4-27. A. The results for Carver Industries are shown below.

The values boldfaced for 2010 are

improvements over 2009.
industry
average 2009 2010 calculation equation
current ratio 2.00 1.84 0.90 (current assets)/(current liabilities) 4-1
acid-test ratio 0.80 0.78 0.24 (current assets - inventory)/(current liabilities) 4-2
average collection period 37.00 30.42 18.98 (A/R)/(annual credit sales/365) 4-3
inventory turnover 2.50 3.10 4.06 (COGS)/(inventory) 4-5
debt ratio 58.00% 0.50 0.61 (total debt)/(total assets) 4-6
times interest earned 3.80 3.15 4.67 (EBIT)/(interest) 4-7
operating profit margin 10.00% 9.60% 10.63% (EBIT)/(sales) 4-11
total asset turnover 1.14 1.33 2.05 (sales)/(total assets) 4-8
fixed asset turnover 1.40 2.42 3.50 (sales)/(net plant & equipment) 4-9
operating return on assets 11.40% 12.80% 21.79% (EBIT)/(total assets) 4-13
return on equity 9.50% 8.73% 22.13% (net income)/(common equity) 4-14
B. and D. We can evaluate Carver’s relative performance by considering both their trend
(2010 vs. 2009), and their comparisons to the industry average. We will use both of
these approaches for the firm’s liquidity, capital structure, asset management
efficiency, and profitability ratios.
LIQUIDITY
5

3
industry average
2009
2 2010

0
current ratio acid-test ratio inventory turnover

The liquidity ratios are the current ratio, acid-test ratio, average collection period, and
accounts receivable turnover.
Current ratio: Carver’s current ratio has deteriorated over the last year. While its
current assets have stayed relatively stable (45% vs. 41% of total assets for 2009 and
2010, respectively), the current liabilities have blown up in 2010, going from 24% of
total assets to 46%. The firm’s accounts payable have more than doubled, and short-
term bank notes have almost tripled. The firm now has a current ratio that is less than
half of the industry average, suggesting compromised liquidity.
Acid-test ratio: The acid-test ratio tells a similar bleak story. While the firm’s ratio
was close to the industry average in 2009, it has fallen to about ¼ of that value in 2010.
Accounts receivable has remained relatively stable over this period; inventory,
however, rose from about 26% of total assets to 30%. However, the real story here is
cash and the huge swelling in current liabilities in 2010: Cash fell from 8% of total
assets to 0.3%. Carver’s cash has disappeared, and has dragged its acid-test ratio along
with it. The firm is dangerously lacking in liquidity, especially given current liabilities,
which have increased 160% year/year.
Inventory turnover: Carver’s inventory turnover is higher than the industry average,
and has increased significantly over the last year. The firm’s cost of goods sold more
than doubled, while inventory only increased by 63%. This is one bright spot for
Carver.
40

35

30

25

20 industry average
2009
2010
15

10

average collection period

Average collection period: Carver’s ACP is improving from a level that was already
better than the industry average. The firm receives cash for its sales after about 19 days,
while the industry average is 37. The firm’s A/R has only increased by a third, even
though its sales more than doubled. This is an impressive result.
Thus the ratios involving income statement values look OK for Carver, but its current
asset and current liability situations—especially its low cash—are troubling.
CAPITAL STRUCTURE
5.0

4.5

4.0

3.5

3.0

2.5
industry average
2009
2.0 2010

1.5

1.0

0.5

0.0

debt ratio times interest earned

The firm’s relevant capital structure ratios are the debt ratio and the times interest
earned ratio.
Debt ratio: The firm’s debt ratio has risen over the year, but is not much higher than
the industry average. While long-term debt has actually fallen (from 26% of total assets
to 15%), current liabilities have almost doubled. We have seen this already, in the
deterioration of the current ratio.
Times interest earned: The firm’s TIE has improved over the year, and is now higher
than the industry average. EBIT has risen as a percentage of sales, while interest
charges (while rising in absolute terms) have fallen relative to sales. Carver appears to
have a comfortable ability to generate cash to pay its interest charges.
ASSET MANAGEMENT EFFICIENCY
The relevant asset management efficiency ratios are total asset turnover and fixed asset
turnover.
3.5

3.0

2.5

2.0

industry average
2009
1.5
2010

1.0

0.5

0.0

total asset turnover fixed asset turnover

Total asset turnover: This ratio has improved over the period; it has been above the
industry average in both years. The firm’s sales more than doubled, but its assets only
increased by 39%. Carver is demonstrating an ability to use its growing assets with
increasing efficiency.
Fixed asset turnover: The story for fixed assets is similar: better than the industry
norm in both years, and improving. Carver supported its doubling in sales with only a
48% increase in fixed assets.
PROFITABILITY
We will consider Carver’s operating profit margin, operating return on assets, and return
on equity.

20%

15%

industry average
2009
10% 2010

5%

0%
operating profit margin operating return on assets return on equity

Operating profit margin: Carver is close to the industry average in both years,
although its trend is improving, and its 2010 results put it ahead of the industry. We’ve
already seen that the firm’s sales have more than doubled. Their operating costs have
also increased, but not as much: COGS and variable operating expenses have remained
constant (at 60% and 10% of sales, respectively); fixed cash operating expenses have
decreased significantly (from 17% to13%); depreciation expenses have almost
quadrupled ($6750 to $25,000) increasing from 3.6% of sales to 6.3% (we already saw
that fixed assets 4-27, continued increased). However, the drastic increase in sales
overwhelms the relatively smaller increases in costs, allowing EBIT to rise from 9.6%
to 10.6% of sales (an increase of 136%).
Operating return on assets: For both years, Carver outperformed the industry on the
measure, and its performance was even better in 2010. We have already seen that
Carver increased its total assets by only 39%, while doubling sales. It also improved its
operating margin, increasing the relative size of EBIT. EBIT is therefore a larger
proportion of a much larger sales base; its ratio to assets, which only increased
modestly, therefore increased.
Return on equity: Carver’s return on equity was slightly below the industry norm in
2009, but was much higher in 2010. The firm increased its net income by over 170%,
while increasing its equity only 7%. (Liabilities, on the other hand, rose 70%.)
 C. Finally, we consider Carver’s 2010 market-value ratios. The firm has 5000 shares of
common stock, so that its earnings per share (net income/number of shares) equals
($16,703/5,000)  $3.34. Its price-earnings ratio, (price/EPS), equals ($15/$3.34)  4.49.
The market-to-book ratio depends on the book value per share, (common equity/number
of shares), or ($75,465/5,000)  $15.09. The market-to-book ratio is therefore
($15/$15.09)  0.99. The P/E and market-to-book ratios are very low—the firm’s
shares are only selling for full book value, perhaps due to the perceived risk given its
low cash and liquidity position.
Given the values found above, Carver seems to be effectively managing its assets, with
the exception of its current assets. Its biggest problem here is its unsustainably low cash
position. The firm must take steps to become more liquid. It is already very effectively
managing its A/R and its inventories. It seems to have spent down its cash and
increased short-term notes payable to increase fixed assets, and used current liabilities
to reduce long-term debt. While this investment was effectively translated into sales, it
has left the firm in a temporarily awkward cash position. Its short-term liabilities have
risen, but so has its times interest earned. Nonetheless, the cash cushion is too small to
protect the firm against even a minimal downturn.
Despite the poor cash position, it’s difficult to understand Carver’s low price. Its
performance is improving and is better than its industry average in many categories of
evaluation. If the firm even managed to increase its earnings multiple (P/E) ratio to a
historical norm for stocks in general, 10 times, then it should be selling for $33.41. As
mentioned above, perhaps its dangerous liquidity position explains its poor stock price
performance, as equity holders are worried about the default potential.

4-30. A. The results for Pamplin, Inc. Industries are shown below. The values boldfaced for
2010 are improvements over 2009.
industry
average 2009 2010 calculation equation
current ratio 5.00 6.00 4.00 (current assets)/(current liabilities) 4-1
acid-test ratio 3.00 3.25 1.92 (current assets - inventory)/(current liabilities) 4-2
average collection period 90.00 136.88 106.98 (A/R)/(annual credit sales/365) 4-3
inventory turnover 2.20 1.27 1.36 (COGS)/(inventory) 4-5
debt ratio 0.33 0.33 0.35 (total debt)/(total assets) 4-6
times interest earned 7.00 5.00 5.63 (EBIT)/(interest) 4-7
operating profit margin 20.00% 20.83% 24.83% (EBIT)/(sales) 4-11
total asset turnover 0.75 0.50 0.56 (sales)/(total assets) 4-8
fixed asset turnover 1.00 1.00 1.04 (sales)/(net plant & equipment) 4-9
return on equity 9.00% 7.50% 10.45% (net income)/(common equity) 4-14

We can evaluate Pamplin’s relative performance by considering both their trend (2010
vs. 2009), and their comparisons to the industry average. We will use both of these
approaches for the firm’s liquidity, capital structure, asset management efficiency, and
profitability ratios.
LIQUIDITY
7

4
industry average
2009
3 2010

0
current ratio acid-test ratio inventory turnover

The liquidity ratios are the current ratio, acid-test ratio, average collection period, and
inventory turnover.
Current ratio: Pamplin’s current ratio has deteriorated over the last year and is now
below the industry average. As a percentage of total assets, both cash and A/R have
fallen, as has A/P. However, the big story here is the addition of the note payable.
Combined with the A/P, this note brings Pamplin’s current liabilities up to 11.5% of
total assets, from 8.33% in 2009. Combined with the slight decrease in current assets
(down to 46% of total assets, from 50%), this implies a lower current ratio for the
company.
Acid-test ratio: The acid-test ratio follows the same pattern: better than industry
average in 2009; worse in 2010. Given Pamplin’s decrease in cash, its A/R plus cash
total has fallen from 27% of assets to 22%. Inventories, in the meantime, have grown a
bit (up 1 percentage point). Thus Pamplin is holding less cash and A/R (in relative and
absolute terms), and has increased its current liabilities, all while generating more sales.
Given how much lower its liquidity looks relative to industry norms—at least on these
two measures—Pamplin may want to evaluate whether its ability to comfortably make
its current liability payments is sufficient.
(We should note that the company does have an acid-test ratio of almost 2, which it
may indeed consider sufficient.)
Inventory turnover: Pamplin’s inventory turnover is better in 2010 than it was in
2009, but is still below the industry average. While the firm’s COGS has remained
fairly constant as a percentage of sales, and inventory has increased as a percentage of
assets, the increase in sales means that COGS grew 21% over the period, while
inventory grew only 13.6%. The larger increase in COGS relative to inventory means
that Pamplin’s inventory turnover has increased. However, at 1.36 times, it is still well
below the industry average of 2.2 times. The company may be carrying too much stock
in inventory, which would contribute to its relatively poor liquidity.
 160

140

120

100

80 industry average
2009
2010
60

40

20

average collection period

Average collection period: Pamplin’s ACP is better in 2010 than it was in 2009, but
remains higher than the industry average. The 2010 ratio was lower than 2009’s since
A/R fell while sales rose—two good outcomes that both worked to improve payment
speeds. However, the industry average is still more than 2 weeks faster than Pamplin’s,
suggesting that there is more work to be done here, especially given the deteriorating
liquidity position.
Overall, Pamplin’s liquidity position needs improvement. It has taken on new short-
term debt, while reducing its cash cushion. It has too much money tied up in inventory
and A/R. While the situation is probably not dire, it is not ideal, either.
CAPITAL STRUCTURE
8.0

7.0

6.0

5.0

4.0
industry average
2009
2010
3.0

2.0

1.0

0.33 0.33 0.35

0.0

debt ratio times interest earned

The firm’s relevant capital structure ratios are the debt ratio and the times interest
earned ratio.
Debt ratio: The firm’s debt ratio has risen over the year, but is about the same as the
industry average. Total liabilities are up because of the new short-term borrowing.
Assets have also risen, but not by as large a percentage. The net result is a very slight
increase in Pamplin’s debt ratio, but nothing that’s concerning (beyond the liquidity
issues discussed earlier).
Times interest earned: Pamplin’s TIE has improved in 2010 over 2009, but is still
below the industry average. 2010’s EBIT grew 44% over the period, and interest grew
only 28%; thus the improvement in TIE. However, the industry’s average of 7 times is
still larger than Pamplin’s. Should the company be concerned? Pamplin is generating a
higher operating margin than average, so it’s the interest charges which seem to be
causing the variation with the industry.
At 5.63 times coverage, though, Pamplin’s debt does not seem excessive.
ASSET MANAGEMENT EFFICIENCY
The relevant asset management efficiency ratios are total asset turnover and fixed asset
turnover.
1.1

0.9

0.7

industry average
0.5 2009
2010

0.3

0.1

total asset turnover fixed asset turnover

-0.1

Total asset turnover: This ratio has improved over the period, but is still below the
industry average. The firm has increased sales by almost 21%, by increasing assets by
only about 8%. However, the industry average is almost 50% higher than Pamplin’s,
suggesting room for improvement.
Fixed asset turnover: Here, Pamplin is not only improving, but is better—just
barely—than average. When increasing sales, the company increased its fixed assets by
almost 17%. However, since sales growth was even higher, the fixed asset turnover
improved. The improvement leaves the firm so close to average that Pamplin should
not expect that there are no further efficiency gains here.
PROFITABILITY
We will consider Pamplin’s operating profit margin and return on equity.
Operating profit margin: Pamplin’s ratio is improving, and has been better than the
industry average in both years. The firm’s sales increased about 21%, while EBIT
increased 44%; the (EBIT/sales) ratio therefore increased. The big story here is
depreciation: The firm’s absolute depreciation deduction actually fell, despite an
increase in fixed assets. Thus the main difference in 2010 came after gross profit—in
depreciation expense.
 20%

15%

industry average
2009
10% 2010

5%

0%
operating profit margin return on equity

Return on equity: Pamplin’s ROE has improved, and is now better than the industry
average. Net income increased by almost 50%. Thus the firm made a much higher
profit relative to its equity investment.
Given these values, Pamplin seems to be in good shape relative to its peers. Its primary
area of concern is its liquidity, but even here, the firm is not in dire straits.