Thorpe Company is a wholesale distributor of professional equipment and supplies. The company’s sales have averaged about $900,000 annually for the three year period 2007–2009. The firm’s total assets at the end of 2009 amounted to $850,000.
The president of Thorpe Company has asked the controller to prepare a report that summarizes the financial aspects of the company’s operations for the past three years. This report will be presented to the board of directors at its next meeting.
In addition to comparative financial statements, the controller has decided to present a number of relevant financial ratios that can assist in the identification and interpretation of trends. At the request of the controller, the accounting staff has calculated the following ratios for the three year period 2007–2009:
|
Ratio |
2007 |
2008 |
2009 |
|
Current ratio |
2 |
2.13 |
2.18 |
|
Acid test (quick) ratio |
1.2 |
1.1 |
0.97 |
|
Accounts receivable turnover |
9.72 |
8.57 |
7.13 |
|
Inventory turnover |
5.25 |
4.8 |
3.8 |
|
Percent of total debt to total assets |
44.00% |
41.00% |
38.00% |
|
Percent of long term debt to total assets |
25.00% |
22.00% |
19.00% |
|
Sales to fixed assets (fixed asset turnover) |
1.75 |
1.88 |
1.99 |
|
Sales as a percent of 2007 sales |
100.00% |
103.00% |
106.00% |
|
Gross profit percentage |
40.00% |
33.60% |
38.50% |
|
Net income to sales |
7.80% |
7.80% |
8.00% |
|
Return on total assets |
8.50% |
8.60% |
8.70% |
|
Return on stockholders’ equity |
15.10% |
14.60% |
14.10% |
In preparing his report, the controller has decided first to examine the financial ratios independently of any other data to determine whether the ratios themselves reveal any significant trends over the first three year period.
Required
a. The current ratio is increasing, while the acid test (quick) ratio is decreasing. Using the ratios provided, identify and explain the contributing factor(s) for this apparently divergent trend.
b. In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s use of financial leverage during the 2007–2009 period?
c. Using the ratios provided, what conclusion(s) can be drawn regarding the company’s net investment in plant and equipment?
Source: Materials identified as CFA Examination I, June 4, 1988, June 6, 1987 and June 6, 1988 are reproduced with permission from the Association for Investment Management and Research and the Institute of Chartered Financial Analysts.