Chapter 4

Can a company's shares exhibit a negative P/E ratio? No Yes

yes

One year later, Cold Goose's shares are trading at $48.36 per share, and the company reports the value of its total common equity as $46,768,000. Given this information, Cold Goose's market-to-book (M/B) ratio is ______

8.27 x BVPS= Common Equity/Shares Outstanding = $46,768,000/8,000,000 shares = $5.85 M/B Ratio= Market Price per Share/BVPS = $48.36 per share/$5.85 = 8.27 ×

Based on your understanding of the uses and limitations of ROE, which of the following projects should be chosen if they have the same risk and cost of capital? Project X, with 35% ROE and a large investment, generating high expected cash flows Project Y, with 40% ROE and a small investment, generating low expected cash flows

Project X, with 35% ROE and a large investment, generating high expected cash flows

1.Our Play has ___ days of sales tied up in receivables, which is much ______ than the industry average. It takes Our Play ____ time to collect cash from its customers than it takes Like Games.

14.24 higher more Days of Sales Outstanding=Receivables/Average Sales per Day Like Games 9.86 days Our Play 14.24 days Industry Average 5.51 days

Which of the following asset classes is generally considered to be the most liquid? Accounts receivable Inventories Cash

Cash

Green Penguin Pencil Company has a total asset turnover ratio of 6.00x, net annual sales of $25 million, and operating expenses of $11 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $1.75 million on which it pays a 11% interest rate. To analyze a company's financial leverage situation, you need to measure the firm's debt management ratios. Based on the preceding information, what are the values for Green Penguin Pencil's debt management ratios?

Debt Ratio 41.97% Times-interest-earned ratio 77.73x Total Asset Turnover Ratio = Sales / Total Assets 6.00= $25 million / Total Assets Total Assets= $25 million / 6.00 = $4.17million Debt Ratio=Total Debt / Total Assets =Total Debt / Total Debt & Equity Debt Ratio=$1.75 million / $4.17 million =41.97% EBIT= Total Sales - Total Operating Costs = $25 million - $11 million = $14.00million Interest Charges= Interest Rate × Debt Outstanding = 11% × $1.75million = $0.1925 million TIE Ratio = EBIT / Interest Charges TIE Ratio=$14.00 million / $0.1925 million=72.73 x

The DuPont Equation A DuPont analysis is conducted using the DuPont equation, which helps to identify and analyze three important factors that drive a company's ROE. Complete the following equations, which are needed to conduct a DuPont analysis:

ROE=Profit Margin×Total Assets Turnover×Equity Multiplier =Net Income / Sales × Sales / Total Assets × Total Assets / Total Common Equity

Referring to these data, which of the following conclusions will be true about the companies' ROEs? The main driver of Company A's inferior ROE, as compared with that of Company B's and Company C's ROE, is its use of higher debt financing. The main driver of Company C's superior ROE, as compared with that of Company A's and Company B's ROE, is its operational efficiency. The main driver of Company C's superior ROE, as compared with that of Company A's and Company B's ROE, is its greater use of debt financing.

The main driver of Company C's superior ROE, as compared with that of Company A's and Company B's ROE, is its greater use of debt financing. Company C has an equity multiplier of 3.60, which is greater than the equity multiplier of the other companies.

If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: thenet profit margin , the total asset turnover ratio, and the _____

equity multiplier

Influenced by a firm's ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with _____ times-interest-earned ratios (TIE).

high

And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company's _____ , effectiveness in using the company's assets, and _____

use of debt versus equity financing control over its expenses

Cold Goose Metal Works Inc. just reported earnings after tax (also called net income) of $9,000,000 and a current stock price of $34.00 per share. The company is forecasting an increase of 25% for its after-tax income next year, but it also expects it will have to issue 2,500,000 new shares of stock (raising its shares outstanding from 5,500,000 to 8,000,000). If Cold Goose's forecast turns out to be correct and its price/earnings (P/E) ratio does not change, what does the company's management expect its stock price to be one year from now? (Round any P/E ratio calculation to four decimal places.) $29.23 per share $34.00 per share $21.92 per share $36.54 per share

$29.23 per share EPS= Net Income/Shares Outstanding = $9,000,000/5,500,000shares = $1.64 P/E Ratio = Price per Share/EPS P/E Ratio= $34.00/$1.64 = 20.7317× Expected EPS= Expected Net Income/Outstanding Shares Next Year = $11,250,000/8,000,000 = $1.41 Expected Stock Price = Expected EPS × P/E Ratio = $1.41 × 20.7317 = $29.23 per share

Debt or financial leverage ratios help analysts determine whether a company has sufficient cash to repay its short-term debt obligations.

False

which of the following strategies should improve the company's ROE? Check all that apply. Use more equity financing in its capital structure, which will increase the equity multiplier. Increase the cost and amount of assets necessary to generate each dollar of sales because it will increase the company's total assets turnover. Increase the firm's bottom-line profitability for the same volume of sales, which will increase the company's net profit margin. Reduce the company's operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company's net profit margin.

Increase the firm's bottom-line profitability for the same volume of sales, which will increase the company's net profit margin. Reduce the company's operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company's net profit margin.

What is the most commonly used base item for a common size balance sheet? Total assets Net sales Net income Earnings before interest and taxes

Total assets

3.The average total assets turnover in the electronic toys industry is _____ , which means that _____ of sales is being generated with every dollar of investment in assets. A _____ total assets turnover ratio indicates greater efficiency. Both companies' total assets turnover ratios are _______ than the industry average.

1.09x $1.09 higher lower Total Assets Turnover Ratio=Sales/Total Assets Like Games 1.05x Our Play 0.80x Industry Average 1.09x

Which of the following is considered a financially leveraged firm? A company that uses only equity to finance its assets A company that uses debt to finance some of its assets

A company that uses debt to finance some of its assets

Your boss asked you to analyze Green Hamster Manufacturing's performance for the past three years and prepare a report that includes a benchmarking of the company's performance. Using the company's last three years of financial reports, you've calculated its financial ratios, including the ratios of Green Hamster Manufacturing's competitors—that is, comparable ratios of other participants in the industry—and submitted the report. Along with calculating the ratios, what else is needed for your report? Making observations and identifying trends that are suggested by the ratio analysis Identifying the factors that drive the trends in the ratios Both of the above

Both of the above

Which of the following statements is true about market value ratios? Low P/E ratios could mean that the company has a great deal of uncertainty in its future earnings. High P/E ratios could mean that the company has a great deal of uncertainty in its future earnings.

Low P/E ratios could mean that the company has a great deal of uncertainty in its future earnings.

Which of the following statements represent a weakness or limitation of ratio analysis? Check all that apply. Seasonal factors can distort data. Market data is not sufficiently considered. Window dressing might be in effect.

Seasonal factors can distort data. Window dressing might be in effect.

A company exhibiting a high liquidity ratio is likely to have enough resources to pay off its short-term obligations.

True

Asset management or activity ratios provide insights into management's efficiency in using a firm's working capital and long-term assets.

True

Market value or market based ratios help analysts figure out what investors and the markets think about the firm's growth prospects or current and future operational performance.

True

One possible explanation for an increase in a firm's profitability ratios over a certain time span is that the company's income has increased.

True

Monroe Manufacturing has a quick ratio of 2.00x, $34,875 in cash, $19,375 in accounts receivable, some inventory, total current assets of $77,500, and total current liabilities of $27,125. The company reported annual sales of $800,000 in the most recent annual report. Over the past year, how often did Monroe Manufacturing sell and replace its inventory? 37.85x 8.01x 2.86x 34.41x

34.41x Inventories = Current Assets - (Quick Ratio × Current Liabilities) = $77,500 - (2.00 × $27,125) = $23,250 another formula Inventories= Current Assets - (Cash + Accounts Receivable) = $77,500 − ($34,875 + $19,375) = $23,250 Inventory Turnover Ratio = $800,000/$23,250 = 34.41x

Suppose you are conducting an analysis of the financial performance of Cute Camel Woodcraft Company over the past three years. The company did not issue new shares during these three years and has faced some operational difficulties. The company has thus pilot tested some new forecasting strategies for better operations management. You have collected the company's relevant financial data, made reasonable assumptions based on the information available, and calculated the following ratios. Ratios Calculated Year 1 Year 2 Year 3 Price-to-cash-flow 3.20 2.24 1.79 Inventory turnover 6.40 5.12 4.10 Debt-to-equity 0.40 0.32 0.26 Based on the preceding information, your calculations, and your assumptions, which of the following statements can be included in your analysis report? Check all that apply. A decline in the inventory turnover ratio can be explained by the new inventory management system that the company recently adopted, which led to more efficient inventory management. A decline in the debt-to-equity ratio implies a decline in the creditworthiness of the firm. A decline in the inventory turnover ratio could likely be explained by operational difficulties that the company faced, which led to duplicate orders placed to vendors. A plausible reason why Cute Camel Woodcraft Company's price-to-cash-flow ratio has decreased is that investors expect lower cash flow per share in the future.

A decline in the inventory turnover ratio could likely be explained by operational difficulties that the company faced, which led to duplicate orders placed to vendors. A plausible reason why Cute Camel Woodcraft Company's price-to-cash-flow ratio has decreased is that investors expect lower cash flow per share in the future.

Suppose you are trying to decide whether to invest in a company that generates a high expected ROE, and you want to conduct further analysis on the company's performance. If you wanted to conduct a trend analysis, you would: Compare the firm's financial ratios with other firms in the industry for a particular year Analyze the firm's financial ratios over time

Analyze the firm's financial ratios over time

Which of the following statements are true? Check all that apply. Fitcom Corporation has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than Zebra Paper Corporation. A current ratio of 1 indicates that the book value of the company's current assets is equal to the book value of its current liabilities. If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations. Fitcom Corporation has a better ability to meet its short-term liabilities than Zebra Paper Corporation. An increase in the current ratio over time always means that the company's liquidity position is improving.

Fitcom Corporation has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than Zebra Paper Corporation. A current ratio of 1 indicates that the book value of the company's current assets is equal to the book value of its current liabilities. If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations.

Fitcom Corporation's current ratio is ____ , and its quick ratio is _______ ; Zebra Paper Corporation's current ratio is ______ , and its quick ratio is ____

Fitcom Current Ratio 1.3333 Current Ratio = Current Assets/Current Liabilities = 4500/3375 =1.3333 Fitcom Quick ratio 0.7467 = (Current Assets-Inventories)/Current Liabilities =(4500-1980)/3375 = 0.7467 Zebra Paper Corporation Current Ratio = 1.6592 = Current Assets/Current Liabilities = 7000/4219 =1.6592 Zebra Paper Corporation Quick Ratio = 0.9291 = (Current Assets-Inventories)/Current Liabilities =(7000-3080)/4219 =0.9291

Decision makers and analysts look deeply into profitability ratios to identify trends in a company's profitability. Profitability ratios give insights into both the survivability of a company and the benefits that shareholders receive. Identify which of the following statements are true about profitability ratios. Check all that apply. If a company has a profit margin of 10%, it means that the company earned a net income of $0.10 for each dollar of sales. If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes. An increase in a company's earnings means that the profit margin is increasing. If a company issues new common shares but its net income does not increase, return on common equity will increase.

If a company has a profit margin of 10%, it means that the company earned a net income of $0.10 for each dollar of sales. If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.

The inventory turnover ratio across companies in the manufacturing industry is 37.851x. Based on this information, which of the following statements is true for Monroe Manufacturing? Monroe Manufacturing is holding more inventory per dollar of sales compared with the industry average. Monroe Manufacturing is holding less inventory per dollar of sales compared with the industry average.

Monroe Manufacturing is holding more inventory per dollar of sales compared with the industry average.

Your boss has asked you to calculate the profitability ratios of Spandust Industries Inc. and make comments on its second-year performance as compared with its first-year performance. The following shows Spandust Industries Inc.'s income statement for the last two years. The company had assets of $4,700 million in the first year and $7,518 million in the second year. Common equity was equal to $2,500 million in the first year, and the company distributed 100% of its earnings out as dividends during the first and the second years. In addition, the firm did not issue new stock during either year.

Operating Margin=EBIT / Sales= y2 21.97% y1 9.85% Profit Margin=Net Income / Sales= y2 11.42% y1 5.45% Return on Total Assets=Net Income / Total Assets= y2 3.86% y1 2.32% Return on Common Equity=Net Income / Common Equity= y2 11.60% y1 4.36% Basic Earning Power = EBIT / Total Assets=y2 7.42% y1 4.19%

The American Association of Individual Investors (AAII) has identified several qualitative factors that should also be considered when evaluating a company's likely future financial performance. Consider the scenario and indicate how you would expect the described event or situation to affect the described business organization. Southern Supply Inc. The family who founded and operates Southern Supply Inc. is headed by a strong-willed and very astute octogenarian. The company has no succession plan for replacing him in the event of his injury, death, or incapacitation. How would you expect this situation to affect the assessment of Southern's financial condition and performance? Because the company is family owned, succession planning should not be an issue, and the family can pull together to run the organization when the leader dies. This should ensure that the company's expected future performance is maintained. The absence of a succession plan for Southern's leader and driving force can place the organization in serious jeopardy. A firm's financial condition and performance are the result of decisions made by the firm's leadership and staff. Although nonquantitative factors may be relevant to a company's financial evaluation in general terms, the details of this specific situation are not relevant to the firm's financial condition or performance.

The absence of a succession plan for Southern's leader and driving force can place the organization in serious jeopardy. A firm's financial condition and performance are the result of decisions made by the firm's leadership and staff.

Which of the following is true about the leveraging effect? Under economic growth conditions, firms with relatively low leverage will have higher expected returns. Under economic growth conditions, firms with relatively more leverage will have higher expected returns.

Under economic growth conditions, firms with relatively more leverage will have higher expected returns.

2.Like Games's fixed assets turnover ratio is _____ than that of Our Play. This is because Like Games was formed eight years ago, so the acquisition cost of its fixed assets is recorded at historic values when the company bought its assets and has been depreciated since then. Assuming that fixed assets prices (not book values) rose over the past six years due to inflation, Our Play paid a _____ amount for its fixed assets.

higher higher Fixed Assets Turnover Ratio=Sales/Net Fixed Assets Like Games 1.82x Our Play 1.25x Industry Average 1.18x

You decide also to conduct a qualitative analysis based on the factors summarized by the American Association of Individual Investors (AAII). According to your understanding, a company with one key customer is considered to be ______ risky than companies with several customers.

more

If a firm takes steps that increase its expected future ROE, its stock price will _____ increase.

not necessarily