Question

You have just been hired as a financial analyst for Lydex Company, a manufacturer of safety helmets. Your boss has asked you to perform a comprehensive analysis of the company’s financial statements, including comparing Lydex’s performance to its major competitors. The company’s financial statements for the last two years are as follows:

Lydex Company Comparative Balance Sheet
	This Year		Last Year
Assets
Current assets:
Cash	$	870,000	$	1,110,000
Marketable securities		0		300,000
Accounts receivable, net		2,340,000		1,440,000
Inventory		3,510,000		2,100,000
Prepaid expenses		240,000		180,000
Total current assets		6,960,000		5,130,000
Plant and equipment, net		9,340,000		8,960,000
Total assets	$	16,300,000	$	14,090,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities	$	3,920,000	$	2,800,000
Note payable, 10%		3,600,000		3,000,000
Total liabilities		7,520,000		5,800,000
Stockholders' equity:
Common stock, $70 par value		7,000,000		7,000,000
Retained earnings		1,780,000		1,290,000
Total stockholders' equity		8,780,000		8,290,000
Total liabilities and stockholders' equity	$	16,300,000	$	14,090,000

Lydex Company Comparative Income Statement and Reconciliation
	This Year		Last Year
Sales (all on account)	$	15,770,000	$	12,680,000
Cost of goods sold		12,616,000		9,510,000
Gross margin		3,154,000		3,170,000
Selling and administrative expenses		1,594,000		1,568,000
Net operating income		1,560,000		1,602,000
Interest expense		360,000		300,000
Net income before taxes		1,200,000		1,302,000
Income taxes (30%)		360,000		390,600
Net income		840,000		911,400
Common dividends		350,000		455,700
Net income retained		490,000		455,700
Beginning retained earnings		1,290,000		834,300
Ending retained earnings	$	1,780,000	$	1,290,000

To begin your assigment you gather the following financial data and ratios that are typical of companies in Lydex Company’s industry:

Current ratio	2.3
Acid-test ratio	1.0
Average collection period	30	days
Average sale period	60	days
Return on assets	8.3	%
Debt-to-equity ratio	.67
Times interest earned ratio	5.9
Price-earnings ratio	10
You decide first to assess the company’s performance in terms of debt management and profitability. Compute the following for both this year and last year: (Round your intermediate calculations and final percentage answers to 1 decimal place. i.e., 0.123 should be considered as 12.3%. Round the rest of the intermediate calculations and final answers to 2 decimal places.) a. The times interest earned ratio. b. The debt-to-equity ratio. c. The gross margin percentage. d. The return on total assets. (Total assets at the beginning of last year were $12,980,000.) e. The return on equity. (Stockholders’ equity at the beginning of last year totaled $7,834,300. There has been no change in common stock over the last two years.) f. Is the company’s financial leverage positive or negative? This Year Last Year a. b. c. % % d. % % e. % % f.

          

Answer 1

	This Year	Last Year
a.The times interest earned ratio.
Earnings before interest and income taxes (a)	$1,560,000.00	$1,602,000.00
Interest expense (b)	$360,000.00	$300,000.00
Times interest earned (a) ÷ (b)	4.33	5.34
b. The debt-to-equity ratio.
Total liabilities (a)	$7,520,000.00	$5,800,000.00
Stockholders’ equity (b)	$8,780,000.00	$8,290,000.00
Debt-to-equity ratio (a) ÷ (b)	0.86	0.70
c.The gross margin percentage.
Gross margin (a)	$3,154,000.00	$3,170,000.00
Sales (b)	$15,770,000.00	$12,680,000.00
Gross margin percentage (a) ÷ (b)	20.00%	25.00%
d.The return on total assets. (Total assets at the beginning of last year were $12,980,000.)
Net income	$840,000.00	$911,400.00
Add after-tax cost of interest:
$360,000 × (1 – 0.30) ; $300,000 × (1 – 0.30)	$252,000.00	$210,000.00
Total (a)	$1,092,000.00	$1,121,400.00
Average total assets (b)	$15,195,000.00	$13,535,000.00
Return on total assets (a) ÷ (b)	7.19%	8.29%
e.The return on equity. (Stockholders’ equity at the beginning of last year totaled $7,834,300. There has been no change in common stock over the last two years.)
Net income (a)	$840,000.00	$911,400.00
Average total stockholders’ equity (b)	$8,535,000.00	$8,062,150.00
Return on equity (a) ÷ (b)	9.84%	11.30%
f.Is the company’s financial leverage positive or negative?
The company's financial leverage is positive for this year because the return on equity (9.84%) is greater than the return on total assets (7.19%). For last year, leverage is also positive because the return on equity (11.30%) is greater than the return on total assets (8.29%).