Question

A firm has been experiencing low profitability in recent years. Perform an analysis of the firm's financial position using the DuPont equation. The firm has no lease payments but has a $3 million sinking fund payment on its debt. The most recent industry average ratios and the firm's financial statements are as follows:

Industry Average Ratios
Current ratio	3.21x		Fixed assets turnover	5.38x
Debt-to-capital ratio	19.99%		Total assets turnover	2.87x
Times interest earned	2.92x		Profit margin	2.07%
EBITDA coverage	4.03x		Return on total assets	6.08%
Inventory turnover	10.40x		Return on common equity	9.33%
Days sales outstandinga	31.66 days		Return on invested capital	9.09%

^aCalculation is based on a 365-day year.

Balance Sheet as of December 31, 2018 (Millions of Dollars)
Cash and equivalents	$66		Accounts payable	$31
Accounts receivables	66		Other current liabilities	23
Inventories	125		Notes payable	47
Total current assets	$257		Total current liabilities	$101
			Long-term debt	20
			Total liabilities	$121
Gross fixed assets	187		Common stock	98
Less depreciation	54		Retained earnings	171
Net fixed assets	$133		Total stockholders' equity	$269
Total assets	$390		Total liabilities and equity	$390

Income Statement for Year Ended December 31, 2018 (Millions of Dollars)
Net sales	$650.0
Cost of goods sold	539.5
Gross profit	$110.5
Selling expenses	71.5
EBITDA	$39.0
Depreciation expense	7.1
Earnings before interest and taxes (EBIT)	$31.8
Interest expense	6.0
Earnings before taxes (EBT)	$25.8
Taxes (40%)	10.3
Net income	$15.5

1. Calculate the following ratios. Do not round intermediate calculations. Round your answers to two decimal places.

   	Firm	Industry Average
   Current ratio	x	3.21x
   Debt to total capital	%	19.99%
   Times interest earned	x	2.92x
   EBITDA coverage	x	4.03x
   Inventory turnover	x	10.40x
   Days sales outstanding	days	31.66 days
   Fixed assets turnover	x	5.38x
   Total assets turnover	x	2.87x
   Profit margin	%	2.07%
   Return on total assets	%	6.08%
   Return on common equity	%	9.33%
   Return on invested capital	%	9.09%

2. Construct a DuPont equation for the firm and the industry. Do not round intermediate calculations. Round your answers to two decimal places.

   	Firm	Industry
   Profit margin	%	2.07%
   Total assets turnover	x	2.87x
   Equity multiplier	x	x

3. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?
   -Select-IIIIIIIVVItem 17
   1. Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low; however, its profit margin compares favorably with the industry average. Either sales should be lower given the present level of assets, or the firm is carrying less assets than it needs to support its sales.
   2. Analysis of the extended Du Pont equation and the set of ratios shows that most of the Asset Management ratios are below the averages. Either assets should be higher given the present level of sales, or the firm is carrying less assets than it needs to support its sales.
   3. The low ROE for the firm is due to the fact that the firm is utilizing more debt than the average firm in the industry and the low ROA is mainly a result of an excess investment in assets.
   4. The low ROE for the firm is due to the fact that the firm is utilizing less debt than the average firm in the industry and the low ROA is mainly a result of an lower than average investment in assets.
   5. Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low; however, its profit margin compares favorably with the industry average. Either sales should be higher given the present level of assets, or the firm is carrying more assets than it needs to support its sales.
      
4. Which specific accounts seem to be most out of line relative to other firms in the industry?
   -Select-IIIIIIIVVItem 18
   1. The accounts which seem to be most out of line include the following ratios: Debt to Total Capital, Inventory Turnover, Total Asset Turnover, Return on Assets, and Profit Margin.
   2. The accounts which seem to be most out of line include the following ratios: Times Interest Earned, Total Asset Turnover, Profit Margin, Return on Assets, and Return on Equity.
   3. The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Fixed Asset Turnover, Profit Margin, and Return on Equity.
   4. The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Total Asset Turnover, Return on Assets, and Return on Equity.
   5. The accounts which seem to be most out of line include the following ratios: Current, EBITDA Coverage, Inventory Turnover, Days Sales Outstanding, and Return on Equity.
      
5. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis?
   -Select-IIIIIIIVVItem 19
   1. Rapid growth would most likely affect the coverage ratios, with little effect on asset management ratios. Seasonal sales patterns would not substantially affect your analysis.
   2. Seasonal sales patterns would most likely affect the liquidity ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.
   3. If the firm had sharp seasonal sales patterns, or if it grew rapidly during the year, many ratios would most likely be distorted.
   4. It is more important to adjust the debt ratio than the inventory turnover ratio to account for any seasonal fluctuations.
   5. Seasonal sales patterns would most likely affect the profitability ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.
      
   
   How might you correct for such potential problems?
   -Select-IIIIIIIVVItem 20
   1. It is possible to correct for such problems by insuring that all firms in the same industry group are using the same accounting techniques.
   2. It is possible to correct for such problems by using average rather than end-of-period financial statement information.
   3. It is possible to correct for such problems by comparing the calculated ratios to the ratios of firms in a different line of business.
   4. It is possible to correct for such problems by comparing the calculated ratios to the ratios of firms in the same industry group over an extended period.
   5. There is no need to correct for these potential problems since you are comparing the calculated ratios to the ratios of firms in the same industry group.

Answer 1

Calculate the following ratios. Do not round intermediate steps. Round your answers to two decimal places.
	Firm		Industry Average
Current ratio = Current Assets/ Current Liabilities = $257/101	2.54	X	3.21x
Debt to total capital = Total liabilities/ Total liabilities & shareholders equity = 121/390	31.03%		19.99%
Times interest earned = EBIT/ Interest = $31.8/6	5.30	X	2.92x
EBITDA coverage = EBITDA + Lease Payments/(Interest + Lease Pay. + Principal Pay,) = $39/$6 + $1	5.57	X	4.03x
Inventory turnover = Sales/ Inventories = $650/$125	5.20	X	10.40x
Days sales outstanding = Account Receivables / (Sales /365) = 66/(650/365)	37.06	Days	31.66	days
Fixed assets turnover = Sales/Total Fixed Assets = $650/$133	4.89	X	5.38x
Total assets turnover = Sales/ Total Assets = $650/$390	1.67	X	2.87x
Profit margin = Net Profit/ Sales = $15.50/$650	2.38%		2.07%
Return on total assets = Net Profit/Total Assets = $15.50 / $390	3.97%		6.08%
Return on common equity = Net profit/ Total shareholder's equity = $15.50/269	5.76%		9.33%
Return on invested capital = EBIT x (1 – tax rate)/ Long term Debt + Total shareholder equity = ($31.8 x (1 - 40%))/($20+$269)	6.60%		9.09%
b)
Construct a DuPont equation for the firm and the industry. Do not round intermediate steps. Round your answers to two decimal places.
	Firm		Industry
Profit margin	2.38%		2.07%
Total assets turnover	1.67	X	2.87x
Equity multiplier = ROE/ROA	1.45	X	x
ROE = Profit Margin x Total Asset Turnover x Equity Multiplier	5.76%		9.09%
c)
Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?
Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be higher given the present level of assets, or the firm is carrying more assets than it needs to support its sales.
d) Which specific accounts seem to be most out of line relative to other firms in the industry?
IV The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Total Asset Turnover, Return on Assets, and Return on Equity.
e) If the firm had a pronounced seasonal sales pattern, or if it grew rapidly during the year, how might that affect the validity of your ratio analysis?
If the firm had seasonal sales patterns, or if it grew rapidly during the year, many ratios would most likely be distorted.
f)How might you correct for such potential Problems?
It is possible to correct for such Problems by using average rather than end-of-period financial statement information.