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Why are ratios useful? What are the five major categories of ratios?


General Instruction:

1. Students should work on the assignment collaboratively in groups of three or four students.

2. The purpose of this assignment is to provide students with the opportunity to: analyse the financial performance of the given companies; practice communication skills, both in writing (through word processing) and in speaking (through giving a Power Point presentation); enhance teamwork skills. 

4. Students will report on how the company performs as compared to the industry norms and where the company stands relative to its competitors in the industry. The company's weak and/or strong areas of performance must be identified and recommendations for improvement presented.

Problem #1: Financial Analysis

Chala was brought in as assistant to Bona Gemecu, 3F’s chairman, who had the task of getting the company back into a sound financial position. 3F’s 2001 and 2002 balance sheets and income statements, together with projections for 2003, are shown in the following tables. Also, the tables show the 2001 and 2002 financial ratios, along with industry average data. The 2003 projected financial statement data represent Chala’s and Bona’s best guess for 2003 results, assuming that some new financing is arranged to get the company “over the hump.”

Chala examined monthly data for 2002 (not given in the case), and she detected an improving pattern during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data looked somewhat worse than final monthly data. Also, it appears to be taking longer for the advertising program to get the message across, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between spending money and deriving benefits were longer than 3F’s managers had anticipated. For these reasons, Chala and Bona see hope for the company—provided it can survive in the short run.


Chala must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help his answer the following questions. Provide clear explanations, not yes or no answers.

a) Why are ratios useful? What are the five major categories of ratios?

b) Calculate the 2003 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity position in 2001, 2002, and as projected for 2003? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the liquidity ratios?

c) Calculate the 2003 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does 3F’s utilization of assets stack up against other firms in its industry?

d) Calculate the 2003 debt, times-interest-earned, and EBITDA coverage ratios. How does 3F compare with the industry with respect to financial leverage? What can you conclude from these ratios?

e) Calculate the 2003 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?

f) Perform a common size analysis and percent change analysis. What do these analyses tell you about 3F? What are the firm’s major strengths and weaknesses?

g) What are some potential problems and limitations of financial ratio analysis?



Problem #2: Cost-Volume Profit (CVP) Analysis


Monet Company produces memory enhancement kits for fax machines.  Sales have been very erratic with some months showing a profit and some months showing a loss.  The company’s contribution format income statement for the most recent month is given below:

               Sales(13,500 units at $20 per unit)                     $270,000

               Variable expenses                                                 189,000

                  Contribution Margin                                           81,000

                  Fixed expenses                                                    90,000

                  Net operating loss                                           $ (9,000)



1. Compute the company’s CM ratio and its break-even point in both units and dollars

2. The sales manager feels that an $8,000 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will result in a $70,000 increase in monthly sales. If the sales manager is right, what will be the effect on the company’s monthly net operating income or loss? (use the incremental approach in preparing your answer).

3. Refer to the original data.  The president is convinced that a 10% reduction in the selling price, combined with an increase of $35,000 in the monthly advertising budget will cause unit sales to double.  What will the new contribution format income statement look like if these changes are adopted?

4. Refer to the original data.  The company’s advertising agency thinks that a new package would help sales.  The new package being proposed would increase packaging costs by $0.60 per unit.  Assuming no other changes, how many units would have to be sold each month to earn a profit of $4,500?

5. Refer to the original data.  By automating certain operations, the company could slash its variable expenses in half.  However, fixed costs would increase by $118,000 per month.

a. Compute the new CM ratio and the new break-even point in both units and dollars.

b. Assume that the company expects to sell 20,000 units next month.  Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are.

c. Would you recommend that the company automate its operations?  Explain.



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