Profitability Analysis– Practice Problem
Problem #1
The balance sheet for Goodrich Corporation for 20X1 is as follows:
Assets
Current assets:
Cash $ 24,000
Accounts receivable 46,000
Total current assets $ 70,000
Long-term investments 55,000
Property, plant, and equipment 90,000
Total assets $215,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable $ 33,000
Salaries payable 12,000
Total current liabilities $ 45,000
Long-term liabilities 40,000
Total liabilities $ 85,000
Stockholders’ equity:
Paid-in capital $100,000
Retained earnings 30,000
Total stockholders’ equity 130,000
Total liabilities and stockholders’ equity $215,000
In addition, the following information for 20X1 has been assembled:
Sales $340,000
Net income 30,000
Market value at December 31, 20X1 250,000
Required
Compute the following ratios:
Return on Equity
Return on Assets
Profit Margin aka Return on sales
Asset turnover
A/R Turnover (assume all sales are on credit)
Fixed Asset Turnover
Current ratio
Problem #2
You are a bank loan officer and have been told that you can make a loan to only one of two companies.
For confidentiality reasons, the companies are identified only as Applicant X and Applicant Y. The
following information is extracted from the financial statements of the two applicants.
Applicant X Applicant Y
Total assets $400,000 $350,000
Net income 25,000 32,500
Total liabilities 150,000 250,000
Interest expense 7,000 29,500
Income tax expense 15,000 19,500
Total owners’ equity 250,000 100,000
For each of the two applicants, compute the following: Debt ratio, Debt-to-equity ratio, Times
interest earned. To which one of the two applicants would you recommend making a loan and
why?
Problem #3
According to the DuPont Framework, which of the following are drivers of ROE?
A. Profit margin, financial leverage, return on assets
B. Financial leverage, profit margin, asset turnover
C. Asset turnover, net income, stockholders’ equity
D. Gross profit, times interest earned, return on assets
Problem #4
Company X has sales of 2,500, net income of 400, total assets of 1,200, total liabilities of 500, and total
equity of 700. Calculate the ratios in the DuPont analysis. What is the primary driver of company X's ROE
of 57%?
A. High profit margins
B. High asset turnover
C. High leverage
ANSWERS
Problem #1
The balance sheet for Goodrich Corporation for 20X1 is as follows:
Assets
Current assets:
Cash $ 24,000
Accounts receivable 46,000
Total current assets $ 70,000
Long-term investments 55,000
Property, plant, and equipment 90,000
Total assets $215,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable $ 33,000
Salaries payable 12,000
Total current liabilities $ 45,000
Long-term liabilities 40,000
Total liabilities $ 85,000
Stockholders’ equity:
Paid-in capital $100,000
Retained earnings 30,000
Total stockholders’ equity 130,000
Total liabilities and stockholders’ equity $215,000
In addition, the following information for 20X1 has been assembled:
Sales $340,000
Net income 30,000
Market value at December 31, 20X1 250,000
Required
Compute the following ratios:
Return on Equity
Return on Assets
Profit Margin aka Return on sales
Asset turnover
A/R Turnover (assume all sales are on credit)
Fixed Asset Turnover
Current ratio
ROE = $30,000 / 130,000 = 23%
ROA = $30,000 / $215,000 = 14%
Profit Margin aka Return on sales = $30,000 / $340,000 = 8.8%
Asset turnover = $340,000 / $215,000 = 1.58
A/R turnover = $340,000/46,000 = 7.39
Fixed Asset turnover = $340,000 / 90,000 = 3.78
Current ratio = $70,000 / $45,000 = 1.56
Problem #2
You are a bank loan officer and have been told that you can make a loan to only one of two companies.
For confidentiality reasons, the companies are identified only as Applicant X and Applicant Y. The
following information is extracted from the financial statements of the two applicants.
Applicant X Applicant Y
Total assets $400,000 $350,000
Net income 25,000 32,500
Total liabilities 150,000 250,000
Interest expense 7,000 29,500
Income tax expense 15,000 19,500
Total owners’ equity 250,000 100,000
For each of the two applicants, compute the following: Debt ratio, Debt-to-equity ratio, Times
interest earned. To which one of the two applicants would you recommend making a loan and
why?
Applicant X Applicant Y
Debt ratio (Total liabilities / Total assets) 37.5% 71.4%
Debt-to-equity ratio (Total liabilities / Total owners’ equity) 0.60 2.50
Times interest earned 6.71 times 2.76 times
(Earnings before interest and taxes / ($47,000/$7,000) ($81,500/$29,500)
interest expense) or
(Net income + income tax expense +
interest expense /interest expense)
Applicant X is the more attractive loan candidate. Applicant X has borrowed a smaller
proportion of its past financing, making it less likely that a decline in asset value will
reduce the value of its assets below the amount of its liabilities. In addition, Applicant X
is able to cover its existing interest expense almost seven times with its existing earnings
before interest and taxes, compared to just 2.76 times for Applicant Y
Problem #3
According to the DuPont Framework, which of the following are drivers of ROE?
A. Profit margin, financial leverage, return on assets
B. Financial leverage, profit margin, asset turnover
C. Asset turnover, net income, stockholders’ equity
D. Gross profit, times interest earned, return on assets
Problem #4
Company X has sales of 2,500, net income of 400, total assets of 1,200, total liabilities of 500, and total
equity of 700. Calculate the ratios in the DuPont analysis. What is the primary driver of company X's ROE
of 57%?
A. High profit margins
B. High asset turnover
C. High leverage
Profit Margin = 400/2500 = .16
Asset Turnover = 2500/1200 = 2.08
Leverage = 1200/700 = 1.71
