# ACCounting WEEK 4

Analyzing Profitability –

From the textbook – Financial Analysis with Microsoft Excel

Review PPT Chapter 3. ***ATTACHED

Using your financial statements from Southwest Airlines in Week 2, calculate the  following ratios : ***ATTACHED (Professor comments to fix it: For your internet exercise, you need to follow the rules for Common Sized statements – also referred to as a vertical analysis. You need to make the sales = to 100% and it will be the denominator to everything on the income statement. Total Assets will be the denominator on the balance sheet.)

Gross Profit Margin, Operating Profit Margin, Current Ratio,

From the Red Company Software Materials –

Drilling down into the Dupont Analysis

Read Red Company Chapter 4 pages 35-57. ***ATTACHED

Watch the videos at the Red Company website on the Dupont Analysis (04A, 04B, 04C)

Complete Homework EX 4-1 through 4-10

Chapter 3

Financial Statement Analysis Tools

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Analysis Tools Covered in this Chapter
In this chapter will see:
How to calculate many financial ratios
How to use financial ratios to make predictions about potential bankruptcy
How to calculate the economic profit (as opposed to net income) that a firm earned in a period

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial Ratios
Financial ratios are simply comparisons of two financial statement items
These comparisons help us to draw conclusions about the financial health of the firm that aren’t immediately obvious by looking at the raw values (e.g., net income may be positive, but what matters is how large it is relative to sales, assets, or equity)
We will calculate five categories of ratios:
Liquidity ratios
Efficiency ratios
Leverage ratios
Coverage ratios
Profitability ratios

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Liquidity Ratios
Liquidity ratios describe the ability of a firm to meets its short-term obligations by comparing current assets to current liabilities
Current assets will be converted to cash which will then be used to retire current liabilities

For both ratios, higher values are indicative of a higher probability of being able to pay off short-term debts

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Efficiency Ratios
Efficiency ratios, also called asset management ratios, provide information about how well the company is using its assets to generate sales

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Leverage Ratios (1 of 2)
Leverage ratios describe the degree to which the firm uses debt in its capital structure

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Leverage Ratios (2 of 2)
Generally, lower leverage ratios are preferred though a reasonable amount of debt is usually considered to be a good thing

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Coverage Ratios
Coverage ratios describe the quantity of funds available to “cover” certain expenses, particularly interest expense (though this is not the only one)

We generally prefer higher coverage ratios as that indicates a level of debt that is easy for the firm to service

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Ratios (1 of 2)
Profitability ratios measure how profitable a firm is relative to sales, total assets, or equity

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Profitability Ratios (2 of 2)
Without exception, higher profitability ratios are preferred over lower ones

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10

E P I’s Financial Ratios
The image to the right shows the calculations of all financial ratios that we discussed
These values were calculated using the financial statements given in Chapter 2

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

DuPont Analysis
DuPont analysis refers to a method of decomposing the return on equity into its components to better understand the R O E and why it may have changed (or why it is different than that of some other firm)
There are two versions of DuPont analysis:

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Using Financial Ratios
Financial ratios can be analyzed in three ways:
Trend Analysis
Comparing to Industry Averages
Compared to Company Goals and Debt Covenants
Additionally, ratios can be used in valuation analysis and for financial distress prediction

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Financial Distress Prediction (Z-Scores)
In 19 68, Edward Altman first used discriminant analysis to classify firms into one of three categories: bankruptcy predicted, possible bankruptcy, and no financial distress
Today, this model would be considered to be a “machine learning” model alongside other classification methods (e.g., k-means or support vector machines)
We covered two Z-Score models:
The Original Z-Score Model
The Z-Score Model for Private Firms

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Original Z-Score Model
The original Z-Score model was for publicly traded firms:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + X5
where

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Z-Score Model for Private Firms
Altman also estimated a model for privately held firms to allow for the fact that you cannot calculate the market value of equity for a private firm
This model is very similar, but the coefficients changed (note that X4 has been redefined):
Z = 0.717X1 + 0.847X2 + 3.107X3 + 0.420X4 + 0.998X5
where

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Economic Profit Measures of Performance
Economic profit is the profit earned in excess of the firm’s costs, including its implicit opportunity costs (primarily its cost of equity, which is ignored by accounting profit)
Definition of Economic Profit:
Note that economic profit is often referred to as Economic Value Added (E V A), which is a trademark of Stern Stewart and Company

Timothy R. Mayes, Financial Analysis with Microsoft Excel, 9th Edition. © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Assets
Current Ratio
Current Liabilities
=
Current AssetsInventories
Quick Ratio
Current Liabilities

=
Cost of Goods Sold
Inventory Turnover
Inventory
=
Credit Sales
Accounts Receivable Turnover
Accounts Receivable
=
Accounts Receivable
Average Collection Period
Credit Sales
360
=
Sales
Fixed Asset Turnover
Net Fixed Assets
=
Sales
Total Asset Turnover
Total Assets
=
Total Liabilities
Total Debt Ratio
Total Assets
=
Long-term Debt
Long-term Debt Ratio
Total Assets
=
Long-term Debt
LTD to Total Capitalization
Long-term DebtTotal Equity
=
+
Total Liabilities
Debt to Equity
Total Equity
=
Long-term Debt
LTD to Equity
Total Equity
=
EBIT
Times Interest Earned
Interest Expense
=
EBITNoncash Expenses
Cash Coverage Ratio
Interest Expense
+
=
Gross Profit
Gross Profit Margin
Sales
=
Net Operating Profit
Operating Profit Margin
Sales
=
Net Income
Net Profit Margin
Sales
=
Net Income
Return on Assets (ROA)
Total Assets
=
Net Income
Return on Equity (ROE)
Total Equity
=
Net Income
Return on Common Equity
Common Equity
=
Net IncomeSalesTotal Assets
DuPont ROE
SalesTotal AssetsTotal Equity
=´´
EBITEBTNet IncomeSalesTotal Assets
Extended DuPont ROE
SalesEBITEBTTotal AssetsTotal Equity
=´´´´
1
2
3
4
5
Total Assets
Retained EarningsTotal Assets
EBITTotal Assets
Market Value of EquityBook Value of Liab
ilities
SalesTotal Assets
Net WorkingCapital
X
X
X
X
X
=
=
=
=
=
1.8102.675
Bankruptcy
Predicted
Gray ZoneNo Financial
Distress
1
2
3
4
5
Total Assets
Retained EarningsTotal Assets
EBITTotal Assets
Book Value of EquityBook Value of Liabil
ities
SalesTotal Assets
Net WorkingCapital
X
X
X
X
X
=
=
=
=
=
1.212.90
Bankruptcy
Predicted
Gray ZoneNo Financial
Distress
Economic ProfitNOPATAfter-tax Cost of Op
erating Capital
NOPAT(Total Net Operating CapitalWACC)
=-
=-´

2

>Red Company Homework

numbers only with

7

% of net sales

1

.20%

0%

2

0%

3

22.50%

4

5

or selling, general and administrative expense) helped to increase the operating earnings and net earnings as a % of Net Sales from 2016 to

2017 2016

% of net sales % of net sales

1

2

3

14.17%

4

5

B.

or equity finance more of Toro’s Total assets in 2017?

liabilities

2017 2016

% of net sales % of net sales

1

2 Cost of sales

3 Gross profit

4 selling, general, and admin expense 4.72%

5 net earnings

B.

2017 2016

% of net sales % of net sales

1 Total receivables, net

2 Inventories, net

3 Accounts payable

4

B.

 Enter your answers below – 20 1 2016 EX2-1 % of net sales Cost of Sales 6 3 63. 4 Gross profit 36.70% 36. 5 selling, general, and admin expense 22.50% operating earnings 14.17% 13.97% net earnings 10.60% 9.65% B. Discuss which line item ( Cost of sales 2017 This helped operating earnings and net earnings as a percent of sales go up from 2016 to 2017, because the cost of sales was a little less in 2017. This helped. EX 2-2 Total receivables, net 12.25% 11.79% Inventories, net 22% 22.17% Accounts payable 13.61% Retained earnings 7.50% 7.88% Total stockholders’ equity 41.31% 39.72% Did liabilities EX-2-3 Net sales 4.72% 0.05% 4.21% 2.40% 5.28% 4.69% 0.62% 18.89% 14.58% Coment on the percent change in gross profit from 2016 to 2017 compared to the percent change in net sales from 2016 to 2017 It is the percentage change in net sales from 2016 to 2017. Even though net sales have gone up a lot from last year compared to gross profit. EX2-4 \$19,808 12.13% \$21,958 7.15% \$37,084 21.23% Retained Earnings \$54,285 11.30% Comment on the percent change in inventory from 2016 to 2017 compared to the percent change in cost of sales from 2016 to 2017 When you compare the percentage changes in inventory from 2016 to 2017 to the percentage changes in cost of sales from 2016 to 2017, you see that inventory changed more than cost of sales changed.

## Internet Exercise

2020

Sales

Sold

Expense

Taxes

0.25

52,100

\$0.40

2020 2019

58,664

136,807

Retained Earnings

467,507 453,591

Big Rock Candy Mountain Mining Co.

Income Statement Common Size Income Statement
2020 2019 2020 2019
Sales

100.00%

Cost of Goods

Gross Profit

Depreciation

Interest Expense

Taxes

Net Income

Net Change in Cash Balance 5,779.00

 Big RockCandy Mountain Mining Co. Income Statement For the Year Ended Dec. 31, 2020 2019 412,500 398,600 Cost of Goods 318,786 315,300 Gross Profit 93,714 83,300 =B5-B6 Selling and G&A Expenses 26,250 24,550 Other Expenses 1,210 1,245 Depreciation 29,800 29,652 EBIT 36,454 27,853 =B7-SUM(B8:B10) Interest Expense 8,582 8,457 Earnings Before Taxes 27,872 19,396 =B11-B12 6,968 4,849 =B13*B18 Netlncome 20,904 14,547 =B13-B14 Notes: Tax Rate 0.25 Shares 52,100 EPS \$0.40 Big Rock Candy Mountain Mining Co. Balance Sheet As of Dec. 31,2020 Assets Cash 16,435 11,596 Accounts Receivable 45,896 47,404 Marketable Securities 3,656 619 Inventory 52,397 54,599 Total Current Assets 118,384 114,218 =SUM(B5:B8) Gross Fixed Assets 436,573 397,023 Accumulated Depreciation 87,450 57,650 Net Plant & Equipment 349,123 339,373 =B10-B11 Total Assets 467,507 453,591 =B9+B12 Liabilities and Owner’s Equity Accounts Payable 37,752 36,819 Accured Expenses 3,183 3,085 Total Current Liabilities 40,935 39,904 =SUM(B15:B16) Long-term Debt 170,562 178,581 Total Liabilities 211,497 218,485 =B17+B18 Common Stock 58,664 Additional Paid-In-Capital 136,807 60,539 39,635 Total Shareholder’s Equity 256,010 235,106 =SUM(B20:B22) Total Liabilities and Owner’s Equity =B19+B23 Common Size Income Statement For the years 2019 and 2020 412,500.00 398,600.00 100.00% 318,786.00 315,300.00 77.28% 79.10% 93,714.00 83,300.00 22.72% 20.90% 29,800.00 29,652.00 7.22% 7.44% Selling & Admin. Expense 26,250.00 24,550.00 6.36% 6.16% Other Operating Expense ___ 1,210.00 1,245.00 0.29% 0.31% Net Operating Income 36,454.00 27,853.00 8.84% 6.99% 8,582.00 8,457.00 2.08% 2.12% Earnings Before Taxes 27,872.00 19,396.00 6.76% 4.87% 6,968.00 4,849.00 1.69% 1.22% Net Income 20,904.00 14,547.00 5.07% 3.65% New Smyrna Surf Shop Statement of Cash Flows For the Year 2020 Cash Flows from Operations 120.540.00 Depreciation Expense 7,148 Change in Accounts Receivable (11,248) Change in Inventories (8,276) Change in Accounts Payable 1,589 Total Cash Flows from Operations 109,753.00 Cash Flows from Investing Change in fixed assets (41,704) Total Cash Flows from Investing S (41,704) Cash Flows from Financing Change in Notes Payable (3,025) Change in Long-Term Debt 755 Change in Common Stock Change in Paid-In Capital Cash Dividends (60,000) Total Cash Flows from Financing (62,270.00) Net Change in Cash Balance 5,779.00 Check answer against Balance Sheet Beginning Cash From Balance Sheet 15,187 Ending Cash From Balance Sheet 20,966

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

 .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:

 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 Ratio
would 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, RC
purchases 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 Cycle
indicator, 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

 .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’s
Inventory 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. RC
now 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 end
of 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 of
stockholders’ 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 RC
has 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 Assets
come 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 RC
had 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?

____________________________

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 .

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 .

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

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

C. The Inventory Turnover Ratio is a(n):
up-arrow indicator down-arrow indicator up-down-arrow indicator

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 Ratio
Number 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

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

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 the
Debt % 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

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

1. Textfield-0:
2. Textfield-1:
3. Textfield-2:
4. Textfield-3:
5. Textfield-4:
6. Textfield-5:
7. Operating Profit Margin and Net
8. Profit Margin:
9. Yes:
10. Textfield-6:
11. Yes-0:
12. Profit Margin:

13. Yes-1:
14. highest Accounts Receivable Turnover Ratio:
15. company with zero Accounts Receivable:
16. Inventory Turnover Ratio:
17. Textfield-8:
18. Textfield-9:
19. has the lowest Accounts Payable Turnover Ratio:
20. Textfield-10:
21. Textfield-11:
22. Textfield-12:
23. Textfield-13:
24. Textfield-14:
25. Debt-0:
26. DebttoEquity Ratio-0:
27. creditors:
28. Yes-2:
29. Textfield-16:
30. Textfield-17:

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