Chapter 4, Problem 10EYK

1)

To determine

Calculate the return on sales ratio for each year and comment on Company L’s profitability.

Explanation of Solution

Return on sales ratio: The ratio which evaluates the amount of net income earned for every dollar of net sales is referred to as return on sales ratio. Higher ratio indicates highly profitable company.

$\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}$

Compute the return on sales ratio for Company L for the year 2010.

Net income = $65 million

Net sales = $1,967 million

$\begin{array}{c}\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}\\ \text{= }\frac{\text{\$65 million}}{\text{\$1,967 million}}\\ \text{= 0}\text{.033 or 3}\text{.3\%}\end{array}$

Compute the return on sales ratio for Company L for the year 2011.

Net income = $128 million

Net sales = $2,363 million

$\begin{array}{c}\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}\\ \text{= }\frac{\text{\$128 million}}{\text{\$2,363 million}}\\ \text{= 0}\text{.054 or 5}\text{.4\%}\end{array}$

Comments:

• Profitability of Company L is measured by return on sales ratio.
• The ratio has increased from 3.3% in 2010 to 5.4% in 2011.
• This shows that the company’s profitability has increased.

2.

To determine

Calculate the current ratio for each year and comment on Company L’s liquidity.

Explanation of Solution

Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. The ideal current ratio is 2:1. The following formula is used to calculate current ratio.

$\text{Current ratio}\text{=}\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$

Compute current ratio for Company L for the year 2010.

Current assets = $794 million

Current liabilities = $440 million

$\begin{array}{c}\text{Current Ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\text{\$794 million}}{\text{\$440 million}}\\ =\text{1}\text{.8 times}\end{array}$

Compute current ratio for Company L for the year 2011.

Current assets = $1,076 million

Current liabilities = $471 million

$\begin{array}{c}\text{Current Ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\text{\$1,076 million}}{\text{\$471 million}}\\ =\text{2}\text{.3 times}\end{array}$

Comments:

• Liquidity of Company L is evaluated by current ratio.
• The ratio shows an increasing trend from 1.8 in 2010 to 2.3 in 2011.
• This shows that the capacity to pay for short-term liabilities has increased.

3.

To determine

Calculate the debt-to-total-assets ratio for each year and comment on Company L’s solvency.

Explanation of Solution

Debt to Asset Ratio: Debt to asset ratio is the ratio between total asset and total liability of the company. Debt ratio reflects the finance strategy of the company. It is used to evaluate company’s ability to pay its debts. Higher debt ratio implies the higher financial risk.

$\text{Debt-to-assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}$

Compute debt-to-total assets ratio for Company L for the year 2010.

Total assets = $1,600 million

Total liabilities = $600 million

$\begin{array}{c}\text{Debt-to-total assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{\text{\$600 million}}{\text{\$1,600 million}}\\ \text{= 0}\text{.375 or 37}\text{.5\%}\end{array}$

Compute debt-to-total assets ratio for Company L for the year 2011.

Total assets = $1,862 million

Total liabilities = $657 million

$\begin{array}{c}\text{Debt-to-total assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{\text{\$657 million}}{\text{\$1,862 million}}\\ \text{= 0}\text{.353 or 35}\text{.3\%}\end{array}$

Comments:

• Liquidity of Company L is measured by debt-to-total assets ratio.
• The ratio shows a decreasing trend from 37.5% in 2010 to 35.3% in 2011.
• This shows that the repaying capacity of the corporation has increased.

4.

To determine

Calculate the free cash flows for each year and comment on free cash flows of Company L.

Explanation of Solution

Free cash flow: Free cash flow describes the net cash provided from operating activities after making required adjustments for capital expenditures. In other words, it is the cash flow arrived after making payment for capital expenditures.

$\text{Free cash flow = Cash flows from operations – Capital expenditures}$

Particulars	2010	2011
Free cash flows:	($ in million)
Cash flow from operating activities	$365	$157
Less: Cash investment in property, plant and equipment	40	40
Free cash flow	$325	$117

Table (1)

Comments:

• The ratio shows a decreasing trend from $325 in 2010 to $117 in 2011.
• But Company L had a healthy free cash flow in the years to repay its lenders, pay dividends to stockholders.

5.

To determine

Explain the way of two different fiscal year endings that affect the comparison of Incorporation A and Company L’s financial results.

Explanation of Solution

Comparing ratios of Company L with Incorporation A’s ratios:

Ratios	Company L		Incorporation A
	2010	2011	2010	2011
Return on sales ratio	3.3%	5.4%	21.5%	23.9%
Current ratio	1.8:1	2.3:1	2.01:1	1.61:1
Debt-to-total assets ratio	37.5%	35%	36.4%	34.2%
Free cash flow	$325	$117	$16,590	$33,269

Table (2)

Note:

• Refer to the requirements 1-4 for the values and calculations of the ratios furnished above for Company L.
• Refer to the Exhibits-4.6, 4.7, 4.8, and page number 194 of the text book for the values and calculations of the ratios furnished above for Incorporation A.

The effect of financial results of Company L and Incorporation A due to different fiscal year-ends:

• As the Incorporation A’s fiscal year end is September and Company L’s fiscal year-end is March, the available financial data would be more for Incorporation A (January to September) and Company L (January to March).
• The benchmarking process would be difficult due to volume of financial data.
• As the fiscal year ends are different the sales volume also depends on the number of months in the fiscal year. Therefore, the return on sales ratio for Incorporation A is more than the L International.