Question

Light Touch Balance Sheets (in $000s) As At December 31 20Y3 20Y2 20Y1 ASSETS Current assets Cash 0 600 2,158 Accounts receivable 2,454 1,440 Inventory 3,480 3,168 2,500 Prepaid expenses 416 240 302 400 Other current assets 224 180 Total current assets 6,574 5,746 5,242 Fixed assets 2,030 1,542 1,470 Other noncurrent assets 640 420 428 TOTAL ASSETS 9,244 7,708 7,140 LIABILITIES AND EQUITY Current liabilities Short-term debt $ 604 20 0 Current portion-LTD Accounts payable 400 400 400 1,672 1,426 890 Accrued expenses 412 384 340 Dividends payable 90 0 0 Taxes payable 216 138 128 Other current liabilities 60 32 152 2,400 Total current liabilities 3,454 1,910 Long-term debt 1,984 2,384 2,784 Deferred taxes 120 116 108 Stockholder's equity Paid-in capital 2,306 2,000 2,000 Retained earnings 1,380 808 338 3,686 Total stockholders' equity 2,808 2,338 TOTAL LIABILITIES AND EQUITY $ 9,244 7,708 7,140 Working investment 3,850 $ 3,516 2,710

Answer 1

Light touch profitability analysis: Particulars Formula Given in question Observations 2043 21,420 2042 18,000 2041 15,000 Sales Gross profit Given in question 6,520 5,340 % gross profit margin Gross profit/Sales 30.4% 29.7% 29.1% 4,360 - Increase in company's gross profit margins in both 20X2 and 2013 - In 20Y2, it increased by 600 basis points and in 2023 by 700 basis points Operating expenses (Opex) Given in question 3,988 3,218 2,454 Opex as % of sales Operating expenses/Sales 18.6% 17.9% 16.4% - The main reason behind company's declining margins have been increase in operating expenses - In 20Y2, Operating expenses as % of sales increased 1.5% and in 2083, increased by 0.7% Operating profit Gross profit-Operating expenses 2,532 2,122 1,906 Op. profit as % of sales Operating expenses/Sales 11.8% 11.8% 12.7% - In 20Y2, operating margins fell by 0.9% due to rise in operating expenses partially compensated by increased gross profit margins - In 20Y3, operating margins remained flat with 0.7% increase in gross profit margins completely offset by increase in operating expenses Income before taxes (EBT) Given in question 2,272 1,870 1,620 - In 2012 & 2043 combined, EBT margins stayed more or less flat and fell marginally by just 0.2% as rise in operating expenses partially pulled back by increased gross profit margins and benefit of scale as fixed interest expenses remained flat despite increase in sales % EBT margin Income before taxes/Sales 10.6% 10.4% Taxes Given in question 1,128 892 648 Taxes as % of EBT Taxes/Income before taxes 49.6% 47.7% 40.0% - Increase in effective tax rate (as % of EBT) from 40% in 20Y1 to 48% in 20Y2 and 50% in 2013. Net income Given in question 1,144 978 972 - In 20Y2 and 2043 combined, net income margins fell by 1.2%, primarily due 6.5% increase in tax rates as we see that EBT margins were almost flat during that period % net income margin Net income/Sales 5.3% 5.4%

Analysis and Conclusions: Important Note: The below options have been analyzed with the assumption that only one correct option can be chosen and multiple options can't be correct. Option A: - The company's operating expenses increased in 2022 and 2013 but got mostly offset by benefits of increase in gross profit margins and benefits of scale as fixed interest expenses haven't increased with increase in sales, which has resulted in flattish EBT margins (decreased by just 0.2% in two years combined). It is the increase in tax rate that is the main reason behind net income margins falling below 20x1 levels. Tax rates increased from 40% of income before taxes in 20Y1 to 50% in 2013 which makes it quite unlikely that the profitability expectations of getting back to 20Y1 levels will be met. Therefore, this option is correct Option B: - We see that though company's gross profit margins are expanding, they are being offset by increase in operating expenses. Therefore, the benefit of rising gross profit margins is not reaching the net income level. Even if operating expenses could be controlled and remained flat, the 0.7% expected increase in gross profit margin won't be enough to pull back net income margin by 1.2% as required to get back to 20Y1 level of profitability. Hence, this option is not correct. Option C: - The company's operating profit margins fell from 20Y1 levels and became flat in 20Y3. This decline was partially offset by benefits of scale as interest expenses did not increase with increase in sales (in fact saw a slight decline), resulting in flattish EBT margins as compared to 2011 levels. However, flat operating margins won't contribute much at this stage to getting net income profitability back at 20Y1 levels as tax rates have increased. Therefore, this option is not correct Option D: - The company's operating expenses have increased in 2022 and 20Y3 which has been mostly offset by benefits of increase in gross profit margins and benefits of scale as fixed interest expenses haven't increased with increase in sales, which has resulted in flattish EBT margins. It is the increase in tax rate that is the main reason behind net income margins falling below 20X1 levels. Just controlling operating costs will not bring net income margins back to 20Y1 levels as the expected increase in gross profits and benefits of scale will not be enough to pull back net profit margins by 1.2% which is required to get back to 20Y1 levels. Therefore, this option is not correct. Therefore, the correct option is option A.