Question

You have just been hired as a financial analyst for Lydex Company, a manufacturer of safety helmets. Your boss has asked you to perform a comprehensive analysis of the company’s financial statements, including comparing Lydex’s performance to its major competitors. The company’s financial statements for the last two years are as follows:

Lydex Company Comparative Balance Sheet
	This Year		Last Year
Assets
Current assets:
Cash	$	1,000,000	$	1,240,000
Marketable securities		0		300,000
Accounts receivable, net		2,860,000		1,960,000
Inventory		3,640,000		2,400,000
Prepaid expenses		270,000		210,000
Total current assets		7,770,000		6,110,000
Plant and equipment, net		9,600,000		9,090,000
Total assets	$	17,370,000	$	15,200,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities	$	4,050,000	$	3,060,000
Note payable, 10%		3,700,000		3,100,000
Total liabilities		7,750,000		6,160,000
Stockholders' equity:
Common stock, $75 par value		7,500,000		7,500,000
Retained earnings		2,120,000		1,540,000
Total stockholders' equity		9,620,000		9,040,000
Total liabilities and stockholders' equity	$	17,370,000	$	15,200,000

Lydex Company Comparative Income Statement and Reconciliation
	This Year		Last Year
Sales (all on account)	$	15,900,000	$	13,980,000
Cost of goods sold		12,720,000		10,485,000
Gross margin		3,180,000		3,495,000
Selling and administrative expenses		1,410,000		1,620,000
Net operating income		1,770,000		1,875,000
Interest expense		370,000		310,000
Net income before taxes		1,400,000		1,565,000
Income taxes (30%)		420,000		469,500
Net income		980,000		1,095,500
Common dividends		400,000		547,750
Net income retained		580,000		547,750
Beginning retained earnings		1,540,000		992,250
Ending retained earnings	$	2,120,000	$	1,540,000

To begin your assignment you gather the following financial data and ratios that are typical of companies in Lydex Company’s industry:

Current ratio	2.3
Acid-test ratio	1.1
Average collection period	32	days
Average sale period	60	days
Return on assets	9.7	%
Debt-to-equity ratio	0.7
Times interest earned ratio	5.7
Price-earnings ratio	10

Required:

1. You decide first to assess the company’s performance in terms of debt management and profitability. Compute the following for both this year and last year: (Round your "Percentage" answers to 1 decimal place and other answers to 2 decimal places.)

a. The times interest earned ratio.

b. The debt-to-equity ratio.

c. The gross margin percentage.

d. The return on total assets. (Total assets at the beginning of last year were $13,110,000.)

e. The return on equity. (Stockholders’ equity at the beginning of last year totaled $8,492,250. There has been no change in common stock over the last two years.)

f. Is the company’s financial leverage positive or negative?

Answer 1

a) The times interest earned ratio= Earning before interest and tax/Interest expense

This Year= $1770000/370000= 4.78

Last Year= $1875000/310000= 6.05

b) The debt-to-equity ratio= Total debts/Total equity

This Year= $7750000/9620000= 0.81

Last Year= $6160000/9040000= 0.68

c)  The gross margin percentage= Gross margin*100/Sales

This Year= $3180000*100/15900000= 20%

Last Year= $3495000*100/13980000= 25%

d) The return on total assets= Net income+Interest expense(1-tax rate)/Average total assets

This Year

Average total assets= ($17370000+15200000)/2= $16285000

The return on total assets= $980000+370000(1-30%)/16285000

= $980000+259000/16285000= 7.6%

Last Year

Average total assets= ($15200000+13110000)/2= $14155000

The return on total assets= $1095500+310000(1-30%)/14155000

= $1095500+222000/14155000= 9.3%

e) The return on equity= Net income/Average stockholders' equity

This Year

Average stockholders' equity= ($9620000+9040000)/2= $9330000

The return on equity= $980000*100/9330000= 10.5%

Last Year

Average stockholders' equity= ($9040000+8492250)/2= $8766125

The return on equity= $1095500*100/8766125= 12.5%

f) Yes, both the company's has positive financial leverage because in both the year return on equity is greater than return on assets. So, the financial leverage is positive.