FIN3403 Chapter 4

T/F: Issuing a new stock and then proceeding to purchase additional inventory and hold the remainder as cash will strengthen its financial position

True

T/F: Second, REO does not consider the amount of invested capital.

True

T/F: The five categories of financial statement ratios are: liquidity ratios, market value ratios, debt management ratios, profitability ratios, and asset management ratios.

True

T/F: The higher debt ratios are, the lower returns there will be.

True

T/F: The primary liquidity ratio is the current ratio, which is calculated by dividing current assets by current liabilities.

True

Kanye's Kutlery has a market/book ratio equal to 1. Its stock price is $11 per share and it has 3.4 million shares outstanding. The firms' total capital is $120 million and it finances with only debt and common equity. What is its debt-to-capital ratio?

.71 Market Value of Equity = Stock Price * # Shares Outstanding Value of Debt in Capital Structure = Total Capital - Market Value of Equity Debt-to-Capital Ratio = Value of Debt in Capital Structure/Total Capital 11*3,400,000= 37,400,000 120,000,000-37,400,000=85,300,000 85,300,000/120,000,000=0.71

XYZ Company wants to analyze the current debt ratio in order to determine whether they are able to ask creditors for a loan of $10,000. The total debt is $12,000 and their equity is $11,000. What is the company's debt ratio?

52.2% Total Debt/ Total Capital=Total Debt / Total Debt + Equity 12,000/ 12000+11000= 0.521739130434783 = 52.2%

1. What is the average length of time XYZ company has to wait after making a sale before receiving cash in a 30- day period? Calculate the Days Sales Outstanding (DSO). 30-day Period Total Accounts Receivable= 18,000 Current Accounts Receivable= 4,000 Credit Sales = 10,000

54 Days DSO = Accounts Receivables / Net Credit Sales X Number of Days DSO= 18,000/10,000 X 30 days = 54 days

Define, explain and give examples of a current ratio and what does it mean when the ratio is high or low.

A current ratio is the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. It is calculated by dividing current assets by current liabilities. When the current ratio is high, it means that the company has a very strong and safe liquidity position. Sometimes it may mean that a firm has too much old inventory that will have to be written off and too many old accounts receivable that may turn into bad debt. Other cases it means that the firm has too much cash, receivable, and inventory relative to its sales, in which case these assets are not being managed efficiently. A low current ratio means that the company's liquidity position is somewhat weak but it does not mean that their situation is dire.

Which of the following statements is correct? A. If a firm's expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, adding assets and financing them with debt will raise the firm's expected return on common equity (ROE). B. The higher a firm's tax rate, the lower its BEP ratio, other things held constant. C. The higher the interest rate on a firm's debt, the lower its BEP ratio, other things held constant. D. The higher a firm's debt ratio, the lower its BEP ratio, other things held constant.

A. If a firm's expected basic earning power (BEP) is constant for all of its assets and exceeds the interest rate on its debt, adding assets and financing them with debt will raise the firm's expected return on common equity (ROE).

Which of these is an example of Profitability Ratios? A) Total Debt to Total Capital B) Return on Invested Capital C)Total Assets Turnover D)Times-Interest-Earned (TIE)

B) Return on Invested Capital

Which of the following is the least liquid of a firm's current assets? A. Accounts receivable B. Inventories C. Marketable Securities D. Cash

B. Inventories

What is one of the major five categories of ratios that provides an idea of what investors think about the firm and its outlook. A. Liquidity B. Market Value C. Profitability D. Asset Management

B. Market Value

A company has made $3 million in sales. Their cost of goods sold is 65% of their sales. Their inventories in their assets total to be $500,000. What is their inventory turnover ratio?

Costs of Goods Sold)/(Inventories) = Inventory Turnover Ratio Inventories = $500,000 Cost of Goods Sold = (Sales) * (% of Sales) Sales = $3,000,000 % of Sales = 65% Cost of Goods Sold = ($3,000,000) * (0.65) = $1,950,000 Answer: Inventory Turnover Ratio = ($1,950,000)/($500,000) = *3.9

Mary buys a car from a mean salesman who charges her 12% over the original price of a $15,000 car. Luke buys the same car from a much nicer salesman who gives him an 8% discount off of the original price. How much more does Mary spend on the car than Luke does? A. $1,200 B. $2,500 C. $2,000 D. $3,000

D. $3,000 M: 12% of 15,000 is 0.12 * 15,000 = $1,800 L: 8% of 15,000 is 0.08 * 15,000 = $1,200 $1,800 + $1,200 = $3000

Define DuPoint Equation, explain how the DuPoint Equation can analyze the Return on Equity (ROE) for a specific company versus another in the industry, and give examples.

DuPoint Equation is a formula that shows that the rate of return on equity can be found as the product of profit margin, the total asset turnover, and the equity which all affect the ROE. If the profit margin is below average-The costs are not being controlled as it should be and cannot charge premiums. If the total asset turnover is below industry average - More assets are then needed. Equity Multiplier is relatively high -The heavy use of debt offsets to some extent low profit margin and total asset turnover.

T/F: Asset management ratios give an idea of the firm's ability to pay off debts that are maturing within an year.

False

T/F: Benchmarking is the firm's own ratios analyzed over time to see if its financial situation is getting better or worse

False

T/F: Firms with a higher debt ratio tend to have a lower return than firms with a lower debt ratio when the economy is normal.

False

T/F: The two types of Liquidity Ratios are Current and Rapid Ratios.

False

On December 31, 2019, the balance sheet of Chevron company shows the total current assets of $1,100,000 and the total current liabilities of $400,000. Compute the current ratio of the company.

Formula: Current Ratio = Current Assets / Current Liabilities $1,100,00 / $400,000 = 2.75

Reinhold company has a balance sheet, stating that Reinhold has $150,000 in short-term notes payable, $630,000 in long-term bonds. Also noted in the balance sheet, Reinhold company has $1.7 million in total equity. What would Reinhold's company total debt to total capital ratio be? (Answer in a percentage)

Formula: Debt Ratio = Total Debt / Total Capital ($150,000 + $630,000) / $1,700,00 = .4588 = 45.88%

Wayne Enterprises has been conducting business under an operating income of around $3,570 and a net income of around $2,150.60 as of recent memory. After a massive technological advancement on their product sales are now at $57,000. Calculate both the Operating Margin and Profit Margin Ratio. Round to the nearest hundredth.

Operating Margin = Operating Income (EBIT)/Sales = 3,570/57,000 = 0.0626 x 100 = 6.26 Profit Margin = Net Income/Sales = 2,150.60/57,000 = 0.0377 x 100 = 3.77

Define, explain, and give examples of profitability ratios and how they can be used.

Profitability ratios show how profitable a company is operating. In other words, they show how successful a company is at making profit or money. The company and its shareholders would want to know how the company is doing financially to see if there needs to be any improvement. If they know that they aren't making enough profit, they would need to reassess their plans and determine how to make their company profitable. Depending on if the company is profitable or not will determine if investors would want to invest in that company. Investors usually invest in companies that they know will be successful and will give them a high return on their investment. Some examples of profitability ratios are profit margin, return on total assets, and return on common equity (other examples are operating margin and return on invested capital). Profit margin allows companies to know how much net income is gained from every dollar of sales. It divides net income by sales. Return on total assets shows how much return a company is getting from their use of total assets. It divides net income by total assets. Return on common equity shows companies how much return they are getting on common stockholders' investment. It divides net income by common equity. Overall, profitability ratios allow firms to see how profitable they are, and these ratios can be used by companies to improve their operations as well as by people who are determining whether to invest in the company.

What are the three potential misuses of Return on Equity (ROE)?

ROE does not consider risk, ROE does not consider capital invested, and A focus on ROE may cause managers to turn down profitable projects

Define ROE and ROIC, and explain how they differ from one another.

Return on Common Equity (ROE), is the ratio of net income to common equity. Return on invested capital (ROIC), is the ratio of after-tax operating income to total invested capital. ROE and ROIC differ from each other in that ROIC's return is calculated by looking at total invested capital rather than total assets. Also, ROIC uses after-tax operating income rather than net income as ROE does.

How do you calculate the inventory turnover ratio?

Sales / Inventories

Define, explain and give examples of BEP Ratio.

The basic earning power ratio formula is simple and takes Earnings Before Interest and Taxes (EBIT) and divides it by Total Assets. To calculate EBIT, start with net profit and then add back interest and taxes the company paid. EBIT measures the ability of the firm's assets to generate operating income and shows raw earning power of the firm's assets before influence of taxes and debt.

Define, explain, and give some examples that illustrate how having (a) seasonal factors and (b) divisions involved in different industries might distort a comparative ratio analysis. How might these problems be alleviated?

a. Seasonal factors are factors that determine changes in production, distribution, sales, etc. for a part of a year (with produce, usually a season of the year, hence the name). These factors can distort comparative ratio analysis in several ways. Seasonal growth rates could distort a comparative ratio analysis for stores that see more business in one season than others, like some department stores that see much more business during the holiday season. Large seasonal changes in revenue can also create false imbalances in the balance sheets of some organizations. For example, following a natural disaster that occurs during tornado season, a house repair firm may have a terrible first quarter but a robust second quarter. With this in mind it is better to analyze yearly ratios compared to quarterly or monthly in some cases. Another option to solve this problem is to compare the first quarter of this year to the first quarter of the prior year. b. A company having divisions in different industries means that it is a conglomerate competing and selling products, services, or other goods in multiple industries at the same time. An example of this would be Pepsico, which is involved in the soda, chip, breakfast, and even juice industries. A company like this may have different products that have their own individual growth rates based on different market variables. When a corporation attempts to do a comparative ratio study across the entire organization, the results can be confusing and deceptive. To address this problem, each product should have its own comparative ratio study, which will give management a clearer picture of which goods are underperforming and which are outperforming the others..

Define, explain, and give examples of market value ratios, and explain the primary ways in which they are used.

● Market values ratios are ratios that relate the firm's stock price to its earnings and book value per share. ● If the liquidity asset management, debt management, and profitability ratios all look good, and if investors think these ratios will continue to look diffegood in the future, the market value ratios will be high; the stock price will be as high as can be expected; and management will be judged as having done a good job. ● The market value ratios are used in three primary ways: by investors when they are deciding to buy or sell a stock, by investment bankers when setting the share price for a new stock issue (an IPO), and by firms when they are deciding how much to offer for another firm in a potential merger. ● Some examples of market value ratios include: Price/Earnings ratio, which shows how much investors are willing to pay per dollar of reported profits and market/book ratio. Which gives an indication of how investors regard the company. Companies that are well regarded by investors (which means low risk and high growth-have high M/b ratios.

1. Company XYZ has the following: 78M In Total Debt 120M In Total Capital 20M In Operating Expenses 40M In Bonds Payable 20M In Long Term Debt What is Company XYZ's debt management ratio (D/E ratio)?

0.65 Formula: Total Debt / Total Capital 78/120 = 0.65

In 2022 Company ABC made 250M in sales. Their cost of goods sold totaled 55M, long term debt 67M, and total assets equaled 160M. What is Company ABC's total asset turnover ratio? Round to second decimal

1.56 Formula: Sales / Total Assets 250/160 = 1.5625 = 1.56

Ospina's company's sales last year were $550,000, its operating costs were $179,000, and interest charges were $100,000. What is the TIE ratio?

3.71 Times-interest earned (TIE) ratio = EBIT/Interest charges EBIT = Sales Revenue - Operating Costs EBIT = 550,000-179,000= $371,000 Interest charges= $100,000 TIE ratio = $371,000/$100,000 *TIE=3.71

1) Frutas Corp. has been working on their balance sheet and has concluded that their current assets accumulate to $1,500,000. Their current liabilities added up to $950,000 and their inventory came up to around $100,000. Calculate both the Current and Quick Ratio. Round to the nearest hundredth.

Current Ratio = Current Assets/Current Liabilities = 1,500,000/950,000 = 1.58 Quick Ratio = (Current Assets -Inventories)/Current Liabilities = (1,500,000 - 100,000)/950,000 = 1,400,000/950,000 = 1.47

The Balance Sheet and Income statement below are the Casablanca Inc. Note the firm has no amortization charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable will be rolled over. What is the firm's total debt to total Capital ratio? Balance Sheet (Millions of $) Assets 2015 Cash & Securities $2,500 Account Receivable 11,500 Inventories 16,000 Total Current Assets $30,000 Net Plant and Equipment $20,000 Total Assets $50,000 Liabilities & Equity Accounts Payable $9,500 Accruals $5,500 Notes Payable 7,000 Total Current Liabilities $22,000 Long Term Bonds $15,000 Total Liabilities $37,000 Common Stock $2,000 Retained Earnings 11,000 Total Common Equity $13,000 Total Liabilities and Equity $50,000 Income statement (Millions of $) 2015 Net sales $87,500 Operating Costs Except Depreciation 81,813 Depreciation 1,531 Earnings before Interest and taxes (EBIT) $4,156 Less Interest 1,375 Earnings before taxes (EBIT) $2,781 Taxes 973 Net Income $1,808 Other DATA Shares Outstanding (millions) 500.00 Common Dividends $632.73 Int Rate on notes payable & L-T bonds 6.25% Federal Plus rate income tax rate 35% Year-end stock price $43.39 A. 48.55% B. 53.95% C. 59.94% D. 62.80% E. 68.11%

D. 62.80% Formula: Total Debt / Total Capital = Total Debt / total debt + Equity (15,000 + 7,000) / (15,000 + 7,000 + $13,000) = 22,000 / 35,000 = 62.80%

Which of the following is the correct formula to calculate Return on Common Equity? A. Net income/ Total invested capital B. Net income/ Total assets C. Total invested capital/ assets- liabilities D. Net Income/ Common Equity

D. Net Income/ Common Equity

Accounts receivable are evaluated by the ______________ ratio

Days sales outstanding

Precious Metal Mining has $17 million in sales, its ROE is 17%, and its total assets turnover is 3.2X. Common equity on the firm's balance sheet is 50% of its total assets. What is its net income?

$0.45 Million Total asset turnover ratio = turnover/total assets 3.2 = 17/total assets 3.2* total assets = 17 Total assets = 17/3.2 = $5.31 Million Step 2 Common stock = 50% of total assets = 50% of 5.3 = $ 2.66 million Step 3 ROE is 17% Hence net income $2.66 * 17% = 0.45 Million

Barley & Bartmen Inc. has a DSO of 25 days, and its annual sales are $3.5 million. What is its account receivable balance? Assume that it uses a 365-day year and round to the nearest dollar.

$239,726 Formula: DSO = Accounts Receivable/Average Sales Per Day Average Sales Per Day = 365/25 = 14.6 3,500,000/14.6= 239,726

Ospina's company's total invested capital is $780,000 for solar panels in India. Their total debt outstanding is $150,000. What is the total debt needed to achieve a debt to capital ratio of 60%, knowing that the size of the firm will not change?

$318,000 Debt to Capital Ratio = Debt/ Capital Current Debt to Capital Ratio = $150,000/ 780,000= 19% Target Debt to Capital Ratio = 60% = 0.60 debt/ capital = .0.60 Let's say the new debt is x... x/ $780,000=0.60 x= $468,000 Excess debt needed by the company is $468,000 - $150,000 *=$318,000

DSO AND ACCOUNTS RECEIVABLE: FastTrans Inc. currently has $205,000 in accounts receivable, and its day sales outstanding (DSO) is 71 days. It wants to reduce its DSO to 20 days by pressuring more of its customers to pay their bills on time. If this policy is adopted, the company's average sales will fall by 15%. What will be the level of accounts receivable following the change? Assume a 365-day year.

$49084.51 DSO= Accounts receivable * 365/sales 71= 205,000 * 365/71 = 1053873.239 Expected sales post new policy: 1053873.239*(1-0.15) = 896792.25 DSO=Accounts receivable * 365/sales 20=Accounts receivable * 365/895792.25 Accounts receivable= 20*895792.25/365 Accounts receivable= 49084.51

A company has a total capital of $5 million. They have short-term debt of $125,000 and long-term debt of $1,000,000. What is their debt ratio?

(Total Debt)/(Total Capital) = Debt Ratio Total Debt = (Short-term Debt) + (Long-term Debt) Short-term Debt = $125,000 Long-term Debt = $1,000,000 Total Debt = ($125,000) + ($1,000,000) = $1,125,000 Total Capital = $5,000,000 Answer: Debt Ratio = $1,125,000/$5,000,000 = 0.225 = *22.5%

Define, explain, and give examples of Ratio Analysis and its limitations

- Ratio Analysis helps corporations evaluate financial statements and is typically used for comparison of between other companies within the same industry and is typically used by managers, credit analysts, and stock analysts. - Examples would be liquidity, debt management, profitability, etc. - Since all things within business needs it limitations, some examples would be that when a company is multidivisional it can be Trichy to set an industry average or firms can use "window dressing" techniques to improve upon their financial statements.

Which of the following is NOT a ratio? A. Liquid Ratio B. Market Value Ratio C. Asset Management Ratio D. Equity Ratio

D. Equity Ratio

Give some examples that illustrate how (a) seasonal factors and (b) different growth rates might distort a comparative ratio analysis. How might these problems be alleviated?

The following accounts can be used to explain seasonal factors: For businesses with seasonal sales patterns, cash, receivables, and inventory, as well as current obligations, fluctuate throughout the year. As a result, unless averages (monthly ones are better) are employed, those ratios that assess balance sheet statistics will change. Common equity is calculated at a specific period in time, such as December 31, 2016, for various growth rates. Profits are earned over a period of time, such as in 2016. Because year-end equity will be substantially bigger than beginning-of-year equity if a company is growing quickly, the computed rate of return on equity will fluctuate depending on whether the denominator is end-of-year, beginning-of-year, or average common equity. The ideal statistic to utilize is the average common equity. People are said to have utilized end-of-year or beginning-of-year equity to make returns on equity look excessive or inadequate in public utility rate arguments. When a company is being reviewed, similar issues might occur.

T/F: Current ratio is calculated by dividing current assets by current liabilities

True

What describes days sales outstanding the best? a. It is a ratio that divides accounts payables by net income to give you how long you have left until you go into debt b. It is a ratio that divides sales by assets to show how effective assets are being used. c. It is a ratio that divides accounts receivables by average sales per day to show how long it will take for the firm to receive cash after making a sale. d. It is a ratio that divides the cost of goods sold by inventories to show how many times inventory is being turned over.

c. It is a ratio that divides accounts receivables by average sales per day to show how long it will take for the firm to receive cash after making a sale.

Which of the following is not a potential problem and limitation of financial ratio analysis a. Comparison with industry averages is difficult for a conglomerate firm that operates in many different divisions b. Different operating and accounting practices can distort comparisons. c. Sometimes it is easy to tell if a ratio is "good" or "bad." d. Difficult to tell whether a company is, on balance, in a strong or weak position.

c. Sometimes it is easy to tell if a ratio is "good" or "bad."