Chapter 14, Problem 19P

Financial Ratios for Assessing Profitability and Market Performance
Refer to the financial statements and other data in Problem 14-18. Assume Paul Sabin has asked you to assess his company's profitability and stock market performance.
Required:

1. You decide first to assess the company's stock market performance. For both this year and last year, compute:
  a. The earnings per share. There has been no change in common stock over the last two years.
  b. The dividend yield ratio. The company's stock is currently selling for $40 per share; last year it sold for $36 per share.
  c. The dividend payout ratio.
  d. The price-earnings ratio. How do investors regard Sabin Electronics as compared to other companies in the industry if the industry norm for the price-earnings ratio is 12? Explain.
  e. The book value per share of common stock. Does the difference between market value and book value suggest that the stock is overpriced? Explain.
2. You decide next to assess the company's profitability. Compute the following for both this year and last year:
  a. The gross margin percentage.
  b. The net profit margin percentage.
  c. The return on total assets. (Total assets at the beginning of last year were $2,420,000.)
  d. The return on equity. (Stockho1ders ' equity at the beginning of 1ast year was $ 1.420.000.)
  e. Is the company's financial leverage positive or negative? Explain.
3. Comment on the company's profit performance and stock market performance over the two-year period.

To determine

To compute:

The following ratios for this year and last year −

Gross margin percentage

Net profit margin percentage

Return on total assets

Return on equity

Financial leverage of the company

Answer to Problem 19P

Solution:

	Ratios	This year	Last Year
a	Gross margin	22.50%	20.67%
b	Net margin percentage	5.60%	4.51%
c	Return on total assets	12.10%	10.10%
d	Return on equity	18.48%	13.75%
e	Financial Leverage	Positive	Positive

Explanation of Solution

The above answers can be explained as under −

Gross margin percentage −

For this year − Given

Sales = $ 5,000,000

Gross margin = $ 1,125,000

  $\begin{array}{l}Grossmarginpercentage=\frac{GrossMargin}{Sales}X100\hfill \\ Grossmarginpercentage=\frac{\$\text{ 1},125,000}{\$5,000,000}X100\hfill \\ Grossmarginpercentage=22.5\%\hfill \end{array}$

Gross margin percentage = 22.5 %

For last year − Given

• Sales = $ 4,350,000
• Gross margin = $ 900,000

  $\begin{array}{l}Grossmarginpercentage=\frac{GrossMargin}{Sales}X100\hfill \\ Grossmarginpercentage=\frac{\$\text{ 90}0,000}{\$\text{ 4},350,000}X100\hfill \\ Grossmarginpercentage=20.69\%\hfill \end{array}$

Gross margin percentage = 20.67 %

Net profit margin percentage −

For this year − Given

Sales = $ 5,000,000

Net profit margin = $ 280,000

  $\begin{array}{l}\text{Net profit }marginpercentage=\frac{\text{Net profit }Margin}{Sales}X100\hfill \\ \text{Net profit }marginpercentage=\frac{\$\text{ 28}0,000}{\$\text{ 5},000,000}X100\hfill \\ \text{Net profit }marginpercentage=\text{ 5}.6\%\hfill \end{array}$

For last year − Given

• Sales = $ 4,350,000
• Net profit margin = $ 196,000

  $\begin{array}{l}\text{Net profit }marginpercentage=\frac{\text{Net profit }Margin}{Sales}X100\hfill \\ \text{Net profit }marginpercentage=\frac{\$196,000}{\$\text{ 4},350,000}X100\hfill \\ \text{Net profit }marginpercentage=\text{ 4}.51\%\hfill \end{array}$

Return on total assets −

For this year − Given,

Net Income = $ 280,000

Beginning total assets = $ 24,600,000

Ending total assets = $ 3,000,000

Interest Expense = $ 72,000

Tax Rate = 30 %

$\text{Average total assets}=\frac{\text{Beginning Total assets}+\text{Ending total assets}}{2}$

$\begin{array}{l}\text{Average total assets}=\frac{\$2,460,000+\$3,000,000}{2}\\ \text{Average total assets}=\$2,730,000\end{array}$

  $\text{Rate of Return on Total Assets}=\frac{\text{Net Income + Interest Expense ( 1- tax rate)}}{\text{Average Total assets}}$

  $\begin{array}{l}=\frac{\$280,000+(\$72,000X(1-30\%)}{\$2,730,000}\\ =\text{ 12}\text{.10\%}\end{array}$

For last year − Given,

• Net Income = $ 196,000
• Beginning total assets = $ 2,420,000
• Ending total assets = $ 2,460,000
• Interest Expense = $ 72,000
• Tax Rate = 30 %
$\text{Average total assets}=\frac{\text{Beginning Total assets}+\text{Ending total assets}}{2}$

$\begin{array}{l}\text{Average total assets}=\frac{\$2,420,000+\$2,460,000}{2}\\ \text{Average total assets}=\$2,440,000\end{array}$

  $\text{Rate of Return on Total Assets}=\frac{\text{Net Income + Interest Expense ( 1- tax rate)}}{\text{Average Total assets}}$

  $\begin{array}{l}=\frac{\$196,000+(\$72,000X(1-30\%)}{\$2,440,000}\\ =\text{ 10}\text{.10\%}\end{array}$

Return on Equity −

For this year − Given,

Net Income = $ 280,000

Beginning Stockholder’s equity = $ 1,430,000

Ending stockholder’s equity = $ 1,600,000

Now, average stockholder’s equity −

$\text{Average }stockholder’sequity=\frac{\text{Beginning }stockholder’sequity+\text{Ending }stockholder’sequity}{2}$

  $\begin{array}{l}\text{Average }Stockholder’sequity=\frac{\$1,600,000+\$1,430,000}{2}\\ \text{Average }Stockholder’sequity=\$1,515,000\end{array}$

  $\begin{array}{l}\text{Return on Common Stockholder’s Equity = }\frac{\text{Net Income }}{\text{Average Common Stockholder’s Equity}}\\ \text{Return on Common Stockholder’s Equity = }\frac{\text{\$ 280,000}}{\$1,515,000}\\ \text{Return on Common Stockholder’s Equity = 18}\text{.48\%}\end{array}$

For last year − Given,

• Net Income = $ 196,000
• Beginning Stockholder’s equity = $ 1,420,000
• Ending stockholder’s equity = $ 1,430,000
Now, average stockholder’s equity −

$\text{Average }stockholder’sequity=\frac{\text{Beginning }stockholder’sequity+\text{Ending }stockholder’sequity}{2}$

  $\begin{array}{l}\text{Average }Stockholder’sequity=\frac{\$1,420,000+\$1,430,000}{2}\\ \text{Average }Stockholder’sequity=\$1,425,000\end{array}$

  $\begin{array}{l}\text{Return on Common Stockholder’s Equity = }\frac{\text{Net Income }}{\text{Average Common Stockholder’s Equity}}\\ \text{Return on Common Stockholder’s Equity = }\frac{\text{\$ 196,000}}{\$1,425,000}\\ \text{Return on Common Stockholder’s Equity = 13}\text{.75\%}\end{array}$

Financial leverage −

For both the years, the financial leverage is positive due to return on total assets is more than return on equity. For all the liability obligations, it can be traced that that enough sources are available to pay off its debt obligations.

Conclusion

Thus, all the ratio for requirements 2 have been calculated.

Requirement 3

To determine

To comment:

Company’s profit performance and Stock market performance

Answer to Problem 19P

Solution:

The profit ratios showed an increasing trend and earnings per share also increased. The price earnings ratio declined from last year. The return on total assets and return on equity also increased from last year. The price earnings ratio per share decreased from 9.18 to 7.14. But the market price of the share increased from last year.

It can be said that stock price will have potential growth in future years.

Explanation of Solution

The above observations can be explained as, the profitability ratio improved from last year to this year. This signifies that there is an increase in the profit earning efficiency of the company. Further, the other stock ratios like, earnings per share, dividend yield ratio, book value per share also increased, explaining that the stock of the company will have potential growth in the future years.

The dividend pay-out ratio decreased. The reason may be company is planning to pay less as dividend and utilize the retained income for future growth.

Conclusion

Thus, the observations on the profitability and stock performance have been explained.