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	$	860,000	$	1,100,000
Marketable securities		0		300,000
Accounts receivable, net		2,300,000		1,400,000
Inventory		3,500,000		2,000,000
Prepaid expenses		240,000		180,000
Total current assets		6,900,000		4,980,000
Plant and equipment, net		9,320,000		8,950,000
Total assets	$	16,220,000	$	13,930,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities	$	3,910,000	$	2,780,000
Note payable, 10%		3,600,000		3,000,000
Total liabilities		7,510,000		5,780,000
Stockholders' equity:
Common stock, $75 par value		7,500,000		7,500,000
Retained earnings		1,210,000		650,000
Total stockholders' equity		8,710,000		8,150,000
Total liabilities and stockholders' equity	$	16,220,000	$	13,930,000

Lydex Company Comparative Income Statement and Reconciliation
	This Year		Last Year
Sales (all on account)	$	15,760,000	$	12,580,000
Cost of goods sold		12,608,000		9,435,000
Gross margin		3,152,000		3,145,000
Selling and administrative expenses		1,592,000		1,564,000
Net operating income		1,560,000		1,581,000
Interest expense		360,000		300,000
Net income before taxes		1,200,000		1,281,000
Income taxes (30%)		360,000		384,300
Net income		840,000		896,700
Common dividends		280,000		448,350
Net income retained		560,000		448,350
Beginning retained earnings		650,000		201,650
Ending retained earnings	$	1,210,000	$	650,000

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

Current ratio	2.3
Acid-test ratio	1.0
Average collection period	30	days
Average sale period	60	days
Return on assets	8.2	%
Debt-to-equity ratio	0.7
Times interest earned ratio	5.8
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 $12,970,000.)

e. The return on equity. (Stockholders’ equity at the beginning of last year totaled $7,701,650. 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

Answer a.

This Year:

Times Interest Earned = Net Operating Income / Interest Expense
Times Interest Earned = $1,560,000 / $360,000
Times Interest Earned = 4.33 times

Last Year:

Times Interest Earned = Net Operating Income / Interest Expense
Times Interest Earned = $1,581,000 / $300,000
Times Interest Earned = 5.27 times

Answer b.

This Year:

Debt-to-equity Ratio = Total Liabilities / Total Stockholders’ Equity
Debt-to-equity Ratio = $7,510,000 / $8,710,000
Debt-to-equity Ratio = 0.86

Last Year:

Debt-to-equity Ratio = Total Liabilities / Total Stockholders’ Equity
Debt-to-equity Ratio = $5,780,000 / $8,150,000
Debt-to-equity Ratio = 0.71

Answer c.

This Year:

Gross Margin Percentage = Gross Margin / Sales
Gross Margin Percentage = $3,152,000 / $15,760,000
Gross Margin Percentage = 20.00%

Last Year:

Gross Margin Percentage = Gross Margin / Sales
Gross Margin Percentage = $3,145,000 / $12,580,000
Gross Margin Percentage = 25.00%

Answer d.

This Year:

Average Assets = ($16,220,000 + $13,930,000) / 2
Average Assets = $15,075,000

Return on Total Assets = Net Operating Income * (1 - tax) / Average Assets
Return on Total Assets = $1,560,000 * (1 - 0.30) / $15,075,000
Return on Total Assets = 7.2%

Last Year:

Average Assets = ($13,930,000 + $12,970,000) / 2
Average Assets = $13,450,000

Return on Total Assets = Net Operating Income * (1 - tax) / Average Assets
Return on Total Assets = $1,581,000 * (1 - 0.30) / $13,450,000
Return on Total Assets = 8.2%

Answer e.

This Year:

Average Stockholders’ Equity = ($8,710,000 + $8,150,000) / 2
Average Stockholders’ Equity = $8,430,000

Return on Equity = Net Income / Average Stockholders’ Equity
Return on Equity = $840,000 / $8,430,000
Return on Equity = 10.0%

Last Year:

Average Stockholders’ Equity = ($8,150,000 + $7,701,650) / 2
Average Stockholders’ Equity = $7,925,825

Return on Equity = Net Income / Average Stockholders’ Equity
Return on Equity = $896,700 / $7,925,825
Return on Equity = 11.3%

Answer f.

Financial Leverage = Total Debt / Shareholders’ Equity

Company’s financial leverage is positive in both years.