Question :
144. Financial statement analysis often assess the profitability and risk of : 1245965
144. Financial statement analysis often assess the profitability and risk of an organization. Specific ratios target each of these areas to answer questions such as “How profitable is this company?” or “How risky (liquid) is an investment in this company?”Required:
a.
Discuss three ratios that address how profitable a company might be.
b.
Discuss three ratios that address how risky (liquid) a company might be.
145. (CMA adapted, Jun 90 #3) Flores Company is a manufacturer of highly specialized products for networking video-conferencing equipment. Production of specialized units are, to a large extent, under contract, with standard units manufactured to marketing projections. Maintenance of customer equipment is an important area of customer satisfaction. With the recent downturn in the computer industry, the video-conferencing equipment segment has suffered, causing a slide in Flores’ performance. Flores’ Income Statement for the fiscal year ended October 31, Year 3, is presented below.
Flores CompanyIncome StatementFor the Year Ended October 31, Year 3($000 omitted)
Net sales
Equipment
$6,000
Maintenance contracts
Total net sales
Expenses
Cost of goods sold
4,600
Customer maintenance
1,000
Selling expense
600
Administrative expense
900
Interest expense
Total expenses
Income before income taxes
$ 550
Income taxes
Net income
Flores’ return on sales before interest and taxes was 9 percent in fiscal Year 3 while the industry average was 12 percent. Flores’ total asset turnover was three times, and its return on average assets before interest and taxes was 27 percent, both well below the industry average. In order to improve performance and raise these ratios nearer to, or above, industry averages, Bill Hunt, Flores’ president, established the following goals for fiscal Year 4.
·
Return on sales before interest and taxes 11 percent
·
Total asset turnover 4 times
·
Return on average assets before interest and taxes 35 percent
To achieve Hunt’s goals, Flores’ management team took into consideration the growing international video-conferencing market and proposed the following actions for fiscal Year 4.
·
Increase equipment sales prices by 10 percent.
·
Increase the cost of each unit sold by 3 percent for needed technology and quality improvements, and increased variable costs.
·
Increase maintenance inventory by $250,000 at the beginning of the year and add two maintenance technicians at a total cost of $130,000 to cover wages and related travel expenses. These revisions are intended to improve customer service and response time. The increased inventory will be financed at an annual interest rate of 12 percent; no other borrowings or loan reductions are contemplated during fiscal Year 4. All other assets will be held to fiscal Year 3 levels.
·
Increase selling expenses by $250,000 but hold administrative expenses at Year 3 levels.
·
The effective rate for Year 4 federal and state taxes is expected to be 40 percent, the same as Year 3.
It is expected that these actions will increase equipment unit sales by 6 percent, with a corresponding 6 percent growth in maintenance contracts.Required:
a.
Prepare a Pro Forma Income Statement for Flores Company for the fiscal year ending October 31, Year 4, on the assumption that the proposed actions are implemented as planned and that the increased sales objectives will be met. (All numbers should be rounded to the nearest thousand, i.e., $000 omitted.)
b.
Calculate the following ratios for Flores Company for fiscal Year 4 and determine whether Bill Hunt’s goals will be achieved.
1.
Return on sales before interest and taxes.
2.
Total asset turnover.
3.
Return on average assets before interest and taxes.
c.
Discuss the limitations and difficulties that can be encountered in using ratio analysis, particularly when making comparisons to industry averages.
b.
1.
Return on sales before interest and taxes = (Income before interest taxes) / Sales
= ($493 +329 +180) / $8,904 = 11.25%
The goal of 11 percent return on sales before interest and taxes would be exceeded by .25%.
2.
Total asset turnover = Sales / Average assets
= [$8,904 / ($2,600* + 250)] = 3.12
*
Year 3 average assets = Year 3 sales / Year 3 turnover of average assets
= $7,800 / 3 = $2,600
The goal of total asset turnover of four times would not be achieved (3.12 is less than 4).
3.
Return on average assets before interest and taxes = (Income before interest and taxes) / Average assets
= ($493 + 329 + 180) / ($2,600 + 250) = 35.15%
The goal of thirty-five percent return on average assets before interest and taxes would be exceeded by .15%.
c.
The limitations and difficulties that can be encountered in using ratio analyses include the following:
·
Various techniques are used in the analysis of financial data to emphasize the comparative and relative importance of data presented and to evaluate the position of the firm. These techniques include ratio analysis, common size analysis, examination of relative size among firms, etc. The information derived from these types of analyses should be blended. No one type of analysis is best or sufficient to support overall findings or to serve all types of users.
·
The nature of the general business environment and direct competition in a company’s geographical area can result in special situations not encountered throughout the industry which creates deviations from the industry norm.
·
Identical companies may use different valuation or expense methods (e.g., LIFO, FIFO, average cost, standard costs, different depreciation methods, etc.). Consequently, footnotes to the financial statements must be carefully analyzed to determine comparability.
