Integrative-Complete ratio analysis Given the ff.

Financial statements (below and

on the facing page), historical ratios and industry averages, calculate Sterling
Company’s financial ratios for the most recent year. (Assume a 365-day year).
Analyze its overall financial situations from both a cross-sectional and a time-series
viewpoint. Break your analysis into evaluations of the firms liquidity, activity, debt,
profitability, and market.

Sterling Company
Income Statement
for the year ended December 31,2006
Sales revenue $10,000,000
Less: Cost of good sold __7,500,000
Gross profits $ 2,500,000
Less: Operating expenses
Selling expense $300,000
General & administrative expenses 650,000
Lease expense 50,000
Depreciation expense _200,000
Total operating expense __ 1,200,000
Operating profits $ 1,300,000
Less: Interestsexpense 200,000
Net profits before taxes $ 1,100,000
Less: Taxes (rate = 40%) 440,000
Net profits after taxes $ 660,000
Less: Preffered stock dividends 50,000
Earnings available for common stockholders $ 610,000

Earnings per share (EPS) $3.05

Sterling Company
Balance Sheet
 December 31, 2006
Assets

Current assets
Cash $ 200,000
Marketable securities 50,000
Accounts receivable 800,000
Inventories $ 950,000
Total current assets $ 2,000,000
Gross fixed assets (at cost)ͣ $12,000,000
Less: Accumulated depreciation 3,000,000
Net fixed assets $ 9,000,000
Other assets $ 1,000,000
Total assets $12,000,000

Liabilities and Stockholder’s Equity

Current liabilities
Accounts payableᵇ $ 900,000
Notes payable 200,000
Accruals 100,000
Total current liabilities $ 1,200,000
Long-term debt (includes financial leases)ᶜ $ 3,000,000
Stockholder’s equity
Preffered stock (25,000 shares, $2 dividend) $ 1,000,000
Common stock (200,000 shares at $3 par)ᵈ 600,000
Paid-in capital in excess of par value 5,200,000
Retained earnings 1,000,000
Total stockholder’s equity $ 7,800,000
Total liabilities and stockholder’s equity $12,000,000
 ͣThe firm has an 8-year financial lease requiring annual beginning-of-year payments of
$50,000. Five years of the lease have yet to run.
ᵇAnnual credit purchases of $6,200,000 were made during the year.
ᶜThe annual principal payment on the long-term is $100,000.
ᵈOn December 31, 2006, the firm’s common stock closed at $39.50 per share.

Historical and Industry Average Ratios for Sterling Company

Ratio Actual 2004 Actual 2005 Actual 2006 Industry average,

2006
Current ratio 1.40 1.55 1.67 1.85
Quick ratio 1.00 0.92 0.88 1.05
Inventory turnover 9.52 9.21 7.89 8.60
Average collection period 45.6 days 36.9 days 29.2 days 35.5 days
Total asset turnover 0.74 0.80 0.83 0.74
Debt ratio 0.20 0.20 0.35 0.30
Times interest earned ratio 8.2 7.3 6.50 8.0
Gross profit margin 0.30 0.27 0.25 0.25
Net profit margin 0.062 0.062 0.066 0.053
Return on total asset 0.045 0.050 0.055 0.040
Return on common equity 0.061 0.067 0.085 0.066
Earnings per share (EPS) $1.75 $2.20 $3.05 $1.50
Price/earnings ratio 12.0 10.5 12.95 11.2
Market/book ratio 1.20 1.05 1.16 1.10
COMPUTATION:

Current ratio = Current assets 2,000,000 1.67

Current liabilities 1,200,000

Quick ratio = Current assets - Inventory 2,000,000 - 950,000 1,050,000

Current liabilities 1,200,000 1,200,000
= 0.88
Inventory turnover = Cost of good sold
Average merchandise inventory
= 7,500,000 7.89
950,000
Average collection period = 365 days 365 29.2 days
Receivables turnover 12.5
Receivables turnover = Net sales 10,000,000 12.5
Ave. Receivables 800,000
Total asset turnover = Total revenue 10,000,000 0.83
Average total assets 12,000,000
Debt ratio = Total liabilities 4,200,000 0.35
Total asset 12,000,000
Times interest earned = Operating profits 1,300,000 6.50
Annual interest expense 200,000
Gross profit margin = Gross profit 2,500,000 0.25
Total revenue 10,000,000
Net profit margin = Net profit 660,000 0.066
Total revenue 10,000,000
Return on total asset = Net income 660,000 0.055
Average total asset 12,000,000
Return on common equity = Net income 660,000
 Average shareholder’s equity 7,800,000
= 0.085
Earnings per share = Net income - Preference share dividends
No. Of ordinary share outstanding
= 660,000 - 50,000 610,000 $3.05
200,000 200,000
Price/earnings ratio = Market price per share 39.50 12.95
Earnings per share 3.05
Market/book ratio = Market capitalization 120,476 1.16
Market total book value 7,800,000

ANALYSIS

Liquidity
In current ratio time series improving which is good because the higher the current
ratio, the more liquid the firm is considered to be and in cross-sectional analysis is fair.
Generally the higher the current ratio, the more liquid the firm is considered to be. In
quick ratio time series deteriorating and cross-sectional is poor.

Activity
Sterling inventory turnover in time series is deteriorating and lower than the
preceeding years while cross- sectional analysis yields a fair result which is lower
than the industry average. This might indicate excessive or obsolete inventory. The
average collection period in time series is improving and better than the preceeding
years while cross-sectional analysis yields a good result which is better than the
industry average. Their collection methods are good and have improved progressively
over the past two years. The total asset turnover in time series is improving and better
than the preceeding years while in cross-sectional analysis yields a good result which
is better than the industry average.

Debt
In time series analysis sterling company indebtedness increased over the 2004-2006
period and is currently above the industry average in cross-sectional analysis.
Although this increase in the debt ratio could be cause for alarm, the firm’s ability to
meet interest improved, from 2005 to 2006, to a level that outperforms the industry.
The firm’s equal indebtedness in 2004 from 2005 apparently stable in its ability to pay
debt adequately. Sterling has evidently improved its income in 2006 so that it is able
to meet its interest obligation at a level consistent with the average in the industry.

Profitability
Sterling gross profit margin is declining in time series analysis because on the year
2004 the ratio is 0.30 on 2005 it decrease in 0.27 and on 2006 it is also decrease in
0.25 while in cross-sectional analysis it is good because it is in the industry average.
The net profit margin of the company comparing it to time series analysis on
2004-2005 the ratio is 0.062 which is not moving on 2006 it increase in 0.066 and
comparing it to cross-sectional analysis yields a good result which is better than the
industry average. Sterling’s return on total assets, return on common equity and
earnings per share is improving and better than the preceeding years which is good
when it comes in time series analysis while in cross-sectional analysis yields a good
result which is better than the industry average.
Market
In time series analysis the investors have greater confidence in 2006 than in the two
years, as reflected in the price/earnings (P/E) ratio of 13.0. The P/E ratio suggests that
the firm’s risk has decline but remains above that of the average firm in its industry.
In cross-sectional analysis in 2006 the ratio is 13.0 which is higher than the industry
average it is good because the higher the P/E ratio, the greater is investor confidence.
The firm’s market/book ratio in time series analysis in 2005 is decline of 0.15 while in
2006 it increase of 0.49 which is being favorably viewed by investors. In
cross-sectional analysis in 2006 it exceeds the industry average of 0.44 this implies
that investor’s are optimistic about the firm’s future performance.