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Rushen Chahal
CHAPTER 3
CHAPTER OUTLINE
I II. III. Financial ratios help us identify some of the financial strengths and weaknesses of a company. The ratios give us a way of making meaningful comparisons of a firms financial data at different points in time and with other firms. We could use ratios to answer the following important questions about a firms operations. A. Question 1: How liquid is the firm? 1. The liquidity of a business is defined as its ability to meet maturing debt obligations. That isdoes or will the firm have the resources to pay the creditors when the debt comes due? There are two ways to approach the liquidity question. a. We can look at the firms assets that are relatively liquid in nature and compare them to the amount of the debt coming due in the near term. We can look at how quickly the firms liquid assets are being converted into cash.
2.
b. B.
Question 2: Is management generating adequate operating profits on the firms assets? 1. 2. We want to know if the profits are sufficient relative to the assets being invested. We have several choices as to how we measure profits: gross profits, operating profits, or net income. Gross profits would not be acceptable 30
Question 3: How is the firm financing its assets? 1. 2. Here we are concerned with the mix of debt and equity capital the firm is using. Two primary ratios used to answer this question are the debt ratio and times interest earned. a. b. The debt ratio is the proportion of total debt to total assets. Times interest earned compares operating income to interest expense for a crude measure of the firms capacity to service its debt.
D.
Question 4: Are the owners (stockholders) receiving an adequate return on their investment? 1. We want to know if the earnings available to the firms owners, or common equity investors, are attractive when compared to the returns of owners of similar companies in the same industry. Return on equity (ROE) = net income common equity
2. 3. 4.
We demonstrate the effect of using debt on net income through an example showing how the use of debt affects a firms return on equity. Return on equity is presented as a function of: a. b. the operating income return on investment less the interest rate paid, and the amount of debt used in the capital structure relative to the equity.
IV.
An Integrative Approach to Ratio Analysis: The DuPont Analysis A. B. C. The DuPont analysis is another approach used to evaluate a firms profitability and return on equity. Its graphic technique may be helpful in seeing how ratios relate to one another and the account balances. Return on Equity is a function of a firms net profit margin, total asset turnover, and debt ratio.
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2.
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3-3.
3-4.
3-5.
3-6.
Thus, we see that OIROI is a function of how well we manage the income statement, as measured by the operating profit margin, and how well we manage the balance sheet (the firms assets), as measured by the asset turnover ratio.
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3-8.
3-2A. Mitchem's present current ratio of 2.5 to 1 in conjunction with its $2.5 million investment in current assets indicates that its current liabilities are presently $1 million.
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$4,000 $8,000
accounts receivable credit sales / 365 = $3,300 $1,000 $8,000 $4,500 = = = $8,000 $8,000
Inventory turnover
cost of goods sold inventory = = net sales = fixed assets net sales total assets
= = =
$4,700 $8,000
$1,700 = $8,000 =
Operating operating income income return = total assets on investment Return on net income = equity common equity =
$1,700 $8,000 =
.21 or 21%
.20 or 20%
or, we can calculate return on equity as: = Return on assets (1- debt ratio)
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Sales =
Thus, the needed sales growth is $7.5 million ($17.5m - $10m), or an increase of 75%: $7.5m $10m c. For last year, Operating Income Return on Investment = = = operating profit margin 10% 20% X X total asset turnover 2.0 = 75%
If sales grow by 75%, then for next year-end assuming a 10% operating profit margin: Operating Income Return on Investment = = = 3-5A. a. operating profit margin 10% 35% X X total asset turnover 3.5
Average Collection Accounts Receivable = Period Credit Sales/365 Avg Collection Period Avg Collection Period = = $562,500 (.75 x $9m)/365 30 days
Note that the average collection period is based on credit sales, which are 75% of total firm sales. b. Average collection period = 20 = Accounts Receivable (.75 x $9m)/365
Thus, Brenmar would reduce its accounts receivable by $562,500 - $369,863 = $192,637.
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3-6A. a. RATIO Liquidity: Current Ratio Acid-test (Quick) Ratio Average Collection Period Inventory Turnover Operating profitability: Operating Profit Margin Total Asset Turnover Average Collection Period Inventory Turnover Fixed Asset Turnover Financing: Debt Ratio Times Interest Earned 2002 6.0x 3.25x 137 days 1.27x 20.8% .5x 137 days 1.27x 1.00x 0.33 5.0x 2003 4.0x 1.92x 107 days 1.36x 24.8% .56x 107 days 1.36x 1.04x 0.35 5.63x 10.5%
Industry Norm 5.0x 3.0x 90 days 2.2x 20.0% .75x 90 days 2.2x 1.00x 0.33 7.0x 9.0%
b.
Regarding the firms liquidity in 2003, the current and acid-test (quick) ratios are both well below the industry averages and have decreased considerably from the prior year. Also, the average collection period and inventory turnover do not compare favorably against the industry averages, which suggests that accounts receivable and inventories are not of equal quality of these assets in other firms in the industry. So, we may reasonably conclude that Pamplin is less liquid than the average company in its industry.
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Thus, given the low operating income return on investment for Pamplin relative to the industry, we must conclude that management is not doing an adequate job of generating operating profits on the firms assets. However, they did improve between 2002 and 2003. The problem lies not with the operating profit margin, which addresses the operating costs and expenses relative to sales. Instead, the problem arises from Pamplins management not using the firms assets efficiently, as indicated by the low asset turnover ratios. Here the problem occurs in managing accounts receivable and inventories, where we see the low turnover ratios. The firm does appear to be using the fixed assets reasonably wellnote the satisfactory fixed assets turnover. d. Financing decisions A balance-sheet perspective: The debt ratio for Pamplin in 2003 is around 35%, an increase from 33% in 2002; that is, they finance slightly more than one-third of their assets with debt and a little less than two-thirds with common equity. Also, the average firm in the industry uses about the same amount of debt per dollar of assets as Pamplin. An income-statement perspective: Pamplins times interest earned is below the industry norm5.0 and 5.63 in 2002 and 2003, respectively, compared to 7.0 for the industry average. In thinking about why, we should remember that a companys times interest earned is affected by (1) the level of the firms operating profitability (EBIT), (2) the amount of debt used, and (3) the interest rate. Items 2 and 3 determine the amount of interest paid by the company. Here is what we know about Pamplin: 1. The firms operating income return on investment is below average, but improving. Thus, we would expect this fact to contribute to a lower, but also improving, times interest earned. The evidence is consistent with this thought. Pamplin uses about the same amount of debt as the average firm, which should mean that its times interest earned, all else equal, would be about the same as for the average firm. Thus, Pamplins low times interest earned is not the consequence of using more debt.
2.
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e.
Pamplin has improved its return on common equity from 7.5% in 2002 to 10.5% in 2003, compared to an industry norm of 9%. The sharp improvement has come from a significant increase in the firms operating income return on investment and a modest increase in the use of debt financing. It is also possible that the higher return on equity comes from Pamplin paying a lower interest rate on its debt, but we do not have enough information to know for certain. Nevertheless, Pamplin has enhanced the returns to its owners, but with a touch of additional financial risk (slightly higher debt ratio) in the process. Salcos total asset turnover, operating profit margin, and operating income return on investment. Total Asset Turnover = = = Operating Profit Margin = = = Operating Income Return on Investment = = = or = = = Sales Total Assets $4,500,000 $2,000,000 2.25 times Operating Income Sales $500,000 $4,500,000 11.11% Operating Income Total Assets $500,000 $2,000,000 25% Operating Income Sales x Sales Total Assets .1111 X 2.25 25%
3-7A. a.
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Net income available to common stockholders following the renovation was calculated as follows: Operating Income (.13 x $4.5m) Less: Interest ($100,000 + $50,000) Earnings Before Taxes Less: Taxes (50%) Net Income Available to Common Stockholders The increase in Common equity was calculated as follows: Total assets purchased Less: Increase in debt ($1,500,000 - $1,000,000) Increase in equity to finance purchase $ 1,000,000 (500,000) $ 500,000 $ 585,000 (150,000) 435,000 (217,500) $ 217,500
The computation above is measuring the return on equity based on the beginning-of-the-year common equity. The equity would increase $217,500 by year end.
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Comparative Analysis: A comparison of the two rates of return would argue that the renovation not be undertaken. However, since investments in fixed assets generally produce cash flows over many years, it is not appropriate to base decisions about their acquisition on a single years ratios. There are additional problems with this approach to fixed asset decision making which we will discover when we discuss capital budgeting in a later chapter. Instructors Note: To help convince those students who simply cannot accept the fact that the renovation may be worthwhile even though the return on common equity falls in the first year, we note that the existing plant is recorded on the firms books at original cost less accounting depreciation. In a period of rising replacement costs, this means that the return on common equity of 20% without renovation may actually overstate the true return earned on a more realistic replacement cost common equity base. In addition, the issue is probably one of when to renovate (this year or next) rather than whether or not to renovate. That is, the existing facility may require renovation in the next two years to continue to operate. These considerations simply cannot be incorporated in the ratio analysis performed here. We find this a very useful point to make at this juncture of the course since industry practice still frequently involves use of rules of thumb and ratio guides to the analysis of capital expenditures. 3-8A. T.P. Jarmon Instructors note: This problem serves to integrate the use of the DuPont analysis with financial ratios. The student is guided through a thorough analysis of a loan applicant that (on the surface) appears acceptable. However, an in-depth analysis reveals that the firm is not nearly so liquid as it first appears and has used a substantial amount of current debt to finance its assets. a. b. See the accompanying table. The most important ratios to consider in evaluating the firms credit request relate to its liquidity and use of financial leverage. However, the credit analyst can also evaluate the firms profitability ratios as a general indication as to how effective the firms management has been in managing the resources available to it. This latter analysis would be useful in evaluating the prospects for a long and fruitful relationship with the new client.
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43
Formula
Acid-Test Ratio
.9
.5
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Inventory Turnover Operating Income Return on Investment
= 5.48
16.8%
14%
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Ratio
Formula
Calculation $140,000 = .233 $600,000 or 23.3% $600,000 = 1.47 $408,300 $600,000 = 2.22 $270,000
1.2
1.8
Return on Assets
Net Income Total Assets Earnings Available to Common Stockholde rs Common Equity
6%
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Return on Equity
= .234
12%
or 23.4%
divided by
multipled by
divided by
Sales $600,000
Sales $600,000
Total costs and expenses $557,100 Cost of goods sold $460,000 Cash and Marketable Securites $20,200 Accounts Receivable $33,000
Cash operating expenses $30,000 Depreciation $30,000 Interest Expense $10,000 Taxes $27,100 Collection Period 20.08 days
Inventory $84,000
Inventory $84,000
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The above analysis of HiTech reveals a strong company in many areas. First, lets look at the liquidity question. How liquid is HiTechs balance sheet? The current ratio surpasses the industry, and when we subtract inventories in the acid-test ratio, HiTech still surpasses the industry. It is the same with the inventory turnover ratio. This suggests that HiTech has a lower than normal inventory level. The receivable turnover and average collection period also reveal that HiTech controls this asset better than its competitors. These ratios tell us that HiTechs liquidity relies on assets other than inventory and receivables. When we review the balance sheet, this assumption is supported for we see that $11.8 million of the $17.8 million of HiTechs current assets is in cash and cash equivalents alone. We next turn to the profitability question. HiTech compares impressively on the OIROI and operating profit margin ratios. The OIROI ratio tells us that either HiTech must be doing a superior job at sales, expenses, or generating greater sales from a lower asset level. When we look at the total asset turnover, HiTech rates slightly lower than normal. HiTech is generating the same proportionate level of sales from the same level of assets as its competitors. We know that HiTech is doing a good job of turning over its current assets. The fixed asset turnover tells us that part of the problem is in the level of fixed assets that HiTech is maintaining. As we look at the balance sheet, we see that HiTech also maintains a high level of other investments. HiTech must be doing an excellent job at controlling costs, which is supported by the excellent operating profit margin ratio. We now look at the financing question. HiTech is maintaining a 46
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Current ratio 3.11 2.83 2.54 Acid-test ratio 1.64 1.78 1.56 Average collection period 53.16 62.00 56.29 Accounts receivable turnover 6.87 5.89 6.48 Inventory turnover 3.28 3.87 4.00 Operating income return on 0.22 0.15 0.16 investment Gross profit margin 0.40 0.39 0.38 Operating profit margin 0.10 0.08 0.08 Total asset turnover 2.10 1.95 2.07 Fixed asset turnover 18.13 18.81 23.21 Debt ratio 0.43 0.79 0.71 Times interest earned 14.00 6.31 4.31 Return on equity 0.18 0.36 0.27 Note: Above ratio calculations may be subject to rounding errors.
Question #1 It is apparent that Blakes liquidity is decreasing over time, as the current and acid-test ratios indicate. However, the receivable turnover and average collection period stayed relatively constant while the inventory turnover actually increased. When we review the balance sheet, we note that the cash balance has actually increased while the receivable and inventory balances decreased, creating more liquidity within the total current assets, even though the net current asset balance decreased in total. The real problem lies with the increase in current liabilities over time in combination with the decrease in current assets. Question #2 Also of great concern is the decrease in operating profitability that is shown in the OIROI ratios over time. The problem does not seem to be in the cost of goods sold as indicated by the gross profit margin ratio. The problem appears in the operating profit margin having also decreased over time. Upon review of the income statement, we will see that while sales have decreased, the operating expenses have stayed the same. The total asset turnover and fixed asset turnover have also decreased, although not to the same degree. Blake has lowered the asset balances as sales have lowered, but still needs to work further to lower fixed assets, decrease expenses, and increase sales. Question #3 While sales and assets have decreased over time, the level of debt to equity has increased. As of 2003, 66% of Blakes assets are being financed through the use of 48
Current ratio 1.85 1.86 2.05 Acid-test ratio 1.28 1.22 1.33 Average collection period 80.75 75.92 69.69 Accounts receivable turnover 4.52 4.81 5.24 Inventory turnover 4.45 4.11 4.01 Operating income return on 0.21 0.24 0.25 investment Gross profit margin 0.41 0.41 0.42 Operating profit margin 0.14 0.14 0.15 Total asset turnover 1.51 1.64 1.71 Fixed asset turnover 8.58 10.06 9.96 Debt ratio 0.37 0.38 0.41 Times interest earned 27.54 23.45 24.73 Return on equity 0.20 0.23 0.25 Note: Above ratio calculations may be subject to rounding errors.
Question #1 Scotts liquidity increased over the last five years, despite its growth. While current liabilities increased, current assets grew by over 60%. This is reflected in the positive trend of the current ratio. Despite inventory growth of 90%, the acid-test ratio and inventory turnover both increased positively over time due to strong growth in other areas such as receivables and sales (which in turn impacted cost of goods sold on which the inventory turnover ratio is based). The receivable turnover ratio and average collection period also trended positively due to a slight increase in receivables as compared to an 84% increase in sales. Question #2 Operating profitability seems to have decreased slightly over the last five years. Upon review of the ratios in combination with the financial statements, this seems to be the result of two factors. One, operating expenses have grown disproportionately to sales over the years. Depreciation has grown due to the fixed asset growth, which is the second factor. The total asset turnover has increased as a result of the positive use of 49
50
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3-2B. Allandales present current ratio of 2.75 in conjunction with its $3.0 million investment in current assets indicates that its current liabilities are presently $1.09 million. Letting x represent the additional borrowing against the firms line of credit (which also equals the addition to current assets), we can solve for that level of x which forces the firms current ratio down to 2 to 1, i.e., 2 = ($3.0 million + x) / ($1.09 million + x) x = $.82 million 3-3B. Instructors Note: This is a very rudimentary "getting started" exercise. It requires no analysis beyond looking up the appropriate formula and plugging in the corresponding figures. Current Ratio Debt Ratio = = = = $3,500 $1,800 = = 1.94X
$3,900 = .49 or 49% $8,000 $1,500 = 4.09X $367 = $1,500 $7,500 365 3.0X = 73 days
$3,000 = $1,000
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= =
Return on assets (1- debt ratio) Total debt Net income 1 Total assets Total assets 680 (1 - .49 ) = 8,000 = = .17 or 17% Sales Total Assets $11m $6m = 1.83X
b.
2.5 = Sales = $15m Thus, the needed sales growth is $4 million ($15m - $11m) or an increase of 36%: = 36%
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If sales grow by 36%, then for next year-end assuming a 6% operating profit margin: = = = Average Collection Period Avg Collection Period Avg Collection Period X 6% 15% X 2.5
3-5B. a.
Note that the average collection period is based on credit sales, which are 75% of total firm sales. b. = 20 = Accounts Receivable (.75 x $9.75m)/36 5 Accounts = $400,685 Receivable Thus, Brenda Smith, Inc. would reduce its accounts receivable by $562,500 - $400,685 = $161,815 c. Inventory Turnover 8 Inventories = = = = $914,062.50
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3-6B. a. RATIO Liquidity: Current Ratio Acid-test (Quick) Ratio Average Collection Period Inventory Turnover Operating profitability: Operating Income Return on Investment Operating Profit Margin Total Asset Turnover Average Collection Period Inventory Turnover Fixed Asset Turnover Financing: Debt Ratio Times Interest Earned 2002 5.00 2.70 131.40 1.22 2003 5.35 2.63 108.24 1.40 Industry Norm 5.00 3.00 90.00 2.20
Regarding the firms liquidity, the acid-test (quick) ratios are below the industry average and have decreased from the prior year. Also, the average collection period and inventory turnover are well below the industry averages, which suggests that inventories and receivables are not of equal quality of these assets in other firms in the industry. Since the current ratio is satisfactory, the problem apparently lies in the management of inventories and receivables. So, we may reasonably conclude that Chavez is less liquid than the average company in its industry because it has a greater investment in inventories and receivables than the industry average.
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Thus, given the low operating income return on investment for Chavez relative to the industry, we must conclude that management is not doing an adequate job of generating operating profits on the firms assets. However, they did improve between 2002 and 2003. The problem lies not with the operating profit margin, which addresses the operating costs and expenses relative to sales. Instead, the problem arises from Chavezs management not using the firms assets efficiently, as indicated by the low asset turnover ratios. Here, the problem occurs in managing accounts receivable and inventories, where we see the low turnover ratios. The firm does appear to be using the fixed assets reasonably wellnote the satisfactory fixed assets turnover. d. Financing decisions A balance-sheet perspective: The debt ratio for Chavez in 2003 is around 33%, a decrease from 34.7% in 2002; that is, they finance about one-third of their assets with debt and a little more than two-thirds with common equity. The average firm in the industry uses about the same amount of debt per dollar of assets as Chavez. An income-statement perspective: Chavezs times interest earned is below the industry norm6.0 and 5.5 in 2002 and 2003, respectively, compared to 7.0 for the industry average. In thinking about why, we should remember that a companys times interest earned is affected by (1) the level of the firms operating profitability (EBIT), (2) the amount of debt used, and (3) the interest rate. Items 2 and 3 determine the amount of interest paid by the company. Here is what we know about Chavez: 1. The firms operating profitability is below average, but improving. Thus, we would expect this fact to contribute to a lower times interest earned. The evidence is consistent with this thought. Chavez uses about the same amount of debt as the average firm, which should mean that its times interest earned, all else equal, would be about the same as for the average firm. Thus, Chavezs low times interest earned is not the consequence of using more debt. We do not have any information about Chavezs interest rate, so we cannot make any observation about the effect of the interest rate. But we 56
2.
3.
3-7B. a.
= = or b. = =
The new operating income return on investment for Mels after the plant renovation: = = = = x .13 X $5,000,000 $3,000,000
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Net income available to common stockholders following the renovation was calculated as follows: Operating Income (.13 x $5m) Less: Interest ($100,000 + $40,000) Earnings Before Taxes Less: Taxes (40%) Net Income Available to Common Stockholders The increase in Common equity was calculated as follows: Total assets purchased Less: Increase in debt ($1,500,000 - $1,000,000) Increase in equity to finance purchase $ 1,000,000 (500,000) $ 500,000 $ 650,000 (140,000) 510,000 (204,000) $ 306,000
The computation above is measuring the return on equity based on the beginning-of-the-year common equity. The equity would increase $217,500 by year end. Pre-renovation Analysis: The pre-renovation rate of return on common equity is calculated as follows: Return on Common Equity = $240,000 $1,000,000 = 24%
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Ratio
Formula
Industry Average
1.8
Acid-Test Ratio
.9
.5
$120,000 $10,000
= 12
10 20 days 7
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Inventory Turnover
Formula
14%
$200,000 = .2857 $700,000 or 28.57% $700,000 $446,300 $700,000 $290,000 Return on Assets Net Income Total Assets Earnings Available to Common Stockholde rs Common Equity $82,900 $446,300 or $82,900 $223,300 or = 1.57
25%
1.2
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Return on Equity
= 2.41
1.8
6.0%
12%
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divided by
multipled by
divided by
Sales $700,000
Sales $700,000
Total costs and expenses $617,100 Cost of goods sold $500,000 Cash and Marketable Securites $24,200 Accounts Receivable $38,000
Cash operating expenses $50,000 Depreciation $30,000 Interest Expense $10,000 Taxes $27,100 Collection Period 19.81 days
Inventory $93,000
divided by
Inventory $93,000
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Liquidity Based on the current and acid-test ratios, Reynolds Computer is performing as well as the industry average in the area of liquidity. At a detail level, Reynolds Computer is doing much better than average in managing both receivables and inventory. As you can observe, the acid-test ratio changes little from the current ratio. Based upon the small effect that inventory has on the current ratio, we might assume that Reynolds Computer is not holding a large amount of inventory. Upon review of the balance sheet, inventory only accounts for 5% of total current assets. Cash accounts for 54% of the total current assets making Reynolds Computer much more liquid than the current ratio indicates. Profitability Reynolds Computer seems to be doing an excellent job at operating profitability based on the OIROI ratio. Lets break down this ratio into its two components We have already ascertained that Reynolds Computer is managing its accounts receivable and inventory effectively. From the fixed asset ratio, Reynolds Computer is also managing a much lower amount of fixed assets as compared to sales than the industry. Overall, Reynolds Computer is generating more sales from every $1 of assets than its competitors. Reynolds Computer is also doing a good job at managing its income statement. The operating profit margin shows that Reynolds Computer is controlling costs efficiently. Both the asset turnover and profit margin contribute to Reynolds Computers favorable operating profitability. Financing Reynolds Computer finances more of its assets through debt than its competitors. This involves more risk, but it can also provide higher returns as we will note in the next section. Reynolds Computer must be careful not to over-leverage itself. However, Reynolds Computers times interest earned ratio indicates that Reynolds Computer can service its debt more easily than the average firm. Return on Investment- As noted above, Reynolds Computer finances more of its assets through debt than the industry average. With more debt and less equity, this will provide a higher return to its owners as long as the earned rate of return is higher than the cost of debt. Based on the high operating profitability and times interest earned ratios, we can assume this is the case. As a result, the common equity owners are receiving a higher return on their investment than the industry average.
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