Question

The financial statements and industry norms are shown below for Pamplin, Inc.:

a. Compute the financial ratios for Pamplin for 2014 and for 2015 to compare both against the industry norms.

b. How liquid is the firm?

c. Areitsmanagersgeneratinganadequateoperatingprofitonthefirm’sassets?

d. How is the firm financing its assets?

e. Are its managers generating a good return on equity?

INDUSTRY NORM

Current ratio

5.00

Acid-test (quick) ratio

3.00

Inventory turnover

2.20

Average collection period

90.00

Debt ratio

0.33

Times interest earned

7.00

Total asset turnover

0.75

Fixed-asset turnover

1.00

Operating profit margin

20%

Return on common equity

9%

Pamplin, Inc. Balance Sheet at 12/31/2014 and 12/31/2015

Assets

2014

2015

Cash

$ 200

$ 150

Accounts receivable

450

425

Inventory

550

625

Current assets

$ 1,200

$1,200

Plant and equipment

$2,200

$ 2,600

Less accumulated depreciation

(1,000)

(1,200)

Net plant and equipment

$ 1,200

$1,400

Total

Total assets

$2,400

$2,600

Liabilities and Owners’ Equity

Accounts payable

$ 200

$ 150

Notes payable–current (9%)

0

150

Current liabilities

$ 200

$ 300

Bonds (8.33% interest)

600

600

Total debt

$ 800

$ 900

Owners’ equity common stock

$ 300

$ 300

Paid-in capital

600

600

Retained earnings

700

800

Total owners’ equity

$1,600

$1,700

Total liabilities and owners’ equity

$2,400

$2,600

CHAPTER 4 • Evaluating a Firm’s Financial Performance 145 Pamplin, Inc. Income Statement for Years Ending 12/31/2014 and 12/31/2015

2014

2015

Sales*

$1,200

$1,450

Cost of goods sold

700

850

Gross profit

$ 500

$ 600

Operating (expenses)

(30)

(40)

Depreciation

220

250

200

240

Operating profits

$ 250

$ 360

Interest expense

(50)

(64)

Net income before taxes

$ 200

$ 296

Taxes (40%)

80

118

Net income

$ 120

$ 178

Answer 1

Below are the financial ratios:

	Industry	Pamplin 2014	Pamplin 2015	Formula
Current ratio	5.00	6.00	4.00	currnet assets / current liabilities
Quick ratio	3.00	3.25	1.92	(cash + acc receivables) / current liabilities
inventory turnover	2.20	1.27	1.36	cost of goods sold / inventory
avg collection period	90.00	136.88	106.98	365/(sales / acc receivables)
debt ratio	0.33	0.33	0.35	total debt / total assets
Time interest earned	7.00	5.00	5.63	op profit / interest expense
total asset turnover	0.75	0.50	0.56	sales/ total assets
Fixed asset turnover	1.00	1.00	1.04	sales / net plant and equipment
Op profit margin	20%	20.83%	24.83%	op profit / sales
return on common equity	9%	7.50%	10.47%	net income / total owner's equity

The calculations are shown below:

	Industry	Pamplin 2014	Pamplin 2015	Formula
Current ratio	5	=1200/200	=1200/300	currnet assets / current liabilities
Quick ratio	3	=+(200+450)/200	=+(150+425)/300	(cash + acc receivables) / current liabilities
inventory turnover	2.2	=700/550	850/625	cost of goods sold / inventory
avg collection period	90	=365/(1200/450)	=365/(1450/425)	365/(sales / acc receivables)
debt ratio	0.33	800/2400	900/2600	total debt / total assets
Time interest earned	7	250/50	360/64	op profit / interest expense
total asset turnover	0.75	1200/2400	1450/2600	sales/ total assets
Fixed asset turnover	1	1200/1200	1450/1400	sales / net plant and equipment
Op profit margin	0.2	=250/1200	=360/1450	op profit / sales
return on common equity	0.09	=120/1600	178/1700	net income / total owner's equity

Note:

1. Turnover ratios are calculate using the average cost of goods sold for last two years. I have taken current year figures due to lack of sufficient data.

2. debt ratio : debt ratio use total debt. However, in this case, total debt also includes current liabilities. If you want to take pure debt ratio, use bonds/total assets formula. the debt ratio in that case will be (600/2400=0.25) and (600/2600=0.23) for 2014 and 2015 respectively.

b. The firm is very liquid as is evident by the high quick ratio. It has enough liquid assets (cash + acc receivables) to cover its current liabilities.

c. Given the low asset turnover compared to the industry, we can say that the assets of the firm are not used efficiently and hence are not generating sufficient returns.

d. The firm is primarily financing its assets through equity and only around one-third is financed through debt.

debt/ equity ratio (2014) = 600/1600 = 0.38

debt/ equity ratio (2015) = 600/1700 = 0.35

note that I have used Bond for debt here. you can also take total debt.

e. The company did not generate good return on common equity (ROCE) as the roce was lower than industry standards. However, in 2015, the roce was improved and was more than the industry. so we can say that the managers are currently generating  good roce.