Financial Management: Principles and Applications , 12/E solutions manual and test bank by Titman, Keown & Martin
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:
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:
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:
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?
Based on these data, I would tell my boss:
· To consider changing the firm’s financing mix, substituting some long-term debt for its short-term 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.
· 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:
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 ratio = 
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:
current ratio = 
(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:
current ratio = 
Setting this equal to 2, then solving for x, we have:
2 * ($858,000 + x) = $2,145,000 + x
$1,716,000 + 2 * x = $2,145,000 + x
x = $429,000.
Verifying, we see that:
current ratio = 
= 
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:
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.
4-6. Here is Campbell Industries’ current situation:
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:
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):
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:
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):
operating profit margin = 
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:
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):
Its return on equity, given by equation 4-14, is:
(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
(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:
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:
If ALei wants its ACP to be 40 days, then we can solve for the maximum accounts receivable (A/R) as follows:
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:
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:
operating profit margin 
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.
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:
Callaway was able to generate $188,500 in net income on sales of $5M.
B. Callaway’s operating profit margin is 
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:
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.
D. To find Callaway’s return on equity, 
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:
4-13. As shown in equation 4-14a, a firm’s equity multiplier is found as follows:
Since Garwryk’s debt ratio was given as 80%, its equity multiplier is simply 
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
to 
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.)
4-14. We are given the following values for Triangular Chemicals:
total assets = $100M
ROE = 40% = 
net profit margin = 5% = 
equity multiplier = 2.5 = 
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 à total liabilities à common equity
common equity & ROE à NI
NI & net profit margin à sales
Step 1:
An equity multiplier of 2.5 and total assets of $100M imply total liabilities of $60M and total equity of $40M. (It is easy to see this if we rewrite the equity multiplier as 
Step 2:
ROE = 0.40 = (NI/common equity) = (NI/$40M)
à net income = $16M.
Step 3:
net profit margin = 5% = (NI/sales)
= ($16M/sales)
à sales = $320M.
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:
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 à NI
2. NI & ROE à common equity
3. common equity & total assets à total liabilities à debt ratio.
Step 1:
net profit margin = 0.075 = (NI/sales) = (NI/$200M)
à net income = $15M.
Step 2:
ROE = 0.30 = (NI/common equity)
= ($15M/common equity)
à common equity = $50M.
Step 3:
total liabilities = total assets – common equity
= $100M - $50M = $50M
à debt ratio = TL/TA = 50%.
4-16. We are given the following values for Bryley, Inc.:
total assets = $100M
total sales = $150M
net profit margin = 5% = 
equity multiplier = 3 = 
To find ROE, which is (NI/common equity), we can follow this strategy:
1. net profit margin & sales à NI
2. total assets & equity multiplier à total liabilities à common equity
3. equity & NI à ROE.
Step 1:
net profit margin = 5% = (NI/sales)
= (NI/$150M)
à NI = $7.5M.
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