Question

A firm has been experiencing low profitability in recent years. Perform an analysis of the firm's financial position using the DuPont equation. The firm has no lease payments but has a $3 million sinking fund payment on its debt. The most recent industry average ratios and the firm's financial statements are as follows:

Industry Average Ratios
Current ratio	3	×		Fixed assets turnover	6	×
Debt-to-capital ratio	17	%		Total assets turnover	3	×
Times interest earned	6	×		Profit margin	2.25	%
EBITDA coverage	6	×		Return on total assets	6.75	%
Inventory turnover	11	×		Return on common equity	13.30	%
Days sales outstandinga	24	days		Return on invested capital	13.20	%
aCalculation is based on a 365-day year.

Balance Sheet as of December 31, 2019 (Millions of Dollars)
Cash and equivalents	$	72		Accounts payable	$	34
Accounts receivables		64		Other current liabilities		13
Inventories		145		Notes payable		34
Total current assets	$	281		Total current liabilities	$	81
				Long-term debt		30
				Total liabilities	$	111
Gross fixed assets		196		Common stock		106
Less depreciation		52		Retained earnings		208
Net fixed assets	$	144		Total stockholders' equity	$	314
Total assets	$	425		Total liabilities and equity	$	425

Income Statement for Year Ended December 31, 2019 (Millions of Dollars)
Net sales	$	765.00
Cost of goods sold		660.00
Gross profit	$	105.00
Selling expenses		59.50
EBITDA	$	45.50
Depreciation expense		10.00
Earnings before interest and taxes (EBIT)	$	35.50
Interest expense		3.50
Earnings before taxes (EBT)	$	32.00
Taxes (25%)		8.00
Net income	$	24.00

1. Calculate the following ratios. Do not round intermediate calculations. Round your answers to two decimal places.

   	Firm	Industry Average
   Current ratio	×	3	×
   Debt to total capital	%	17	%
   Times interest earned	×	6	×
   EBITDA coverage	×	6	×
   Inventory turnover	×	11	×
   Days sales outstanding	days	24	days
   Fixed assets turnover	×	6	×
   Total assets turnover	×	3	×
   Profit margin	%	2.25	%
   Return on total assets	%	6.75	%
   Return on common equity	%	13.30	%
   Return on invested capital	%	13.20	%

2. Construct a DuPont equation for the firm and the industry. Do not round intermediate calculations. Round your answers to two decimal places.

   	Firm	Industry
   Profit margin	%	2.25%
   Total assets turnover	×	3×
   Equity multiplier	×	×

3. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?
   1. Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low; however, its profit margin compares favorably with the industry average. Either sales should be lower given the present level of assets, or the firm is carrying less assets than it needs to support its sales.
   2. Analysis of the extended Du Pont equation and the set of ratios shows that most of the Asset Management ratios are below the averages. Either assets should be higher given the present level of sales, or the firm is carrying less assets than it needs to support its sales.
   3. The low ROE for the firm is due to the fact that the firm is utilizing more debt than the average firm in the industry and the low ROA is mainly a result of an excess investment in assets.
   4. The low ROE for the firm is due to the fact that the firm is utilizing less debt than the average firm in the industry and the low ROA is mainly a result of an lower than average investment in assets.
   5. Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low; however, its profit margin compares favorably with the industry average. Either sales should be higher given the present level of assets, or the firm is carrying more assets than it needs to support its sales.
   -Select-IIIIIIIVVItem 17
4. Which specific accounts seem to be most out of line relative to other firms in the industry?
   1. The accounts which seem to be most out of line include the following ratios: Debt to Total Capital, Inventory Turnover, Total Asset Turnover, Return on Assets, and Profit Margin.
   2. The accounts which seem to be most out of line include the following ratios: Times Interest Earned, Total Asset Turnover, Profit Margin, Return on Assets, and Return on Equity.
   3. The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Fixed Asset Turnover, Profit Margin, and Return on Equity.
   4. The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Total Asset Turnover, Return on Assets, and Return on Equity.
   5. The accounts which seem to be most out of line include the following ratios: Current, EBITDA Coverage, Inventory Turnover, Days Sales Outstanding, and Return on Equity.
   -Select-IIIIIIIVVItem 18
5. If the firm had a pronounced seasonal sales pattern or if it grew rapidly during the year, how might that affect the validity of your ratio analysis?
   1. Seasonal sales patterns would most likely affect the profitability ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.
   2. Rapid growth would most likely affect the coverage ratios, with little effect on asset management ratios. Seasonal sales patterns would not substantially affect your analysis.
   3. Seasonal sales patterns would most likely affect the liquidity ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.
   4. If the firm had sharp seasonal sales patterns, or if it grew rapidly during the year, many ratios would most likely be distorted.
   5. It is more important to adjust the debt ratio than the inventory turnover ratio to account for any seasonal fluctuations.
   -Select-IIIIIIIVVItem 19
   How might you correct for such potential problems?
   1. It is possible to correct for such problems by comparing the calculated ratios to the ratios of firms in a different line of business.
   2. It is possible to correct for such problems by comparing the calculated ratios to the ratios of firms in the same industry group over an extended period.
   3. There is no need to correct for these potential problems since you are comparing the calculated ratios to the ratios of firms in the same industry group.
   4. It is possible to correct for such problems by insuring that all firms in the same industry group are using the same accounting techniques.
   5. It is possible to correct for such problems by using average rather than end-of-period financial statement information.

Answer 1

a.

	Firm	Industry Average	Formula
Current ratio	3.47x	3x	Total current Assets/ Total Current Liabilities
Debt to total capital	26%	17%	Total Liabilities/Total Assets
Times interest earned	10.14x	6x	Earnings earned before interest and Tax(EBIT)/ Interest expense
EBITDA coverage	13x	6x	EBITDA/Interest Expense
Inventory turnover	4.55x	11x	Cost of Goods sold/Inventories
Days sales outstanding	30.54 days	24 days	Days Sales Outstanding = 365/ Sales Turnover Sales Turnover = Net Sales/ Account Recievables
Fixed assets turnover	5.31x	6x	Net Sales/ Net Fixed Assets
Total assets turnover	1.8x	3x	Net Sales/ Total Assets
Profit margin	3.14%	2.25%	Net Income/Net Sales
Return on total assets	5.65%	6.75%	Net Income/Total Assets
Return on common equity	7.64%	13.30%	Net Income/Total Stockholders Equity
Return on invested capital	7.54%	13.20%	EBIT*(1 - Taxes)/(Total Assets - Cash and Equivalents)

b.

	Firm	Industry	Formula
Profit margin	3.14%	2.25%	Net Income/Net Sales
Total assets turnover	1.8x	3×	Net Sales/ Total Assets
Equity multiplier	1.3535x	1.97037×	Total Assets/ Total Stockholders Equity
ROE (Dupont Equation)	7.65%	13.30%	Profit Margin* Total Asset Turnover*Equity Multiplier

Note : Industry Equity Multiplier can be found out by dividing Return of Common Equity (Industry) over Return of Total Assets (Industry)

c. Correct Answer: (V)

From the above analysis of the various ratios of the firm as well as of the Dupont Equation, we can see that Asset Turnover ratio of the firm (1.8x) is less than the Industry Average (3x), whereas the profit margin of the firm (3.14%) is higher than the Industry average (2.25%). Hence the firm should try to increase its sales given the present level of assets or the firm is carrying more assets than it needs to support its current level of sales.

d. Correct Answer: (IV)

The following ratios seem to be most out of line:

Ratio	Firm	Industry
Inventory Turnover	4.55x	11x
Days Sales Outstanding	30.24 Days	24 Days
Total Asset Turnover	1.8x	3x
Return on Assets	5.65%	6.75%
Return on Equity	7.64%	13.30%