Chapter 3, Problem 10P

a)

Summary Introduction

To evaluate: Liquidity position of Company J compared to industry averages by considering current, quick ratio and networking capital and give suggestions.

Explanation of Solution

Calculation of current ratio and quick ratio and net working capital:

$\begin{array}{c}\text{Current ratio}=\frac{\$1,600,000}{\$850,000}\\ =1.88\text{x}\end{array}$

$\begin{array}{c}\text{Quick ratio}=\frac{\left(\$1,600,000-\$1,040,000\right)}{\$850,000}\\ =0.66\text{x}\end{array}$

$\begin{array}{c}\text{Net}\text{working capital}=\$1,600,000-\$850,000\\ =\$750,000\end{array}$

Hence, the industry average current ratio is 2.5 as compared to Company J (1.88) which means that, the company maintains lower liquidity.

The quick ratio also indicates the same position. The problem is not sufficient liquidity to cover unforeseen situations wherein there may be a large cash outflow and the firm won’t be able to service it.

b)

Summary Introduction

To evaluate: Company J’s performance by examining key asset management ratios. Whether any problems seeming to this analysis.

Explanation of Solution

Calculation of asset management ratios:

$\begin{array}{c}\text{Average collection period}=\frac{\text{Average accounts receivables}}{\text{Net}\text{credit}\text{sales}}\times 365\\ =\frac{\$320,000}{\$3,000,000}\times 365\\ =38.93\text{days}\end{array}$

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost}\text{of}\text{goods}\text{sold}}{\text{Average}\text{inventory}}\\ =\frac{\$1,800,000}{\$1,040,000}\\ =1.73\end{array}$

$\begin{array}{c}\text{Total}\text{asset turnover}=\frac{\text{Net}\text{sales}}{\text{Total}\text{assets}}\\ =\frac{\$3,000,000}{\$2,400,000}\\ =1.25\end{array}$

The average collection period of company J is 38.93 as compared to 35 days of industry showing that it takes longer period to collect receivables.

The inventory turnover is less and it is a good sign for company J and asset turnover is slightly lower than industry so it indicates a slight underperformance of company J.

c)

Summary Introduction

To evaluate: Company J’s financial risk by examining equity multiplier, times interest earned ratio as compared to industry averages.

Explanation of Solution

Calculation of times interest earned and equity multiplier:

$\begin{array}{c}\text{Times interest earned}=\frac{\text{EBIT}}{\text{Interest}\text{expense}}\\ =\frac{\$340,000}{\$117,800}\\ =2.88\end{array}$

$\begin{array}{c}\text{Equity}\text{multiplier}=1+\frac{\text{D}}{\text{E}}\\ =1+\frac{\$1,650,000}{\$750,000}\\ =3.2\end{array}$

Hence, the times interest earned by company is lower than industry so it is a negative sign shows a higher interest payments and equity multiplier also indicates a higher debt.

d)

Summary Introduction

To evaluate: Profitability of Company J as compared to industry averages.

Explanation of Solution

Calculation of profit margin:

$\begin{array}{c}\text{Profit margin}=\frac{\text{Net}\text{income}}{\text{Net}\text{sales}}\\ =\frac{\$133,320}{\$3,000,000}\\ =4.44\%\end{array}$

Hence, the profitability of company J is 4.4% as compared to profitability of industry with 4% which is a positive and able to generate higher profits.

$\begin{array}{c}\text{Quick ratio}=\frac{\left(\$3.0-\$1.0+\$1.0\right)}{\left(\$1.5\right)}\\ =2.0\text{x}\end{array}$

Hence, the current ratio and quick ratios are 2.67x and 2.0x, both ratios rise.

e)

Summary Introduction

To discuss: Overall performance of Company J.

Explanation of Solution

An excessive inventory is being carried by company J and this results in a lesser asset turnover with a weak liquidity position. In all these areas a prospective development is required and the company has outperformed the average firm in the industry in doing this.

f)

Summary Introduction

To perform: DuPont analysis of Company J.

Explanation of Solution

Calculation of ROE:

$\begin{array}{c}\text{ROE}=\text{Net}\text{profit}\text{margin}\times \text{Total}\text{asset}\text{turnover}\times \text{Equity}\text{multiplier}\\ =\frac{\$133,320}{\$3,000,000}\times \frac{\$3,000,000}{\$2,400,000}\times \frac{\$2,400,000}{\$750,000}\\ =17.8\%\end{array}$

Hence, ROE is 17.8% and the main area for improvement is total asset turnover.

g)

Summary Introduction

To discuss: Factors most likely to account price earnings ratio of Company J compared to industry averages.

Explanation of Solution

The main factor is the advanced amount of financial risk possessed by firm and also may be supposed as having a lower growth potential than the average firm, although there is no direct proof provided in the information to suggest this.