Question

Easecom Company is a manufacturer of highly specialized products for networking video-conferencing equipment. Production of specialized units is, to a large extent, performed under contract, with standard units manufactured to marketing projections. Maintenance of customer equipment is an important area of customer satisfaction. With the recent downturn in the computer industry, the video-conferencing equipment segment has suffered, causing a slide in Easecom’s performance. Easecom’s income statement for the fiscal year ended October 31, Year 1, is presented below.

Easecom Company
Income Statement
For the Year Ended October 31, Year 1
($000 Omitted)

Net Sales:
Equipment	$6,000
Maintenance contract	$1,800
Total Net Sales	$7,800
Expenses:
Cost of goods sold	$4,600
Customer maintenance	$1,000
Selling expense	$600
Administrative expense	$900
Interest expense	$150
Total expenses	$7,250
Income before income taxes	$550
Income taxes	$220
Net Income:	$330

Easecom’s return on sales before interest and taxes was 9% in Fiscal Year 1, while the industry average was 12%. Easecom’s total asset turnover was three times, and its return on average assets before interest and taxes was 27%, both well below the industry average. In order to improve performance and raise these ratios near to, or above, industry averages, Bill Hunt, Easecom’s president, established the following goals for Fiscal Year 2:

• Return on sales before interest and taxes 11%
• Total asset turnover 4 times
• Return on average assets before interest and taxes 35%

To achieve Hunt’s goals, Easecom’s management team took into consideration the rowing international video-conferencing market and proposed the following actions for Fiscal Year 2:

• Increase equipment sales by 10%.
• Increase the cost of each unit sold by 3% for needed technology and quality improvements, and increased variable costs.
• Increase maintenance inventory by $250,000 at the beginning of the year and add 2 maintenance technicians at a total cost of $130,000 to cover wages and related travel expenses. These revisions are intended to improve customer service and response time. The increased inventory will be financed at an annual interest rate of 12%; no other borrowings or loan reductions are contemplated during Fiscal Year 2. All other assets will be held to Fiscal Year 1 levels.
• Increase selling expenses by $250,000 but hold administrative expenses at Year 1 levels.
• The effective rate for Year 2 federal and state taxes is expected to be 40%, the same as Year 1.

Questions:

1) Prepare a pro forma income statement for Easecom Company for the fiscal year ending October 31, Year 2, on the assumption that the proposed actions are implemented as planned and that the increased sales objectives will be met. (All numbers should be rounded to the nearest thousand, i.e., $000 omitted.)

2) Calculate the following ratios for Easecom Company for Fiscal Year 2 and determine whether Bill Hunt’s goals will be achieved:

a. Return on sales before interest and taxes

b. Total asset turnover.

c. Return on average assets before interest and taxes.

3) Discuss the limitations and difficulties that can be encountered in using ratio analysis, particularly when making comparisons to industry averages.

Answer 1

Easecom Company

Answer 1)

Income Statement

For the Year Ended October 31, Year 2
($000 Omitted)

Net Sales:
Equipment	$6600
Maintenance contract	$1800
Total Net Sales	$8400
Expenses:
Cost of goods sold	$5215
Customer maintenance	$1130
Selling expense	$850
Administrative expense	$900
Interest expense	$180
Total expenses	$8275
Income before income taxes	$125
Income taxes	$50
Net Income:	$75

Answer 2) Calculation of given ratios

a. Return on sales before interest and taxes

Income before interest & Tax / Net Sales x 100

= 305 / 8400*100 = 3.63% (Far below from taget of 11%)

b. Total asset turnover.

Net Sales / Total Assets  

= 8400 / 2850 = 2.94 Times (Below from target of 4 times)

c. Return on average assets before interest and taxes.

Income before interest & tax / Average Assets x 100

305 / 2843*100 = 10.73% (Far below of target decided of 35%)

Supportive Calculations

Net Sales = (6600+ 1800) = 8400

Cost of goods sold = 4600/6000 = .77 = .77*1.03 = .79 = .79*6600 = 5214 or can say $5215

Selling exps. in Year 2 increased by $250 so total = 600+250 = 850

No change in administrative Exps.

Interest cost on extra finance in year 2 = 250000 x 12/100 = 30000

total interest cost in year 2 = (150+30) = 180

Total Assets = Sales / Total Assets = 3 = 7800/Total Assets =3 = Total Assets = $2600 in Year 1

hense Total Assets in Year 2 = $2600 + $250 (Increased inventory) = $2850

Average Assets = Income before int & tax / Average Assets = 27% = Average Assets = $ 2593 in year 1 hense in year 2 = $2593 + $250 = $2843

Answer 3) Limitations and difficulties in using ratio analysis

Below are the limitations of ration analysis which makes it uses limited and risky.

1. Ratio Analysis does not possess any universal recognised standereds, so it does not provide full analysis of any axtivity of the firm.

2. Ratio analysis is always depend on financial data, and if there is any discripency in financial data the use of ration analysis is not meaningful and every company may maintain it financial heads according to its prudence.

3. No means a single ration only a set of ratio can explain.

4. Many problem are qualitative rather than numeritic, ratio analysis does not provide any solution for these problems.

5. It is not work like a accurate and fast system for problem discovery.

6. Ratio analysis does not account for external causes or on macro industry data.

7. Seasonal factors can disturb the result of ration analysis.

So above are the limitation and difficulties in using ration analysis particularly when making comparison to industry.