Question

I am trying to solve the mini case Financial Statement and Cash Flow Analysis chapter 2 page 64 & 65 question 6. The test book is ISBN: 9781111222284 Introduction to Corporate Finance Third Edition.

Chapter 2 Financial Statement and Cash Flow Analysis 65 Balance Sheet (in 000s) Cash Accounts receivable Inventory Total current assets Net fixed assets Total assets $ 5,000 20,000 40,000 $ 65,000 135,000 $200,000 Accounts payable Notes payable Total current liabilities Long-term debt Stockholder equity Total liabilities and equity $ 15,000 20,000 $ 35,000 $100,000 $ 65,000 $200,000 Income Statement (in 000s) Net sales (all credit) Less: Cost of goods sold Earnings before interest and taxes Less: Interest Earnings before taxes Less: Taxes (40%) Net income $300,000 250,000 $ 50,000 40,000 $ 10,000 4,000 $ 6,000 6.4% 30 days 50% 23 Industry Averages for Key Ratios Net profit margin Average collection period (365 days) Debt ratio P/E ratio Inventory turnover ratio ROE Average payment period (365 days) Times interest earned ratio Total asset turnover Current ratio Assets-to-equity ratio ROA Quick ratio Fixed asset turnover ratio 12.0 18% 20 days 85 1.4 1.5 2.0 9% 1.25

Answer 1

..

Ratios to be calculated:

a) Liquidity position:

Current ratio = current assets/current liabilities = 65000/35000 = 1.86

Quick ratio = (cash equivalents + current receivables)/current liabilities = 25000/35000 = 0.71

b) Business activity:

Total asset turnover ratio = Net sales/Total assets = 300000/200000 = 1.5

Inventory turnover ratio = COGS/Average Inventory = 250000/40000 = 6.25

Fixed asset turnover ratio = Net Sales/Average fixed assets = 250000/135000 = 1.85

Average collection period = 365/average receivable turnover ratio = 365*accounts receivable/net sales = 365*20000/250000 = 28.48

c) Debt position:

Debt ratio = Total liabilities/total assets = 135000/200000 = 0.675

Times interest earned ratio = Earnings before taxes/Interest expense = 50000/40000 = 1.25

d) Profitability ratio:

Net Profit Margin = 6000/300000 = 2%

ROE = Net income/equity = 6000/65000 = 9.2%

ROA = Net income/Total assets = 6000/200000 = 3%

e) Market comparability

P/E ratio: Data not available (Share price or total number of shares outstanding)

1. In terms of liquidity position, the current ratio, 1.86 is better than the industry average of 1.5, however the quick ratio is way less than the industry average which suggests lack of cash equivalents. This can be attributed to high inventory build up of the company that has increased the current assets considerably, hence increasing the current ratio while low quick ratio

2. In terms of business activity ratios:

Positive: Average collection period is lesser than industry average

Negative: Inventory turnover ratio is lesser than the industry average suggesting build up of inventory

3. Debt Position: Bradley's debt position is inferior as compared to the industry both in terms of debt (0.675 compared t .5) and Times interest earned ratio (1.25 compared to 8.5). It means Bradley has more debt than the industry norm. Lesser Times interest earned ratio suggests that Bradley is paying huge interest as compared to the money that it is making. Hence increasing the interest burden.

4. Bradley's profitability position is worse than the industry. Its net profit margin is at 2% as compared to 6.4% of the industry. Also, the ROE at 9.2% is way lower than the industry average of 18%.

By Dupont Analysis, ROE = EBIT Margin * Interest burden * Tax burden * Asset turnover * Financial leverage

= EBIT/Sales * EBT/EBIT * Net Income/EBT * Sales/Total Assets * Total Assets/Total Equity

= (50000/300000) * (10000/50000) * (6000/10000) * (300000/200000) * (200000/65000) = 9.2%

We can see from DuPont Analysis that the lower EBIT margin, very low interest burden and low asset turnover are major caof lower ROE