Chapter 3 - Foundations of Financial Management 11th Canadian edition PDF

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Foundations of Financial Management 11th Canadian edition...

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Chapter 3 Discussion Questions

3-1.

Short-term lenders - liquidity because their concern is with the firm's ability to pay shortterm obligations as they come due. Long-term lenders - leverage because they are concerned with the relationship of debt to total assets. They also will examine profitability to ensure that interest payments can be made. Shareholders - profitability, with secondary consideration given to debt utilization, liquidity, and other ratios. Since shareholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.

3-2. a.

Return on investment =

Net income Total assets

Inflation may cause net income to be overstated and total assets to be understated. Too high a ratio could be reported.

b.

Inventory turnover

= Sales or COGS Inventory

*Sales may be used when COGS is not available (rival private firms). Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect "inflation-influenced" dollars and the net effect will be nil. If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported.

c.

Capital asset turnover

=

Sales Capital assets

Capital assets will be understated relative to sales and too high a ratio could be reported.

d.

Debt to total assets

=

Total debt Total assets

Since both are based on historical costs, no major inflationary impact will take place in the ratio. Assets are likely understated, however, causing ratio to be overstated. Foundations of Fin. Mgt. 10Ce

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Chapter 3 3-3.

The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover. ROA

= Profit Margin

×

Asset Turnover

Net income Total assets

= Net income Sales

×

Sales . Total assets

In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a company in the capital goods industry may have a high profit margin and a low asset turnover, while a food-processing firm may suffer from low profit margins, but enjoy a rapid turnover of assets. The modified Du Pont formula shows: ROE

=

×

ROA

Return on equity = Return on assets (investment) ×

Equity multiplier Total assets Equity

This indicates that return on shareholders' equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on shareholders' equity that is influenced by large amounts of debt.

3-4.

The fixed charge coverage ratio measures the firm's ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.

3-5.

In both instances, we would not reflect a very significant cost of doing business. Of course, one could argue that, to the extent that differential tax rates of financing plans (and associated interest costs) did not reflect the operating capability of the firm, omission of these changes could provide new insights.

3-6.

No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-ofthumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information.

3-7.

Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last ten years. Trend analysis must also be compared to

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Chapter 3 industry patterns of change. The change in accounting rules with the use of IFRS for public companies and ASPE for private enterprises results in financial statements being significantly different with those prepared before January 1, 2011 which makes trend analysis inappropriate for decision making. However, the conversion of previous years’ statements will make the years prior to 2011 comparative and useful for trend analysis.

3-8.

Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm's income statement resulting in decreased net income. This is particularly true for firms in highly cyclical industries, such as oil based products, where prices tend to rise and fall quickly.

3-9.

Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar. Lower inflation also means that the required return that investors demand on financial assets will be lower, and with this lower demanded return, future earnings or interest should receive a higher current valuation.

3-10. There

are many different methods of financial reporting accepted by the accounting profession as promulgated by the Canadian Institute of Chartered Accountants (now CPA Canada). The implementation of IFRS (public firms) and ASPE (private firms) should result in better comparison of statements among companies using the same rules of accounting. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items.

Internet Resources and Questions 1. 2. 3. 4.

www.adviceforinvestors.com www.sedar.com/search/search_form_pc_en.htm www.bmo.com www.rbc.com

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Chapter 3 Problems 3-1.

Griffey Junior Wear

Return on assets= a.

Net income $ 100 , 000 =.125=12 .5 % = Total assets $ 800 , 000

Shareholders' equity = Total asssets-total debt =$ 800 , 000 −$ 200 , 000 =$ 600 , 000 b. Net income $ 100 , 000 Return on equity= =. 1667=16 . 67 % = Shareholders' equity $ 600 , 000 OR

Equity multiplier=

Total assets $ 800 , 000 = =1 .3 3 Equity $ 600 , 000

ROE= ROA × Equity multiplier=12.5%×1.33=16.67 %

c.

Sales=total assets× asset turnover =$ 800 , 000×2 .75=$ 2 ,200 , 000

Net income $ 100 , 000 Profit margin= =. 0455=4 . 55 % = $ 2 ,200 , 000 Sales

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Chapter 3 3-2.

Easter Egg and Poultry Company

Return on assets= a.

Net income $ 200 ,000 =. 10=10 . 0 % = Total assets $ 2 ,000 , 000

Shareholders' equity = Total asssets-total debt =$ 2, 000 , 000−$ 1, 400 , 000=$ 600 , 000 b. Net income $ 200 , 000 Return on equity= = =. 3333=33 . 33 % Shareholders' equity $ 600 , 000 OR

Equity multiplier=

Total assets $ 2 , 000 , 000 =3. 3 3 = $ 600 , 000 Equity

ROE= ROA × Equity multiplier=10 .0%×3.33=33.33% c.

Sales=total assets× asset turnover =$ 2 ,000 , 000×2. 5=$ 5 , 000 , 000

Profit margin=

3-3.

Net income $ 200 , 000 = =. 04=4 . 0 % Sales $ 5 , 000 ,000 Diet Health Foods Inc.

Division A: Profit margin = Net income / Sales = $100,000 / $2,000,000 = 5% Division B: Profit margin = Net income / Sales = $25,000 / $300,000 = 8.33% Division B is superior in terms of profit margin with 8.33% against Division A's profit margin of 5.00%.

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Chapter 3 3-4.

Dr. Gupta Diagnostics Profit margin (2015) 

a.

Net income $175, 000  .0875 8.75% Sales $2,000,000

b. Sales ($2,000,000 × 1.10)…….………………….. Cost of goods sold ($1,400,000 × 1.20)………… Gross profit…………………………………... Selling and administration expense………........... Operating profit……………………………… Interest expense…………………………………. Income before taxes..………………………… Taxes @ 30% …………………………………… Income after taxes….………………………… Profit margin (2016) 

3-5.

$2,200,000 1,680,000 520,000 300,000 220,000 50,000 170,000 51,000 $ 119,000

Net income $119,000  .0541 5.41% Sales $2,200,000

Watson Data Systems Net income

= = =

Return on assets (investment)

Sales  profit margin $1,200,000  6% $72,000 = = =

Foundations of Fin. Mgt. 10Ce

Net income Total assets $ 72,000 $500,000 0.144= 14.4%

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Chapter 3 3-6.

Walker Glove and Bat Shop Net income

Assets

= = =

Sales Total asset turnover = $1,250,000/ 3.4 = $367,647 =

Return on Assets ( investments)=

3-7.

Sales  profit margin $1,250,000  0.08 $100,000

Net income $ 100 , 000 = =0 . 2720= 27. 2 % Total assets $ 367 , 647

Hugh Snore Bedding Sales

= = =

Net income = = =

Profit margin=

Foundations of Fin. Mgt. 10Ce

Total assets × total asset turnover $400,000 × 1.5 $600,000 Total assets × return on assets $400,000 × 12% $48,000

Net income $ 48 , 000 = =0.08=8 . 0 % Sales $ 600 , 000

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Chapter 3 3-8.

Sharpe Razor Company Total assets ─ Current assets $2,500,000 ─ 1,000,000

= Capital assets = $1,500,000

Sales = Capital assets × Capital asset turnover = $1,500,000 × 5 = $7,500,000 Total assets ─ debt $2,500,000 ─ 700,000

= Shareholders’ equity = $1,800,000

Net income = Sales × profit margin = $7,500,000 × 3% = $225,000

ROE=

$ 225 , 000 Net income = =.125=12. 5 % Shareholders' equity $ 1 , 800 ,000

3-9.

Global Heathcare Products

Global Heathcare has a higher asset turnover ratio than the industry. ROA = Asset turnover × profit margin Asset turnover =

3-10.

ROA 12% 18 % =1 .2׿ =9× versus = 10% 2% Profit margin ¿

Acme Transportation Company

Acme Transportation has a lower debt/total assets ratio than the industry and therefore a lower equity multiplier. ROE = ROA × equity multiplier 24% ROE 12 % = 4 . 0׿ = =1 .33× versus Equity turnover = 6% ROA 9% ¿

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Chapter 3 3-11. a.

King Card Company

Equity multiplier=

Total assets 100 % = =1. 667 Equity 1−40 %

ROE= ROA × Equity multiplier =12%×1 . 667=20 . 0 % b. With no debt ROE = ROA. In this case 12%.

3-12.

Lollar Corporation

a. Total asset turnover  Profit margin = Return on total assets (ROA) ?  5% = 13.5% Total asset turnover= ¿

Equity multiplier= b.

13 .5 % = 2. 7× ¿ 5%

Total assets 100 % = =2 . 5 Equity 1−60 %

ROE= ROA × Equity multiplier =13. 5 % ×2 .5 =33 .75 %

Equity multiplier= c.

Total assets 100 % = =1. 67 Equity 1−40 %

ROE= ROA × Equity multiplier =13. 5 %×1 .67=22 .50 %

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Chapter 3

3-13.

Pony Express Return on assets 

a.

Net income $55,000  .0733 7.33% Total assets $750,000

Shareholders' equity Total assets - total debt  $750,000  $300,000 $450,000

b.

Net income $55,000 Return on equity   .1222 12.22% Shareholders' equity $450,000

OR Total assets $750,000 Equity multiplier   1.67 Equity $450,000 ROE ROA Equity multiplier 7.33% 1.67 12.22%

c. Sales total assets asset turnover $750,000 2.2 $1,650,000 Profit margin 

Foundations of Fin. Mgt. 10Ce

Net income $55,000  .033 3.3% Sales $1,650,000

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Chapter 3 3-14.

Donovan Bailey’s Shoe Stores = Sales  profit margin = $3,000,000  6.2% = $186,000

a. Net income

Shareholders equity

= Total assets  total liabilities

Total assets

= Sales/Total asset turnover = $3,000,000/3.75 = $800,000

Total liabilities

= Current liabilities + long-term liabilities = $90,000 + $200,000 = $290,000

Shareholders' equity = $800,000  $290,000 = $510,000

Return on equity ( ROE)= b. Sales

Net income

$ 186 , 000 Net income = =. 3647=36 . 47 % Shareholders' equity $ 510 , 000

= = =

Total assets  total asset turnover $800,000  3 $2,400,000

= = =

Sales  Profit margin $2,400,000  6.2% $148,800

Net income $ 148 ,800 Return on equity(ROE )= =0 .2918=29 .18 % = Shareholders' equity $ 510 ,000

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Chapter 3 3-15.

Interactive Technology and Silicon Software Interactive Technology

Silicon Software

a.

ROE=

Net income $ 15 , 000 = =15% Equity $ 100 , 000

$ 50, 000 =31.25 % $ 160 , 000

b.

Net income $ 15 , 000 Profit margin = = =10% Sales $ 150 , 000 Net income $ 15,000 ROA= =9. 375% = Total assets $ 160 , 000

$ 50 , 000 =5 % $ 1, 000 , 000 $ 50 ,000 =12. 5 % $ 400 , 000

$ 150 , 000 Sales =0 . 9375× = Total assets $ 160 , 000 ¿

$ 1 ,000 , 000 =2 . 5׿ $ 400 , 000

$ 60 , 000 Debt = =37.5 % Total assets $ 160 , 000

$ 240 ,000 =60% $ 400 , 000

c. Silicon Software has a significantly higher return on equity (31.25% versus 15%). This is despite a lower profit margin (5% vs.10%). However Silicon has achieved a higher return on total assets (12.5% vs. 9.375%) through a strong total asset turnover (2.5× vs. 0.9375×). The superior return on equity is further enhanced with higher use of debt (60% vs. 37.5%). This is called leverage and can magnify shareholder returns.

3-16.

Foundations of Fin. Mgt. 10Ce

A Firm

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Chapter 3

Accounts receivable Average daily credit sales $ 360 , 000 = ( $ 1 ,200 ,000×90 % )/365 $ 360 , 000 = =122 days $ 2 , 959

Average collection period=

3-17.

Chamberlain Corporation

Credit sales Average credit sales= 365 To determine credit sales, multiply accounts receivable by accounts receivable turnover. $90,000  12 = $1,080,000

Average credit sales=

Foundations of Fin. Mgt. 10Ce

$ 1, 080 , 000 =$ 2 , 959 365

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Chapter 3 3-18.

2GFU Corporation 2014

2015

a. Sales $ 3 , 500 ,000 Inventory turnover= =14× = $ 250 , 000 Inventory ¿

$ 4 , 200 ,000 =14׿ $ 300 , 000

b. Inventory turnover 

COGS $2,500,000  10  Inventory $250,000

$3,500,000 11.67  $300,000

c. Based on the sales to inventory ratio the turnover ratio has remained constant at 14 ×. However based on the cost of goods sold to inventory ratio, it has improved from 10 × to 11.67 ×. The later ratio may be providing a false picture of improvement in this example simply because COGS has gone up as a percentage of sales (from 71.43 percent to 83.33 percent). Inventory is not really turning over any faster. Nevertheless, COGS is used by many analysts in the numerator of the inventory turnover ratio because it is stated on a ‘cost’ basis as inventory. This is an important theoretical consideration. Dun and Bradstreet, the most widely quoted source for ratio analysis uses sales in the numerator. Furthermore, for private companies, information may be only available for sales and net COGS.

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Chapter 3 3-19.

Jim Kovacs Company

a. 1. Accounts receivable turnover = Sales/Accounts Receivable

$4,000,000 =5 x 800,000 2. Inventory turnover = Sales/Inventory

$4,000,000 =10 x 400,000 3. Fixed asset turnover = Sales/(Net Plant & Equipment)

$4,000,000 =8 x 500,000 4. Total asset turnover = Sales/Total Assets

$4,000,000 =2. 22 x 1,800,000 b. 1. Accounts receivable turnover

$5,000,000 =5 . 56 x 900,000 2. Inventory turnover

$5,000,000 =5 . 13 x 975,000 3.

Fixed asset turnover

$5,000,000 =9.09 x 550,000 4.

Total asset turnover

$5,000,000 =1 . 98 x 2,525,000 c.

There is a decline in total asset turnover from 2.22x to 1.98x. This development has taken place because of the slowdown in inventory

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Chapter 3 turnover (10x down to 5.13x). The other two ratios are slightly improved.

Bryan Corporation

3-20.

$ 650 , 000 Current assets =2. 6׿ = Current ratio = Current liabilities $ 250 , 000 ¿

a.

Quick ratio =

b.

Current assets-inventory $ 300 ,000 =1. 2׿ = $ 250 , 000 Current liabilities ¿

Debt to total assets = c. Asset turnover =

d.

$ 400 , 000 Total debt =38 % = Total assets $ 1 ,060 , 000

$ 3 , 040 ,000 Sales = =2 . 87׿ Total assets $ 1 ,060 , 000 ¿

e.

Accounts receivable Average daily credit sales $ 240,000 $ 240,000 = =38. 42 days = 6 ,247 ( $ 3 , 040 , 000×75 % ) /365 Average collection period =

Simmons Corporation

3-21.

a. Times interest earned=

¿

Foundations of Fin. Mgt. 10Ce

Income before interest and taxes (EBIT ) Interest $ 60 ,000 =5׿ = $ 12, 000

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Chapter 3 b. Income before fixed charges and taxes Fixed charges $ 60 , 000+$ 24 , 000 $ 84 , 000 = =2. 33׿ = $ 12 ,000+ $ 24 , 000 $ 36 ,000

Fixed charge coverage=

¿

Sports Car Tire Company

3-22.

a.

$ 6 , 000 EBIT = Times interest earned = =12׿ Interest $ 500 ¿

b. Income before fixed charges and taxes Fixed charge coverage= Fixed charges $ 6 , 000 +$ 1 , 000 $ 7 ,000 = =4 . 67׿ = $ 1 ,500 $ 1, 000+$ 500 ¿

Profit margin= c.
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