Tutorial 3

1. Dr. Zhivàgo Diagnostics Corp. income statements for 20X1 are as follows:

Sales.......................................................................................$2,790,000
Cost of goods sold.................................................................. 1,790,000
Gross profit............................................................................ 1,000,000
Selling and administrative expense........................................ 302,000
Operating profit...................................................................... 698,000
Interest expense...................................................................... 54,800
Income before taxes............................................................... 643,200
Taxes (30%)........................................................................... 192,960
Income after taxes.................................................................. $ 450,240

a. Compute the profit margin for 20X1.

b. Assume that in 20X2, sales increase by 10 percent and cost of goods sold increases by
20 percent. The firm is able to keep all other expenses the same. Assume a tax rate of
30 percent on income before taxes. What is income after taxes and the profit margin
for 20X2?

3-1.Solution:
Dr. Zhivàgo Diagnostics

a. Profit margin for 20X1

b. Sales............................................................. $3,069,000*
Cost of goods sold........................................ 2,148,000**
Gross profit.................................................. 921,000
Selling and administrative expense.............. 302,000
Operating profit............................................ 619,000
Interest expense............................................ 54,800
Income before taxes..................................... 564,200
Taxes (30%)................................................. 169,260
Income after taxes (20X2)............................ $ 394,940

* $2,790,000 × 1.10 = $3,069,000

 ** $1,790,000 × 1.20 = $2,148,000
Profit margin for 20X2

2. Assume the following data for Cable Corporation and Multi-Media Inc.
Cable Multi-
Corporation Media Inc.
Net income................................ $ 31,200 $ 140,000
Sales.......................................... 317,000 2,700,000
Total assets................................ 402,000 965,000
Total debt.................................. 163,000 542,000
Stockholders’ equity................. 239,000 423,000

a. Compute the return on stockholders’ equity for both firms using ratio 3a. Which
firm has the higher return? NI/SE = 31,200/239,000 = 13.05%
b. Compute the following additional ratios for both firms:
Net income/Sales
Net income/Total assets
Sales/Total assets
Debt/Total assets
c. Discuss the factors from part b that added or detracted from one firm having a
higher return on stockholders’ equity than the other firm as computed in part a.

3.2- Solution:
Cable Corporation and Multi-Media Inc.
a. Cable Multi-
Corporation Media Inc.
 Multi-Media Inc. has a much higher return on
stockholders’ equity than Cable Corporation.

3-2. (Continued)
b. Cable Multi-
Corporation Media Inc.

a. As previously indicated, Multi-Media Inc. has a

substantially higher return on stockholders’ equity than
Cable Corporation (33.1 percent versus 13.05 percent). The
reason is certainly not to be found on return on the sales
dollar where Cable Corporation has a higher return than
Multi-Media Inc. (9.84 percent versus 5.19 percent).

However, Multi-Media Inc. has a higher return than Cable

Corporation on total assets (14.51 percent versus 7.76
percent). The reason is clearly to be found in total asset
turnover, which strongly favors Multi-Media Inc. over Cable
Corporation (2.8x versus .79x). This factor alone leads to the
higher return on total assets.

Multi-Media Inc.’s superior return on stockholders’ equity

is further enhanced by a higher debt ratio than Cable
Corporation (56.17 percent versus 40.55 percent). This
means that a smaller percentage of Multi-Media Inc.’s total
 assets are being financed by stockholders’ equity and thus
the potentially higher return on stockholders’ equity.

3-2. (Continued)
Although not requested in the question, one could show the
following:

Multi-Media Inc. = 14.51%/(1–.5617) = 14.51%/.4383 =

33.1%
Cable Corporation = 7.76%/(1–.4055) = 7.76%/.5945 =
13.05%

3-3. Average collection period (LO2) A firm has sales of $3 million, and 10 percent of the
sales are for cash. The year-end accounts receivable balance is $285,000. What is the
average collection period? (Use a 360-day year.)

3-3. Solution:
4. NZ’s Shoe Stores has RM 2,000,000 in yearly sales. The firm earns 3.8 percent on each
Ringgit of sales and turns over its assets 2.5 times per year. It has RM60,000 in current
liabilities and RM140,000 in long-term liabilities.
a) What is its return on stockholders’ equity?
b) If the asset base remains the same as computed in part a, but total asset turnover goes
up to 3, what will be the new return on stockholders’ equity? Assume that the profit
margin stays the same as do current and long-term liabilities.

ROE= NI/SE = 76,000 / 600,000 = 12.67%

STEP 1 (NET INCOME)
NET PROFIT MARGIN = NI/SALES
NI= NET PROFIT MARGIN *SALES = 3.8%*2,000,000 = 76,000
-------------------------------------------------------------------------------
STEP 2 (STOCKHOLDERS EQUITY)
TA= TL+SE ;
SE= TA-TL = 800,000 – 200,000 = 600,000
----------------------------------------------------------------
STEP 2 a (TOTAL ASSET)
TOTAL TURNOVER = SALES/ TA
TA= 2,000,000/2.5 = 800,000
----------------------------------------------------------------
STEP 2b (TOTAL LIABILITIES)
TL= CL+LL = 60,000+ 140,000 = 200,000

STEP 1
SALES = 800,000*3 = 2,400,000
STEP 2
NI = PROFIT MARGIN * SALES = 3.8% * 2,400,000 = 91,200
ROE= NI/SE
= 91,200 / 600,000 = 15.2%
Solution:
a) Net Income= Sales X Profit margin
 = RM 2,000,000 X 3.8%
= RM 76,000
Stockholders’ equity= Total assets- Total liabilities
Total assets= Sales/Total asset turnover
= RM 2,000,000/ 2.5
= RM 800,000
Total liabilities= Current Liabilities + Long-term liabilities
= RM 60,000 + RM140,000
= RM 200,000
Stockholders’ equity= RM 800,000- RM 200,000= RM 600,000
Return on stockholders’ equity= (Net Income/ Stockholders’ equity)
= RM 76,000/ RM 600,000 = 12.67%
b) The Value for sales will be:
Sales= Total assets X Total asset turnover
= RM 800,000 X 3
= RM 2,400,000
Net Income= Sales X Profit Margin
= RM 2,400,000 X 3.8%
= RM 91,200

Return on stockholders’ equity = (Net Income/ Stockholders’ equity)

= RM 91,200/ RM 600,000 = 15.2%
3.5 Ratio comparisons Robert Arias recently inherited a stock portfolio from his uncle.
Wishing to learn more about the companies in which he is now invested, Robert
performs a ratio analysis on each one and decides to compare them to each other.
Some of his ratios are listed below.

Island Burger Fink Roland

Ratio Electric Utility Heaven Software Motors
Current ratio 1.10 1.3 6.8 4.5
Quick ratio 0.90 0.82 5.2 3.7
Debt ratio 0.68 0.46 0.0 0.35
Net profit margin 6.2% 14.3% 28.5% 8.4%

Assuming that his uncle was a wise investor who assembled the portfolio with care,
Robert finds the wide differences in these ratios confusing. Help him out.

a) What problems might Robert encounter in comparing these companies to one another
on the basis of their ratios?
b) Why might the current and quick ratios for the electric utility and the fast-food stock
be so much lower than the same ratios for the other companies?
c) Why might it be all right for the electric utility to carry a large amount of debt, but not
the software company?
d) Why wouldn’t investors invest all of their money in software companies instead of in
less profitable companies? (Focus on risk and return.

a) The four companies are in very different industries. The operating characteristics of
firms across different industries vary significantly resulting in very different ratio
values.
b) The explanation for the lower current and quick ratios most likely rests on the fact
that these two industries operate primarily on high level of debt.
c) High level of debt can be maintained if the firm has a large, predictable, and steady
cash flow. Utilities tend to meet these cash flow requirements. The software firm will
have very uncertain and changing cash flow. The software industry is subject to
greater competition resulting in more volatile cash flow.
d) Although the software industry has potentially high profits and investment return
performance, it also has a large amount of uncertainty associated with the profits.
Also,
by placing all of the money in one stock, the benefits of reduced risk associated with
diversification are lost.