Chapter 4
Financial Analysis—Sizing Up Firm Performance
4-1.
To create a common size income statement for Carver Enterprises, we need to express the given
dollar amounts as proportions of sales. Transforming the dollar amounts into proportions allows us
to compare Carver’s situation with other firms, even if those other firms have drastically higher or
lower sales than Carver’s.
Expressing each dollar amount as a percentage of Carver’s $30,000 in sales, we find:
Income Statement
Revenues
Cost of goods sold
Gross profit
Operating expenses
Net Operating Income
Interest expense
Earnings before taxes
Taxes
Net income
2010
$30,000
($20,000)
$10,000
($8,000)
$2,000
($900)
$1,100
($400)
$700
% of sales example calculations:
100%
-67%
= ($20,000)/$30,000
33%
-27%
7%
-3%
4%
-1%
2%
= $700/$30,000
Carver’s cost of goods sold represents 2/3 of its sales revenue, making it by far the most important
driver of Carver’s profitability. Operating expenses are still a hefty 27%, however.
To create Carver’s common size balance sheet, we will again translate the relevant dollar amounts
by expressing them as proportions of a given whole. However, while we used sales (an income
statement total) as our reference figure for the income statement, here we will use total assets (a
balance sheet total). Thus for Carver, we divide all of the given values by $33,000, which gives us
the following:
80
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Solutions to End-of-Chapter Problems—Chapter 4
Balance Sheet
Cash & Marketable Securities
Accounts Receivable
Inventories
Total Current Assets
Net Property Plant & Equipment
Total Assets
2010
$500
$6,000
$9,500
$16,000
$17,000
$33,000
% of TA
2%
18%
29%
48%
52%
100%
Accounts payable
Short-term Debt
Total current liabilities
Long-term Liabilities
Total Liabilities
Total Owner's Equity
Total Liabilities & Owner's Equity
$7,200
$6,800
$14,000
$7,000
$21,000
$12,000
$33,000
22%
21%
42%
21%
64%
36%
100%
81
example calculations:
= $9,500/$33,000
= $21,000/$33,000
We will assess these common-size statements in the next problem.
4-2.
To assess Carver’s situation, we can evaluate its relative proportions of expenses and liabilities,
using the common-size financials we created in Problem 4-1. It also may help to look at these
proportions graphically. For example, the graph below shows the relative balance sheet proportions
(% of total assets) for various asset and liability accounts:
70%
60%
50%
40%
assets
30%
debt & equity
20%
10%
0%
Cash &
Accounts Inventories
Marketable Receivable
Securities
Total
Current
Assets
Net
Accounts Short-term
Total
Long-term
Property
Payable
Debt
Current
Liabilities
Plant &
Liabilities
Equipment
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Total
Liabilities
Total
Owner's
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Solutions to End-of-Chapter Problems—Chapter 4
82
Cash represents a very small proportion of the firm’s total assets—only 2%. This could mean that
Carver has inadequate liquidity. This is especially concerning since the firm’s current liabilities
equal 42% of assets—Carver has lots of bills to pay soon, and very little cash on hand. Even if all of
its accounts receivable were to pay off immediately, it would still only have 20% of its assets in
cash—less than its accounts payable. Most (about 60%) of the firm’s current assets are tied up in
inventory.
A. Carver’s long-term debt is 21% of assets—the same as its short-term debt, and slightly less than
its accounts payable. Interest expenses are low—3% of sales. Carver uses very little long-term
debt. Carver is relying too heavily on short-term financing; this must be paid or continually
rolled over, exposing Carver to interest rate risk and liquidity risk, i.e. having to have sufficient
liquidity to constantly meet required payments.
B. Carver’s net income is 2% of sales. This is not a very high profit margin. (Of course, it may be
usual for Carver’s industry—if Carver’s in a very unattractive industry!)
C. The majority of Carver’s expenses come from COGS (67%) and operating expenses (27%).
Both items are cause for concern. Why does Carver only have a 33% gross margin? This is quite
low and makes it difficult to be profitable if the company has significant operating expenses.
Secondly, why do operating costs eat up more than a quarter of the firm’s sales?
80%
70%
60%
50%
40%
expenses
profits
30%
20%
10%
0%
Cost of goods
sold
Operating
expenses
Interest
expense
Taxes
Gross prof it
Net Operating
Income
Earnings
bef ore taxes
Net income
Based on these data, I would tell my boss:
 To consider changing the firm’s financing mix, substituting some long-term debt for its shortterm credit.
 To evaluate the firm’s inventory policies, to see if it can reduce its investment there (just in time?).
 To reevaluate its credit policies—there is too much money tied up in A/R.
 To look for efficiencies in its operating procedures; operating expenses seem very high.
 To look to reduce cost of goods sold, by finding less expensive suppliers or by driving
manufacturing efficiencies in production.
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Solutions to End-of-Chapter Problems—Chapter 4
83
 To consider increasing price—the only ways to increase gross margin are to drive down cost of
goods sold or to increase price. The firm should explore both options.
The most urgent of the firm’s issues is its liquidity position—the firm is skating dangerously close
to not being able to pay its bills (if it’s not already there).
4-3.
S&H will have net income of $780,000 next year, as found below:
Income Statement
Revenues
Cost of goods sold
Gross profit
Operating expenses
Net Operating Income
Interest expense
Earnings before taxes
Taxes (@35%)
Net income
next
year
% of sales
$15,000,000
100%
($9,000,000)
60%
$6,000,000
40%
($4,500,000)
30%
$1,500,000
10%
($300,000)
-2%
$1,200,000
8%
($420,000)
-3%
$780,000
5%
notes
$ given
% given
% given
tax rate given
We know that COGS and operating expenses total (60%  30%)  90% of revenues. The firm then
must pay interest expense of $300,000, and taxes at 35%. Thus we could also have found the NI
figure algebraically as follows:
net income  revenues  COGS  operating expenses  interest expense  taxes
 [revenues  COGS  operating expenses  interest expense]  (1  T)
 [revenues – (60%)  (revenues) – (30%)  (revenues) – $300,000]  (1  0.35)
 [(10%)  (revenues)  $300,000]  (0.65)
 [(.10)  ($15M)  $300,000]  (0.65)
 ($1.2M)  (0.65)
 $780,000.
4-4.
Airspot Motors now has a current ratio of 2.5:
 current assets   $2,145,000 
current ratio  
 
  2.5.
 current liabilities   $858,000 
If the firm wants to use short-term debt (a current liability) to increase inventory (a current asset),
its current ratio will look like this:
 $2,145,000  inventory 
current ratio  

 $858,000  new debt 
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Solutions to End-of-Chapter Problems—Chapter 4
84
(where “inventory” means the increment to inventory). Since the inventory amount and the new
short-term debt amount are the same, we can simplify this ratio:
 $2,145,000  x 
current ratio  
.
 $858,000  x 
Setting this equal to 2, then solving for x, we have:
 $2,145,000  x 
2

 $858,000  x 
2  ($858,000  x)  $2,145,000  x
$1,716,000  2  x  $2,145,000  x
x  $429,000.
Verifying, we see that:
 $2,145,000  $429,000 
current ratio  

 $858,000  $429,000 
 $2,574,000 

  2.
 $1,287,000 
4-5.
If King Carpet reduces cash to $1M, its new value of current assets will be:
new CA  old CA  change in CA
 (noncash CA  old cash) – cash spent
 ($9M  $3M)  $2M  $10M.
(This expression will calculate our new current asset value, since none of the cash that King
spent—a reduction in CA—was used to buy new current assets.)
We now need to find the current liability value after the change. $500,000 of the cash spent was on
trucks, which are a fixed asset. Only $1.5M was used to retire a short-term note—a reduction in
current liabilities. Thus, the new value is:
new CL  old CL  change in CL
 $6M  $1.5M  $4.5M.
King’s new current ratio is therefore:
 current assets 
current ratio  

 current liabilities 
 $10M 


 $4.5M 
 2.22.
The firm’s current ratio has improved. The $2M decrease in CA was only a 16.67% decrease, while
the decrease in CL was 25%. Thus, since the numerator of the ratio fell by a smaller percentage
than did the denominator, the ratio increased.
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Solutions to End-of-Chapter Problems—Chapter 4
4-6.
85
Here is Campbell Industries’ current situation:
from Balance Sheet
accounts payable
notes payable
current liabilities
long-tem debt
total liabilities
common equity
total liabilities & equity
$500,000
$250,000
$750,000
$1,200,000
$1,950,000
$5,000,000
$6,950,000
% of TA
7%
4%
11%
17%
28%
72%
100%
A. Even though we weren’t given the firm’s total asset value, we know it’s the same as its total of
liabilities and equity, $6,950,000. Dividing each of the dollar amounts by this TA figure gives
the percentages shown in the table above (see Table 4-2). Thus, we can see that Campbell
finances 28% of its assets with debt.
B. If Campbell were to purchase a new $1M warehouse (an asset) using long-term debt (a liability),
then both the numerator and the denominator of the debt ratio would rise by $1M. Here is how
this would affect the firm’s debt ratio:
 total liabilities 
debt ratio  

 total assets 
 $1.95M  $1M 


 $6.95M  $1M 
 $2.95M 


 $7.95M 
 37.1%.
The firm now has a higher debt ratio. This is because the numerator—the debt—has risen by 51%,
while the denominator—the assets—has risen by only 14%. Since the numerator rose by a larger
proportion than did the denominator, the ratio rises.
4-7.
A. Times interest earned (TIE) is the ratio of EBIT (operating income) to interest expense. Thus,
for Karson, the current TIE is (using equation 4-7):
 EBIT 
TIE  

 int 
 $500,000 


 $200,000 
 2.5.
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Solutions to End-of-Chapter Problems—Chapter 4
86
B. If Karson goes ahead with the new investment, it will increase its interest expenses by (10%) 
($1M)  $100,000 and its net operating income by $400,000. Its new situation will therefore be:
 $500,000  $400,000 
TIE  

 $200,000  $100,000 
 $900,000 


 $300,000 
 3.
This investment allows Karson to almost double its EBIT—increase it by 80%—while only
increasing its interest charges by 50%. Increasing the numerator of the times interest earned ratio by
so much more than the increase in the denominator causes the ratio to rise. After this investment,
Karson will have greater ability than before to meet its interest obligations, even after increasing
those obligations by half.
4-8.
A. To determine Allen Corporation’s net operating income (EBIT) and net income, we start with
EBIT. Since the firm’s operating profit margin is 12%, we have (using equation 4-11):
 EBIT 
operating profit margin  

 sales 
 EBIT 
0.12  

 $65M 
Rearranging, we find that EBIT  ($65M)  (12%)  $7.8M.
Now, to find net income, we must subtract interest and taxes. We are told that the firm’s interest
rate is 6%, but we’re only given total liabilities, not interest-bearing debt. Assuming that all of
the firm total liabilities bear interest (which is consistent with the explicit hint given in part b),
we find interest expense of (6%)  ($20M)  $1.2M. Subtracting this from EBIT gives us taxable
income of $6.6M; taxes on this amount at 35% total $2.31M. Thus after paying its taxes, Allen
Corporation will have net income of $4.29M, as shown below:
from Income Statement
Revenues
Net Operating Income
Interest expense
Earnings before taxes
Taxes (@35%)
Net income
$65,000,000
$7,800,000
($1,200,000)
$6,600,000
($2,310,000)
$4,290,000
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Solutions to End-of-Chapter Problems—Chapter 4
87
B. Now, we evaluate this net income. Is Allen effectively using its assets to generate profits? Using
equation 4-13, we can calculate the firm’s operating return on assets (OROA):
 EBIT 
OROA  

 TA 
 $7.8M 


 $42M 
 18.6%.
Its return on equity, given by equation 4-14, is:
 NI 
ROE  

 E 
$4.29M




 $42M  $20M 
 19.5%
(where we have found total equity as total assets less total liabilities).
While we don’t know anything about the risk of the Allen Corporation, the OROA and ROE
values suggest that the firm is using its assets effectively, generating a good return for its
shareholders.
4-9.
A. Baryla’s gross profit margin is 40%, which tells us that
 gross profit 
0.40 = 

 sales 
(using equation 4-10). Since our sales are $100M, we can now determine that gross profit is
($100M)  (0.40)  $40M, so that cost of goods sold must be ($100M  $40M)  $60M. Since
the firm wants to maintain an inventory turnover ratio of at least 6.0, we can now find the
maximum inventory level, using equation 4-5, as:
 COGS 
inventory turnover  

 inventory 
 $60M 
6

 inventory 
so that the maximum inventory is ($60M/6)  $10M. Any higher level of inventory will cause
the firm’s turnover ratio to fall below 6.0.
B. Since Baryla’s inventory includes $2M of unsalable items, the firm can have a maximum of
($10M  $2M)  $8M in salable items. Thus the inventory turnover for good inventory cannot
fall below ($60M/$8M)  7.5 if the firm wishes its overall inventory turnover to remain at least 6.0.
4-10. A. Average collection period (ACP) is calculated as:


A/R
ACP  
.
 annual credit sales/365 
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Solutions to End-of-Chapter Problems—Chapter 4
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If ALei wants its ACP to be 40 days, then we can solve for the maximum accounts receivable
(A/R) as follows:
A/R


40  
,
 $150,000,000/365 
so that the firm’s daily credit sales (the denominator of the ratio) equal $410,959. Multiplying
these daily credit sales by the average collection period, we find that ALei’s maximum accounts
receivable are ($410,959)  (40)  $16,438,356.
If the firm sells nearly $411,000 per day, and has, on average, 40 days’ worth of sales in
accounts receivable, it will have just over $16M in A/R. If the firm’s A/R is higher than this, its
average collection period (and its liquidity) will fall.
B. The firm currently has an ACP of 50 days, so it does actually have more than $16,438,356 in
A/R now: It has (50)  ($410,959)  $20,547,945. If it wants to improve its ACP to 40 days, it
must therefore reduce its A/R by ($20,547,945  $16,438,356)  $4,109,589 (or 10 days’ worth
of sales!).
4-11. A. Given P.M. Postem’s sales, cost of goods sold, operating expenses, and tax rate, we can create
its income statement as follows:
Income Statement
sales
cost of goods sold
gross profit
operating expenses
net operating income (EBIT)
interest expense
earnings before taxes (EBT)
taxes (@35%)
net income
last
year
$400,000
($112,000)
$288,000
($130,000)
$158,000
$0
$158,000
($55,300)
$102,700
notes
given
given
given
no interest-bearing debt
B. The firm therefore was able to generate $102,700 in net income last year.
The firm’s operating profit margin is found using equation 4-11:
 EBIT 
operating profit margin  

 sales 
 $158,000 
OPM  

 $400,000 
 39.5%.
Thus, COGS and operating expenses consume (100%  39.5%)  60.5% of the firm’s revenues.
Note that we were given, but did not need, Postem’s shares outstanding, increase in retained
earnings, and dividend per share.
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Solutions to End-of-Chapter Problems—Chapter 4
89
4-12. A. Given Callaway Lighting’s sales, cost of goods sold, operating expenses, and interest-bearing
debt information, we can construct its income statement as follows:
Income Statement
sales
cost of goods sold
gross profit
operating expenses
net operating income (EBIT)
interest expense
earnings before taxes (EBT)
taxes (@35%)
net income
last
year
$5,000,000
($4,500,000)
$500,000
($130,000)
$370,000
($80,000)
$290,000
($101,500)
$188,500
notes
given
given
given
$1M in interest-bearing debt, at 8%
Callaway was able to generate $188,500 in net income on sales of $5M.
B. Callaway’s operating profit margin is ( EBIT
) (from equation 4-11), so we have ($370,000/$5M) 
sales
NI
7.4%. Its net profit margin, ( sales
) , (from equation 4-12) will, as always, be lower, since this ratio
incorporates not only operating costs, but also interest and taxes. For Callaway, this is
($188,500/$5M)  3.77%.
C. To evaluate whether Callaway can comfortably meet its interest obligations, we can use
equation 4-7 to calculate the times interest earned (TIE) ratio:
 EBIT 
TIE  

 int 
 $370,000 


 $80,000 
 4.63 times,
so Callaway earns almost 5 times as much money from operations than it needs to meet its
interest payments. This is a comfortable cushion; Callaway does not appear to be using
excessive amounts of debt.
NI
), we need to find the amount of its common
D. To find Callaway’s return on equity, ( common
equity
equity. We know that the firm increased its retained earnings by $40,000 for the year; this is
consistent with their having paid aggregate dividends of ($1.485/share)  (100,000 shares) 
$148,500, given that they generated net income of $188,500.
However, we still need to know what the firm’s common equity was before it added the
$40,000; adding this initial value to the RE increment gives us this year’s common equity, the
denominator of the ROE ratio. Since we do not have this value, we cannot complete our
calculation of the ROE:


NI
ROE  

 common equity 


$188,500

.
 $40,000  last year's common.equity 
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Solutions to End-of-Chapter Problems—Chapter 4
90
4-13. As shown in equation 4-14a, a firm’s equity multiplier is found as follows:


1
equity multiplier  

 1  debt ratio 


1

.
total
liabilities
1

total
assets


1
Since Garwryk’s debt ratio was given as 80%, its equity multiplier is simply ( 10.80
), or 5.
The equity multiplier accounts for a firm’s leverage—its use of debt. For a given level of total
assets, the more debt a firm uses, the less equity it uses. As the firm substitutes debt for equity, it
trades residual claims for relatively low, fixed financing costs (interest), potentially magnifying the
returns for the (fewer) equityholders who are left. (At some point, increases in debt ratio increases
the risk of the firm’s default, i.e., bankruptcy, and interest rates increase appreciably and equity
holders drive the stock price down to reflect the increased risk, thereby negating the benefits of
increased debt.) Thus if Garwryk increased its debt ratio to 90%, its equity multiplier would rise
1
to ( 10.90
), or 10.
The chart below shows these relationships. As the debt ratio (measured on the x axis) rises, the
proportion of equity to total assets falls (of course), and the equity multiplier rises rapidly. This is
the effect of leverage—it magnifies returns to equity. (This cuts both ways! It’s great when the firm
is doing well, but it increases shareholders’ pain when the firm does poorly—since debtholders
must be repaid in any case.)
100%
25.00
90%
80%
20.00
70%
60%
15.00
50%
E/TA
40%
10.00
30%
20%
5.00
10%
0%
0.00
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
debt ratio
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100%
equity multiplier
Solutions to End-of-Chapter Problems—Chapter 4
91
4-14. We are given the following values for Triangular Chemicals:
total assets  $100M


NI
ROE  40%  

 common.equity 
 NI 
net profit margin  5%  

 sales 




1
equity multiplier  2.5  
.
 1  total.liabilities 
total.assets 

Since the net profit margin has sales as a component, we can find sales if we have net income, the
ratio’s numerator. Let’s try the following strategy:
equity multiplier & total assets
common equity & ROE
NI & net profit margin



total liabilities
NI
sales
 common equity
Step 1:
An equity multiplier of 2.5 and total assets of $100M imply total liabilities of $60M and total equity
TA
)  ( common
) .)
of $40M. (It is easy to see this if we rewrite the equity multiplier as ( TATA
TL
equity
Step 2:
ROE




(NI/common equity)  (NI/$40M)
$16M.
5%

(NI/sales)
sales


($16M/sales)
$320M.
0.40
net income
Step 3:
net profit margin 

4-15. As with Problem 4-14, we are given a series of dollar amounts and ratios for our company, now
Dearborn Supplies, and we are asked to manipulate them to determine an implied value. Thus, to
find Dearborn’s debt ratio, we will proceed as we did above:
total sales  $200M
total assets  $100M


NI
ROE  30%  

 common equity 
 NI 
net profit margin  7.5  
.
 sales 
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Solutions to End-of-Chapter Problems—Chapter 4
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Since the ROE has common equity in the denominator, and we can use total assets and total equity
to find total liabilities, let’s try the following strategy:
1. net profit margin & sales

NI
2. NI & ROE

common equity
3. common equity & total assets

total liabilities

debt ratio.
Step 1:
net profit margin 

0.075
net income
Step 2:
ROE
0.30
Step 3:
total liabilities


(NI/sales)
$15M.



common equity 
=
=

total assets – common equity
$100M  $50M 
$50M
debt ratio

TL/TA
=

(NI/$200M)
(NI/common equity)
($15M/common equity)
$50M.

50%.
4-16. We are given the following values for Bryley, Inc.:
total assets

$100M
total sales

$150M
net profit margin 
 NI 
5%  

 sales 
equity multiplier 


1
3 
.
total
liabilities
1

total
assets


To find ROE, which is (NI/common equity), we can follow this strategy:
1. net profit margin & sales

NI
2. total assets & equity multiplier

total liabilities
 common equity
3. equity & NI

ROE.
Step 1:
net profit margin 

5%
NI



(NI/sales)
(NI/$150M)
$7.5M.
ScholarStock
Solutions to End-of-Chapter Problems—Chapter 4
93
Step 2:


1
equity multiplier  3  

total
liabilities
1

total assets 



TA


common
equity


equity multiplier  3

equity



$100M


 common equity 

$33.33M.
Step 3:
ROE
 $7.5M 


 $33.33M 
 22.5%.
4-17. If Rondoelea Products has $140M in sales and a net profit margin of 10% ([NI/sales]  10%), then
it must have net income of ($140M)  (10%)  $14M. This net income, of course, if after taxes, so:
NI
=
EBT  (1  T)
$14M 
EBT  (1  0.30)

EBT  $20M.
Now, since interest expense is 10% of the debt amount of $40M, or $4M, it must be that
EBIT  ($20M  $4M)  $24M. Now we can find times interest earned:
 EBIT 
TIE  

 int 
 $24M 


 $4M 
 6 times.
from Income Statement
sales
EBIT
interest expense
earnings before taxes (EBT)
taxes (@30%)
net income
TIE =
last
year
$140,000,000
$24,000,000
($4,000,000)
$20,000,000
($6,000,000)
$14,000,000
6.00
ScholarStock
notes
given
$40M in debt @ 10%
10% net profit margin given
EBIT/int
Solutions to End-of-Chapter Problems—Chapter 4
94
4-18. A. Raconteurs, Inc.’s current ratio is (from equation 4-1):
 current assets   $110M 
current ratio  
 
  1.57.
 current liabilities   $70M 
Its acid test ratio, which subtracts inventory from the numerator, is:
 current assets-inventory 
acid test ratio  

current liabilities


 $110M  $60M 

  0.71.
$70M


This is, of course, is lower than the current ratio, since its numerator is smaller.
B. Comparing Raconteurs’ ratios for its competitors’, we see that the firm has a about the same
level of current ratio, but a lower acid test ratio. Raconteurs’ therefore has a higher investment in
inventory than does its competitors. The company is therefore less liquid than its competitors,
and it should evaluate its relatively high level of inventory.
4-19. Triangular Resources’ information is as follows:
net operating income (EBIT)  $5M
 EBIT 
operating profit margin  20%  

 sales 
 sales 
total asset turnover  1.5  
.
 TA 
We are asked to find total assets. Since TA is in the denominator of the total asset turnover (TATO),
using this ratio will be our last step. To find sales, the other input to the TATO, we can use the
operating profit margin (OPM). Thus, we can use the following strategy:
1. OPM & EBIT

sales
2. sales & TATO

TA
Step 1:
OPM
=
20%


sales

=
1.5


TA

 $5M 
 sales 


$25M.
Step 2:
TATO
 $25M 
 TA 


$16.67M.
Thus, Triangular uses $16.67M in assets to generate 1.5 times that amount in sales, $25M.
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Solutions to End-of-Chapter Problems—Chapter 4
95
4-20. To evaluate Greene’s market-to-book ratio, we first must find both its price per share (the “market”
part) and its book value (BV) per share (the “book” part). Greene’s book value for all of its equity is
given as $750,500, and we are told that there are 50,000 shares outstanding. Thus, the BV per share
is ($750,500/50,000)  $15.01. To find price per share, we can use the P/E ratio:
P
price     EPS  (12.25)  ($3)  $36.75.
E
Now, we can see that Greene’s market-to-book is ($36.75/$15.01) = 2.45. The firm’s value is
estimated by the market to be almost 2 1/2 times larger than the accumulated historical investment
in the firm’s equity.
Investors are willing to pay more for a share of the firm than is suggested by their proportional
claim on the assets shown on the balance sheet. Why? Both because historical values are poor
estimates of current values (historical costs may be objective, but they do not represent current
reality), and because investors expect Greene’s earnings to grow over time, through productive
employment of the firm’s assets.
4-21. A. As we did in Problem 4-20, we can use the P/E ratio to find price:
P
price     EPS  (20)  ($0.25)  $5.00.
E
Thus if we expect that Larry Underwood Motors would have a similar earnings multiplier (P/E
ratio) to that of comparable firms, then we would expect its price to be $5.00/share.
B. To find book value per share, we need the number of shares outstanding. Since the firm had net
NI
income of $500,000, which translated into an earnings per share (or ( # shares
) ) of $0.25, there
must be ($500,000/$0.25)  2,000,000 shares outstanding. Given the firm’s book value of equity
of $1,300,000, this implies a book value per share of ($1,300,000/2,000,000)  $0.65.
Underwood’s market/book is therefore $5.00/$0.65  7.69. The market values the firm more
highly—given its growth prospects—than would be indicated by its book value.
4-22. We are to find the market-to-book ratio for Lei Materials. Since we were given the stock price of
$50 (the “market” part), all we need to find is the firm’s book value per share.
We know that the firm’s total assets are $1B. Total liabilities are the sum of current liabilities
($100M) and long-term debt ($400M), so total liabilities equal $500M. Thus we would find the
firm’s book value of common equity as (TA  TL)  ($1B  $500M)  $500M, which,
conveniently, is exactly what we were given.
Now we can find book value per share as ($500M equity book value/50M outstanding shares)  $10.
)  ($50/$10)  5.0. The market values Lei’s
The firm’s market-to-book ratio is therefore ( price/share
BV/share
shares at 5 times their per-share book value.
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Solutions to End-of-Chapter Problems—Chapter 4
96
4-23. This problem is similar to Problem 4-4, and we will follow a similar strategy. Mitchem Marble now
has a current ratio of 2.5:
 current assets   $2,500,000 
current ratio  
 
  2.5.
 current liabilities   current liabilities 
Since we know the firm’s current assets, this ratio implies that Mitchem’s current liabilities are now
$1M.
If the firm wants to use a short-term line of credit (a current liability) to expand receivables and
inventory (current assets), its current ratio will look like this:
 $2,500,000  inventory  A/R 
current ratio  
,
 $1,000,000  new line of credit 
(where “inventory” and “A/R” mean the increments to those accounts). Since the A/R and
inventory increments equal the new short-term debt amount, we can simplify this ratio:
 $2,500,000  x 
current ratio  
.
 $1,000,000  x 
Setting this equal to 2, the firm’s minimum standard for this ratio, then solving for x, we have:
 $2,500,000  x 
2

 $1,000,000  x 
2  ($1,000,000  x )  $2,500,000  x
$2,000,000  2  x  $2,500,000  x
x  $500,000.
Verifying, we see that:
 $2,500,000  $500,000 
current ratio  

 $1,000,000  $500,000 
 3,000,000 

  2.
 $1,500,000 
4-24. A. Since Advanced Autoparts (AAP) had current assets of $1,807,626,000 and current liabilities of
$1,364,994,000, its current ratio is:
 current assets   $1,807,626,000 
current ratio  
 
  1.32.
 current liabilities   $1,364,994,000 
AAP has current assets that are only 32% larger than its current liabilities.
B. If the firm wishes to increase its inventory (a current asset), financing the expansion with
accounts payable (a current liability), the current ratio will change. To determine the inventory
expansion that would leave the ratio at 1.2, we work as follows:
 $1,807,626,000  inventory 
current ratio  

 $1,364,994,000  A/P 
(where “inventory” and “A/P” mean the increments to those accounts). Since the A/P and
inventory increments are the same, we can simplify this ratio:
ScholarStock
Solutions to End-of-Chapter Problems—Chapter 4
97
 $1,807,626,000  x 
current ratio  
.
 $1,364,994,000  x 
Setting this equal to 1.2, the firm’s minimum standard for this ratio, then solving for x, we have:
 $1,807,626,000  x 
1.2  

 $1,364,994,000  x 
1.2 * ($1,364,994,000  x )  $1,807,626,000  x
$1,637,992,800  1.2 * x  $1,807,626,000  x
x  $848,166,000.
Verifying, we see that:
 $1,807,626,000  $848,166,000 
current ratio  

 $1,364,994,000  $848,166,000 
 $2,655,792,000 


 $2,213,160,000 
 1.2.
AAP can increase short-term borrowing by $848,166,000 to finance inventory, without
decreasing its current ratio below its target of 1.2.
C. If we now want to know how AAP could improve its ratio to 1.5 by simultaneously reducing
both its current assets and current liabilities, we manipulate the ratio just slightly differently:
 $1,807,626,000  x 
1.5  

 $1,364,994,000  x 
1.5* ($1,364,994,000  x )  $1,807,626,000  x
$2,047,491,000  1.5* x  $1,807,626,000  x
x  $479,730,000.
Verifying, we see that:
 $1,807,626,000  $479,730,000 
current ratio  

 $1,364,994,000  $479,730,000 
 $1,327,896,000 


 $885,264,000 
 1.5.
AAP would have to reduce its current assets and liabilities by almost $500M in order to meet its
more stringent target for its current ratio.
ScholarStock
Solutions to End-of-Chapter Problems—Chapter 4
98
4-25. We are asked to find various ratios for the J.P. Robard Manufacturing Company. Some of these
ratios use only balance sheet data (the current ratio and the debt ratio); others use only income
statement values (times interest earned and operating profit margin); the rest use values from both
statements. Below, you will find the financial statement data and the relevant ratios.
cash
accounts receivable
inventories
Total Current Assets
net fixed assets
Total Assets
this
year
$500,000
$2,000,000
$1,000,000
$3,500,000
$4,500,000
$8,000,000
accounts payable
accrued expenses
short-term notes payable
Total Current Liabilities
long-term debt
Total Liabilities
Total Owner's Equity
Total Liabilities & Owner's Equity
$1,100,000
$600,000
$300,000
$2,000,000
$2,000,000
$4,000,000
$4,000,000
$8,000,000
Balance Sheet
BALANCE SHEET
value calculation
current ratio = 1.75 (current assets)/(current liabilities)
debt ratio =
0.5
(total debt)/(total assets)
equation
4-1
4-6
Robard has almost twice as much in current assets as in current liabilities. Its quick ratio is slightly
lower, at ($2.5M/$2M)  1.25, telling us that Robard has 25% more in current assets (excluding
inventories) than in current debt. The firm uses a 50% debt mix overall, employing equal
proportions of debt and equity to finance its assets.
Income Statement
net sales (all credit)
Cost of goods sold
Gross profit
operating expenses (incl. depreciation)
Net Operating Income (EBIT)
Interest expense
Earnings before taxes
Taxes (@40%)
Net income
this
year
$8,000,000
($3,300,000)
$4,700,000
($3,000,000)
$1,700,000
($367,000)
$1,333,000
($533,200)
$799,800
INCOME STATEMENT
value calculation
times interest earned = 4.63 (EBIT)/(interest)
operating profit margin = 0.21 (EBIT)/(sales)
equation
4-7
4-11
Looking at the firm’s income statement, we see that Robard generates 4.63 times as much EBIT as
it needs to make its interest payments. Its cost of goods sold and operating expenses represent 79%
of its sales revenue, leaving an operating profit margin of 21%.
ScholarStock
Solutions to End-of-Chapter Problems—Chapter 4
99
The ratios below employ values from both financial statements:
inventory turnover =
total asset turnover =
operating return on assets =
average collection period =
fixed asset turnover =
return on equity =
value
3.30
1.00
0.21
91.25
1.78
0.20
BOTH
calculation
(COGS)/(inventory)
(sales)/(total assets)
(EBIT)/(total assets)
(A/R)/(annual credit sales/365)
(sales)/(net plant & equipment)
(net income)/(common equity)
equation
4-5
4-8
4-13
4-3
4-9
4-13
The firm turns its inventory 3.3 times per year. In contrast, fixed asset turnover is lower, at 1.78
times, reflecting the firm’s heavier reliance on fixed versus current assets (56% and 44% of total
assets, respectively). Its total asset turnover even less efficient: It employs $8M in total assets to
generate $8M in sales.
Since its total assets and sales are the same, its operating return on assets equals its operating profit
margin, 21%. Its return on equity is comparable, at 20%.
Given that Robard makes all of its sales on credit, it might want to evaluate its average collection
period of 91.25 days—3 months. We do not know if this is an outlier for Robard’s industry; perhaps
3 months is not overly long for a manufacturer of this type. Nonetheless, it might behoove the
company to explore changes that could speed its customers’ payments.
4-26. As in Problem 4-25, we are asked to calculate various ratios for a firm; these ratios use A balance
sheet and income statement data. We are also asked to compare our firm, Carson Electronics, with
an industry leader, BGT Electronics. Using ratios will facilitate these comparisons, since ratios
allow us to express various quantities relative to other firm data, abstracting from the actual dollar
scale of the businesses.
We look first at the balance sheet ratios, the debt ratio, and the current ratio:
Balance Sheet
cash
accounts receivable
inventories
current assets
net fixed assets
Total Assets
CARSON
$2,000,000
$4,500,000
$1,500,000
$8,000,000
$16,000,000
$24,000,000
accounts payable $2,500,000
accrued expenses $1,000,000
short-term notes payable $3,500,000
Total Current Liabilities $7,000,000
long-term debt $8,000,000
Total Liabilities $15,000,000
Total Owner's Equity $9,000,000
Total Liabilities & Owner's Equity $24,000,000
ScholarStock
BGT ELECTRONICS
$1,500,000
$6,000,000
$2,500,000
$10,000,000
$25,000,000
$35,000,000
$5,000,000
$1,500,000
$1,500,000
$8,000,000
$4,000,000
$12,000,000
$23,000,000
$35,000,000
Solutions to End-of-Chapter Problems—Chapter 4
current ratio =
debt ratio =
CARSON
1.143
0.625
100
BALANCE SHEET
BGT
calculation
equation
1.25
(current assets)/(current liabilities) 4-1
0.343
(total debt)/(total assets)
4-6
For each ratio, the value that’s considered more desirable is boldfaced—here, both belong to BGT.
BGT has slightly better coverage of its short-term liabilities—having 25% more current assets than
it has current liabilities. The difference is not huge, however. The two firm’s quick ratios are almost
identical: 0.93 and 0.94, respectively (this ratio simply subtracts inventories from the numerator of
the current ratio). The firms therefore differ slightly in their investments in cash and A/R. Carson
has much more cash on hand than does BGT (8.3% of total assets, vs. 4.3% for BGT), but also has
a slightly larger investment in accounts receivable (18.75% vs. 17.14%). We will need to further
evaluate the latter number when we look at average collection period. However, given these current
asset values, we can’t say that Carson is really less liquid than BGT. Good news!
However, the news is not so good on the total debt front. Carson has a much higher debt ratio than
BGT. Carson finances 62.5% of its assets with debt, while BGT uses only 34.3% debt. (We will see
more implications of this when we consider times interest earned.) Carson’s higher leverage means
that its breakeven point is relatively higher, and that it is operating with more risk than is BGT.
There should be a magnifying effect on return on equity as a result; we’ll consider this below.
Now, let’s look at the income statement ratios:
Income Statement
net sales (all credit)
cost of goods sold
gross profit
operating expenses
Net Operating Income (EBIT)
Interest expense
Earnings before taxes
Taxes (@40%)
Net income
CARSON
$48,000,000
($36,000,000)
$12,000,000
($8,000,000)
$4,000,000
($1,150,000)
$2,850,000
($1,140,000)
$1,710,000
BGT ELECTRONICS
$70,000,000
($42,000,000)
$28,000,000
($12,000,000)
$16,000,000
($550,000)
$15,450,000
($6,180,000)
$9,270,000
INCOME STATEMENT
CARSON
BGT
calculation
times interest earned =
3.48
29.09
(EBIT)/(interest)
operating profit margin =
8.33%
22.86%
(EBIT)/(sales)
equation
4-7
4-11
As hinted at above, Carson’s times interest earned is much lower than BGT’s. Carson’s relatively
heavy use of debt means relatively high interest charges, so that the firm is able to cover those
charges fewer times with its EBIT. However, 3.48 times is not obviously a bad coverage ratio, and
perhaps BGT’s, at over 29 times, is exceptionally high. It would be interesting to look at the TIE for
a few other firms in their industry to better gauge the adequacy of Carson’s coverage.
ScholarStock
Solutions to End-of-Chapter Problems—Chapter 4
101
However, there’s no denying that BGT’s operating profit margin is vastly better than Carson’s.
Why? Looking at relative operating expenses, Carson’s are 16.67% of sales, while BGT’s are
17.14%; this, then, cannot explain BGT’s superior performance. It must be the cost of goods sold.
Indeed, Carson’s COGS represent 75% of sales, while BGT’s are only 60%. BGT’s superior gross
margin explains its superior operating profit margin.
Now, let’s look at the ratios that use data from both the balance sheet and the income
statement:
inventory turnover =
total asset turnover =
operating return on assets =
average collection period =
fixed asset turnover =
return on equity =
CARSON
24.00
2.00
16.67%
34.22
3.00
19.00%
BOTH
BGT
16.80
2.00
45.71%
31.29
2.80
40.30%
calculation
(COGS)/(inventory)
(sales)/(total assets)
(EBIT)/(total assets)
(A/R)/(annual credit sales/365)
(sales)/(net plant & equipment)
(net income)/(common equity)
equation
4-5
4-8
4-13
4-3
4-9
4-14
The most salient of these are the operating return on assets and the return on equity: BGT is vastly
better than Carson’s. Both firms have the same ratio of total assets to sales, but BGT is able to
generate 45.71% EBIT/TA, while Carson can only muster 16.67%. (We have already explained this
difference: BGT generates higher relative EBIT because its cost of goods sold is so much lower
than Carson’s.) BGT’s return on equity is higher than Carson’s, since BGT has higher EBIT and
lower interest charges; it therefore has higher relative net income (a net profit margin of 13.24%, vs.
Carson’s 3.56%). This is despite BGT’s higher proportion of equity to total assets (66% vs. 38%).
On other measures, Carson is doing better. It turns its inventory and fixed assets somewhat more
than BGT, but collects its A/R just a few days later than BGT.
Thus, we can identify Carson’s biggest problem: its cost of goods sold. BGT’s ability to keep its
COGS at 60% of sales translates into much higher profit margins than Carson can generate. I would
suggest that Carson’s management focus its attention on lowering the costs of its manufacturing
inputs or raising its prices to generate more revenue per unit.
4-27. A. The results for Carver Industries are shown below. The values boldfaced for 2010 are
improvements over 2009.
current ratio
acid-test ratio
average collection period
inventory turnover
debt ratio
times interest earned
operating profit margin
total asset turnover
fixed asset turnover
operating return on assets
return on equity
industry
average
2.00
0.80
37.00
2.50
58.00%
3.80
10.00%
1.14
1.40
11.40%
9.50%
2009
1.84
0.78
30.42
3.10
0.50
3.15
9.60%
1.33
2.42
12.80%
8.73%
2010
0.90
0.24
18.98
4.06
0.61
4.67
10.63%
2.05
3.50
21.79%
22.13%
ScholarStock
calculation
(current assets)/(current liabilities)
(current assets - inventory)/(current liabilities)
(A/R)/(annual credit sales/365)
(COGS)/(inventory)
(total debt)/(total assets)
(EBIT)/(interest)
(EBIT)/(sales)
(sales)/(total assets)
(sales)/(net plant & equipment)
(EBIT)/(total assets)
(net income)/(common equity)
equation
4-1
4-2
4-3
4-5
4-6
4-7
4-11
4-8
4-9
4-13
4-14
Solutions to End-of-Chapter Problems—Chapter 4
102
B. and D. We can evaluate Carver’s relative performance by considering both their trend (2010 vs.
2009), and their comparisons to the industry average. We will use both of these approaches for
the firm’s liquidity, capital structure, asset management efficiency, and profitability ratios.
LIQUIDITY
5
4
4
3
3
industry average
2009
2
2010
2
1
1
0
current ratio
acid-test ratio
inventory turnover
The liquidity ratios are the current ratio, acid-test ratio, average collection period, and accounts
receivable turnover.
Current ratio: Carver’s current ratio has deteriorated over the last year. While its current assets
have stayed relatively stable (45% vs. 41% of total assets for 2009 and 2010, respectively), the
current liabilities have blown up in 2010, going from 24% of total assets to 46%. The firm’s
accounts payable have more than doubled, and short-term bank notes have almost tripled. The
firm now has a current ratio that is less than half of the industry average, suggesting
compromised liquidity.
Acid-test ratio: The acid-test ratio tells a similar bleak story. While the firm’s ratio was close to
the industry average in 2009, it has fallen to about ¼ of that value in 2010. Accounts receivable
has remained relatively stable over this period; inventory, however, rose from about 26% of total
assets to 30%. However, the real story here is cash and the huge swelling in current liabilities in
2010: Cash fell from 8% of total assets to 0.3%. Carver’s cash has disappeared, and has dragged
its acid-test ratio along with it. The firm is dangerously lacking in liquidity, especially given
current liabilities, which have increased 160% year/year.
Inventory turnover: Carver’s inventory turnover is higher than the industry average, and has
increased significantly over the last year. The firm’s cost of goods sold more than doubled,
while inventory only increased by 63%. This is one bright spot for Carver.
40
35
30
25
industry average
20
2009
2010
15
10
5
0
average collection period
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Average collection period: Carver’s ACP is improving from a level that was already better than
the industry average. The firm receives cash for its sales after about 19 days, while the industry
average is 37. The firm’s A/R has only increased by a third, even though its sales more than
doubled. This is an impressive result.
Thus the ratios involving income statement values look OK for Carver, but its current asset and
current liability situations—especially its low cash—are troubling.
CAPITAL STRUCTURE
5.0
4.5
4.0
3.5
3.0
industry average
2.5
2009
2010
2.0
1.5
1.0
0.5
0.0
debt ratio
times interest earned
The firm’s relevant capital structure ratios are the debt ratio and the times interest earned ratio.
Debt ratio: The firm’s debt ratio has risen over the year, but is not much higher than the
industry average. While long-term debt has actually fallen (from 26% of total assets to 15%),
current liabilities have almost doubled. We have seen this already, in the deterioration of the
current ratio.
Times interest earned: The firm’s TIE has improved over the year, and is now higher than the
industry average. EBIT has risen as a percentage of sales, while interest charges (while rising in
absolute terms) have fallen relative to sales. Carver appears to have a comfortable ability to
generate cash to pay its interest charges.
ASSET MANAGEMENT EFFICIENCY
The relevant asset management efficiency ratios are total asset turnover and fixed asset turnover.
3.5
3.0
2.5
2.0
industry average
2009
1.5
2010
1.0
0.5
0.0
total asset turnover
fixed asset turnover
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Total asset turnover: This ratio has improved over the period; it has been above the industry
average in both years. The firm’s sales more than doubled, but its assets only increased by 39%.
Carver is demonstrating an ability to use its growing assets with increasing efficiency.
Fixed asset turnover: The story for fixed assets is similar: better than the industry norm in both
years, and improving. Carver supported its doubling in sales with only a 48% increase in fixed
assets.
PROFITABILITY
We will consider Carver’s operating profit margin, operating return on assets, and return on equity.
20%
15%
industry average
2009
10%
2010
5%
0%
operating profit margin
operating return on assets
return on equity
Operating profit margin: Carver is close to the industry average in both years, although its
trend is improving, and its 2010 results put it ahead of the industry. We’ve already seen that the
firm’s sales have more than doubled. Their operating costs have also increased, but not as much:
COGS and variable operating expenses have remained constant (at 60% and 10% of sales,
respectively); fixed cash operating expenses have decreased significantly (from 17% to13%);
depreciation expenses have almost quadrupled ($6750 to $25,000) increasing from 3.6% of sales
to 6.3% (we already saw that fixed assets 4-27, continued increased). However, the drastic
increase in sales overwhelms the relatively smaller increases in costs, allowing EBIT to rise
from 9.6% to 10.6% of sales (an increase of 136%).
Operating return on assets: For both years, Carver outperformed the industry on the measure,
and its performance was even better in 2010. We have already seen that Carver increased its
total assets by only 39%, while doubling sales. It also improved its operating margin, increasing
the relative size of EBIT. EBIT is therefore a larger proportion of a much larger sales base; its
ratio to assets, which only increased modestly, therefore increased.
Return on equity: Carver’s return on equity was slightly below the industry norm in 2009, but
was much higher in 2010. The firm increased its net income by over 170%, while increasing its
equity only 7%. (Liabilities, on the other hand, rose 70%.)
C. Finally, we consider Carver’s 2010 market-value ratios. The firm has 5000 shares of common
stock, so that its earnings per share (net income/number of shares) equals ($16,703/5,000)  $3.34.
Its price-earnings ratio, (price/EPS), equals ($15/$3.34)  4.49. The market-to-book ratio depends
on the book value per share, (common equity/number of shares), or ($75,465/5,000)  $15.09.
The market-to-book ratio is therefore ($15/$15.09)  0.99. The P/E and market-to-book ratios
are very low—the firm’s shares are only selling for full book value, perhaps due to the perceived
risk given its low cash and liquidity position.
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Given the values found above, Carver seems to be effectively managing its assets, with the
exception of its current assets. Its biggest problem here is its unsustainably low cash position.
The firm must take steps to become more liquid. It is already very effectively managing its A/R
and its inventories. It seems to have spent down its cash and increased short-term notes payable
to increase fixed assets, and used current liabilities to reduce long-term debt. While this
investment was effectively translated into sales, it has left the firm in a temporarily awkward
cash position. Its short-term liabilities have risen, but so has its times interest earned.
Nonetheless, the cash cushion is too small to protect the firm against even a minimal downturn.
Despite the poor cash position, it’s difficult to understand Carver’s low price. Its performance is
improving and is better than its industry average in many categories of evaluation. If the firm
even managed to increase its earnings multiple (P/E) ratio to a historical norm for stocks in
general, 10 times, then it should be selling for $33.41. As mentioned above, perhaps its
dangerous liquidity position explains its poor stock price performance, as equity holders are
worried about the default potential.
4-28. A. R.M. Smithers’ total asset turnover is simply:
 sales 
TATO  

 total assets 
 $10M 

  2.
 $5M 
B. If the firm wants to increase this ratio to 3.5, leaving total assets the same, then sales
must increase to (TA)  (3.5)  ($5M)  (3.5)  $17.5M. This would be an increase of
($17.5M  $10M)/($10M)  75%, a huge increase.
C. The firm’s operating return on assets is:
 EBIT 
OROA  
.
 total assets 
Since its operating profit margin, ( EBIT
) , is 10%, its EBIT must be 10% of sales, or (10%) 
sales
($10M)  $1M. Its operating return on assets is therefore ($1M/$5M), or 20%.
If, however, sales increase to $17.5M (giving the firm the total asset turnover goal of 3.5),
then its EBIT will be (10%)  ($17.5M)  $1.75M (assuming the operating profit margin
remains at 10%). Its OROA in this case would be ($1.75M/$5M)  35%.
4-29. A. Brenmar’s average collection period is found as follows (using equation 4-3):


A/R
ACP  

 annual credit sales/365 
Since Brenmar makes 75% of its sales on credit, we can find the denominator for this ratio using
($9M total sales)  (75% credit sales)  $6.75M. Now we can find the average collection period as:
$562,500


ACP  

 $6,750,000 / 365 
 $562,500 


 $18,493 
 30.4 days.
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B. In order to reduce its average collection period to 20 days, the firm will need to decrease its
level of accounts receivable. We can determine the new, lower level as:
A/R


20  

 $6,750,000/365 
A/R  20 * ($18,493)  $369,863,
a 34% decrease.
C. The company’s inventory turnover, or (COGS/inventory), is 9 times. In order to use this value to
find the firm’s inventory level, we need its cost of goods sold. Since the firm’s gross profit
margin is 30%, 70% (100%  30%) of its sales revenue must go to COGS. For a sales level of
$9M, this implies a COGS of (70%)  ($9M)  $6.3M. We can now easily find the firm’s
inventory as follows:
 COGS 
inventory turnover  

 inventory 
 $6.3M 
9

 inventory 
 inventory  $700,000.
(We should be able to justify that with the other current asset information we were given. The
firm’s current assets are given as $1.5M. It has cash and marketable securities of $100,000. If
the firm’s A/R is $562,500 and its inventory is $700,000, we have accounted for current assets
of $1,362,500. There is $137,500 of current assets unaccounted for—maybe prepaids?)
4-30. A. The results for Pamplin, Inc. Industries are shown below. The values boldfaced for 2010 are
improvements over 2009.
current ratio
acid-test ratio
average collection period
inventory turnover
debt ratio
times interest earned
operating profit margin
total asset turnover
fixed asset turnover
return on equity
industry
average
5.00
3.00
90.00
2.20
0.33
7.00
20.00%
0.75
1.00
9.00%
2009
6.00
3.25
136.88
1.27
0.33
5.00
20.83%
0.50
1.00
7.50%
2010
4.00
1.92
106.98
1.36
0.35
5.63
24.83%
0.56
1.04
10.45%
calculation
(current assets)/(current liabilities)
(current assets - inventory)/(current liabilities)
(A/R)/(annual credit sales/365)
(COGS)/(inventory)
(total debt)/(total assets)
(EBIT)/(interest)
(EBIT)/(sales)
(sales)/(total assets)
(sales)/(net plant & equipment)
(net income)/(common equity)
equation
4-1
4-2
4-3
4-5
4-6
4-7
4-11
4-8
4-9
4-14
We can evaluate Pamplin’s relative performance by considering both their trend (2010 vs. 2009),
and their comparisons to the industry average. We will use both of these approaches for the
firm’s liquidity, capital structure, asset management efficiency, and profitability ratios.
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LIQUIDITY
7
6
5
4
industry average
2009
2010
3
2
1
0
current ratio
acid-test ratio
inventory turnover
The liquidity ratios are the current ratio, acid-test ratio, average collection period, and inventory
turnover.
Current ratio: Pamplin’s current ratio has deteriorated over the last year and is now below the
industry average. As a percentage of total assets, both cash and A/R have fallen, as has A/P.
However, the big story here is the addition of the note payable. Combined with the A/P, this
note brings Pamplin’s current liabilities up to 11.5% of total assets, from 8.33% in 2009.
Combined with the slight decrease in current assets (down to 46% of total assets, from 50%),
this implies a lower current ratio for the company.
Acid-test ratio: The acid-test ratio follows the same pattern: better than industry average in
2009; worse in 2010. Given Pamplin’s decrease in cash, its A/R plus cash total has fallen from
27% of assets to 22%. Inventories, in the meantime, have grown a bit (up 1 percentage point).
Thus Pamplin is holding less cash and A/R (in relative and absolute terms), and has increased its
current liabilities, all while generating more sales. Given how much lower its liquidity looks
relative to industry norms—at least on these two measures—Pamplin may want to evaluate
whether its ability to comfortably make its current liability payments is sufficient.
(We should note that the company does have an acid-test ratio of almost 2, which it may indeed
consider sufficient.)
Inventory turnover: Pamplin’s inventory turnover is better in 2010 than it was in 2009, but is
still below the industry average. While the firm’s COGS has remained fairly constant as a
percentage of sales, and inventory has increased as a percentage of assets, the increase in sales
means that COGS grew 21% over the period, while inventory grew only 13.6%. The larger
increase in COGS relative to inventory means that Pamplin’s inventory turnover has increased.
However, at 1.36 times, it is still well below the industry average of 2.2 times. The company
may be carrying too much stock in inventory, which would contribute to its relatively poor
liquidity.
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160
140
120
100
industry average
80
2009
2010
60
40
20
0
average collection period
Average collection period: Pamplin’s ACP is better in 2010 than it was in 2009, but remains
higher than the industry average. The 2010 ratio was lower than 2009’s since A/R fell while
sales rose—two good outcomes that both worked to improve payment speeds. However, the
industry average is still more than 2 weeks faster than Pamplin’s, suggesting that there is more
work to be done here, especially given the deteriorating liquidity position.
Overall, Pamplin’s liquidity position needs improvement. It has taken on new short-term debt,
while reducing its cash cushion. It has too much money tied up in inventory and A/R. While the
situation is probably not dire, it is not ideal, either.
CAPITAL STRUCTURE
8.0
7.0
6.0
5.0
industry average
4.0
2009
2010
3.0
2.0
1.0
0.33
0.33
0.35
0.0
debt ratio
times interest earned
The firm’s relevant capital structure ratios are the debt ratio and the times interest earned ratio.
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Debt ratio: The firm’s debt ratio has risen over the year, but is about the same as the industry
average. Total liabilities are up because of the new short-term borrowing. Assets have also risen,
but not by as large a percentage. The net result is a very slight increase in Pamplin’s debt ratio,
but nothing that’s concerning (beyond the liquidity issues discussed earlier).
Times interest earned: Pamplin’s TIE has improved in 2010 over 2009, but is still below the
industry average. 2010’s EBIT grew 44% over the period, and interest grew only 28%; thus the
improvement in TIE. However, the industry’s average of 7 times is still larger than Pamplin’s.
Should the company be concerned? Pamplin is generating a higher operating margin than
average, so it’s the interest charges which seem to be causing the variation with the industry.
At 5.63 times coverage, though, Pamplin’s debt does not seem excessive.
ASSET MANAGEMENT EFFICIENCY
The relevant asset management efficiency ratios are total asset turnover and fixed asset turnover.
1.1
0.9
0.7
industry average
2009
0.5
2010
0.3
0.1
total asset turnover
fixed asset turnover
-0.1
Total asset turnover: This ratio has improved over the period, but is still below the industry
average. The firm has increased sales by almost 21%, by increasing assets by only about 8%.
However, the industry average is almost 50% higher than Pamplin’s, suggesting room for
improvement.
Fixed asset turnover: Here, Pamplin is not only improving, but is better—just barely—than
average. When increasing sales, the company increased its fixed assets by almost 17%. However,
since sales growth was even higher, the fixed asset turnover improved. The improvement leaves
the firm so close to average that Pamplin should not expect that there are no further efficiency
gains here.
PROFITABILITY
We will consider Pamplin’s operating profit margin and return on equity.
Operating profit margin: Pamplin’s ratio is improving, and has been better than the industry
average in both years. The firm’s sales increased about 21%, while EBIT increased 44%; the
(EBIT/sales) ratio therefore increased. The big story here is depreciation: The firm’s absolute
depreciation deduction actually fell, despite an increase in fixed assets. Thus the main difference
in 2010 came after gross profit—in depreciation expense.
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20%
15%
industry average
2009
10%
2010
5%
0%
operating profit margin
return on equity
Return on equity: Pamplin’s ROE has improved, and is now better than the industry average.
Net income increased by almost 50%. Thus the firm made a much higher profit relative to its
equity investment.
Given these values, Pamplin seems to be in good shape relative to its peers. Its primary area of
concern is its liquidity, but even here, the firm is not in dire straits.
4-31. A. Salco’s total asset turnover is (sales/total assets)  ($4.5M/$2M)  2.25. (Equation 4-8)
Its operating profit margin is (EBIT/sales)  ($500,000/$4.5M)  11.11%. (Equation 4-11)
Its operating return on assets is (EBIT/total assets)  ($500,000/$2M)  0.25. (Equation 4-13)
B. If the firm goes ahead with its renovation, it will add $1M to fixed assets, raising total assets
to $3M. If sales remain at $4.5M, but the operating profit margin, (EBIT/sales), rises to 13%,
then EBIT must rise to (13%)  ($4.5M)  $585,000. The new operating return on assets,
(EBIT/total assets), must therefore be ($585,000/$3M)  19.5%.
C. If the firm’s interest expense rises by $50,000, the new total interest will be $150,000. EBT now
becomes ($585,000  $150,000)  $435,000, which leaves $435,000  (1  0.35)  $282,750
after taxes:
sales $4,500,000
net operating income (EBIT) $585,000 13% of sales (given)
Interest expense ($150,000)
EBT $435,000
Taxes (@35%) ($152,250)
net income $282,750
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To determine ROE, we must compare this net income to the new common equity. Before the
renovation, Salco had $1M in equity. However, when the firm raised the new $1M for the plant,
it got half of its money from equity, or $500,000. (This is because the firm wanted to maintain
its debt ratio of 50%, so that half of its new assets were financed with debt and the other half
with equity.) The new common equity value is $1.5M, so that ROE  (NI/common equity) 
($282,750/$1.5M)  18.85%.
Before the renovation, Salco’s ROE was ($260,000/$1M) = 26%. Thus the renovation has
eroded Salco’s ROE, as equity increased by 50% but NI only increased by 8.75%. What
happened? The investment did not increase sales, so the only potential benefit came from the
increased operating profit margin. However, since the increase in EBIT—to 13% of sales from
11%—did not improve ROE, there must have been a problem after net operating income. EBIT
rose by $85,000; interest rose 50% ($50,000); taxes rose 8.75% ($12,250). Only $22,750 of the
improvement in EBIT makes it to the bottom line—not a great return on Salco’s equityholders’
new investment of $500,000.
We can think of the new ROE as a weighted average: the first $1M in equity earned 26%, but
the $500,000 increment earned only ($22,750/$500,000)  4.55%. Thus after the renovation,
ROE is a weighted average of these two returns: ($22,750/$500,000)  ($500,000/$1.5M) 
($260,000/$1M)  ($1M/$1.5M)  (4.55%)  (1/3)  (26%)  (2/3)  18.85%. The marginal
investment’s return of less than 5% is unlikely to be adequate compensation for the firm’s new
equityholders.
4-32. (Note that the correct values for cash for J.T. Jarmon Company are $15,000 and $14,000 for 2009
and 2010, respectively. The corrected balance sheets are shown below.)
Balance Sheet
cash
marketable securities
accounts receivable
inventories
prepaid rent
current assets
net plant & equipment
Total Assets
2009
$15,000
$6,000
$42,000
$51,000
$1,200
$115,200
$286,000
$401,200
2010
$14,000
$6,200
$33,000
$84,000
$1,100
$138,300
$270,000
$408,300
accounts payable
notes payable
accruals
total current liabilities
long-term debt
total liabiliities
total owners' equity
total liabilities & owner's equity
$48,000
$15,000
$6,000
$69,000
$160,000
$229,000
$172,200
$401,200
$57,000
$13,000
$5,000
$75,000
$150,000
$225,000
$183,300
$408,300
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A. Here are the relevant ratios for J.T. Jarmon Company:
current ratio
acid-test ratio
debt ratio
times interest earned
average collection period
inventory turnover
return on equity
operating return on assets
operating profit margin
total asset turnover
fixed asset turnover
industry
average
1.80
0.90
0.50
10.00
20.00
7.00
12.00%
16.80%
14.00%
1.20
1.80
2009
1.67
0.93
0.57
2010
1.84
0.72
0.55
8.00
20.08
5.48
23.4%
19.59%
13.33%
1.47
2.22
calculation
(current assets)/(current liabilities)
(current assets - inventory)/(current liabilities)
(total debt)/(total assets)
(EBIT)/(interest)
(A/R)/(annual credit sales/365)
(COGS)/(inventory)
(net income)/(common equity)
(EBIT)/(total assets)
(EBIT)/(sales)
(sales)/(total assets)
(sales)/(net plant & equipment)
equation
4-1
4-2
4-6
4-7
4-3
4-5
4-14
4-13
4-11
4-8
4-9
B. Jarmon wishes to open a line of credit for $80,000, using the credit line to finance inventory
(since the company can get good discounts for paying its suppliers quickly). A lender considering
such a credit request would want to make sure that Jarmon was sufficiently liquid to ensure
comfortable repayment of the loan obligations. He would therefore be very interested in
Jarmon’s liquidity ratios.
Jarmon’s current ratio is higher in 2010 than it was in 2009, and is slightly higher than the industry
average. However, its acid-test ratio is deteriorating, and is below average. These ratios together
imply that Jarmon has a substantial investment in inventory: In 2010, the ratio of inventory to total
assets rose to almost 21%, from about 13%. This is a large jump. Whether it’s very concerning
depends in part on how Jarmon is employing that inventory. However, the lower-than-average
inventory turnover suggests again that inventory is too high relative to sales.
Looking at the asset efficiency ratios, we see that both total asset and fixed asset turnover ratios
are significantly higher than average, with the fixed asset ratio slightly more so. The slightly
lower relative value for total assets may be another implication of Jarmon’s overinvestment in
inventory.
The firm’s accounts receivable has fallen as a percentage of total assets (from about 10.5% to 8%),
a good sign perhaps, but its average collection period is just about average. In sum, though, A/R
is probably not a concern for the lender.
A big concern, however, is the times interest earned. Jarmon is already significantly below the
industry average on this coverage ratio. Its debt ratio is about 5% higher than average (55% vs.
50%). Long-term debt is 37% of total assets, down from almost 40%; current liabilities represent
18%, up from 17%. Again we see the emphasis on current liabilities for the firm.
The firm’s average daily credit sales are over $1,600; the credit line the CFO wants therefore
represents almost 49 days’ worth of sales—almost two and a half times the average collection
period. Given the low TIE, the relatively high level of inventory, and the relatively high amount
of the credit line—enough to finance almost the entire value of inventory—I would suggest that
the lender ask Jarmon to justify more fully its loan request, and explain more carefully its
inventory level. Jarmon is probably an acceptable credit risk, but they need to provide more
information to convince me. The bank should also evaluate the amount of discounts Jarmon will
earn by using the loan to pay off accounts payable more quickly. How will these discounts
improve profitability?
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4-33. We are asked to compare Dell to Apple, using the information given below. Is Apple more
valuable, since its stock price is so much higher?
2007
net income
shares outstanding
EPS
price
P/E
BV of CE
BV/share
M/B
market cap
DELL
$3,572
2,300
$1.55
$27.76
17.91
$4,129
$1.80
15.42
$63,848
APPLE
$3,130
869.16
$3.60
$133.64
37.11
$9,984
$11.49
11.63
$116,155
We can answer the question directly by calculating the market capitalization, (price/share)  (# of
shares outstanding). As we see above, using this measure Apple is more valuable: The total of the
firm’s equity is worth $116,155M, while Dell is worth only $64,848M. This is true even though
Apple has fewer shares (that’s the effect of the much higher share price).
If we look at more standardized measures, we can abstract from size a bit and consider investment
potential. Apple’s P/E is much higher than Dell’s, and is much higher than the average 10–15 times
that we’ve observed for stocks over decades. Investors are clearly pricing in a lot of growth for
Apple. If Apple’s earnings ever disappoint and this multiple decreases, the stock will be severely
affected. Dell, on the other hand, has a P/E in the more usual range. Of Dell’s earnings $1 costs an
investor $17.91; $1 of Apple’s earnings costs $37.11.
Oddly, this relationship reversed when we consider the market-to-book ratio: Now Dell’s is higher.
Dell’s market price is over 15 times its book value per share, while Apple’s is only 11.63 times.
Using this metric, Dell looks more expensive. Apple investors have invested much more per share
that Dell investors have: $11.49 vs. $1.80, respectively. Of course, there are fewer shares; however,
the aggregate BV of equity for Apple is more than twice that of Dell. This is reflected in their
relative returns on equity: Dell’s ROE is 86.5%; Apple’s is 31.4%.
The driver for the differences between Apple’s and Dell’s P/E and M/B ratios is the large difference
in number of shares. Dell’s P/E is lower because its EPS is lower—and its EPS is lower because its
number of shares is higher, not because its earnings are lower. Thus we can’t look at Dell’s lower
P/E and pronounce it more reasonably priced—the P/E is lower because there are so many shares
outstanding. The market-to-book ratio tells the more accurate story here: Dell’s stock is being
priced more aggressively by the market. Thus perhaps this means that Dell is actually the more
“valuable” company. On the other hand, perhaps this means that Apple is actually the better
investment.
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Solutions to End-of-Chapter Problems—Chapter 4
114
4-34. We have the following data for comparing Emerson Electric and General Electric:
2009
net income
shares outstanding
EPS
price
P/E
BV of CE
BV/share
M/B
market cap
ROE
EMR
$2,170,000,000
787,658,802
$2.76
$32.18
11.68
$8,608,000,000
$10.929
2.94
$25,346,860,248
GE
$16,420,000,000
10,662,337,662
$1.54
$13.11
8.51
$101,708,000,000
$9.539
1.37
$139,783,246,749
25.21%
16.14%
Although EMR’s stock price is much higher than GE’s, we can’t use this to determine the
companies’ relative pricing. GE has many more shares outstanding, and a much higher market
capitalization. Thus, to answer the question, we must compare the P/E and M/B ratios.
Unlike in Problem 4-33, in this case we have a consistent story: EMR’s P/E and M/B are higher
than GE’s. Investors are willing to pay almost $12 for $1 of EMR’s earnings, but only about $8.50
for one of GE’s. Although EMR’s book value per share is higher than GE’s, its market-to-book is
also higher, again reflecting investors’ bullishness on EMR. EMR’s current ROE is much greater
than GE’s; investors must expect good earnings growth and continued excellent performance, and
have priced up the shares accordingly.
4-35.
revenue
gross margin
operating margin
net income
EPS
P/E
NSM
$1.64
64.41%
25.35%
$220.20M
$0.924
15.56
ADI
$2.27
58.83%
20.09%
$349.78M
$1.225
20.48
TXN
$11.32
46.80%
17.67%
$1.28B
$0.978
21.31
To determine whether Analog Devices or Texas Instruments is a better benchmark for National
Semiconductor, we need to specify what the benchmark is meant to achieve. Is it a measure of best
practices, an ideal against which we should gauge our firm’s performance? Or is it a representation
of what firms similar to ours are doing, so that we can see if we are far outside the norm?
Assuming it’s the latter, then it appears that Analog Devices is more like NSM. TXN is of a different
order of magnitude than the other two firms with regard to revenue and net income. Given the firm’s
vastly larger size, it is conceivable that TXN is involved in more types of businesses (is more
diversified) than are NSM and ADI, making TXN a poor proxy for NSM.
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Solutions to End-of-Chapter Problems—Chapter 4
115
ADI is also closer to NSM in gross margin—both are significantly higher than TXN. (This also
may suggest that TXN is operating in other, less profitable businesses, as it expanded in the past to
deploy earnings into new, lower-margin activities.) The same is true for operating margin. On both
of these measures, not only is NSM more like ADI, it is also generating higher returns than either of
its competitors.
On EPS, NSM is actually closer to TXN. On P/E, it falls far below the other two firms. It will help
us to interpret these numbers if we look at each firm’s price and shares outstanding:
price
# shares
NSM
$14.38
238,311,688
ADI
$25.09
285,534,694
TXN
$20.84
1,308,793,456
We can see that NSM’s P/E is relatively low because its price is relatively low. This is especially
noticeable since its earnings—the denominator of the ratio—are also low. Given NSM’s superior
gross and operating margins but poor relative net income, there must be something going on below
EBIT (too much interest?), and the firm is being punished for this.
Overall, it appears that ADI is the better benchmark for NSM—it’s closer in size and in current results.
4-36. (Note that there is a problem with the income statements. We have used the adjusted statements
shown below.)
revenue
cost of revenue
gross profit
operating expenses
operating income or loss
interest expense
net income
INCOME STATEMENTS
SHLD
TGT
$46,770,000
$64,948,000
($34,118,000)
($44,157,000)
$12,652,000
$20,791,000
($12,050,000)
($16,389,000)
$602,000
$4,402,000
($272,000)
($894,000)
$330,000
$3,508,000
(Note that there is also a problem with the balance sheets: The other long-term liabilities numbers
are too high and the totals do not foot. The balance sheets below have been adjusted in, making
TL&OE equal to TA, and keeping common equity totals the same.)
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Solutions to End-of-Chapter Problems—Chapter 4
2009
BALANCE SHEETS
SHLD
TGT
$864,000
$1,297,000
$9,446,000
$866,000
$6,705,000
$8,795,000
$473,000
$458,000.00
$17,488,000
$11,416,000
$163,000
$25,756,000
$8,091,000
$699,000
$5,835,000
$44,106,000
$25,342,000
cash & cash equivalents
accounts receivable
inventory
other current assets
total current assets
long-term investments
property, plant, & equipment
other assets
total assets
accounts payable
short/current long-term debt
other current liabilities
total current liabilities
long-term debt
other long-term liabilities
total liabilities
total stockholders' equity
total liabilities & stockholders' equity
$7,366,000
$1,262,000
$1,884,000
$10,512,000
$17,490,000
$2,392,000
$30,394,000
$13,712,000
$44,106,000
$3,430,000
$787,000
$4,295,000
$8,512,000
$2,132,000
$5,318,000
$15,962,000
$9,380,000
$25,342,000
(adjusted values)
We will assume that all of both firms’ sales are credit sales (not true, undoubtedly).
We have used all of the ratios used in the H.J. Boswell example from Table 4.3 of the text. The
results are shown below. Values that are in bold are the better values for a given metric.
SHLD
current ratio
acid-test ratio
average collection period
accounts receivable turnover
inventory turnover
TGT
1.66
1.03
73.72
4.95
5.09
1.34
0.31
4.87
75.00
5.02
debt ratio
times interest earned
0.69
2.21
0.63
4.92
total asset turnover
fixed asset turnover
1.06
1.82
2.56
8.03
27.05%
1.29%
0.71%
1.36%
2.41%
32.01%
6.78%
5.40%
17.37%
37.40%
gross profit margin
operating profit margin
net profit margin
operating return on assets
return on equity
116
calculation
LIQUIDITY
(current assets)/(current liabilities)
(current assets - inventory)/(current liabilities)
(A/R)/(annual credit sales/365)
(annual credit sales)/(A/R)
(COGS)/(inventory)
CAPITAL STRUCTURE
(total debt)/(total assets)
(EBIT)/(interest)
ASSET MANAGEMENT EFFICIENCY
(sales)/(total assets)
(sales)/(net plant & equipment)
PROFITABILITY
(gross profits)/(sales
(EBIT)/(sales)
(NI)/(sales)
(EBIT)/(total assets)
(net income)/(common equity)
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equation
4-1
4-2
4-3
4-4
4-5
4-6
4-7
4-8
4-9
4-10
4-11
4-12
4-13
4-14
Solutions to End-of-Chapter Problems—Chapter 4
117
TGT dominates SHLD on almost every measure. The only area in which SHLD is doing well is in
liquidity: It has a better current ratio and acid-test ratio that TGT (with the second being more
noticeable: TGT has almost 35% of its assets in inventory, while SHLD has less than half of that).
SHLD has about the same inventory turnover—although, given much lower relative investment in
inventory, one would expect much better inventory turnover metrics. The conclusion here is that
SHLD sales are too low, even for its inventory level.
TGT has better ACP and A/R turnover, but this is probably not a fair comparison; it’s probably just
an artifact of our assumption that all sales for both firms were credit sales. SHLD has a huge credit
operation relative to TGT’s, so we shouldn’t really be trying to make these comparisons without
better information about the relative credit sales for each firm.
Both firms use similar amounts of leverage. TGT, however, does a much better job covering its
interest expenses since it is more profitable ($4402 vs. $602 EBIT).
TGT has better asset turnover ratios than SHLD, with fixed asset turnover especially noticeable.
SHLD has almost twice the investment in fixed assets (relative to total assets) than TGT does
(probably because SHLD owns a lot of its stores’ real estate).
All of TGT’s profitability ratios are better than SHLD’s, especially once we get the gross profit
margin. These ratios should be of the most concern to the financial manager at Sears. Relative to
TGT, his firm’s:
 operating costs are too high.
 interest and tax costs (the wedges between EBIT and NI) are too high.
 asset base is too large relative to the net income generated.
 equity investment is too large relative to the net income generated (even though TGT’s E/A ratio
is higher than SHLD’s—meaning that NI is the problem here).
The bottom line is that SHLD is not generating sufficient sales revenue from its large asset base,
and is not able to turn its sales into net income effectively. If it wants to compete with TGT, it
needs to more effectively utilize its assets, and lower its costs almost across the board (with the
possible exception of cost of goods sold). Given the results in the statements presented, it’s
almost impossible to see how an investor could choose SHLD over TGT.
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