Question

Analyze Ryan Boot Company, using ratio analysis. Compute the Ryan ratios and compare them to the industry data that are given. Discuss the weak points, strong points, and what you think should be done to improve the company’s performance.

b. In your analysis, calculate the overall break-even point in sales dollars and the

cash break-even point. Also compute the degree of operating leverage, degree of

financial leverage, and degree of combined leverage. (Use footnote 2 for DOL

and footnote 3 for DCL.)

c. Use the information in parts a and b to discuss the risk associated with

this company. Given the risk, decide whether a bank should lend funds to

Ryan Boot.

Ryan Boot Company is trying to plan the funds needed for 20X2. The management anticipates an increase in sales of 20 percent, which can be absorbed without increasing fixed assets.

d. What would be Ryan’s needs for external funds based on the current balance

sheet? Compute RNF (required new funds). Notes payable (current) and bonds

are not part of the liability calculation.

e. What would be the required new funds if the company brings its ratios into line

with the industry average during 20X2? Specifically examine receivables turnover, inventory turnover, and the profit margin. Use the new values to recomputed the factors in RNF (assume liabilities stay the same).

RYAN BOOT COMPANY Balance Sheet December 31,20X1
Assets	Amount (\()	Liabilities and stockholder’s Equity	Amount (\))
Cash	\(50,000	Accounts payable	\)2,200,000
Marketable securities	80,000	Accrued expenses	150,000
Accounts receivable	3,000,000	Notes payable (current)	400,000
Inventory	1,000,000	Bonds (10%)	2,500,000
Gross plant and equipment	6,000,000	Common stock (1.7 million share, par value \(1)	1,700,000
Less: accumulated depreciation	2,000,000	Retained earnings	1,180,000
Total assets	\)8,130,000	Total liabilities and stockholder’s equity	\(8,130,000
Income statement – 20X1

Sales (credit)	\)7,000,000
Fixed cost*	2,100,000
Variable cost (0.6)	4,200,000
Earning before interest and taxes	\(700,000
Less: interest	250,000
Earning before taxes	\)450,000
Less: taxes @35%	157,500

Earning after taxes	\(292,500
Dividend (40% payout)	117,000
Increased retained earnings	\)175,500
*Fixed costs include (a) lease expense of \(200,000 and (b) depreciation of \)500,000. Note: Ryan Boots also has $65,000 per year in sinking fund obligations associated with its bond issue. The sinking fund represents an annual repayment of the principal amount of the bond. It is not tax-deductible.

Ratios
	Ryan Boot (to be filled in)	Industry
Profit margin		5.75%
Return on assets		6.90%
Return on equity		9.20%
Receivable turnover		4.35 X
Inventory turnover		6.50 X
Fixed assets turnover		1.85 X
Total assets turnover		1.20 X
Current ratio		1.45 X
Quick ratio		1.10 X
Debts to total assets		25.05%
Interest coverage		5.35 X
Fixed charges coverage		4.62 X

f. Do not calculate—only comment on these questions. How would required new

funds change if the company

(1) Were at full capacity?

(2) Raised the dividend payout ratio?

(3) Suffered a decreased growth in sales?

(4) Faced an accelerated inflation rate?

Short answer

a. Analysisof the company by using ratio analysis

Ratios	Company’s Ratio	Industry ratio	Comment
Profit margin	4.17%	5.75%	Week point
Return on assets	3.60%	6.90%	Week point
Return on equity	10.16%	9.20%	Strong point
Receivable turnover	2.33 X	4.35 X	Week point
Inventory turnover	7 X	6.50 X	Strong point
Fixed assets turnover	1.75 X	1.85 X	Week point
Total assets turnover	0.86 X	1.20 X	Week point
Current ratio	1.50 X	1.45 X	Strong point
Quick ratio	1.14 X	1.10 X	Strong point
Debt to total assets	31%	25.05%	Week point
Interest coverage	4.8 X	5.35 X	Week point
Fixed-charge coverage	2 X	4.62 X	Week point

Using the ratio analysis, we conclude that the company's ratios are weaker than the industry's ratios, which means lower profitability for the company. The company's debt to total asset ratio (31%) is higher than the industry (25.05%), which shows that the company uses more debt in the company. Hence, the company's profitability is lower due to the high debt repayment or interest expenses. It is advisable to improve the company's performance that the company should reduce its debt.

b. Overall break-even point in sales dollar is $0.75, Cash break-even point is $0.57, Degree of operating leverage is 4, Degree of financial leverage is 1.55, and the Degree of combined leverage is 6.22

c. By using the information in parts a and b, the company has low financial leverage, low profitability, and a fixed charge coverage ratio compared to industry ratios. Hence, it is risky for the bank to lend a loan to the company.

d. The additional fund requirement of the company due to increment is $365,832.

e. Additional fund requirement to bring its ratios into line with the average industry ratio is $130,869.

f. (1). The required new funds increase if the company is at total capacity.

(2). The required new fund increases when the dividend pay out ratio is increased.

(3). The required new fund is decreased when the company suffers a decreased growth in sales.

(4). The required new fund is increased when the company faces an accelerated inflation rate

Step-by-step solution

Step-by-Step SolutionStep 1: Ratios

The accounting ratios are computed for comparing the two line items in the financial statements of the company. It is classified as the financial ratios and the operating ratios.

Calculation of company’s ratios

Ratios	Formula	Calculation
Profit margin	Net profit/Sales	$292,500/$7,000,000	4.17%
Return on assets	Net profit/total assets	$292,500/$8,130,000	3.60%
Return on equity	Net profit/Shareholder’s equity	$292,500/$2,880,000	10.16%
Receivable turnover	Net sale/average accounts receivable	$7,000,000/$3,000,000	2.33 X
Inventory turnover	Net sale/Average inventory	$7,000,000/$1,000,000	7 X
Fixed assets turnover	Net sale/Average fixed assets	$7,000,000/$4,000,000	1.75 X
Total assets turnover	Net sale/average total assets	$7,000,000/$8,130,000	0.86 X
Current ratio	Current assets/current liabilities	$4,130,000/$2,750,000	1.50 X
Quick ratio	(current assets-Inventory)/current liabilities	($4,130,000-$1,000,000)/$2,750,000	1.14 X
Debt to total assets	Total debts/total assets	$2,500,000/$8,130,000	31%
Interest coverage	EBITDA/interest expense	($700,000+$500,000)/$250,000	4.8 X
Fixed charge coverage	(EBIT+Lease payment)/(Total interest+Lease payment)	($700,000+$200,000)/($250,000+$200,000)	2 X

Calculation of break-even point in sales

$\begin{array}{c}\mathbf{Breakevenpointinsales}\mathbf{=}\frac{\mathrm{Fixedcost}}{(\mathbf{Sales}\mathbf{-}\mathbf{Variablecost})}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$2,100,000}{(\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000})}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{\$}\mathbf{0}\mathbf{.}\mathbf{75}\end{array}$

Calculation of cash break-even point

$\begin{array}{c}\mathbf{Cashbreakevenpoint}\mathbf{=}\frac{\mathrm{Fixedcost}-\mathrm{Depreciation}}{(\mathbf{Sales}\mathbf{-}\mathbf{Variablecost})}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$2,100,000-\$500,000}{(\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000})}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{\$}\mathbf{0}\mathbf{.}\mathbf{57}\end{array}$

Calculation of Degree of Operating Leverage

$\begin{array}{c}\mathbf{Degreeofoperatingleverage}\mathbf{=}\frac{\mathrm{Sales}-\mathrm{Variablecost}}{(\mathbf{Sales}\mathbf{-}\mathbf{Variablecost}\mathbf{-}\mathbf{Fixedcost})}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$7,000,000-\$4,200,000}{(\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{100}\mathbf{,}\mathbf{000})}\\ =4\end{array}$

Calculation of Degree of financial Leverage

$\begin{array}{c}\mathbf{Degreeoffinancialleverage}\mathbf{=}\frac{\mathrm{EBIT}}{\mathrm{EBIT}-\mathrm{Interest}}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$700,000}{\$700,000-\$250,000}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{1}\mathbf{.}\mathbf{55}\end{array}$

Calculation of Degree of combined Leverage

$\begin{array}{c}\mathbf{Degree}\mathbf{}\mathbf{of}\mathbf{}\mathbf{combined}\mathbf{}\mathbf{leverage}\mathbf{=}\frac{\mathrm{Sales}-\mathrm{Variablecost}}{(\mathbf{Sales}\mathbf{-}\mathbf{Variablecost}\mathbf{-}\mathbf{Fixedcost}\mathbf{-}\mathbf{Interest})}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\$7,000,000-\$4,200,000}{(\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{100}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{250}\mathbf{,}\mathbf{000})}\\ \mathbf{=}\mathbf{6}\mathbf{.}\mathbf{22}\end{array}$

Increase in sales

$\begin{array}{c}\mathrm{Increase}\mathrm{in}\mathrm{sales}=\mathrm{Currentsale}\times \mathrm{Growthrate}\\ =\$7,000,000\times 20\%\\ =\$1,400,000\end{array}$

Required new funds

$\begin{array}{c}\mathbf{Requirednewfunds}\mathbf{=}(\frac{\mathrm{Assets}}{\mathrm{Sales}}\mathbf{\times }\mathbf{Changeinsale})\mathbf{-}(\frac{\mathrm{Liabilities}}{\mathrm{Sales}}\mathbf{\times }\mathbf{Changeinsale})\mathbf{-}\mathbf{Profitmargin}\mathbf{\times }\mathbf{Newsales}\mathbf{\times }(\mathbf{1}\mathbf{-}\mathbf{Dividendpayout})\\ \\ \mathbf{=}(\frac{\$8,130,000}{\$7,000,000}\mathbf{\times }\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000})\mathbf{-}(\frac{\$5,250,000}{\$7,000,000}\mathbf{\times }\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000})\mathbf{-}\mathbf{4}\mathbf{.}\mathbf{17}\mathbf{\%}\mathbf{\times }\mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{\times }(\mathbf{1}\mathbf{-}\mathbf{0}\mathbf{.}\mathbf{40})\\ \\ =\$1,626,000-\$1,050,000-\$210,168\\ \\ =\$365,832\end{array}$

Calculation of the additional account receivable if the receivable turnover ratio is 4.35 times

$\begin{array}{c}\mathbf{Receivableturnoverratio}\mathbf{=}\frac{\mathrm{Netsalesof}20X2}{\mathrm{Averagereceivable}+\mathrm{Increament}}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{4}\mathbf{.}\mathbf{35}\mathbf{=}\frac{(\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{120}\mathbf{\%})}{\$3,000,000+\mathrm{Increament}}\\ \mathrm{Increament}=(\$1,068,965)\end{array}$

Calculation of the increment in inventory requirement if the inventory turnover ratio is 6.50 times

$\begin{array}{c}\mathbf{Inventoryturnoverratio}\mathbf{=}\frac{\mathrm{Netsalesof}20X2}{\mathrm{Averageinventory}+\mathrm{Increament}}\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{6}\mathbf{.}\mathbf{50}\mathbf{=}\frac{(\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{120}\mathbf{\%})}{\$1,000,000+\mathrm{Increament}}\\ \mathrm{Increament}=\$292,308\end{array}$

Total assets after growth

$\begin{array}{c}\mathrm{Totalassetsaftergrowth}=\mathrm{Currentassets}+\mathrm{increamentinaccountreceivable}+\mathrm{increamentininventory}\\ \mathbf{=}\mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{130}\mathbf{,}\mathbf{000}\mathbf{+}(\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{068}\mathbf{,}\mathbf{965})\mathbf{+}\mathbf{\$}\mathbf{292}\mathbf{,}\mathbf{308}\\ =\$7,353,343\end{array}$

Required new fund to line up with the industry ratio

$\begin{array}{c}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{Requirednewfunds}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}(\frac{\mathrm{Assets}}{\mathrm{Sales}}\mathbf{\times }\mathbf{Changeinsale})\mathbf{-}(\frac{\mathrm{Liabilities}}{\mathrm{Sales}}\mathbf{\times }\mathbf{Changeinsale})\mathbf{-}\mathbf{Profitmargin}\mathbf{\times }\mathbf{Newsales}\mathbf{\times }(\mathbf{1}\mathbf{-}\mathbf{Dividendpayout})\\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}(\frac{\$7,353,343}{\$7,000,000}\mathbf{\times }\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000})\mathbf{-}(\frac{\$5,250,000}{\$7,000,000}\mathbf{\times }\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000})\mathbf{-}\mathbf{5}\mathbf{.}\mathbf{75}\mathbf{\%}\mathbf{\times }\mathbf{\$}\mathbf{8}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{\times }(\mathbf{1}\mathbf{-}\mathbf{0}\mathbf{.}\mathbf{40})\\ =\$1,470,669-\$1,050,000-\$289,800\\ =\$130,869\end{array}$

Required new funds when the company is working at full capacity

When the company is working at full capacity and there is growth in sales, the company is required to raise the new funds for buying the machinery to produce more goods to sell.

Required new fund when the dividend payout ratio is increased

When the dividend payout ratio is increased, the company is required to raise new funds because the increased dividend payout ratio may decrease the retention amount. Hence a company needs to raise new funds.

Required new funds when the company suffered a decrease in growth rate

When the company suffers a decrease in growth rate, the company need not raise any funds. It is so because they do not need to invest in the new assets.

Required new funds when the company faces the accelerated inflation rate

When the company faces an accelerated inflation rate, the company require more fund to run the business smoothly. Hence, the company requires to raise new funds.