Question : 149. (CMA adapted, Jun 90 #3) 2com Company a manufacturer of : 1230594

149. (CMA adapted, Jun 90 #3) 2com 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 2com’s performance. 2com’s Income Statement for the fiscal year ended October 31, Year 3, is presented below. 

2com CompanyIncome StatementFor the Year Ended October 31, Year 3($000 omitted)

Net sales

   Equipment

$6,000

   Maintenance contracts

  1,800

      Total net sales

$7,800

Expenses

   Cost of goods sold

4,600

   Customer maintenance

1,000

   Selling expense

600

   Administrative expense

900

   Interest expense

     150

      Total expenses

$7,250

Income before income taxes

$   550

   Income taxes

     220

Net income

$   330

2com’s return on sales before interest and taxes was 9 percent in fiscal Year 3 while the industry average was 12 percent. 2com’s 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, 2com’s 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, 2com’s 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 2com 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 2com 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.