Explain why ratio analysis is usually the first step in the analysis of a companys financial

statements.
List the five groups of ratios, specify which ratios belong in each group, and explain what
information each group gives us about the firms financial position.
State what trend analysis is, and why it is important.
Describe how the Du Pont euation is used, and how it may be modified to include the
effect of financial leverage.
Explain !benchmar"ing# and its purpose.
List several limitations of ratio analysis.
$dentify some of the problems with %&E that can arise when firms use it as a sole measure
of performance.
$dentify some of the ualitative factors that must be considered when evaluating a
companys financial performance.
OVERVIEW
'inancial analysis is designed to determine the
relative strengths and wea"nesses of a
company. $nvestors need this information to
estimate both future cash flows from the firm
and the ris"iness of those cash flows.
'inancial managers need the information
provided by analysis both to evaluate the
firms past performance and to map future
plans. 'inancial analysis concentrates on
financial statement analysis, which highlights
the "ey aspects of a firms operations.
'inancial statement analysis involves a
study of the relationships between income
statement and balance sheet accounts, how
these relationships change over time (trend
analysis), and how a particular firm compares
with other firms in its industry (bench*
mar"ing). +lthough financial analysis has
limitations, when used with care and
CHAPTER 3
ANALYSIS OF FINANCIAL STATEMENTS
LEARNING OBJECTIVES
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 2
1udgment, it can provide some very useful
insights into a companys operations.
OUTLINE
Financial statements ae !se" t# $el% %e"ict t$e &im's &!t!e eanin(s an" "i)i "en"s*
F#m an in)est#'s stan"%#int+ %e"ictin( t$e &!t!e is ,$at &inancial statement anal-sis is
all a.#!t* F#m mana(ement's stan"%#int+ &inancial statement anal-sis is !se&!l .#t$ t#
$el% antici%ate &!t!e c#n"iti#ns an"+ m#e im%#tant+ as a statin( %#int &# %lannin(
acti#ns t$at ,ill in&l!ence t$e &!t!e c#!se #& e)ents*
'inancial ratios are designed to help one evaluate a firms financial statements.
/he burden of debt, and the companys ability to repay, can be best evaluated (2) by
comparing the companys debt to its assets and (3) by comparing the interest it must
pay to the income it has available for payment of interest. Such comparisons are made
by ratio analysis.
A li/!i" asset is an asset t$at can .e c#n)ete" t# cas$ /!ic0l- ,it$#!t $a)in( t# e"!ce t$e
asset's %ice )e- m!c$* Li/!i"it- ati#s ae !se" t# meas!e a &im's a.ilit- t# meet its
c!ent #.li(ati#ns as t$e- c#me "!e*
&ne of the most commonly used liuidity ratios is the current ratio.
/he current ratio measures the extent to which current liabilities are covered by
current assets.
$t is determined by dividing current assets by current liabilities.
$t is the most commonly used measure of short*term solvency.
Asset mana(ement ati#s meas!e $#, e&&ecti)el- a &im is mana(in( its assets an" ,$et$e
t$e le)el #& t$#se assets is %#%el- elate" t# t$e le)el #& #%eati#ns as meas!e" .- sales*
/he inventory turnover ratio is defined as sales divided by inventories.
$t is often necessary to use average inventories rather than year*end inventories,
especially if a firms business is highly seasonal, or if there has been a strong upward or
downward sales trend during the year.
Days sales outstanding (DSO), also called the !average collection period# (+.P), is used
to appraise accounts receivable, and it is calculated by dividing accounts receivable by
average daily sales to find the number of days sales tied up in receivables.
/he DS& represents the average length of time that the firm must wait after ma"ing a
sale before receiving cash.
/he DS& can also be evaluated by comparison with the terms on which the firm sells
its goods.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 3
$f the trend in DS& over the past few years has been rising, but the credit policy has
not been changed, this would be strong evidence that steps should be ta"en to expedite
the collection of accounts receivable.
/he fixed assets turnover ratio is the ratio of sales to net fixed assets.
$t measures how effectively the firm uses its plant and euipment.
+ potential problem can exist when interpreting the fixed assets turnover ratio of a
firm with older, lower*cost fixed assets compared to one with recently acuired,
higher*cost fixed assets. 'inancial analysts recogni4e that a problem exists and deal
with it 1udgmentally.
/he total assets turnover ratio is calculated by dividing sales by total assets.
$t measures the utili4ation, or turnover, of all the firms assets.
1e.t mana(ement ati#s meas!e t$e e2tent t# ,$ic$ a &im is !sin( "e.t &inancin(+ #
&inancial le)ea(e+ an" t$e "e(ee #& sa&et- a&&#"e" t# ce"it#s*
'inancial leverage has three important implications5 (2) 6y raising funds through debt,
stoc"holders can maintain control of a firm while limiting their investment. (3) .reditors
loo" to the euity, or owner*supplied funds, to provide a margin of safety, so if the
stoc"holders have provided only a small proportion of the total financing, the firms ris"s
are borne mainly by its creditors. (7) $f the firm earns more on investments financed with
borrowed funds than it pays in interest, the return on the owners capital is magnified, or
!leveraged.#
'irms with relatively high debt ratios have higher expected returns when the economy
is normal, but they are exposed to ris" of loss when the economy goes into a
recession.
'irms with low debt ratios are less ris"y, but also forgo the opportunity to leverage up
their return on euity.
Decisions about the use of debt reuire firms to balance higher expected returns
against increased ris".
+nalysts use two procedures to examine the firms debt5 (2) /hey chec" the balance sheet
to determine the extent to which borrowed funds have been used to finance assets, and
(3) they review the income statement to see the extent to which fixed charges are covered
by operating profits.
/he debt ratio, or ratio of total debt to total assets, measures the percentage of funds
provided by creditors. /otal debt includes both current liabilities and long*term debt.
/he lower the ratio, the greater the protection afforded creditors in the event of
liuidation.
Stoc"holders, on the other hand, may want more leverage because it magnifies
expected earnings.
+ debt ratio that exceeds the industry average raises a red flag and may ma"e it costly
for a firm to borrow additional funds without first raising more euity capital.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 4
/he times-interest-earned (TIE) ratio is determined by dividing earnings before interest
and taxes (E6$/) by the interest charges.
/he /$E measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs.
,ote that E6$/, rather than net income, is used in the numerator. 6ecause interest is
paid with pre*tax dollars, the firms ability to pay current interest is not affected by
taxes.
/his ratio has two shortcomings5 (2) $nterest is not the only fixed financial charge.
(3) E6$/ does not represent all the cash flow available to service debt, especially if a
firm has high depreciation and8or amorti4ation charges.
/o account for the deficiencies of the /$E ratio, ban"ers and others have developed the
EBITD coverage ratio. $t is calculated as E6$/D+ plus lease payments divided by the
sum of interest, principal repayments, and lease payments.
/he E6$/D+ coverage ratio is most useful for relatively short*term lenders such as
ban"s, which rarely ma"e loans (except real estate*bac"ed loans) for longer than about
five years.
&ver a relatively short period, depreciation*generated funds can be used to service
debt.
&ver a longer time, depreciation*generated funds must be reinvested to maintain
the plant and euipment or else the company cannot remain in business.
6an"s and other relatively short*term lenders focus on the ED$/D+ coverage ratio,
whereas long*term bondholders focus on the /$E ratio.
P#&ita.ilit- ati#s s$#, t$e c#m.ine" e&&ects #& li/!i"it-+ asset mana(ement+ an" "e.t #n
#%eatin( es!lts*
/he !rofit margin on sales is calculated by dividing net income by sales.
$t gives the profit per dollar of sales.
/he basic earning !o"er (BE#) ratio is calculated by dividing earnings before interest and
taxes (E6$/) by total assets.
$t shows the raw earning power of the firms assets, before the influence of taxes and
leverage.
$t is useful for comparing firms with different tax situations and different degrees of
financial leverage.
/he return on total assets ($O) is the ratio of net income to total assets.
$t measures the return on all the firms assets after interest and taxes.
/he return on common e%uity ($OE) measures the rate of return on the stoc"holders
investment.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 5
$t is eual to net income divided by common euity. Stoc"holders invest to get a return
on their money, and this ratio tells how well they are doing in an accounting sense.
Ma0et )al!e ati#s elate t$e &im's st#c0 %ice t# its eanin(s+ cas$ &l#,+ an" .##0 )al!e
%e s$ae+ an" t$!s (i)e mana(ement an in"icati#n #& ,$at in)est#s t$in0 #& t$e
c#m%an-'s %ast %e&#mance an" &!t!e %#s%ects* I& t$e li/!i"it-+ asset mana(ement+ "e.t
mana(ement+ an" %#&ita.ilit- ati#s all l##0 (##"+ t$en t$e ma0et )al!e ati#s ,ill .e
$i($+ an" t$e st#c0 %ice ,ill %#.a.l- .e as $i($ as can .e e2%ecte"*
/he !rice&earnings (#&E) ratio, or price per share divided by earnings per share, shows
how much investors are willing to pay per dollar of reported profits.
P8E ratios are higher for firms with strong growth prospects, other things held
constant, but they are lower for ris"ier firms.
/he !rice&cas' flo" ratio is the ratio of price per share divided by cash flow per share.
$t shows the dollar amount investors will pay for 92 of cash flow.
/he mar(et&boo( ()&B) ratio, defined as mar"et price per share divided by boo" value per
share, gives another indication of how investors regard the company.
:igher 086 ratios are generally associated with firms with relatively high rates of
return on common euity.
+n 086 ratio greater than 2.; means that investors are willing to pay more for stoc"s
than their accounting boo" values.
It is im%#tant t# anal-3e ten"s in ati#s as ,ell as t$ei a.s#l!te le)els* Ten" anal-sis can
%#)i"e cl!es as t# ,$et$e t$e &im's &inancial sit!ati#n is li0el- t# im%#)e # t#
"etei#ate*
T$e E2ten"e" 1! P#nt E/!ati#n s$#,s $#, et!n #n e/!it- is a&&ecte" .- assets t!n#)e+
%#&it ma(in+ an" le)ea(e* T$is meas!e ,as "e)el#%e" .- 1! P#nt mana(es &#
e)al!atin( %e&#mance an" anal-3in( ,a-s #& im%#)in( %e&#mance*
/he profit margin times the total assets turnover is called the Du #ont E%uation. /his
euation gives the rate of return on assets (%&+)5
%&+ < Profit margin = /otal assets turnover.
/he %&+ times the e%uity multi!lier (total assets divided by common euity) yields the
return on euity (%&E). /his euation is referred to as the Extended Du #ont E%uation*
%&E < Profit margin = /otal assets turnover = Euity multiplier.
$f a company is financed only with common euity, the return on assets (%&+) and the
return on euity (%&E) are the same because total assets will eual common euity. /his
euality holds only if the company uses no debt.
Rati# anal-sis in)#l)es c#m%ais#ns .eca!se a c#m%an-'s ati#s ae c#m%ae" ,it$ t$#se #&
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 6
#t$e &ims in t$e same in"!st-+ t$at is+ t# in"!st- a)ea(e &i(!es* C#m%aati)e ati#s
ae a)aila.le &#m a n!m.e #& s#!ces incl!"in( ValueLine+ 1!n 4 Ba"steet+ R#.et
M#is Ass#ciates+ an" t$e 5* S* C#mmece 1e%atment*
Benc'mar(ing is the process of comparing the ratios of a particular company with those
of a smaller group of !benchmar"# companies, rather than with the entire industry.
6enchmar"ing ma"es it easy for a firm to see exactly where the company stands relative to
its competition.
T$ee ae s#me in$eent %#.lems an" limitati#ns t# ati# anal-sis t$at necessitate cae an"
6!"(ment* Rati# anal-sis c#n"!cte" in a mec$anical+ !nt$in0in( manne is "an(e#!s+ .!t
!se" intelli(entl- an" ,it$ (##" 6!"(ment+ it can %#)i"e !se&!l insi($ts int# a &im's
#%eati#ns*
'inancial ratios are used by three main groups5
0anagers, who employ ratios to help analy4e, control, and thus improve their firms
operations.
.redit analysts, such as ban" loan officers or bond rating analysts, who analy4e ratios
to help ascertain a companys ability to pay its debts.
Stoc" analysts, who are interested in a companys efficiency, ris", and growth
prospects.
%atios are often not useful for analy4ing the operations of large firms that operate in many
different industries because comparative ratios are not meaningful.
/he use of industry averages may not provide a very challenging target for high*level
performance.
$nflation affects depreciation charges, inventory costs, and therefore, the value of both
balance sheet items and net income. 'or this reason, the analysis of a firm over time, or a
comparative analysis of firms of different ages, can be misleading.
%atios may be distorted by seasonal factors, or manipulated by management to give the
impression of a sound financial condition ("indo" dressing tec'ni%ues).
Different operating policies and accounting practices, such as the decision to lease rather
than to buy euipment, can distort comparisons.
0any ratios can be interpreted in different ways, and whether a particular ratio is good or
bad should be based upon a complete financial analysis rather than the level of a single
ratio at a single point in time.
1es%ite its ,i"es%ea" !se an" t$e &act t$at ROE an" s$ae$#l"e ,ealt$ ae #&ten $i($l-
c#elate"+ s#me %#.lems can aise ,$en &ims !se ROE as t$e s#le meas!e #&
%e&#mance*
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 7
%&E does not consider ris".
%&E does not consider the amount of invested capital.
+ pro1ects return, ris", and si4e combine to determine its impact on shareholder value.
/o the extent that %&E focuses only on rate of return and ignores ris" and si4e, increasing
%&E may in some cases be inconsistent with increasing shareholder wealth.
+lternative measures of performance have been developed, including 0ar"et >alue
+dded (0>+) and Economic >alue +dded (E>+).
W$ile it is im%#tant t# !n"estan" an" inte%et &inancial statements+ s#!n" &inancial
anal-sis in)#l)es m#e t$an 6!st calc!latin( an" inte%etin( n!m.es*
?ood analysts recogni4e that certain ualitative factors must be considered when
evaluating a company. Some of these factors are5
/he extent to which the companys revenues are tied to one "ey customer.
/he extent to which the companys revenues are tied to one "ey product.
/he extent to which the company relies on a single supplier.
/he percentage of the companys business generated overseas.
.ompetition.
'uture prospects.
Legal and regulatory environment.
1e&initi#nal
7* /he current ratio is an example of a(n) @@@@@@@@@@@ ratio. $t measures a firms ability to
meet its @@@@@@@@@ obligations.
8* /he days sales outstanding (DS&) ratio is found by dividing average sales per day into
accounts @@@@@@@@@@@@. /he DS& is the length of time that a firm must wait after
ma"ing a sale before it receives @@@@@@.
3* Debt management ratios are used to evaluate a firms use of financial @@@@@@@@@@.
9* /he debt ratio, which is the ratio of @@@@@@@ @@@@@@ to @@@@@@@ @@@@@@@@, measures the
percentage of funds supplied by creditors.
:* /he @@@@@@@*@@@@@@@@@@*@@@@@@@@ ratio is calculated by dividing earnings before
interest and taxes by the amount of interest charges.
;* /he combined effects of liuidity, asset management, and debt on operating results are
measured by @@@@@@@@@@@@@@@ ratios.
SELF<TEST =5ESTIONS
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 8
>* Dividing net income by sales gives the @@@@@@@@ @@@@@@@@ on sales.
?* /he @@@@@@@8@@@@@@@@@@ ratio measures how much investors are willing to pay for each
dollar of a firms reported profits.
@* 'irms with higher rates of return on stoc"holders euity tend to sell at relatively high
ratios of @@@@@@@@ price to @@@@@@ value.
7A* $ndividual ratios are of little value in analy4ing a companys financial condition. 0ore
important are the @@@@@@@ of a ratio over time and the comparison of the companys ratios
to @@@@@@@@@@ average ratios.
77* /he @@@@@@@@@@ @@@@ @@@@@@ @@@@@@@@@@ shows how return on euity is affected by
total assets turnover, profit margin, and leverage.
78* %eturn on assets is a function of two variables, the profit @@@@@@@@ and @@@@@@@
@@@@@@@@ turnover.
73* +naly4ing a particular ratio over time for an individual firm is "nown as @@@@@@@ analysis.
79* /he process of comparing a particular company with a smaller set of companies in the
same industry is called @@@@@@@@@@@@@@.
7:* 'inancial ratios are used by three main groups5 (2) @@@@@@@@@@, who employ ratios to
help analy4e, control, and thus improve their firms operationsA (3) @@@@@@@@
@@@@@@@@@@, who analy4e ratios to help ascertain a companys ability to pay its debtsA and
(7) @@@@@@@ @@@@@@@@@@, who are interested in a companys efficiency, ris", and growth
prospects.
7;* /he @@@@@@@ @@@@@@@@ @@@@@@@@@@ ratio measures how effectively the firm uses its plant
and euipment.
7>* /he @@@@@@@ @@@@@@@@ @@@@@@@@@@ ratio measures the utili4ation of all the firms assets.
7?* +nalysts use two procedures to examine the firms debt5 (2) /hey chec" the @@@@@@@@@
@@@@@@@ to determine the extent to which borrowed funds have been used to finance
assets, and, (3) they review the @@@@@@@@ @@@@@@@@@@@ to see the extent to which fixed
charges are covered by operating profits.
7@* /o account for the deficiencies of the /$E ratio, ban"ers have developed the @@@@@@@@
@@@@@@@@@@ ratio, which is most useful for relatively short*term lenders.
8A* /he @@@@@@@ @@@@@@@@@ @@@@@@@ ratio is useful for comparing firms with different tax
situations and different degrees of financial leverage.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 9
87* $f a company is financing only with common euity, the firms return on assets and return
on euity will be @@@@@@@.
88* /he @@@@@@@8@@@@@@ @@@@@@ ratio shows the dollar amount investors will pay for 92 of
cash flow.
C#nce%t!al
83* /he euity multiplier can be expressed as 2 B (Debt8+ssets).
a* /rue .* 'alse
89* + high current ratio is al"ays a good indication of a well*managed liuidity position.
a* /rue .* 'alse
8:* $nternational +ppliances $nc. has a current ratio of ;.C. Dhich of the following actions
would improve (increase) this ratioE
a* Fse cash to pay off current liabilities.
.* .ollect some of the current accounts receivable.
c* Fse cash to pay off some long*term debt.
"* Purchase additional inventory on credit (accounts payable).
e* Sell some of the existing inventory at cost.
8;* %efer to Self*/est Guestion 3C. +ssume that $nternational +ppliances has a current ratio
of 2.3. ,ow, which of the following actions would improve (increase) this ratioE
a* Fse cash to pay off current liabilities.
.* .ollect some of the current accounts receivable.
c* Fse cash to pay off some long*term debt.
"* Purchase additional inventory on credit (accounts payable).
e* Fse cash to pay for some fixed assets.
8>* Examining the ratios of a particular firm against the same measures for a small group of
firms from the same industry, at a point in time, is an example of
a* /rend analysis.
.* 6enchmar"ing.
c* Du Pont analysis.
"* Simple ratio analysis.
e* $ndustry analysis.
8?* Dhich of the following statements is most correctE
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 10
a* :aving a high current ratio is always a good indication that a firm is managing its
liuidity position well.
.* + decline in the inventory turnover ratio suggests that the firms liuidity position is
improving.
c* $f a firms times*interest*earned ratio is relatively high, then this is one indication that
the firm should be able to meet its debt obligations.
"* Since %&+ measures the firms effective utili4ation of assets (without considering how
these assets are financed), two firms with the same E6$/ must have the same %&+.
e* $f, through specific managerial actions, a firm has been able to increase its %&+, then,
because of the fixed mathematical relationship between %&+ and %&E, it must also
have increased its %&E.
8@* Dhich of the following statements is most correctE
a* Suppose two firms with the same amount of assets pay the same interest rate on their
debt and earn the same rate of return on their assets and that %&+ is positive.
:owever, one firm has a higher debt ratio. Fnder these conditions, the firm with the
higher debt ratio will also have a higher rate of return on common euity.
.* &ne of the problems of ratio analysis is that the relationships are sub1ect to
manipulation. 'or example, we "now that if we use some cash to pay off some of our
current liabilities, the current ratio will always increase, especially if the current ratio is
wea" initially, for example, below 2.;.
c* ?enerally, firms with high profit margins have high asset turnover ratios and firms with
low profit margins have low turnover ratiosA this result is exactly as predicted by the
extended Du Pont euation.
"* 'irms + and 6 have identical earnings and identical dividend payout ratios. $f 'irm +s
growth rate is higher than 'irm 6s, then 'irm +s P8E ratio must be greater than 'irm
6s P8E ratio.
e* Each of the above statements is false.
1. $nfo /echnics $nc. has an euity multiplier of 3.HC. /he companys assets are financed
with some combination of long*term debt and common euity. Dhat is the companys
debt ratioE
a* 3C.;;I .* 7J.7JI c* C3.KLI "* J7.JKI e* HC.;;I
8* %efer to Self*/est Problem 2. Dhat is the companys common euity ratioE
a* 3C.;;I .* 7J.7JI c* C3.KLI "* J7.JKI e* HC.;;I
3* .utler Enterprises has current assets eual to 9K.C million. /he companys current ratio is
2.3C. Dhat is the firms level of current liabilities (in millions)E
SELF<TEST PROBLEMS
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 11
a* 9;.L .* 92.L c* 93.K "* 93.M e* 97.J
9. Nericho 0otors has 9K billion in total assets. /he other side of its balance sheet consists of
9;.K billion in current liabilities, 92.3 billion in long*term debt, and 93.K billion in common
euity. /he company has C;; million shares of common stoc" outstanding, and its stoc"
price is 93C per share. Dhat is Nerichos mar"et*to*boo" ratioE
a* 3.;; .* K.3H c* C.32 "* 7.CH e* 2.K3
:* /aylor /oys $nc. has 9J billion in assets, and its tax rate is 7C percent. /he companys
basic earning power (6EP) is 2; percent, and its return on assets (%&+) is 3.C percent.
Dhat is /aylors times*interest*earned (/$E) ratioE
a* 2.J3C .* 3.;;; c* 3.K77 "* 3.HC; e* 7.;;;
(T'e follo"ing financial statements a!!ly to t'e next six Self-Test #roblems+)
R#.ets Man!&act!in( Balance S$eet
1ecem.e 37+ 8AA8
B1#llas in T$#!san"sC
.ash 9 3;; +ccounts payable 9 3;C
%eceivables 3KC ,otes payable K3C
$nventory J3C &ther current liabilities 22C
/otal current assets 92,;H; /otal current liabilities 9 HKC
,et fixed assets 2,3;; Long*term debt K3;
.ommon euity 2,2;C
/otal assets 93,3H; /otal liabilities and euity 93,3H;
R#.ets Man!&act!in( Inc#me Statement
&# Yea En"e" 1ecem.e 37+ 8AA8
B1#llas in T$#!san"sC
Sales 93,K;;
.ost of goods sold5
0aterials 92,;;;
Labor J;;
:eat, light, and power LM
$ndirect labor JC
Depreciation L; 2,L7K
?ross profit 9 CJJ
Selling expenses 2HC
?eneral and administrative expenses 32J
Earnings before interest and taxes (E6$/) 9 2HC
$nterest expense 7C
Earnings before taxes (E6/) 9 2K;
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 12
/axes (K;I) CJ
,et income (,$) 9 LK
;* .alculate the current ratio.
a* 2.3; .* 2.77 c* 2.KK "* 2.C2 e* 2.J;
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 13
>* .alculate the asset management ratios, that is, the inventory turnover ratio, fixed assets
turnover, total assets turnover, and days sales outstanding. +ssume a 7JC*day year.
a* 7.LKA 3.;;A 2.;JA 7H.3J days "* 7.LKA 3.;;A 2.3KA 7K.2; days
.* 7.LKA 3.;;A 2.;JA 7C.3C days e* 7.LKA 3.3;A 2.KLA 7K.2; days
c* 7.LKA 3.;;A 2.;JA 7K.2; days
?* .alculate the debt and times*interest*earned ratios.
a* ;.7MA 7.2J .* ;.7MA C.;; c* ;.C2A 7.2J "* ;.C2A C.;; e* ;.H7A 7.2J
@* .alculate the profitability ratios, that is, the profit margin on sales, return on total assets,
return on common euity, and basic earning power of assets.
a* 7.C;IA K.3CIA H.J;IA L.;;I "* 7.H;IA 7.C;IA L.;;IA L.;;I
.* 7.C;IA 7.H;IA H.J;IA H.H2I e* K.3CIA 7.H;IA H.J;IA L.;;I
c* 7.H;IA 7.C;IA H.J;IA H.H2I
7A* .alculate the mar"et value ratios, that is, the price8earnings ratio, the price8cash flow ratio,
and the mar"et8boo" value ratio. %oberts had an average of 2;,;;; shares outstanding
during 3;;3, and the stoc" price on December 72, 3;;3, was 9K;.;;.
a* K.32A 3.;;A ;.7J "* K.HJA 3.KKA 2.CK
.* 7.3;A 2.HCA 2.CK e* K.HJA 3.KKA ;.7J
c* 7.3;A 3.KKA ;.7J
77* Fse the Extended Du Pont Euation to determine %oberts return on euity.
a* J.M;I .* H.3KI c* H.KHI "* H.J;I e* L.K2I
78* Lewis $nc. has sales of 93 million per year, all of which are credit sales. $ts days sales
outstanding is K3 days. Dhat is its average accounts receivable balanceE +ssume a 7JC*
day year.
a* 937;,27H .* 93JJ,JJH c* 9777,777 "* 97C;,;;; e* 97JJ,HC;
73* Southeast Newelers $nc. sells only on credit. $ts days sales outstanding is H7 days, and its
average accounts receivable balance is 9C;;,;;;. Dhat are its sales for the yearE +ssume
a 7JC*day year.
a* 92,C;;,;;; .* 93,C;;,;;; c* 93,;;;,;;; "* 93,HC;,;;; e*
97,;;;,;;;
79* + firm has total interest charges of 93;,;;; per year, sales of 93 million, a tax rate of K;
percent, and a profit margin of J percent. Dhat is the firms times*interest*earned ratioE
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 14
a* 2; .* 22 c* 23 "* 27 e* 2K
7:* %efer to Self*/est Problem 2K. Dhat is the firms /$E, if its profit margin decreases to
7 percent and its interest charges double to 9K;,;;; per yearE
a* 7.; .* 3.C c* 7.C "* K.3 e* 7.H
7;* Dilson Datercrafts .ompany has 923 billion in total assets. /he companys basic earning
power (6EP) is 2C percent, and its times*interest*earned ratio is K.;. Dilsons depreciation
and amorti4ation expense totals 92.3L billion. $t has 9;.L billion in lease payments and 9;.K
billion must go towards principal payments on outstanding loans and long*term debt. Dhat
is Dilsons E6$/D+ coverage ratioE
a* 2.;; .* 2.77 c* 2.C; "* 3.2; e* 3.7C
7>* + fire has destroyed many of the financial records at +nderson +ssociates. -ou are
assigned to piece together information to prepare a financial report. -ou have found that
the firms return on euity is 23 percent and its debt ratio is ;.K;. Dhat is its return on
assetsE
a* K.M;I .* C.7CI c* J.J;I "* H.3;I e* L.K;I
7?* %efer to Self*/est Problem 2H. Dhat is the firms debt ratio if its %&E is 2C percent and
its %&+ is 2; percentE
a* JHI .* C;I c* 3CI "* 77I e* KCI
7@* %owe and .ompany has a debt ratio of ;.C;, a total assets turnover of ;.3C, and a profit
margin of 2; percent. /he president is unhappy with the current return on euity, and he
thin"s it could be doubled. /his could be accomplished (2) by increasing the profit margin
to 2K percent and (3) by increasing debt utili4ation. /otal assets turnover will not change.
Dhat new debt ratio, along with the 2K percent profit margin, is reuired to double the
return on euityE
a* ;.CC .* ;.J; c* ;.JC "* ;.H; e* ;.HC
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 15
8A* +ltman .orporation has 92,;;;,;;; of debt outstanding, and it pays an interest rate of 23
percent annually. +ltmans annual sales are 9K million, its federal*plus*state tax rate is K;
percent, and its net profit margin on sales is 2; percent. $f the company does not maintain
a /$E ratio of at least C times, its ban" will refuse to renew the loan, and ban"ruptcy will
result. Dhat is +ltmans /$E ratioE
a* M.77 .* K.KK c* 3.C; "* K.;; e* J.CJ
87* %efer to Self*/est Problem 3;. Dhat is the maximum amount +ltmans E6$/ could
decrease and its ban" still renew its loanE
a* 92LJ,JJH .* 9KC,K73 c* 9JJ,HJH "* 9KH,LML e* 92K7,M3C
88* Pin"erton Pac"agings %&E last year was 3.C percent, but its management has developed a
new operating plan designed to improve things. /he new plan calls for a total debt ratio of
C; percent, which will result in interest charges of 93K; per year. 0anagement pro1ects an
E6$/ of 9L;; on sales of 9L,;;;, and it expects to have a total assets turnover ratio of
2.J. Fnder these conditions, the federal*plus*state tax rate will be K; percent. $f the
changes are made, what return on euity will Pin"erton earnE
a* 3.C;I .* 27.KKI c* 27.;;I "* 2K.;3I e* 2K.CHI
(T'e follo"ing financial statement a!!lies to t'e next t'ree Self-Test #roblems+)
Ba0e C#%#ati#n Balance S$eet
1ecem.e 37+ 8AA8
.ash and mar"etable securities 9 C; +ccounts payable 9 3C;
+ccounts receivable 3;; +ccrued liabilities 3C;
$nventory 3C; ,otes payable C;;
/otal current assets 9 C;; /otal current liabilities 92,;;;
,et fixed assets 2,C;; Long*term debt 3C;
.ommon stoc" K;;
%etained earnings 7C;
/otal assets 93,;;; /otal liabilities and euity 93,;;;
83* Dhat is 6a"er .orporations current ratio as of December 72, 3;;3E
a* ;.7C .* ;.JC c* ;.C; "* ;.3C e* ;.HC
89* $f 6a"er uses 9C; of cash to pay off 9C; of its accounts payable, what is its new current
ratio after this actionE
a* ;.KH .* ;.KK c* ;.CK "* ;.77 e* ;.J3
8:* $f 6a"er uses its 9C; cash balance to pay off 9C; of its long*term debt, what will be its
new current ratioE
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 16
a* ;.7C .* ;.C; c* ;.CC "* ;.J; e* ;.KC
(T'e follo"ing financial statements a!!ly to t'e next Self-Test #roblem+)
W$itne- Inc* Balance S$eet
1ecem.e 37+ 8AA8
/otal current liabilities 92;;
Long*term debt 3C;
.ommon stoc"holders euity K;;
/otal assets 9HC; /otal liabilities and euity 9HC;
W$itne- Inc* Inc#me Statement
&# Yea En"e" 1ecem.e 37+ 8AA8
Sales 92,;;;
.ost of goods sold (excluding depreciation) 9CC;
&ther operating expenses 2;;
Depreciation C;
/otal operating costs H;;
Earnings before interest and taxes (E6$/) 9 7;;
$nterest expense 3C
Earnings before taxes (E6/) 9 3HC
/axes (K;I) 22;
,et income 9 2JC
8;* Dhat are Dhitney $nc.s basic earning power and %&+ ratiosE
a* 7;IA 33I .* K;IA 7;I c* C;IA 33I "* K;IA 33I e* K;IA K;I
(/he following financial statements apply to the next Self*/est Problem.)
C#tne Ente%ises Balance S$eet
1ecem.e 37+ 8AA8
/otal current liabilities 9 7;;
Long*term debt C;;
.ommon stoc"holders euity KC;
/otal assets 92,3C; /otal liabilities and euity 92,3C;
C#tne Ente%ises Inc#me Statement
&# Yea En"e" 1ecem.e 37+ 8AA8
Sales 92,H;;
.ost of goods sold (excluding depreciation) 92,2M;
&ther operating expenses 27C
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 17
Depreciation HC
/otal operating costs 2,K;;
Earnings before interest and taxes (E6$/) 9 7;;
$nterest expense CK
Earnings before taxes (E6/) 9 3KJ
/axes (7CI) LJ
,et income 9 2J;
8>* Dhat are .otner Enterprises basic earning power and %&+ ratiosE
a* 3;IA 23.LI "* 2H.CIA 23.LI
.* 3KIA 23.LI e* 3KIA 2;.CI
c* 3KIA 2C.LI
8?* Dauten Enterprises is 1ust being formed. $t will need 93 million of assets, and it expects to
have an E6$/ of 9K;;,;;;. Dauten will own no securities, so all of its income will be
operating income. $f it chooses to, Dauten can finance up to C; percent of its assets with
debt that will have a M percent interest rate. Dauten has no other liabilities. +ssuming a
K; percent federal*plus*state tax rate on all taxable income, what is the difference between
the expected %&E if Dauten finances with C; percent debt versus the expected %&E if it
finances entirely with common stoc"E
a* H.3I .* J.JI c* J.;I "* C.LI e* M.;I
8@* :elens 'ashion Designs recently reported net income of 97,C;;,;;;. /he company has
H;;,;;; shares of common stoc", and it currently trades at 93C a share. /he company
continues to expand and anticipates that one year from now its net income will be
9K,C;;,;;;. &ver the next year the company also anticipates issuing an additional
2;;,;;; shares of stoc", so that one year from now the company will have L;;,;;; shares
of common stoc". +ssuming the companys price8earnings ratio remains at its current
level, what will be the companys stoc" price one year from nowE
a* 93C.3C .* 93H.C; c* 93L.23C "* 972.;; e* 977.;;
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 18
3A* :enderson .hemical .ompany has 9C million in sales. $ts %&E is 2; percent and its total
assets turnover is 3.C. /he company is J; percent euity financed. Dhat is the
companys net incomeE
a* 9MC,HC; .* 92;C,7;; c* 922;,3C; "* 923;,;;; e* 92KC,;;;
37* 6radberry 6olts $nc. recently reported the following information5
,et income 9HC;,;;;
%&+ JI
$nterest expense 932;,;;;
/he companys tax rate is 7C percent. Dhat is the companys basic earning power (6EP)E
a* H.3CI .* L.77I c* M.KCI "* 2;.;;I e* 2;.M2I
ANSWERS TO SELF-TEST QUESTIONS
7* liuidityA current
8* receivableA cash
3* leverage
9* total debtA total assets
:* times*interest*earned
;* profitability
>* profit margin
?* price8earnings
@* mar"etA boo"
7A* trendA industry
77. Extended Du Pont Euation
78* marginA total assets
73* trend
79* benchmar"ing
7:* managersA credit analystsA stoc"
analysts
7;* fixed assets turnover
7>* total assets turnover
7?* balance sheetA income statement
7@* E6$/D+ coverage
8A* basic earning power
87. eual
88* price8cash flow
83* b. 2 B (Debt8+ssets) < Euity8+ssets. /he euity multiplier is eual to +ssets8Euity.
89* b. Excess cash resulting from poor management could produce a high current ratio.
Similarly, if accounts receivable are not collected promptly, this could also lead to a
high current ratio. $n addition, excess inventory which might include obsolete
inventory could also lead to a high current ratio.
8:* d. /his uestion is best analy4ed using numbers. 'or example, assume current assets
eual 9C; and current liabilities eual 92;;A thus, the current ratio euals ;.C. 'or
answer a, assume 9C in cash is used to pay off 9C in current liabilities. /he new
current ratio would be 9KC89MC < ;.KH. 'or answer d, assume a 92; purchase of
inventory is made on credit (accounts payable). /he new current ratio would be
9J;8922; < ;.CC, which is an increase over the old current ratio of ;.C
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 19
8;* a. +gain, this uestion is best analy4ed using numbers. 'or example, assume current
assets eual 923; and current liabilities eual 92;;A thus, the current ratio euals 2.3.
'or answer a, assume 9C in cash is used to pay off 9C in current liabilities. /he new
current ratio would be 922C89MC < 2.32, which is an increase over the old current ratio
of 2.3. 'or answer d, assume a 92; purchase of inventory is made on credit (accounts
payable). /he new current ratio would be 927;8922; < 2.2L, which is a decrease over
the old current ratio of 2.3.
8>* b. /he correct answer is benchmar"ing. + trend analysis compares the firms ratios over
time, while a Du Pont analysis shows how return on euity is affected by assets
turnover, profit margin, and leverage.
8?* c. Excess cash resulting from poor management could produce a high current ratioA thus
statement a is false. + decline in the inventory turnover ratio suggests that either sales
have decreased or inventory has increased, which suggests that the firms liuidity
position is not improvingA thus statement b is false. %&+ < ,et income8/otal assets, and
E6$/ does not eual net income. /wo firms with the same E6$/ could have different
financing and different tax rates resulting in different net incomes. +lso, two firms with
the same E6$/ do not necessarily have the same total assetsA thus, statement d is false.
%&E < %&+ = +ssets8Euity. $f %&+ increases because total assets decrease, then the
euity multiplier decreases, and depending on which effect is greater, %&E may or may
not increaseA thus, statement e is false. Statement c is correctA the /$E ratio is used to
measure whether the firm can meet its debt obligation, and a high /$E ratio would
indicate this is so.
8@* a. %atio analysis is sub1ect to manipulationA however, if the current ratio is less than 2.; and
we use cash to pay off some current liabilities, the current ratio will decrease, not
increaseA thus statement b is false. Statement c is 1ust the reverse of what actually
occurs. 'irms with high profit margins have low turnover ratios and vice versa.
Statement d is falseA it does not necessarily follow that if a firms growth rate is higher
that its stoc" price will be higher. Statement a is correct. 'rom the information given in
statement a, one can determine that the two firms net incomes are eualA thus, the firm
with the higher debt ratio (lower euity ratio) will indeed have a higher %&E.
SOL5TIONS TO SELF<TEST PROBLEMS
7* d. 3.HC < +8E
E8+ < 283.HC
E8+ < 7J.7JI.
D8+ < 2 B E8+
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 20
< 2 B 7J.7JI
< J7.JKI.
8* b. 'rom Self*/est Problem O2 above, E8+ < 7J.7JI.
3* e. .+ < 9K.C millionA .+8.L < 2.3C.
9K.C8.L < 2.3C
2.3C(.L) < 9K.C
.L < 97.J million.
9* c. /+ < 9K,;;;,;;;,;;;A .L < 9K;;,;;;,;;;A L/ debt < 92,3;;,;;;,;;;A .E <
93,K;;,;;;,;;;A Shares outstanding < C;;,;;;,;;;A P; < 93CA 086 < E
6oo" value <
;;; , ;;; , C;;
;;; , ;;; , K;; , 3 9
< 9K.L;.
086 <
L; . K 9
;; . 3C 9
< C.3;L7 C.32.
:* a. /+ < 9J,;;;,;;;,;;;A / < 7CIA E6$/8/+ < 2;IA %&+ < 3.CIA /$E < E
;;; , ;;; , ;;; , J 9
E6$/
< ;.2;
E6$/ < 9J;;,;;;,;;;.
;;; , ;;; , ;;; , J 9
,$
< ;.;3C
,$ < 92C;,;;;,;;;.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 21
,ow use the income statement format to determine interest so you can calculate the
firms /$E ratio.
E6$/ 9J;;,;;;,;;; See above.
$,/ 7JM,37;,HJM
E6/ 937;,HJM,372 E6/ < 92C;,;;;,;;;8;.JC
/axes (7CI) L;,HJM,372
,$ 92C;,;;;,;;; See above.
/$E < E6$/8$,/
< 9J;;,;;;,;;;897JM,37;,HJM
< 2.J3C.
;* c.
. 2.KK <
9HKC
92,;H;
<
s liabilitie .urrent
assets .urrent
< ratio .urrent
>* a.
. 7.LK <
9J3C
93,K;;
<
$nventory
Sales
< turnover $nventory
. 3.;; <
92,3;;
93,K;;
<
assets fixed ,et
Sales
< turnover assets 'ixed
. 2.;J <
93,3H;
93,K;;
<
assets /otal
Sales
< turnover assets /otal
. days 3J . H 7 <
C 7J 8 93,K;;
93KC
<
C 7J Sales8
receivable +ccounts
< DS&
?* d. Debt ratio < /otal debt8/otal assets < 92,2JC893,3H; < ;.C2 < C2I.
/$E ratio < E6$/8$nterest < 92HC897C < C.;;.
@* b. Profit margin <
,et income
Sales
<
9LK
93,K;;
< ;.;7C; < 7.C;I.
%&+ <
,et income
/otal assets
<
9LK
93,3H;
< ;.;7H; < 7.H;I.
I. J; . H ;HJ; . ;
2;C , 2 9
LK 9
euity .ommon
income ,et
%&E = = = =
I. H2 . H ;HH2 . ;
3H; , 3 9
2HC 9
assets /otal
E6$/
6EP = = = =
$,/ < E6$/ B E6/
< 9J;;,;;;,;;; B 937;,HJM,372
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 22
7A* e.
EPS <
,et income
,umber of shares outstanding
<
9LK,;;;
2;,;;;
< 9L.K;.
P8E ratio <
EPS
ice Pr
<
K; . L 9
;; . K; 9
< K.HJ.
.ash flow8share <
g outstandin shares of ,umber
on Depreciati income ,et +
<
;;; , 2;
;;; , L; 9 ;;; , LK 9 +
< 92J.K;.
Price8cash flow <
K; . 2J 9
;; . K; 9
< 3.KK.
. ;.7J <
92,2;C,;;;
) 9K;(2;,;;;
<
6oo" value
price 0ar"et
< value 6oo" 0ar"et8
77* d. %&E < Profit margin = /otal assets turnover = Euity multiplier
<

9LK
93,K;;

93,K;;
93,3H;

93,3H;
92,2;C
< ;.;7C 2.;CH 3.;CK
< ;.;HJ; < H.J;I.
78* a. DS& <
C 7J Sales8
receivable +ccounts

K3 days <
C 7J 8 93,;;;,;;;
+%
+% < 937;,27H.
73* b. DS& < +ccounts receivable8(Sales87JC)
H7 days < 9C;;,;;;8(Sales87JC)
H7(Sales87JC) < 9C;;,;;;
Sales < 93,C;;,;;;.
79* b. ,et income < 93,;;;,;;;(;.;J) < 923;,;;;.
Earnings before taxes < 923;,;;;8(2 B ;.K) < 93;;,;;;.
E6$/ < 93;;,;;; P 93;,;;; < 933;,;;;.
/$E < E6$/8$nterest < 933;,;;;893;,;;; < 22.
7:* c. ,et income < 93,;;;,;;;(;.;7) < 9J;,;;;.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 23
Earnings before taxes < 9J;,;;;8(2 B ;.K) < 92;;,;;;.
E6$/ < 92;;,;;; P 9K;,;;; < 92K;,;;;.
/$E < E6$/8$nterest < 92K;,;;;89K;,;;; < 7.C.
7;* e. /+ < 923,;;;,;;;,;;;A E6$/8/+ < 2CIA /$E < KA D+ < 92,3L;,;;;,;;;A Lease
payments < 9L;;,;;;,;;;A Principal payments < 9K;;,;;;,;;;A E6$/D+ coverage < E
E6$/8923,;;;,;;;,;;;< ;.2C
E6$/ < 92,L;;,;;;,;;;.
K < E6$/8$,/
K < 92,L;;,;;;,;;;8$,/
$,/ < 9KC;,;;;,;;;.
E6$/D+ < E6$/ P D+
< 92,L;;,;;;,;;; P 92,3L;,;;;,;;;
< 97,;L;,;;;,;;;.
E6$/D+ coverage ratio <
pmts Lease pmts Princ. $,/
payments Lease E6$/D+
+ +
+
<
;;; , ;;; , L;; 9 ;;; , ;;; , K;; 9 ;;; , ;;; , KC; 9
;;; , ;;; , L;; 9 ;;; , ;;; , ;L; , 7 9
+ +
+
<
;;; , ;;; , JC; , 2 9
;;; , ;;; , LL; , 7 9
< 3.7C2C 3.7C.
7>* d. $f /otal debt8/otal assets < ;.K;, then /otal euity8/otal assets < ;.J;, and the euity
multiplier (+ssets8Euity) < 28;.J; < 2.JJH.

E
,$
<
+
,$

E
+
%&E < %&+ = E0
23I < %&+ = 2.JJH
%&+ < H.3;I.
7?* d. %&E < %&+ = Euity multiplier
2CI < 2;I = /+8Euity
2.C < /+8Euity.
Euity8/+ < 282.C < ;.JH.
Debt8/+ < 2 B Euity8/+ < 2 B ;.JH < ;.77 < 77I.
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 24
7@* c. $f /otal debt8/otal assets < ;.C;, then /otal euity8/otal assets < ;.C; and the euity
multiplier (+ssets8Euity) < 28;.C; < 3.;.
%&E < P0 = /otal assets turnover = E0.
6efore5 %&E < 2;I = ;.3C = 3.;; < C.;;I.
+fter5 2;.;;I < 2KI = ;.3C = E0A thus E0 < 3.LCH2.
Euity multiplier <
+ssets
Euity
3.LCH2 <
+ssets Euity8
2
;.7C < Euity8+ssets.
Debt8/+ < 2 B Euity8/+ < 2;;I B 7CI < JCI.
8A* e. /$E < E6$/8$nterest, so find E6$/ and $nterest.
$nterest < 92,;;;,;;;(;.23) < 923;,;;;.
,et income < 9K,;;;,;;;(;.2;) < 9K;;,;;;.
Pre*tax income < 9K;;,;;;8(2 B /) < 9K;;,;;;8;.J < 9JJJ,JJH.
E6$/ < 9JJJ,JJH P 923;,;;; < 9HLJ,JJH.
/$E < 9HLJ,JJH8923;,;;; < J.CJ=.
87* a. /$E < E6$/8$,/
C < E6$/8923;,;;;
E6$/ < 9J;;,;;;.
'rom Self*/est Problem O3;, E6$/ < 9HLJ,JJH, so E6$/ could decrease by 9HLJ,JJH
B 9J;;,;;; < 92LJ,JJH.
88* b. %&E < Profit margin = /otal assets turnover = Euity multiplier
< ,$8Sales = Sales8/+ = /+8Euity.
,ow we need to determine the inputs for the euation from the data that were given.
&n the left we set up an income statement, and we put numbers in it on the right5
Sales (given) 9L,;;;
.ost ,+
E6$/ (given) 9 L;;
$nterest (given) 3K;
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 25
E6/ 9 CJ;
/axes (K;I) 33K
,et income 9 77J
,ow we can use some ratios to get some more data5
/otal assets turnover < S8/+ < 2.J (given).
D8+ < C;I, so E8+ < C;I, and therefore /+8E < 28(E8+) < 28;.C < 3.;;.
,ow we can complete the Extended Du Pont Euation to determine %&E5
%&E < 977J89L,;;; 2.J 3.; < 27.KKI.
83* c. 6a"er .orporations current ratio euals .urrent assets8.urrent liabilities <
9C;;892,;;; < ;.C;.
89* a. 6a"er .orporations new current ratio euals (9C;; B 9C;)8(92,;;; B 9C;) <
9KC;89MC; < ;.KH.
8:* e. &nly the current assets balance is affected by this action. 6a"ers new current ratio <
(9C;; B 9C;)892,;;; < 9KC;892,;;; < ;.KC.
8;* d. Dhitneys 6EP ratio euals E6$/8/otal assets < 97;;89HC; < K;I.
Dhitneys %&+ euals ,et income8/otal assets < 92JC89HC; < 33I.
8>* b. .otners 6EP ratio euals E6$/8/otal assets < 97;;892,3C; < 3KI.
.otners %&+ euals ,et income8/otal assets < 92J;892,3C; < 23.LI.
8?* b. Qnown data5 /otal assets < 93,;;;,;;;A E6$/ < 9K;;,;;;A "d < MI, / < K;I.
D8+ < ;.C < C;I, so Euity < ;.C(93,;;;,;;;) < 92,;;;,;;;.
D8+ < ;I D8+ < C;I
E6$/ 9K;;,;;; 9K;;,;;;
$nterest ; M;,;;;R
/axable income 9K;;,;;; 972;,;;;
/axes (K;I) 2J;,;;; 23K,;;;
,et income (,$) 93K;,;;; 92LJ,;;;
+,+L-S$S &' '$,+,.$+L S/+/E0E,/S
3 - 26
R$f D8+ < C;I, then half of assets are financed by debt, so Debt < ;.C(93,;;;,;;;) <
92,;;;,;;;. +t a M percent interest rate, $,/ < ;.;M(92,;;;,;;;) < 9M;,;;;.
'or D8+ < ;I, %&E < ,$8Euity < 93K;,;;;893,;;;,;;; < 23I. 'or D8+ < C;I,
%&E < 92LJ,;;;892,;;;,;;; < 2L.JI. Difference < 2L.JI B 23.;I < J.JI.
8@* c. /he current EPS is 97,C;;,;;;8H;;,;;; shares or 9C.;;. /he current P8E ratio is then
93C89C < C.;;. /he new number of shares outstanding will be L;;,;;;. /hus, the
new EPS < 9K,C;;,;;;8L;;,;;; < 9C.J3C. $f the shares are selling for C times EPS,
then they must be selling for 9C.J3C(C) < 93L.23C.
3A* d. Step 25 .alculate total assets from information given.
Sales < 9C million.


3.C < Sales8/+
3.C <
+ssets
;;; , ;;; , C 9
+ssets < 93,;;;,;;;.
Step 35 .alculate net income.
/here is K;I debt and J;I euity, so Euity < 93,;;;,;;; ;.J <
92,3;;,;;;.
%&E < ,$8S S8/+ /+8E
;.2; < ,$89C,;;;,;;; 3.C 93,;;;,;;;892,3;;,;;;
;.2; <
;;; , ;;; , C 9
) ,$ ( 2JJH . K
9C;;,;;; < K.2JJH(,$)
923;,;;; < ,$.
37* e. ?iven %&+ < JI and net income of 9HC;,;;;, then total assets must be 923,C;;,;;;.
%&+<
/+
,$
JI <
/+
;;; , HC; 9
/+ < 923,C;;,;;;.
/o calculate 6EP, we still need E6$/. /o calculate E6$/ construct a partial income
statement5
E6$/ 92,7J7,LKJ (932;,;;; P 92,2C7,LKJ)
$nterest 32;,;;; (?iven)
E6/ 92,2C7,LKJ 9HC;,;;;8;.JC
/axes (7CI) K;7,LKJ
,$ 9 HC;,;;;
6EP <
/+
E6$/
<
;;; , C;; , 23 9
LKJ , 7J7 , 2 9
< ;.2;M2 < 2;.M2I.