Chapter 4, Problem 23P

RATIO ANALYSIS Data for Barry Computer Co. and its industry averages follow.

1. a. Calculate the indicated ratios for Barry.
2. b. Construct the DuPont equation for both Barry and the industry.
3. c. Outline Barry’s strengths and weaknesses as revealed by your analysis.
4. d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and common equity during 2016. How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.)

Ratio	Barry	Industry Average
Current	-----	2.0×
Quick	-----	13×
Days sales outstandinga	-----	35 days
Inventory turnover	-----	6.7×
Total assets turnover	-----	3.0×
Profit margin	-----	1.2%
ROA	------	3.6%
ROE	-----	9.0%
ROIC	-----	73%
TIE	-----	3.0×
Debt/Total capital	-----	47.0%

^aCalculation is based on a 365-day year.

Summary Introduction

To determine: The indicated ratios.

Ratio Analysis

Ratio is used to compare two arithmetical figures. In case of the ratio analysis of the company the financial ratios are calculated. The financial ratios examine the performance of the company and is used in comparing with other same business. It indicates the relationship of two or more parts of financial statements.

Current Ratio

Current ratio is a part of liquidity ratio which reflects the capability of the company to payback its short term debts. It is calculated based on the current assets and current liabilities that a company possesses in an accounting period.

Explanation of Solution

Given,

Current asset is$655,000.

Current liabilities is $330,000.

The formula to calculate present current ratio is,

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

Substitute $655,000 for current asset and $330,000 for current liabilities.

$\begin{array}{c}\text{Current Ratio}=\frac{\$655,000}{\$330,000}\\ =1.98\text{times}\end{array}$

Thus, current ratio is 1.98 times.

Quick Ratio

It is also known as the acid-test ratio which is used to determine the company’s capability to satisfy the dues using only liquid assets. The excluding of less liquid assets inventory shows the liquidity of a company in a better manner.

Given,

Current asset is $655,000.

Inventory is $241,500.

The formula of quick ratio is,

$\text{Quick Ratio}=\frac{\text{Current Assets}-\text{Inventory}}{\text{Current Liabilities}}$

Substitute $655,000 for current assets, $330,000 for current liabilities and $241,500 for inventory.

$\begin{array}{c}\text{Quick Ratio}=\frac{\$655,000-\$241,500}{\$330,000}\\ =\frac{\$413,500}{\$330,000}\\ =1.25\text{ times}\end{array}$

Thus, quick ratio is 1.25 times.

Days sales Outstanding

Days sales outstanding is used to measure days that a business usually requires to collects its receivable in average. It indicates account receivable of the firm and the firm’s efficiency in collecting the account receivable.

Given,

Receivables are $336,000.

Annual sale is $1,607,500.

The formula to calculate Days sales outstanding is,

$\begin{array}{c}\text{Days Sales Outstanding}=\frac{\text{Account Receivable}}{\text{Annual Sales/365}}\\ =\frac{\text{Account Receivables}}{\text{Annual Sales}}\times 365\end{array}$

Substitute $336,000 for account receivables and $1,607,500 for annual sales.

$\begin{array}{c}\text{Days Sales Outstanding}=\frac{\text{Account Receivables}}{\text{Annual Sales}}\times 365\\ =\frac{\$336,000}{\$1,607,500}\times 365\\ =76.29\text{ days}\end{array}$

Thus, Days sales outstanding is 76.29 days.

Inventory Turnover Ratio

Inventory turnover reflects the number of times an average inventory is converted into sales during a period. It is used to measure the efficiency of business operations.

Given,

Total sale is $1,607,500.

Total inventory $241,500.

The formula of inventory turnover ratio is,

$\text{ Inventory Turnover Ratio}=\frac{\text{Total Sales}}{\text{Total Inventory }}$

Substitute $1,607,500 for total sales and $241,500 for total inventory.

$\begin{array}{c}\text{ Inventory Turnover Ratio}=\frac{\$1,607,500}{\$241,500}\\ =6.66\end{array}$

Thus, inventory turnover ratio is 6.66 times.

Total Assets Turnover Ratio

It indicates how effectively the asset of the company is utilized. Total asset is the sum of current assets and fixed assets.

Given,

Total sales are $1,607,500.

Total assets are $947,500.

The formula of total assets turnover is,

$\text{Total Assets Turnover}=\frac{\text{Total Sales}}{\text{Total Assets}}$

Substitute $1,607,500 for total sales and $947,500 for total assets.

$\begin{array}{c}\text{Total Assets Turnover}=\frac{\$1,607,500}{\$947,500}\\ =1.70\text{ times}\end{array}$

Thus, total assets turnover is 1.70 times.

Return on Assets

It is a profitability ratio. This ratio shows profit earning capability on per dollar of assets. It shows the percentage of net income on total assets. Higher the returns on assets better the profitability. Total assets include fixed as well as current assets.

Given,

Net income is$27,300.

Total assets are $947,500.

The formula of return on asset is,

$\text{ROA}=\frac{\text{Net Income}}{\text{Total Value of Asset}}$

Substitute $27,300 for net income and $947,500 for total value of assets.

$\begin{array}{c}\text{ROA}=\frac{\$27,300}{\$947,500}\\ =2.88\%\end{array}$

Thus, return on assets is 2.88%.

Return on Equity

Return on equity is the return from the equity. It is the ratio of net income and shareholders’ equity. This ratio measures the performance of the company and tells how well the company is performing. This ratio is used to compare a firm with their competitors.

Given,

Net income is $27,300.

Common equity is $361,000.

The formula of return on equity is,

$\text{Return on Equity}=\frac{\text{Net Income}}{\text{Common Equity}}\times 100$

Substitute $27,300 for net income and $361,000 for common equity in above formula.

$\begin{array}{c}\text{Return on Equity}=\frac{\$27,300}{\$361,000}\times 100\\ =7.56\%\end{array}$

Thus, return on equity is 7.56%.

Return on Invested Capital (ROIC)

It represent the amount of return earned by all investors and can be calculated by dividing total earnings available for investors to total invested capital.

Given,

Earnings before interest and tax (EBIT) are $70,000.

Tax rate is 40%.

Total debt is $340,500 (working note).

Total equity is $361,000.

The formula of ROIC is,

$\text{ROIC}=\frac{\text{EBIT}\left(1-\text{Tax}\right)}{\text{Debt}+\text{Equity}}$

Substitute $70,000 for EBIT, $340,500 for debt, 40% for tax and $361,000 for equity in above formula.

$\begin{array}{c}\text{ROIC}=\frac{\$70,000\left(1-40\%\right)}{340,500+\$361,000}\\ =\frac{\$42,000}{\$701,500}\\ =5.99\%\end{array}$

Thus, Return on invested capital is 5.99%.

Working note:

Compute total debt.

Long term debt is $256,500.

Notes payable to bank is $84,000.

The total debt of the company is:

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$256,500+\$84,000\\ =\$340,500\end{array}$

Times-Interest Earned Ratio

It is the type of solvency ratio which indicates the capability of business to repay interest and provide debt related services. It shows the relation between EBIT and long-term debt. It determines the debt servicing capacity of a business keeping in view of the fixed interest on long-term debt.

Given,

EBIT is $70,000.

Interest expense is $24,500.

The formula to calculate times interest earned is,

$\text{Times Interest Earned}=\frac{\text{EBIT}}{\text{Interest Expenses}}$

Substitute $70,000 for EBIT and $24,500 for interest expense.

$\begin{array}{c}\text{Times Interest Earned}=\frac{\$70,000}{\$24,500}\\ =2.86\%\end{array}$

Thus, the Times Interest Earned ratio is 2.86%.

Debt/Total Capital

It is percentage of total capital which is financed by borrowed fund. Borrowed fund includes short and long term debts. Operating debt like account payable, accrual are not considered.

Given,

Total debt is $340,500 (working note).

Equity is $361,000

The formula of Debt/Total capital is,

$\text{Debt/Total Capital}=\frac{\text{Total Debt}}{\text{Total Debt+Equity}}$

Substitute $340,500 for total debt and $361,000 for equity.

$\begin{array}{c}\text{Debt/Total Capital}=\frac{\$340,500}{\text{\$340,500+\$361,000}}\\ =\frac{\$340,500}{\$701,500}\\ =48.54\%\end{array}$

Thus, debt/total capital ratio is 48.54%.

Working notes:

Compute total debt.

Given,

Long term debt is $256,500.

Notes payable to bank is $84,000.

Calculation of total debt,

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$256,500+\$84,000\\ =\$340,500\end{array}$

Thus, total debt is $340,500.

Summary Introduction

To construct: The Du Pont equation for both Company B and Industry.

Du Pont Equation

Among all ratios, return on equity is very common. It shows the value of the firm. Improvement in the ROE is considered as valued addition to the firm. ROE can be linked with other ratios. Analysis of such ratios will indicate proper reason for a change in ROE. The combination is known as Du Pont equation which is shown below,

$\begin{array}{c}\text{ROE }=\frac{\text{Net Income}}{\text{Common Equity}}\\ =\frac{\text{Net Income}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\mathrm{Common}\text{Equity}}\\ =\frac{\text{Net Income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\text{Common Equity}}\\ =\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}\end{array}$

Explanation of Solution

Company B

Given,

Net income of the company is$27,300.

Sales of the company is $1,607,500.

Total asset is $947,500.

Total common equity is $361,000.

The Du point relation of the company’s ratios is shown below:

$\begin{array}{c}\text{ROE}=\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}\\ =\frac{\text{Net Income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\text{Total Common Equity}}\end{array}$

Substitute $27,300 for the net income, $1,607,500 for sales, and $947,000 for total assets and $361,000 for the total common equity.

$\begin{array}{c}\text{ROE}=\frac{\$27,300}{\$1,607,500}\times \frac{\$1,607,500}{\$947,500}\times \frac{\$947,500}{\$361,000}\\ =1.70\%\times 1.70\text{ times}\times \text{2}\text{.62 times}\\ =\text{7}\text{.56\%}\end{array}$

Thus, the Du Pont equation of company is $7.56\%=1.70\%\times 1.70\text{times}\times \text{2}\text{.62 times}$.

Industry

Given,

ROE of industry is 9%.

Profit margin is1.20%.

Total assets turnover is 3.0 times.

Equity multiplier is 2.5 times(working note).

The DU Pont equation is,

$\text{ROE}=\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}$

Substitute 9% for ROE, 1.20 % for the profit margin, 3.0 times for the total assets turnover and 2.5 times for the equity multiplier in above formula.

$9\%=1.20\%\times 3.0\text{times}\times 2.5\%$

Thus the Du Pont equation of Industry is $9.0\%=1.20\%\times 3.0\text{times}\times \text{2}\text{.50times}$.

Working notes:

In case of industry, there is no equity multiplier. So, calculate equity multiplier.

Given,

Profit margin of the industry is1.2%.

Return on equity is 9.0%.

Total assets turnover ratio is 3.0 times.

Calculation of equity multiplier,

$\begin{array}{c}\text{ROE}=\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}\\ \text{9}\text{.0\%}=1.2\%\times 3.0\text{ times}\times \text{Equity Multiplier}\\ \text{Equity Multiplier}=\frac{9\%}{3.60\%}\\ \text{Equity Multiplier}=\text{2}\text{.50times}\end{array}$

Thus, equity multiplier is 2.50 times.

Conclusion

Therefore, the Du Pont equation of Company B and Industry is outlined.

Summary Introduction

To outline: The strength and weakness of the company revealed by the analysis.

Answer to Problem 23P

The analysis shows the following data about the company.

Ratios	Company	Industry
(a) Liquidity Ratio:
Current	1.98x	2.0x
Quick	1.25x	1.3x
(b) Assets Management:
Days sales outstanding	76.29days	35 days
Inventory turnover	6.66x	6.7x
Total assets turnover	1.70x	3.0x
(c) Debt Management:
Total debt to capital	48.54%	47.0%
TIE	2.86%	3.0x
(d) Profitability:
Profit margin	1.70%	1.20%
ROA	2.88%	3.60%
ROE	7.56%	9.0%
ROIC	5.99%	7.50%

Table (1)

Explanation of Solution

• Liquidity ratio shows the ability to pay back short term dues. The figures of the company are almost at par with industry’s average. The liquidity seems strong.
• Assets management is the ability to utilize assets. Total assets turnover is low. The inventory turnover of the company is half of the industry but the day’s sales outstanding of the company is very high. Thus the company should improve the collection from account receivables.
• Debt management is the capability of the company to pay back its debts. Total debt/total capital of the company is higher than industry but times-interest-earned ratio (TIE) of the company is lower than industry.
• Profit margin of the company is higher as compared to industry. ROA,ROE and ROIC are below the industry’s average.

Conclusion

Therefore, based on above given points it can be said that the company liquidity is strong, assets management seems weak, the debt management is average and profitability can be considered strong.

Summary Introduction

To identify: The affect in the ratio analysis of the company supposing the company had doubled its sales as well as inventories, account receivables and common equity during 2016.

Answer to Problem 23P

If the company had doubled its sales, account receivables and inventory. The ratio analysis will be affected in the given way:

• Liquidity Ratios: When the inventory and account receivables are doubled, the current assets will increase. But there will be no change in the current liability. The current assets will be improved and it will also improve the quick ratio. Thus it can be said the liquidity ratio will be improved.
• Assets Management: There will be no change in days sales outstanding since both the numerator and denominators are doubled. Inventory ratio will remain unchanged because both the numerator and denominators are doubled. The assets turnover will be little improved as the sales will be doubled. The assets increase by a little amount.
• Total debt to capital: The equity will be doubled but debt will remain same. The proportion of debt to capital will be decreased. The solvency position of the company will be improved.
• Profitability: Company already has better profit margin than industry. If there is an increase in sales, the profit will also increase.

Explanation of Solution

If the account receivables and inventory are doubled, the total assets of the company will be increased and it will affect the asset turnover ratio slightly because the sales are also being doubled. So, it can be said there will be a little change in total assets ratio or can be unchanged also.

Conclusion

Therefore, if the sales, receivables, inventories and equities will be doubled, the liquidity, profitability and solvency will be improved but the assets utilization will remain same.