Chapter 3

Problems
3-1. 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?

Solution:
Griffey Junior Wear
a.

Net income
Return on assets investment  
Total assets

$100,000
 12.5%
$800,000

b.
Net income
Return on equity 
Stockholde rs' equity

Stockholde rs' equity  total assets  total debt

 $800,000  $200,000  $600,000

Net income $100,000

  16.67%%
Stockholde r' s equity $600,000

OR

Page-1 of 44
3-1. Continued

Return on assets investment 

Return on equity 
1  Debt/Asset s 

$200,000
Debt/Asset s   25%
$800,000

12.5% 12.5%
Return on equity   16.67%
1  .25 .75
3-2. Bass Chemical, Inc., is considering expanding into a new product line. New assets to
support 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?

Solution:
Bass Chemical, Inc.

Net income  Sales  profit margin

 $2,000,000  0.05
 $100,000

Return on assets Net income


(investment) Total assets

$100,000

$1,200,000

 8.33%

Page-2 of 44
3-3. 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?

Solution:
Franklin Mint and Candy Shop

Net income  Sales  Profit Margin

 $750,000  0.06
 $45,000

Sales
Assets 
Total asset turn over

$750,000

2.5

 $300,000

Net income
Return on assets investment  
Total assets

$45,000

$300,000

 15%

Page-3 of 44
3-4. 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)?

Solution:
Hugh Snore Bedding, Inc.

Sales  Assets  total asset turn over

 $400,000  1.5%
 $600,000

Net income  Assets  Return on assets

$48,000  $400,000  12%

Net income
 $48,000 / $600,000  8%
Sales

3-5. 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 return on assets?

b. What is the 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)?

Page-4 of 44
Solution:

Easter Egg and Poultry Company

a.
Net income
Return on assets (investmen t) 
Total assets

$200,000
 10%
$2,000,000

b.
Net income
Return on equity 
Stockholde rs' equity

Stockholde rs' equity  total assets  total debt

 $2,000,000  $1,400,000
 $600,000

Net income $200,000

  33%
Stockholde rs' equity $600,000

OR

Page-5 of 44
3-5. Continued

Return on assets (investmen t)

Return on equity 
1  Debt/Asset s 
$1,400,000
Debt/Asset s   70%
$2,000,000
10% 10%
Return on equity   33%
1  .70 .30

c. Sales  total assets  total assets turnover

 $2,000,000  2.5
 $5,000,000
Net income $200,000
Profit margin    4%
Sales $5,000,000

3-6. 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. It has $700,000 of debt.
Its return on sales is 3 percent. What is its return on stockholders' equity?

Solution:
Sharpe Razor Company

total assets $2,500,000

– current assets 1,000,000
Fixed assets $1,500,000

Sales = Fixed assets x Fixed asset turnover =

$1,500,000 x 5 = $7,500,000

total assets $2,500,000

– debt 700,000
Stockholders' equity $1,800,000

Page-6 of 44
3-6. Continued

Net income = Sales x profit margin =

$7,500,000 x 3% = $225,000

Net income
Return on stockholde rs' equity 
Stockholde rs' equity

$225,000
  12.5%
$1,800,000

3-7. 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 asset 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?

Solution:
Baker Oats
a. Total asset turnover  Profit Margin = Return on Total assets
1.6  ?  11.2%

11.2%
Profit margin   7.0%
1.6

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.

Page-7 of 44
3-8. Global Healthcare Products has the following ratios compared to its industry for
2004.

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.

Solution:
Global Healthcare Products

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

Return on Assets
 Asset Turnover
Return on Sales

18% 12%
vs
2% 10%

9  vs 1.2 
3-9. Acme Transportation Company has the following ratios compared to its industry
for 2005.

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.

Page-8 of 44
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.

3-10. 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?

Solution:
Gates Appliances

a.
Return on assets investment 
Return on equity 
1  Debt/Asset s 

8%

1  0.40

8%

0.60

 13.33%

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

Page-9 of 44
3-11. Using the Du Pont method, please 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 asset turnover ratio?
b. If the Butters Corporation has a debt-to-total-assets ratio of 50 percent, what
will 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?

Solution:
Butters Corporation

a. Profit margin  Total asset turn over 

Return on asset investment 
7%  ?  25.2%
25.2%
Total asset turn over 
7%
 3.6x

b.
Return on assets investment 
Return on equity 
1  Debt/Asset s 

25.2%

1  0.50

25.2%

0.50

 50.40%

Page-10 of 44
3-11. Continued

Return on assets investment 

c. Return on equity 
1  Debt/Asset s 

25.2%

1  .35

25.2%

0.65

 38.77%
3-12. Jennifer’s Shoe Stores has $2,000,000 in yearly sales. The firm earns 3.8 percent
on each dollar of sales and turns over its assets 2.5 times per year. It has $60,000
in current liabilities and $140,000 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.

Solution:
Jennifer Shoe Stores
a. Net income  Sales  profit margin

 $2,000,000  3.8%

 $76,000

Page-11 of 44
3-12. Continued

Stockholde rs equity  Total assets  Total liabilitie s

Total assets  Sales/Tota l asset turn over

 $2,000,000 / 2.5

 $800,000

Total liabilitie s  Current liabilitie s  Long - term liabilitie s

 $60,000  $140,000

 $200,000

Stockholde rs' equity  $800,000  $200,000  $600,000

Net income
Return on stockholde rs' equity 
Stockholde rs' equity

$76,000
  12.67%
$600,000

Page-12 of 44
3-12. Continued
b. The Value for sales will be:

Sales  Total assets  Total asset turn over

 $800,000  3

 $2,400,000

Net income  Sales  Profit margin

 $2,400,000  3.8%

 $91,200

Net income
Return on stockholders' equity 
Stockholders' equity

$91,200
  15.2%
$600,000

3-13. Assume the following data for Interactive Technology and Silicon Software:

Interactive Silicon
Technology (IT) 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. 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

Page-13 of 44
 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.

Solution:

Interactive Technology and Silicon Software

a. Interactive Silicon
Technology (IT) Software (SS)

Net income $15,000 $50,000

  15%  31.25%
Stockholde rs' equity $100,000 $160,000

Silicon Software (SS) has a much higher return on stockholders' equity

than Interactive Technology (IT).

b. Interactive Silicon
Technology (IT) Software (SS)

Net income $15,000 $50,000

  10%  5%
Sales $150,000 $1,000,000

Net income $15,000 $50,000

  9.37%  12.5%
Total assets $160,000 $400,000

Sales $150,000 $1,000,000

  .937 x  2.5x
Total assets $160,000 $400,000

Debt $60,000 $240,000

  37.5%  60%
Total assets $160,000 $400,000

Page-14 of 44
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.

Page-15 of 44
3-13. Continued

Silicon Software’s superior return on stockholders' equity is further

enhanced by a higher debt ratio than Interactive Technology (60% versus
37.5%). This means that a smaller percentage of Silicon Software’s total
assets are being financed by stockholders' equity and thus the potentially
higher return on stockholders' equity.

Although not requested in the question, one could show the following:

Net income Net income/Tot al asssets


Stockholde rs' equity 1  debt/asset s 

Silicon Software  12.5%1  .60  12.5% / .40  31.25%

Interactiv e Technology  .937%1  .375  9.37% / .625  15%

3-14. 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.)

Accounts receivable
Average collection period 
Average daily credit sales

 $285000 /
$3,000,000  90% 
360 days
Solution:
$285,000

$7,500 per day

 38 days

Page-16 of 44
3-15. 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

Credit sales
Average daily credit sales 
360

To determine credit sales, multiply accounts receivable by accounts

receivable turnover.

$80,000 x 15 = $1,200,000

$1,200,000
Average daily credit sales   $3,333
360
3-16. Perez Corporation has the following financial data for the years 2003 and 2004:

2003 2004
Sales $8,000,000 $10,000,000
Cost of good 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?

Solution:
Perez Corporation

2003 2004

Sales $8,000,000 $10,000,000

a.   10x  10x
Inventory 800,000 1,000,000

Page-17 of 44
 Cost of goods sold $6,000,000 $9,000,000
b.   7.5x  9x
Inventory 800,000 1,000,000

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.
Nevertheless, cost of goods sold used by many analysis in the
numerator of the inventory turnover ratio because it is stated on a "cost"
basis as is inventory. This is an important theoretical consideration.

However, the authors prefer to use sales in the numerator of the

inventory turnover ratio because that is the procedure used by Dun &
Bradstreet, the most widely quoted sources for ratio analysis.
Furthermore, for privately traded companies there may be only
information available on sales and not cost of goods sold.
3-17. The balance sheet for the Stud Clothiers is given below. Sales for the year were
$2,400,000, with 90 percent of sales sold on credit.

Stud Clothiers
Balance Sheet 199X

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 liabilities and equity ..... $1,060,000
Total assets.................. $1,060,000

Page-18 of 44
 Compute the following ratios:

a. Current ratio.
b. Quick ratio.
c. Debt-to-total-assets ratio.
d. Asset turnover.
e. Average collection period.

Solution:
Stud Clothiers

Current assets
a. Current ratio 
Current liabilitie s

$650,000

$250,000

 2.6x

b. Quick ratio 
Current assets  inventory 
Current liabilitie s

$650,000  $350,000

$250,000

$300,000

$250,000

 1.2x

Page-19 of 44
3-17. Continued
Total debt
c. Debt to total assets 
Total assets

$400,000

$1,060,000

 37.74%

Sales
d. Asset turn over 
Total assets

$2,400,000

$1,060,000

 2.26x

e. Average collection Accounts receivable


period Average daily credit sales

 $240,000 /
$2,400,000  0.90
360 days

$240,000

$6,000 per day

 40 days

Page-20 of 44
3-18. 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

Solution:
Neeley Office Supplies

Income before interest and taxes

a. Times interest earned 
Interest

$60,000

15,000

 4x
Income before fixed charges and taxes
b. Fixed charge coverage 
Fixed charges

$60,000  25,000

$15,000  25,000

$85,000

$40,000

 2.125x

Page-21 of 44
 Income before fixed charges and taxes
b. Fixed charge coverage 
Fixed charges

$60,000  25,000

$15,000  25,000

$85,000

$40,000

 2.125x
3-19. Using the income statement for Paste Management Company, compute the
following ratios:

a. Times interest earned.

b. 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).

Paste Management 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.

Page-22 of 44
3-19. Continued

Solution:
Paste Management Company

Income before interest and taxes

a. Times interest earned 
Interest

$18,000

$3,000

 6x

Income before fixed charges and taxes

b. Fixed charge coverage 
Fixed charges

$18,000  4,000

$3,000  $4,000

$22,000

$7,000

 3.14x

Page-23 of 44
3-19. Continued
Net Income
c. Profit Margin 
Sales

$10,500

$126,000

 8.33%

Sales
d. Total asset turn over 
Total assets

$126,000

$80,000

 1.575x

e. Return on assets Net income Sales

 
(investment) Sales Total assets

 8.33%  1.575x

 13.12%

3-20. 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?

Page-24 of 44
Solution:

Income before interest and taxes

a. Times interest earned 
Interest

 120,000 / $24,000

 5x
IBIT  Before tax fixed charges
b. Fixed charge coverage 
Interest  Fixed charges

$120,000  $40,000

$24,000  $40,000

 2.5x
3-21. In January 1995, 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 1995 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 1995.

a. Compute return on assets at year-end for 1995, 1997, 2000, 2002 and 2004.
(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? Comment.

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:

Page-25 of 44
 1995 = $270,000;
1997 = $210,000;
2000 = $120,000;
2002 = $60,000;
2004 = -0-
Income after taxe s
Return on assets (investment) 
Current assets  Fixed assets
1995 = $26,000/$470,000 = 5.53%
1997 = $26,000/$410,000 = 6.34%
2000 = $26,000/$320,000 = 8.13%
2002 = $26,000/$260,000 = 10.00%
2004 = $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.

3-22. Calloway Products has the following data. Industry information also is shown.

Industry Data on Net

Year Net Income Total Assets Income/Total Assets
2002 $360,000 $3,000,000 11%
2003 380,000 3,400,000 8%
2004 380,000 3,800,000 5%
Industry Data on
Year Debt Total Assets Debt/Total Assets
2002 $1,600,000 $3,000,000 52%
2003 1,750,000 3,400,000 40%
2004 1,900,000 3,800,000 31%

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

a. Net income/Total assets?

b. Debt/Total assets?

Page-26 of 44
Solution:
Calloway Products

a. Net income/total assets

Year Calloway Ratio Industry Ratio

2002 12.0% 11.0%
2003 11.18% 8.0%
2004 10.0% 5.0%

Although the company has shown a declining return on assets since

1997, it has performed much better than the industry. Praise may be
more appropriate than criticism.

b. Debt/total assets

Year Calloway Ratio Industry Ratio

2002 53.33% 52.0%
2003 51.47% 40.0%
2004 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.

3-23. Quantum Moving Company has the following data. Industry information also is
shown.

Company Data Industry Data on Net

Year Net Income Total Assets Income/Total Assets
2003 $350,000 $2,800,000 11.5%
2004 375,000 3,200,000 8.4%
2005 375,000 3,750,000 5.5%

Page-27 of 44
 Industry Data on
Year Debt Total Assets Debt/Total Assets
2003 $1,624,000 $2,800,000 54.1%
2004 1,730,000 3,200,000 42.0%
2005 1,900,000 3,750,000 33.4%

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

a. Net income/total assets?

b. Debt/total assets?

Solution:
Quantum Moving Company

a. Net income/total assets

Year Quantum Ratio Industry Ratio

2003 12.5% 11.5%
2004 11.7% 8.4%
2005 10.0% 5.5%

Although the company has shown a declining return on assets since

2003, it has performed much better than the industry. Praise may be
more appropriate than criticism.

b. Debt/total assets

Year Quantum Ratio Industry Ratio

2003 58.0% 54.1%
2004 54.1% 42.0%
2005 50.7% 33.4%

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.

Page-28 of 44
3-24. 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 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?

Solution:
United World Corporation

Computers Magazines Cable TV

a. Net income/sal es
6.25% 4.00% 7.50%

The magazine division has the lowest return on sales.

Computers Magazines Cable TV

b. Net income/tot al assets
20.0% 8.00% 12.00%

The computer division has the highest return on assets.

Corporate net income $1,000,000  $160,000  $600,000

c. 
Corporate total assets $5,000,000  $2,000,000  $5,000,000

$1,760,000

$12,000,000

 14.67%

Page-29 of 44
3-24 Continued

d. Return on redeployed assets in computers.

20% x $5,000,000 = $1,000,000

Return on assets for the entire corporation:

Corporate net income $1,000,000  $160,000  $1,000,000


Corporate total asset $12,000,000

$2,160,000

$12,000,000

 18%
3-25. Bard Corporation shows the following income statement. The firm uses FIFO
inventory accounting.

Bard Corporation
Income Statement for 2004

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 the year 2005 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 the year
2005.

Page-30 of 44
3-25. Continued

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 2006 the volume remains constant at 10,000 units, but the
sales price decreases by 15 percent from its year 2000 level. Also, because of
FIFO inventory policy, cost of goods sold reflects that inflationary conditions
of the prior year and is $11 per unit. Further, assume that 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.

Solution:
Bard Corporation
a. 2005
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

b. Gain in aftertax income

2005 $62,300
2004 49,000
Increase $13,300

Increase $13,300
  27.14%
Base value 2004 $49,000

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).

Page-31 of 44
3-25. Continued
c. 2006
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 x 0.85 = $18.70

The low profits indicate the effect of inflation followed by

disinflation.

3-26. 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 . ______

Page-32 of 44
3-26. Continued

Solution:

Inventory = $720,000/6
= $120,000
Account rec. = ($720,000/360) x 35
= $70,000
Current assets = 2 x $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

3-27. The Griggs Corporation has credit sales of $1,200,000. Given the following
ratios, fill in the balance sheet.

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 2004

Assets Liabilities and Stockholders' Equity

Cash ................................ _________ Current debt .................. _________
Accounts receivable ........ _________ Long-term debt.............. _________
Inventory ......................... _________ Total debt .................... _________
Total current assets ....... _________ Equity ............................ _________
Fixed assets ..................... _________ Total debt and
Total assets.................... _________ Stockholders' equity .. _________

Page-33 of 44
3-27. Continued

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% x $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 x $500,000
Total debt = $305,000

Page-34 of 44
3-27. Continued
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 2004

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 $500,000
stockholders'
equity

Page-35 of 44
3-28. 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.

Page-36 of 44
3-28. Continued

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 x Current liabilities
= 2.5 x $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 x total assets
= 40% x $6,000,000
= $2,400,000
Long-term debt = $2,400,000 – $1,400,000
= $1,000,000

Page-37 of 44
3-29. The following data are from Sharon Stone, Inc., financial statements. The firm
manufactures home decorative material. Sales (all credit) were $60 million for
2004.

Sales to total assets ....................................... 3.0 times

Total debt to 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 .................. _________

Accounts receivable ........ _________ Long-term debt.............. _________
Inventory ......................... _________ Total debt .................... _________
Total current assets ....... _________ Equity ............................ _________
Fixed assets ..................... _________ Total debt and stockholders’
Total assets...................... _________ equity......................... _________

Solution:
Sharon Stone, Inc.

Sales/total assets = 3.0x

Total assets = $60 million/3.0
Total assets = $20 million

Total debt/total assets = 40%

Total debt = $20 million x .4
Total debt = $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 x $166,667
= $3 million (or)

Page-38 of 44
3-29. Continued
$60 million
Accounts receivable =  $3,000,000
360
18

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/2x

= $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

Page-39 of 44
3-29. Continued

Cash ...................
$ 3.0 million Current debt ...... $ 6.0 million
Accounts Long-term debt . $ 2.0
receivable ...........
$ 3.0
Inventory ............
$ 6.0 Total debt .......... $ 8.0
Total current Equity ............... $12.0
assets ................
$12.0
Fixed assets ........$ 8.0
Total assets.........$20.0 million Total debt and $20.0 million
equity ................
3-30. 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, 2004

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

Page-40 of 44
 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, 2004
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.

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

Page-41 of 44
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
3-31. Given the financial statements for Jones Corporation and Smith Corporation
shown below:

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: Accum. Dep. ........ (150,000) Paid-in capital .................. 70,000
*Net fixed assets ............. 350,000 Retained earnings ............. 100,000
Total assets.................. $ 500,000 Total liab. 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.

Page-42 of 44
3-31. Continued
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: Accum. Dep. ........ (250,000) Paid-in capital .................. 30,000
*Net fixed assets ............. 250,000 Retained earnings ............. 47,500
Total assets.................. $ 437,500 Total liab. 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.

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

Page-43 of 44
 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 (200/15) (133/28)
calculation

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.

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.

Page-44 of 44