Chapter 13 problems

13.1:
A) Current ratio = total current asset / total current liabilities

1) If cash is used to pay off current liabilities, both the current assets and the
current liabilities numbers will decrease so the current ratio will decrease to
less than 0.5.
2) Collection of accounts receivable: if accounts receivable are collected, the
amount just increases the cash available so total asset remains the same
while the total current liability is not affected at all. Therefore, the ratio will
stay the same at 0.5 if there is collection of accounts receivable.
3) Using cash to pay off long-term debt will decrease the amount for current
assets while not affect current liability. The ratio would decrease from 0.5
because the numerator is decreasing.
4) Purchase additional inventory on credit: purchasing additional inventory
will increase the current asset (by addition of that inventory) and will also
increase the current liability by the same amount. Since both assets and
liabilities are increasing, the ratio will increase from the current ratio of 0.5.
5) Sell some of the existing inventory at cost (book value): selling inventory
at cost will decrease the inventory but increase the cash by the same
amount so there wont be any different on current assets or liability.
Therefore, the ratio will still stay the same at 0.5.

B) IF the current ratio is changed to 1.20: the ratio will only be increased if
cash is used to pay off current liabilities

1) Use cash to pay off current liabilities: ratio will increase slightly even
though both current assets and current liabilities are decreased by the same
amount.
2) Collect some of the current accounts receivable: ratio will stay the same at
1.20 because there will be no change in variable (current assets will stay the
same if cash is collected from accounts receivable).
3) Use cash to pay off long term debt: the ratio will decrease from 1.20
because current liability (denominator) will stay the same while the current
assets (numerator) will decrease by the amount of cash being used to pay
the debt. Decreasing numerator while denominator stays the same will
decrease ratio.
4) Purchase additional inventory on credit: if inventory is purchased on
credit, current ratio is decreased because numerator will increase while the
denominator decreases. The ratio will decrease from 1.2.
5) Sell some of the inventory at cost: The ratio will again stay the same at
1.2 because inventory sold at cost will increase cash and decrease inventory
the same amount, having no effect on current assets or liability.
13.2) Assuming that the debt alternative has no impact on the expected
total margin, what is the difference between the expected return on equity
(ROE) if the group finances with 50 percent debt versus the expected ROE if
it finances entirely with equity capital?

Return on equity (ROE) = total margin x total asset turnover x equity

multiplier
ROE = (net income / total revenue) x (total revenue / total asset) x (total
asset / total equity)

Assets of SP: $2,000,000

Total margin: 5%
Revenue generated: $3 million

ROE = 5% x ($3,000,000/$2,000,000) x ($3,000,000/$3,000,000)

ROE = 7.5%

ROE with 100% financing through equity is 7.5%

If 50% of asset is debt financed, the total equity changes:

Equity becomes $1,500,000 instead of $3,000,000

ROE = 5% x ($3,000,000/$2,000,000) x ($3,000,000/$3,000,000)

ROE = 5% x 1.5 x 2
ROE = 15%

The difference in return on equity when it is 100% equity financing then

when it is 50% debt financing is 7.5% (15% - 7.5%). The debt financing
doubles when it is 50% debt financing versus then when it is 100%.

13.3)
1) Calculate the businesss financial ratios for 2007. Assume that Park Ridge
had $18,000 in lease payments in 2007. (Use the ratio analysis discussion to
identify the applicable ratios.)
Ratios for 2007:
a) Operations margin: operating income / operating revenue
$71,000/$2,698,000
Operation margin=2.63%

b) Profitability margin: net income (PAT) / total revenue

$99,000/$2,726,000
Profitability margin= 3.63%

c) Return on asset: net income / total asset

$99,000/$853,000
Return on asset=11.61%

d) Current ratio: total current asset / total current liabilities

$676,000/$371,000
current ratio= 1.82

e) Cash on hand: (cash equivalent + short term investment) /

(expense-depreciation/365)
$178,000/$7,156.16
Cash on hand= 25 days

f) Return on equity: net income / total equity

$99,000/$315,000
Return on equity= 31.43%

g) Debt ratio: total liabilities / total assets

$538,000/$853,000
Debt ratio= 63%

h) Debt management (capitalization ratio): long term debt / (long term

debt + equity)
$167,000/$482,000
Capitalization=34.65%

I) Equity ratio: total liabilities / total equity

$538,000/$315,000
Equity ratio= 1.707

J) Times interest earned ratio: earning before interest and tax (EBIT) /
interest expense
$118,000/$19,000
Earned interest ratio=6.2

k) Cash flow ratio: (EBIT + lease payment + depreciation expense) /

(interest expense + lease payment + debt principal)
$151,000/$50,000
Cash flow ratio=3.02

L) Asset turnover ratio: total revenue / net fixed asset

$2,726,000/$77,000
Turnover ratio= 35.4

M) Asset turnover: total revenue / total asset

$2,726,000/$853,000
Asset turnover= 3.2
 N) Collection: net account receivable / (net service revenue/365)
$476,000/$7,304.11
Collection= 65 days

2) Interpret the ratios. For the analysis, assume that the industry average
data presented in the ratio analysis section is valid for 2007.
a) Profitability margin: PRHs profitability margin is 3.63% which is below
the industry average of 6.8%. It means that it is not generating enough
revenue or expenses are too high when compared to other companies
in the same industry
b) Operating margin: PRHs operating margin is 2.63% while industry
average for operating margin is 5.5%. It means that the operating
expenses at PRH are high compared to others.
c) Return on asset: at 11.61%, PRHs ROA is more than the average for
other industries (9.5%). This means that PRHs per dollar revenue
generated by total assets is more than compared to other companies
within the industry.
d) Return on equity: PRHs ROE is 31.43%, it is higher than the industry
average of 26.3%. There is more return on equity when compared to
other companies. This mens that shareholders and investors are more
profitable.
e) Current ratio: PRHs current ratio is 1.82 while industrys is $2 which
means that PRH has slightly less amount of current asset to pay for $1
of current liability than the industry average.
f) Cash on hand: For PRH its 24.87 while the industry average for days
cash on hand is 22.6 days. This means that the liquidity position if
greater for PRH than the industry average.
g) Debt ratio: PRH debt ratio is 63% while industry average is also 63%.
This means that PRH doesnt have a greater debt finance than the
industry average.
h) Debt to capitalization ratio: PRH has greater debt to capitalization ratio
of 34.6% while industry standard is 28.6%. This means that PRH
finances more with long term debt compared to other companies.
i) Debt to equity ratio: Cant be interpreted because industry average is
not given.
j) Times interest earned ratio: PRH has higher interest earned ratio (6.2)
than the industry average (5.9). This means that PRH has $6.2 dollar of
accounting income per dollar of interest expense.
k) Cash flow coverage ratio: PRH has 3.67 while industry standard is 2.8.
This means that PRH can better cover its fixed payments with cash
than other companies
l) Fixed asset turnover ratio: PRH is 35.4 which is greater than the
industry standard of 31.4 which means that per dollar of fixed asset,
PRH generates more revenue than the industry average.
 m) Total asset turnover: PRH has better asset turnover ratio than other
companies (3.2 vs 1.4 of other companies). This means that it
effectively utilizes its assets.
n) Average collection period: PRH average collection period is 65 days
while industry average is 55.2 days so PRH takes more days to collect
receivable and the industry standard is more efficient than PRH.

13.4
a) Perform a DuPoint analysis on Best Care:
Return on equity (ROE) = total margin x total asset turnover x equity
multiplier
ROE = (net income / total revenue) x (total revenue / total asset) x (total
asset / total equity)

Total margin = net income / total revenue

X = $1,218,000/$218,613,000 = 0.0426 or 4.26%

Asset turnover: total revenue / total asset

X = $28,613,000/$9,869,000 = 2.9

Equity multiplier = total asset / equity

X = $9,869,000/$2,118,000= 4.65

ROE = total margin x total asset turnover x equity multipler

ROE = 4.26% x 2.9 x 4.65
ROE = 57.45%

This ROE is above the industry average of 25.5%. BestCares total margin
percentage, along with total asset turnover and equity multiplier are all
higher than the industry average listed. This suggests that BestCare is
performing better than other companies in the same industry.

b)
Return on assets: BestCare is generating a higher return on assets than
industry average (8%) which means that it is generating more revenue
per dollar of asset investment than other companies in its field.
$1,218,000/$9,869,000
Return on asset= 12.34%

Current ratio: BestCares is less than the industry average which

means that BestCare has $1.14 of current asset to pay for $1 of current
liability while industry average has to pay more amount for current
 asset.
$3,945,000/$3,456,000
Current ratio= 1.14

Days cash on hand: BestCares HMO cash on hand is less than industry
average which means liquidity position is lower at BCHMO than other
companies, because days cash on hand is a measure of liquidity ratio.
$2,737,000/$74.049.32
Cash on hand= 37 days

Average collection period: BestCares HMOs collection period is

greater than industry average (7 days) which means that the company
takes more days to collect its receivables than the industry collection
period. This suggests that the company can be more efficient in this
regards.
$821,000/$73,101.37
Collection period= 11.2 days

Debt ratio: BCHMOs ratio is greater than industry average (69%)

which means cost of debt will be more for BHCMO than the industry
cost of debt.
$7,751,000/$9,869,000
Debt ratio=79%

Debt-to-equity ratio: BCHMO has a greater debt to equity ratio than

industry average (2.2) which means BCHMOs one equity dollar is
financed with 3.7 dollars of debt while industry standard is financed
with a less amount.
7,751,000/2,118,000
Debt equity ratio=3.7

Times interest earned ratio: Times interest earned ratio for BCHMO is
greater than industry average (2.8) which means that the company
has $4.16 dollars of accounting income per dollar of interest expense
while the industry only has $2.2 dollars of accounting income per dollar
of account expense.
$1,603,000/$385,000
Times interest ratio=4.16

Fixed asset turnover ratio: BHCMO has a less fixed asset turnover than
the industry average (5.2). This means that it generates less revenue
per fixed dollar of fixed asset so it is underutilizing fixed assets as
compared to industry average.
$28,613,000/$5,924,000
Fixed asset ratio=4.83
13.5:
a) Perform a DuPoint analysis on Green Valley Health Care:
Return on equity (ROE) = total margin x total asset turnover x equity
multiplier
ROE = (net income / total revenue) x (total revenue / total asset) x (total
asset / total equity)

Profibility margin = net income / total revenue

X = $57,881/$3,269,404
X = 1.31

Asset turnover: total revenue / total asset

X = $3,269,404/$2,502,992 = 1.31

Equity multiplier = total asset / equity

EM = $2,502,992/$357,842 = 7.0

ROE = total margin x total asset turnover x equity multiplier

ROE = 1.77% x 1.31 x 6.99
ROE = 16.20%

This ROE for GVNH is 16.20% which is greater than industry average for
13.1%. However, industry average has higher total margins as well as total
assets turnover but GVNH has higher equity multiplier which resulted in a
higher ROE

B)
Return on assets: GVNH is generating a less return on assets than
industry average (5.2%) which means that it is generating less revenue
per dollar of asset investment than other companies in its field.
$57,881/$2,502,992
Return on asset=2.31%

Current ratio: GVNH is less than the industry average which means that
GVNH has $1.37 of current asset to pay for $1 of current liability while
industry average has to pay more amount for current asset ($2).
$608,992/$445,150
Current ratio=1.37

Days cash on hand: GVNHs cash on hand is more than industry

average (22) which means liquidity position is higher at GVNH than
other companies, because days cash on hand is a measure of liquidity
 ratio.
$305,737/$8,480.43
Cash on hand=36 days

Average collection period: GVNH collection period is greater than

industry average (19 days) which means that the company takes more
days to collect its receivables than the industry collection period. This
suggests that the company can be more efficient in this regards.
$215,000/$8,333.46
Collection period= 25 days

Debt ratio: GVNH ratio is greater than industry average (71%), which
means cost of debt will be more for GVNH than the industry cost of
debt.
$2,145,150/$2,502,992
Debt ratio= 85.7, 86%

Debt-to-equity ratio: GVNH has a greater debt to equity ratio than

industry average (2.5) which means GVNHs one equity dollar is
financed with 6 dollars of debt while industry standard is financed with
a less amount.
$2,145,150/$357,842
Equity ratio=6

Times interest earned ratio: Times interest earned ratio for GVNH is
greater than industry average (.6) which means that the company has
$1.42 dollars of accounting income per dollar of interest expense while
the industry only has $.6 dollars of accounting income per dollar of
account expense.
$295,828/$206,780
Times interest earned ratio= 1.43

Fixed asset turnover ratio: GVNH has a greater fixed asset turnover
than the industry average (1.4). This means that it generates more
revenue per fixed dollar of fixed asset than other companies in the
industry.
$3,269,404/$1,894,000
Fixed assets ratio=1.73

13.6:

The industry average ratios represented in problems 13.4 and 13.5 represent
different type of companies. 13.5 represented a managed care organization
that utilize different payment plans and services to reduce unnecessary
health costs. These organizations tend to be smaller than nursing home
industries and they work with a limited range of companies. Problem 13.5
represented a nursing home that is different from an HMO and is more
focused on providing continuous services to its residents. They usually deal
with larger number of people and provide more services than a managed
care organization. The differences in ratios were primarily in the following
areas:
The industry average for days cash on hand was different for the
managed health care industry (41 days) than the nursing home
industry (22 days). This difference probably reflects the scale of
operations of the company where nursing home industry operates on a
larger scale so they have less days of cash on hand than a managed
care organization.
The average collection period is greater for nursing homes (19 days)
than for managed care (7 days). A nursing home probably tames more
time to collect its receivable because it has more patients and more
companies involved than a managed care organization so its not as
efficient.