
View only
Upload & Edit
Ch03.doc
Download
Share
Add to my account
Buy ads here

Chapter 3

Discussion Questions

3-1.

If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons?


Short-term lenders–liquidity ratios because their concern is with the firm’s ability to pay short-term obligations as they come due.


Long-term lenders–leverage ratios because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made.


Stockholders–profitability ratios, with secondary consideration given to debt utilization, liquidity, and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.



3-2.

Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity.


The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover.


Return on Assets = Profit Margin × Asset Turnover


In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a company in the capital goods industry may have a high profit margin and a low asset turnover, while a food processing firm may suffer from low profit margins, but enjoy a rapid turnover of assets.


The modified form of the Du Pont formula shows:



This indicates that return on stockholders’ equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on stockholders’ equity that is influenced by large amounts of debt.



3-3.

If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?


If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer period of time. This means the average collection period will be increasing.



3-4.

What advantage does the fixed charge coverage ratio offer over simply using times interest earned?


The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.



3-5.

Is there any validity in rule-of-thumb ratios for all corporations, for example, a current ratio of 2 to 1 or debt to assets of 50 percent?


No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information.



3-6.

Why is trend analysis helpful in analyzing ratios?


Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last ten years. Trend analysis must also be compared to industry patterns of change.



3-7.

Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions.


  1. Return on investment.

  2. Inventory turnover.

  3. Fixed asset turnover.

  4. Debt-to-assets ratio.


a.


Inflation may cause net income to be overstated and total assets to be understated causing an artificially high ratio that is misleading.


b.


Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect “inflation-influenced” dollars and the net effect will be nil.


If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported.


c.


Fixed assets will be understated relative to their replacement cost and to sales and too high a ratio could be reported.


d.


Since both are based on historical costs, no major inflationary impact will take place in the ratio.



3-8.

What effect will disinflation following a highly inflationary period have on the reported income of the firm?


Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm’s income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly.



3-9.

Why might disinflation prove to be favorable to financial assets?


Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar, lessening inflation also means that the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current evaluation.



3-10.

Comparisons of income can be very difficult for two companies even though they sell the same products in equal volume. Why?


There are many different methods of financial reporting accepted by the accounting profession as promulgated by the Financial Accounting Standards Board. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items.


Problems

1. Dental Delights has two divisions. Division A has a profit of $200,000 on sales of $4,000,000. Division B is only able to make $30,000 on sales of $480,000. Based on the profit margins (returns on sales), which division is superior?

3-1. Solution:

Dental Delights

Division A Division B

Division B is superior


2. Griffey Junior Wear, Inc., has $800,000 in assets and $200,000 of debt. It reports net income of $100,000.

a. What is the return on assets?

b. What is the return on stockholders’ equity?

3-2. Solution:

Griffey Junior Wear

a.


b.

3. Bass Chemical, Inc., is considering expanding into a new product line. Assets to support this expansion will cost $1,200,000. Bass estimates that it can generate $2 million in annual sales, with a 5 percent profit margin. What would net income and return on assets (investment) be for the year?

3-3. Solution: Bass Chemical, Inc.


4. Franklin Mint and Candy Shop can open a new store that will do an annual sales volume of $750,000. It will turn over its assets 2.5 times per year. The profit margin on sales will be
6 percent. What would net income and return on assets (investment) be for the year?

3-4. Solution: Franklin Mint and Candy Shop


5. Hugh Snore Bedding, Inc., has assets of $400,000 and turns over its assets 1.5 times per year. Return on assets is 12 percent. What is its profit margin (return on sales)?

3-5. Solution: Hugh Snore Bedding, Inc.


6. One-Size-Fits-All Casket Co.’s income statement for 2008 is as follows:



Sales $3,000,000

Cost of goods sold 2,100,000

Gross profit 900,000

Selling and administrative expense 450,000

Operating profit 450,000

Interest expense 75,000

Income before taxes 375,000

Taxes (30%) 112,500

Income after taxes $262,500



a. Compute the profit margin for 2008.

b. Assume in 2009, sales increase by 10 percent and cost of goods sold increases by 25%. The firm is able to keep all other expenses the same. Once again, assume a tax rate of 30 percent on income before taxes. What are income after taxes and the profit margin for 2009?


3-6. Solution:

One Size-Fits-All Casket Co.

a. Profit margin for 2008


b. Sales $3,300,000*

Cost of goods sold 2,625,000**

Gross profit 675,000

Selling and administrative expense 450,000

Operating profit 225,000

Interest expense 75,000

Income before taxes 150,000

Taxes (30%) 45,000

Income after taxes (2008) $105,000

* $3,000,000 × 1.10 = $3,300,000

** $2,100,000 × 1.25 = $2,625,000

Profit Margin for 2009

7. Easter Egg and Poultry Company has $2,000,000 in assets and $1,400,000 of debt. It reports net income of $200,000.

a. What is the firm’s return on assets?

b. What is its return on stockholders’ equity?

c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin
(return on sales)?

3-7. Solution: Easter Egg and Poultry Company

a.


b.



3-7. (Continued)

c.


8. Sharpe Razor Company has total assets of $2,500,000 and current assets of $1,000,000. It turns over its fixed assets 5 times a year and has $700,000 of debt. Its return on sales is
3 percent. What is Sharpe’s return on stockholders’ equity?

3-8. Solution: Sharpe Razor Company

total assets $2,500,000

current assets 1,000,000

Fixed assets $1,500,000

total assets $2,500,000

debt 700,000

Stockholders’ equity $1,800,000


9. Baker Oats had an asset turnover of 1.6 times per year.

a. If the return on total assets (investment) was 11.2 percent, what was Baker’s profit margin?

b. The following year, on the same level of assets, Baker’s assets turnover declined to 1.4 times and its profit margin was 8 percent. How did the return on total assets change from that of the previous year?

3-9. Solution:

Baker Oats

a. Total asset turnover × Profit Margin = Return on Total assets

1.6 × ? = 11.2%

b. 1.4 × 8% = 11.2%

It did not change at all because the increase in profit margin made up for the decrease in the asset turnover.


10. Global Healthcare Products has the following ratios compared to its industry for 2008.


Global Healthcare

Industry

Return on sales………..

2%

10%

Return on assets………

18%

12%

Explain why the return-on-assets ratio is so much more favorable than the return-on-sales ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required.


3-10. Solution:

Global Healthcare Products

Global Healthcare Products has a higher asset turnover ratio than the industry.

11. Acme Transportation Company has the following ratios compared to its industry for 2009.


Acme Transportation

Industry

Return on assets……………

9%

6%

Return on equity……………

12%

24%

Explain why the return-on-equity ratio is so much less favorable than the return-on-assets ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that is required.

3-11. Solution: Acme Transportation Company

Acme Transportation has a lower debt/total assets ratio than the industry.

For those who did a calculation, Acme’s debt to assets were
25% vs 75% for the industry.


12. Gates Appliances has a return-on-assets (investment) ratio of 8 percent.

a. If the debt-to-total-assets ratio is 40 percent, what is the return on equity?

b. If the firm had no debt, what would the return-on-equity ratio be?

3-12. Solution: Gates Appliances

a.

b. The same as return on assets (8%).


13. Using the Du Pont method, evaluate the effects of the following relationships for the Butters Corporation.

a. Butters Corporation has a profit margin of 7 percent and its return on assets (investment) is 25.2 percent. What is its assets turnover?

b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what would the firm’s return on equity be?

c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 35 percent?

3-13. Solution: Butters Corporation

a.


b.


3-13. (Continued)

c.


14. Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3.5 percent on each dollar of sales and turns over its assets 2.5 times per year. It has $100,000 in current liabilities and $300,000 in long-term liabilities.

a. What is its return on stockholders’ equity?

b. If the asset base remains the same as computed in part a, but total asset turnover goes up to 3, what will be the new return on stockholders’ equity? Assume that the profit margin stays the same as do current and long-term liabilities.

3-14. Solution: Jerry Rice and Grain Store

a.

b. The new level of sales will be:


15. Assume the following data for Interactive Technology and Silicon Software.


Interactive Technology (IT)

Silicon Software (SS)

Net income…………………..

$ 15,000

$ 50,000

Sales…………………………

150,000

1,000,000

Total assets…………………..

160,000

400,000

Total debt…………………….

60,000

240,000

Stockholders’ equity………….

100,000

160,000

a. Compute return on stockholders’ equity for both firms using ratio 3a in the text. Which firm has the higher return?

b. Compute the following additional ratios for both firms.

Net income/Sales

Net income/Total assets

Sales/Total assets

Debt/Total assets

c. Discuss the factors from part b that added or detracted from one firm having a higher return on stockholders’ equity than the other firm as computed in part a.


3-15. Solution

Interactive Technology and Silicon Software

a. Interactive Silicon

Technology (IT) Software (SS)

Silicon Software (SS) has a much higher return on stockholders’ equity than Interactive Technology (IT).


3-15. (Continued)

b. Interactive Silicon

Technology (IT) Software (SS)


  1. As previously indicated, Silicon Software (SS) has a substantially higher return on stockholder’s equity than Interactive Technology (IT). The reason is certainly not to be found on return on the sales dollar where Interactive Technology has a higher return than Silicon Software (10% vs. 5%).


However, Silicon Software has a higher return than Interactive Technology on total assets (12.5% versus 9.37%). The reason is clearly to be found in total asset turnover, which strongly favors Silicon Software over Interactive Technology (2.5x versus .937x). This factor alone leads to the higher return on total assets.

16. A firm has sales of $3 million, and 10 percent of the sales are for cash. The year-end accounts receivable balance is $285,000. What is the average collection period?
(Use a 360-day year.)


3-16. Solution:


17. Martin Electronics has an accounts receivable turnover equal to 15 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales?


Solution:

Martin Electronics

To determine credit sales, multiply accounts receivable by accounts receivable turnover.


18. Perez Corporation has the following financial data for the years 2007 and 2008:


2007

2008

Sales…………………………

$8,000,000

$10,000,000

Cost of goods sold……………

6,000,000

9,000,000

Inventory……………………..

800,000

1,000,000

a. Compute inventory turnover based on ratio number 6, Sales/Inventory, for each year.

b. Compute inventory turnover based on an alternative calculation that is used by many financial analysts, Cost of goods sold/Inventory, for each year.

c. What conclusions can you draw from part a and part b?


3-18. Solution:

Perez Corporation

2007 2008

a.

b.

c. Based on the sales to inventory ratio, the turnover has remained constant at 10x. However, based on the cost of goods sold to inventory ratio, it has improved from
7.5x to 9x.

The latter ratio may be providing a false picture of improvement in this example simply because cost of goods sold has gone up as percentage of sales (from 75 percent to 90 percent). Inventory is not really turning over any faster.

19. The Speed-O Company makes scooters for kids. Sales in 2008 were $8,000,000. Assets were as follows:

Cash……………………………………….

$200,000

Accounts receivable……………………….

1,600,000

Inventory…………………………………..

800,000

Net plant and equipment…………………..

1,000,000

Total assets……………………………

$3,600,000

a. Compute the following:

1. Accounts receivable turnover

2. Inventory turnover

3. Fixed asset turnover

4. Total asset turnover

b. In 2009, sales increased to $10,000,000 and the assets for that year were as follows:

Cash………………………………………...

$200,000

Accounts receivable………………………..

1,800,000

Inventory…………………………………...

2,200,000

Net plant and equipment…………………...

1,050,000

Total assets……………………………..

$5,250,000

Once again, compute the four ratios listed in 19a.

c. Indicate if there is an improvement or decline in total asset turnover, and based on the other ratios, indicate why this development has taken place.

3-19. Solution: Speed-O Company

a. 1. Accounts receivable turnover = Sales/Accounts Receivable

2. Inventory turnover = Sales/Inventory

3. Fixed asset turnover = Sales/(Net Plant & Equipment)

4. Total asset turnover = Sales/Total Assets

b. 1. Accounts receivable turnover

2. Inventory turnover

3. Fixed asset turnover

4. Total asset turnover

c. There is a decline in total asset turnover from 2.22 to 1.90. This development has taken place because of the slowdown in inventory turnover (10x down to 4.55x). The other two ratios are slightly improved.

20. The balance sheet for Stud Clothiers is shown below. Sales for the year were $2,400,000, with 90 percent of sales sold on credit.

STUD CLOTHIERS

Balance Sheet 200X

Assets

Liabilities and Equity

Cash……………………

$ 60,000

Accounts payable……………..

$ 220,000

Accounts receivable…...

240,000

Accrued taxes…………………

30,000

Inventory………………

350,000

Bonds payable
(long-term)……………………

150,000

Plant and equipment…...

410,000

Common stock………………..

80,000



Paid-in capital…………………

200,000



Retained earnings……………..

380,000

Total assets………...

$1,060,000

Total liabilities and equity…

$1,060,000

Compute the following ratios:

a. Current ratio.

b. Quick ratio.

c. Debt-to-total-assets ratio.

d. Asset turnover.

e. Average collection period.

3-20. Solution: Stud Clothiers

a.

b.

c.

d.

e.



21. Neeley Office Supplies income statement is given below.

a. What is the times interest earned ratio?

b. What would be the fixed charge coverage ratio?


NEELEY OFFICE SUPPLIES

Sales $200,000

Cost of goods sold 115,000

Gross profit 85,000

Fixed charges (other than interest) 25,000

Income before interest and taxes 60,000

Interest 15,000

Income before taxes 45,000

Taxes 15,300

Income after taxes $ 29,700


3-21. Solution:

Neeley Office Supplies

a.

b.

22. Using the income statement for Times Mirror and Glass Co., compute the following ratios:

a. The interest coverage.

b. The fixed charge coverage.

The total assets for this company equal $80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e.

c. Profit margin.

d. Total asset turnover.

e. Return on assets (investment).


TIMES MIRROR AND GLASS COMPANY

Sales $126,000

Less: Cost of goods sold 93,000

Gross profit $ 33,000

Less: Selling and administrative expense 11,000

Less: Lease expense 4,000

Operating profit* $ 18,000

Less: Interest expense 3,000

Earnings before taxes $ 15,000

Less: Taxes (30%) 4,500

Earnings after taxes $ 10,500

*Equals income before interest and taxes.


3-22. Solution: Times Mirror and Glass Co.

a.

b.

c.


3-22. (Continued)

d.

e.


23. A firm has net income before interest and taxes of $120,000 and interest expense of $24,000.

a. What is the times interest earned ratio?

b. If the firm’s lease payments are $40,000, what is the fixed charge coverage?


3-23. Solution:

a.

b.


24. In January 1999, the Status Quo Company was formed. Total assets were $500,000, of which $300,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation, and in 1999 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $26,000 per year each of the last 10 years. Other assets have not changed since 1999.

a. Compute return on assets at year-end for 1999, 2001, 2004, 2006, and 2008.
(Use $26,000 in the numerator for each year.)

b. To what do you attribute the phenomenon shown in part a?

c. Now assume income increased by 10 percent each year. What effect would this have on your above answers? Merely comment.

3-24. Solution:

Status Quo Company

a. Return on assets (investment) = Income after taxes/Total assets.

The return on assets for Status Quo will increase over time as the assets depreciate and the denominator gets smaller. Fixed assets at the beginning of 1995 equal $300,000 with a ten-year life which means the depreciation expense will be $30,000 per year. Book values at year-end are as follows:

1999 = $270,000;

2001 = $210,000;

2004 = $120,000;

2006 = $ 60,000;

2008 = -0-

1999 = $26,000/$470,000 = 5.53%

2001 = $26,000/$410,000 = 6.34%

2004 = $26,000/$320,000 = 8.13%

2006 = $26,000/$260,000 = 10.00%

2008 = $26,000/$200,000 = 13.00%

b. The increasing return on assets over time is due solely to the fact that annual depreciation charges reduce the amount of investment. The increasing return is in no way due to operations.

Financial analysts should be aware of the effect of overall asset age on the return-on-investment ratio and be able to search elsewhere for indications of operating efficiency when ROI is very high or very low.

c. As income rises, return on assets will be higher than in part (b) and would indicate an increase in return partially from more profitable operations.


25. Calloway Products has the following data. Industry information is also shown.

Industry Data on Net Year Net Income Total Assets Income/Total Assets

2006 $360,000 $3,000,000 11%

2007 380,000 3,400,000 8

2008 380,000 3,800,000 5

Industry Data on

Year Debt Total Assets Debt/Total Assets

2006 $1,600,000 $3,000,000 52%

2007 1,750,000 3,400,000 40

2008 1,900,000 3,800,000 31

As an industry analyst comparing the firm to the industry, are you likely to praise or criticize the firm in terms of:

a. Net income/Total assets?

b. Debt/Total assets?

3-25. Solution: Calloway Products

a. Net income/total assets

Year

Calloway Ratio

Industry Ratio

2006

12.0%

11.0%

2007

11.18%

8.0%

2008

10.0%

5.0%

Although the company has shown a declining return on assets since 2006, it has performed much better than the industry. Praise may be more appropriate than criticism.

3-25. (Continued)

b. Debt/total assets


Year

Calloway Ratio

Industry Ratio

2006

53.33%

52.0%

2007

51.47%

40.0%

2008

50.0%

31.0%


While the company’s debt ratio is improving, it is not improving nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise.


26. Jodie Foster Care Homes, Inc., shows the following data:


Year Net Income Total Assets Stockholders’ Equity Total Debt

2005 $118,000 $1,900,000 $ 700,000 $1,200,000

2006 131,000 1,950,000 950,000 1,000,000

2007 148,000 2,010,000 1,100,000 910,000

2008 175,700 2,050,000 1,420,000 630,000


a. Compute the ratio of net income to total assets for each year and comment on the trend.

b. Compute the ratio of net income to stockholders’ equity and comment on the trend. Explain why there may be a difference in the trends between parts a and b.


3-26. Solution:

Jodie Foster Care Homes, Inc.

a.

2005 $118,000/$1,900,000 = 6.21%

2006 $131,000/$1,950,000 = 6.72%

2007 $148,000/$2,010,000 = 7.36%

2008 $175,700/$2,050,000 = 8.57%


Comment: There is a strong upward movement in return on assets over the four year period.


b.

2005 $118,000/$700,000 = 16.86%

2006 $131,000/$950,000 = 13.79%

2007 $148,000/$1,100,000 = 13.45%

2008 $175,700/$1,420,000 = 12.37%


Comment: The return on stockholders’ equity ratio is going down each year. The difference in trends between a and b is due to the larger portion of assets that are financed by stockholders’ equity as opposed to debt.

Optional: This can be confirmed by computing total debt to total assets for each year.

2005 63.2%

2006 51.3%

2007 45.3%

2008 30.7%

27. The United World Corporation has three subsidiaries.


Computers Magazines Cable TV

Sales $16,000,000 $4,000,000 $8,000,000

Net income (after taxes) 1,000,000 160,000 600,000

Assets 5,000,000 2,000,000 5,000,000

.

a. Which division has the lowest return on sales?

b. Which division has the highest return on assets?

c. Compute the return on assets for the entire corporation.

d. If the $5,000,000 investment in the cable TV division is sold off and redeployed in the computer division at the same rate of return on assets currently achieved in the computer division, what will be the new return on assets for the entire corporation?


3-27. Solution:

United World Corporation

a.

The magazine division has the lowest return on sales.

b.

The computer division has the highest return on assets.

c.

3-27. (Continued)

d. Return on redeployed assets in computers.

20% × $5,000,000 = $1,000,000

Return on assets for the entire corporation:

28. Omni Technology Holding Company has the following three affiliates:


Personal Foreign

Software Computers Operations

Sales $40,000,000 $60,000,000 $100,000,000

Net income (after taxes) 2,000,000 2,000,000 8,000,000

Assets 5,000,000 25,000,000 60,000,000

Stockholders’ equity 4,000,000 10,000,000 50,000,000


a. Which affiliate has the highest return on sales?

b. Which affiliate has the lowest return on assets?

c. Which affiliate has the highest total asset turnover?

d. Which affiliate has the highest return on stockholders’ equity?

e. Which affiliate has the highest debt ratio? (Assets minus stockholders’ equity equals debt.)

f. Returning to question b, explain why the software affiliate has the highest return on total assets.

g. Returning to question d, explain why the personal computer affiliate has a higher return on stockholders’ equity than the foreign operations affiliate even though it has a lower return on total assets.


3-28. Solution:

Omni Technology Holding Company

a. Net income/sales

The foreign operation affiliate has the highest return on sales.

b. Net income/total assets

The personal computer affiliate has the lowest return on assets

c. Sales/total assets

T

he software affiliate has the highest return on total asset turnover.

  1. Net income/

Stockholders’ equity

The Software affiliate has the highest return on stockholder’s equity.

e. Debt/total assets

The personal computer affiliate has the highest debt/total assets ratio.

f. This is because of its high total turnover ratio of 8.0x times in part c.

g. This is because the personal computer affiliate has a higher debt ratio (60.0%) than the foreign operations affiliate (16.7%).

29. Bard Corporation shows the following income statement. The firm uses FIFO inventory accounting.


BARD CORPORATION

Income Statement for 2008

Sales $200,000 (10,000 units at $20)

Cost of goods sold 100,000 (10,000 units at $10)

Gross profit 100,000

Selling and administrative expense 10,000

Depreciation 20,000

Operating profit 70,000

Taxes (30%) 21,000

Aftertax income $ 49,000



a. Assume in 2009 the same 10,000-unit volume is maintained, but that the sales price increases by 10 percent. Because of FIFO inventory policy, old inventory will still be charged off at $10 per unit. Also assume that selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute aftertax income for 2009.

b. In part a, by what percent did aftertax income increase as a result of a 10 percent increase in the sales price? Explain why this impact occurred.

c. Now assume that in 2010 the volume remains constant at 10,000 units, but the sales price decreases by 15 percent from its year 2009 level. Also, because of FIFO inventory policy, cost of goods sold reflects the inflationary conditions of the prior year and is $11 per unit. Further, assume selling and administrative expense will be 5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent. Compute the aftertax income.


3-29. Solution:

Bard Corporation

a. 2009

Sales $220,000 (10,000 units at $22)

Cost of goods sold 100,000 (10,000 units at $10)

Gross profit $120,000

Selling and adm. expense 11,000 (5% of sales)

Depreciation 20,000

Operating profit $ 89,000

Taxes (30%) $ 26,700

After tax income $ 62,300

3-29. (Continued)

b. Gain in aftertax income

2009 $62,300

2008 49,000

Increase $13,300

Aftertax income increased much more than sales because of FIFO inventory policy (in this case, the cost of old inventory did not go up at all), and because of historical cost depreciation (which did not change).

c. 2010

Sales $187,000 (10,000 units at $18.70*)

Cost of goods sold 110,000 (10,000 units at $11.00)

Gross profit $ 77,000

Selling and adm. expense 9,350 (5% of sales)

Depreciation 20,000

Operating profit $ 47,650

Taxes (30%) $ 14,295

After tax income $ 33,355

*$22 × 0.85 = $18.70

The low profits indicate the effect of inflation followed by disinflation.

30. Construct the current assets section of the balance sheet from the following data. (Use cash as a plug figure after computing the other values.)


Yearly sales (credit) $720,000

Inventory turnover 6 times

Current liabilities $105,000

Current ratio 2

Average collection period 35 days

Current assets:

Cash $______

Accounts receivable ______

Inventory ______

Total current assets ______



3-30. Solution:

Inventory = $720,000/6

= $120,000

Account rec. = ($720,000/360) × 35

= $70,000

Current assets = 2 × $105,000

= $210,000

Cash = $210,000 – $120,000 – $70,000

= $ 20,000


Cash $ 20,000

Accounts receivable 70,000

Inventory 120,000

Total current assets $210,000


31. The Griggs Corporation has credit sales of $1,200,000. Given the following ratios, fill in the balance sheet below.


Total assets turnover 2.4 times

Cash to total assets 2.0%

Accounts receivable turnover 8.0 times

Inventory turnover 10.0 times

Current ratio 2.0 times

Debt to total assets 61.0%



GRIGGS CORPORATION

Balance Sheet 2008

Assets Liabilities and Stockholders’ Equity

Cash _____ Current debt _____

Accounts receivable _____ Long-term debt _____

Inventory _____ Total debt _____

Total current assets _____ Equity _____

Fixed assets _____

Total assets _____ Total debt and stockholders’ equity _____



3-31. Solution:

Griggs Corporation

Sales/total assets = 2.4 times

Total assets = $1,200,000/2.4

Total assets = $500,000

Cash = 2% of total assets

Cash = 2% × $500,000

Cash = $10,000

Sales/accounts receivable = 8 times

Accounts receivable = $1,200,000/8

Accounts receivable = $150,000

Sales/inventory = 10 times

Inventory = $1,200,000/10

Inventory = $120,000

Fixed assets = Total assets – current assets

Current asset = $10,000 + $150,000 +
$120,000 = $280,000

Fixed assets = $500,000 – $280,000

= $220,000

Current assets/current debt = 2

Current debt = Current assets/2

Current debt = $280,000/2

Current debt = $140,000

Total debt/total assets = 61%

Total debt = .61 × $500,000

Total debt = $305,000

Long-term debt = Total debt – current debt

Long-term debt = $305,000 – 140,000

Long-term debt = $165,000

Equity = Total assets – total debt

Equity = $500,000 – $305,000

Equity = $195,000

Griggs Corporation
Balance Sheet 2008

Cash

$ 10,000

Current debt

$140,000

A/R

150,000

Long-term debt

165,000

Inventory

$120,000

Total debt

$305,000

Total current assets

280,000



Fixed assets

220,000

Equity

195,000

Total assets

$500,000

Total debt and

stockholders’
equity

$500,000


32. We are given the following information for the Coleman Machine Tools Corporation.


Sales (credit) $7,200,000

Cash 300,000

Inventory 2,150,000

Current liabilities 1,400,000

Asset turnover 1.20 times

Current ratio 2.50 times

Debt-to-assets ratio 40%

Receivables turnover 8 times



Current assets are composed of cash, marketable securities, accounts receivable, and inventory. Calculate the following balance sheet items.

a. Accounts receivable.

b. Marketable securities.

c. Fixed assets.

d. Long-term debt.


3-32. Solution:

Coleman Machine Corporation

a. Accounts receivable = Sales/Receivable turnover

= $7,200,000/8x

= $900,000

b. Marketable securities = Current assets – (cash +

accounts rec. + inventory)

Current Assets = Current ratio × Current liabilities

= 2.5 × $1,400,000

= $3,500,000

Marketable securities = $3,500,000 – ($300,000 +

$900,000 + $2,150,000)

= $3,500,000 – $3,350,000

= $150,000

c. Fixed assets = Total assets – Current assets

Total assets = Sales/Asset turnover

= $7,200,000/1.20x

= $6,000,000

Fixed assets = $6,000,000 – $3,500,000

= $2,500,000

d. Long-term debt = Total debt – current liabilities

Total debt = Debt to assets × total assets

= 40% × $6,000,000

= $2,400,000

Long-term debt = $2,400,000 – $1,400,000

= $1,000,000

33. The following data are from Sharon Stone and Gravel, Inc., financial statements. The firm manufactures home decorative material. Sales (all credit) were $60 million for 2008.


Sales to total assets 3.0 times

Total debt to total assets 40%

Current ratio 2.0 times

Inventory turnover 10.0 times

Average collection period 18.0 days

Fixed asset turnover 7.5 times



Fill in the balance sheet:


Cash ______ Current debt _____t_

Accounts receivable ______ Long-term debt ______

Inventory ______ Total debt ______

Total current assets ______ Equity ______

Fixed assets ______

Total assets ______ Total debt and stockholders’ equity ______


3-33. Solution:

Sharon Stone and Gravel, Inc.

Sales/total assets = 3.0x

Total assets = $60 million/3.0

Total assets = $20 million

Total debt/total asset = 40%

Total assets = $20 million x .4

Total assets = $8 million

Sales/inventory = 10.0x

Inventory = $60 million/10.0x

Inventory = $6 million

Average daily sales = $60 million/360 days

= $166,667 per day

Accounts receivable = 18 days × $166,667

= $3 million (or)

Fixed assets = $60 million/7.5x

= $8 million

Cash = Total assets – inventory –
accounts receivable – fixed assets

= $20 million – $6 million – $3 million –
$8 million

= $3 million

Current assets = Cash + accounts receivable + inventory

= $3 million + $3 million + $6 million

= $12 million

Current debt = Current assets/2×

= $12 million/2

= $6 million

Long-term debt = Total debt – current debt

= $8 million – $6 million

= $2 million

Equity = Total assets – total debt

= $20 million – $8 million

= $12 million

3-33. (Continued)

Cash.................

$ 3.0 million

Current debt.............

$ 6.0 million

Accounts receivable.....

$ 3.0

Long-term debt.............

$ 2.0

Inventory.........

$ 6.0

Total debt.......

$ 8.0

Total current assets............

$12.0

Equity.............

$12.0

Fixed assets.....

$ 8.0



Total assets.....

$20.0 million

Total debt and equity...........

$20.0 million


34. Using the financial statements for the Goodyear Calendar Company, calculate the 13 basic ratios found in the chapter.

GOODYEAR CALENDAR COMPANY

Balance Sheet
December 31, 2008

Assets

Current assets:


Cash

$ 40,000

Marketable securities

30,000

Accounts receivable (net)

120,000

Inventory

180,000

Total current assets

$370,000

Investments

40,000

Plant and equipment

450,000

Less: Accumulated depreciation

(100,000)

Net plant and equipment

350,000

Total assets

$760,000

GOODYEAR CALENDAR COMPANY

Liabilities and Stockholders’ Equity

Current liabilities:


Accounts payable

$ 90,000

Notes payable

10,000

Accrued taxes

10,000

Total current liabilities

110,000

Long-term liabilities:


Bonds payable

170,000

Total liabilities

280,000

Stockholders’ equity


Preferred stock, $100 par value

90,000

Common stock, $1 par value

60,000

Capital paid in excess of par

230,000

Retained earnings

100,000

Total stockholders’ equity

480,000

Total liabilities and stockholders’ equity

$760,000


GOODYEAR CALENDAR COMPANY

Income Statement
For the Year Ending December 31, 2008

Sales (on credit)

$2,000,000

Less: Cost of goods sold

1,300,000

Gross profit

700,000

Less: Selling and administrative expenses

400,000*

Operating profit (EBIT)

300,000

Less: Interest expense

20,000

Earnings before taxes (EBT)

280,000

Less: Taxes

112,000

Earnings after taxes (EAT)

$ 168,000

*Includes $10,000 in lease payments.



3-34. Solution:

Goodyear Calendar Company

Profitability ratios

Profit margin = $168,000/$2,000,000 = 8.40%

Return on assets (investment) = $168,000/$760,000 = 22.1%

Return on equity = $168,000/$480,000 = 35%

Assets utilization ratios

Receivable turnover = $2,000,000/$120,000 = 16.66x

Average collection period = $120,000/$5,555 = 21.6 days

Inventory turnover = $2,000,000/$180,000 = 11.11x

Fixed asset turnover = $2,000,000/$350,000 = 5.71x

Total asset turnover = $2,000,000/$760,000 = 2.63x

Liquidity ratio

Current ratio = $370,000/$110,000 = 3.36x

Quick ratio = $190,000/$110,000 = 1.72x

Debt utilization ratios

Debt to total assets = $280,000/$760,000 = 36.84%

Times interest earned = $300,000/$20,000 = 15x

Fixed charge coverage = $310,000/$30,000 = 10.33x


35. Given the following financial statements for Jones Corporation and Smith Corporation:

a. To which company would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering.

b. In which one would you buy stock? Why?

JONES CORPORATION

Current Assets

Liabilities

Cash

$ 20,000

Accounts payable

$100,000

Accounts receivable

80,000

Bonds payable (long-term)

80,000

Inventory

50,000



Long-Term Assets

Stockholders’ Equity

Fixed assets

$500,000

Common stock

$150,000

Less: Accumulated

depreciation

(150,000)

Paid-in capital

Retained earnings

70,000

100,000

*Net fixed assets

350,000


Total assets

$500,000

Total liabilities and equity

$500,000


Sales (on credit)

$1,250,000

Cost of goods sold

750,000

Gross profit

500,000

Selling and administrative expense

257,000

Less: Depreciation expense

50,000

Operating profit

193,000

Interest expense

8,000

Earnings before taxes

185,000

Tax expense

92,500

Net income

$ 92,500

*Use net fixed assets in computing fixed asset turnover.

Includes $7,000 in lease payments.


SMITH CORPORATION

Current Assets

Liabilities

Cash

$ 35,000

Accounts payable

$ 75,000

Marketable securities

7,500

Bonds payable (long-term)

210,000

Accounts receivable

70,000



Inventory

75,000



Long-Term Assets

Stockholders’ Equity

Fixed assets

$500,000

Common stock

$ 75,000

Less: Accumulated
depreciation

(250,000)

Paid-in capital

Retained earnings

30,000

47,500

*Net fixed assets

250,000



Total assets

$437,500

Total liabilities and equity

$437,500


Sales (on credit)

$1,000,000

Cost of goods sold

600,000

Gross profit

400,000

Selling and administrative expense

224,000

Less: Depreciation expense

50,000

Operating profit

126,000

Interest expense

21,000

Earnings before taxes

105,000

Tax expense

52,500

Net income

$ 52,500

*Use net fixed assets in computing fixed asset turnover.

Includes $7,000 in lease payments.



3-35. Solution:

Jones and Smith Comparison

One way of analyzing the situation for each company is to compare the respective ratios for each on, examining those ratios which would be most important to a supplier or short-term lender and a stockholder.



Jones Corp.

Smith Corp.

Profit margin

7.4%

5.25%

Return on assets (investments)

18.5%

12.00%

Return on equity

28.9%

34.4%

Receivable turnover

15.63x

14.29x

Average collection period

23.04 days

25.2 days

Inventory turnover

25x

13.3x

Fixed asset turnover

3.57x

4x

Total asset turnover

2.5x

2.29x

Current ratio

1.5x

2.5x

Quick ratio

1.0x

1.5x

Debt to total assets

36%

65.1%

Times interest earned

24.13x

6x

Fixed charge coverage

13.33x

4.75x

Fixed charge coverage calculation

(200/15)

(133/28)


a. Since suppliers and short-term lenders are most concerned with liquidity ratios, Smith Corporation would get the nod as having the best ratios in this category. One could argue, however, that Smith had benefited from having its debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios.

3-35. (Continued)

b. Stockholders are most concerned with profitability. In this category, Jones has much better ratios than Smith. Smith does have a higher return on equity than Jones, but this is due to its much larger use of debt. Its return on equity is higher than Jones’ because it has taken more financial risk. In terms of other ratios, Jones has its interest and fixed charges well covered and in general its long-term ratios and outlook are better than Smith’s. Jones has asset utilization ratios equal to or better than Smith and its lower liquidity ratios could reflect better short-term asset management, and that point was covered in part a.

Note: Remember that to make actual financial decisions more than one year’s comparative data is usually required. Industry comparisons should also be made.

COMPREHENSIVE PROBLEM

Comprehensive Problem 1.

Al Thomas has recently been approached by his brother-in-law, Robert Watson, with a proposal to buy a 20 percent interest in Watson Leisure Time Sporting Goods. The company manufactures golf clubs, baseball bats, basketball goals, and other similar items.

Mr. Watson is quick to point out the increase in sales over the last three years as indicated in the income statement, Exhibit 1. The annual growth rate is 20 percent. A balance sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in Exhibit 3. Note the industry growth rate in sales is only approximately 10 percent per year.

There was a steady real growth of 2 to 3 percent in gross domestic product during the period under study. The rate of inflation was in the 3 to 4 percent range.

The stock in the corporation has become available due to the ill health of a current stockholder, who needs cash. The issue here is not to determine the exact price for the stock, but rather whether Watson Leisure Time Sporting Goods represents an attractive investment situation. Although Mr. Thomas has a primary interest in the profitability ratios, he will take a close look at all the ratios. He has no fast and firm rules about required return on investment, but rather wishes to analyze the overall condition of the firm. The firm does not currently pay a cash dividend, and return to the investor must come from selling the stock in the future. After doing a thorough analysis (including ratios for each year and comparisons to the industry), what comments and recommendations do you offer to Mr. Thomas?


Exhibit 1

WATSON LEISURE TIME SPORTING GOODS

Income Statement


200X

200Y

200Z

Sales (all on credit)

$1,500,000

$1,800,000

$2,160,000

Cost of goods sold

950,000

1,120,000

1,300,000

Gross profit

550,000

680,000

860,000

Selling and administrative expense*

380,000

490,000

590,000

Operating profit

170,000

190,000

270,000

Interest expense

30,000

40,000

85,000

Net income before taxes

140,000

150,000

185,000

Taxes

46,120

48,720

64,850

Net income

$ 93,880

$ 101,280

$ 120,150

Shares

40,000

40,000

46,000

Earnings per share

$2.35

$2.53

$2.61

*Includes $20,000 in lease payments for each year.




Exhibit 2

WATSON LEISURE TIME SPORTING GOODS

Balance Sheet


200X

200Y

200Z

Assets

Cash

$ 20,000

$ 30,000

$ 20,000

Marketable securities

30,000

35,000

50,000

Accounts receivable

150,000

230,000

330,000

Inventory

250,000

285,000

325,000

Total current assets

450,000

580,000

725,000

Net plant and equipment

550,000

720,000

1,169,000

Total assets

$1,000,000

$1,300,000

$1,894,000

Liabilities and Stockholders’ Equity

Accounts payable

$ 100,000

$ 225,000

$ 200,000

Notes payable (bank)

100,000

100,000

300,000

Total current liabilities

200,000

325,000

500,000

Long-term liabilities

250,000

331,120

550,740

Total liabilities

450,000

656,120

1,050,740

Common stock ($10 par)

400,000

400,000

460,000

Capital paid in excess of par

50,000

50,000

80,000

Retained earnings

100,000

193,880

303,260

Total stockholders’ equity

550,000

643,880

843,260

Total liabilities and stockholders’ equity

$1,000,000

$1,300,000

$1,894,000

Comprehensive Problem 1 (Continued)

Exhibit 3

Selected Industry Ratios


200X

200Y

200Z

Growth in sales

9.98%

10.02%

Profit margin

5.75%

5.80%

5.81%

Return on assets (investment)

8.22%

8.24%

8.48%

Return on equity

13.26%

13.62%

14.16%

Receivable turnover

10x

9.5x

10.1x

Average collection period

36 days

37.9 days

35.6 days

Inventory turnover

5.71x

5.62x

5.84x

Fixed asset turnover

2.75x

2.66x

2.20x

Total asset turnover

1.43x

1.42x

1.46x

Current ratio

2.10x

2.08x

2.15x

Quick ratio

1.05x

1.02x

1.10x

Debt to total assets

38%

39.5%

40.1%

Times interest earned

5.00x

5.20x

5.26x

Fixed charge coverage

3.85x

3.95x

3.97x

Growth in EPS

9.7%

9.8%


CP 3-1. Solution:

Watson Leisure Time Sporting Goods




200X

200Y

200Z

Growth in sales

(Company)


20%

20%

(Industry)


9.98%

10.02%

Profit margin

(Company)

6.26%

5.63%

5.56%

(Industry)

5.75%

5.80%

5.81%

Return on assets

(Company)

9.39%

7.79%

6.34%

(Industry)

8.22%

8.24%

8.48%

Return on equity

(Company)

17.07%

15.73%

14.25%

(Industry)

13.26%

13.62%

14.16%

Receivable turnover

(Company)

10.0x

7.83x

6.55x

(Industry)

10.0x

9.5x

10.1x

Average collection period

(Company)

36 days

46.0 days

55.0 days

(Industry)

36 days

37.9 days

35.6 days

Inventory turnover

(Company)

6.0x

6.32x

6.65x

(Industry)

5.71x

5.62x

5.84x

Fixed asset turnover

(Company)

2.73x

2.50x

1.85x

(Industry)

2.75x

2.66x

2.20x

Total asset turnover

(Company)

1.50x

1.38x

1.14x

(Industry)

1.43x

1.42x

1.44x

Current ratio

(Company)

2.25x

1.78x

1.45x

(Industry)

2.10x

2.08x

2.15x

Quick ratio

(Company)

1.00x

.91x

0.80x

(Industry)

1.05x

1.02x

1.10x

Debt to total assets

(Company)

45.0%

50.47%

55.48%

(Industry)

38.0%

39.50%

40.10%

Times interest earned

(Company)

5.67x

4.75x

3.18x

(Industry)

5.0x

5.20x

5.26x

Fixed charge coverage

(Company)

3.80x

3.50x

2.76x

(Industry)

3.85x

3.95x

3.97x

Growth in E.P.S.

(Company)

----

7.7%

3.2%

(Industry)

----

9.7%

9.8%


CP 3-1. (Continued)

Discussion of Ratios

While Watson Leisure Time Sporting Goods is expanding its sales much more rapidly than others in the industry, there are some clear deficiencies in their performance. These can be seen in terms of a trend analysis over time as well as a comparative analysis with industry data.

In terms of profitability, the profit margin is declining over time. This is surprising in light of the 44 percent increase in sales over two years
(20 percent per year). There obviously are no economies of scale for this firm. Higher selling and administrative costs and interest expense appear to be causing the problem. The return-on-asset ratio starts out in 200X above the industry average (9.39 percent versus 8.22 percent) and ends up well below it (6.34 percent versus 8.48 percent) in 200Z. The decline of 3.05 percent for return on assets at Watson Sporting Goods is serious, and can be attributed to the previously mentioned declining profit margin as well as a slowing total asset turnover (going from 1.5X to 1.14X).

Return on equity is higher than the industry ratio, but in a downtrend.
It is superior to the industry average for one reason: the firm has a heavier debt position than the industry. Lower returns on assets are translated into higher returns on equity because of the firm’s high debt.

The previously mentioned slower turnover of assets can be analyzed through the turnover ratios. A very real problem can be found in accounts receivable where turnover has gone from 10X to 6.55X.
This can also be stated in terms of an average collection period that has increased from 36 days to 55 days. While inventory turnover has been and remains superior to the industry, the same cannot be said for fixed asset turnover. A decline from 2.73X to 1.85X was caused by an increase in 112.5 percent in fixed assets (representing $619,000).
We can summarize the discussion of the turnover ratios by saying that despite a 44 percent increase in sales, assets grew even more rapidly causing a decline in total asset turnover from 1.50X to 1.14X.


The liquidity ratios also are not encouraging. Both the current and quick ratios are falling against a stable industry norm of approximately two and one respectively.

The debt to total assets ratio is particularly noticeable in regard to industry comparisons. Watson Sporting Goods has gone from being seven percent over the industry average to 15.38 percent above the norm (55.48 percent versus 40.1 percent). Their heavy debt position is clearly out of line with their competitors. Their downtrend in times interest earned and fixed charge coverage confirms the heavy debt burden on the company.

Finally, we see that the firm has a slower growth rate in earnings per share than the industry. This is a function of less rapid growth in earnings as well as an increase in shares outstanding (with the sale of 6,000 shares in 200Z). Once again, we see that the rapid growth in sales is not being translated down into significant earnings gains. This is true in spite of the fact that there is a very stable economic environment.
It does not appear that this is an attractive investment opportunity.


Optional Discussion:

Although the student was not specifically asked to address the issue, the instructor may wish to comment on the shares that were sold in 200Z. Looking at the capital section of the balance sheet, it appears that 6,000 shares were sold for a total value of $90,000.

$60,000 increase in par value

30,000 increase in capital paid in excess of par

$90,000 total value of 6,000 shares


The $90,000 proceeds indicates the 6,000 shares were sold at an average price of $15.00 each. The $15.00 represents a fairly low multiplier of 200Z earnings of $2.61. The price/earnings ratio is 5.75X. Book value per share (including the new shares) is $18.33 ($843,260/46,000), so once again the price of $15 is fairly modest (81.8 percent of book value).

If Mr. Thomas were to purchase 20 percent of the shares outstanding at $15 per share, the total cost would be:

92,000 shares (20 percent of 46,000)

$15 price per share

$138,000

He would probably have difficulty justifying such an investment based on the performance of the firm. There are no dividend payouts, so return to the investor would have to come in the form of capital appreciation if and when he was able to resell the shares. The prospects, at this point, would not appear to justify the purchase. This is particularly true when one considers that Mr. Thomas would be buying a minority interest (20%) and would not have control of the firm.


Comprehensive Problem 2

Sun Microsystems is a leading supplier of computer related products, including servers, workstations, storage devices, and network switches.

In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G. McNealy offered the following remarks:

Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still, we finished with revenue growth of 16 percent—and that’s significant. We believe it’s a good indication that Sun continued to pull away from the pack and gain market share. For that, we owe a debt of gratitude to our employees worldwide, who aggressively brought costs down—even as they continued to bring exciting new products to market.

The statement would not appear to be telling you enough. For example, McNealy says the year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can delve further by examining the income statement in Exhibit 1. Also, for additional analysis of other factors, consolidated balance sheet(s) are presented in Exhibit 2.

1. Referring to Exhibit 1, compute the annual percentage change in net income per common share-diluted (2nd numerical line from the bottom) for 1998–1999, 1999–2000, and
2000–2001.

2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years. Begin with 1998.

3. What is the major reason for the change in the answer for question 2 between 2000 and 2001? To answer this question for each of the two years, take the ratio of the major income statement accounts (which follow Exhibit 1 on the next page) to net revenues (sales).

Cost of sales

Research and development

Selling, general and administrative expense

Provision for income tax


Exhibit 1

SUN MICROSYSTEMS, INC.

Summary Consolidated Statement of Income (in millions)


2001

2000

1999

1998


Dollars

Dollars

Dollars

Dollars

Net revenues

$18,250

$15,721

$11,806

$9,862

Costs and expenses:





Cost of sales

10,041

7,549

5,670

4,713

Research and development

2,016

1,630

1,280

1,029

Selling, general and administrative

4,544

4,072

3,196

2,826

Goodwill amortization

261

65

19

4

In-process research and development

77

12

121

176

Total costs and expenses

16,939

13,328

10,286

8,748

Operating income

1,311

2,393

1,520

1,114

Gain (loss) on strategic investments

(90)

208

Interest income, net

363

170

85

48

Litigation settlement

Income before taxes

1,584

2,771

1,605

1,162

Provision for income taxes

603

917

575

407

Cumulative effect of change in accounting principle, net


(54)




Net income

$ 927

$ 1,854

$ 1,030

$ 755

Net income per common share—diluted


$ 0.27


$ 0.55


$ 0.31


$ 0.24

Shares used in the calculation of net income per common share—diluted


3,417


3,379


3,282


3,180

4. Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 1 and 2.

5. Analyze your results to question 4 more completely by computing ratios 1, 2a, 2b, and 3b (all from this chapter) for 2000 and 2001. Actually the answer to ratio 1 can be found as part of the answer to question 2, but it is helpful to look at it again.

What do you think was the main contributing factor to the change in return on stockholders’ equity between 2000 and 2001? Think in terms of the Du Pont system of analysis.

Comprehensive Problem 2 (Continued)

6. The average stock prices for each of the four years shown in Exhibit 1 were as follows:

1998 11¼

1999 16¾

2000 28½

2001 9½

Exhibit 2

SUN MICROSYSTEMS, INC.

Consolidated Balance Sheets (in millions)


2001

2000

Assets

Current assets:



Cash and cash equivalents

$ 1,472

$ 1,849

Short-term investments

387

626

Accounts receivable, net of allowances of $410 in 2001
and $534 in 2000


2,955


2,690

Inventories

1,049

557

Deferred tax assets

1,102

673

Prepaids and other current assets

969

482

Total current assets

7,934

6,877

Property, plant and equipment, net

2,697

2,095

Long-term Investments

4,677

4,496

Goodwill, net of accumulated amortization of $349 in 2001
and $88 in 2000

2,041

163

Other assets, net

832

521


$18,181

$14,152

Liabilities and Stockholders’ Equity

Current liabilities:



Short-term borrowings

$ 3

$ 7

Accounts payable

1,050

924

Accrued payroll-related liabilities

488

751

Accrued liabilities and other

1,374

1,155

Deferred revenues and customer deposits

1,827

1,289

Warranty reserve

314

211

Income taxes payable

90

209

Total current liabilities

5,146

4,546

Deferred income taxes

744

577

Long-term debt and other obligations

1,705

1,720

Total debt

$ 7,595

$ 6,843

Commitments and contingencies



Stockholders’ equity:



Preferred stock, $0.001 par value, 10 shares authorized
(1 share which has been designated as Series A Preferred participating stock); no shares issued and outstanding



Common stock and additional paid-in-capital, $0.00067 par value, 7,200 shares authorized; issued: 3,536 shares in 2001 and 3,495 shares in 2000



6,238



2,728

Treasury stock, at cost: 288 shares in 2001 and 301
shares in 2000

(2,435)

(1,438)

Deferred equity compensation

(73)

(15)

Retained earnings

6,885

5,959

Accumulated other comprehensive income (loss)

(29)

75

Total stockholders’ equity

10,586

7,309


$18,181

$14,152

a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown above and divide by net income per common stock-dilution from Exhibit 1.

b. Why do you think the P/E has changed from its 2000 level to its 2001 level? A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio Applied to Earnings per Share in Chapter 2.

7. The book values per share for the same four years discussed in the preceding question were:

1998 $1.18

1999 $1.55

2000 $2.29

2001 $3.26

a. Compute the ratio of price to book value for each year.

b. Is there any dramatic shift in the ratios worthy of note?


CP 3-2. Solution

Sun Microsystems, Inc.

1. Percentage change in net income per common share-diluted

1999

$ .31

2000

$ .55

2001

$ .27

1998

$ .24

1999

$ .31

2000

$ .55


$ .07


$ .24


$–.28


+29.2%


+77.4%


50.9%

2. Profit margin

1998 1999 2000 2001

7.66% 8.72% 11.79% 5.08%

3. Percent of net revenue

2000 2001

Net revenues $15,721 $18,250

Cost of sales 7,549 48.02% 10,041 55.02%

Research and

development 1,630 10.37 2,016 11.05

S, G, and A 4,072 25.90 4,544 24.90

Provision for

income taxes 917 5.83 603 3.30

The main problem between 2000 and 2001 was the increase in cost of sales as a percentage of net revenue (48.02% to 55.02%).


4. Return on stockholders’ equity

2000 2001

25.37% 8.76%


5. 2000 2001

1. 11.79% 5.08%

2.a. 13.1% 5.10%

2.b.

13.09% 5.08%

3.b.

25.37% 8.73%

The main contributing factor to the decline in the return on stockholders’ equity (25.37% to 8.73%) was the decline in the profit margin (11.79% vs. 5.08%). The decrease in asset turnover (1.11 to 1.00) made a small contribution to the decline as did the decline in the debt ratio (48.4% to 41.8%).


CP 3-2. (Continued)

6.a. P/E = Stock price/net income per common share-diluted (EPS)

1998 1999 2000 2001

P/E 46.9 54.0 51.8 35.2

b. The sharp decline in performance caused investors to pay a lower multiple for the stock.

7.a. Price to book value = Stock price/book value

1998 1999 2000 2001

P/BV 9.53 10.81 12.45 2.91

b. Once again, the sharp fall off in price to book value between 2000 and 2001 can be attributed to the decline in performance (and the impact on the stock prices). Book value was going up, but the ratio declined sharply due to the declining stock prices.

S3-38