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cost of goods sold

Inventory turnover =

(4 average inventory

$1,902,500

= 29 times

For 19x2:

($50,000 + $80,000)/2

net income

Return on assets =

(4 total assets

-=

$1209000 13.6%

For 19x1:

$881,000

$151,500

-= 15.6%

For 19x2:

$970,000

Percent changes are as follows (in thousands of dollars):

(e)

Amounts

YO increase

19x2 19x1

$300.0 11.11%

-=

$2,700.0

Sales $3,000.0

$2,700.0

--

$1,720.0 - 10.61%

$182â€™5

Cost of goods sold $1,902.5 $1,720.0

$117.5

-= 11.99%

Gross margin $1,097.5 $ 980.0

$980.0

$31.5

-- - 26.25%

Net income after taxes $ 151.5 $ 120.0 $120.0

!

21

.6 Financial Ratios. Ratio analysis is employed to gain insight into the financial character of a firm.

The calculation of ratios can often lead to a better understanding of a firmâ€™s financial position

50 [CHAP. 2

FINANCIAL ANALYSIS

and performance. A specific ratio or a number of selected ratios can be calculated and used to

measure or evaluate a specific financial or operating characteristic of a firm. ( a ) Identify and

explain what financial characteristic of a firm would be measured by an analysis in which the

following four ratios were calculated: (1)current ratio; (2) acid-test ratio; (3) accounts receivable

turnover ratio; and (4) inventory turnover ratio. ( b )Do the ratios in part ( a ) provide adequate

information to measure this characteristic or are additional data needed? If so, provide two

examples of other data that would be required. ( c ) Identify and explain what specific

characteristic regarding a firmâ€™s operations would be measured by an analysis in which the

following three ratios were calculated: (1)gross profit margin; (2) operating income margin; and

(3) net income to sales (profit margin). ( d ) Do these ratios provide adequate information to

measure this characteristic or are additional data needed? If so, provide two examples of other

data that would be required.

SOLUTION

These four ratios are used to measure short-term liquidity and to evaluate the management of net

working capital of a firm, i.e., the ability to meet financial obligations in the near future.

For a thorough analysis of the firmâ€™s ability to meet its financial obligations in the near future, we would

also need to know the normal and/or industry standards for these ratios in order to have a basis of

comparison. In addition, we would need to know if any current assets are pledged or restricted for

any reason, if open lines of credit are available to the firm, the firmâ€™s credit rating, and any capital

investment plans that might require an inordinate amount of cash.

These three ratios are used to measure the profitability of a firm; respectively, each ratio relates sales

revenue with (1) the cost of goods or services sold; (2) the costs of operating the business, which would

include the cost of goods sold, the marketing expenses, the administrative expenses, and other general

operating expenses; and (3) the final net result of all the corporate financial activity for the accounting

period.

These ratios do provide an indication of the firmâ€™s profitability. However, to complete a thorough

analysis, it would be necessary to determine the return on investment, earnings per share, inventory

valuation methods, depreciation methods, and any nonrecurring items included in the statement. In

addition, data about the cost/volume/profit relationships would be useful. All this information should

be evaluated while considering industry averages, results of prior periods, and future projections.

217

.1 The Du Pont Formula and Return on Total Assets. Industry A has three companies whose income

statements and balance sheets are summarized below.

Company X Company Y Company Z

(d

$500,000 (4

Sales

$25,000

Net income $30,000 (h)

(4

$100,000

Total assets $250,000

(f)

(4 0.4

Total asset turnover

tb ) 5 yo

0.4%

Profit margin

(4 (9

Return on total assets (ROA) 2YO

First supply the missing data in the table above. Then comment on the relative performance

of each company.

SOLUTION

- $500,000

sales _--

(4 - 5 times

Total asset turnover =

average total assets $lOo,OOO

net income - $25,000

Profit margin - --=

(b) 5%

$SOO,OOO

sales

51

FINANCIAL ANALYSIS

CHAP. 21

net income

ROA =

average total assets

If we multiply both the numerator and denominator by sales, we get

net income sales

ROA = X

sales average total assets

= profit margin X total asset turnover

= 5% [from ( b ) ]x 5 [from (a)] = 25%

net income

Profit margin =

sales

Sales = net income - $309000

--=

$7,500,000

profit margin 0.004

net income

ROA =

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