Question

Adams Corporation manufactures fasteners. The company’s income statements for three years are indicated in Exhibit 1. The balance Sheets for the same period are shown in Exhibit 2.

Exhibit 1

ADAMS CORPORATION
Income Statement
	2015	2016	2017
Sales (all on credit)…………………………	$1,500,000	$1,800,000	$2,160,000
Cost of goods sold………………………	950,000	1,120,000	1,300,000
Gross profit…………………………………	550,000	680,000	860,000
Selling and administrative expense………	380,000	490,000	590,000
Operating profit……………………………	170,000	190,000	270,000
Interest expense…………………….....	30,000	40,000	85,000
Net income before taxes…………………	140,000	150,000	185,000
Taxes…………………………………………	46,120	48,720	64,850
Net Income……………………………..	$93,880	$101,280	$120,150
Shares………………………………………	40,000	40,000	46,000

Adams Corporation has made the following projections 2018. All sales are on credit.

April	$24,000	July	$28,000
May	16,000	August	35,000
June	18,000	September	38,000

Sales in February and March were $36,000 and $28,000, respectively. Experience has shown that of total sales, 5 percent of the sales are not collectible, 35 percent are collected in the month of sale, 50 percent are collected in the following month, and 10 percent are collected two months after sale. Total annual sales for the year 2020 are forecasted to be $2,500,000.

Monthly material purchases are set equal to 20 percent of forecasted sales for the next month. Of the total material costs, 40 percent are paid in the month of purchase and 60 percent in the following month. Labour costs will run $6,000 per month, and fixed overheads is $3,000 per month. Interest payments on the debt will be $4,500 for both March and June. A cash dividend of $20,000 is scheduled to be paid in September. Tax payments of $3,500 are due in June and September.

Exhibit 2

ADAMS CORPORATION
Balance Sheet
Assets	2015	2016	2017
Cash………………………………………………	$20,000	$30,000	$20,000
Marketable securities…………………………	30,000	35,000	50,000
Accounts receivable………………………………	150,000	230,000	330,000
Inventory……………………………………	250,000	285,000	325,000
Total Current Assets………………………………	450,000	580,000	725,000
Net Plant and equipment……………………………	550,000	720,000	1,169,000
Total Assets………………………………………..	$1,000,000	$1,300,000	$1,894,000
Liabilities & Equity
Accounts payable…………………………….	$100,000	$225,000	$200,000
Notes payable (bank)………………………………	100,000	100,000	300,000
Total Current liabilities……………………………	200,000	325,000	500,000
Long-term liabilities……………………………	250,000	331,120	550,740
Total liabilities………………………………………	450,000	656,120	1,050,740
Common stock ($10 par)……………………	400,000	400,000	460,000
Capital paid in excess of par……………….	50,000	50,000	80,000
Retained earnings…………………………………	100,000	193,880	303,260
Total stockholders’ equity……………………………..	550,000	643,880	843,260
Total liabilities and stockholders’ equity………………	$1,000,000	$1,300,000	$1,894,000

Adams Corporation is evaluating three possible investment alternatives for 2018, and their probabilities of occurrence are given below in Exhibit 3:

Exhibit 3: Adams Corporation investment choices

	Alternative 1		Alternative 2		Alternative 3
	Outcomes	Probability	Outcomes	Probability	Outcomes	Probability
Failure	$50	20%	$90	30%	$80	40%
Acceptable	80	40%	160	50%	200	50%
Successful	120	40%	200	20%	400	10%

(a) calculate the inventory turnover ratio for years 2015 through 2017.

(b) using the Du Pont System, describe the changes in the return on assets from year to year ( 7 marks)

Answer 1

A) calculate the inventory turnover ratio for years 2015 through 2017

Inventory turnover ratio = Cost of goods sold/Inventory

2015 = 950,000/250,000

= 3.8

2016 = 1,120,000/285,000

= 3.93

2017 = 1,300,000/325,000

= 4.0

Part B

Return on equity = Return on assets * Financial leverage (Du pont system)

= Net income/Total assets * Total asset/Equity, (Equity = Total assets - Total liabilities)

2015 = 93,880/1,000,000 * 1,000,000 (1,000,000 - 450,000)

2015 = 0.094 * 1.82 = 0.171 or 17.1%

Return on assets = 0.094 and Equity multiplier = 1.82

2016 = 101,280/1,300,000 * 1,300,000/(1,300,000 - 656,120)

2016 = 0.078 * 2.02 = 0.15756 or 15.756%

Return on assets = 0.078 and Equity multiplier = 2.02

# Return on assets has reduced from 0.094 to 0.078 in 2016 which is leading to decrease in Return on equity

2017 = 120,150/1,894,000 * 1,894,000/(1,894,000 - 1,050,740)

2017= 0.063 * 2.25 = 0.14175 or 14.175%

Return on assets = 0.063 and Equity multiplier = 2.25

# Return on assets has reduced from 0.078 to 0.063 in 2017 which is leading to decrease in Return on equity further