ABC Company is a manufacturer of highly specialized products for networking video-conferencing equipment. Production of specialized units is, to a large extent, performed under contract, with standard units manufactured to marketing projections. Maintenance of customer equipment is an important area of customer satisfaction. With the recent downturn in the computer industry, the video-conferencing equipment segment has suffered, causing a slide in ABC's performance. ABC's income statement for the fiscal year ended October 31, Year 1, is presented below.

ABC Company
Income Statement
For the Year Ended October 31, Year 1
($000 Omitted)

Net Sales:
Equipment	$6,000
Maintenance contract	$1,800
Total Net Sales	$7,800
Expenses:
Cost of goods sold	$4,600
Customer maintenance	$1,000
Selling expense	$600
Administrative expense	$900
Interest expense	$150
Total expenses	$7,250
Income before income taxes	$550
Income taxes	$220
Net Income:	$330

ABC's return on sales before interest and taxes was 5% in Fiscal Year 1, while the industry average was 9%. ABC's total asset turnover was three times, and its return on average assets before interest and taxes was 20%, both well below the industry average. In order to improve performance and raise these ratios near to, or above, industry averages, Bill Hunt, ABC's president, established the following goals for Fiscal Year 2:

• Return on sales before interest and taxes 11%
• Total asset turnover 4 times
• Return on average assets before interest and taxes 35%

To achieve Hunt’s goals, ABC's management team took into consideration the rowing international video-conferencing market and proposed the following actions for Fiscal Year 2:

• Increase equipment sales by 10%.
• Increase the cost of each unit sold by 3% for needed technology and quality improvements, and increased variable costs.
• Increase maintenance inventory by $250,000 at the beginning of the year and add 2 maintenance technicians at a total cost of $130,000 to cover wages and related travel expenses. These revisions are intended to improve customer service and response time. The increased inventory will be financed at an annual interest rate of 12%; no other borrowings or loan reductions are contemplated during Fiscal Year 2. All other assets will be held to Fiscal Year 1 levels.
• Increase selling expenses by $250,000 but hold administrative expenses at Year 1 levels.
• The effective rate for Year 2 federal and state taxes is expected to be 40%, the same as Year 1.

Questions:

1) Prepare a pro forma income statement for ABC Company for the fiscal year ending October 31, Year 2, on the assumption that the proposed actions are implemented as planned and that the increased sales objectives will be met. (All numbers should be rounded to the nearest thousand, i.e., $000 omitted.)

2) Calculate the following ratios for ABC Company for Fiscal Year 2 and determine whether Bill Hunt’s goals will be achieved:

a. Return on sales before interest and taxes

b. Total asset turnover.

c. Return on average assets before interest and taxes.

3) Discuss the limitations and difficulties that can be encountered in using ratio analysis, particularly when making comparisons to industry averages.