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In: Finance

Analysis of Financial Statements: Tying the Ratios Together The DuPont equation shows the relationships among asset...

Analysis of Financial Statements: Tying the Ratios Together

The DuPont equation shows the relationships among asset management, debt management, and -Select-liquiditymarketprofitabilityCorrect 1 of Item 1  ratios. Management can use the DuPont equation to analyze ways of improving the firm's performance.

Ratio analysis is important to understand and interpret financial statements; however, sound financial analysis involves more than just calculating and interpreting numbers.

-Select-QuantitativeQualitativeForeignCorrect 2 of Item 1  

factors also need to be considered.

Quantitative Problem: Rosnan Industries' 2018 and 2017 balance sheets and income statements are shown below.

Balance Sheets:
2018 2017
Cash and equivalents $80   $65  
Accounts receivable 275   300  
Inventories 375   350  
      Total current assets $730   $715  
Net plant and equipment 2,000   1,490  
Total assets $2,730   $2,205  
Accounts payable $150   $85  
Accruals 75   50  
Notes payable 130   155  
      Total current liabilities $355   $290  
Long-term debt 450   290  
Common stock 1,225   1,225  
Retained earnings 700   400  
Total liabilities and equity $2,730   $2,205  


Income Statements:
2018 2017
Sales $2,000   $1,500  
Operating costs excluding depreciation 1,250   1,000  
EBITDA $750   $500  
Depreciation and amortization 100   75  
EBIT $650   $425  
Interest 62   45  
EBT $588   $380  
Taxes (40%) 235   152  
Net income $353   $228  
Dividends paid $53   $48  
Addition to retained earnings $300   $180  
Shares outstanding 100   100  
Price $25.00   $22.50  
WACC 10.00%     

What is the firm’s 2018 current ratio? Round your answer to two decimal places.

If the industry average debt-to-total-assets ratio is 30%, then Rosnan’s creditors have a -Select-smallerbiggerCorrect 1 of Item 3  cushion than indicated by the industry average.

What is the firm’s 2018 net profit margin? Round your answer to four decimal places.
%

If the industry average profit margin is 12%, then Rosnan’s lower than average debt-to-total-assets ratio might be one reason for its high profit margin.
-Select-TrueFalseCorrect 1 of Item 4

What is the firm’s 2018 price/earnings ratio? Round your answer to two decimal places.

Using the DuPont equation, what is the firm’s 2018 ROE? Round your answer to two decimal places.
%

Solutions

Expert Solution

1). The DuPont equation shows the relationships among asset management, debt management, and profitability ratios.

(Explanation: DuPont equation analyzes ROE (Return on Equity) as profit margin times total asset turnover times financial leverage.)

2). Ratio analysis is important to understand and interpret financial statements; however, sound financial analysis involves more than just calculating and interpreting numbers. Qualitative factors also need to be considered. (Explanation: For a comprehensive financial analysis, aside from ratio analysis, qualitative factors such as business environment, state of economy, etc. also need to be taken into account.)

3). Current ratio = current assets/current liabilities = 730/355 = 2.06 (For year 2018)

4). Debt to total assets ratio = (notes payable + long-term debt)/total assets = (130 + 450)/2,730 = 21.25% (For year 2018)

If the industry average debt-to-total-assets ratio is 30%, then Rosnan’s creditors have a bigger cushion than indicated by the industry average. (Explanation: Rosnan has around 21% debt compared to an industry average of 30% which indicates that it has more assets to cover debt than the industry.)

5). 2018 net profit margin = net income/sales = 353/2,000 = 17.6500%

If the industry average profit margin is 12%, then Rosnan’s lower than average debt-to-total-assets ratio might be one reason for its high profit margin - True. (Explanation: Without more information, it is difficult to give a reason for the high profit margin of Rosnan but lower debt would mean lower interest payments which would lead to higher net income so that could be one reason for the high profit margin.)

6). 2018 Price/Earnings ratio = Share price/(Net income/number of shares) = 25/(353/100) = 7.08

7). 2018 ROE (using DuPont equation) = profit margin * total assets turnover * financial leverage

= net income/net sales *net sales/total assets *total assets/total equity

= (353/2,000) *(2,000/2,730) * (2,730/(1,225 + 700)) = (353/2,000) *(2,000/2,730) *(2,730/1,925) = 18.34%


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