Income before taxes
a) Bauman Company’s current and quick ratios for the past four years are as follows:
b) The firm’s liquidity during the 2009-2010 period was generally good. Both the current ratio and the quick ratio during this period were relatively high, to the point where a creditor would be comfortable lending this company money in the short run. There was, however, a decline in both ratios over this period. The current ratio slipped slightly, and there was an equally slight slip in the quick ratio. Neither decline was strong, and both were partially reversed the next year. The decline was because the current liabilities grew at a faster rate than the current assets.
c) This information would neither support nor conflict with my evaluation. Inventory played a less significant role in my evaluation than the current liabilities did; one would reasonably look at both the numerator and denominator for an explanation. Indeed, inventory growth in 2010 was slow compared with the growth in other current assets as well. Bauman’s inventory turnover is well below the industry average, but that is not relevant to the firm’s liquidity except in context of industry-average liquidity, figures for which we do not have. However, a slight increase in inventory turnover in the 2009-2011 period would, all other factors being equal, reduce the current ratio, because it would reduce the current assets relative to the growth of other factors like current liabilities. This assumes that ordinarily current asset and liabilities classes would grow with sales. So bearing in mind all of the assumptions, the movement in the current ratio is in line with expectations given the change in inventory turnover. That said, the turnover ratio is not particularly consequential. In 2011, for example, the only thing that changed on the balance sheet was other current assets. Perhaps some growth in inventory might have been expected, but that assumption was never explicitly stated.
Part 3. a) The DuPont formula is ROE = profit margin * * equity multiplier (Investopedia, 2013).
So for 2012 at Johnson it is:
.049 * 2.34 * 1.85 = 0.212, or 21.2%
b) The ROE for Johnson and the industry for all three years is:
Johnson has a higher ROE than the industry in all three years. The first explanation is that Johnson has more leverage. Johnson also has superior margins. Johnson’s total asset turnover is also higher. Thus, it is through a combination of the three factors that Johnson has a higher ROE. The biggest red flag that the DuPont analysis is supposed to reveal is whether a high ROE is the result of leverage rather than operating metrics. While the higher degree of leverage is certainly a factor in the higher ROE that Johnson enjoys, it is worth taking into consideration that it is not the only factor.
3. While all three factors contribute to Johnson’s ROE, the trend for the company is worrying. The company’s lowest ROE was in 2012, and in that year it recorded lower than . It had increased its leverage, which is something of a concern. However, Johnson also enjoyed a higher total asset turnover, so leverage was not the only thing propping up the ROE in the year of tight margins in 2012. Johnson’s margins, while growing progressively tighter, are following the industry trend, so are perhaps more the result of specific industry dynamics than Johnson’s own inherent competitiveness. Johnson has held up its ROE, where the industry has not, in part because it is increasing its leverage. This seems to be the primary factor, since at both Johnson and the industry the total asset turnover has increased in recent years. It is worth asking the question of why Johnson is bucking the industry trend on leverage, as this may be a tactic that management is undertaking to prop up the ROE. However, it could also be a response to the rock bottom interest rates of recent years — a company with solid credit can borrow at real interest rates close to zero. These are the types of things that would be uncovered by an investigation of the company’s increase in debt. The other issues perhaps need less investigation, but the company should consider what it can do to buck the industry trend towards lower margins, and it cannot borrow its way to a higher ROE forever and will therefore need to address the margins issue sooner or later.
Investopedia. (2013). Definition of DuPont analysis. Investopedia. Retrieved March 7, 2013 from http://www.investopedia.com/terms/d/dupontanalysis.asp#axzz2MnoRW6v9