You have just been hired as a loan officer at Slippery Rock State Bank.

Your supervisor has given you a file containing a request from Lydex Company, a manufacturer of safety helmets. For a $3,000,000, five-year loan. Financial statement data on the company for the last two years Follow:

Helen McGuire, who just a year ago was appointed president of Lydex Company, argues that although the company has had a spotty record in the past, it has turned the corner; as evidenced by a 25% jump in sales and by a greatly improved earnings picture between last year and this year. McGuire also points out that investors generally have recognized the improving situation at Lydex, as shown by the increase in market value of the companys common stock, which is currently selling for $72 per share (up from $40 per share last year). McGuire feels that with her leadership and with the modernized equipment that the $3,000,000 loan will permit the company to buy, profits will be even stronger in the future. McGuire has a reputation in the industry for being a good manager who runs a tight ship. Not wanting to botch your first assignment, you decide to generate all the information that you can about the company. You determine that the following ratios are typical of companies in Lydex Companys industry:

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 $12,960,000.)
b) The return on common stockholders equity. (Stockholders equity at the beginning of

last year totaled $9,048,000. There has been no change in preferred or common stock over the last two years.) c) Is the companys 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 Lydex 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) f. The gross margin percentage. 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 capital. b) The current ratio. c) The acid-test ratio. d) The average collection period. (The accounts receivable at the beginning of last year totaled $1,560,000.)
e) The average sale period. (The inventory at the beginning of last year totaled

$1,920,000.) f) The debt-to-equity ratio. g) The times interest earned ratio. 4. Make a recommendation to your supervisor as to whether the loan should be approved.

SOLUTION: 1. This Year $ 840,000 252,000 $ 1,092,000 $15,990,000 6.8% $ 840,000 144,000 $ 696,000 $ 9,360,000 1,800,000 $ 7,560,000 9.2% 210,000 $ 714,000 $13,920,000 5.1% $ 504,000 144,000 $ 360,000 $ 9,084,000 1,800,000 $ 7,284,000 4.9% Last Year $ 504,000

a. Net income Add after-tax cost of interest: $360,000 (1 0.30) $300,000 (1 0.30) Total (a) Average total assets (b) Return on total assets (a) (b) b. Net income Less preferred dividends Net income remaining for common (a) Average total stockholders equity Less average preferred stock Average common equity (b) Return on common stockholders equity (a) (b)

c. Leverage is positive for this year because the return on common equity (9.2%) is greater than the return on total assets (6.8%). For last year, leverage is negative because the return on common equity (4.9%) is less than the return on total assets (5.1%).

2. This Year Last Year a. Net income remaining for common [see above] (a) $696,000 $360,000 Average number of common shares outstanding (b) 75,000 75,000 Earnings per share (a) (b) $9.28 $4.80 b. Dividends per share (a) $2.88 $1.44 Market price per share (b) $72.00 $40.00 Dividend yield ratio (a) (b) 4.0% 3.6% c. Dividends per share (a) $2.88 $1.44 Earnings per share (b) $9.28 $4.80 Dividend payout ratio (a) (b) 31.0% 30.0% d. Market price per share (a) $72.00 $40.00 Earnings per share (b) $9.28 $4.80 Price-earnings ratio (a) (b) 7.8 8.3 Notice from the data given in the problem that the typical P/E ratio for companies in Lydex Companys industry is 10. Since Lydex Company presently has a P/E ratio of only 7.8, so investors appear to regard it less well than they do other companies in the industry. That is, investors are willing to pay only 7.8 times current earnings for a share of Lydex Companys stock, as compared to 10 times current earnings for a share of stock for the typical company in the industry. e. Stockholders equity Less preferred stock Common stockholders equity (a) Number of common shares outstanding (b) Book value per share (a) (b) $9,600,000 1,800,000 $7,800,000 75,000 $104.00 $9,120,000 1,800,000 $7,320,000 75,000 $97.60

Notice that market value of common stock is below its book value for both years. This does not necessarily indicate that the stock is selling at a bargain price. Market value reflects investors expectations concerning future earnings, whereas book value is a result of already completed transactions and is geared to the past. This Year $3,150,000 $15,750,000 20.0% This Year $7,800,000 3,900,000 Last Year $2,580,000 $12,480,000 20.7% Last Year $5,940,000 2,760,000

Gross margin (a) Sales (b) Gross margin percentage (a) (b) 3. a. Current assets Current liabilities

Working capital b. Current assets (a) Current liabilities (b) Current ratio (a) (b) c. Quick assets (a) Current liabilities (b) Acid-test ratio (a) (b) d. Sales on account (a) Average receivables (b) Accounts receivable turnover (a) (b) Average collection period, 365 days turnover e. Cost of goods sold (a) Average inventory balance (b) Inventory turnover ratio (a) (b) Average sale period, 365 days Inventory turnover ratio f. Total liabilities (a) Stockholders equity (b) Debt-to-equity ratio (a) (b)

$3,900,000 $7,800,000 $3,900,000 2.0 $3,660,000 $3,900,000 0.94 $15,750,000 $2,250,000 7.0 52.1 days This Year $12,600,000 $3,150,000 4.0 91.3 days $7,500,000 $9,600,000 0.78

$3,180,000 $5,940,000 $2,760,000 2.15 $3,360,000 $2,760,000 1.22 $12,480,000 $1,680,000 7.4 49.3 days Last Year $9,900,000 $2,160,000 4.6 79.3 days $5,760,000 $9,120,000 0.63

g. Net income before interest and income taxes (a) $1,560,000 $1,020,000 Interest expense (b) $360,000 $300,000 Times interest earned (a) (b) 4.3 3.4 4. Both net income and sales are up from last year. The return on total assets has improved from 5.1% to 6.8%, and the return on common equity is up from 4.9% to 9.2%. But this is the only bright spot. Virtually all other ratios are below what is typical of the industry, and, more important, they are trending downward. The deterioration in the gross margin percentage, while not large, is worrisome. Sales and inventories have increased substantially. Ordinarily, this should result in an improvement in the gross margin percentage due to fixed costs being spread over a greater number of units. However, the gross margin percentage has declined. Notice particularly that the average collection period has lengthened to 52 daysabout three weeks over the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Notice also that the debt-to-equity ratio is rising rapidly. If the $3,000,000 loan is granted, the ratio will rise further to 1.09. What the company probably needs is more equitynot more debt. Therefore, the loan should not be approved. The company should be encouraged to issue more common stock to provide

a broader equity base on which to operate.