Chap 3 Solutions

Chapter 03: Financial Analysis
Chapter 3
Financial Analysis
Discussion Questions
3-1.
If we divide users of ratios into short-term lenders, long-term lenders, and

stockholders, in which ratios would each group be most interested, and for what
reasons?
Short-term lendersliquidity ratios because their concern is with the firms
ability to pay short-term obligations as they come due.
Long-term lendersleverage ratios because they are concerned with the
relationship of debt to total assets. They also will examine profitability to insure
that interest payments can be made.
Stockholdersprofitability ratios, with secondary consideration given to debt
utilization, liquidity, and other ratios. Since stockholders are the ultimate
owners of the firm, they are primarily concerned with profits or the return on
their investment.
3-1
3-2.
Explain how the Du Pont system of analysis breaks down return on assets. Also
explain how it breaks down return on stockholders equity.
The Du Pont system of analysis breaks out the return on assets between the
profit margin and asset turnover.
Return on Assets
Net income
Total assets
Profit Margin
Net income
Sales
Asset Turnover
Sales
Total assets
In this fashion, we can assess the joint impact of profitability and asset turnover
on the overall return on assets. This is a particularly useful analysis because we
can determine the source of strength and weakness for a given firm. For example,
a company in the capital goods industry may have a high profit margin and a
low asset turnover, while a food processing firm may suffer from low profit
margins, but enjoy a rapid turnover of assets.
The modified form of the Du Pont formula shows:
Return on equity =
Return on assets investment

1 Debt/Assets
This indicates that return on stockholders equity may be influenced by return

on assets, the debt-to-assets ratio or a combination of both. Analysts or
investors should be particularly sensitive to a high return on stockholders
equity that is influenced by large amounts of debt.
3-3.
If the accounts receivable turnover ratio is decreasing, what will be happening

to the average collection period?
If the accounts receivable turnover ratio is decreasing, accounts receivable will
be on the books for a longer period of time. This means the average collection
period will be increasing.
3-2
3-4.
What advantage does the fixed charge coverage ratio offer over simply using
times interest earned?
The fixed charge coverage ratio measures the firms ability to meet all fixed
obligations rather than interest payments alone, on the assumption that failure
to meet any financial obligation will endanger the position of the firm.
3-5.
Is there any validity in rule-of-thumb ratios for all corporations, for example, a
current ratio of 2 to 1 or debt to assets of 50 percent?
No rule-of-thumb ratio is valid for all corporations. There is simply too much
difference between industries or time periods in which ratios are computed.
Nevertheless, rules-of-thumb ratios do offer some initial insight into the
operations of the firm, and when used with caution by the analyst can provide
information.
3-6.
Why is trend analysis helpful in analyzing ratios?

Trend analysis allows us to compare the present with the past and evaluate our
progress through time. A profit margin of 5 percent may be particularly
impressive if it has been running only 3 percent in the last ten years. Trend
analysis must also be compared to industry patterns of change.
3-3
3-7.
Inflation can have significant effects on income statements and balance sheets,
and therefore on the calculation of ratios. Discuss the possible impact of
inflation on the following ratios, and explain the direction of the impact based
on your assumptions.
a.
b.
c.
d.
Return on investment.
Inventory turnover.
Fixed asset turnover.
Debt-to-assets ratio.
a. Return on investment
Net income
Total assets
Inflation may cause net income to be overstated and total assets to be

understated causing an artificially high ratio that is misleading.
b. Inventory turnover
Sales
Inventory
Inflation may cause sales to be overstated. If the firm uses FIFO accounting,
inventory will also reflect inflation-influenced dollars and the net effect
will be nil.
If the firm uses LIFO accounting, inventory will be stated in old dollars and
too high a ratio could be reported.
c. Fixed asset turnover
Sales
Fixed assets
Fixed assets will be understated relative to their replacement cost and to

sales and too high a ratio could be reported.
d. Debt to total assets
Total debt
Total assets
Since both are based on historical costs, no major inflationary impact will
take place in the ratio.
3-4
3-8.
What effect will disinflation following a highly inflationary period have on the
reported income of the firm?
Disinflation tends to lower reported earnings as inflation-induced income is
squeezed out of the firms income statement. This is particularly true for firms
in highly cyclical industries where prices tend to rise and fall quickly.
3-9.
Why might disinflation prove to be favorable to financial assets?

Because it is possible that prior inflationary pressures will no longer seriously
impair the purchasing power of the dollar, lessening inflation also means that
the required return that investors demand on financial assets will be going
down, and with this lower demanded return, future earnings or interest should
receive a higher current evaluation.
3-10.
Comparisons of income can be very difficult for two companies even though
they sell the same products in equal volume. Why?
There are many different methods of financial reporting accepted by the
accounting profession as promulgated by the Financial Accounting Standards
Board. Though the industry has continually tried to provide uniform guidelines
and procedures, many options remain open to the reporting firm. Every item on
the income statement and balance sheet must be given careful attention. Two
apparently similar firms may show different values for sales, research and
development, extraordinary losses, and many other items.
Chapter 3
Problems
1.
Profitability ratios (LO2) Low Carb Diet Supplement, Inc., has two divisions. Division A
has a profit of $100,000 on sales of $2,000,000. Division B is only able to make $25,000
on sales of $300,000. Based on the profit margins (returns on sales), which division is
superior?
3-5
3-1.
Solution:
Low Carb Diet Supplements
Division A
Net income
Sales
2.
3-2.
Division B
$100,000
$25,000
5%
8.33%
2,000,000
$300,000
Profitability ratios (LO2) Database Systems is considering expansion into a new product
line. Assets to support expansion will cost $500,000. It is estimated that Database can
generate $1,200,000 in annual sales, with a 6 percent profit margin. What would net
income and return on assets (investment) be for the year?
Solution:
Database Systems
Net income = Sales profit margin
= $1,200,000 0.06
= $72,000
Return on assets
(investment)
Net income
Total assets
$72,000
$500,000
14.4%
3-6
3.
3-3.
Profitability ratios (LO2) Polly Esther Dress Shops, Inc., can open a new store that will
do an annual sales volume of $960,000. It will turn over its assets 2.4 times per year. The
profit margin on sales will be 7 percent. What would net income and return on assets
(investment) be for the year?
Solution:
Polly Esther Dress Shops, Inc.
Assets
Sales
Total asset turnover
$960,000
$400,000
2.4
Net income Sales Profit Margin

$960,000 0.07 = $67,200
Return on assets (investment)
4.
Net income
Total assets
$67,200
16.8%
$400,000
Profitability ratios (LO2) Billys Chrystal Stores, Inc., has assets of $5,000,000 and turns
over its assets 1.2 times per year. Return on assets is 8 percent. What is the firms profit
margin (return on sales)?
3-7
3-4.
Solution:
Billy Crystal Stores, Inc.
Sales Assets total asset turnover

$6,000,000 $5,000,000 1.2
Net income Assets Return on assets
$400,000 $5,000,000 8%
Net income
$400,000/$6,000,000 = 6.67%
Sales
5.
3-5.
Profitability ratios (LO2) Elizabeth Tailors, Inc., has assets of $8,000,000 and turns over
its assets 2.5 times per year. Return on assets is 9.5 percent. What is the firms profit
margin (returns on sales)?
Solution:
Elizabeth Tailors, Inc.
Sales Assets total asset turnover

$20,000,000 $8,000,000 2.5
Net income Assets Return on assets
$760,000 $8,000,000 9.5%
Net Income
$760,000 / $20,000,000 3.8%
Sales
3-8
6.
Profitability ratios (LO2) Dr.Zhivago Diagnostics Corp. income statements for 2010 is as
follows:
Sales .......................................................................................$2,000,000
Cost of goods sold .................................................................. 1,400,000
Gross profit ............................................................................ 600,000
Selling and administrative expense ........................................ 300,000
Operating profit ...................................................................... 300,000
Interest expense ......................................................................
50,000
Income before taxes ............................................................... 250,000
Taxes (30%) ...........................................................................
75,000
Income after taxes .................................................................. $ 175,000
a. Compute the profit margin for 2010.
b. Assume in 2011, sales increase by 10 percent and cost of goods sold increases by 20
percent. The firm is able to keep all other expenses the same. Once again, assume a tax
rate of 30 percent on income before taxes. What are income after taxes and the profit
margin for 2011?
3-6.
Solution:
Dr. Zhivgo Diagnostics
a. Profit margin for 2010
Net income
$175,000
8.75%
Sales
$2,000,000
b. Sales .............................................................. $2,200,000*
Cost of goods sold ........................................ 1,680,000**
Gross profit ...................................................
520,000
Selling and administrative expense ..............
300,000
Operating profit ............................................
220,000
Interest expense ............................................
50,000
Income before taxes .....................................
170,000
Taxes (30%) .................................................
51,000
Income after taxes (2011)............................. $ 119,000
3-9
3-6. (Continued)
* $2,000,000 1.10 = $2,200,000
** $1,400,000 1.20 = $1,680,000
Profit Margin for 2011
Net income
$119,000
5.41%
Sales
$2,200,000
7.
Profitability ratios (L02) The Haines Corp. shows the following financial data for 2009
and 2010.
2009
$ 2,500,000
1,500,000
1,000,000
205,000
795,000
40,000
755,000
264,250
$490,750
Sales
Cost of goods sold
Gross Profit
Selling & administrative expense
Operating Profit
Interest expense
Income before taxes
Taxes (35%)
Income after taxes
2010
$3,000,000
1,875,000
1,125,000
210,000
915,000
45,000
870,000
304,500
$565,500
For each year, compute the following and indicate whether it is increasing or decreasing
profitability in 2010 as indicated by the ratio.
a.
b.
c.
3-7.
Cost of goods sold to sales.

Selling and administrative expense to sales.
Interest expenses to sales.
Solution:
3-10
Haines Corp.
a.
Cost of goods sold

Sales
2009
2010
$1,500,000
60.0%
2,500,000
$1,875,000
62.5%
3,000,000
It is decreasing profitability.
b.
Selling & admin. expense

Sales
$205,000
$210,000
8.2%
7.0%
2,500,000
3,000,000
It is increasing profitability.
Interest expense
Sales
It is increasing profitability.
c.
8.
$40,000
$45,000
1.6%
1.5%
2,500,000
3,000,000
Profitability ratios (L02) Neon Light Company has $1,000,000 in assets and $600,000 of
debt. It reports net income of $100,000.
a. What is the return on the assets?
b. What is the return on the stockholders equity?
c. If the firm has an asset turnover ratio of 3 times, what is the profit margin (return on
sales)?
3-8. Solution:
Neon Light Company
a.
Net income
Total assets
$100,000
10%
$1,000,000
3-11
b.
Return on equity
Net income
Stockholders' equity
Stockholders' equity total assets total debt

$1,000,000 $600,000 $400,000
Net income
$100,000
25%
Stockholders' equity $400,000
OR
Return on equity
Debt/Assets
Return on equity

(1 Debt/Assets)
$600,000
60%
$1,000,000
10%
(1 .60)
10%
25%
.40
3-8. (Continued)
c.
Sales total assets total assets turnover

$1,000,000 3 $3,000,000
Profit margin
Net income $100,000
3.3%
Sales
$3,000,000
3-12
9.
3-9.
Profitability ratios (LO2) Network Communications has total assets of $1,400,000 and
current assets of $600,000. It turns over its fixed assets 4 times a year. It has $300,000 of
debt. Its return on sales is 5 percent. What is its return on stockholders equity?
Solution:
Network Communications
total assets
current assets
Fixed assets
$1,400,000
600,000
$ 800,000
Sales Fixed assets Fixed asset turnover

$3,200,000 $800,000 4
total assets
$1,400,000
debt
300,000
Stockholders equity $1,100,000
= $3,200,000 5% = $160,000
Net income
$160,000
14.55%
$1,100,000
Return on stockholders' equity
3-13
10.
Profitability ratios (LO2) Fondren Machine Tools has total assets of $3,000,000 and
current assets of $800,000. It turns over its fixed assets 2.6 times per year. Its return on
sales is 6.5 percent. It has $1,200,000 of debt. What is its return of stockholders equity?
3-10. Solution:
Fondren Machine Tools
Total assets
Current assets
Fixed assets
$3,000,000
800,000
$2,200,000
Sales Fixed assets Fixed asset turnover

$5,720,000 $2,200,000 2.6
$5,720,000 6.5% = $371,800
Total assets
Debt
Stockholders equity
$3,000,000
1,200,000
$1,800,000
11. a.
b.
Net income
$371,800
20.66%
$1,800,000
Profitability ratios (LO2) Alpha Industries had an asset turnover of 1.4 times per
year. If the return on total assets (investment) was 8.4 percent, what was Alphas profit
margin?
The following year, on the same level of assets, Alphas assets turnover declined to 1.2
times and its profit margin was 7 percent.
How did the return on total assets change from that of the previous year?
3-14
3-11. Solution:
Alpha Industries
a.
Total asset turnover Profit Margin = Return on Total assets

1.4
?
= 8.4%
Profit margin =
b.
1.2
7%
8.4%
6.0%
1.4
= 8.4%
It did not change at all because the increase in profit margin made
up for the decrease in the asset turnover.
12.
Du Pont system of analysis (LO3) AllState Trucking Co. has the following ratios
compared to its industry for 2010.
Return on sales..
AllState
Trucking
3%
Industry
8%
Return on assets
15%
10%
Explain why the return-on-assets ratio is so much more favorable than the return-on-sales
ratio compared to the industry. No numbers are necessary; a one-sentence answer is all that
is required.
3-12. Solution:
Allstate Trucking Company
Allstate Trucking Company has a higher asset turnover ratio than
the industry.
Calculations are not necessary to answer the question, but just in
case a student did the calculations here is the comparison.
3-15
Return on Assets
=Asset Turnover
Return on Sales
15% 10%
vs
3%
8%
Allstates Turnover 5vs 1.25Industry Turnover

13.
Du Pont system of analysis (LO3)

Front Beam Lighting Company has the following
ratios compared to its industry for 2010.
Return on assets
Front Beam
Lighting
12%
Industry
5%
Return on equity
16%
20%
Explain why the return-on-equity ratio is so much less favorable than the return-on-assets
ratio compared to the industry. No numbers are necessary; a one-sentence answer is all
that is required.
3-13. Solution:
Front Beam Lighting Company
Front Beam has a lower debt/total assets ratio than the industry.
For those who did a calculation, Front Beams debt to assets was
25% vs 75% for the industry.
3-16
14.
Du Pont system of analysis (LO3) The King Card Company has a return-on-assets
(investment) ratio of 12 percent.
a.
If the debt-to-total-assets ratio is 40 percent, what is the return on equity?
b.
If the firm had no debt, what would the return-on-equity ratio be?
3-14. Solution:
King Card Company
a.
Return on equity

(1 Debt/Assets)
12%
(1 0.40)
12%
0.60
20%
b.
15.
The same as return on assets of 12% because with no debt,

the denominator would be 1.
Du Pont system of analysis (LO3) Using the Du Pont method, evaluate the effects of the
following relationships for the Lollar Corporation.
a. Lollar Corporation has a profit margin of 5 percent and its return on assets
(investment) is 13.5 percent. What is its assets turnover ratio?
b. If the Lollar Corporation has a debt-to-total-assets ratio of 60 percent, what would the
firms return on equity be?
c. What would happen to return on equity if the debt-to-total-assets ratio decreased to 40
percent?
3-15. Solution
3-17
Lollar Corporation
a.
Profit margin Total asset turnover Return on Investment

5%
13.5%

(1 Debt/Assets)
Return on equity
b.
13.5%
(1 0.60)
Existing return on equity
13.5%
2.7x
5%
13.5%
0.40
33.75%
3-15. (Continued)
c.
Return on equity

(1 Debt/Assets)
13.5%
(1 .40)
13.5%
0.60
22.50%
3-18
16.
Du Pont system of analysis (LO3) Jerry Rice and Grain Stores has $4,000,000 in yearly
sales. The firm earns 3.5 percent on each dollar of sales and turns over its assets 2.5 times
per year. It has $100,000 in current liabilities and $300,000 in long-term liabilities.
a. What is its return on stockholders equity?
b. If the asset base remains the same as computed in part a, but total asset turnover goes
up to 3, what will be the new return on stockholders equity? Assume that the profit
margin stays the same as do current and long-term liabilities.
3-16. Solution:
Jerry Rice and Grain Stores
a.
Net income Sales profit margin

$4,000,000 3.5%
$140,000
Stockholders' equity Total assets Total liabilities
Total assets Sales/Total asset turnover
$4,000,000/2.5
$1,600,000
Total liabilities Current liabilities Long term liabilities
$100,000 $300,000
$400,000
Stockholders' equity $1,600,000 $400,000 $1,200,000

Net income
$140,000
11.67%
$1,200,000
3-19
3-16. (Continued)
b. The new level of sales will be:
Sales Total assets Total asset turnover

$1,600,000 3
$4,800,000
Net income Sales Profit margin
$4,800,000 3.5%
$168,000
17.
Net income
$168,000
14%
$1, 200,000
Interpreting results from the Du Pont system of analysis (LO3) Assume the following
data for Cable Corporation and Multi-Media, Inc.
Net income ................................

Sales ..........................................
Total assets ................................
Total debt ..................................
Stockholders equity .................
Cable
Corporation
$ 30,000
300,000
400,000
150,000
250,000
Mu1ti
Media, Inc.
$ 100,000
2,000,000
900,000
450,000
450,000
a. Compute return on stockholders equity for both firms using ratio 3a. Which firm has
the higher return?
b. Compute the following additional ratios for both firms.
Net income/Sales
Net income/Total assets
Sales/Total assets
Debt/Total assets
c. Discuss the factors from part b that added or detracted from one firm having a higher
return on stockholders equity than the other firm as computed in Part a.
3-20
3-17. Solution:
Cable Corporation and Multi-Media, Inc.
a.
Cable
Corporation
MultiMedia, Inc.
Net income
$30,000
12%
Stockholders' equity $250,000
$100,000
22.2%
$450,000
Multi-Media Inc. has a much higher return on stockholders

equity than Cable Corporation.
3-17. (Continued)
b.
Net income
Sales
Net income
Total assets
Sales
Total assets
Debt
Total assets
Cable
Corporation
$30,000
10%
$300,000
$30,000
7.5%
$400,000
$300,000
.75x
$400,000
$150,000
37.5%
$400,000
MultiMedia, Inc.
$100,000
5%
$2,000,000
$100,000
11.1%
$900,000
$2,000,000
2.2x
$900,000
$450,000
50%
$900,000
c. As previously indicated, Multi-Media, Inc. has a substantially

higher return on stockholders equity than Cable Corporation
(22.2% versus 12%). The reason is certainly not to be found
on return on the sales dollar where Cable Corporation has a
higher return than Multi-Media, Inc. (10% vs. 5%).
3-21
However, Multi-Media, Inc. has a higher return than Cable

Corporation on total assets (11.1% vs 7.5%). The reason is
clearly to be found in total asset turnover, which strongly
favors Multi-Media, Inc. over Cable Corporation (2.2x versus
.75x). This factor alone leads to the higher return on total
assets.
Multi-Media, Inc.s superior return on stockholders equity is
further enhanced by a higher debt ratio than Cable Corporation
(50% vs. 37.5%). This means that a smaller percentage of
Multi-Media, Inc.s total assets are being financed by
stockholders equity and thus the potentially higher return on
stockholders equity.
3-17. (Continued)
Although not requested in the question, one could show the
following:
Net income
Net income / TotalAssets
(1- debt/assets)
Multi-Media, Inc. = 11.1%(1.05) = 11.17%/.50 = 22.2%
Cable Corporation = 7.5%(1.375) = 7.5%/.625 = 12%
18.
Average collection period (LO2) A firm has sales of $1.2 million, and 10 percent of the
sales are for cash. The year-end accounts receivable balance is $180,000. What is the
average collection period?
(Use a 360-day year.)
3-22
3-18. Solution:
Accounts receivable
Average daily credit sales
($1,200,000 90%)
$180,000
360 days
$180,000
$3,000 per day

60 days
Average collection period
19.
Average daily sales (LO2) The Chamberlain Corporation has an accounts receivable
turnover equal to 12 times. If accounts receivable are equal to $90,000, what is the value
for average daily credit sales?
3-19. Solution:
Chamberlain Corporation
Credit sales
360
To determine credit sales, multiply accounts receivable by

accounts receivable turnover.
$90,000 12 $1,080,000
$1,080,000
$3,000
360
3-23
20.
Inventory turnover (LO2) Kamin Corporation has the following financial data for the
years 2009 and 2010:
2009
2010
Sales
$4,000,000
$5,000,000
Cost of goods sold
3,000,000
4,500,000
Inventory..
400,000
500,000
a. Compute inventory turnover based on ratio number 6, Sales/Inventory, for each year.
b. Compute inventory turnover based on an alternative calculation that is used by many
financial analysts, Cost of goods sold/Inventory, for each year.
c. What conclusions can you draw from part a and part b?
3-20. Solution:
Kamin Corporation
2009
a.
b.
Sales
Inventory
$4,000,000
10x
400,000
Cost of goods sold $3,000,000
7.5x
Inventory
400,000
2010
$5,000,000
10x
500,000
$4,500,000
9x
500,000
c. Based on the sales to inventory ratio, the turnover has

remained constant at 10x. However, based on the cost of
goods sold to inventory ratio, it has improved from
7.5x to 9x.
The latter ratio may be providing a false picture of
improvement in this example simply because cost of goods
sold has gone up as percentage of sales (from 75 percent to
90 percent). Inventory is not really turning over any faster.
3-24
3-20. (Continued)
Nevertheless, cost of goods sold is used by many analysts in
the numerator of the inventory turnover ratio because it is
stated on a cost basis as is inventory. This is an important
theoretical consideration.
Nevertheless, the authors prefer to use sales in the numerator
of the inventory turnover ratio because that is the procedure
used by Dun & Bradstreet, the most widely quoted sources
for ratio analysis. Furthermore, for privately traded
companies there may be only information available on sales
and net cost of goods sold.
21.
Turnover ratios (LO2) Jim Shorts Company makes clothing for schools. Sales in 2010
were $4,000,000. Assets were as follows:
Cash.
Accounts receivable.
Inventory..
Net plant and equipment..
Total assets
$ 100,000
800,000
400,000
500,000
$1,800,000
a. Compute the following:

1. Accounts receivable turnover
2. Inventory turnover
3. Fixed asset turnover
4. Total asset turnover
b. In 2011, sales increased to $5,000,000 and the assets for that year were as follows:
Cash... $ 100,000
Accounts receivable..
900,000
Inventory...
975,000
Net plant and equipment...
500,000
Total assets.. $2,475,000
Once again, compute the four ratios.
c.
Indicate if there is an improvement or decline in total asset turnover, and based on the
other ratios, indicate why this development has taken place.
3-25
3-21. Solution:
Jim Shorts Company
a. 1. Accounts receivable turnover = Sales/Accounts
Receivable
$4,000,000
5x
800,000
2. Inventory turnover = Sales/Inventory
$4,000,000
10 x
400,000
3-21. (Continued)
3. Fixed asset turnover = Sales/(Net Plant & Equipment)
$4,000,000
8x
500,000
4. Total asset turnover = Sales/Total Assets
$4,000,000
2.22 x
1,800,000
b. 1. Accounts receivable turnover
$5,000,000
5.56 x
900,000
2. Inventory turnover
$5,000,000
5.13x
975,000
3. Fixed asset turnover
3-26
$5,000,000
10.00 x
500,000
4. Total asset turnover
$5,000,000
2.02 x
2,475,000
c. There is a decline in total asset turnover from 2.22 to 2.02.
This development has taken place because of the slowdown in
inventory turnover (10x down to 5.13x). The other two ratios
are slightly improved.
22.
Overall ratio analysis (LO2)The balance sheet for the Bryan Corporation is shown below.
Sales for the year were $3,040,000, with 75 percent of sales sold on credit.
BRYAN CORPORATION
Balance Sheet 201X

Liabilities and Stockholders Equity
Assets
Cash
$ 50,000
Accounts payable..
$220,000
Accounts receivable...
280,000
Accrued taxes
80,000
Inventory
240,000
Bonds payable
118,000
(long-term)
Plant and equipment...
380,000
Common stock..
100,000
Paid-in capital
150,000
Retained earnings..
282,000
Total liabilities and

Total assets...
$950,000
stockholders equity
Compute the following ratios:

a.
b.
c.
d.
e.
Current ratio.
Quick ratio.
Debt-to-total-assets ratio.
Asset turnover.
Average collection period.
3-27
$950,000
3-22. Solution:
Bryan Corporation
a.
Current ratio
Current assets
Current liabilities
$570,000
$300,000
1.9x
3-22. (Continued)
b.
Quick ratio
(Current assets inventory)

Current liabilities
$330,000
$300,000
1.1x
c.
Total debt
Total assets
Debt to total assets
$418,000
$950,000
44%
d.
Asset turnover
Sales
Total assets
$3,040,000
$950,000
3.2x
3-28
Accounts receivable
($3,040,000 0.75)
$280,000
360 days
$280,000
$6,333 per day

e.
44.21 days
23.
Debt utilization ratios (LO2) The Lancaster Corporations income statement is given
below.
a.
What is the times-interest-earned ratio?
b.
What would be the fixed-charge-coverage ratio?
LANCASTER CORPORATION
Sales ..............................................................................
Cost of goods sold .........................................................
Gross profit ...................................................................
Fixed charges (other than interest) ................................
Income before interest and taxes...................................
Interest...........................................................................
Income before taxes ......................................................
Taxes (35%) ..................................................................
Income after taxes .........................................................
$200,000
116,000
84,000
24,000
60,000
12,000
48,000
16,800
$ 31,200
3-23. Solution:
Lancaster Corporation
a.
Income before interest and taxes

Interest
Times interested earned
$60,000
12,000
5x
3-29
b.
Fixed charge coverage
Income before fixed charges and taxes

Fixed charges
$60,000 24,000
$12,000 24,000
$84,000
$36,000
2.33x
24.
Debt utilization and Du Pont system of analysis (LO3) Using the income statement for
J. Lo Wedding Gowns, compute the following ratios:
a.
The interest coverage.
b.
The fixed charge coverage.
The total assets for this company equal $160,000. Set up the equation for the Du Pont
system of ratio analysis, and compute the answer to part c below using ratio 2 b on
page 59.
c.
Return on assets (investment).
J.LO WEDDING GOWNS
Income Statement
Sales ..............................................................................
Less: Cost of goods sold ............................................
Gross profit ...................................................................
Less: Selling and administrative expense ..................
Less: Lease expense ...................................................
Operating profit* ...........................................................
Less: Interest expense ................................................
Earnings before taxes ....................................................
Less: Taxes (40%) ......................................................
Earnings after taxes .......................................................
*Equals income before interest and taxes.
3-24. Solution:
3-30
$200,000
90,000
110,000
40,000
10,000
$ 60,000
5,000
$ 55,000
22,000
$ 33,000
J. Lo Wedding Gowns
a.
Times interest earned

Interest
$60,000
5,000
12x
3-24. (Continued)
b.
Income before fixed charges and taxes

Fixed charges
$60,000 10,000
$5,000 10,000
$70,000
$15,000
4.67x
c.
Return on assets (Investment)
Net Income
Sales
Sales
Total assets
$33,000 $200,000
$200,000 $160,000
16.5% 1.25x
= 20.625%
3-31
25.
Debt utilization (LO2) A firm has net income before interest and taxes of $96,000 and
interest expense of $24,000.
a.
What is the times-interest-earned ratio?
b.
If the firms lease payments are $40,000, what is the fixed charge coverage?
3-25. Solution:
a.

Interest
$96,000
$24,000
4x
b.
IBIT + Before tax fixed charges

Interest Fixed charges
Fixed charge converage
$96,000 $40,000
$24,000 $40,000
$136,000
$64,000
2.13x
26.
Return on assets analysis (LO2) In January 2001, the Status Quo Company was formed.
Total assets were $500,000, of which $300,000 consisted of depreciable fixed assets. Status
Quo uses straight-line depreciation of $30,000 per year, and in 2001 it estimated its fixed
assets to have useful lives of 10 years. Aftertax income has been $26,000 per year each of
the last 10 years. Other assets have not changed since 2001.
a.
Compute return on assets at year-end for 2001, 2003, 2006, 2008, and 2010.
(Use $26,000 in the numerator for each year.)
b.
To what do you attribute the phenomenon shown in part a?
c.
Now assume income increased by 10 percent each year. What effect would this have
on your above answers (A comment is all that is necessary.)
3-32
3-26. Solution:
Status Quo Company
a.
Return on assets (investment) =
Income after taxes

Total Assets
The return on assets for Status Quo will increase over time as
the assets depreciate and the denominator gets smaller. Fixed
assets at the beginning of 2001 equal $300,000 with a ten-year
life which means the depreciation expense will be $30,000
per year. Book values at year-end are as follows:
2001 = $270,000;
2003 = $210,000;
2006 = $120,000;
2008 = $ 60,000;
2010 = -0Return on assets (investment) =
Income after taxes

Current assets + Fixed assets
2001 = $26,000/$470,000 = 5.53%

2003 = $26,000/$410,000 = 6.34%
2006 = $26,000/$320,000 = 8.13%
2008 = $26,000/$260,000 = 10.00%
2010 = $26,000/$200,000 = 13.00%
3-26. (Continued)
b. The increasing return on assets over time is due solely to the
fact that annual depreciation charges reduce the amount of
investment. The increasing return is in no way due to
operations.
3-33
Financial analysts should be aware of the effect of overall

asset age on the return-on-investment ratio and be able to
search elsewhere for indications of operating efficiency when
ROI is very high or very low.
c.
27.
As income rises, return on assets will be higher than in part

(b) and would indicate an increase in return partially from
more profitable operations.
Trend analysis (LO4) Jodie Foster Care Homes, Inc., shows the following data:
Year
2007
2008
2009
2010
a.
b.
Net Income
$118,000
131,000
148,000
175,700
Total Assets
$1,900,000
1,950,000
2,010,000
2,050,000
Stockholders Equity
$ 700,000
950,000
1,100,000
1,420,000
Total Debt
$1,200,000
1,000,000
910,000
630,000
Compute the ratio of net income to total assets for each year and comment on the trend.
Compute the ratio of net income to stockholders equity and comment on the trend.
Explain why there may be a difference in the trends between parts a and b.
3-27. Solution:
Jodie Foster Care Homes, Inc.
a.
Net income
Total assets
2007
2008
2009
2010
$118,000/$1,900,000 = 6.21%
$131,000/$1,950,000 = 6.72
$148,000/$2,010,000 = 7.36
$175,700/$2,050,000 = 8.57
Comment: There is a strong upward movement in return on

assets over the four year period.
3-34
b.
Net income
2007
2008
2009
2010
$118,000/$700,000 = 16.86%
$131,000/$950,000 = 13.79
$148,000/$1,100,000
= 13.45
$175,700/$1,420,000
= 12.37
Comment: The return on stockholders equity ratio is going

down each year. The difference in trends between a and b is
due to the larger portion of assets that are financed by
stockholders equity as opposed to debt.
3-27. (Continued)
Optional: This can be confirmed by computing total debt to
total assets for each year.
Total debt
Total assets
2007
2008
2009
2010
63.2%
51.3
45.3
30.7
3-35
28.
Trend analysis (LO4) Quantum Moving Company has the following data. Industry
information also is shown.
Industry Data on
Net Income/Total Assets
Year
2008
2009
2010
Company Data
Net Income
$350,000
375,000
375,000
Total Assets
$2,800,000
3,200,000
3,750,000
Year
2008
2009
2010
Debt
$1,624,000
1,730,000
1,900,000
Total Assets
$2,800,000
3,200,000
3,750,000
11.5%
8.4
5.5
Industry Data on
Debt/Total Assets
54.1%
42.0
33.4
As an industry analyst comparing the firm to the industry, are you likely to praise or
criticize the firm in terms of:
a.
Net income/Total assets.
b.
Debt/Total assets.
3-28. Solution:
Quantum Moving Company
a. Net income/total assets
Year
2008
2009
2010
Quantum Ratio
12.5%
11.7%
10.0%
Industry Ratio
11.5%
8.4%
5.5%
Although the company has shown a declining return on assets

since 2008, it has performed much better than the industry.
Praise may be more appropriate than criticism.
3-36
3-28. (Continued)
b. Debt/total assets
Year
2008
2009
2010
Quantum Ratio
58.0%
54.1%
50.7%
Industry Ratio
54.0%
42.0%
33.4%
While the companys debt ratio is declining, it is not

declining nearly as rapidly as the industry ratio. Criticism
may be more appropriate than praise.
29.
Analysis by divisions (LO2) The Global Products Corporation has three subsidiaries.
Medical Supplies Heavy Machinery
Sales .......................................
Net income (after taxes) .........
Assets .....................................
$20,000,000
1,200,000
8,000,000
$5,000,000
190,000
8,000,000
Electronics
$4,000,000
320,000
3,000,000
a.
b.
c.
d.
Which division has the lowest return on sales?

Which division has the highest return on assets?
Compute the return on assets for the entire corporation.
If the $8,000,000 investment in the heavy machinery division is sold off and
redeployed in the medical supplies subsidiary at the same rate of return on assets
currently achieved in the medical supplies division, what will be the new return on
assets for the entire corporation?
3-29. Solution:
Global Products Corporation
a.
Net income/sales
Medical
Supplies
6.0%
Heavy
Machinery Electronics
3.8%
8.0%
The heavy machinery division has the lowest return on sales.
3-37
b.
Net income/
total assets
Medical
Heavy
Supplies Machinery Electronics
15.0%
2.375%
10.67%
The medical supplies division has the highest return on assets.

3-29. (Continued)
Corporate net income
$1, 200,000 $190,000 $320,000
c.
Corporate total assets $8,000,000 $8,000,000 $3,000,000
$1,710,000
$19,000,000
9.0%
d. Return on redeployed assets in heavy machinery.

15% x $8,000,000 = $1,200,000
Return on assets for the entire corporation:
Corporate net income $1, 200,000 $1, 200,000 $320,000
Corporate total assets

$19,000,000
$2,720,000
$19,000,000
14.32%
3-38
30.
Analysis by affiliates (LO1) Omni Technology Holding Company has the following three
affiliates:
Sales .................................
Net income (after taxes) ...
Assets ...............................
Stockholders equity ........
a.
b.
c.
d.
e.
f.
g.
Software
Personal
Computers
Foreign
Operations
$40,000,000
2,000,000
5,000,000
4,000,000
$60,000,000
2,000,000
25,000,000
10,000,000
$100,000,000
8,000,000
60,000,000
50,000,000
Which affiliate has the highest return on sales?

Which affiliate has the lowest return on assets?
Which affiliate has the highest total asset turnover?
Which affiliate has the highest return on stockholders equity?
Which affiliate has the highest debt ratio? (Assets minus stockholders equity
equals debt.)
Returning to question b, explain why the software affiliate has the highest return on
total assets.
Returning to question d, explain why the personal computer affiliate has a higher
return on stockholders equity than the foreign operations affiliate even though it has
a lower return on total assets.
3-30. Solution:
Omni Technology Holding Company
a.
Net income/sales
Personal
Foreign
Software Computers Operations
5.0%
3.3%
8.0%
The foreign operation affiliate has the highest return on sales.
Personal
Foreign
b. Net income/total assets
40.0%
8.0%
13.3%
The personal computer affiliate has the lowest return on
assets.
3-39
3-30. (Continued)
c.
Sales/total assets
Software
8.0x
Personal
Foreign
Computers Operations
2.4x
1.7x
The software affiliate has the highest return on total asset

turnover.
Personal
Foreign
d. Net income/
Stockholders equity 50.0%
20.0%
16.0%
The Software affiliate has the highest return on stockholders

equity.
e.
Debt/total assets
Personal
Foreign
20.0%
60.0%
16.7%
The personal computer affiliate has the highest debt/total

assets ratio.
f.
This is because of its high total asset turnover ratio of 8.0x in

part c.
g. This is because the personal computer affiliate has a higher

debt ratio (60.0%) than the foreign operations affiliate
(16.7%).
3-40
31.
Inflation and inventory accounting effect (LO5) The Canton Corporation shows the
following income statement. The firm uses FIFO inventory accounting.
CANTON CORPORATION
Income Statement for 2010
Sales .....................................................................
Cost of goods sold ................................................
Gross profit ..........................................................
Selling and administrative expense ......................
Depreciation .........................................................
Operating profit ....................................................
Taxes (30%) .........................................................
Aftertax income ...................................................
a.
b.
c.
$100,000 (10,000 units at $10)

50,000 (10,000 units at $5)
50,000
5,000
10,000
35,000
10,500
$ 24,500
Assume in 2011 the same 10,000-unit volume is maintained, but that the sales price
increases by 10 percent. Because of FIFO inventory policy, old inventory will still be
charged off at $5 per unit. Also assume selling and administrative expense will be 5
percent of sales and depreciation will be unchanged. The tax rate is 30 percent.
Compute aftertax income for 2011.
In part a, by what percent did aftertax income increase as a result of a 10 percent
increase in the sales price? Explain why this impact took place.
Now assume that in 2012 the volume remains constant at 10,000 units, but the sales
price decreases by 15 percent from its year 2011 level. Also, because of FIFO
inventory policy, cost of goods sold reflects the inflationary conditions of the prior
year and is $5.50 per unit. Further, assume selling and administrative expense will be
5 percent of sales and depreciation will be unchanged. The tax rate is 30 percent.
Compute the aftertax income.
3-31. Solution:
Canton Corporation
a. 2011
Sales ..................................
Cost of goods sold ............
Gross profit ....................
Selling and adm. expense
Depreciation .....................
Operating profit .............
Taxes (30%) .....................
After tax income ............
3-41
$110,000 (10,000 units at $11)

50,000 (10,000 units at $5)
$ 60,000
5,500 (5% of sales)
10,000
$ 44,500
$ 13,350
$ 31,150
3-31. (Continued)
b. Gain in aftertax income
2011
2010
Increase
$31,150
24,500
$6,650
Increase
$6,650
27.14%
Base value (2010) $24,500
Aftertax income increased much more than sales because of
FIFO inventory policy (in this case, the cost of old inventory
did not go up at all), and because of historical cost
depreciation (which did not change).
c. 2012
Sales ..................................
Cost of goods sold ............
Gross profit ....................
Selling and adm. expense
Depreciation .....................
Operating profit .............
Taxes (30%) .....................
After tax income ............
*$11 0.85 = $9.35
$93,500 (10,000 units at $9.35*)

55,000 (10,000 units at $5.50)
$38,500
4,675 (5% of sales)
10,000
$23,825
$ 7,148
$16,677
The low profits indicate the effect of inflation followed by

disinflation.
3-42
32.
Using ratios to construct financial statements (LO2) Construct the current assets section
of the balance sheet from the following data. (Use cash as a plug figure after computing the
other values.)
Yearly sales (credit) .....................................................................
Inventory turnover .......................................................................
Current liabilities .........................................................................
Current ratio .................................................................................
Average collection period ............................................................
Current assets:
$
Cash.........................................................................
______
Accounts receivable ................................................
______
Inventory .................................................................
______
Total current assets .............................................
______
$420,000
7 times
$80,000
2
36 days
3-32. Solution:
Inventory
= $420,000/7
= $60,000
Current assets
= 2 $80,000
= $160,000
Account rec.
= ($420,000/360) x 36
= $42,000
Cash
= $160,000 $60,000 $42,000

= $ 58,000
Cash ................................
Accounts receivable .......
Inventory ........................
Total current assets
$ 58,000
42,000
60,000
$160,000
3-43
33.
Using ratios to construct financial statements (LO2) The Shannon Corporation has
credit sales of $750,000. Given the following ratios, fill in the balance sheet.
Total assets turnover ...................................
Cash to total assets ......................................
Accounts receivable turnover .....................
Inventory turnover ......................................
Current ratio ................................................
Debt to total assets ......................................
2.5 times
2.0 percent
10.0 times
15.0 times
2.0 times
45.0percent
SHANNON CORPORATION
Balance Sheet 201X
Assets
Cash ..............................
Accounts receivable ......
Inventory .......................
Total current assets ...
Fixed assets ..................
Total assets ................
_____
_____
_____
_____
_____
_____
Current debt .............................................

Long-term debt.........................................
Total debt ..............................................
Net worth .................................................
Total debt and
stockholders equity ............................
3-33. Solution:
Shannon Corporation
Sales/total assets
Total assets
Total assets
= 2.5 times
= $750,000/2.5
= $300,000
Cash
Cash
Cash
= 2% of total assets
= 2% $300,000
= $6,000
Sales/accounts receivable
Accounts receivable
Accounts receivable
= 10 times
= $750,000/10
= $75,000
Sales/inventory
Inventory
Inventory
= 15 times
= $750,000/15
= $50,000
3-44
_____
_____
_____
_____
_____
3-45
3-33. (Continued)
Fixed assets
Current assets
Fixed assets
= Total assets current assets

= $6,000 + $75,000 + $50,000
= $131,000
= $300,000 $131,000
= $169,000
Current assets/current debt

Current debt
Current debt
Current debt
=2
= Current assets/2
= $131,000/2
= $65,500
Total debt/total assets

Total debt
Total debt
= 45%
= .45 $300,000
= $135,000
Long-term debt
Long-term debt
Long-term debt
= Total debt current debt

= $135,000 $65,500
= $69,500
Net worth
Net worth
Net worth
= Total assets total debt

= $300,000 $135,000
= $165,000
3-46
Shannon Corporation
Balance Sheet 201X
Cash .....................
A/R ......................
Inventory .............
Total current
assets
Fixed assets .........
Total assets ..........
34.
$ 6,000 Current debt ........

$ 75,000 Long-term debt ...
$ 50,000 Total debt ........
$ 131,000
$ 169,000 Net worth ............
$ 300,000 Total debt and
stockholders
equity
$ 65,500
$ 69,500
$135,000
$165,000
$300,000
Using ratios to determine account balances (LO2) We are given the following
information for the Pettit Corporation.
Sales (credit) .............................................................
Cash ..........................................................................
Inventory ..................................................................
Current liabilities ......................................................
Asset turnover ..........................................................
Current ratio .............................................................
Debt-to-assets ratio ...................................................
Receivables turnover ................................................
$3,000,000
150,000
850,000
700,000
1.25 times
2.50 times
40%
6 times
Current assets are composed of cash, marketable securities, accounts receivable, and
inventory. Calculate the following balance sheet items.
a.
Accounts receivable.
b.
Marketable securities.
c.
Fixed assets.
d.
Long-term debt.
3-34. Solution:
3-47
Pettit Corporation
a. Accounts receivable
= Sales/Receivable turnover
= $3,000,000/6x
= $500,000
b. Marketable securities = Current assets (cash +

accounts rec. + inventory)
Current Assets
= Current ratio Current liabilities

= 2.5 $700,000
= $1,750,000
Marketable securities = $1,750,000 ($150,000 +

$500,000 + $850,000)
= $1,750,000 $1,500,000
= $250,000
3-34. (Continued)
c. Fixed assets
Total assets
Fixed assets
d. Long-term debt
Total debt
Long-term debt
= Total assets Current assets

= Sales/Asset turnover
= $3,000,000/1.25x
= $2,400,000
= $2,400,000 $1,750,000
= $650,000
= Total debt current liabilities
= Debt to assets total assets
= 40% $2,400,000
= $960,000
= $960,000 $700,000
= $260,000
3-48
35.
Using ratios to construct financial statements (LO2) The following information is from
Harrelson, Inc.s, financial statements. Sales (all credit) were $20 million for 2010.
Sales to total assets.........................................
Total debt to total assets .................................
Current ratio ...................................................
Inventory turnover .........................................
Average collection period ..............................
Fixed asset turnover .......................................
2 times
30%
3.0 times
5.0 times
18 days
5.0 times
Fill in the balance sheet:

Cash.....................................
Accounts receivable ............
Inventory .............................
Total current assets ...........
Fixed assets .........................
Total assets ........................
______
______
______
______
______
______
Current debt ..........................................

Long-term debt......................................
Total debt ............................................
Equity ....................................................
Total debt and equity ..........................
3-35. Solution:
Harrelson Inc.
Sales/total assets
Total assets
Total assets
=2
= $20 million/2
= $10 million
Total debt/total asset

Total debt
Total debt
= 30%
= $10 million x .3
= $3 million
Sales/inventory
Inventory
Inventory
= 5.0x
= $20 million/5x
= $4 million
Average daily sales
= $20 million/360 days

= $55,555.55 per day
Accounts receivable
= 18 days $55,555.56
= $1 million (or)
3-49
______
______
______
______
______
3-35. (Continued)
Accounts receivable =
$20 million
$1,000,000
360
18
Fixed assets
= $20 million/5x
= $4 million
Current assets
= Total assets Fixed assets

= $10 million - $4 million
= $6 million
Cash
= Current assets accounts receivable

inventory
= $6 million $1 million $4 million
= $1 million
Current liabilities
= Current assets/3
= $6 million/3
= $2 million
Long-term debt
= Total debt current debt

= $3 million $2 million
= $1 million
Equity
= Total assets total debt

= $10 million $3 million
= $7 million
3-50
3-35. (Continued)
Cash................
Accounts
receivable.....
Inventory.........
Total current
assets............
Fixed assets.....
Total assets.....
36.
$ 1.0 million Current debt.............$ 2.0 million

$ 1.0
$ 4.0
Long-term debt.............
$ 1.0
Total debt.......
$ 3.0
Equity.............
$ 7.0
$ 6.0
$ 4.0
$10.0 million Total debt and
equity...........
$10.0 million
Comparing all the ratios (LO2) Using the financial statements for the Snider Corporation,
calculate the 13 basic ratios found in the chapter.
SNIDER CORPORATION
Balance Sheet
December 31, 2010
Assets
Current assets:
Cash......................................................
Marketable securities ...........................
Accounts receivable (net) ....................
Inventory ..............................................
Total current assets ...........................
Investments .............................................
Plant and equipment................................
Less: Accumulated depreciation ..........
Net plant and equipment ......................
Total assets ..............................................
Current liabilities
Account payable...................................
Notes payable .......................................
Accrued taxes .......................................
Total current liabilities ......................
Long-term liabilities:
3-51
$ 50,000
20,000
160,000
200,000
$430,000
60,000
600,000
(190,000)
410,000
$900,000
$90,000
70,000
10,000
170,000
3-52
Bonds payable ......................................

Total liabilities .....................................
Stockholders equity
Preferred stock, $50 per value .............
Common stock, $1 par value ...............
Capital paid in excess of par ................
Retained earnings .................................
Total stockholders equity.................
Total liabilities and stockholders equity
150,000
$320,000
100,000
80,000
190,000
210,000
580,000
$900,000
SNIDER CORPORATION
Income statement
For the Year Ending December 31, 2010
Sales (on credit).................................................................................
Less: Cost of goods sold ...............................................................
Gross profit .......................................................................................
Less: Selling and administrative expenses ....................................
Operating profit (EBIT) ....................................................................
Less: Interest expense ...................................................................
Earnings before taxes (EBT) .............................................................
Less: Taxes....................................................................................
Earnings after taxes (EAT)................................................................
*Includes $35,000 in lease payments.
$1,980,000
1,280,000
700,000
475,000*
225,000
25,000
200,000
80,000
$ 120,000
3-36. Solution:
Snider Corporation
Profitability ratios
Profit margin = $120,000/$1,980,000 = 6.06%
Return on assets (investment) = $120,000/$900,000 = 13.3%
Return on equity = $120,000/$580,000 = 20.69%
Assets utilization ratios
3-53
Receivable turnover = $1,980,000/$160,000 = 12.38x

Average collection period = $160,000/$5,500 = 29.09 days
Inventory turnover = $1,980,000/$200,000 = 9.9x
Fixed asset turnover = $1,980,000/$410,000 = 4.83x
Total asset turnover = $1,980,000/$900,000 = 2.2x
Liquidity ratio
Current ratio = $430,000/$170,000 = 2.53x
Quick ratio = $230,000/$170,000 = 1.35x
Debt utilization ratios
Debt to total assets = $320,000/$900,000 = 35.56%
Times interest earned = $225,000/$25,000 = 9x
Fixed charge coverage = $260,000/$60,000 = 4.33x
37.
Ratio computation and analysis (LO2) Given the financial statements for Jones
Corporation and Smith Corporation shown here:
a.
To which one would you, as credit manager for a supplier, approve the extension of
(short-term) trade credit? Why? Compute all ratios before answering.
b.
In which one would you buy stock? Why?
JONES CORPORATION
Current Assets
Cash..............................................
Accounts receivable .....................
Inventory ......................................
Long-Term Assets
Fixed assets ..................................
Less: Accumulated depreciation
Net fixed assets* ..........................
Total assets ...............................
$ 20,000
80,000
50,000
$500,000
(150,000)
350,000
$500,000
Liabilities
Accounts payable ..................
Bonds payable (long-term) ....
Stockholders Equity
Common stock ....................... $150,000
Paid-in capital ........................
70,000
Retained earnings ..................
100,000
Total liab. and equity ........ $500,000
Sales (on credit) .......................................................................................

$1,250,000
Cost of goods sold ...................................................................................
750,000
Gross profit ..............................................................................................
500,000
Selling and administrative expense .....................................................

257,000
Less: Depreciation expense ..................................................................
50,000
Operating profit .......................................................................................
193,000
Interest expense .......................................................................................
8,000
Earnings before taxes ..............................................................................
185,000
3-54
$100,000
80,000
Tax expense .............................................................................................

92,500
Net income ..............................................................................................
$ 92,500
*Use net fixed assets in computing fixed asset turnover.
Includes $7,000 in lease payments.
SMITH CORPORATION
Current Assets
Cash ................................. $ 35,000
Marketable securities ......
7,500
Accounts receivable ........
70,000
Inventory .........................
75,000
Liabilities
Accounts payable ..................
Bonds payable (long-term) ....
Long-Term Assets
Fixed assets ..................... $500,000
Less: Accum. dep.......... (250,000)
Net fixed assets* .............
250,000
Total assets ................. $437,500
Stockholders Equity
Common stock.......................
$ 75,000
Paid-in capital ........................
30,000
Retained earnings ..................
47,500
Total liab. and equity ...........
$437,500
$ 75,000
210,000
*Use net fixed assets in computing fixed asset turnover.

SMITH CORPORATION
Sales (on credit).......................................................................................
$1,000,000
Cost of goods sold ...................................................................................
600,000
Gross profit .............................................................................................
400,000
Selling and administrative expense.....................................................
224,000
Less: Depreciation expense ..................................................................
50,000
Operating profit .......................................................................................
126,000
Interest expense .......................................................................................
21,000
Earnings before taxes ..............................................................................
105,000
Tax expense.............................................................................................
52,500
Net income ..............................................................................................
$ 52,500
3-37. Solution:
Jones and Smith Comparison
One way of analyzing the situation for each company is to
compare the respective ratios for each. Examining those ratios
which would be most important to a supplier or short-term lender
and a stockholder.
3-55
Jones Corp.
7.4%
18.5%
28.9%
15.63x
23.04 days
25x
3.57x
2.5x
1.5x
1.0x
36%
24.13x
13.33x
(200/15)
Smith Corp.
5.25%
12.00%
34.4%
14.29x
25.2 days
13.3x
4x
2.29x
2.5x
1.5x
65.1%
6x
4.75x
(133/28)
Profit margin
Return on assets (investments)
Return on equity
Receivable turnover
Inventory turnover
Fixed asset turnover
Current ratio
Quick ratio
Debt to total assets
calculation
3-37. (Continued)
a. Since suppliers and short-term lenders are most concerned with
liquidity ratios, Smith Corporation would get the nod as having
the best ratios in this category. One could argue, however, that
Smith had benefited from having its debt primarily long term
rather than short term. Nevertheless, it appears to have better
liquidity ratios.
b. Stockholders are most concerned with profitability. In this
category, Jones has much better ratios than Smith. Smith does
have a higher return on equity than Jones, but this is due to its
much larger use of debt. Its return on equity is higher than
Jones because it has taken more financial risk. In terms of other
ratios, Jones has its interest and fixed charges well covered and
in general its long-term ratios and outlook are better than
Smiths. Jones has asset utilization ratios equal to or better than
3-56
Smith and its lower liquidity ratios could reflect better short-term
asset management, and that point was covered in part a.
Note: Remember that to make actual financial decisions more than
one years comparative data is usually required. Industry
comparisons should also be made.
SMITH CORPORATION
Sales (on credit) ..........................................
Cost of goods sold .......................................
Gross profit ..................................................
Selling and administrative expense..........
Less: Depreciation expense .......................
Operating profit ...........................................
Interest expense ...........................................
Earnings before taxes...................................
Tax expense .................................................
Net income ...................................................
$1,000,000
600,000
400,000
224,000
50,000
126,000
21,000
105,000
52,500
$ 52,500
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Lamar Swimwear (trend analysis and industry comparisons)(LO3) Bob Adkins has recently
been approached by his first cousin, Ed Lamar, with a proposal to buy a 15 percent interest in
Lamar Swimwear. The firm manufactures stylish bathing suits and sunscreen products.
Mr. Lamar is quick to point out the increase in sales that has taken place over the last three years
as indicated in the income statement, Exhibit 1. The annual growth rate is 25 percent. A balance
sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in
Exhibit 3. Note the industry growth rate in sales is only 10 to 12 percent per year.
There was a steady real growth of 3 to 4 percent in gross domestic product during the period
under study.
3-57
Comprehensive Problem 1 (Continued)

Exhibit 1
LAMAR SWIMWEAR
Income Sheet
201X
Sales (all on credit) .............................................
$1,200,000
Cost of goods sold...............................................
800,000
Gross profit .........................................................
$ 400,000
Selling and administrative expense* ...................
239,900
Operating profit (EBIT) ......................................
$ 160,100
Interest expense...................................................
35,000
Net income before taxes .....................................
$ 125,100
Taxes ...................................................................
36,900
Net income ..........................................................
$ 88,200
Shares ..................................................................
30,000
$ 2.94
Earnings per share ...............................................
*
201Y
$1,500,000
1,040,000
$ 460,000
274,000
$ 186,000
45,000
$ 141,000
49,200
$ 91,800
30,000
$ 3.06
201Z
$1,875,000
1,310,000
$ 565,000
304,700
$ 260,300
85,000
$ 175,300
55,600
$ 119,700
38,000
$ 3.15
Includes $15,000 in lease payments for each year.
Exhibit 2
LAMAR SWIMWEAR
Balance Sheet
Assets
201X
Cash....................................................................
$ 30,000
Marketable securities .........................................
20,000
Accounts receivable ...........................................
170,000
Inventory ............................................................
230,000
Total current assets ........................................
$ 450,000
Net plant and equipment ....................................
650,000
Total assets .........................................................
$1,100,000
Accounts payable ...............................................
$ 200,000
Accrued expenses...............................................
20,400
Total current liabilities ...................................
$ 220,400
Long-term liabilities...........................................
325,000
Total liabilities ...............................................
$ 545,400
Common stock ($2 par) .....................................
60,000
Capital paid in excess of par ..............................
190,000
Retained earnings ...............................................
304,600
Total stockholders equity..............................
$ 554,600
Total liabilities and stockholders equity ...........
$1,100,000
3-58
201Y
40,000
25,000
259,000
261,000
$ 585,000
765,000
$1,350,000
201Z
30,000
30,000
360,000
290,000
$ 710,000
1,390,000
$ 2,100,000
$ 310,000
30,000
$ 340,000
363,600
$ 703,600
60,000
190,000
396,400
$ 646,400
$1,350,000
505,000
35,000
$ 540,000
703,900
$ 1,243,900
76,000
264,000
516,100
$ 856,100
$2, 100,000
Exhibit 3
Selected Industry Ratios
201X
Growth in sales ..................................
Profit margin ......................................

7.71%
Return on assets (investment) ............
7.94%
Return on equity.................................
14.31%
Receivable turnover ...........................
9.02X
Average collection period ..................
39.9 days
Inventory turnover .............................
4.24X
Fixed asset turnover ...........................
1.60X
Total asset turnover ............................
1.05X
Current ratio .......................................
1.96X
Quick ratio .........................................
1.37X
Debt to total assets .............................
43.47%
Times interest earned .........................
6.50X
Fixed charge coverage .......................
4.70X
Growth in EPS ...................................
201Y
10.00%
7.82%
8.86%
15.26%
8.86X
40.6 days
5.10X
1.64X
1.10X
2.25X
1.41X
43.11%
5.99X
4.69X
10.10%
201Z
12.00%
7.96%
8.95%
16.01%
9.31X
38.7 days
5.11X
1.75X
1.12X
2.40X
1.38X
44.10%
6.61X
4.73X
13.30%
The stock in the corporation has become available due to the ill health of a current stockholder,
who is in need of cash. The issue here is not to determine the exact price for the stock, but rather
whether Lamar Swimwear represents an attractive investment situation. Although Mr. Adkins
has a primary interest in the profitability ratios, he will take a close look at all the ratios. He has
no fast and firm rules about required return on investment, but rather wishes to analyze the
overall condition of the firm. The firm does not currently pay a cash dividend, and return to the
investor must come from selling the stock in the future. After doing a thorough analysis
(including ratios for each year and comparisons to the industry), what comments and
recommendations do you offer to Mr. Adkins?
3-59
CP 3-1.
Solution:
Lamar Swimwear
201X
Growth in sales
(Company)
(Industry)
Profit margin
(Company) 7.35%
(Industry)
7.71%
Return on assets
(Company) 8.02%
(Industry)
7.94%
Return on equity
(Company) 15.90%
(Industry)
14.31%
Receivable turnover (Company) 7.06x
(Industry)
9.02x
Average collection (Company) 51.0 days
period
(Industry)
39.9 days
Inventory turnover (Company) 5.22x
(Industry)
4.24x
Fixed asset turnover (Company) 1.85x
(Industry)
1.60x
Total asset turnover (Company) 1.09x
(Industry)
1.05x
Current ratio
(Company) 2.04x
(Industry)
1.96x
Quick ratio
(Company) 1.00x
(Industry)
1.37x
Debt to total assets (Company) 49.58%
(Industry)
43.47%
Times interest
(Company) 4.57x
earned
(Industry)
6.50x
Fixed charge
(Company) 3.50x
coverage
(Industry)
4.70x
Growth in E.P.S.
(Company) ---(Industry)
----
3-60
201Y
25%
10%
6.12%
7.82%
6.80%
8.68%
14.20%
15.26%
5.79x
8.86x
62.2 days
40.6 days
5.75x
5.10x
1.96x
1.64
1.11x
1.10x
1.72x
2.25x
.95x
1.41x
52.12%
43.11%
4.13x
5.99x
3.35x
4.69x
4.1%
10.1%
201Z
25%
12%
6.38%
7.96%
5.70%
8.95%
13.98%
16.01%
5.21x
9.31x
69.1 days
38.7 days
6.47x
5.11x
1.35x
1.75x
0.89x
1.12x
1.31x
2.40x
0.78x
1.38x
59.23%
44.10%
3.06x
6.61x
2.75x
4.73x
2.9%
13.3%
CP 3-1. (Continued)
Discussion of Ratios
While Lamar Swimwear is expanding its sales much more rapidly than
others in the industry, there are some clear deficiencies in their
performance. These can be seen in terms of a trend analysis over time as
well as a comparative analysis with industry data.
In terms of profitability, the profit margin is declining over time. This is
surprising in light of the 56.25 percent increase in sales over two years
(25 percent per year). There obviously are no economies of scale for this
firm. Higher costs of goods sold and interest expense appear to be
causing the problem. The return-on-asset ratio starts out in 201X above
the industry average (8.02 percent versus 7.94 percent) and ends up well
below it (5.70 percent versus 8.95 percent) in 201Z. The decline of 2.32
percent for return on assets is serious, and can be attributed to the
previously mentioned declining profit margin as well as a slowing total
asset turnover (going from 1.09x to 0.89x).
Return on equity is higher than the industry average the first year, and
then also falls far below it. This decline is particularly significant in light
of the progressively larger debt that the firm is using. High debt
utilization tends to contribute to high return on equity, but not in this
case. There is simply too much deterioration in return on assets
translating into low return on equity.
The previously mentioned slower turnover of assets can be analyzed
through the turnover ratios. A problem can be found in accounts
receivable where turnover has gone from 7.06x to 5.21x.
This can also be stated in terms of an average collection period that has
increased from 51 days to 69.1 days. While inventory turnover has been
and remains superior to the industry, the same cannot be said for fixed
asset turnover. A decline from 1.85x to 1.35x was caused by an increase
in 113.8 percent in fixed assets (representing $740,000).
We can summarize the discussion of the turnover ratios by saying that
despite a 56.25 percent increase in sales, assets grew even more rapidly
causing a decline in total asset turnover from 1.09x to 0.89x.
3-61
CP 3-1. (Continued)
The liquidity ratios also are not encouraging. Both the current and quick
ratios are falling against a stable industry norm of approximately two to
one and one to one respectively.
The debt to total assets ratio is particularly noticeable in regard to
industry comparisons. Lamar Swimwear has gone from being only 6.11
percent over the industry average to 15.13 percent above the norm
(59.23 percent versus 44.10 percent). Their heavy debt position is clearly
out of line with their competitors. Their downtrend in times interest
earned and fixed charge coverage confirms the heavy debt burden on the
company.
Finally, we see that the firm has a slower growth rate in earnings per
share than the industry. This is a function of less rapid growth in
earnings as well as an increase in shares outstanding (with the sale of
8,000 shares in 201Z). Once again, we see that the rapid growth in sales
is not being translated down into significant earnings gains. This is true
in spite of the fact that there is a very stable economic environment.
Investment Comments:
He would probably have difficulty justifying such an investment based
on the performance of the firm. There are no dividend payouts, so return
to the investor would have to come in the form of capital appreciation if
and when he was able to resell the shares. The prospects, at this point,
would not appear to justify the purchase. This is particularly true when
one considers that Mr. Adkins would be buying a minority interest
(15%) and would not have control of the firm.
3-62
Comprehensive Problem 2
Sun Microsystems (trends, ratios stock performance) (LO3) Sun Microsystems is a leading
supplier of computer related products, including servers, workstations, storage devices, and
network switches.
In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G.
McNealy offered the following remarks:
Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still,
we finished with revenue growth of 16 percentand thats significant. We believe its a good
indication that Sun continued to pull away from the pack and gain market share. For that, we
owe a debt of gratitude to our employees worldwide, who aggressively brought costs down
even as they continued to bring exciting new products to market.
The statement would not appear to be telling you enough. For example, McNealy says the
year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can
delve further by examining the income statement in Exhibit 1. Also, for additional analysis of
other factors, consolidated balance sheet(s) are presented in Exhibit 2 on page 92.
1. Referring to Exhibit 1, compute the annual percentage change in net income per common
share-diluted (second numerical line from the bottom) for 19981999, 19992000, and
20002001.
2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years.
Begin with 1998.
3. What is the major reason for the change in the answer for Question 2 between 2000 and
2001? To answer this question for each of the two years, take the ratio of the major
income statement accounts to net revenues (sales).
Cost of sales
Research and development
Selling, general and administrative expense
Provision for income tax
4. Compute return on stockholders equity for 2000 and 2001 using data from Exhibits 1
and 2.
In 2009, Sun Microsystems was acquired by Oracle Corporation.
3-63

Exhibit 1
SUN MICROSYSTEMS, INC.
Summary Consolidated Statement of Income (in millions)
2001
2000
1999
Dollars
Dollars
Dollars
Net revenues ...............................................
$18,250
$15,721
$11,806
Costs and expenses:
Cost of sales .........................................
10,041
7,549
5,670
Research and development ..................
2,016
1,630
1,280
Selling, general and administrative ......
4,544
4,072
3,196
Goodwill amortization .........................
261
65
19
In-process research and development ..
77
12
121
Total costs and expenses .............................
16,939
13,328
10,286
Operating Income .......................................
1,311
2,393
1,520
Gain (loss) on strategic investments ...........
(90)
208
Interest income, net .....................................

363
170
85
Litigation settlement ...................................
Income before taxes ....................................

1,584
2,771
1,605
Provision for income taxes .........................
603
917
575
Cumulative effect of change
in accounting principle, net .....................
(54)
Net income ..................................................

$ 927
$ 1,854
$ 1,030
Net income per common sharediluted ....
$ 0.27
$ 0.55
$ 0.31
Shares used in the calculation of net
income per common sharediluted ...........
3,417
3,379
3,282
1998
Dollars
$9,862
4,713
1,029
2,826
.4
176
8,748
1,114
48
1,162
407
$ 755
$ 0.24
3,180
5. Analyze your results to Question 4 more completely by computing ratios 1, 2a, 2b, and 3b
(all from this chapter) for 2000 and 2001. Actually the answer to ratio 1 can be found as part
of the answer to question 2, but it is helpful to look at it again.
What do you think was the main contributing factor to the change in return on stockholders
equity between 2000 and 2001? Think in terms of the Du Pont system of analysis.
6. The average stock prices for each of the four years shown in Exhibit 1 were as follows:
1998
11 1/4
1999
16 3/4
2000
28 1/2
2001
9 1/2
a. Computer the price/earnings (P/E) ratio for each year. That is, take the stock price shown
above and divide by net income per common stock-dilution from Exhibit 1.
b. Why do you think the P/E has changed from its 2000 level to its 2001 level?
A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio
Applied to Earnings per Share in Chapter 2.
3-64

Exhibit 2
SUN MICROSYSTEMS, INC
Consolidated Balance Sheets (in millions)
Assets
Current assets:
Cash and cash equivalents .....................................................................
Short-term investments ..........................................................................
Accounts receivable, net allowances of $410 in 2001 and
$534 in 2000 .......................................................................................
Inventories..............................................................................................
Deferred tax assets .................................................................................
Prepaids and other current assets ...........................................................
Total current assets .............................................................................
Property, plant and equipment, net ............................................................
Long-term investments ..............................................................................
Goodwill, net of accumulated amortization of $349 in 2001 and
$88 in 2000 ............................................................................................
Other assets, net .........................................................................................
Current liabilities:
Short-term borrowings ...........................................................................
Accounts payable ...................................................................................
Accrued payroll-related liabilities..........................................................
Accrued liabilities and other ..................................................................
Deferred revenues and customer deposits..............................................
Warranty reserve ....................................................................................
Income taxes payable .............................................................................
Total current liabilities ........................................................................
Deferred income taxes ...............................................................................
Long-term debt and other obligations........................................................
Total debt ............................................................................................
Commitments and contingencies
Stockholders equity:
Preferred stock, $0.001 par value, 10 shares authorized (1 share which
has been designated as Series A Preferred participating stock): no
shares issued and outstanding .............................................................
Common stock and additional paid-in-capital, $0.00067 par value, 7,200
shares authorized; issued: 3,536 shares in 2001 and 3,495 shares in 2000 ...
Treasury stock, at cost: 288 shares in 2001 and 301 shares in 2000 .........
Deferred equity compensation ...................................................................
Retained earnings.......................................................................................
Accumulated other comprehensive income (loss) .....................................
Total stockholders equity .......................................................................
3-65
2001
2000
$ 1,472
387
$ 1,849
626
2,955
1,049
1,102
969
7,934
2,697
4,677
2,690
557
673
482
6,877
2,095
4,496
2,041
832
$18,181
163
521
$14,152
3
1,050
488
1,374
1,827
314
90
5,146
744
1,705
$ 7,595
7
924
751
1,155
1,289
211
209
4,546
577
1,720
$ 6,843
6,238
(2,435)
(73)
6,885
(29)
10,586
2,728
(1,438)
(15)
5,959
75
7,309
$18,181
$14,152
7. The book values per share for the same four years discussed in the preceding question were:
1998 $1.18
1999 $1.55
2000 $2.29
2001 $3.26
a. Compute the ratio of price to book value for each year.
b. Is there any dramatic shift in the ratios worthy of note?
CP 3-2.
Solution
Sun Microsystems
1. Percentage change in net income per common share-diluted

1999
1998
$ .31
$ .24
$ .07
+29.2%
2000
1999
$ .55
$ .31
$ .24
+77.4%
2001
2000
$ .27
$ .55
$.28
50.9%
2. Profit margin
1998
Net income $755

=
Net revenues 9,862
7.66%
1999
2000
2001
$1,030
11,806
$1,854
15,721
$927
18,250
8.72%
11.79%
5.08%
3. Percent of net revenue

2000
Net revenues
Cost of sales
Research and
development
S, G, and A
Provision for
income taxes
$15,721
7,549
2001
48.02%
$18,250
10,041
55.02%
1,630
4,072
10.37
25.90
2,016
4,544
11.05
24.90
917
5.83
603
3.30
3-66
3-67
The main problem between 2000 and 2001 was the increase in cost
of sales as a percentage of net revenue (48.02% to 55.02%).
CP 3-2. (Continued)
4. Return on stockholders equity
Net income
2000
2001
$1,854
7,309
$ 927
10,586
25.37%
8.76%
2000
2001
5.
1.
Net income
Net revenues (sales)
11.79%
5.08%
2.a.
Net income
Total assets
13.1%
5.10%
2.b.
Net income
Sales
Sales
Total assets
11.79% 1.11 5.08% 1.00
13.09%
3.b.
Return on assets
1 Debt/Assets
13.09%
1 .484
25.37%
3-68
5.08%
5.08%
1 .418
8.73%
The main contributing factor to the decline in the return on

stockholders equity (25.37% to 8.73%) was the decline in the
profit margin (11.79% vs. 5.08%). The decrease in asset turnover
(1.11 to 1.00) made a small contribution to the decline as did the
decline in the debt ratio (48.4% to 41.8%).
CP 3-2. (Continued)
6.a. P/E = Stock price/net income per common share-diluted (EPS)
1998
1999
2000
2001
Shares prices
EPS
$11.25
.24
$16.75
.31
$28.50
.55
$9.50
.27
P/E
46.9
51.8
35.2
54.0
b. The sharp decline in performance caused investors to pay a lower

multiple for the stock.
7.a. Price to book value = Stock price/book value
1998
1999
2000
2001
Shares prices
Book value
$11.25
1.18
$16.75
1.55
$28.50
2.29
$9.50
3.26
P/BV
9.53
12.45
2.91
10.81
b. Once again, the sharp fall off in price to book value between 2000
and 2001 can be attributed to the decline in performance (and the
impact on the stock prices). Book value was going up, but the ratio
declined sharply due to the declining stock prices.
3-69
WEB EXERCISE
1. IBM was mentioned in the chapter as having an uneven performance. Lets check this out.
Go to its Web site www.ibm.com, and follow the following steps.
Select About IBM on the bottom of the page. Select Investors (US) on the next page on
the right side. Select Financial Snapshot on the next page.
2. Click on Stock Chart. How has IBMs stock been doing currently?
3. Click on Financial Snapshot. Assuming IBMs historical Price/Earnings Ratio is 15, how
does it currently stand?
4. Assuming its annual dividend yield is 2.5 percent, how does it currently stand?
5. Assuming IBMs historical LT (Long-term Debt/Equity) is 100 percent, how does it
currently stand? Generally speaking, is that good or bad?
6. Assuming its historical return on assets is 10 percent, how does it currently stand? Generally
speaking, is that good or bad?
Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a
Web site. If you click on the site map or site index, you will be introduced to a table of contents which should aid
you in finding the topic you are looking for.
3-70

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Chapter 03: Financial Analysis

If we divide users of ratios into short-term lenders, long-term lenders, and

Chapter 03: Financial Analysis

Return on assets investment

This indicates that return on stockholders equity may be influenced by return

If the accounts receivable turnover ratio is decreasing, what will be happening

Chapter 03: Financial Analysis

Why is trend analysis helpful in analyzing ratios?

Chapter 03: Financial Analysis

Inflation may cause net income to be overstated and total assets to be

Fixed assets will be understated relative to their replacement cost and to

Chapter 03: Financial Analysis

Why might disinflation prove to be favorable to financial assets?

Chapter 03: Financial Analysis

Chapter 03: Financial Analysis

Net income Sales Profit Margin

Chapter 03: Financial Analysis

Sales Assets total asset turnover

Sales Assets total asset turnover

Chapter 03: Financial Analysis

Chapter 03: Financial Analysis

Cost of goods sold to sales.

Chapter 03: Financial Analysis

Cost of goods sold

Selling & admin. expense

Return on assets (investment)

Chapter 03: Financial Analysis

Stockholders' equity total assets total debt

Return on assets (investment)

Sales total assets total assets turnover

Net income $100,000

Chapter 03: Financial Analysis

Sales Fixed assets Fixed asset turnover

Return on stockholders' equity

Chapter 03: Financial Analysis

Sales Fixed assets Fixed asset turnover

Return on stockholders' equity

Chapter 03: Financial Analysis

Total asset turnover Profit Margin = Return on Total assets

Chapter 03: Financial Analysis

Allstates Turnover 5vs 1.25Industry Turnover

Du Pont system of analysis (LO3)

Chapter 03: Financial Analysis

Return on assets (investment)

The same as return on assets of 12% because with no debt,

Chapter 03: Financial Analysis

Profit margin Total asset turnover Return on Investment

Total asset turnover

Return on assets (investment)

Existing return on equity

Return on assets (investment)

Chapter 03: Financial Analysis

Net income Sales profit margin

Stockholders' equity $1,600,000 $400,000 $1,200,000

Return on stockholders' equity

Chapter 03: Financial Analysis

Sales Total assets Total asset turnover

Net income ................................

Chapter 03: Financial Analysis

Multi-Media Inc. has a much higher return on stockholders

c. As previously indicated, Multi-Media, Inc. has a substantially

Chapter 03: Financial Analysis

However, Multi-Media, Inc. has a higher return than Cable