Question

4. Sky Metals, Inc. is a metal fabrication firm that manufactures prefabricated metal parts for customers in a variety of industries. The firm’s motto is “If you need it, we can make it.” The CEO of Sky Metals recently held a board meeting during which he extolled the virtues of the corporation. The company, he stated confidently, had the capability to build any product and could do so using a lean manufacturing model. The firm would soon be profitable, claimed the CEO, because the company used state-of-the-art technology to build a variety of products while keeping inventory levels low. As a business press reporter, you have calculated some ratios to analyze the financial health of the firm. Sky Metals' current ratios and quick ratios for the past 6 years are shown in the following table:

	2010	2011	2012	2013	2014        2015	2015
Current ratio	1.2	1.4	1.3	1.6	1.8           2.2	2.2
Quick ratio	1.1	1.3	1.2	0.8	0.6          0.4	0.4

What do you think of the CEO’s claim that the firm is lean and soon to be profitable?

5. If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72, and a financial leverage multiplier of 1.43, what is its ROE? What is the advantage to using the DuPont system to calculate ROE over the direct calculation of earnings available for common stockholders divided by common stock equity?

Answer 1

a)The Current ratio= Current Assets/ Current Liabilities, Quick ratio = (Current Assets- Inventories)/ Current Liabilities
From 2011 to 2015 current ratio is increasing .Current Assets can increase due to cash , account receivable and inventories. However, The quick ratio is decreasing from 2011 to 2015 so inventories have increased from 2011 to 2015. Higher the inventories lower the quick ratio If inventories increase then profitability decreases if it is not converted to sales and the company is not lean.

b) Financial leverage = Debt /Equity = 1.43,
Equity multiplier = Total assets /Total Equity = (1 + debt./equity ) = 1+ 1.43 = 2.43
ROE = Net profit margin * Total asset turnover * Equity Multiplier = 4.5% * 0.72 * 2.43 = 0.07873 or 7.87%

c)
?Advantage of Dupoint ratio Instead of Return on Equity Du point helps to focus on the factors like profit margins ( profitability), Operational efficiency ( Asset Turnover ) and leverage or financial health of the firm (Equity Multiplier). So by analysing these ratios the company can focus on profit margin, asset turnover or optimal debt equity ratio to increase ROE

Best of luck. God Bless