XYZ Co is a manufacturer of highly specialized products for networking equipment. Production of specialized units are, to a large extent, under contract, with standard units manufactured to marketing projections. Maintenance of customer equipment is an important area of customer satisfaction. With the recent downturn in the computer industry, the equipment segment has suffered, causing a slide in XYZ’s performance. XYZ’s Income Statement for the fiscal year ended Oct 31, 2006, is presented below.

XYZ Coy
Income Statement
For the Year Ended October 31, 2006
($000 omitted)
Net sales
Equipment $6,000
Maintenance contracts 1,800
Total net sales $7,800
Expenses
Cost of goods sold 4,600
Customer maintenance 1,000
Selling expense 600
Administrative expense 900
Interest expense 150
Total expenses $7,250
Income before income taxes $ 550
Income taxes 220
Net income $ 330

XYZ’s return on sales before interest and taxes was 9% in fiscal 2006 while the industry average was 12%. XYZ’s total asset turnover was 3 times, and its return on average assets before interest and taxes was 27%, both well below the industry average. In order to improve performance and raise these ratios nearer to, or above, industry averages, Tom Pond, XYZ’s president, established the following goals for fiscal 2007.
• Operating Margin – 11%
• Total asset turnover - 4 times
• Return on average assets before interest and taxes 35%

To achieve Hunt’s goals, XYZ’s management team took into consideration the growing international video-conferencing market and proposed the following actions for fiscal 2007.
• Increase equipment sales prices by 10%.
• Increase the cost of each unit sold by 3% for needed technology and quality improvements, and increased variable costs.
• Increase maintenance inventory by $250,000 at the beginning of the year and add two maintenance technicians at a total cost of $130,000 to cover wages and
related travel expenses. These revisions are intended to improve customer service and response time. The increased inventory will be financed at an annual interest rate of 12%; no other borrowings or loan reductions are contemplated during fiscal 07. All other assets will be held to fiscal 06 levels.
• Increase selling expenses by $250,000 but hold administrative expenses at 2006 levels.
• The effective rate for 2007 federal and state taxes is expected to be 40%, the same as 2006.
It is expected that these actions will increase equipment unit sales by 6%, with a corresponding 6% growth in maintenance contracts.

Required:
a. Prepare a Pro Forma Income Statement for XYZ Company for the fiscal year ending Oct 31, 2007, on the assumption that the proposed actions are implemented as planned and that the increased sales objectives will be met. (All numbers should be rounded to the nearest thousand, i.e., $000 omitted.)

b.Calculate the following ratios for XYZ Company for fiscal 2007 and determine whether Tom Pond’s goals will be achieved.
1. Operating Margin.
2. Total asset turnover.
3. Return on average assets before interest and taxes.

c.Discuss the limitations and difficulties that can be encountered in using ratio analysis, particularly when making comparisons to industry averages.