RED COMPANY 35
Chapter 4
Drilling Down Into the DuPont Analysis
Profitability – Efficiency – Leverage
To begin this chapter, open the Red Company model 1-Red Company 15e if it is not already open on your computer.
.7-DPont. tab
.Reset the Model.
In the last chapter, you learned how the Return on Equity % is driven by:
Net Profit Margin % Profitability
Total Assets Turnover Ratio Efficiency
Assets-to-Equity Ratio Leverage
In this chapter, you will “drill down” into each of these three elements of Return on Equity %. You will be adding thirteen new tools to your financial statement analysis tool-kit. These new tools will enable you to analyze: Profitability, Efficiency, and Leverage.
P R O F I T A B I L I T Y I N D I C A T O R S
Profitability is the ability of a company to have some number of cents left over from each $1 of Net Sales after covering all expenses. As you can see on the .7-DPont. tab, Net Profit Margin %measures Profitability and is the first ratio in the DuPont Analysis. Below you will add two additional Profitability ratios to your tool-kit. These two new ratios will measure Profitability at two different points above Net Income on the Income Statement. Thus these two new ratios will provide additional insight into what is driving the Net Profit Margin %, which is measuring Profitability at the Net Income level on the Income Statement.
.8-Prof. tab
Gross Profit Margin %
The Gross Profit Margin % measures how many cents of each $1 of Net Sales are left after deducting Cost of Goods Sold. RC’s Gross Profit Margin % of 43.00% indicates that there are 43.00 cents of each $1 of Net Sales left after deducting 57.00 cents for Cost of Goods Sold. You have previously seen this 43.00%.
1-IS tab
The 43.00% is the Gross Profit percent in the % of Net Sales column.
36 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Look at RC’s Income Statement and observe that the 43.00 cents of Gross Profit must cover:
Selling & General Expenses, and
Depreciation Expense, and
Interest Expense, and
Provision for Income Taxes, and
hopefully still have a few cents left over for Net Income.
.8-Prof. tab
Observe the up-arrow after Gross Profit Margin %—indicating that a higher value is always better. A higher value would indicate that fewer pennies are being consumed by Cost of Goods Sold and that Gross Profit is increased.
The Gross Profit Margin % is an important Profitability measure for merchandising and manufacturing companies. For merchandisers and manufacturers, the Gross Profit Margin % measures the combined effectiveness of:
Inventory purchasing
Production efficiencies
Product innovation
Product marketing
Product pricing
In summary, Gross Profit Margin % shows how many cents of each $1 of Net Sales is left after deducting Cost of Goods Sold.
Operating Profit Margin %
The Operating Profit Margin % measures how many cents of each $1 of Net Sales are left after deducting operating expenses from Gross Profit. RC’s Operating Profit Margin % of 12.33% indicates that there are 12.33 cents of each $1 of Net Sales left after deducting operating expenses from the 43.00 cents of Gross Profit. You have previously seen this 12.33%.
Annual Report Project Companies
Look at the Gross Profit Margin % for the ARP companies.
Which company has the highest Gross Profit Margin %?
_____________________________
Which company has the lowest Gross Profit Margin%?
_____________________________
For which of the companies does the Gross Profit Margin % not apply?
_____________________________
Why does the Gross Profit Margin% not apply to certain companies?
_____________________________________________________________________
As you can see from the ARP companies, the Gross Profit Margin % will vary significantly depending on the company’s industry.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 37
1-IS tab
The 12.33% is the Operating Income percent in the % of Net Sales column.
Observe that on RC’s Income Statement there are two operating expense line items, Selling & General Expenses and Depreciation Expense. The number of operating expense line items, and the titles of those operating expense line items, will vary by the type of company and by how much detail the company chooses to show on its Income Statement.
The Operating Profit Margin % measures how many cents per $1 of Net Sales is generated from operating the business. This is a measure of operating profitability. Notice on the Income Statement that the 12.33% is before deducting Interest Expense and before deducting Provision for Income Taxes. Interest Expense is the result of how management chooses to finance (debt vs. equity) not operate the company. Provision for Income Taxes (an expense) is the result of tax rates (government policy) and Pre-Tax Income. Thus you can see that the Operating Profit Margin %, which is a measurement before interest and taxes, is a good indicator of how profitably management is able to operate the business.
.8-Prof. tab
Observe the up-arrow after Operating Profit Margin %—indicating that a higher value is always better. A higher value would indicate a more profitable operation of the business.
In summary, Operating Profit Margin % measures the operating profitability of a company.
Net Profit Margin %
The Net Profit Margin % ratio shown on the .8-Prof. tab is a repeat of the Net Profit Margin % ratio
shown at the top of the .7-DPont. tab. For a discussion of Net Profit Margin %, see Pg 26. The
Net Profit Margin % is repeated on the .8-Prof. tab so that you can see all three Profitability ratios together on one tab.
Let’s make a change to the Red Company model and see how the change impacts the three Profitability ratios.
Annual Report Project Companies
Look at the Operating Profit Margin % for the ARP companies.
Which company has the highest Operating Profit Margin %?
_____________________________
Which company has the lowest Operating Profit Margin%?
_____________________________
As you can see from the ARP companies, the Operating Profit Margin % will vary a lot from company to company and industry to industry.
38 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
1-IS tab
.Reset the Model.
Enter 55 in Cost of Goods Sold Percent Tab key
.8-Prof. tab
All three of the Profitability ratios increased as a result of decreasing the number of cents Cost of Goods Sold consumes of each $1 of Net Sales:
The Gross Profit Margin % increased from 43.00% to 45.00%. This is exactly the change that would be expected when Cost of Goods Sold is decreased from 57.00% to 55.00%. Cost of Goods Sold is now consuming 2.00 fewer cents of each $1 of Net Sales; thus there are 2.00 more cents of Gross Profit available from each $1 of Net Sales.
The Operating Profit Margin % increased from 12.33% to 14.33%. This shows that the additional 2.00 cents of Gross Profit made it to the Operating Income level on the Income Statement.
The Net Profit Margin % increased from 7.71% to 9.07%. This is an increase, but the increase is less than the 2.00 percentage points increase in the Gross Profit Margin % and the Operating Profit Margin %. Let’s take a look at the Income Statement to see why the Net Profit Margin % increased less than the other two Profitability ratios.
1-IS tab
By looking at the Income Statement, you can see a 2.00 percentage point increase in Gross Profit, Operating Income, and Pre-Tax Income. You can also see that Net Income as a % of Net Sales (Net Profit Margin %) increased from 7.71% to 9.07%, an increase of only 1.36 percentage points.
Provision for Income Taxes (an expense) is the reason that all of the 2.00 additional cents did not make it down to Net Income. Currently Red Company’s Effective Income Tax Rate is 32%. This means that when Pre-Tax Income increases by 2.00 cents, the Provision for Income Taxes increases by .64 cents (2.00 cents x 32%). As a result of the .64 cents increase in taxes, only 1.36
cents (2.00 – .64) make it down to Net Income.
As you have seen, a decrease in the Cost of Goods Sold Percent has a very favorable impact on all three of the Profitability ratios. One or more of the following favorable management actions can cause a decrease in Cost of Goods Sold as a percent of Net Sales and an increase in profitability:
Purchase products more effectively.
Produce products more efficiently.
Market products more effectively, which results in the ability to increase prices.
Let’s examine the impact an increase in sales would have on the three Profitability ratios.
1-IS tab
.Reset the Model.
Enter 2,500,000 in Net Sales Tab key
.8-Prof. tab
Two of the three Profitability ratios increased as a result of increasing Net Sales by $400,000.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 39
The Gross Profit Margin % did not change. It did not change because the Cost of Goods Sold Percent stayed at 57%. The total Gross Profit dollars (the numerator) did increase, but that increase was in the same proportion as the increase in Net Sales dollars (the denominator); thus there was no change in the Gross Profit Margin %.
The Operating Profit Margin % increased from 12.33% to 14.60%, an increase of 2.27 percentage points. This increase in the Operating Profit Margin % is the result of Operating Income dollars (the numerator) increasing faster than Net Sales dollars (the denominator). Let’s take a look at the Income Statement to see the details of why the Operating Profit Margin % increased.
1-IS tab
On the Income Statement, observe that Operating Income in the % of Net Sales column is 14.60% and that it was 12.33% before the $400,000 increase in Net Sales. Also observe that Gross Profit in the % of Net Sales column is 43.00% both before and after the sales increase. If the Gross Profit Margin % stayed the same and the Operating Profit Margin %increased, it must mean that operating expenses decreased as a percent of Net Sales. That is exactly what happened. Selling & General Expenses decreased from 27.22% down to 25.50% of Net Sales. Depreciation Expense decreased from 3.45% down to 2.90% of Net Sales. As a result of these two operating expenses decreasing as a percent of Net Sales, the Operating Profit Margin % increased by 2.27 percentage points.
.8-Prof. tab
The Net Profit Margin % increased from 7.71% to 9.36%. This increase of 1.65 percentage points is .62 percentage points smaller than the increase in the Operating Profit Margin %. The two non-operating expenses on RC’s Income Statement are what caused this .62 percentage points smaller increase. Interest Expense, a non-operating item, decreased by .16 percentage points; this helped the Net Profit Margin %. Provision for Income Taxes, the other non-operating item, increased by .78 percentage points; this hurt the Net Profit Margin %.
Note: The discussion in this box is not necessary for your understanding of the Gross Profit Margin %. This discussion is based on managerial accounting concepts – but there is certainly an interplay between Financial Statement Analysis and managerial accounting.
Cost of Goods Sold is programmed in the Red Company model to be a totally variable cost. This means that Cost of Goods Sold will change by the same proportion as the change in Net Sales (and assumes that the change in Net Sales resulted from a change in the number of units sold and not a change in selling price).
For a merchandising company, Cost of Goods Sold is normally a totally variable cost. For a manufacturing company, Cost of Goods Sold is normally a mixture of variable costs and fixed costs. Thus for most manufacturing companies, the Gross Profit Margin % would be expected to increase as a result of an increase in Net Sales.
Note: The discussion in this box is not necessary for your understanding of the Operating Profit Margin %. Like the discussion in the box above, this discussion is based on managerial accounting concepts.
Selling & General Expenses (S&G Expenses) are programmed in the Red Company model as a mixture of fixed costs and variable costs. Saying the same thing in a different way—some of the S&G Expenses stay the same when sales increase (a fixed cost) and some of the S&G Expenses increase proportionally with the increase in sales (a variable cost). This results in the total S&G Expenses increasing at a lower rate than the increase in Net Sales.
Depreciation Expense is programmed in the Red Company model as a fixed cost. Depreciation does not change with a change in sales. Depreciation Expense only changes when new Equipment is purchased.
40 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
In summary, the three Profitability ratios provide insight into how much of each $1 of Net Sales makes it from the Net Sales (top) line of the Income Statement to the Net Income (bottom) line on the Income Statement.
E F F I C I E N C Y I N D I C A T O R S
.7-DPont. tab
.Reset the Model.
Efficiency, as used in DuPont Analysis, is the measurement of how effective a company is at utilizing its assets to generate sales. As you can see on the .7-DPont. tab, the Total Assets Turnover Ratio is the second ratio in the DuPont Analysis and is the ratio that measures Efficiency. The Total Assets Turnover Ratio shows how many dollars of Net Sales are generated from each $1 of Total Assets.
By looking at the Total Assets Turnover Ratio, you can see that the denominator of the ratio is Average Total Assets. To better understand what is driving this ratio, it would be helpful to develop some tools that measure the Efficiency of each of the major categories of assets that make up Total Assets. Most companies have three major asset categories:
Accounts Receivable
Inventory
Fixed Assets (property, plant, and equipment)
Next you will be introduced to a new set of financial statement analysis tools that will measure how efficiently these asset categories are being managed.
.9-Eff. tab
Annual Report Project Companies
For the ARP companies, observe the Profitability pattern that is shown by their: Gross Profit Margin %, Operating Profit Margin %, and Net Profit Margin %.
Does the company with the highest Gross Profit Margin % also have the highest
Operating Profit Margin % and Net Profit Margin %? ____ Yes ____ No (enter an X in one box)
Do the two companies in the same industry have similar Gross Profit Margin %’s?
____ Yes ____ No (enter an X in one box)
Does the company with the lowest Operating Profit Margin % also have the lowest Net
Profit Margin %? ____ Yes ____ No (enter an X in one box)
Read the box titled Discussion of Profitability.
As you can see from the ARP companies, Profitability will vary a lot from company to company and industry to industry.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 41
Accounts Receivable Turnover Ratio – Number of Days’ Sales in Receivables
To help you understand these two Efficiency Indicators for Accounts Receivable, let’s assume that a hypothetical company named Goofy Pattern Company (GPC) has the following sales and cash collection pattern. GPC sells $100 of product each day, and all of those sales are on credit. The following day GPC collects all $100 of the previous day’s credit sales—and then GPC makes another $100 of sales on credit. This sales and cash collection pattern continues for all 365 days of the year. This pattern will result in the following:
GPC will collect their Accounts Receivable balance 365 times each year.
At the end of each day, the balance in Accounts Receivable will be $100. The $100 Accounts Receivable balance is from that 1 day’s sales (the current day’s sales).
Total sales for the year will be $36,500 ($100 sales per day x 365 days in a year).
The Accounts Receivable Turnover Ratio measures how many times per year a company collects its average Accounts Receivable balance. Based on the above facts, you can easily see that GPC collects its Accounts Receivable balance 365 times per year; thus the value of GPC’s Accounts Receivable Turnover Ratio should be 365 times.
Number of Days’ Sales in Receivables measures how many days’ sales are in a company’s average Accounts Receivable balance. Based on the above facts, you can easily see that GPC has 1 day of sales in its Accounts Receivable balance; thus the value of GPC’s Number of Days’ Sales in Receivables should be 1 day.
Using the calculation formula shown on the .9-Eff. tab and the data for GPC, we can verify our observation that GPC’s Accounts Receivable Turnover Ratio is 365 times.
Net Sales $36,500 = 365.00 Times
Average Accounts Receivable, net ($100 + $100) / 2 (A/R bal. beg. of yr + A/R bal. end of yr) / 2
Using the calculation formula shown on the .9-Eff. tab and GPC’s Accounts Receivable Turnover Ratio value, we can verify our observation that GPC’s Number of Days’ Sales in Receivables is 1 day.
365 Days in a Year 365 = 1.00 Day
Accounts Receivable Turnover Ratio 365.00
While no company would have the sales and cash collection pattern of GPC, hopefully the use of this hypothetical company has given you an intuitive feel for what is being measured by the Accounts Receivable Turnover Ratio and Number of Days’ Sales in Receivables.
42 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Look at the .9-Eff. tab and observe RC’s values for these two Accounts Receivable Efficiency Indicators. RC’s values are fairly typical for a company that makes most of its sales to customers on credit1.
RC’s Accounts Receivable Turnover Ratio of 8.69 indicates that RC collects its average Accounts Receivable balance 8.69 times per year. Using RC’s Accounts Receivable Turnover Ratio value of 8.69, we can calculate that RC’s Number of Days’ Sales in Receivables is 42.00 days. Saying that RC’s Accounts Receivable Turnover Ratio is 8.69 times and that RC’s Number of Days’ Sales in Receivables is 42.00 days is saying the same thing, just in a different way.
RC’s Number of Days’ Sales in Receivables value of 42.00 days indicates that when RC makes a sale to a customer on credit, 42.00 days later that customer pays the cash to RC for the credit sale. Note that the 42.00 days is an average and will vary from customer to customer. A company’s Number of Days’ Sales in Receivables will vary depending on many factors, some of those factors are:
The current state of the economy.
The normal credit terms for the industry in which the company operates.
The actual credit terms of the company.
The credit worthiness of the customers sold to on credit.
The Accounts Receivable collection efforts of the company.
Observe the up-arrow after Accounts Receivable Turnover Ratio—indicating that a higher value is always better. Observe the down-arrow after Number of Days’ Sales in Receivables—indicating that a lower value is always better. These two arrows are indicating the same thing, collecting Accounts Receivable more often (higher turnover); and thus collecting from customers in a shorter period of time (lower days), results in a lower average Accounts Receivable balance. A lower average Accounts Receivable balance means that we are getting our cash quicker, and getting cash quicker is always a good thing.
While the discussion above about the Accounts Receivable up and down arrows is normally true, it is important to keep in mind that credit terms granted to customers and collection efforts on past-due Accounts Receivable are always a balancing act between two competing factors:
If credit terms are too restrictive (too few days before payment is expected and/or giving credit to customers with only the absolute best credit rating), customers will be dissatisfied and the company will miss out on sales. If collection efforts are too aggressive, customers will be alienated and could be lost forever.
If credit terms are too loose (too many days before payment is expected and/or granting credit to customers with questionable credit ratings), the investment in Accounts Receivable will be excessive and bad debt expense will be large.
1 Selling to customers on credit does not mean that the customer used a credit card for the transaction. Selling on credit means a company has extended certain credit terms to its customers allowing the customers to pay for the sale after a certain amount of time.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 43
The following are calculation notes related to the Accounts Receivable Efficiency Indicators:
Calculation of Average Accounts Receivable, net for the year 2021:
Dec 31, 2020 Dec 31, 2021 Average Accounts
( Accounts Receivable, net + Accounts Receivable, net ) / 2 = Receivable, net for 2021
( $246,000 + $237,288 ) / 2 = $241,644
Note: The Accounts Receivable amounts come from RC’s Balance Sheets 2-BS tab. The two Accounts Receivable amounts used for the calculation are the amounts at the beginning of 2021 and at the end of 2021. The Dec 31, 2020 amount is 2020’s ending Accounts Receivable amount and is also 2021’s beginning Accounts Receivable amount.
Average Accounts Receivable, net was rounded to a whole number—that is, to 0 decimal places. All averages in this book and in the Red Company software will always be rounded to a whole number. See the appendix on Pg 86 for rounding examples and directions.
Days in a Year will always be 365 days.
The preferred amount to use for the numerator in the Accounts Receivable Turnover Ratiowould be Net Credit Sales. In their published financial statements, companies do not split sales into cash sales and credit sales; thus the Net Sales amount shown on a company’s Income Statement will be used for the numerator in the Accounts Receivable Turnover Ratio.
There is an alternative calculation method for Number of Days’ Sales in Receivables. This alternative calculation method will result in the same value (sometimes there might be a slight difference due to rounding) as the method shown on the .9-Eff. tab . This alternative calculation method does not require that you first calculate the Accounts Receivable Turnover Ratio.
Average Accounts Receivable, net ($246,000 + $237,288) / 2 = $241,644 = 42.00 Days
Average Daily Net Sales $2,100,000 / 365 days = $5,753
In summary, the Accounts Receivable Turnover Ratio and the Number of Days’ Sales in Receivables provide insight into how efficiently a company is managing the Accounts Receivable asset.
Annual Report Project Companies
Look at the Accounts Receivable Turnover Ratio and the Number of Days’ Sales in Receivables for the ARP companies.
Which company collects its Accounts Receivable the most times per year (has the
highest Accounts Receivable Turnover Ratio)? _____________________________
Which company has the lowest Number of Days’ Sales in Receivables (excluding any
company with zero Accounts Receivable)? _____________________________
As you can see from the ARP companies, these indicators will vary a lot from company to company and industry to industry.
44 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Inventory Turnover Ratio – Number of Days’ Sales in Inventory
.9-Eff. tab
.Reset the Model.
Look at the .9-Eff. tab and observe how the Inventory Turnover Ratio is calculated. The Inventory Turnover Ratio measures how many times per year a company sells its average Inventory balance. To make this ratio easier to think about, assume that a hypothetical company has only one item in inventory. If the company’s Inventory Turnover Ratio is 4.00 times, that would mean that 4 times per year the company would:
Purchase the item from a vendor or produce the item, and
Hold the item in inventory for 3 months (12 months / 4.00), and
Sell the item to a customer.
Look at the .9-Eff. tab and observe how the Number of Days’ Sales in Inventory is calculated. Number of Days’ Sales in Inventory measures the number of days between when an inventory item is purchased from a vendor or produced internally and when that item is sold to a customer. Saying the same thing in a different way, Number of Days’ Sales in Inventory measures how long a company could make sales out of its current inventory before the inventory balance would be down to zero.
RC’s Inventory Turnover Ratio of 3.84 indicates that for the average item in inventory, RCpurchases or produces the item and then sells the item to a customer 3.84 times per year. Using RC’s Inventory Turnover Ratio value of 3.84, we can calculate that RC’s Number of Days’ Sales in Inventory is 95.05 days. Saying that RC’s Inventory Turnover Ratio is 3.84 and that RC’s Number of Days’ Sales in Inventory is 95.05 is saying the same thing, just in a different way.
A company’s Inventory Turnover Ratio and Number of Days’ Sales in Inventory will be impacted by many factors. Some of these factors are:
Demand for the company’s products, and the ability to predict that demand.
Reliability and consistency of the company’s suppliers.
Production efficiency, if the company is a manufacturer.
Complexity of the product being produced, if the company is a manufacturer.
Overall efficiency of the company’s inventory control systems.
Observe the up-arrow after Inventory Turnover Ratio—indicating that a higher value is better. Observe the down-arrow after Number of Days’ Sales in Inventory—indicating that a lower value is better. These two arrows are indicating the same thing, holding inventory for a shorter period of time before selling the inventory to a customer, results in a lower average Inventory balance. A lower Inventory balance means that less cash is invested in inventory, and that is a good thing.
While the discussion above about the Inventory up and down arrows is normally true, it is important to keep in mind that the amount of inventory a company keeps on-hand is always a balancing act between two competing factors:
If too little inventory is kept on-hand, customer service goes down as shipments are missed or delayed due to an out-of-stock condition. This will result in missed sales and customer dissatisfaction.
If too much inventory is kept on-hand, financial performance goes down as a result of the excess investment in inventory. Also, as the amount of inventory on-hand increases, the possibility of obsolete inventory increases.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 45
The following are calculation notes related to the Inventory Efficiency Indicators:
Calculation of Average Inventory for the year 2021:
Dec 31, 2020 Dec 31, 2021
( Inventory + Inventory ) / 2 = Average Inventory for 2021
( $280,000 + $343,096 ) / 2 = $311,548
Note: The Inventory amounts come from RC’s Balance Sheets 2-BS tab. The two Inventory amounts used for the calculation are the amounts at the beginning of 2021 and at the end of 2021. The Dec 31, 2020 amount is 2020’s ending Inventory amount and is also 2021’s beginning Inventory amount.
Average Inventory was rounded to a whole number.
Days in a Year will always be 365 days.
There is an alternative calculation method for Number of Days’ Sales in Inventory. This alternative calculation method will result in the same value (sometimes there might be a slight difference due to rounding) as the method shown on the .9-Eff. tab. This alternative calculation method does not require that you first calculate the Inventory Turnover Ratio.
Average Inventory ($280,000 + $343,096) / 2 = $311,548 = 95.01 Days
Average Daily Cost of Goods Sold $1,197,000 / 365 days = $3,279
In summary, the Inventory Turnover Ratio and the Number of Days’ Sales in Inventory provide insight into how efficiently a company is managing the Inventory asset.
.9-Eff. tab
.Reset the Model.
Annual Report Project Companies
Look at the Inventory Turnover Ratio and the Number of Days’ Sales in Inventory for the ARP companies.
Which company turns-over its Inventory the most times per year (has the highest
Inventory Turnover Ratio)? _____________________________
Which company has the lowest Number of Days’ Sales in Inventory?
_____________________________
The Inventory Efficiency Indicators do not apply to which company?
_____________________________
As you can see from the ARP companies, these indicators will vary a lot from company to company and industry to industry. Observe that a service company does not have inventory and thus the Inventory Efficiency Indicators do not apply.
46 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Accounts Payable Turnover Ratio – Number of Days’ Purchases in Accounts Payable
At the start of this section on Efficiency Indicators, there was a listing of the three major categories of assets that most businesses have: Accounts Receivable, Inventory, and Fixed Assets. The two Accounts Payable indicators that will be presented next are not directly related to measuring the efficient management of these three categories of assets. The reasons for including the Accounts Payable indicators as part of this Efficiency Indicators section are:
The efficient management of Accounts Payable can delay when the payment of cash is made for the purchase of inventory. Delaying the payment of Accounts Payable reduces the time cash is tied up in the Inventory asset.
Number of Days’ Purchases in Accounts Payable is needed for the Cash-to-Cash Cycleindicator, which will be introduced later.
Look at the .9-Eff. tab and observe how the Accounts Payable Turnover Ratio is calculated. The Accounts Payable Turnover Ratio measures how many times per year a company pays its average Accounts Payable balance.
Look at the .9-Eff. tab and observe how the Number of Days’ Purchases in Accounts Payable is calculated. The Number of Days’ Purchases in Accounts Payable measures how many days of inventory purchases are in a company’s average Accounts Payable balance.
RC’s Accounts Payable Turnover Ratio of 7.60 indicates that RC pays its average Accounts Payable balance 7.60 times per year. Using RC’s Accounts Payable Turnover Ratio value of 7.60, we can calculate that RC’s Number of Days’ Purchases in Accounts Payable is 48.03 days. This indicates that after making a purchase from a vendor, RC waits an average of 48.03 days before making a cash payment to the vendor. Saying that RC’s Accounts Payable Turnover Ratio is 7.60 and that RC’s Number of Days’ Purchases in Accounts Payable is 48.03 days is saying the same thing, just in a different way.
Observe the down-arrow after the Accounts Payable Turnover Ratio—indicating that a lower value is always better. Observe the up-arrow after Number of Days’ Purchases in Accounts Payable—indicating that a higher value is always better. These two arrows are indicating the same thing, paying Accounts Payable less often; thus waiting more days before paying vendors, results in a higher average Accounts Payable balance. A higher Accounts Payable balance means that we are keeping our cash longer, and that is always a good thing. Think of Accounts Payable as an interest free loan from our vendors.
While the discussion above about the Accounts Payable up and down arrows is normally true, it is important to keep in mind that holding on to our cash as long as possible and good vendor relations are always a balancing act between two competing factors:
If payments to vendors are delayed for too many days, the company’s relationships with its vendors can be damaged. The vendors can place the company on payment-in-advance or cash-on-delivery (COD) terms. Vendors that feel they have been treated badly by delayed payments, will not work with the company to meet special rush order requirements.
If payments to vendors are made too quickly, the company does not get the benefit of higher Accounts Payable balances, which are interest free loans from the vendors.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 47
The following are calculation notes related to the Accounts Payable indicators:
Calculation of Average Accounts Payable for the year 2021:
Dec 31, 2020 Dec 31, 2021
( Accounts Payable + Accounts Payable ) / 2 = Average Accounts Payable for 2021
( $140,000 + $174,827 ) / 2 = $157,414
Note: The Accounts Payable amounts come from RC’s Balance Sheets 2-BS tab. The two Accounts Payable amounts used for the calculation are the amounts at the beginning of 2021 and at the end of 2021. The Dec 31, 2020 amount is 2020’s ending Accounts Payable amount and is also 2021’s beginning Accounts Payable amount.
Average Accounts Payable was rounded to a whole number.
Days in a Year will always be 365 days.
There is an alternative calculation method for Number of Days’ Purchases in Accounts Payable. This alternative calculation method will result in the same value (sometimes there might be a slight difference due to rounding) as the method shown on the .9-Eff. tab. This alternative calculation method does not require that you first calculate the Accounts Payable Turnover Ratio.
Average Accounts Payable ($140,000 + $174,827) / 2 = $157,414 = 48.01 Days
Average Daily Cost of Goods Sold $1,197,000 / 365 days = $3,279
In summary, the Accounts Payable Turnover Ratio and the Number of Days’ Purchases in Accounts Payable provide insight into how long a company waits before paying its vendors for purchases made on credit.
.9-Eff. tab
.Reset the Model.
Annual Report Project Companies
Look at the Accounts Payable Turnover Ratio and the Number of Days’ Purchases in Accounts Payable for the ARP companies.
Which company pays its average Accounts Payable balance the least times per year
(has the lowest Accounts Payable Turnover Ratio)? ____________________________
Which company has the highest Number of Days’ Purchases in A/P?
_____________________________
As you can see from the ARP companies, these indicators will vary a lot from company to company and industry to industry.
48 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Cash-to-Cash Cycle
To better understand the Cash-to-Cash Cycle indicator, let’s follow the flow of cash through a company’s operating cycle. This discussion assumes that the company is a merchandising company. The following are the steps in the operating cycle:
1. The company orders and receives inventory. At this point the company does not pay out any cash because normally the inventory vendor grants the company credit terms. Let’s say the vendor expects payment in 48 days.
2. Cash is paid out to the vendor 48 days after the purchase of the inventory.
3. The inventory sits on the company’s shelf for some period of time—let’s say the inventory sits on the shelf for 95 days. While the company has had the inventory for 95 days, it did not have any cash invested in the inventory for the first 48 of those 95 days, because of the 48 day delay in paying cash to the vendor. Thus while the company has had the inventory on its shelf for 95 days, it only has its cash invested in the inventory for 47 days (95 total days minus 48 days before paying the vendor).
4. After 95 days the inventory is sold to a customer. At this point the company does not receive in any cash, because the company grants credit terms to its customer. Let’s say the company expects its customer to pay 42 days after the sale.
5. Cash is received in from the customer 42 days after the sale; thus completing the operating cycle.
The Cash-to-Cash Cycle indicator combines the Number of Days’ indicators for Inventory, Accounts Payable, and Accounts Receivable to quantify the number of days in the operating cycle between when cash is paid out and when cash is received in. As you can see on the .9-Eff. tab: RC’sInventory sits on the shelf for 95.05 days – RC takes 48.03 days to pay its vendors – the 95.05 days reduced by the 48.03 days results in the 47.02 days RC has its cash invested before selling the Inventory – after selling the Inventory it takes RC 42.00 days to collect cash from the customer – the net result is 89.02 days between when RC pays cash out and when RC receives cash in.
By looking at the Cash-to-Cash Cycle indicator, you can see what can be done to reduce the time between when cash is paid out and when cash is received in:
You can decrease the number of days the inventory sits on the shelf before being sold to a customer.
You can increase the number of days between when inventory is purchased from a vendor and when cash is paid out to the vendor.
You can decrease the number of days between when the inventory is sold to a customer and when cash is collected from that customer.
Observe the down-arrow after Cash-to-Cash Cycle—indicating that a lower value is always better. A lower value means that we are receiving our cash back-in faster, and that is always a good thing.
If RC’s management was to make some positive operational changes in the areas of: Inventory management, Accounts Payable policies, and Accounts Receivable policies and collection efforts, then what would be the impact on RC’s: Cash balance, Turnover Ratios, Number of Days’ indicators, and Cash-to-Cash Cycle indicator?
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 49
First, let’s see what the effects would be of reducing by 10 the number of days Inventory sits on the shelf before it is sold to a customer. This reduction of 10 days is the result of RC making positive changes to its Inventory management system.
2-BS tab
.Reset the Model.
Enter 85 in Number of Days’ Sales in Inventory Tab key
Observe the following positive changes that result from holding Inventory for 10 fewer days:
Inventory decreased from $343,096 to $277,507—a decrease of $65,589.
Cash increased from $149,783 to $215,372—an increase of $65,589.
.9-Eff. tab
The Inventory Turnover Ratio increased from 3.84 times to 4.29 times—the up-arrow after this ratio’s name indicates that an increase is good.
The Number of Days’ Sales in Inventory decreased from 95.05 days to 85.08 days—the down-arrow after this item’s name indicates that a decrease is good.
The Cash-to-Cash Days decreased from 89.02 to 79.05 days—the down-arrow after this indicator’s name shows that a decrease is good.
Next let’s see what the effects would be of increasing by 7 the number of days taken to pay Accounts Payable. This increase in the number of days taken before paying cash to vendors is the result of RC negotiating longer (better) credit terms with its vendors.
2-BS tab
Enter 55 in Number of Days’ Purchases in A/P Tab key
Observe the following positive changes that result from increasing by 7 days the time taken to pay Accounts Payable:
Accounts Payable increase from $174,827 to $220,740—an increase of $45,913.
Cash increased from $215,372 to $261,285—an increase of $45,913. The combined increase in Cash from the Inventory and Accounts Payable changes is $111,502 ($149,783 to $261,285). Observe the red message indicating that Cash is greater than $250,000. After a few more changes, RC will do something with this excess cash.
Note: Given that you entered 85 into the Number of Days’ Sales in Inventory input variable, you would have expected Number of Days’ Sales in Inventory on the 9-Eff tab to be 85.00 rather than 85.08. This slight .08 difference is caused by rounding the Inventory Turnover Ratio to 2 decimal places and then using this rounded value to calculate the Number of Days’ Sales in Inventory. When you are doing your homework and your Annual Report Project, always follow the rounding rules given in the appendix on Pg 86 and you will always be correct.
50 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
.9-Eff. tab
The Accounts Payable Turnover Ratio decreased from 7.60 times to 6.64 times—the down-arrow after this ratio’s name indicates that a decrease is good.
The Number of Days’ Purchases in Accounts Payable increased from 48.03 days to 54.97 days—the up-arrow after this item’s name indicates that an increase is good.
The Cash-to-Cash Days decreased by about 7 more days—the down-arrow after this indicator’s name shows that a decrease is a good thing. The combined decrease in the Cash-to-Cash Days from the Inventory and Accounts Payable changes is about 17 days.
Next let’s see what the effects would be of decreasing by 6 the number of days it takes to collect Accounts Receivable. The decrease in the number of days to collect cash from customers is the result of RC changing its credit terms granted to customers and an increased emphasis on collecting past-due accounts.
2-BS tab
Enter 36 in Number of Days’ Sales in A/R Tab key
Observe the following positive changes that result from decreasing by 6 days the time taken to collect Accounts Receivable:
Accounts Receivable decreased from $237,288 to $168,247—a decrease of $69,041.
Cash increased from $261,285 to $330,326—an increase of $69,041. The combined increase in Cash from the Inventory, Accounts Payable, and Accounts Receivable changes is $180,543 ($149,783 to $330,326).
.9-Eff. tab
The Accounts Receivable Turnover Ratio increased from 8.69 times to 10.14 times—the up-arrow after this ratio’s name indicates that an increase is good.
The Number of Days’ Sales in Accounts Receivable decreased from 42.00 days to 36.00 days—the down-arrow after this item’s name indicates that a decrease is good.
The Cash-to-Cash Days decreased by 6 more days—the down-arrow after this indicator’s name shows that a decrease is a good thing. By comparing the gray box values to the current values for the Cash-to-Cash Cycle indicator, you can see what caused Cash-to-Cash Days to decrease by about 23 days.
As a result of the significant decrease in its Cash-to-Cash Days, RC now has excess cash. RCnow needs to do something with that excess cash to get a positive impact on the Total Assets Turnover Ratio in the DuPont Analysis.
2-BS tab
Enter –115,000 in New Borrowing (Pay Off) on Jan. 1 (Be sure to enter this amount as a negative number.)
Enter 2,400 in Number of Shares of Stock bought back Tab key
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 51
RC has now used the excess cash to reduce the Note Payable Long-Term balance from $300,000 to $185,000, and to buy back 2,400 shares of its outstanding Common Stock.
.7-DPont. tab
Observe that the Total Assets Turnover Ratio in the DuPont Analysis has increased from 1.82 to 1.98 times. As indicated by the up-arrow after this ratio’s name this is a good change. Also observe that the positive change in this ratio has resulted from the decrease in the denominator, Average Total Assets. There has not been any increase in the numerator, Net Sales.
And finally, look at the Return on Equity % and observe the significant change from 27.34% up to 31.29%. This positive change is the result of RC more efficiently managing its assets.
.9-Eff. tab
Next you will learn one last Efficiency Indicator. This indicator will be for assets that are not part of a company’s Cash-to-Cash cycle, but these assets are normally a significant component of Total Assets.
.Reset the Model.
Fixed Asset Turnover Ratio
The Fixed Asset Turnover Ratio is discussed separately from the other Efficiency Indicators because Fixed Assets are not part of a company’s Cash-to-Cash cycle. A company does not purchase Fixed Assets (property, plant, and equipment) with the intent of selling them to customers. A company purchases Fixed Assets to use in the production and sale of products. Thus the logical efficiency measurement for Fixed Assets is how many dollars of Net Sales is the company producing with each $1 invested in Fixed Assets—that is exactly what is measured by the Fixed Asset Turnover Ratio.
As shown by the Fixed Asset Turnover Ratio, RC is currently generating $4.50 of Net Sales from each $1 of Average Net Fixed Assets. The up-arrow after this ratio’s name indicates that the more dollars of sales that can be produced from each $1 of Fixed Assets the better.
Annual Report Project Companies
Look at the Cash-to-Cash Cycle indicator for the ARP companies.
Which company has the shortest amount of time between when cash is paid out and
when cash is received in (has the lowest Cash-to-Cash Days)?
____________________________
Which company has the longest amount of time between when cash is paid out and
when cash is received in (has the highest Cash-to-Cash Days)?
_____________________________
As you can see from the ARP companies, Cash-to-Cash Days will vary a lot from company to company and industry to industry.
52 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
The following are calculation notes related to the Fixed Asset Turnover Ratio:
Calculation of Average Net Fixed Assets for the year 2021:
Dec 31, 2020 Dec 31, 2021
( Net Prop., Plant, & Equip. + Net Prop., Plant, & Equip. ) / 2 = Average Net Fixed Assets for 2021
( $440,000 + $492,500 ) / 2 = $466,250
Note: The Net Prop., Plant, & Equip. amounts come from RC’s Balance Sheets 2-BS tab. The two Net Prop., Plant, & Equip. amounts used for the calculation are the amounts at the beginning of 2021 and at the end of 2021. The Dec 31, 2020 amount is 2020’s ending Net Prop., Plant, & Equip. amount, and is also 2021’s beginning Net Prop., Plant, & Equip. amount.
Average Net Fixed Assets was rounded to a whole number.
Many different titles are used on companies’ Balance Sheets for Fixed Assets. The most often used titles are Net Property, plant, and equipment and Property, plant, and equipment, net.
If Accumulated Depreciation is shown on the Balance Sheet, the amounts used in the Average Net Fixed Assets calculation are the amounts for Property, Plant, and Equipment after deducting Accumulated Depreciation. Look at RC’s Balance Sheets for examples of this.
Let’s see the impact on this ratio if RC is able to increase Net Sales without having to purchase any additional Property, Plant, and Equipment.
1-IS tab
Enter 2,500,000 in Net Sales Tab key
.9-Eff. tab
The Fixed Asset Turnover Ratio increased significantly as a result of the numerator, Net Sales, increasing and the denominator, Average Net Fixed Assets, not changing.
This concludes this section on Efficiency Indicators. In this section, you added eight additional tools to your financial statement analysis tool-kit.
Annual Report Project Companies
Look at the Fixed Asset Turnover Ratio for the ARP companies.
Which company has the highest Fixed Asset Turnover Ratio?
____________________________
Which company has the lowest Fixed Asset Turnover Ratio?
_____________________________
For the ARP companies, review all of their Efficiency Indicators and then read the box titled Discussion of Efficiency Indicators.
As you can see from the ARP companies, the Efficiency Indicators will vary a lot from company to company and industry to industry.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 53
L E V E R A G E I N D I C A T O R S
.7-DPont. tab
.Reset the Model.
Leverage, as used in the DuPont Analysis, is the measurement of how the stockholders’ investment is leveraged up to obtain the assets used in the business. As can see on the .7-DPont. tab, the Assets-to-Equity Ratio is the third ratio in the DuPont Analysis and is the ratio that measures Leverage. The Assets-to-Equity Ratio measures how many dollars of assets a company has for each $1 of stockholders’ (owners’) investment. As discussed in Chapter 3, leverage is also referred to as financial leverage; thus the terms Leverage and financial leverage will be used interchangeably in this section.
Before leaving the .7-DPont. tab, observe the following about the Assets-to-Equity Ratio:
As calculated and used in the DuPont Analysis, this ratio measures average Leverage for the year being analyzed. Saying the same thing in a different way, the numerator is Average Total Assets and the denominator is Average Total Stockholders’ Equity. The two additional Leverage ratios that you will learn in this section will not measure the average Leverage for the year, but rather will measure the company’s Leverage at the endof the year.
As currently shown on the .7-DPont. tab, RC’s Assets-to-Equity Ratio has a value of 1.95 to 1. This indicates that on average, for the year 2021, RC has $1.95 of assets for each $1 ofstockholders’ investment. The additional $.95 of assets is the result of RC borrowing from creditors. Saying the same thing in a different way, on average for the year 2021, for each $1 of stockholders’ investment RC has borrowed $.95 from creditors. This shows that RChas a little less debt than equity.
.10-Lev. tab
On the .10-Lev. tab, you see two additional Leverage Indicators, the Debt % and the Debt-to-Equity Ratio. Like the Assets-to-Equity Ratio, these two new indicators are also measuring Leverage. The new indicators are just measuring Leverage in different ways. The reason you are being introduced to these two new indicators is because the three Leverage Indicators:
Assets-to-Equity Ratio
Debt %
Debt-to-Equity Ratio
are often used interchangeably in the financial press when discussing a company’s leverage.
Debt %
The Debt % shows the percent of each $1 of Total Assets that is financed with debt. RC’s Debt %shows that 47.42 cents of each $1 of Total Assets is financed with debt. If 47.42 cents of each $1 of Total Assets is financed with debt, then 52.58 cents of each $1 of Total Assets must be financed with equity.
54 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
The Debt % is measuring the amount of financial leverage a company has at the end of the accounting year. RC’s Debt % shown on the .10-Lev. tab is for 2021; thus the Total Liabilities amount of $579,827 and the Total Assets amount of $1,222,667 are the December 31, 2021 amounts from RC’s 2021 Balance Sheet.
2-BS tab
Observe where the dollar amount for Total Liabilities and the dollar amount for Total Assetscome from on RC’s December 31, 2021 Balance Sheet. Also note that the Debt % value of 47.42% is also shown in the % of Total column for Total Liabilities.
.10-Lev. tab
Like the DuPont Analysis Leverage indicator, Assets-to-Equity Ratio, the Debt % has up-down-arrows after its name—indicating that the desirable value depends on various factors. For a discussion of the factors that determine the desirable value of a Leverage indicator see Pg 23.
Debt-to-Equity Ratio
The Debt-to-Equity Ratio shows the amount of Total Liabilities (debt) for each $1 of Total Stockholders’ Equity (equity). RC’s Debt-to-Equity Ratio of .90 to 1 shows that RC has $.90 of debt for each $1.00 of equity.
The Debt-to-Equity Ratio is measuring the amount of financial leverage a company has at the end of the accounting year. RC’s Debt-to-Equity Ratio shown on the .10-Lev. tab is for 2021; thus the Total Liabilities amount of $579,827 and the Total Stockholders’ Equity amount of $642,840 are the December 31, 2021 amounts from RC’s 2021 Balance Sheet.
2-BS tab
Observe where the dollar amount for Total Liabilities and the dollar amount for Total Stockholders’ Equity come from on RC’s December 31, 2021 Balance Sheet.
.10-Lev. tab
Like the two other Leverage indicators, Assets-to-Equity Ratio and Debt %, the Debt-to-Equity Ratio has up-down-arrows after its name—indicating that the desirable value depends on various factors.
Observe that the Debt % and the Debt-to-Equity Ratio are each indicating the same thing—just in a different way:
A Debt % of 47.42% indicates that RC has 47.42 cents of debt and 52.58 cents of equity for each $1 of assets—a little less debt than equity.
A Debt-to-Equity Ratio of .90 shows that RC has $.90 of debt for each $1.00 of equity—a little less debt than equity.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 55
Let’s significantly increase RC’s financial leverage and see if the Debt % and the Debt-to-Equity Ratio indicate the same change in financial leverage.
2-BS tab
.Reset the Model.
Enter 250,000 in New Borrowing (Pay Off) on Jan. 1
Enter 5,000 in Number of Shares of Stock bought back Tab key
As a result of the above changes, Notes Payable Long-Term has increased from $300,000 to $550,000—increased debt. Treasury Stock has gone from $0 to ($250,000)—decreased equity.
.10-Lev. tab
Observe that the Debt % and the Debt-to-Equity Ratio still provide a consistent message:
A Debt % of 68.54% indicates that RC has 68.54 cents of debt and 31.46 cents of equity for each $1 of assets—a lot more debt than equity.
A Debt-to-Equity Ratio of 2.18 shows that RC has $2.18 of debt for each $1.00 of equity—a lot more debt than equity.
In summary, the three Leverage indicators:
Assets-to-Equity Ratio
Debt %
Debt-to-Equity Ratio
are all measuring the same thing, Leverage.
Annual Report Project Companies
Look at the Debt % and the Debt-to-Equity Ratio for the ARP companies.
Based on the Debt %, which company has the highest financial leverage (the highest
Debt %)? ____________________________
Which company has the lowest financial leverage (the lowest Debt % and the lowest
Debt-to-Equity Ratio)? ____________________________
For any of the companies, do shareholders have a larger claim to assets than the
creditors? ____ Yes ____ No (enter an X in one box)
Read the discussion about these two Leverage indicators in the box titled Discussion of Financial Leverage and Interest Coverage.
As you can see from the ARP companies, the blending of debt and equity varies a lot from company to company and industry to industry.
56 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
I N T E R E S T C O V E RA G E
.10-Lev. tab
.Reset the Model.
The Times Interest Earned Ratio is included on the .10-Lev. tab with the Debt % and the Debt-to-Equity Ratio because the debt that creates financial leverage also creates the requirement for a company to pay interest on that debt.
The Times Interest Earned Ratio measures a company’s ability to pay the interest on its debt. This ratio is currently showing that RC has available $12.33 of earnings before interest and taxes for each $1 of interest it must pay to creditors. At this level of coverage, the creditors can feel quite certain there will be adequate earnings to cover their interest.
The amounts needed to calculate this ratio are shown on the Income Statement.
1-IS tab
The numerator of the Times Interest Earned Ratio is earnings before interest expense and before income tax expense. It is calculated as follows:
Net Income …………………………………… $161,840
plus Interest Expense ……………………. 21,000
plus Provision for Income Taxes ……… 76,160
Earnings before interest and taxes … $259,000
Income taxes are paid on income after interest has been deducted; therefore the earnings available to pay interest are before income taxes. Saying the same thing in a different way, creditors get their interest before the government gets its income taxes. Given the structure of RC’s Income Statement, earnings before interest and taxes is the same as Operating Income. This will not always be true, but in RC’s case it is.
Let us see what the Income Statement and the Times Interest Earned Ratio would look like if RChad just enough earnings before interest and taxes to cover interest expense.
Enter 1,248,938 in Net Sales
Enter 60 in Cost of Goods Sold Percent Tab key
At this greatly reduced level of sales and increased cost of goods sold percent, RC has just enough earnings before interest and taxes to cover interest expense. Notice that Pre-Tax Income, Provision for Income Taxes, and Net Income are all now zero.
.10-Lev. tab
Observe that the Times Interest Earned Ratio is now equal to 1.00. RC now has available just $1 of earnings before interest and taxes for each $1 of interest expense.
Before you made the changes to Net Sales and the Cost of Goods Sold Percent, the Times Interest Earned Ratio had a value over 12. With a value that high, the creditor’s interest payments had a good margin of safety. The fact that RC still has adequate earnings to cover interest expense, after Net Sales decreased by over $850,000 (a decrease of over 40%) and after the Cost of Goods Sold Percent increased from 57 to 60, shows how large that margin of safety was.
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 57
Observe the up-arrow after this ratios name—indicating that a higher value is always better. A higher value indicates a greater ability to pay interest out of current earnings.
In summary, the Times Interest Earned Ratio provides information about a company’s ability to pay the interest on its debt. Creditors look to this ratio as one indication of the safety of their future interest payments.
Annual Report Project Companies
Look at the Times Interest Earned Ratios for the ARP companies.
Which company has the highest (best) Times Interest Earned Ratio?
____________________________
Which company has the lowest Times Interest Earned Ratio?
____________________________
Read the discussion about this ratio in the box titled Discussion of Financial Leverage and Interest Coverage.
As you can see from the ARP companies, interest coverage varies a lot from company to company and industry to industry.
58 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Chapter 4 Homework
In these exercises, you will be calculating financial statement analysis indicators that provide additional insight into what drives The Toro Company’s DuPont ratios. Specifically you will be drilling down into Toro’s: Profitability, Efficiency, and Leverage. Use the form in the Excel file Red Company Chapter 4 Homework Form to record your answers. For information and examples on how to round your answers, see the appendix on Pg 86 in the file 6 – Annual Report Project and Rounding Rules.pdf.
For these exercises, you will be using the financial statements of The Toro Company. Use Toro's financial statements that you printed when you worked the Chapter 2 Homework. For an introduction to Toro's financial statements, see Pg 18 in the file 2 – Vertical and Horizontal Analysis.pdf.
Exercise 4-1 Gross Profit Margin % (a driver of Profitability)
A. When calculating the 2017 Gross Profit Margin %, which financial statement line items are used for the:
1. Numerator? – The line item name on Toro’s financial statement and the $ amount.
2. Denominator? – The line item name on Toro’s financial statement and the $ amount.
B. Calculate Toro’s Gross Profit Margin % for 2017. Round your percent answer to 2 decimal places.
C. The Gross Profit Margin % is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Gross Profit Margin %.Which year, 2017 or 2016, had a better Gross Profit Margin %?
Exercise 4-2 Operating Profit Margin % (a driver of Profitability)
A. When calculating the 2017 Operating Profit Margin %, which financial statement line items are used for the:
1. Numerator? – The line item name on Toro’s financial statement and the $ amount.
2. Denominator? – The line item name on Toro’s financial statement and the $ amount.
B. Calculate Toro’s Operating Profit Margin % for 2017. Round your percent answer to 2 decimal places.
C. The Operating Profit Margin % is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Operating Profit Margin %. Which year, 2017 or 2016, had a better Operating Profit Margin %?
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 59
Exercise 4-3 Accounts Receivable Turnover Ratio (a driver of Efficiency) Number of Days’ Sales in Receivables
A. When calculating the 2017 Accounts Receivable Turnover Ratio, which financial statement line items are used for the:
1. Numerator? – The line item name on Toro’s financial statement and the $ amount.
2. Denominator? – (Note that the answers for this item are on the Answer Sheet. Just the Receivables, net: Customers amount should be used for the denominator.)
B. Calculate Toro’s Accounts Receivable Turnover Ratio for 2017. Round Average Accounts Receivable to a whole number. Round your final answer to 2 decimal places.
C. The Accounts Receivable Turnover Ratio is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Accounts Receivable Turnover Ratio. Which year, 2017 or 2016, had a better Accounts Receivable Turnover Ratio?
E. Calculate Toro’s Number of Days’ Sales in Receivables for 2017. Utilize the Turnover Ratio calculated in B. above. Round your final answer to 2 decimal places.
F. Number of Days’ Sales in Receivables is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
G. On the Answer Sheet under your answer for item E. is Toro’s 2016 Number of Days’ Sales in Receivables. Which year, 2017 or 2016, had a better Number of Days’ Sales in Receivables?
Exercise 4-4 Inventory Turnover Ratio (a driver of Efficiency) Number of Days’ Sales in Inventory
A. When calculating the 2017 Inventory Turnover Ratio, which financial statement line items are used for the:
1. Numerator? – The line item name on Toro’s financial statement and the $ amount.
2. Denominator? – The line item name on Toro’s financial statement and the $ amounts.
B. Calculate Toro’s Inventory Turnover Ratio for 2017. Round Average Inventory to a whole number. Round your final answer to 2 decimal places.
C. The Inventory Turnover Ratio is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Inventory Turnover Ratio. Which year, 2017 or 2016, had a better Inventory Turnover Ratio?
E. Calculate Toro’s Number of Days’ Sales in Inventory for 2017. Utilize the Turnover Ratio calculated in B. above. Round your final answer to 2 decimal places.
F. Number of Days’ Sales in Inventory is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
G. On the Answer Sheet under your answer for item E. is Toro’s 2016 Number of Days’ Sales in Inventory. Which year, 2017 or 2016, had a better Number of Days’ Sales in Inventory?
60 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
Exercise 4-5 Accounts Payable Turnover RatioNumber of Days’ Purchases in Accounts Payable
A. When calculating the 2017 Accounts Payable Turnover Ratio, which financial statement line items are used for the:
1. Numerator? – The line item name on Toro’s financial statement and the $ amount.
2. Denominator? – The line item name on Toro’s financial statement and the $ amounts.
B. Calculate Toro’s Accounts Payable Turnover Ratio for 2017. Round Average Accounts Payable to a whole number. Round your final answer to 2 decimal places.
C. The Accounts Payable Turnover Ratio is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Accounts Payable Turnover Ratio. Which year, 2017 or 2016, had a better Accounts Payable Turnover Ratio?
E. Calculate Toro’s Number of Days’ Purchases in Accounts Payable for 2017. Utilize the Turnover Ratio calculated in B. above. Round your final answer to 2 decimal places.
F. Number of Days’ Purchases in Accounts Payable is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
G. On the Answer Sheet under your answer for item E. is Toro’s 2016 Number of Days’ Purchases in Accounts Payable. Which year, 2017 or 2016, had a better Number of Days’ Purchases in Accounts Payable?
Exercise 4-6 Cash-to-Cash Cycle
A. On the Answer Sheet complete Toro’s Cash-to-Cash Cycle table for 2017 and 2016.
B. Utilizing your answer for item A., discuss Toro’s Cash-to-Cash Days for 2017 compared to 2016.
Exercise 4-7 Fixed Asset Turnover Ratio (a driver of Efficiency)
A. When calculating the 2017 Fixed Asset Turnover Ratio, which financial statement line items are used for the:
1. Numerator? – The line item name on Toro’s financial statement and the $ amount.
2. Denominator? – The line item name on Toro’s financial statement and the $ amounts.
B. Calculate Toro’s Fixed Asset Turnover Ratio for 2017. Round Average Fixed Assets to a whole number. Round your final answer to 2 decimal places.
C. The Fixed Asset Turnover Ratio is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Fixed Asset Turnover Ratio. Which year, 2017 or 2016, had a better Fixed Asset Turnover Ratio?
Chapter 4 – Profitability – Efficiency – Leverage RED COMPANY 61
Exercise 4-8 Debt % (an indicator of Leverage at year-end)
A. When calculating the 2017 Debt %, which financial statement line items are used for the:
1. Numerator? – (Note that the answer to this item is a schedule on which you will calculate the numerator, Total Liabilities for 2017. Toro does not show a line item on their Balance Sheet for Total Liabilities.)
2. Denominator? – The line item name on Toro’s financial statement and the $ amount.
B. Calculate Toro’s Debt % for 2017. Round your final answer to 2 decimal places.
C. The Debt % is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Debt %. Based on theDebt % which year, 2017 or 2016, had more financial leverage at the end of the year?
Exercise 4-9 Debt-to-Equity Ratio (an indicator of Leverage at year-end)
A. When calculating the 2017 Debt-to-Equity Ratio, which financial statement line items are used for the:
1. Numerator? – See the answer to Exercise 4-8 item A.1.
2. Denominator? – The line item name on Toro’s financial statement and the $ amount.
B. Calculate Toro’s Debt-to-Equity Ratio for 2017. Round your final answer to 2 decimal places.
C. The Debt-to-Equity Ratio is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Debt-to-Equity Ratio.Based on the Debt-to-Equity Ratio which year, 2017 or 2016, had more financial leverage at the end of the year?
Exercise 4-10 Times Interest Earned Ratio (an indicator of interest coverage)
A. When calculating the 2017 Times Interest Earned Ratio, which financial statement line items are used for the:
1. Numerator? – (Note that the answer to this item is a schedule on which you will calculate the numerator, Earnings before Interest and Taxes for 2017.)
2. Denominator? – The line item name on Toro’s financial statement and the $ amount.
B. Calculate Toro’s Times Interest Earned Ratio for 2017. Round your final answer to 2 decimal places.
C. The Times Interest Earned Ratio is a(n): up-arrow indicator down-arrow indicator up-down-arrow indicator
D. On the Answer Sheet under your answer for item B. is Toro’s 2016 Times Interest Earned Ratio. Which year, 2017 or 2016, had a better Times Interest Earned Ratio?
62 RED COMPANY Chapter 4 – Profitability – Efficiency – Leverage
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