4-10

4-10 LG 6: DuPont System of Analysis

2000 Margin(%) x Turnover = ROA(%) x FL Multiple = ROE(%)

Johnson 4.9 x 2.34 = 11.47 x 1.85 = 21.21

Industry 4.1 x 2.15 = 8.82 x 1.64 = 14.46

1999

Johnson 5.8 x 2.18 = 12.64 x 1.75 = 22.13

Industry 4.7 x 2.13 = 10.01 x 1.69 = 16.92

1998

Johnson 5.9 x 2.11 = 12.45 x 1.75 = 21.79

Industry 5.4 x 2.05 = 11.07 x 1.67 = 18.49

b. Profitability: Industry net profit margins are decreasing; Johnson's net profit margins have fallen less.

Efficiency: Both industry and Johnson's asset turnover has increased.

Leverage: Only Johnson shows an increase in leverage.

As a result of these changes, the ROE has fallen for both Johnson and the industry, but Johnson has experienced a much smaller decline in its ROE.

c. Areas which require further analysis are profitability and debt. Since the total asset turnover is increasing and is superior to that of the industry, Johnson is generating an appropriate sales level for the given level of assets. But why is the net profit margin falling for both industry and Johnson? Has there been increased competition causing downward pressure on prices? Is the cost of raw materials, labor, or other expenses rising? A common-size income statement could be useful in determining the cause of the falling net profit margin.

Note: Some management teams attempt to magnify returns through the use of leverage to offset declining margins. This strategy is effective only within a narrow range. A high leverage strategy may actually result in a decline in stock price due to the increased risk.

4-11 LG 6: Cross-Sectional Ratio Analysis

Fox Manufacturing Company

Ratio Analysis

Industry Average Actual

2000 2000

Net working capital $125,000 $63,300

Current ratio 2.35 1.84

Quick ratio .87 .75

Inventory turnover 4.55 times 5.61 times

Average collection period 35.3 days 20.5 days

Fixed asset turnover 1.97 2.22

Total asset turnover 1.09 1.47

Debt ratio .30 .55

Debt-equity .615 .818

Times interest earned 12.3 8.0

Gross profit margin .202 .233

Operating profit margin .135 .133

Net profit margin .091 .072

Return on investment .099 .105

Return on equity .167 .234

Earnings per share $3.10 $2.15

Liquidity: The current and quick ratios show a weaker position relative to the industry average. (The net working capital figure should not be used in this cross-sectional analysis. It would be better applied for comparison against a trend in a time-series analysis.)

Activity: All activity ratios indicate a faster turnover of assets compared to the industry. Further analysis is necessary to determine whether the firm is in a weaker or stronger position than the industry. A higher inventory turnover ratio may indicate low inventory, resulting in stockouts, and lost sales. A shorter average collection period may indicate extremely efficient receivables management, an overly zealous credit department, or credit terms which prohibit growth in sales.

Debt: The firm uses more debt than the average firm, resulting in higher interest obligations which could reduce its ability to meet other financial obligations.

Profitability: The firm has a higher gross profit margin than the industry, indicating either a higher sales price or a lower cost of goods sold. The operating profit margin is in line with the industry, but the net profit margin is lower than industry, an indication that expenses other than cost of goods sold are higher than the industry. Most likely, the damaging factor is high interest expenses due to a greater than average amount of debt. The increased leverage, however, magnifies the return the owners receive, as evidenced by the superior ROE.

b. Fox Manufacturing Company needs improvement in its liquidity ratios and possibly a reduction in its total liabilities. The firm is more highly leveraged than the average firm in its industry, and therefore, has more financial risk. The profitability of the firm is lower than average but is enhanced by the use of debt in the capital structure resulting in a superior ROE.

4-12 LG 6: Financial Statement Analysis

Ratio Analysis

Zach Industries

Industry Actual Actual

Average 1999 2000

Current ratio 1.80 1.84 1.04

Quick ratio .70 .78 .38

Average collection period 37 days 36 days 56 days

Inventory turnover 2.50 2.59 2.33

Debt-equity 50% 51% 40%

Times interest earned 3.8 4.0 2.8

Gross profit margin 38% 40% 34%

Net profit margin 3.5% 3.6% 4.1%

Return on investment 4.0% 4.0% 4.4%

Return on equity 9.5% 8.0% 11.3%

(1) Liquidity: Zach Industries' liquidity position has deteriorated from 1999 to 2000 and is inferior to the industry average. The firm may not be able to satisfy short-term obligations as they come due.

(2) Activity: Zach Industries' ability to convert assets into cash has deteriorated from 1999 to 2000. Examination into the cause of the 21 day increase in the average collection period is warranted. Inventory turnover has also decreased for the period under review and is fair compared to industry. The firm may be holding slightly excessive inventory.

(3) Debt: Zach Industries' long-term debt position has improved since 1999 and is significantly below average. Zach Industries ability to service interest payments has deteriorated and is significantly below industry.

(4) Profitability: Although Zach Industries' gross profit margin is below its industry average, indicating high cost of goods sold, the firm has a superior net profit margin in comparison to average. The firm has lower than average operating expenses. The firm has a superior return on investment and return on equity in comparison to the industry and shows an upward trend.

Overall, the firm maintains superior profitability at the risk of illiquidity. Investigation into the management of accounts receivable and inventory is warranted.

4-13 LG 6: Integrative-Complete Ratio Analysis

Ratio Analysis

Sterling Company

Industry

Actual Actual Actual Average TS: Time-series

Ratio 1998 1999 2000 2000 CS: Cross-sectional

Net working capital $760 $720 $800 $1,600 TS: Stable

(000) CS: Poor

Current ratio 1.40 1.55 1.67 1.85 TS: Improving

CS: Fair

Quick ratio 1.00 .92 .88 1.05 TS: Deteriorating

CS: Poor

Inventory turnover 9.52 9.21 7.89 8.60 TS: Deteriorating

CS: Fair

Average collection 45.0 days 36.4 days 28.8 days 35 days TS: Improving

period CS: Good

Average payment 58.5 days 60.8 days 52.3 days 45.8 days TS: Unstable

period CS: Poor

Fixed asset turnover 1.08 1.05 1.11 1.07 TS: Unstable

CS: Good

Total asset turnover 0.74 0.80 .83 0.74 TS: Improving

CS: Good

Industry

Actual Actual Actual Average TS: Time-series

Ratio 1998 1999 2000 2000 CS: Cross-sectional

Debt ratio 0.20 0.20 0.35 0.30 TS: Increasing

CS: Fair

Debt-equity ratio 0.25 0.27 0.38 0.39 TS: Increasing

CS: Good

Times interest earned 8.2 7.3 6.5 8.0 TS: Deteriorating

CS: Poor

Fixed payment 4.5 4.2 2.7 4.2 TS: Deteriorating

coverage ratio CS: Poor

Gross profit margin 0.30 0.27 0.25 0.25 TS: Deteriorating

CS: Good

Operating profit 0.12 0.12 0.13 0.10 TS: Improving

margin CS: Good

Net profit margin 0.067 0.067 0.066 0.058 TS: Stable

CS: Good

Return on TS: Improving

investment (ROA) 0.049 0.054 0.055 0.043 CS: Good

Return on equity 0.066 0.073 0.085 0.072 TS: Improving

(ROE) CS: Good

Earnings per share $1.75 $2.20 $3.05 $1.50 TS: Improving

(EPS) CS: Good

Price/earnings 12.0 10.5 9.0 11.2 TS: Deteriorating

(P/E) CS: Poor

Liquidity: Sterling Company's overall liquidity as reflected by the current ratio, net working capital, and acid-test ratio appears to have remained relatively stable but is below the industry average.

Activity: The activity of accounts receivable has improved, but inventory turnover has deteriorated and is currently below the industry average. The firm's average payment period appears to have improved from 1998, although the firm is still paying slower than the average company.

Debt: The firm's debt ratios have increased from 1998 and are very close to the industry averages, indicating currently acceptable values but an undesirable trend. The firm's fixed payment coverage has declined and is below the industry average figure, indicating a deterioration in servicing ability.

Profitability: The firm's gross profit margin, while in line with the industry average, has declined, probably due to higher cost of goods sold. The operating and net profit margins have been stable and are also in the range of industry averages. Both the return on total assets and return on equity appear to have improved slightly and are better than the industry averages. Earnings per share made a significant increase in 1999 and 2000. The P/E ratio indicates a decreasing degree of investor confidence in the firm's future earnings potential, perhaps due to the increased debt load and higher servicing requirements.

In summary, the firm needs to attend to inventory and accounts payable and should not incur added debts until their leverage and fixed charge coverage ratios are improved. Other than these indicators, the firm appears to be doing well¾especially in generating return on sales.