RATIO ANALYSIS Data for Barry Computer Co. and its industry averages follow.
- a. Calculate the indicated ratios for Barry.
- b. Construct the DuPont equation for both Barry and the industry.
- c. Outline Barry’s strengths and weaknesses as revealed by your analysis.
- d. Suppose Barry had doubled its sales as well as its inventories, accounts receivable, and common equity during 2015. 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.)
Barry Computer Company:
Cash | $ 77,500 | Accounts payable | $129,000 |
Receivables | 336,000 | Other current liabilities | 117,000 |
Inventories | 241,500 | Notes payable to bank | 84,000 |
Total current assets $655,000 | Total current liabilities | $330,000 | |
Long-term debt | 256,500 | ||
Net fixed assets | 292,500 | Common equity | 361,000 |
Total assets | $947,500 | Total liabilities and equity | $947,500 |
Barry Computer Company: Income Statement for Year Ended December 31, 2015 (in Thousands)
Sales | $1,607,500 | |
Cost of goods sold | ||
Materials | $717,000 | |
Labor | 453,000 | |
Heat, light, and power | 68,000 | |
Indirect labor | 113,000 | |
41,500 | 1,392,500 | |
Gross profit | $215,000 | |
Selling expenses | 115,000 | |
General and administrative expenses | 30,000 | |
Earnings before interest and taxes (EBIT) | $70,000 | |
Interest expense | 24,500 | |
Earnings before taxes (EBT) | $45,500 | |
Federal and state income taxes (40%) | 18,200 | |
Net income | $27,300 |
Ratio | Barry | Industry Average |
Current | _____ | 2.0× |
Quick | _____ | 1.3× |
Days sales outstandinga | _____ | 35 days |
Inventory turnover | _____ | 6.7× |
aCalculation is based on a 365-day year | ||
Total assets turnover | _____ | 3.0× |
Profit margin | _____ | 1.20% |
_____ | 0 | |
_____ | 9.00% | |
_____ | 0 | |
TIE | _____ | 3.0× |
Debt/Total capital | _____ | 47.00% |
(a)
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 ratio examines the performance of the company and is used in comparing with other same business. It indicates relationship of two or more parts of financial statements.
Explanation of Solution
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.
Given,
Current asset is $655,000.
Current liabilities are $330,000.
The formula to calculate present current ratio is
Substitute $655,000 for current ratio and $330,000 for current liabilities.
Therefore, current ratio is 1.98 times.
Quick Ratio
It is also known as acid-test ratio which is used to determine the company’s capability to satisfy dues using only liquid assets. The less liquid assets inventory is excluded due to this it shows liquidity in better manner.
Given,
Current asset is $655,000.
Inventory is $241,500.
The formula of quick ratio is,
Substitute $655,000 for current assets, $330,000 for current liabilities and $241,500 for inventory.
Therefore, 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 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,
Substitute $336,000 for account receivables and $1,607,500 for annual sales.
Therefore, Days sales outstanding are 76.29 days.
Inventory Turnover Ratio
Inventory turnover reflects the number of times 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 is $241,500.
The formula of inventory turnover ratio is,
Substitute $1,607,500 for total sales and $241,500 for total inventory.
Therefore, inventory turnover ratio is 6.66 times.
Total Assets Turnover Ratio
It indicates how effectively the asset of 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,
Substitute $1,607,500 for total sales and $947,500 for total assets.
Therefore, 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,
Substitute $27,300 for net income and $947,500 for total value of assets.
Therefore, 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 own firm with competitors.
Given,
Net income is $27,300.
Common equity is $361,000.
The formula of return on equity is,
Substitute $27,300 for net income and $361,000 for common equity in above formula
Therefore, 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,
Substitute $70,000 for EBIT, $340,500 for debt, 40% for tax and $361,000 for equity in above formula.
Therefore, 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:
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 business keeping in view fixed interest on long-term debt.
Given,
EBIT is $70,000.
Interest expense is $24,500.
The formula to calculate times interest earned is,
Substitute $70,000 for EBIT and $24,500 for interest expense.
Therefore, 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,
Substitute $340,500 for total debt and $361,000 for equity.
Therefore, 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,
Therefore, total debt is $340,500.
(b)
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 change in ROE. The combination is known as Du Pont equation which is shown below,
Explanation of Solution
Determine the Du point relation
Company B
Given,
Net income of the company is$27,500.
Sales of the company are $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:
Substitute $27,500 for the net income, $1,607,500 for sales, and $947,000 for total assets and $361,000 for the total common equity.
Therefore, the Du Pont equation of company is
Industry
Given,
ROE of industry is 9%.
Profit margin is 1.20%.
Total assets turnover is 3.0 times.
Equity multiplier is 2.5 times (working note).
The DU Pont equation is,
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.
Therefore the Du Pont equation of Industry is
Working notes:
In case of industry, there is no equity multiplier. So, calculate equity multiplier.
Given,
Profit margin of the industry is 1.2%.
Return on equity is 9.0%.
Total assets turnover ratio is 3.0 times.
Calculation of equity multiplier,
Therefore, equity multiplier is 2.50 times.
(c)
To outline: The strength and weakness of the company revealed by the analysis.
Explanation of Solution
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)
- 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. The company weak in this respect. Total assets turnover is low. The inventory turnover of the company is half of the industry but the Days sales outstanding of the company is very high. Therefore, the company should improve 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 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.
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.
(d)
To identify: The effect in the ratio analysis of the company, supposing the company had doubled its sales as well as inventories, account receivables and common equity during 2015.
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, then the current assets will increase. But there will be no change in current liability. The current assets will be improved and it will also improve the quick ratio. Therefore, it can be said the liquidity ratio will be improved.
- Assets Management: There will be no change in days sales outstanding since both 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 increases by 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 will be an increase in sale, the profit margin of the company. Hence, the profitability will be improved.
Explanation of Solution
If the account receivables and inventory will be 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 little change in total assets ratio or can be unchanged also.
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.
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