Ex. 14.

2 2018 2017 2016 2015

Sales ……………………. 163% 148% 123% 118%
Cost of goods sold ……. 195% 160% 135% 123%
The trend of sales is favorable with an increase each year. However, the trend of cost of goods sold is
unfavorable, because it is increasing faster than sales. This means that the gross profit margin is shrinking
Perhaps the increase in sales volume is being achieved through cutting sales prices. Another possibility is t
the company’s purchasing policies are becoming less efficient. Investigation of the cause of the trend in cos
of goods sold is essential.
 2014
100%
100%
trend of cost of goods sold is
he gross profit margin is shrinking.
sales prices. Another possibility is that
tion of the cause of the trend in cost
 PROBLEM 14.6A
DICKSON, INC
a. In the statement of cash flows, amounts are reported on a cash basis, whereas in
the income statement, they are reported under the accrual basis. Apparently,
$5,000 of the interest expense incurred during the year had not been paid as of
year-end. This amount should be included among the accrued expenses appearing
as a current liability in the company’s balance sheet.

b. (1) Current ratio:

($189,000 ÷ .075)
($189,000
Current
÷ .075)
assets:
Cash $ 30,000
Accounts receivable 150,000
Inventory 200,000
Total current assets $ 380,000
Current liabilit $ 150,000
Current ratio ($380,000 ÷ $ 2.5 to 1

(2) Quick ratio:

($189,000 ÷ .075)
($189,000
Quick÷assets:
.075)
Cash $ 30,000
Accounts receivable 150,000
Total quick assets $ 180,000
Current liabilities $ 150,000
Quick ratio 1.2 to 1

(3) Working capital:

($189,000 ÷ .075)
($189,000
Current
÷ .075)
assets [part b (1)] $ 380,000
Less: Current liabilities 150,000
Working capital $ 230,000

(4) Debt ratio:

($189,000 ÷ .075) Total liabilities
Total assets $ 1,000,000
Less: Total 300,000
Total liabilities $ 700,000
Total assets $ 1,000,000
Debt ratio ($700,000 ÷ $1,000,000) 70%

c. By traditional measures, the company’s current ratio (2.5 to 1) and quick ratio
(1.2 to 1) appear quite adequate. The company also generates a positive cash flow
from operating activities which is twice the amount of its dividend payments to
stockholders. If this is a typical year, the company appears reasonably liquid.

d. (1) Return on assets:

Operating income:
Net sales $ 1,500,000
Less: Cost of goods sold (1,080,000)
Operating expenses (315,000)
Operating income $ 105,000
($189,000 ÷ .075)
($189,000
Total ÷
assets
.075) (at year-end) $ 1,000,000
Return on assets ($105,000 ÷ $1,000,000) 10.5%
 (2) Return on equity:
Net income $ 15,000
Total stockholders' equity (at year-end) $ 300,000
Return on equity ($15,000 ÷ $300,000) 5%

e. The 10.5% return on assets is adequate by traditional standards. However, the

5% return on equity is low. The problem arises because of Dickson, Inc.’s
relatively large interest expense, which is $84,000 for the year.

At year-end, Dickson, Inc. has total liabilities of $700,000 ($1,000,000 total assets
less $300,000 in stockholders’ equity). But $150,000 of these are current liabilities,
most of which do not bear interest. Dickson, Inc. has only about $550,000 in
interest-bearing debt.

Interest expense of $84,000 on $550,000 of interest-bearing debt indicates an

interest rate of approximately 15.27%. Obviously, it is not profitable to borrow
money at 15.27%, and then reinvest these borrowed funds to earn a pretax return
of only 10.5%. If Dickson cannot earn a return on assets that is higher than the
cost of borrowing, it should not borrow money.

f. (1) Long-term creditors do not appear to have a high margin of safety.

The debt ratio of 70% is high for American industry. Also, debt is
continuing to rise. During the current year, the company borrowed
an additional $50,000, while repaying only $14,000 of existing
liabilities. In the current year, interest payments alone amounted to
nearly twice the net cash flow from operating activities.
(2) If the current year is typical, it is doubtful that Dickson, Inc. can
continue its $20,000 annual dividend. In the current year, investing
activities consumed more than the net cash flow from operating
activities. This company is not “earning” the money it pays out as
dividends; it is borrowing it.

If it were not for the $50,000 in borrowing during the year, cash
would have decreased by $40,000, rather than increasing by $10,000.
As the year-end cash balance amounts to only $30,000, the company
obviously cannot afford to let its cash balance fall by $40,000. If the
company is not able to borrow the money to fund its dividend
payments, these payments must be reduced.
 PROBLEM 14.1A
OUTDOOR WORLD INC.
a. Common size income statement:
Outdoor World Industry
Inc. Average
Sales (net) 100% 100%
Cost of goods sold 49 58
Gross profit on sales 51% 42%
Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 6%
Income tax expense 6 3
Net income 7% 3%

b. Outdoor World, Inc.’s operating results are significantly better

than the average performance within the industry. As a percentage
of sales revenue, operating income and net income are over twice
the average for the industry. As a percentage of total assets, profits
equal an impressive 23%, as compared to 14% for the industry.
The key to success for Outdoor World, Inc. is its ability to earn a
relatively high rate of gross profit. The company’s exceptional gross
profit rate (51%) exceeds the industry average of 42%. This
probably results from a combination of factors, such as an ability to
command a premium price for the company’s products and
production efficiencies which result in lower manufacturing costs.
As a percentage of sales, Outdoor World, Inc.’s selling expenses are
five percent higher than the industry average (21% compared to
16%). These higher expenses may explain the company’s ability to
command a premium price for its products. Since the company’s
gross profit rate exceeds the industry average by 9 percentage
points, the higher-than-average selling costs may be part of a
successful marketing strategy. The company’s general and
administrative expenses are lower than the industry average, which
indicates that Outdoor World, Inc.’s management is able to
effectively control expenses.
 PROBLEM 14.7A
BEST BUY

($ in
Millions)
a. Current ratio:
(1) Beginning of year ($10,485 ÷ $7,436) 1.41 to 1

(2) End of year ($11,729 ÷ 7,777) 1.51 to 1

b. Working capital:
(1) Beginning of year ($10,485 − $7,436) $ 3,049

(2) End of year ($11,729 − $7,777) $ 3,952

d. (1) Return on average total assets:

Operating income $ 1,450
Average total assets [($14,013 + $15,256) ÷ 2] $ 14,635
Return on average total assets [$1,450 ÷ $14,635] 9.91%

(2) Return on average stockholders' equity:

Net income $ 1,235
Average stockholders' equity [($3,989 + $5,000) ÷2] $ 4,495
Return on average stockholders' equity: 27.5%
[$1,235 ÷ $4,495]

c. Best Buy's short-term debt-paying ability has increased, as evidenced by its

higher current ratio at the end of the year (1.51 vs. 1.41). The dollar amount of
working capital has also increased ($3,049 million to $3,952 million) which means
that the company has a greater 'cushion' between its currently-maturing
obligations and its most liquid assets.
e. Yes, Best Buy's management is using the company's assets to generate a strong
return on both assets (9.91%) and stockholders' equity (27.5%), while
maintaining strong liquidity with which to satisfy its obligations as they mature.
 CASE 14.2
THIRD NEBRASKA
BANK
Nebraska The
Steak Stockyards
a. Current assets ………………………………………….. Ranch
$75,000 $24,000
Current liabilities ……………………………………….. $30,000 $30,000
Current ratio:
($75,000 ÷ $30,000) ……………………… 2.5 to 1
($24,000 ÷ $30,000) ……………………… 0.80 to 1
Working capital:
$45,000
($75,000 - $30,000) ………………………………..
($24,000 - $30,000) ………………………………… ($6,000)

b. Based solely upon the financial data presented here, neither restaurant appears to
be a good risk for a $250,000 loan. Although Nebraska Steak Ranch has a strong
current ratio now, the addition of a $250,000 current liability would reduce it to
about 0.27 to 1. The $45,000 in working capital pales in significance when
compared with the need to repay a $250,000 loan in one year. The numbers for
The Stockyards show even weaker financial position.

Considering the form of business organization, however, The Stockyards appears

to be the better credit risk. The reason is that this business is organized as a sole
proprietorship. A loan to this business is actually a loan to its owner, Joe West,
because he is personally liable for the debts of the business. West, a billionaire, is a
far better candidate for a $250,000 loan than is either of these two business
entities.
Nebraska Steak Ranch, on the other hand, is organized as a corporation.
Therefore, the owner (West) is not personally responsible for the debts of the
business. In seeking payment, creditors may look only to the assets of the
corporate entity.
An interesting question arises as to why West doesn’t put more of his own money
into these businesses. In the case of Nebraska Steak Ranch, it may simply be that
he recognizes the risks inherent in the restaurant business and doesn’t want to
put his personal assets at risk. This is probably the reason that the business was
organized as a corporation in the first place.

Note to instructor: It is a common practice for wealthy individuals to organize businesses as

corporations for the specific purpose of limiting the owner’s personal liability.

c. Nebraska Steak Ranch would become as good a credit risk as The Stockyards if
West personally guarantees the loan to the corporation. This essentially removes
the difference in risk that the bank would be taking in loaning to the two
companies.
 CASE 14.5
EVALUATING LIQUIDITY AND PROFITABILITY
INTERNET

a. Student responses will vary, but they should indicate an understanding that companies have unique
operating characteristics, and understanding those before diving into financial analysis will allow one to
better understand the financial information. For example, a merchandising company has significant
inventory issues that a service company does not have. Some companies rely heavily on plant and
equipment-type assets while others do not. Some companies have significant international activities while
others operate primarily in a single country. These and other operating characteristics are important to
understand as one begins to do serious financial analysis.

b. Because students can choose both the company and the ratios they compute, no set answer can be given for
this question. The following are probably the ratios in the categories of liquidity and profitability that are
most likely to be selected by students:

Liquidity
Current ratio
Quick ratio
Inventory
turnover
Receivables
turnover
Profitability
Gross profit rate
Net income as a percentage of net sales
Basic earnings per share
Return on assets
Return on equity

c. Again, student responses will likely vary, but reasons for the popularity of the Internet for receiving
financial information include the following:

·         Timeliness and ease and frequency with which information can be updated.
·         Availability of extensive amounts of information from a single source.
·         Technology-based access and ease of storing and printing information.
·         Ease of transferring information and applying it to analytical techniques.
 CASE 14.5
ROFITABILITY
INTERNET

s have unique
s will allow one to
has significant
n plant and
onal activities while
s are important to

swer can be given for

rofitability that are

t for receiving