Chapter 15 Solutions: Solutions To Questions For Review and Discussion

CHAPTER 15 SOLUTIONS
Solutions to Questions for Review and Discussion
1. Asset turnover is sales divided by the total assets employed and is a measure of how
effectively assets are used in generating sales revenue. A low turnover indicates that assets
are not being used effectively and may indicate that unproductive assets are being carried on
the books rather than being written off as obsolete. A higher asset turnover indicates more
efficient use of assets and tends to increase the rate of return on assets. However, it may also
be an indication that sufficient assets are not available to support the level of activity within the
firm.
2. The "risk" areas in financial performance analysis include the measures of liquidity, capital
adequacy, and asset quality. These ratios are considered to be "risk" measures because they
give indications of the likelihood of the firm to experience financial difficulty and/or of a threat
to the existence of the firm.
The "return" areas in financial performance analysis include the measures of earnings, growth,
and market performance. These ratios indicate the firm's ability to grow as well as its ability to
earn a return on its sales, assets, or equity.
Limiting a financial risk is also a financial success, creating a positive effect. And, poor returns
can place a firm in risky financial situations, creating a threat to the firm.
A strong risk area can give investors and creditors confidence in the financial strength of a firm
even though another risk area is weak. If multiple risk areas are weak, the firm may have
serious financial difficulties. If several areas are excessively strong, the firm may not be
allocating its resources efficiently to achieve the highest returns.
One example of trade-offs is having a strong liquidity position (more cash on hand) if a firm's
capital position is weak (low equity to total assets). Another firm that has a strong capital
position might be able to take on more risk in the quality of its assets (sales to customers who
might create higher bad debt losses).
3. If a company has more liquid assets than it needs, it is missing opportunities to invest these
funds in longer-term assets that will yield higher returns. If the firm has too few liquid assets, it
may have difficultly meeting its current obligations. The firm may even have to incur additional
interest costs if it is forced to borrow funds to meet its current obligations.
4. One of the conflicting questions concerns how much capital is necessary to protect creditors
and shareholders against expected and unexpected losses. The second question concerns
how little capital is necessary to allow shareholders to enjoy maximum return on equity and
dividends.
The conflict is resolved through the use of the debt and capital markets. If capital drops too
low relative to total assets, creditors will demand higher interest rates on the firm's debt, profits
will decline, and the stock price will decline. If the capital ratios are too high, the owners will
become disappointed by the low returns on equity and attempt to sell their stock, thus
depressing the stock price again.
5. The key question in assessing liquidity is whether sufficient liquid assets are available or
accessible to meet the firm's demands for cash from expected and unexpected sources. The
Managerial Accounting Solutions, Schneider/Sollenberger, 4th Edition, Chapter 15, Page 15-1
typical ratios used to measure liquidity include the current ratio and quick ratio. Knowing the
future cash inflows and outflows will allow a firm to predict its liquidity position in the future.
The element missing in all of these liquidity measures is the firm's ability to borrow cash when
needed. These short-term borrowing agreements are often called "off-balance-sheet
financing." They include banking lines of credit, possible sales of commercial paper, ability to
sell receivables, financing inventories, and sales of short-term investments.
6. The primary concerns in assessing asset quality are measuring whether assets are being used
efficiently and determining what risk exists that the book values will not recover. The key
financial ratios in this area are the accounts receivable, inventory, and total asset turnovers.
Turnover ratios that are too high may indicate that the asset balances are not adequate for the
firm's current level of business. Turnover ratios that are too low may indicate that not enough
productivity is being generated from the assets being carried on the books.
7. The key question regarding earnings and profitability is whether net income is adequate to
satisfy investors' dividend and rate of return expectations and to support growth. There are
two concerns buried in this question; however, they are related. Investors earn a return on
their investment in two different ways: dividends and capital gains. Any net income not
distributed in the form of dividends is retained in the firm for the purposes of growth and
internal investment. Therefore, the higher the retention rate of net income, the greater is the
potential for growth, capital gains, and future dividends.
Long-term investors prefer reinvestment of earnings in the future of the company. This allows
the company to grow and the stock to appreciate. Also, the investor pays no tax on the
appreciation until the stock is actually sold. Short-term investors are more interested in today.
They want to maximize the price and dividend today so that they can make their profit and move
on. Obviously, the two types of investors conflict over the best use of current profits funds.
Also, the short-term investor is looking for immediate profits and quick cash inflows --
accepting lower total profits, but getting dividends now. The long-term investor is looking for
investments in areas that will have long-term payoffs and greater growth potential.
8. The primary concerns related to growth are whether it is adequate given the conditions in the
firm's markets and whether the firm's growth patterns are balanced and/or within planned
goals. These questions cannot be answered from financial statement data alone. External
information about the general economic environment and market growth rates must also be
obtained. Balanced growth is internally measured. But market share information must be
evaluated relative to competitors and total market growth patterns.
9. A firm must be concerned with how the external financial markets assess its financial condition
because it must interact with these external markets, as does the firm's creditors and owners.
In the debt market, creditors assess the risks of the firm and determine what rate of interest the
firm will have to pay. In the equity market, current and potential investors assess the firm's
strengths and weaknesses and determine the market price for the firm's stock.
10. Financial leverage is the use of borrowed funds instead of equity funds to enhance the rate of
return to the owners. By using borrowed funds, operating profits can be earned while using
less equity. A second possibility is that a "profit margin" can be obtained by earning more on
the assets that were financed with debt than the debt incurs in interest expense.
11. The earning-power ratios combine return on sales, asset turnover, and the capital multiplier to
form the return on equity ratio as follows:
Net income = Return on sales

Sales
Net income x Sales = Return on assets
Sales Average total assets
Net income x Sales x Average total assets = Return on equity

Sales Average total assets Average common equity
By using these relationships a manager can break down the return on equity into its
component parts and analyze the particular firm's strengths and weaknesses. Increasing any
of the three component ratios while holding the others constant will lead to an improvement in
the return on equity.
12. Many caveats must be considered when analyzing financial statements. Seven such caveats
mentioned in the text are as follows:
1. No consistently valid "rules of thumb" exist.

2. No one ratio can tell the whole story.
3. Ratios must be defined uniformly and consistently.
4. Beware of off-balance-sheet events.
5. Allow for differences in accounting methods.
6. Industry averages are just that -- averages.
7. More ratios do not necessarily make a better analysis.
13. The current ratio and the quick ratio are indicators of the firm's liquidity – its ability to meet current
obligations with currently available assets. Both ratios use current liabilities in the denominator.
The current ratio includes all current assets in the numerator, while the quick (acid-test) ratio
excludes inventory from the numerator. Since inventory is normally the least liquid current asset,
the acid test ratio is a measure of shorter term liquidity than the current ratio.
14. The strategic profit model decomposes the return on assets and return on equity into all of
their component parts. For example, return on assets can be broken down into asset turnover
multiplied by the return on sales. The asset turnover and return on sales, in turn, can be
broken down into their components, and so on, until the original account balances are
reached. An understanding of this model can help managers achieve many goals by showing
the sensitivity of the earning-power ratios to changes in specific account balances, by
identifying differences among firms, and by testing the impacts of proposed changes in
operations, debt structure, and working capital.
15. If the rate of return on assets is to be used to evaluate the manager at the operating level,
controllable contribution margin (or at least income before the deduction of interest expense
and income tax) should be used in the calculation. In addition, the asset base used in the
calculation should be adjusted to exclude those assets that the manager does not control.
If the rate of return on assets is to be used to evaluate a segment, income should be adjusted
to include only those revenues and expenses that are traceable to the segment. Likewise, the
assets used in the calculation should be only those assets that are directly identifiable with the
segment.
16.
(a) A sharp increase in the current ratio indicates that current assets have increased greatly
relative to current liabilities. The firm is more liquid and thus less risky; however, it may be
missing opportunities to invest in long-term assets with higher returns. A large cash inflow or
using cash to pay off current liabilities could also explain the "sharp" change.
(b) A return on shareholders' equity that is nearly equal to the return on assets indicates that the
firm is financed almost exclusively with equity. The firm may not be taking advantage of
leverage to improve the shareholders' returns.
(c) A large increase in the dividend payout ratio occurs when the firm substantially increases its
dividend payments as a percentage of net income. This may be an indication that
management feels the firm's prospects for future earnings are positive and that it can support
the higher dividend payouts. It could also indicate that earnings have dropped severely.
(d) A drop in the inventory turnover and an increase in the days sales in inventory indicate that
inventory is being used less efficiently. There is a possibility that demand has fallen off or that
much of the inventory has become obsolete.
(e) A decline of the gross margin percentage over several years indicates that the cost of goods
sold, as a percentage sales, has gradually increased over the same time period. Perhaps, the
firm was unable to raise prices due to competition.
(f) An increase in the earnings per share means that the firm has earned a higher net income
given the number of outstanding shares or has reduced the number of outstanding common
shares. Investors look to this ratio as a measure of the return on their investment.
(g) A decline in the price-earnings ratio would generally indicate that investors have lowered their
expectations of future growth in earnings and dividends. Earnings may have increased, but
the firm has not convinced the stock market that this is a long-term jump in earnings.
Solutions To Exercises
15-1.
(1) Return on sales = Net income  Net sales
= $1,500,000  $50,000,000 = 3.0%
Return on sales gives an indication of efficiency. Cutting operating expenses or any other
expense will allow more income per sales dollar; and, subsequently, the ratio will rise.
Average assets = (Beginning assets + Ending assets)  2

= ($10,000,000 + $12,000,000)  2 = $11,000,000
(2) Return on assets = Net income  Average assets

= $1,500,000  $11,000,000 = 13.6%
Selling low-income or nonincome-producing assets will increase this ratio.

(3) Asset turnover = Net sales  Average assets
= $50,000,000  $11,000,000 = 4.54 asset times
Selling low-sales or nonsales-generating assets will benefit this ratio.
15-2. Assets are growing at an annual rate of 10 percent. These acquisitions must be financed
by debt or equity. If equity is growing at a rate of 6 percent per annum, debt must be growing
at a rate greater than 10 percent. An increase in net profit of only 8 percent per year will
eventually be absorbed by the increased investment financing. The firm is expanding assets
at a 10 percent rate while it is only increasing capital at a 6 percent rate. The profit growth of 8
percent is apparently being partially used for dividends.
If these trends continue, the company will not have enough capital to support the level of risk
and the level of assets required to sustain the business. Debt will grow; creditors will demand
higher interest rates or stop providing financing. Also, the high growth of sales relative to
assets will mean that facilities, inventories, and customer credit (receivables) are not growing
at a fast enough pace. Eventually, sales will not be able to continue its growth pattern. Here is
an example of excellent results for a short time. The numbers reflect higher productivity. But
long-term problems arise because of the lack of balance in these four ratios.
15-3.
(a) Days sales in receivables = Average A/R  (Net sales  360 days)
= $3,000,000  ($15,000,000  360 days)
= 72 days
Account receivable turnover = Net sales  Average accounts receivable

= $15,000,000  $3,000,000 = 5 times
(b) Days sales in inventory = Average inventory  (COGS  360 days)

= $600,000  ($7,200,000  360 days) = 30 days
Inventory turnover = Cost of goods sold  Average inventory

= $7,200,000  $600,000 = 12 times
(c) An operating cycle is the amount of time necessary for a firm to convert inventory to cash:
Inventory turnover 60 days (360 days  6)

Accounts receivable collection cycle 40 days
Operating cycle 100 days
15-4.
(1) Average inventory = (Beginning inventory + Ending inventory)  2
= ($130,000 + $70,000)  2 = $100,000

= $216,000  $100,000 = 2.16 times
Days sales in inventory = Average inventory  (COGS  360 days)

= $100,000  ($216,000  360 days) = 166.67 days
(2) Average accounts receivable = (Beginning A/R + Ending A/R)  2
= ($220,000 + $242,000)  2 = $231,000
Account receivable turnover = Net sales  Average accounts receivable

= $357,000  $231,000 = 1.55 times
Days sales in accounts receivables = Average A/R  (Net sales  360 days)
= $231,000  ($357,000  360 days) = 232.94 days
(3) A lower inventory turnover ratio indicates that inventory is being used less efficiently than the
industry average. Decreased demand and obsolete inventory are two possible causes. A
lower accounts receivable turnover indicates the Woolly Company does not collect payment for
charged sales as quickly as the industry does. Possible causes are poor collections efforts
and credit terms that are too relaxed.
15-5.
(a) Common shares outstanding = Total par value  Par value
= $1,500,000  $100 per share = 15,000 shares
EPS = (Net income - Preferred dividends)  Common shares outstanding

= ($398,000 – $36,000)  15,000 shares = $24.13 per share
EPS has grown dramatically, by over 37 percent.
(b) Dividend yield = Common dividend per share  Market price per share
= ($120,000  15,000 shares)  $150 per share = 5.33%
Dividend yield has increased from 5 percent to 5.33 percent, a nominal increase given the
jump in EPS.
(c) Price-earning ratio = Market price per share  Earnings per share
= $150  $24.13 = 6.22
The P-E ratio has declined by over 50 percent. The reason for this is unclear since EPS has
jumped so much. Perhaps the stock market in general has fallen. Perhaps investors expected
a much greater jump in earnings, and a 37 percent increase is disappointing. One would
expect a jump in the P-E ratio with a jump in earnings such as this.
(d) Total equity:

Common stock $1,500,000
Retained earnings 500,000
Paid-in-capital in excess of par 100,000
Preferred stock 600,000
Total equity $2,700,000
Return on total equity = Net income  Total equity

= $398,000  $2,700,000 = 14.74%
The ROE has increased but not by a large percentage.
(e) Return on common equity = (Net income – Preferred dividends)  Common equity
= ($398,000 – $36,000)  $2,100,000 = 17.24%
This ROCE increased from 13.9 percent. This is a larger increase than the ROE. Tying the
ROE, ROCE, EPS, and the P-E ratios together, the unusual figure is the P-E ratio. No good
reason for its decline is apparent.
15-6. Total equity = Equity to debt ratio x Total liabilities

= 4 x $100 = $400
Retained earnings = Total equity – Common stock

= $400 – $100 = $300
Total assets = Total liabilities + Total equity

= $100 + $400 = $500
Current assets = Current ratio x Current liabilities
= 3.00 x $100 = $300
Fixed assets = Total assets – Current assets

= $500 – $300 = $200
Cost of goods sold = Inventory turnover x Average inventory

= 15 x $80 = $1,200
Sales = Cost of goods sold  (1 – Gross margin)

= $1,200  (1 – 0.25)
= $1,200  0.75
= $1,600
Average accounts receivable = Days sales in receivables x Sales per day

= 15 x ($1,600  360 days) = $67
Bernthal Company, Balance Sheet:
Current Assets Current Liabilities & Equity

Cash $153 Current liabilities $100
Accounts receivable 67 Common stock 100
Inventory 80 Retained earnings 300
Fixed assets 200
Total assets $500 Total liabilities & equity $500
15-7.
(1) The good news and bad news:
Ratio Good Bad

Current ratio Decrease may indicate Decrease may indicate a
better cash management, relative increase in
improved collection of current liabilities or a
receivables, or a more decrease in liquidity.
efficient use of inventory. Possibly, inventories
are too low to meet
customer needs.
Inventory Increase indicates that If turnover is too

turnover more sales are being high, frequent "stock
generated from the same outs" may occur; and
size inventory. It may sales may be lost as
indicate increased a result.
demand or more careful
inventory management.
Dividend Decrease indicates that Decrease may indicate

payout firm is retaining cash, that the firm is unsure
possibly for expansion. of its future prospects
Or, income is growing and may not be able to
relative to dividends. support future dividend
payouts.
(2) A possible scenario might be that demand for the firm's products has increased. As a result,
the inventory turnover has increased. To purchase additional inventory, however, the firm has
been forced to use cash reserves, increase its current liabilities, and reduce the current ratio.
Since the firm has used cash to finance additional inventory purchases, cash is not available
for increased dividends even though the profits have increased.
15-8.
(1) Percentage composition income statements:
2005 2006
Dollars Percentages Dollars Percentages
Net sales $15,140,000 100.0% $18,534,000 100.0%
Cost of goods sold 9,175,000 60.6 11,523,000 62.2
Gross profit $ 5,965,000 39.4% $ 7,011,000 37.8%
Operating expenses 3,421,000 22.6 3,906,000 21.1
Operating income $ 2,544,000 16.8% $ 3,105,000 16.7%
Income taxes 1,036,000 6.8 1,233,000 6.6
Net income $ 1,508 000 10.0% $ 1,872,000 10.1%
(2) Base-year comparison income statement:

2005 2006
Net sales 100.0% 122.4%
Cost of goods sold 100.0 125.6
Gross profit 100.0 117.5
Operating expenses 100.0 114.2
Operating income 100.0 122.1
Income taxes 100.0 119.0
Net income 100.0 124.1
(3) The 22.4 percent increase in sales was offset by a 25.6 percent increase in cost of goods sold,
translating into a lower gross profit percentage. Operating income and net income were both
maintained by percentage decreases in operating expenses and income taxes.
In 2006, only some of the president's expectations were realized. Cost of goods sold and
operating expenses were both above expectations. However, due to higher expenses and,
thus, lower income before tax, income tax expense was below expectations. Net income
basically met expectations. The president should be worried about the percentage increases
in cost of goods sold. If this trend continues, increases in sales will not generate increases in
income.
15-9.
X Biz:
 Strong liquidity position – Current assets are 4.5 times current liabilities, and quick assets
are 2.5 times current liabilities.
 Strong equity base – Fewer future obligations are related to interest expenses and debt
repayment.
 Strong debt repayment position – The firm earns enough to pay interest expense 10 times.
 In general, the firm has little debt and significant current assets relative to current liabilities.
Y Biz:
 Somewhat weak liquidity position – Current assets can cover current liabilities, but quick
assets cannot. Very little working capital must be financed.
 Balanced financial structure – Debt and equity are in equal amounts. There is great
probability of difficulty in repaying future debt obligations, but leverage is strong.
 Income is sufficient to cover interest expense only 3 times.
 Y Business is highly leveraged and is in a poorer liquidity position. As a result, Y Business
is much riskier than X Business.
15-10.
(a) A stronger current ratio might indicate improved profitability as higher profit could mean higher
cash and accounts receivable balances. However, since the quick ratio is falling, cash and
accounts receivable are falling rather than increasing. The increase in the current ratio must
be the result of increased inventory, possibly indicating poor sales and thus lower profitability.
(b) A falling quick ratio indicates that cash, receivables, and/or marketable securities must be
falling. The increase in the current ratio, then, must be the result of increased inventory, due
either to decreased demand or possibly obsolescence.
(c) The quick ratio is a measure of a firm's ability to pay its bills quickly from readily available cash
and near-cash assets. If the ratio is falling, however, the firm lacks the liquid assets to pay
these bills. Quick assets are decreasing faster than current liabilities. The desire may be
there, but the liquid assets are not.
(d) Whether a ratio is too high (or too low) is a subjective matter. To make this determination,
other information such as the type of industry, current ratios for similar firms, current ratios for
successful firms in the same industry, and available investment opportunities would be
required.
(e) The company is more liquid if inventories are included in the liquidity measure (current ratio).
In terms of very short-term liquidity (quick ratio), the firm is much less liquid in 2007 than in
2004.
15-11.
(1) Earnings per share = Net income  Average shares outstanding
= £400,000  £100,000 = £4.00 per share
Price-earnings ratio = Market price per share  Earnings per share

= £32.00  £4.00 = 8.00:1
(2) Dividend yield = Dividend per share  Market price per share
= £3.00  £32.00 = 9.375%
15-12. Income statement calculations:
Sales = Net income  Return on sales

= $6,000  0.04 = $150,000
Cost of goods sold: Gross margin = Sales – Cost of goods sold

Gross margin percentage = Gross margin  Sales
= (Sales – Cost of goods sold)  Sales
0.60 = ($150,000 – COGS)  $150,000
0.60 ($150,000) = $150,000 – COGS
Cost of goods sold = $60,000
Gross margin: Gross margin = Sales – COGS

= $150,000 – $60,000 = $90,000
Operating income: Operating income = Income after tax  (1 – Tax rate)

= $6,000  (1 – 0.40) = $10,000
Operating expenses: Operating expenses = Gross profit – Operating income

= $90,000 – $10,000 = $80,000
Income statement: Sales $150,000

Cost of goods sold 60,000
Gross profit $90,000
Operating expenses 80,000
Operating income $10,000
Income taxes 4,000
Net income $6,000
Balance sheet calculations:
Average assets = Net income  Return on assets

= $6,000  0.05 = $120,000
Equity = Net income  Return on equity

= $6,000  0.10 = $60,000
Total liabilities = Average assets – Equity

= $120,000 – $60,000 = $60,000
Inventory = Cost of goods sold  Inventory turnover

= $60,000  4 turnovers = $15,000
Long-term debt = Equity x Long-term debt to equity ratio

= $60,000 x (2  3) = $40,000
Current liabilities = Total liabilities – Long-term debt

= $60,000 – $40,000 = $20,000
Current assets = Current liabilities x Current ratio
= $20,000 x (3  1) = $60,000
Average accounts receivable = Days sales in receivables x Sales per day

= 90 days x ($150,000  360 days) = $37,500
Cash = Current assets – Accounts receivable – Inventory

= $60,000 – $37,500 – $15,000 = $ 7,500
Fixed assets = Total assets – Current assets

= $120,000 – $60,000 = $60,000
Balance sheet:
Current assets: Liabilities:
Cash $7,500 Current liabilities $20,000
Accounts receivable 37,500 Long-term debt 40,000
Inventory 15,000 Total liabilities $60,000
Total current assets $60,000
Fixed assets 60,000 Equity $60,000
Total assets $120,000 Total liabilities and equity $120,000
15-13. Business event:
Liquidity Capital Adqy Asset Quality Growth Earnings

Lengthening (W) – Decreases (W) – May attract (W) – Decr A/R (S) – Incr in (?) – Should
credit terms A/R turnover, more risky cus- turnover as custom- sales and A/R as increase sales as
to customers since customers tomers requiring ers take longer to customers take new customers
from 30 to 60 take longer to more capital remit payment. advantage of take advantage
of days. remit payment. protection. liberal credit more liberal
credit policy. policy; must
finance higher
A/R; may have
more credit
losses.
Declared and (W) – Uses cash (W) – Decreases (NC) – Will cause (W) – Retains less (?) – Indicates
paid dividends. that would reduce retained earnings small and earnings in the that the firm
feels
current assets and overall immaterial firm preventing it that prospects
for
without reducing capital protection changes. from financing future earnings
current lia- against losses. expansion. are positive and
bilities; reduces net income can
funds available be shared with
for investment. owners.
Issued long- (S) – (source of (W) – Uses more (W) – Increases (S) – Issuing new (?) – Increases
term debt cash) Increases debt for financing; assets without debt should debt; increases
for cash. current assets makes the firm corresponding finance expansion interest expense;
without more risky; increase in sales and therefore the increase in
corresponding causes relatively causing temporary growth. assets should
increase in less capital for decrease in total increase sales
current protection. asset turnover; and contribution
liabilities. more debt means margin.
less risk can be taken
in earning assets.
Issued common (NC) – Has no (S) – Improves (?) – Increases (S) – Should help (?) – Increases
stock in trade effect since debt/equity ratio; investments in new firm increase equity with
for production neither common increases capital productive earnings production and corresponding
equipment. stock nor equip- base; increases assets; increase in growth with new increase in sales
ment is included loss protection. sales causes equipment. causing ROR
in current assets increase or measures to go
or liabilities. decrease in total up or down.
asset turnover.
15-14.
(1) Return on sales = Return on assets  Asset turnover
= 13%  2.6 = 5.0%
(2) Asset turnover = Sales  Average assets

= $28,000,000  $8,000,000 = 3.5 times
(3) Return on assets = Return on sales x Asset turnover

= 15% x 0.80 = 12.0%

= 15%  2.5 = 6.0%
(5) Return on equity = Return on assets  Equity percentage

= 9%  0.60 = 15.0%
(6) Asset turnover = Return on assets  Return on sales

= 16%  0.125 = 2.0 times

= 14%  2 = 7.0%
Sales = Net income  Return on sales

= $840,000  0.07 = $12,000,000
(8) Cost of operations $2,600,000

Plus income tax 250,000
Total cost $2,850,000
Net sales = Total cost  (1 – Net income percentage)

= $2,850,000  (1 – 0.05) = $3,000,000
(9) Return on assets: Return on sales x Asset turnover

Year 1 = 6% x 2.4 = 14.4%
Year 2 = 6% x 1.8 = 10.8%
(10) Net sales $9,600,000

Minus expenses 8,880,000
Net income $720,000
Return on sales = Net income  Net sales

= $720,000  $9,600,000 = 7.5%
Return on assets = Return on sales x Asset turnover
= 7.5% x 1.2 = 9.0%
15-15.
(1) Deep River Brands:
Total average assets SFr20,000,000

Less total average debt 5,000,000
Total average equity SFr15,000,000
Interest expense: SFr5,000,000 * 0.08 = SFr400,000
Return on equity = (Net income – Interest expense)  Average equity

= (SFr1,500,000 – SFr400,000)  SFr15,000,000 = 7.3%
(2) Valley Brands:
Total average assets €20,000,000

Minus total average debt 15,000,000
Total average equity € 5,000,000
Interest expense: €15,000,000 * 0.08 = €1,200,000
Return on equity = (Net income – Interest expense)  Average equity

= (€1,500,000 - €1,200,000)  €5,000,000 = 6.0%
(3) Valley Brands was able to earn the same net income (before interest) figure (though in different
currencies) on the same level of assets as Deep River Brands. Valley Brands has a
proportionately much larger debt obligation and therefore interest expense and, as a result, a
smaller equity base than Deep River. Its return on equity was lower than Deep River because
the cost of debt was more significant than the higher leverage.
15-16.
(1) Earnings per share = Net income  Outstanding shares
= $4,500,000  2,000,000 shares = $2.25 per share
Price-earnings ratio = Market price  Earnings per share

= $45  $2.25 = 20:1
Dividend payout percentage = Dividend per share  Earnings per share

= $0.90  $2.25 = 40.0%
Dividend yield = Dividend per share  Market price

= $0.90  $45 = 2.0%
(2) a. Increase in market price from $38 to $45:
The price may have increased if the earnings per share increased to $2.25 from $1.90 ($38
 20, the price-earnings ratio). An increase in earnings per share may also have impressed
the market and pushed the P-E ratio upward.
(2) b. Decrease in market price from $50 to $45:
The price decline could result from a drop or a leveling of earnings per share from last year.
A cut in dividends could discourage investors.
15-17. To justify carrying a larger inventory, Wilhelm should compare its inventory turnover ratio
with the industry average. A ratio lower than the industry average indicates inefficient use of
inventories that currently are maintained. Adding to the current stockpile would do no good.
However, if the industry average is lower, it is possible that Wilhelm is in fact holding too little
inventory. It would be a good idea to see if stockouts have caused lost sales in the past.
To justify more relaxed credit terms, the company should compare its accounts receivable
turnover with the industry average. If the company ratio is lower, terms may already be too
liberal. Credit sales are not valuable unless the subsequent collection can be made. However,
if the company ratio is higher than the industry average, its credit policy may be too tight.
Wilhelm would then want to consider a more liberal credit policy.
15-18.
(1) Inventory turnovers:
Cost of goods sold = Average inventory x Inventory turnovers

= $900,000 x 6 times = $5,400,000
Inventory turnovers before reduction = 6 times
Inventory turnovers after reduction = Cost of goods sold  Average inventory

= $5,400,000  $600,000 = 9 times
(2) Current ratios:
Current ratio before reduction = Current assets  Current liabilities

= $1,500,000  $600,000 = 2.5:1
Inventory before reduction $ 900,000
Less inventory after reduction 600,000
Decrease in inventory $ 300,000
Current assets before reduction $1,500,000

Less decrease in inventory 300,000
Current assets after reduction $1,200,000
Current liabilities before reduction $ 600,000

Less liability reduction due to
reduced inventory purchases 300,000
Current liabilities after reduction $ 300,000
Current ratio after reduction = Current assets  Current liabilities

= $1,200,000  $300,000 = 4.0:1
(3) Return on assets:
ROA before reduction = Net income  Average assets

= $270,000  $3,300,000 = 8.18%
Average assets before reduction $3,300,000
Less inventory reduction 300,000
Average assets after reduction $3,000,000
ROA after reduction = Net income  Average assets after reduction
= $276,000  $3,000,000 = 9.2%
15-19.
(1) 18-day turnover:
Materials inventory turnovers = Days in a year  Days per turnover
= 360 days  18 days
= 20 times
Average inventory = Cost of materials used  Inventory turnovers

= $18,000,000  20 times
= $900,000
12-day turnover:
Materials inventory turnovers = Days in a year  Days per turnover
= 360 days  12 days
= 30 times
Average inventory = Cost of materials used  Inventory turnovers

= $18,000,000  30 times
= $600,000
(2) 24-day turnover:

Average WIP inventory = Cost of production  WIP turnovers
= $48,000,000  24 times
= $2,000,000
30-day turnover:
Average WIP inventory = Cost of production  WIP turnovers
= $48,000,000  30 times
= $1,600,000
(3) By reducing inventory balances, the firm can reduce its investment in assets. The rate of
return on assets is improved because a smaller asset number is used in the denominator of
the return calculation.
15-20.
(1) Return on current assets = Net income  Current assets
2005: = $130,000  $650,000 = 20.0%

2006: = $288,000  $1,600,000 = 18.0%
(2) Current asset turnover = (COGS + Operating expenses + Net income)  Current assets
2005: = ($1,300,000 + $130,000)  $650,000 = 2.2 times

2006: = ($4,800,000 + $288,000)  $1,600,000 = 3.18 times
(3) Tech Company is growing. The increased volume is being handled with a relatively smaller
investment in current assets. To serve the customers' needs, the company must make
additional purchases of inventory. If the firm does not have sufficient cash for these
purchases, they must be financed with increases in current liabilities.
15-21.
(1) Account receivable turnover = Credit sales  Average A/R
2006: $97,600,000  $28,100,000 = 3.47 times

2005: $83,200,000  $15,400,000 = 5.40 times
2004: $67,600,000  $ 8,000,000 = 8.45 times
(2) Days sales in receivables = Days in a year  A/R turnover
2006: 360 days  3.47 times = 104 days

2005: 360 days  5.40 times = 67 days
2004: 360 days  8.45 times = 43 days
(3) Collection slowdowns may be caused by a variety of sources including poor economic
conditions and/or high interest rates. Dundee Health Services may want to review its credit
policy and perhaps consider offering incentives (e.g., discounts) to encourage prompt
payment. Otherwise, the firm may see cash-flow problems in the near future.
15-22.
(1) Return per division:
ROA = Net income  Average assets
Electrical wiring = €120,000  €2,400,000 = 5.0%

Flexible conduits = W693,000,000  W4,620,000,000 = 15.0%
Fiberglass control boxes = SKr816,000  SKr6,800,000 = 12.0%
Rankings: 1st Flexible conduits 15%

2nd Fiberglass control boxes 12%
3rd Electrical wiring 5%
(2) ROA: Electrical wiring = €120,000 – (0.4 x $250,000 x €1 per $)

€2,400,000 + (1/3 x $1,080,000 x €1 per $)
= €20,000 = 0.72%
€2,760,000
Flexible conduits = W693,000,000 – (0.4 x $250,000 x W1,100 per $)

W4,620,000,000 + (1/3 x $1,080,000 x W1,100 per $)
= W583,000,000 = 11.62%
W5,016,000,000
Fiberglass control boxes = SKr816,000 – (0.2 x $250,000 x SKr8 per $)

SKr6,800,000 + (1/3 x $1,080,000 x SKr8 per $)
= SKr416,000 = 4.30%
SKr9,680,000
Rankings: 1st Flexible conduits 11.62%

2nd Fiberglass control boxes 4.30%
3rd Electrical wiring 0.72%
(3) a. When making decisions about the performance of a segment, the common assets and
expenses should not be used. These assets and expenses will still be incurred regardless
of any specific segment changes.
(3) b. The analysis should be converted to the corporation's home currency. Fluctuations in the
exchange rates can mean substantially higher and/or lower net wealth for the corporation
when profits are repatriated back to dollars.
15-23. To make a company look good on paper, many accounting principles can be manipulated.
Among these are:
 Inventory costs can be "moved" to either push costs into the future, making net income
appear to be higher now, or pull more costs backwards making future profits appear higher.
 Assets could be overstated to reduce charges against revenues to improve net income or
understated to improve return on assets measures in the future.
 Discretionary expenses such as maintenance, R and D, and advertising could be deferred
temporarily.
 Sales could be manipulated to move revenue between periods.
 Managers could attempt to transfer assets to other divisions or corporate.
 As a clearly unethical action, any of the values in the earning power ratios could be
intentionally overstated or understated.
Most of these manipulations are short-term issues that cannot be sustained in the long run.
Short-term understatements and overstatements are often offset by opposite impacts in the
next accounting period. Manipulating asset values could impact long-term evaluations. Also,
low maintenance and R and D spending will quickly negatively impact the income statement.
Solutions To Problems
15-24.
(1) This year’s calculations:

= $140,000  $2,800,000 = 5.0%
Asset turnover = Net sales  Average assets

= $2,800,000  $1,400,000 = 2.0 times
Return on assets = Net income  Average assets

= $140,000  $1,400,000 = 10.0%
(2) Next year’s calculations:

= $150,000  $3,000,000 = 5.0%
Asset turnover = Net sales  Average assets

= $3,000,000  $1,200,000 = 2.5 times

= $150,000  $1,200,000 = 12.5%
By discarding unproductive assets, the firm is able to improve (increase) both the asset
turnover and the return on assets. Since unproductive assets are dropped, no change in
return on sales is expected.
15-25.
(1) Liquidity position, 2006:
Current ratio = Current assets  Current liabilities

= $41,100  $10,000 = 4.11:1
Quick ratio = (Cash + Accounts receivable)  Current liabilities

= ($1,200 + $15,000)  $10,000
= $16,200  $10,000 = 1.62:1
Current and quick ratios both appear to be adequate. Both ratios are significantly higher than
the industry averages. Liquidity appears strong.
(2) Steinhour's position relative to industry:

= $13,100  $98,000 = 13.4%
Gross margin percentage= (Sales - COGS)  Sales
= ($98,000 - $56,000)  $98,000
= $42,000  $98,000 = 42.9%
Times interest earned = (Operating income before interest expense + taxes)  Interest expense
= ($13,100 + $2,900)  $2,900 = 5.5
Steinhour is below the industry average for return on sales, gross margin percentage, and
times interest earned. It appears that Steinhour's cost of goods sold is above that of other
firms in this industry. This fact alone will drive down the gross margin percentage, the return on
sales, and the times interest earned.
15-26.
(a) Inventory turnover = Cost of goods sold  Average inventory
= $240,000  $60,000 = 4.0 turnovers
(b) Earnings per share = Net income after tax  Average shares
= $12,000  6,000 shares = $2.00 per share
Average market price = Earnings per share x P-E ratio
= $2.00 per share x 8 = $16.00 per share
(c) Return on equity = Return on sales x Asset turnover x Capital multiplier
Net income x Sales x Average total assets

Sales Average total assets Average equity
$12,000 x $360,000 x $182,000 = $12,000

$360,000 $182,000 $92,000 $92,000
3.33% x 1.98 x 1.98 = 13.04%
Average total assets = (Beginning assets + Ending asset)  2

= ($186,000 + $178,000)  2
= $364,000  2 = $182,000
Average equity = Average common stock + Average retained earnings

= [($60,000 + $60,000)  2] + [($36,000 + $28,000)  2]
= $60,000 + $32,000 = $92,000
(d) Current ratio = Current assets  Current liabilities

= ($14,000 + $22,000 + $65,000)  $30,000
= $101,000  $30,000 = 3.37:1
(e) Cash flow per share from operations = Cash flow from operations  Total shares
= $43,000  6,000 shares = $7.17 per share
Cash flow from operations:
Net income $12,000
Plus depreciation 20,000
Plus decrease in accounts receivable 6,000
Less increase in inventory (10,000)
Plus increase in accounts payable 15,000
Cash flow from operations $43,000
(f) Gross margin percentage = Gross margin  Sales

= $120,000  $360,000 = 33.3%
15-27.
(1) Butler Products Company:
(a) Return on sales = Net income  Net sales

= $4,200,000  $70,000,000 = 6.0%
(b) Return on assets = Net income  Average assets

= $4,200,000  $50,000,000 = 8.4%
(c) Asset turnover = Net sales  Average assets

= $70,000,000  $50,000,000 = 1.4 times
(d) Return on equity = Net income  Average equity

= $4,200,000  $42,000,000 = 10.0%
Speier Enterprises:
(a) Return on sales = Net income  Net sales
= $6,000,000  $100,000,000 = 6.0%
(b) Return on assets = Net income  Average assets

= $6,000,000  $50,000,000 = 12.0%
(c) Asset turnover = Net sales  Average assets

= $100,000,000  $50,000,000 = 2.0 times
(d) Return on equity = Net income  Average equity

= $6,000,000  $24,000,000 = 25.0%
(2) Chance earns a better return on shareholders' equity. Chance's higher asset turnover and
high-debt level (leverage advantage) allow Chance to earn a better return on equity.
(3) As the name suggests, Chance is more risky. Chance has significantly more debt than
Secure. If the economy turns sour, Chance may have difficulty in paying existing debt
obligations and/or obtaining additional debt financing.
15-28.
(1) Percentage composition income statements:
2006 2005
Dollars Percentages Dollars Percentages
Revenue $91,000,000 100.0% $85,000,000 100.0%
Operating costs:
Materials and supplies $ 5,920,000 6.5 $ 5,500,000 6.5
Wages and salaries 40,200,000 44.2 36,500,000 42.9
Rent 725,000 0.8 725,000 0.9
Taxes and insurance 4,200,000 4.6 3,400,000 4.0
Heat and light 980,000 1.1 850,000 1.0
Advertising 1,480,000 1.6 1,275,000 1.5
Other operating cost 13,880,000 15.2 12,700,000 14.9
Interest expense 7,250,000 8.0 7,350,000 8.6
Income taxes 6,250,000 6.9 6,300,000 7.4
Total expenses 80,885,000 88.9% $74,600,000 87.8%
Net income $10,115,000 11.1% $10,400,000 12.2%
(2) Wages and salaries: A 1.3 percent increase from 2005 to 2006. The board may wish to
investigate this change by looking at pay rates and also the number of people employed.
Wages and salaries are also by far the largest expense for the company.
Taxes and insurance: A 0.6 percent increase from 2005 to 2006. The board may wish to
examine insurance policies and coverages as well as tax assessments and calculations.
Other operating costs: A 0.3 increase from 2005 to 2006. The board may wish to look at any
or all of the individual items that make up this balance. Also, since other operating costs are
15 percent of sales, the highest expense amount after wages and salaries, the board might
consider splitting this account into its components so it can get a better picture of what is going
on in this account.
Interest and taxes: Decreases in amounts. These are possibly a result of debt reduction
measures and of lower net income, respectively.
Other expenses such as materials and supplies and rent have decreased in percentages,
while the amount has either increased or stayed constant. The decrease in percentages is due
to the higher growth in sales in 2006.
The return on revenue ratio decreased from 12.2 percent to 11.1 percent, a decrease of
approximately 9 percent.
Return on revenue = Net income  Revenue

2005: = $10,400,000  $85,000,000 = 12.2%
2006: = $10,115,000  $91,000,000 = 11.1%
(3) Common sized, or percentage composition, income statements express each item as a
percentage of the total revenue on a financial statement. This analysis will show the basic
relationships requested by the board member.
A base-year comparison, or horizontal analysis, will express each item as a percentage of a

predetermined base-year balance. This analysis will show trends within an account over time,
but basic relationships among accounts as requested by the board member are more difficult
to observe.
15-29.
(1) Gilbert's receivables turnover, inventory turnover, and asset turnover are all above his
competitors, as well as above the national averages. This is generally considered a strength
as it indicates that receivables are being collected quickly, that inventory is sold on a regular
basis and is not obsolete, and that assets are being used efficiently. The danger is that Gilbert
may not have enough working capital to finance day-to-day operations.
(2) Gilbert's gross margin percentage is below both his competitors and the national average. This
is an indication that he is pricing below other firms in this industry to get higher turnover.
Gilbert's current ratio is also below the comparison ratios. The low current ratio may indicate
high efficiency in managing inventories and receivables. Gilbert appears to turn inventory
faster at lower margins. This may also allow a higher percentage of current assets to be
funded by trade payables. The current ratio may be lower for similar reasons.
Gilbert's return on equity is above his competitors but well below the national average. This is
the result of relatively lower net incomes versus the respective equity bases.
(3) The three firms in this area may have return on sales measures that are below the national
averages for a variety of reasons. One reason could be that these firms are highly
competitive, particularly on price. Also, they may be located in an area with depressed
economic conditions. Gilbert seems to be a price-cutting, high-volume, small-equity, and high-
debt firm. He may be causing his competitors a lot of grief. His results are not as good as the
national averages, however.
15-30.
(1) Original rates of return:

= $7,200,000  $120,000,000 = 6.0%
Return on equity = Net income  Average equity

= $7,200,000  $90,000,000 = 8.0%
(2) Revised rates of return:

= $15,000,000  ($120,000,000 + $30,000,000) = 10.0%

= $15,000,000  $90,000,000 = 16.7%
(3) Ms. Freed is correct in that a firm should earn a higher rate of return than the return on
government securities. While the new strategy will accomplish this, it is also more risky, as the
higher level of debt requires fixed payments of interest and principal repayment. The
reasonableness of the predictions of the younger board member should also be verified.
15-31.
(1) Revised divisional rates of return:
Division 1 Division 2 Division 3

Net income $ 330,000 $ 200,000 $ 270,000
Plus allocated expenses 160,000 350,000 140,000
Direct net income $ 490,000 $ 550,000 $ 410,000
Asset investment $1,600,000 $2,000,000 $1,080,000

Less allocated assets 200,000 500,000 100,000
Direct assets $1,400,000 $1,500,000 $ 980,000
Rate of return on assets $490,000 $550,000 $410,000

(Net income  Average assets) $1,400,000 $1,500,000 $980,000
35.0% 36.7% 41.8%
(2) Since managers are rewarded according to divisional ROA, the company is encouraging each
manager to operate as an independent business. Each manager must decide how many
assets should be employed and how to use them to achieve the divisional goals. Competition
between the three divisions will probably exist to attract more corporate resources.
(3) Each manager might attempt to direct the division's efforts toward a high ROA now rather than
to develop new products and markets. Efforts to reduce assets or increase reported earnings
might lead to dysfunctional behavior. A division could manipulate its numbers to look better on
paper. Since it is likely that the company budgets its resources in favor of the most profitable
division, the competition among the divisions could grow. Furthermore, the intercompany
competition may hurt the company as a whole.
15-32.
(1) Return on sales = Net income  Sales
2005: = $312,000  $3,240,000 = 9.63%

2006: = $345,000  $4,750,000 = 7.26%
2007: = $546,000  $9,870,000 = 5.53%
Asset turnover = Sales  Average assets
2005: = $3,240,000  $1,465,000 = 2.21 times

2006: = $4,750,000  $2,110,000 = 2.25 times
2007: = $9,870,000  $3,410,000 = 2.89 times
Capital multiplier = Average assets  Average equity
2005: = $1,465,000  $1,220,000 = 1.20

2006: = $2,110,000  $1,470,000 = 1.44
2007: = $3,410,000  $1,965,500 = 1.73
2005: = $312,000  $1,220,000 = 25.57%

2006: = $345,000  $1,470,000 = 23.47%
2007: = $546,000  $1,965,500 = 27.78%
The firm increased its efficiency in using its assets, but its profit from each sales dollar has
declined seriously. It has also apparently levered itself to finance expansion and is using
proportionately much more debt financing. As a result, the return on equity has not changed
much. Perhaps the changes in 2005 and 2006 have set the stage for improved performance
in 2007 and beyond. The debt load may be pulling the earnings down due to higher interest
rates, but the firm needs to get more profits out of its operations. Operating changes have not
produced enough profits.
(2) Liquidity position:
Current ratio = Current assets  Current liabilities
2005: = $720,000  $230,000 = 3.13:1

2006: = $870,000  $550,000 = 1.58:1
2007: = $1,030,000  $889,000 = 1.16:1
Capital adequacy position:
Debt to equity (yearend figures) = Long-term notes payable  Shareholders' equity
2005: = $50,000  $1,300,000 = 0.04%

2006: = $450,000  $1,640,000 = 27.44%
2007: = $1,000,000  $2,291,000 = 43.65%
Times interest earned = (Income before taxes + Interest expense)  Interest expense
2005: = $525,000  $5,000 = 105:1

2006: = $620,000  $45,000 = 13.78:1
2007: = $1,010,000  $100,000 = 10.1:1
Clearly, the debt position has increased in the three years, from nearly no long-term debt to
over 43 percent of long-term funding. Yet the interest burden is very light relative to the
earnings level. The firm can hardly afford to expand its debt financing in the near future.
Apparent expansion has been financed by debt. It has stretched the firm's ability to absorb the
debt and the expanded operations to a level that would concern many analysts. It has gone
from too little debt to possibly too much in three years.
(3) The firm should consider financing with stock as opposed to debt. This will help reduce the
debt to equity ratio. The impact on return on equity is not clear, but it may reduce the potential
growth in ROE. Here is an example of how one more ratio might shed much more light on an
issue. Students should think creatively about financial issues and then find ratios to answer
the question.
15-33.
(1) a. Return on sales = Net income  Net sales
Last year: $400,000  $4,200,000 = 9.5%

This year: $470,000  $6,000,000 = 7.8%
Last year: $400,000  $3,200,000 = 12.5%

This year: $470,000  $3,000,000 = 15.6%
(1) b. Account receivable turnover = Net sales  Average accounts receivable
Last year: $4,200,000  $700,000 = 6.0 times

This year: $6,000,000  $600,000 = 10.0 times
Last year: $3,000,000  $600,000 = 5.0 times

This year: $4,500,000  $450,000 = 10.0 times
(2) The rate of return on assets has been increased as a result of reducing the average asset
investment. However, the return on sales has fallen. The reason for this is unclear. Perhaps,
the incentives for faster payment have been expensive; or, the lower inventory levels have
meant more emergency shipments. Clearly, total sales increased; therefore, the cost of sales
and the operating expenses should be analyzed carefully. Accounts receivable and inventory
balances are lower relative to sales activity. With a lower base for the return calculation, the
rate of return increases.
15-34.
(1) a. Return on sales = Net income  Net sales
2004: $70,000  $1,200,000 = 5.8%

2005: $110,000  $2,000,000 = 5.5%
2006: $170,000  $4,000,000 = 4.3%
2004: $70,000  $1,470,000 = 4.8%
2005: $110,000  $2,060,000 = 5.3%
2006: $170,000  $3,080,000 = 5.5%
Asset = Liabilities + Equity; therefore, to find total assets for each year, add current liabilities,
long-term debt, shareholders' equity, and retained earnings.
Return on shareholders' equity = Net income  Shareholders' equity
2004: $70,000  $710,000 = 9.9%

2005: $110,000  $790,000 = 13.9%
2006: $170,000  $1,030,000 = 16.5%
(1) b. Current ratio = Current assets  Current liabilities
2004: $1,680,000  $760,000 = 2.21:1

2005: $1,780,000  $970,000 = 1.84:1
2006: $1,930,000  $1,250,000 = 1.54:1
Cash flow from operations per share = Cash flow from operations  Outstanding shares
(Certain data for 2004 are not available. Also, the changes in current assets and liabilities are
all assumed to be increases in operating current assets and liabilities. Students might work the
problem by merely adding depreciation back to net income.)
2005: $350,000  60,000 shares = $5.83 per share

2006: $260,000  50,000 shares = $5.20 per share
Cash flow from operations: 2006 2005

Net income $170,000 $110,000
Plus depreciation 50,000 40,000
Less increase in operating assets (150,000) (100,000)
Plus increase in operating liabilities 280,000 210,000
Cash flow from operations $350,000 $260,000
Outstanding shares: 2006 2005 2004

Total par value $600,000 $500,000 $500,000
Divided by par per share  10  10  10
Outstanding shares 60,000 50,000 50,000
Earnings per share = Net income  Outstanding shares
2004: $70,000  50,000 shares = $1.40 per share

2005: $110,000  50,000 shares = $2.20 per share
2006: $170,000  60,000 shares = $2.83 per share
(1) c. Debt to equity = Total liabilities  Total equity
2004: $760,000  $710,000 = 1.07:1

2005: $1,270,000  $790,000 = 1.61:1
2006: $2,050,000  $1,030,000 = 1.99:1
Common equity multiplier = Total assets  Common equity
2004: $1,470,000  $710,000 = 2.07
2005: $2,060,000  $790,000 = 2.61
2006: $3,080,000  $1,030,000 = 2.99
(2) Denny Fink has several good reasons to be concerned. While Egerdal Products is still earning
profits, the returns on sales and assets are relatively low. The firm also has a very unbalanced
financing structure. Debt has increased to nearly 200 percent of equity, and any adversity
could bankrupt the firm. Return on equity has increased substantially over the past three years
due to the heavy reliance on debt as a source of financing. Thus, the firm's liquidity and capital
adequacy measures have both deteriorated in the past three years. These two areas are
offsets to each other. Having both in a weakened state poses potential serious problems for
the firm. Higher earnings may compensate for declines in two areas. The question is whether
Amick's positive view results from a sleeping conservative firm that is moving into an activist
position or from an average firm moving into a high-risk position. Further analysis must be
done.
Solutions To Cases
CASE 15A – Baker, Beg, and Baldree
(1) Present operation:
Rate of return on assets = Net income  Total assets

= $1,560,000  $12,000,000 = 13.0%
Cash-flow rate of return = Cash flow from operations  Total assets

= $1,960,000  $12,000,000 = 16.3%

Net income $1,560,000
Cash flow from operations $1,960,000
New product line (as calculated by Baldree):
Rate of return on assets = Net income  Total assets

= $600,000  $3,000,000 = 20.0%
Cash-flow rate of return = Cash flow from operations  Total assets

= $750,000  $3,000,000 = 25.0%

Net income $600,000
Cash flow from operations $750,000
To make the new product line comparable with the present operation, the interest after income
taxes (as stated by Baker) must be considered:
Revised Estimate
New Product Line
Net income $600,000
Minus interest after income taxes (150,000)
Revised net income $450,000
Rate of return on assets = Revised net income  Total assets

= $450,000  $3,000,000 = 15.0%
It appears that the new product line will still produce a rate of return on assets that is greater
than the present rate of return. The new product line has a 20 percent cash-flow rate of return
versus a 16.3 percent cash-flow rate of return on the present operations.
(2) Present ROR on shareholders' equity = Net income  Shareholders' equity

= $1,560,000  $8,000,000 = 19.5%
Revised ROR on shareholders' equity = (Net income + New line net income) 
Shareholders' equity
= ($1,560,000 + $450,000)  $8,000,000 = 25.1%
Present Operation With New Product Line

Amounts Percentages Amounts
Percentages
Total debt $4,000,000 33.0% $7,000,000 46.7%
Shareholders' equity 8,000,000 67.0 8,000,000 53.3
Total liabilities & equity $12,000,000 100.0% $15,000,000 100.0%
Although the proportion of debt to equity will increase, the rate of return on the shareholders'
equity will increase substantially. Therefore, the shareholders should be very impressed with
and willing to implement the plan.
(3) The investment situation does appear to be attractive. It can be expected to earn a better rate
of return on assets than the present operation. Perhaps some of the leverage benefit of debt
financing should be sacrificed in favor of financing with a mixture of debt and capital stock. If
debt is used exclusively, debt will become 46.7 percent of total equity.
CASE 15B – Deb North's analysis
(1) Return on equity in 2004 was 22.1 percent, and the return on assets was 8.9 percent.
Compared to the 14.3 percent return on equity and the 6.1 percent return on assets in 2007,
2004 had relatively higher returns. Several factors lead to this result. First, all expenses (with
the exception of income taxes) were a smaller percentage of sales back in 2004 than in 2007.
The aftertax profit as a percentage of sales (5.3 percent in 2004 versus 2.9 percent in 2007)
has fallen by nearly 50 percent. Expenses in 2007 were the highest of the five years shown,
particularly for operating expenses.
Second, other income was significantly higher in 2004. This added to the bottom line net
income, thus helping to improve all returns ratios. Higher assets may have contributed to
higher expense levels to implement the new productive assets without generating higher sales
as yet.
Finally, growth in assets was much lower in 2004. Firms were not investing as much in new
assets. Thus, the base for calculating return on assets did not substantially increase. In 2006
and 2007, assets grew faster than sales and profits. The earning power of the new assets
may not have been felt yet.
(2) Growth in sales increased steadily from 2003 through 2005. While the percentage increase in
sales fell off in 2004, the percentage changes remained positive through the five years.
Assets have grown steadily through 2007, particularly in 2005 and 2007. This indicates that
the industry has been growing. But sales and profits have lagged.
Equity has also increased each year but at a slower rate. The percentage increase was the
largest in 2004 at 10.3 percent. This industry has financed growth with nearly equal portions of
debt and equity. Interest coverage has slipped. It also has a lower debt to equity position than
in 2003.
Finally, profits have increased over the five years with the largest increase in 2004. As
mentioned in Part (1), this is due primarily to reductions in expenses as a percentage of sales.
This is also an indication that, as the industry expanded, the firm was able to take advantage
of economies of scale and lower costs. Hopefully, in 2008 the new assets will generate greater
sales and will allow greater operating expense efficiency.
(3) As a potential investor, many of the profitability ratios would be of significance. Return on
equity would be the most influential in determining in which industry to invest.
The debt structure should also be monitored. The increase in long-term debt should be
considered since it creates risk in cash flow.
Furthermore, the debt to equity ratio will provide a comparison of how the company is financing
its growth.
Growth in sales should be watched to determine future expansion.
Net income to sales should be monitored since it has decreased almost continually. The
expenses should be monitored to determine from where the increase in costs is coming.

Chapter 15 Solutions: Solutions To Questions For Review and Discussion

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Chapter 15 Solutions: Solutions To Questions For Review and Discussion

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CHAPTER 15 SOLUTIONS

Solutions to Questions for Review and Discussion

Net income = Return on sales

Net income x Sales x Average total assets = Return on equity

1. No consistently valid "rules of thumb" exist.

Average assets = (Beginning assets + Ending assets)  2

(2) Return on assets = Net income  Average assets

Selling low-income or nonincome-producing assets will increase this ratio.

Selling low-sales or nonsales-generating assets will benefit this ratio.

Account receivable turnover = Net sales  Average accounts receivable

(b) Days sales in inventory = Average inventory  (COGS  360 days)

Inventory turnover = Cost of goods sold  Average inventory

Inventory turnover 60 days (360 days  6)

Inventory turnover = Cost of goods sold  Average inventory

Days sales in inventory = Average inventory  (COGS  360 days)

Account receivable turnover = Net sales  Average accounts receivable

EPS = (Net income - Preferred dividends)  Common shares outstanding

EPS has grown dramatically, by over 37 percent.

(d) Total equity:

Return on total equity = Net income  Total equity

The ROE has increased but not by a large percentage.

15-6. Total equity = Equity to debt ratio x Total liabilities

Retained earnings = Total equity – Common stock

Total assets = Total liabilities + Total equity

Fixed assets = Total assets – Current assets

Cost of goods sold = Inventory turnover x Average inventory

Sales = Cost of goods sold  (1 – Gross margin)

Average accounts receivable = Days sales in receivables x Sales per day

Bernthal Company, Balance Sheet:

Current Assets Current Liabilities & Equity

Ratio Good Bad

Inventory Increase indicates that If turnover is too

Dividend Decrease indicates that Decrease may indicate

(2) Base-year comparison income statement:

Price-earnings ratio = Market price per share  Earnings per share

15-12. Income statement calculations:

Sales = Net income  Return on sales

Cost of goods sold: Gross margin = Sales – Cost of goods sold

Gross margin: Gross margin = Sales – COGS

Operating income: Operating income = Income after tax  (1 – Tax rate)

Operating expenses: Operating expenses = Gross profit – Operating income

Income statement: Sales $150,000

Balance sheet calculations:

Average assets = Net income  Return on assets

Equity = Net income  Return on equity

Total liabilities = Average assets – Equity

Inventory = Cost of goods sold  Inventory turnover

Long-term debt = Equity x Long-term debt to equity ratio

Current liabilities = Total liabilities – Long-term debt

Average accounts receivable = Days sales in receivables x Sales per day

Cash = Current assets – Accounts receivable – Inventory

Fixed assets = Total assets – Current assets

15-13. Business event:

Liquidity Capital Adqy Asset Quality Growth Earnings

(2) Asset turnover = Sales  Average assets

(3) Return on assets = Return on sales x Asset turnover

(4) Return on sales = Return on assets  Asset turnover

(5) Return on equity = Return on assets  Equity percentage

(6) Asset turnover = Return on assets  Return on sales

(7) Return on sales = Return on assets  Asset turnover

Sales = Net income  Return on sales

(8) Cost of operations $2,600,000

Net sales = Total cost  (1 – Net income percentage)