Question

You are asked to perform financial ratio analysis, including the use of Du Pont

      equation, to analyze the underlying cause for recent deteriorating performance of

      East Inc. Based on the information provided below, answer the questions.

Income Statement (in $ million)

          Net sales                                                   800

          Cost of Goods Sold                                          696

          Operating Expenses (including income taxes)               80

        Net Income                                                            24

                 

Balance Sheet

          Cash and Marketable Securities        45              Account Payable           50

          Account Receivable                      90              Short-term Debt           60

          Inventory                        160             Accrued Expenses            20

          Long-lived Assets                         150            Long-term Debt            25

                                                Stockholder's Equity      290

          Total Assets                              445             Liabilities and Equity       445

                            

Definition of Financial Ratios                   Industry Average

      Current Ratio (current asset/current liability)                    2      

      Fixed Assets Turnover Ratio (sales/fixed asset)                 6

      Total Assets Turnover ratio (sales/total asset)                   3

      Debt Ratio (total debt/total asset)                              30%  

      Equity Multiplier (total asset/stockholder's equity)               1.43  

      Inventory Turnover Ratio (sales/inventory)                      10     

      Average Collection Period (account receivables×365/sales)       24 days

      Profit Margin on Sales (net income/sales)                        3%

      Return on Total Assets (net income/total assets)                 9%     

      Return on Common Equity (ROE : net income/common equity)   12.9%

(1) Calculate the financial ratios to be compared against the industry average.

(2) Compute the Du Pont Equation for both East Inc. and for the industry as a whole.

     ROE = Profit Margin × Total Assets Turnover Ratio × Equity Multiplier

     ※ Equity Multiplier = Total Assets/Common Equity

(3) Analyze the reasons for low ROE of East Inc. based on the comparison of Du Pont

    Equation and make recommendations to improve ROE for East Inc.

Answer 1

INCOME STATEMENT

EXPENSES	AMT	INCOME	AMT
cost of goods sold	696	sales	800
operating expenses	80
net income	24

BALANCE SHEET

ASSETS AMOUNT LIABILITIES AMOUNT

Cash and Marketable Securities 45 Account Payable    50

Account Receivable 90 Short-term Debt 60

Inventory 160    Accrued Expenses 20

Long-lived Assets    150 Long-term Debt 25

Stockholder's Equity 290

Total Assets 445 Liabilities and Equity 445

FINANCIAL RATIOS:

1.CURRENT RATIO = CURRENT ASSETS/ CURRENT LIABILITIES

CURRENT ASSETS = cash and marketable securities +inventory+accounts receivables
=  45 +160+90
=295

CURRENT LIABILITIES = short term debts + accounts payable+ accrued expenses
= 60+50+20
=130

current ratio = 295/130 =  2.269230769 ~ 2.27

THE CURRENT RATIO OF INDUSTRY AVERAGE IS 2 WHICH IS AN IDEAL OR CAN SAY GOOD RATIO . THE CURRENT RATIO OF CO IS 2.27 WHICH IS ALSO NOT BAD THAT SHOWS THE CO. HAS ENOUGH CURRENT ASSETS TO MEET ITS SHORT TERM OBLIGATIONS.

2.FIXED ASSETS TURNOVER RATIO =   sales/fixed asset
= 800/150
=5.333333333 ~ 5.33

THE FIXED ASSET TURNOVER RATIO OF INDUSTRY IS 6 WHERE AS IT IS 5.33 OF THE EAST INC.

this ratio measures how well company uses its fixed assets to maximise sales . the turnover of east inc. is good though it needed quite more efforts to meet with industry average.

3.  Total Assets Turnover ratio =sales/total asset
= 800/445= 1.797752809 ~ 1.8

ASSETS TURNOVER RATIO SHOWS HOW EFFECTIVELY CO IS ABLE TO CONVERT ITS ASSETS INTO SALES. IT IS 3 OF INDUSTRY . SO CO NEEDS TO WORK MORE TO REACH ITS BENCHMARK.

4.DEBT RATIO = TOTAL DEBT/TOTAL ASSETS
TOTAL DEBT = SHORT TERM DEBT + LONG TERM DEBT
= 60+25 = 85

DEBT RATIO = (85/445)*100 = 19.1% .

THE DEBT RATIO LESS THAN 100 INDICATES CO HAS MORE ASSETS THAN DEBTS . IT IS 30% OF INDUSTRY AVERAGE AND THE CO HAS 19.1% IN ORDER TO MATCH IT WITH THE INDUSRTY IT NEED TO EITHER RELEASE ITS DEBTS OR INCREASE ITS TOATL ASSETS . THOUGH IT IS GOOD OR SATISFACTORY OR WE CAN SAY CO. IS AT LOW RISK FROM THIS POINT OF VIEW.

5   Equity Multiplier = total asset/stockholder's equity

= 445/ 290
=1.534482759 ~ 1.53

FOR THE INDUSTRY IT IS 1.43 . IT IS VERY CLOSE TO INDUSTRY AVERAGE . IT MEASURES FIRMS ASSETS FINANCED BY SHAREHOLDERS.  

6. Inventory Turnover Ratio = sales/inventory

=800/160
=5

THIS RATIO TELLS US NO OF TIMES THE INVENTORY IS CONVERTED INTO SALES

UNFORTUNATELY IT IS LOW THAN INDUSTRY AVERAGE WHICH IS 10 . SO THE CO NEEDS TO WORK ON IT BY IMPROVING ITS INVENTORY CONVERSION CYCLE

7 Average Collection Period =account receivables×365/sales
=( 90 X 365 )/ 800
= 41.0625 OR 41 DAYS

SO THE CO TAKES 41 DAYS TO CONVERT ITS DEBTORS INTO CASH WHICH IS ALMOST DOUBLE THAN WHAT THE INDUSTRY TAKES SO THE COMPANY NEEDS TO REGENERATE ITS ACCOUNTS RECEIVABLES POLICY.

8.    Profit Margin on Sales = net income/sales
=24/800
= 0.03 OR 3%

PROFIT MARGIN IS SATISFACTORY WITH THAT OF INDUSTRY AVERAGE . BOTH HAS SAME MARGIN.

9. Return on Total Assets =net income/total assets
= 24/445
= 0.053932584 OR 5.4%  

THIS RATIO SHOWS HOW WELL CO IS USING ITS ASSETS TO GENERATE EARNING . UNFORTUNATELY, THE CO IS NOT MEETING ITS TARGET WITH THAT OF INDUSTRY AS INDUSTRY HAS AN ROI OF 9%.

10. Return on Common Equity =ROE : net income/common equity

= 24/290
=0.082758621 ~ 8.2%

THE INDUSTRY HAS ROE OF 12.9% . THIS RATIO INDICATES AMOUNT OF PROFITS CO EARNS PER INVESTMENT SO IT IS QUITE LESS IF WE COMPARE IT WITH INDUSRTY.

2. DU PONT EQUATION FOR EAST INC.

=   ROE = Profit Margin × Total Assets Turnover Ratio × Equity Multiplier

    ※ Equity Multiplier = Total Assets/Common Equity

Equity Multiplier  = 1.53

PROFIT MARGIN = 3%

ASSET TURNOVER RATIO = 1.8

= .03 X 1.8 X 1.53 = 0.08262 OR 8.2%

DU PONT OF INDUSTRY = 1.43 X 3 X 3%

= 0.1287 OR 12.87% .