Comprehensive Ratio Analysis [LO2, LO3, LO4]

You have just been hired as a loan officer at Fairfield State Bank. Your supervisor has given you a file containing a request from Hedrick Company, a manufacturer of auto components, for a $1,000,000 five-year loan. Financial statement data on the company for the last two years are given below:

Hedrick Company Comparative Balance Sheet This Year Last Year Assets Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000 $ 420,000 Marketable securities . . . . . . . . . . . . . . . . 0 100,000 Accounts receivable, net . . . . . . . . . . . . . . 900,000 600,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000 800,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . 80,000 60,000 Total current assets . . . . . . . . . . . . . . . . . . . 2,600,000 1,980,000 Plant and equipment, net . . . . . . . . . . . . . . . 3,100,000 2,980,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $5,700,000 $4,960,000 Liabilities and Stockholders’ Equity Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . $1,300,000 $ 920,000 Bonds payable, 10% . . . . . . . . . . . . . . . . . 1,200,000 1,000,000 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 1,920,000 Stockholders’ equity:
Preferred stock, 8%, $30 par value . . . . . . 600,000 600,000 Common stock, $40 par value . . . . . . . . . 2,000,000 2,000,000 Retained earnings . . . . . . . . . . . . . . . . . . . 600,000 440,000 Total stockholders’ equity . . . . . . . . . . . . . . . 3,200,000 3,040,000 Total liabilities and stockholders’ equity . . . . $5,700,000 $4,960,000 Hedrick Company Comparative Income Statement and Reconciliation This Year Last Year Sales (all on account) . . . . . . . . . . . . . . . . . . $5,250,000 $4,160,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . 4,200,000 3,300,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . 1,050,000 860,000 Selling and administrative expenses . . . . . . 530,000 520,000 Net operating income . . . . . . . . . . . . . . . . . . 520,000 340,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . 120,000 100,000 Net income before taxes . . . . . . . . . . . . . . . . 400,000 240,000 Income taxes (30%) . . . . . . . . . . . . . . . . . . . 120,000 72,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . 280,000 168,000 Dividends paid:
Preferred stock . . . . . . . . . . . . . . . . . . . . . 48,000 48,000 Common stock . . . . . . . . . . . . . . . . . . . . . 72,000 36,000 Total dividends paid . . . . . . . . . . . . . . . . . . . 120,000 84,000 Net income retained . . . . . . . . . . . . . . . . . . . 160,000 84,000 Retained earnings, beginning of year . . . . . . 440,000 356,000 Retained earnings, end of year . . . . . . . . . . $ 600,000 $ 440,000 Marva Rossen, who just two years ago was appointed president of Hedrick Company, admits that the company has been “inconsistent” in its performance over the past several years. But Rossen argues that the company has its costs under control and is now experiencing strong sales growth, as evidenced by the more than 25% increase in sales over the last year. Rossen also argues that investors have recognized the improving situation at Hedrick Company, as shown by the jump in the price of its common stock from $20 per share last year to $36 per share this year. Rossen believes that with strong leadership and with the modernized equipment that the $1,000,000 loan will enable the company to buy, profits will be even stronger in the future.
Anxious to impress your supervisor, you decide to generate all the information you can about the company. You determine that the following ratios are typical of companies in Hedrick’s industry:

Current ratio . . . . . . . . . . . . . . 2.3 Acid-test ratio . . . . . . . . . . . . . 1.2 Average collection period . . . . 31 days Average sale period . . . . . . . . 60 days Return on assets . . . . . . . . . . 9.5%
Debt-to-equity ratio . . . . . . . . . 0.65 Times interest earned . . . . . . . 5.7 Price-earnings ratio . . . . . . . . 10 Required:
1. You decide first to assess the rate of return that the company is generating. Compute the following for both this year and last year:

a. The return on total assets. (Total assets at the beginning of last year were $4,320,000.)

b. The return on common stockholders’ equity. (Stockholders’ equity at the beginning of last year totaled $3,016,000. There has been no change in preferred or common stock over the last two years.)

c. Is the company’s financial leverage positive or negative? Explain.
2. You decide next to assess the well-being of the common stockholders. For both this year and last year, compute:

a. The earnings per share.

b. The dividend yield ratio for common stock.

c. The dividend payout ratio for common stock.

d. The price-earnings ratio. How do investors regard Hedrick Company as compared to other companies in the industry? Explain.

e. The book value per share of common stock. Does the difference between market value per share and book value per share suggest that the stock at its current price is a bargain?
Explain.

f. The gr oss m argin pe rcentage.
3. You decide, finally, to assess creditor ratios to determine both short-term and long-term debt paying ability. For both this year and last year, compute:

a. Working c apital.

b. The c urrent r atio.

c. The a cid-test r atio.

d. The average collection period. (The accounts receivable at the beginning of last year totaled $520,000.)

e. The average sale period. (The inventory at the beginning of last year totaled $640,000.)

f. The de bt-to-equity r atio.
g. The times interest earned.
4. Make a recommendation to your supervisor as to whether the loan should be approved.