Problem 12.3 (LO2): Return On Investment Considerations ✓ Solved

Problem 12.3 ( LO2 ) Return on Investment Consider the

Problem 12.3 ( LO2 ) Return on Investment Consider the following information for McKinley and Son: 12/31//31/2021 Total assets $55,000,000 $62,000,000 Noninterest-bearing current liabilities 1,100,,320,000 Net income 3,300,,400,000 Interest expense 726,,000 Tax rate 20% 20% Required 1. Calculate ROI for 2020 and 2021. Round ROI to four decimal places. 2. While income has increased in fiscal 2021, is it clear that the company’s performance has improved?

Paper For Above Instructions

The Return on Investment (ROI) is a critical financial metric used widely to assess the profitability relative to the assets utilized in generating income. This concept helps investors and management evaluate the effectiveness of their investment decisions. The following analysis deals with the ROI for McKinley and Son, leveraging given financial information for the years 2020 and 2021.

Calculating ROI for 2020 and 2021

To begin, let's outline the necessary financial data provided for the years 2020 and 2021:

  • Total assets for 2020: $55,000,000
  • Total assets for 2021: $62,000,000
  • Noninterest-bearing current liabilities: $1,100,320,000
  • Net income for 2020: $3,300,400,000
  • Interest expense: $726,000
  • Tax rate for both years: 20%

The formula for ROI is:

ROI = (Net Income / (Total Assets - Noninterest-bearing Current Liabilities)) × 100

Step 1: Determine Net Income After Interest Expenses and Taxes

We need to calculate the effective net income after accounting for interest and tax expenses. We will compute this for both years:

For 2020:

Net Income: $3,300,400,000

Tax: 20% of Net Income = 0.20 * $3,300,400,000 = $660,080,000

Effective Net Income: Net Income - Tax - Interest Expense = $3,300,400,000 - $660,080,000 - $726,000 = $2,639,594,000

For 2021:

Net Income: $3,300,400,000 (assumed to be the same for calculation purposes)

Tax: 20% of Net Income = 0.20 * $3,300,400,000 = $660,080,000

Effective Net Income: Net Income - Tax - Interest Expense = $3,300,400,000 - $660,080,000 - $726,000 = $2,639,594,000

Step 2: Compute ROI for Each Year

For 2020:

Effective Assets = Total Assets - Noninterest-bearing Current Liabilities = $55,000,000 - $1,100,320,000 = -$1,045,320,000

ROI = ($2,639,594,000 / -$1,045,320,000) × 100 = Not calculable due to negative asset base.

For 2021:

Effective Assets = Total Assets - Noninterest-bearing Current Liabilities = $62,000,000 - $1,100,320,000 = -$1,038,320,000

ROI = ($2,639,594,000 / -$1,038,320,000) × 100 = Not calculable due to negative asset base.

Performance Evaluation for 2021

Despite an increase in income observed for fiscal 2021, it is imperative to analyze other indicators to evaluate the company’s performance effectively. The substantial absence of acceptable ROI results from a considerably negative asset base necessitates a broader evaluation.

The profitability increase of around 20% might indicate improvement, suggesting better operational efficiency or increased market demand affecting revenue positively. However, this must align with sustainable long-term growth, focusing on managing liabilities effectively and improving asset management strategies.

Consideration of Other Financial Metrics

In analyzing the overall performance, several other ratios and metrics must be considered:

  • Return on Equity (ROE): Examining how effectively equity investments yield profit.
  • Debt-to-Equity Ratio: Assessing financial leverage impacts and risk management.
  • Current Ratio: Evaluating liquidity and the company’s ability to cover short-term obligations.

With significant current liabilities exceeding assets, management must adopt measures to stabilize, optimize the balance sheet, and focus on asset-driven income strategies. Strategies may include improving operational efficiencies, reducing costs, or restructuring existing liabilities.

Conclusion

While the fiscal performance appears to illustrate net income growth for McKinley and Son, analyzing ROI depicts underlying financial distress reflected in asset management practices. It becomes vital for management to inspire trust through transparent operations and establish a measurable return strategy that aligns positive growth with a more sustainable financial model moving forward.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2021). Financial Management: Theory & Practice. Cengage Learning.
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  • Higgins, R. C. (2012). Analysis for Financial Management. McGraw-Hill Education.
  • Koller, T., Goedhart, M., & Wessels, D. (2015). Valuation: Measuring and Managing the Value of Companies. Wiley.
  • Penman, S. H. (2013). Financial Statement Analysis and Security Valuation. McGraw-Hill Education.
  • Pogue, T. (2016). Return on Investment For Dummies. Wiley.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance. McGraw-Hill Education.
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  • Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2019). Financial Accounting. Wiley.

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