Question

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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

Problem 14-15 Part 1

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

times interest earned ratio	earnings before interest and tax / interest expenses
	This year ($)	Last year ($)
net operating income	2166000	1791000
interest expenses	366000	306000
ratio	5.92	5.85
debt-to-equity ratio	total liabilities / total shareholders equity
	This year ($)	Last year ($)
total liabilities	7670000	6040000
total shareholders equity	9370000	8510000
ratio	0.82	0.71
gross margin percentage	(gross profit / sales)*100
	This year ($)	Last year ($)
gross profit	3172000	3395000
sales	15860000	13580000
ratio	20.0%	25.0%
return on total assets	earnings before interest and taxes / avg.total assets
	This year ($)	Last year ($)
net operating income	2166000	1791000
opening total assets	14550000	13070000
closing total assets	17040000	14550000
avg.total assets	15795000	13810000
ratio	13.7%	13.0%
return on equity	net income / avg.shareholders equity
	This year ($)	Last year ($)
net income	1260000	1039500
opening shareholders equity	8510000	7990250
closing shareholders equity	9370000	8510000
avg.shareholders equity	8940000	8250125
ratio	14.1%	12.6%
financial leverage	total debt / shareholders equity
	This year ($)	Last year ($)
total debt - notes payable	3660000	3060000
total shareholders equity	9370000	8510000
ratio	39.1%	36.0%

The financial leverage of the company has increased to 39.1% in the current year from 36.0% from last year. Higher ratio indicates the company is using its issued debt. It also means high interest rate resulting in high interest expense. This can negatively impact the net income and earnings per share.