1. ROE, retention rate
Example 1 :
1. A firm's financial statements reflect the following:
EBIT $2,000,000
Sales $16,000,000
Interest expense $900,000
Total assets $12,300,000
Equity $7,000,000
Effective tax rate 35%
Dividend payout rate 28%
Cacular the firm's sustainable growth rate, tax burden, interest burden , EBIT margin ?
Growth rate Tax burden Interest burden EBIT margin
A. 7.35%. 0.65 0.55 0.125
B. 10.21%. 0.55 0.65 0.125
C. 7.35% 0.5 0.65 0.125
Answer A
Explanation
ROE = tax burden × interest burden × EBIT margin × asset turnover × financial leverage
tax burden = net income/EBT
EBT = EBIT - I = 2,000,000 - 900,000 = 1,100,000
NI = (EBT)(1-t) = (1,100,000)(1 - 0.35) = 715,000
Tax burden = NI/EBT = 715,000/1,100,000 = 0.65
interest burden = EBT/EBIT = 1,100,000/2,000,000 = 0.55
EBIT margin = EBIT/revenue = 2,000,000/16,000,000 = 0.125
asset turnover = revenue/total assets = 16,000,000/12,300,000 = 1.301
ROE = [(EBIT - I)(1-t)]/equity = [(2,000,000 - 900,000)(1 - 0.35)] / 7,000,000 0.1021
-> Sustainable growth = ROE (1 - dividend payout rate)
= 0.1021 × 0.72 = 7.35%.
1.2. Would an increase in net profit margin or in the firm's dividend payout ratio increase a firm's sustainable growth rate?
Net profit margin Dividend payout ratio
A. Yes No
B. Yes Yes
C. No No
Answer A
Explanation
The sustainable growth rate is equal to ROE multiplied by the retention rate. According to the Dupont formula, an increase in net profit margin will result in higher ROE. Thus, an increase in net profit margin will result in a higher growth rate. The retention rate is equal to 1 minus the dividend payout ratio. Thus, an increase in the dividend payout ratio will lower the retention rate and lower the growth rate
2. Activity Ratios
Activity ratios measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory.
Example 2:
2. The following data applies to the XTC Company:
Sales $1,000,000.
Receivables $260,000.
Payables $600,000.
Purchases $800,000.
COGS $800,000.
Inventory $400,000.
Net Income $50,000.
Total Assets $800,000.
Debt/Equity = 200%.
What is the average collection period, the average inventory processing period, and the payables payment period for XTC Company?
A. 45 days 45 days 132 days
B. 55 days 195 days 231 days
C. 95 days 183 days 274 days
Answer CExplanation
Receivables turnover = $1,000,000 / $260,000 = 3.840
Average collection period = 365 / 3.840 = 95.05 or 95 days
Inventory turnover = $800,000 / $400,000 = 2
Average inventory processing period = 365 / 2 = 183 days
Payables turnover ratio = $800,000 / $600,000 = 1.333
Payables payment period = 365 / 1.333 = 273.82 or 274 days
3. Liquidity Ratios
Liquidity ratios measure the company’s ability to meet its short-term obligations and how quickly assets are converted into cash.
Example 3:
3. Johnson Corp. had the following financial results for the fiscal 2004 year:
Current ratio 2.00
Quick ratio 1.25
Current liabilities $100,000
Inventory turnover 12
Gross profit 25%
The only current assets are cash, accounts receivable, and inventory. The balance in these accounts has remained constant throughout the year. Johnson's net sales for 2004 were:
A. $1,200,000.
B. $900,000.
C. $300,000.
Answer A
Explanation
Gross profit = 1- COGS/Sales = 25% -> COGS is 75% of sales (1)
Current ratio = Current asset / Current liabilities
-> Current asset = 100,000*2 = $200,000
Quick ratio = (Current asset - Inventory)/ Current liabilities
-> Inventory = $75000
Inventory turnover = COGS/ Inventories
-> COGS = $900,000 (2)
(1) & (2) Sales = 900,000/75% = 1,200,000
3.1. A firm has a cash conversion cycle of 80 days. The firm's payables turnover goes from 11 to 12, what happens to the firm's cash conversion cycle? It:
A. may shorten or lengthen.
B. shortens.
C. lengthens.
Answer C
Explanation
CCC = collection period + Inv Period - Payment period.
Tăng vòng quay phải trả làm giảm số ngày phải trả đi từ đó CCC dài hơn.
4. Solvency Ratios
Solvency ratios measure a company’s ability to meet long-term obligations. Subsets of these ratios are also known as “leverage” and “long-term debt” ratios.
Example 4:
4.. Given the following income statement:
Net Sales 200
Cost of Goods Sold 55
Gross Profit 145
Operating Expenses 30
Operating Profit (EBIT) 115
Interest 15
Earnings Before Taxes (EBT) 100
Taxes 40
Earnings After Taxes (EAT) 60
What are the interest coverage ratio and the net profit margin?
Interest Coverage Ratio Net Profit Margin
A. 7.67 0.30
B. 0.57 0.56
C. 2.63 0.30
Answer A
Explanation
Interest coverage ratio = (EBIT / interest expense) = (115 / 15) = 7.67
Net profit margin = (net income / net sales) = (60 / 200) = 0.30
5. Profitability Ratios
Profitability ratios measure the company’s ability to generate profits from its resources (assets).
Example 5:
5. McQueen Corporation prepared the following common-size income statement for the year ended December 31, 20X7:Sales 100%
Cost of goods sold 60%
Gross profit 40%
For 20X7, McQueen sold 250 million units at a sales price of $1 each. For 20X8, McQueen has decided to reduce its sales price by 10%. McQueen believes the price cut will double unit sales. The cost of each unit sold is expected to remain the same. Calculate the change in McQueen's expected gross profit for 20X8 assuming the price cut doubles sales.
A. $80 million increase.
B. $150 million increase.
C. $50 million increase.
Answer C
Explanation
When sale reduce 10%, cost of each unit sold is expected to remain the same.
-> cogs/ 0.9 sales = 60%/0.9 = 67%
-> gross profit = 33%
change sale = 33% x 250 x 2 x 0.9 - 250 x1x40% = 48.5
5.1. Income Statements for Royal, Inc. for the years ended December 31, 20X0 and December 31, 20X1 were as follows (in $ millions):
20X0 20X1
Sales 78 82
Cost of Goods Sold (47) (48)
Gross Profit 31 34
Sales and Administration (13) (14)
Operating Profit (EBIT) 18 20
Interest Expense (6) (10)
Earnings Before Taxes 12 10
Income Taxes (5) (4)
Earnings after Taxes 7 6
Analysis of these statements for trends in operating profitability reveals that, with respect to Royal's gross profit margin and net profit margin:
A. Gross profit margin decreased but net profit margin increased in 20X1.
B. Gross profit margin increased in 20X1 but net profit margin decreased.
C. Both gross profit margin and net profit margin increased in 20X1.
Answer B
Explanation
Royal's gross profit margin (gross profit / sales) was higher in 20X1 (34 / 82 = 41.5%) than in 20X0 (31 / 78 = 39.7%), but net profit margin(earnings after taxes / sales) declined from
7 / 78 = 9.0% in 20X0 to 6 / 82 = 7.3% in 20X1.