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 fiveyear
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  
Acidtest ratio  1.2  
Average collection period  31  days 
Average sale period  60  days 
Return on assets  9.5  % 
Debttoequity ratio  0.65  
Times interest earned  5.7  
Priceearnings ratio  10  

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.)

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.)

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

 
This year  Positive 
Last year  Negative 

2. 
You decide next to assess the wellbeing 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.)

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.)

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.)

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

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.)

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.)

3. 
You
decide, finally, to assess creditor ratios to determine both shortterm
and longterm debt paying ability. For both this year and last year,
compute:

a.  Working capital. (Omit the "$" sign in your response.) 
b.  The current ratio. (Round your answers to 2 decimal places.) 
c.  The acidtest ratio. (Round your answers to 2 decimal places.) 
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.)

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.)

f.  The debttoequity ratio. (Round your answers to 2 decimal places.) 
g.  The times interest earned. (Round your answers to 1 decimal place.) 
Explanation:
1.
a.
 This Year  Last Year 
Net income   $ 280,000   $ 168,000 
Add aftertax 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 
Priceearnings 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 
 Acidtest 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 
 Debttoequity 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 
