You have just been hired as a loan officer at Fairfield State Bank. Your supervisor has given you a file

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.) (Round your answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Return on total assets	%	%

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.) (Round your answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Return on common stockholders' equity	%	%

c.	Is the company’s financial leverage positive or negative?

This year	Positive
Last year	Negative

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. (Round your answers to 2 decimal places. Omit the "$" sign in your response.)

	This year	Last year
Earnings per share	$	$

b.	The dividend yield ratio for common stock. (Round your intermediate calculations to 2 decimal places and final answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Dividend yield ratio	%	%

c.	The dividend payout ratio for common stock. (Round your intermediate calculations to 2 decimal places and final answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
Dividend payout ratio	%	%

d.	The price-earnings ratio. (Round your intermediate calculations to 2 decimal places and final answers to 1 decimal place.)

	This year	Last year
Price-earnings ratio

e.	The book value per share of common stock. (Round your intermediate calculations to 2 decimal places and final answers to 1 decimal place. Omit the "$" sign in your response.)

	This year	Last year
Book value per share	$	$

f.	The gross margin percentage. (Round your intermediate calculations to 2 decimal places and final answers to 1 decimal place. Omit the "%" sign in your response.)

	This year	Last year
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. (Omit the "$" sign in your response.)

	This year	Last year
Working capital	$	$

b.	The current ratio. (Round your answers to 2 decimal places.)

	This year	Last year
Current ratio

c.	The acid-test ratio. (Round your answers to 2 decimal places.)

	This year	Last year
Acid-test ratio

d.	The average collection period. (The accounts receivable at the beginning of last year totaled $520,000.) (Use 365 days in a year. Do not round intermediate calculations. Round your answers to the nearest whole number.)

	This year	Last year
Average collection period	days	days

e.	The average sale period. (The inventory at the beginning of last year totaled $640,000.) (Use 365 days in a year. Round your intermediate calculations to 1 decimal places and final answers to the nearest whole number.)

	This year	Last year
Average sale period	days	days

f.	The debt-to-equity ratio. (Round your answers to 2 decimal places.)

	This year	Last year
Debt-to-equity ratio

g.	The times interest earned. (Round your answers to 1 decimal place.)

	This year	Last year
Times interest earned

Explanation:

1.
a.

	This Year		Last Year
Net income		$ 280,000		$ 168,000
Add after-tax cost of interest:
$120,000 × (1 – 0.30)		84,000
$100,000 × (1 – 0.30)				70,000
Total (a)		$ 364,000		$ 238,000
Average total assets (b)	$	5,330,000	$	4,640,000
Return on total assets (a) ÷ (b)		6.8%		5.1%

b.

	This Year		Last Year
Net income	$	280,000	$	168,000
Less preferred dividends		48,000		48,000
Net income remaining for common (a)		232,000		120,000
Average total stockholders' equity		3,120,000		3,028,000
Less average preferred stock		600,000		600,000
Average common equity (b)	$	2,520,000	$	2,428,000
Return on common stockholders' equity (a) ÷ (b)		9.2%		4.9%

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 the common equity (4.9%) is less than the return on total assets (5.1%).

2.
a.

	This Year		Last Year
Net income remaining for common [see above] (a)	$	232,000	$	120,000
Average number of common shares outstanding (b)		50,000		50,000
Earnings per share (a) ÷ (b)		$ 4.64		$ 2.40

b.

	This Year		Last Year
Dividends per share (a)	$	1.44	$	0.72
Market price per share (b)	$	36.00	$	20.00
Dividend yield ratio (a) ÷ (b)		4.0%		3.6%

c.

	This Year		Last Year
Dividends per share (a)	$	1.44	$	0.72
Earnings per share (b)	$	4.64	$	2.40
Dividend payout ratio (a) ÷ (b)	31.0%		30.0%

d.

	This Year		Last Year
Market price per share (a)	$	36.00	$	20.00
Earnings per share (b)	$	4.64	$	2.40
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 Hedrick’s industry is 10. Hedrick 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 Hedrick Company’s stock, as compared to 10 times current earnings for a share of stock for the typical company in the industry.

e.

	This Year		Last Year
Stockholders' equity	$	3,200,000	$	3,040,000
Less preferred stock		600,000		600,000
Common stockholders' equity (a)	$	2,600,000	$	2,440,000
Number of common shares outstanding (b)		50,000		50,000
Book value per share (a) ÷ (b)		$ 52.00		$ 48.80

Note that the book value of Hedrick Company’s stock is greater than its market value for both years. This does not necessarily indicate that the stock is selling at a bargain price. Market value is an indication of investors’ perceptions of future earnings and/or dividends, whereas book value is a result of already completed transactions.

f.

	This Year		Last Year
Gross margin (a)	$	1,050,000	$	860,000
Sales (b)	$	5,250,000	$	4,160,000
Gross margin percentage (a) ÷ (b)		20.0%		20.7%

3.

		This Year		Last Year
a.	Current assets (a)	$	2,600,000	$	1,980,000
	Current liabilities (b)		1,300,000		920,000
	Working capital (a) – (b)	$	1,300,000	$	1,060,000
b.	Current assets (a)	$	2,600,000	$	1,980,000
	Current liabilities (b)	$	1,300,000	$	920,000
	Current ratio (a) ÷ (b)		2.0		2.15
c.	Quick assets (a)	$	1,220,000	$	1,120,000
	Current liabilities (b)	$	1,300,000	$	920,000
	Acid-test ratio (a) ÷ (b)		0.94		1.22
d.	Sales on account (a)	$	5,250,000	$	4,160,000
	Average receivables (b)	$	750,000	$	560,000
	Accounts receivable turnover (a) ÷ (b)		7.0		7.4
	Average collection period: 365 days ÷ accounts receivable turnover		52 days		49 days
e.	Cost of goods sold (a)	$	4,200,000	$	3,300,000
	Average inventory balance (b)	$	1,050,000	$	720,000
	Inventory turnover ratio (a) ÷ (b)		4.0		4.6
	Average sale period: 365 days ÷ inventory turnover ratio		91 days		79 days
f.	Total liabilities (a)	$	2,500,000	$	1,920,000
	Stockholders' equity (b)	$	3,200,000	$	3,040,000
	Debt-to-equity ratio (a) ÷ (b)		0.78		0.63
g.	Net income before interest and income taxes (a)	$	520,000	$	340,000
	Interest expense (b)	$	120,000	$	100,000
	Times interest earned (a) ÷ (b)		4.3		3.4