REVIEW PROBLEM: SELECTED RATIOS AND FINANCIAL LEVERAGE

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1 Questions Assume that two companies in the same industry have equal earnings. Why might these companies have 13 3 different price-earnings ratios? If a company has a price-earnings ratio of 20 and reports earnings per share for the current year of $4, at what price would you expect to find the stock selling on the market? 13 4 Would you expect a company in a rapidly growing technological industry to have a high or low dividend payout ratio? 13 5 What is meant by the dividend yield on a common stock investment? 13 6 What is meant by the term financial leverage? 13 7 The president of a plastics company was quoted in a business journal as stating, "We haven't had a dollar of interest-paying debt in over 10 years. Not many companies can say that." As a stockholder in this company, how would you feel about its policy of not taking on debt? 13 8 If a stock's market value exceeds its book value, then the stock is overpriced. Do you agree? Explain A company seeking a line of credit at a bank was turned down. Among other things, the bank stated that the company's 2 to 1 current ratio was not adequate. Give reasons why a 2 to 1 current ratio might not be adequate. REVIEW PROBLEM: SELECTED RATIOS AND FINANCIAL LEVERAGE Starbucks Corporation is the leading retailer and roaster of specialty coffee in North America selling freshly brewed coffee, pastries, and coffee beans. Data (slightly modified) from the company's financial statements are as follows:

2 Required: 1. Compute the return on total assets. 2. Compute the return on common stockholders' equity. 3. Is Starbucks' financial leverage positive or negative? Explain. 4. Compute the current ratio. 5. Compute the acid-test ratio. 6. Compute the inventory turnover. 7. Compute the average sale period. 8. Compute the debt-to-equity ratio. Solution to Review Problem 1. Return on total assets: 2. Return on common stockholders' equity: 3. The company has positive financial leverage because the return on common stockholders' equity of 29.8% is greater than the return on total assets of 13.8%. The positive financial leverage was obtained from current and long-term liabilities. 4. Current ratio:

3 5. Acid-test ratio: 6. Inventory turnover: 7. Average sale period: 8. Debt-to-equity ratio: THE FOUNDATIONAL 15 Markus Company's common stock sold for $2.75 per share at the end of this year. The company paid preferred stock dividends totaling $4,400 and a common stock dividend of $0.55 per share this year. It also provided the following data excerpts from this year's financial statements:

4 Required: 1. What is the earnings per share? 2. What is the price-earnings ratio? 3. What is the dividend payout ratio? 4. What is the dividend yield ratio? 5. What is the return on total assets (assuming a 30% tax rate)? 6. What is the return on common stockholders' equity? 7. What is the book value per share at the end of this year? 8. What is the amount of working capital and the current ratio at the end of this year? 9. What is the acid-test ratio at the end of this year? 10. What is the accounts receivable turnover? 11. What is the average collection period? 12. What is the inventory turnover? 13. What is the average sale period? 14. What is the time interest earned ratio? 15. What is the debt-to-equity ratio at the end of this year? EXERCISE 13 1 Common-Size Income Statement [LO1] A comparative income statement is given below for Ryder Company: The president is concerned that net income is down even though sales have increased during the year. The president is also concerned that administrative expenses have increased because the company made a concerted effort to cut waste out of the organization. Required: 1. Express each year's income statement in common-size percentages. Carry computations to one decimal place. 2. Comment briefly on the changes between the two years.

5 EXERCISE 13 2 Financial Ratios for Common Stockholders [LO2] Comparative financial statements for Heritage Antiquing Services for the fiscal year ending December 31 appear below and on the following page. The company did not issue any new common or preferred stock during the year. A total of 600 thousand shares of common stock were outstanding. The interest rate on the bond payable was 14%, the income tax rate was 40%, and the dividend per share of common stock was $0.75. The market value of the company's common stock at the end of the year was $26. All of the company's sales are on account.

6 Required: Compute the following financial ratios for common stockholders for this year: 1. Gross margin percentage. 2. Earnings per share of common stock. 3. Price-earnings ratio. 4. Dividend payout ratio. 5. Dividend yield ratio. 6. Return on total assets. 7. Return on common stockholders' equity. 8. Book value per share. EXERCISE Trend Percentages [LO1] Starkey Company's sales, current assets, and current liabilities (all in thousands of dollars) have been reported as follows over the last five years (Year 5 is the most recent year):

7 Required: 1. Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each item.) Use Year 1 as the base year, and carry computations to one decimal place. 2. Comment on the results of your analysis. PROBLEM 13 11A Common-Size Statements and Financial Ratios for Creditors [LO1, LO3, LO4] Modern Building Supply sells various building materials to retail outlets. The company has just approached Linden State Bank requesting a $300,000 loan to strengthen the Cash account and to pay certain pressing short-term obligations. The company's financial statements for the most recent two years follow:

8 During the past year, the company has expanded the number of lines that it carries in order to stimulate sales and increase profits. It has also moved aggressively to acquire new customers. Sales terms are 2/10, n/30. All sales are on account. Assume that the following ratios are typical of companies in the building supply industry: 3. Required: 1. Linden State Bank is uncertain whether the loan should be made. To assist it in making a decision, you have been asked to compute the following amounts and ratios for both this year and last year: a. Working capital. b. Current ratio. c. Acid-test ratio. d. Average collection period. (The accounts receivable at the beginning of last year totaled $350,000.) e. Average sale period. (The inventory at the beginning of last year totaled $720,000.) f. Debt-to-equity ratio. g. Times interest earned. 2. For both this year and last year (carry computations to one decimal place): a. Present the balance sheet in common-size form. b. Present the income statement in common-size form down through net income. 3. From your analysis in (1) and (2) above, what problems or strengths do you see for Modern Building Supply? Make a recommendation as to whether the loan should be approved.

9 PROBLEM 13 12A Financial Ratios for Common Stockholders [LO2] Refer to the financial statements and other data in Problem 13 11A. Assume that you have just inherited several hundred shares of Modern Building Supply stock. Not being acquainted with the company, you decide to do some analytical work before making a decision about whether to retain or sell the stock you have inherited. Required: 1. You decide first to assess the well-being of the common stockholders. For both this year and last year, compute the following: a. The earnings per share. b. The dividend yield ratio for common stock. The company's common stock is currently selling for $45 per share; last year it sold for $36 per share. c. The dividend payout ratio for common stock. d. The price-earnings ratio. How do investors regard Modern Building Supply as compared to other companies in the industry? Explain. e. The book value per share of common stock. Does the difference between market value and book value suggest that the stock at its current price is too high? Explain. 2. You decide next to assess the company's rate of return. Compute the following for both this year and last year: a. The return on total assets. (Total assets at the beginning of last year were $2,700,000.) b. The return on common stockholders' equity. (Stockholders' equity at the beginning of last year was $1,786,000.) c. Is the company's financial leverage positive or negative? Explain. 3. Based on your analytical work (and assuming that you have no immediate need for cash), would you retain or sell the stock you have inherited? Explain.