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	$	960,000	$	1,200,000
Marketable securities		0		300,000
Accounts receivable, net		2,700,000		1,800,000
Inventory		3,600,000		2,000,000
Prepaid expenses		260,000		200,000
Total current assets		7,520,000		5,500,000
Plant and equipment, net		9,520,000		9,050,000
Total assets	$	17,040,000	$	14,550,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities	$	4,010,000	$	2,980,000
Note payable, 10%		3,660,000		3,060,000
Total liabilities		7,670,000		6,040,000
Stockholders' equity:
Common stock, $75 par value		7,500,000		7,500,000
Retained earnings		1,870,000		1,010,000
Total stockholders' equity		9,370,000		8,510,000
Total liabilities and stockholders' equity	$	17,040,000	$	14,550,000

Lydex Company Comparative Income Statement and Reconciliation
	This Year		Last Year
Sales (all on account)	$	15,860,000	$	13,580,000
Cost of goods sold		12,688,000		10,185,000
Gross margin		3,172,000		3,395,000
Selling and administrative expenses		1,006,000		1,604,000
Net operating income		2,166,000		1,791,000
Interest expense		366,000		306,000
Net income before taxes		1,800,000		1,485,000
Income taxes (30%)		540,000		445,500
Net income		1,260,000		1,039,500
Common dividends		400,000		519,750
Net income retained		860,000		519,750
Beginning retained earnings		1,010,000		490,250
Ending retained earnings	$	1,870,000	$	1,010,000

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

Current ratio	2.4
Acid-test ratio	1.1
Average collection period	40	days
Average sale period	60	days
Return on assets	9.3	%
Debt-to-equity ratio	0.7
Times interest earned ratio	5.9
Price-earnings ratio	10

Required:

1. 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 "Percentage" answers to 1 decimal place and other 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 $13,070,000.)

e. The return on equity. (Stockholders’ equity at the beginning of last year totaled $7,990,250. There has been no change in common stock over the last two years.)

f. Is the company’s financial leverage positive or negative?

Answer 1

Ans. 1
Ans. A	Time interest earned = Net operating income / Interest expenses
	This year	$2,166,000 / $366,000	5.92	times
	Last year	$1,791,000 / $306,000	5.85	times
Ans. B	Debt to equity ratio   =   Total liabilities / Total stockholder's equity
	This year	$7,670,000 / $9,370,000	0.82
	Last year	$6,040,000 / $8,510,000	0.71
Ans. C	Gross margin percentage = Gross margin / Net sales * 100
	This year	$3,172,000 / $15,860,000 * 100	20.0%
	Last year	$3,395,000 / $13,580,000 * 100	25.0%
Ans. D	Return on assets =   Net income / Average assets * 100
	This year	$1,260,000 / $15,795,000 * 100	8.0%
	Last year	$1,039,500 / $13,810,000 * 100	7.5%
	*Average assets = (Beginning assets + Ending assets) / 2
	This year	($14,550,000 + $17,040,000) / 2	$15,795,000
	Last year	($13,070,000 + $14,550,000) / 2	$13,810,000
Ans. E	Return on Common stockholder's equity =   Net income / Average Common stockholder's equity * 100
	This year	$1,260,000 / $8,940,000 * 100	14.1%
	Last year	$1,039,500 / $8,250,125 * 100	12.6%
	* Average Stockholder's equity =   (Beginning equity + Ending equity) / 2
	This year	($8,510,000 + $9,370,000) / 2	$8,940,000
	Last year	($7,990,250 + $8,510,000) / 2	$8,250,125
Ans. F	This year	Positive
	Last year	Positive
	Explanations: The return on equity is greater than the return on assets, so the
	financial leverage is positive in both years.
	Return on equity > Return on assets = Positive financial leverage
	Return on equity < Return on assets = Negative financial leverage