3-20.
A firm has net income before interest and taxes of $120,000 and interest expense of $24,000.
a. What is the times interest earned ratio?
b. If the firm's lease payments are $40,000, what is the fixed charge coverage?
Solution:
a.Times interest earned?Income before interest and taxesInterest?120,000/$24,000
b.?5xIBIT?Before tax fixed chargesFixed charge coverage?Interest?Fixed charges?$120,000?$40,000$24,000?$40,000
?2.5xS-69
Copyright ? 2005 by The McGraw-Hill Companies, Inc.
3-21.
In January 1995, the Status Quo Company was formed. Total assets were
$500,000, of which $300,000 consisted of depreciable fixed assets. Status Quo uses straight-line depreciation, and in 1995 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been $26,000 per year each of the last 10 years. Other assets have not changed since 1995.
a. Compute return on assets at year-end for 1995, 1997, 2000, 2002 and 2004.
(Use $26,000 in the numerator for each year.)
b. To what do you attribute the phenomenon shown in part a?
c. Now assume income increased by 10 percent each year. What effect would
this have on your above answers? Comment.
Solution:
Status Quo Company
a. Return on assets (investment) = Income after taxes/Total assets.
The return on assets for Status Quo will increase over time as the assets depreciate and the denominator gets smaller. Fixed assets at the beginning of 1995 equal $300,000 with a ten-year life which means the depreciation expense will be $30,000 per year. Book values at year-end are as follows:
1995 = $270,000; 1997 = $210,000; 2000 = $120,000; 2002 = $60,000; 2004 = -0- Return on assets (investment)?
1995 = $26,000/$470,000 = 5.53% 1997 = $26,000/$410,000 = 6.34% 2000 = $26,000/$320,000 = 8.13% 2002 = $26,000/$260,000 = 10.00% 2004 = $26,000/200,000 = 13.00%
Income after taxesCurrent assets?Fixed assets
Copyright ? 2005 by The McGraw-Hill Companies, Inc.
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3-21. Continued
b. The increasing return on assets over time is due solely to the fact that annual depreciation charges reduce the amount of investment. The increasing return is in no way due to operations.
Financial analysts should be aware of the effect of overall asset age on the return-on-investment ratio and be able to search elsewhere for indications of operating efficiency when ROI is very high or very low.
c. As income rises, return on assets will be higher than in part (b) and would indicate an increase in return partially from more profitable operations.
3-22.
Calloway Products has the following data. Industry information also is shown.
Industry Data on Net
Year Net Income Total Assets Income/Total Assets 2002 $360,000 $3,000,000 11% 2003 380,000 3,400,000 8% 2004 380,000 3,800,000 5%
Industry Data on
Year Debt Total Assets Debt/Total Assets 2002 $1,600,000 $3,000,000 52% 2003 1,750,000 3,400,000 40% 2004 1,900,000 3,800,000 31%
As an industry analyst comparing the firm to the industry, are you more likely to praise or criticize the firm in inters of:
a. Net income/Total assets? b. Debt/Total assets?
S-71
Copyright ? 2005 by The McGraw-Hill Companies, Inc.
3-22. Continued
Solution:
Calloway Products
a. Net income/total assets Year 2002 2003 2004
Industry Ratio
11.0% 8.0% 5.0%
Although the company has shown a declining return on assets since 1997, it has performed much better than the industry. Praise may be more appropriate than criticism.
b. Debt/total assets Year Calloway Ratio Industry Ratio 2002 53.33% 52.0% 2003 51.47% 40.0% 2004 50.0% 31.0%
While the company's debt ratio is improving, it is not improving nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise.
Calloway Ratio 12.0% 11.18% 10.0%
Copyright ? 2005 by The McGraw-Hill Companies, Inc.
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3-23.
Quantum Moving Company has the following data. Industry information also is shown.
Company Data Industry Data on Net
Year Net Income Total Assets Income/Total Assets 2003 $350,000 $2,800,000 11.5% 2004 375,000 3,200,000 8.4% 2005 375,000 3,750,000 5.5%
Industry Data on
Year Debt Total Assets Debt/Total Assets 2003 $1,624,000 $2,800,000 54.1% 2004 1,730,000 3,200,000 42.0% 2005 1,900,000 3,750,000 33.4%
As an industry analyst comparing the firm to the industry, are you more likely to praise or criticize the firm in inters of:
a. Net income/total assets? b. Debt/total assets?
Solution:
Quantum Moving Company
a. Net income/total assets Year 2003 2004 2005
Industry Ratio
11.5% 8.4% 5.5%
Although the company has shown a declining return on assets since 2003, it has performed much better than the industry. Praise may be more appropriate than criticism.
Quantum Ratio 12.5% 11.7% 10.0%
S-73
Copyright ? 2005 by The McGraw-Hill Companies, Inc.