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How might that affect the validity of your ratio analysis
Course:- Financial Management
Reference No.:- EM131030609




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Financial management

Problem

DuPont Analysis

A firm has been experiencing low profitability in recent years. Perform an analysis of the firm's financial position using the extended Du Pont equation. The firm has no lease payments, but has a $1 million sinking fund payment on its debt. The most recent industry average ratios and the firm's financial statements are as follows:

 

Industry Average Ratios


Current ratio

3.09x

Fixed assets turnover

5.24x

Debt/total assets

35.00%

Total assets turnover

2.75x

Times interest earned

12.92x

Profit margin on sales

4.60%

EBITDA coverage

17.57x

Return on total assets

12.64%

Inventory turnover

12.26x

Return on common equity

19.45%

Days sales outstanding

35days

 


A calculation is based on a 365-day year.

Balance Sheet as of December 31, 2012
(Millions of Dollars)

Cash and equivalents

$30

Accounts payable

$20

Net receivables

24

Notes payable

24

Inventories

62

Other current liabilities

12

Total current assets

$116

Total current liabilities

$56

 


Long-term debt

14

 


Total liabilities

$70

Gross fixed assets

108

Common stock

54

Less depreciation

24

Retained earnings

76

Net fixed assets

$84

Total stockholders' equity

$130

Total assets

$200

Total liabilities and equity

$200

Income Statement for Year Ended December 31, 2012 (Millions of Dollars)

Net sales

$400.0

Cost of goods sold

312.0

Gross profit

$88.0

Selling expenses

36.0

EBITDA

$52.0

Depreciation expense

10.4

Earnings before interest and taxes (EBIT)

$41.6

Interest expense

1.9

Earnings before taxes (EBT)

$39.7

Taxes (40%)

15.9

Net income

$23.8

I. Calculate those ratios that you think would be useful in this analysis. Do not round intermediate steps. Round your answers to two decimal places.

 

Firm

Industry Average

Current ratio

x

3.09x

Debt to total assets

%

35.00%

Times interest earned

x

12.92x

EBITDA coverage

x

17.57x

Inventory turnover

x

12.26x

DSO

days

35days

F.A. turnover

x

5.24x

T.A. turnover

x

2.75x

Profit margin

%

4.60%

Return on total assets

%

12.64%

Return on common equity

%

19.45%

II. Construct an extended Du Pont equation, and compare the company's ratios to the industry average ratios. Do not round intermediate steps. Round your answers to two decimal places.

 

Firm

Industry

Profit margin

%

4.60%

Total assets turnover

x

2.75x

Equity multiplier



III. Do the balance sheet accounts or the income statement figures seem to be primarily responsible for the low profits?

1. Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be lower given the present level of assets, or the firm is carrying less assets than it needs to support its sales.

2. Analysis of the extended Du Pont equation and the set of ratios shows that most of the Asset Management ratios are below the averages. Either assets should be higher given the present level of sales, or the firm is carrying less assets than it needs to support its sales.

3. The low ROE for the firm is due to the fact that the firm is utilizing more debt than the average firm in the industry and the low ROA is mainly a result of an excess investment in assets.

4. The low ROE for the firm is due to the fact that the firm is utilizing less debt than the average firm in the industry and the low ROA is mainly a result of an lower than average investment in assets.

5. Analysis of the extended Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be higher given the present level of assets, or the firm is carrying more assets than it needs to support its sales.

IV. Which specific accounts seem to be most out of line relative to other firms in the industry?

1. The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Total Asset Turnover, Return on Assets, and Return on Equity.

2. The accounts which seem to be most out of line include the following ratios: Current, EBITDA Coverage, Inventory Turnover, Days Sales Outstanding, and Return on Equity.

3. The accounts which seem to be most out of line include the following ratios: Debt to Total Assets, Inventory Turnover, Total Asset Turnover, Return on Assets, and Profit Margin.

4. The accounts which seem to be most out of line include the following ratios: Times Interest Earned, Total Asset Turnover, Profit Margin, Return on Assets, and Return on Equity.

5. The accounts which seem to be most out of line include the following ratios: Inventory Turnover, Days Sales Outstanding, Fixed Asset Turnover, Profit Margin, and Return on Equity.

V. If the firm had a pronounced seasonal sales pattern, or if it grew rapidly during the year, how might that affect the validity of your ratio analysis?

1. Seasonal sales patterns would most likely affect the profitability ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.

2. Rapid growth would most likely affect the coverage ratios, with little effect on asset management ratios. Seasonal sales patterns would not substantially affect your analysis.

3. Seasonal sales patterns would most likely affect the liquidity ratios, with little effect on asset management ratios. Rapid growth would not substantially affect your analysis.

4. If the firm had seasonal sales patterns, or if it grew rapidly during the year, many ratios would most likely be distorted.

5. It is more important to adjust the debt ratio than the inventory turnover ratio to account for any seasonal fluctuations.

VI. How might you correct for such potential problems?

1. It is possible to correct for such problems by using average rather than end-of-period financial statement information.

2. It is possible to correct for such problems by comparing the calculated ratios to the ratios of firms in a different line of business.

3. It is possible to correct for such problems by comparing the calculated ratios to the ratios of firms in the same industry group over an extended period.

4. There is no need to correct for these potential problems since you are comparing the calculated ratios to the ratios of firms in the same industry group.

5. It is possible to correct for such problems by insuring that all firms in the same industry group are using the same accounting techniques.




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