"Comprehensive Problem 1. (Continued)Exhibit 1WATSON LEISURE TIME SPORTING GOODSIncome Statement 200X 200Y 200ZSales (all on credit) .......................................$1,500,000 $1,800,000 $2,160,000Cost of goods sold ........................................ 950,000 1,120,000 1,300,000Gross profit ...................................................550,000 680,000 860,000Selling and administrative expense* ............ 380,000490,000590,000Operating profit ............................................170,000 190,000 270,000Interest expense ............................................30,00040,00085,000Net income before taxes ...............................140,000 150,000 185,000Taxes ............................................................46,12048,72064,850Net income ...................................................$93,880 $ 101,280 $ 120,150Shares ...........................................................40,000 40,000 46,000Earnings per share ........................................$2.35 $2.53 $2.61*Includes $20,000 in lease payments for each year.Exhibit 2WATSON LEISURE TIME SPORTING GOODSBalance Sheet200X 200Y 200ZAssetsCash ..............................................................$ 20,000 $ 30,000 $ 20,000Marketable securities ....................................30,000 35,000 50,000Accounts receivable .....................................150,000 230,000 330,000Inventory ...................................................... 250,000285,000325,000Total current assets .................................450,000 580,000 725,000Net plant and equipment .............................. 550,000720,000 1,169,000Total assets ...................................................$1,000,000 $1,300,000 $1,894,000Liabilities and Stockholders ? Equity Accounts payable .........................................$ 100,000 $ 225,000 $ 200,000Notes payable (bank) .................................... 100,000100,000300,000Total current liabilities ............................200,000 325,000 500,000Long-term liabilities ..................................... 250,000331,120550,740Total liabilities ........................................450,000 656,120 1,050,740Common stock ($10 par) ..............................400,000 400,000 460,000Capital paid in excess of par ........................50,000 50,000 80,000Retained earnings ......................................... 100,000193,880303,260Total stockholders ?.....................equity 550,000643,880843,260Total liabilities and stockholders ? ... e $1,000,000 $1,300,000 $1,894,000S3-60 Comprehensive Problem 1 (Continued)Exhibit 3Selected Industry Ratios 200X 200Y 200ZGrowth in sales .............................................— 9.98% 10.02%Profit margin ................................................5.75% 5.80% 5.81%Return on assets (investment) ......................8.22% 8.24% 8.48%Return on equity ...........................................13.26% 13.62% 14.16%Receivable turnover ......................................10x9.5x 10.1xAverage collection period ............................36 days37.9 days 35.6 daysInventory turnover ........................................5.71x 5.62x 5.84xFixed asset turnover .....................................2.75x 2.66x 2.20xTotal asset turnover ......................................1.43x 1.42x 1.46xCurrent ratio .................................................2.10x 2.08x 2.15xQuick ratio ....................................................1.05x 1.02x 1.10xDebt to total assets ........................................38% 39.5% 40.1%Times interest earned ...................................5.00x 5.20x 5.26xFixed charge coverage ..................................3.85x 3.95x 3.97xGrowth in EPS ..............................................— 9.7% 9.8%S3-61 CP 3-1. Solution:Watson Leisure Time Sporting Goods200X 200Y 200ZGrowth in sales (Company)20% 20%(Industry)9.98% 10.02%Profit margin (Company)6.26% 5.63% 5.56%(Industry) 5.75% 5.80% 5.81%Return on assets (Company)9.39% 7.79% 6.34%(Industry) 8.22% 8.24% 8.48%Return on equity (Company) 17.07% 15.73% 14.25%(Industry) 13.26% 13.62% 14.16%Receivable turnover (Company) 10.0x 7.83x 6.55x(Industry) 10.0x 9.5x 10.1xAverage collection (Company) 36 days 46.0 days 55.0 daysperiod(Industry) 36 days 37.9 days 35.6 daysInventory turnover (Company)6.0x 6.32x 6.65x(Industry) 5.71x 5.62x 5.84xFixed asset turnover (Company)2.73x 2.50x 1.85x(Industry) 2.75x 2.66x 2.20xTotal asset turnover (Company) 1.50x 1.38x 1.14x(Industry) 1.43x 1.42x 1.44xCurrent ratio (Company) 2.25x 1.78x 1.45x(Industry) 2.10x 2.08x 2.15xQuick ratio (Company) 1.00x .91x 0.80x(Industry) 1.05x 1.02x 1.10xDebt to total assets (Company)45.0% 50.47% 55.48%(Industry) 38.0% 39.50% 40.10%Times interest (Company)5.67x 4.75x 3.18xearned (Industry) 5.0x 5.20x 5.26xFixed charge (Company) 3.80x 3.50x 2.76xcoverage(Industry) 3.85x 3.95x 3.97xGrowth in E.P.S. (Company) ---- 7.7% 3.2%(Industry) ---- 9.7% 9.8%S3-62 CP 3-1. (Continued)Discussion of RatiosWhile Watson Leisure Time Sporting Goods is expanding its sales muchmore rapidly than others in the industry, there are some cleardeficiencies in their performance. These can be seen in terms of a trendanalysis over time as well as a comparative analysis with industry data.In terms of profitability, the profit margin is declining over time. This issurprising in light of the 44 percent increase in sales over two years (20 percent per year). There obviously are no economies of scale for thisfirm. Higher selling and administrative costs and interest expense appearto be causing the problem. The return-on-asset ratio starts out in 200Xabove the industry average (9.39 percent versus 8.22 percent) and endsup well below it (6.34 percent versus 8.48 percent) in 200Z. The declineof 3.05 percent for return on assets at Watson Sporting Goods is serious,and can be attributed to the previously mentioned declining profitmargin as well as a slowing total asset turnover (going from 1.5X to1.14X).Return on equity is higher than the industry ratio, but in a downtrend. It is superior to the industry average for one reason: the firm has aheavier debt position than the industry. Lower returns on assets aretranslated into higher returns on equity because of the firm ?s high deb The previously mentioned slower turnover of assets can be analyzedthrough the turnover ratios. A very real problem can be found inaccounts receivable where turnover has gone from 10X to 6.55X. This can also be stated in terms of an average collection period that hasincreased from 36 days to 55 days. While inventory turnover has beenand remains superior to the industry, the same cannot be said for fixedasset turnover. A decline from 2.73X to 1.85X was caused by anincrease in 112.5 percent in fixed assets (representing $619,000). We can summarize the discussion of the turnover ratios by saying thatdespite a 44 percent increase in sales, assets grew even more rapidlycausing a decline in total asset turnover from 1.50X to 1.14X.S3-63 CP 3-1. (Continued)The liquidity ratios also are not encouraging. Both the current and quickratios are falling against a stable industry norm of approximately twoand one respectively.The debt to total assets ratio is particularly noticeable in regard toindustry comparisons. Watson Sporting Goods has gone from beingseven percent over the industry average to 15.38 percent above the norm(55.48 percent versus 40.1 percent). Their heavy debt position is clearlyout of line with their competitors. Their downtrend in times interestearned and fixed charge coverage confirms the heavy debt burden on thecompany.Finally, we see that the firm has a slower growth rate in earnings pershare than the industry. This is a function of less rapid growth inearnings as well as an increase in shares outstanding (with the sale of6,000 shares in 200Z). Once again, we see that the rapid growth in salesis not being translated down into significant earnings gains. This is truein spite of the fact that there is a very stable economic environment. It does not appear that this is an attractive investment opportunity.Optional Discussion:Although the student was not specifically asked to address the issue, theinstructor may wish to comment on the shares that were sold in 200Z.Looking at the capital section of the balance sheet, it appears that 6,000shares were sold for a total value of $90,000.$60,000 increase in par value30,000 increase in capital paid in excess of par$90,000 total value of 6,000 sharesS3-64 "