FINC Ch 4 Questions

(a) A company has current liabilities of $500 million, and its current ratio is 2.0. What is the total of its current assets?

$100 million Current ratio = current assets / current liabilities 500 million * 2.0 = current assets

(b) If its this firm's quick ratio is 1.6, how much inventory does it have?

$200 million Quick ratio = current assets - inventories) / current liabilities 1.6 = 100 million - x ) / 500 million

(4-10) List three types of users of ratio analysis. Would the different users emphasize the same or different types of ratios? Explain.

1) managers - use ratios to help analyze, control, and thus improve their firms' operations. 2.) credit analysts - including bank loan officers and bond rating analysis, who analyze ratios to help judge a company's ability to repay its debts. 3.) Stock analysts - are interested in a company's efficiency, risk, and growth prospects.

(4-11) What are some qualitative factors that analysts consider when evaluating a company's likely financial performance?

1. Are the company's revenues tied to one key customer? 2. To what extent are the company's revenues tied to one key product? 3. To what extent does the company rely on a single supplier? 4. What percentage of the company's business is generated overseas? (greater reward but greater risk) 5. How much competition does the firm face? 6. Is is necessary for the company to continually invest in research and development? 7. Are changes in laws and regulations likely to have important implications for the firm?

List several potential difficulties with ratio analysis.

1. Many firms have divisions that operate in different industries. Industry average is better for narrowly focused firms. 2. Most firms want to be better than average. In this case, it is better to look at the industry leaders' ratios. Benchmarking. 3. Inflation has distorted many firms' balance sheets - book values are often different from market values. 4. Seasonal factors can also distort a ratio analysis. The problem can be fixed by using monthly averages for inventory when calculating turnover ratios. 5. Firms can employ "window dressing" techniques to improve their financial statements. 6. Different accounting practices can distort comparisons. 7. It is difficult to generalize about whether a particular ratio is "good" or "bad". 8. Some firms have some good numbers and some bad numbers.

(4.5) Identify five profitability ratios and write their equations.

1. Operating Margin EBIT / Sales 2. Profit Margin Net income / Sales 3. Return on total assets (ROA) Net income / Total assets 4. Basic Earning Power (BEP) EBIT / Total assets 5. Return on common equity (ROE) Net income / Common equity

(4-8) If a firm takes steps that increase its expected future ROE, does this necessarily mean that the stock price will also increase? Explain.

1. ROE doesn't consider risk. 2. ROE doesn't consider the amount of invested capital 3. A focus on ROE can cause managers to turn down profitable projects.

(4.1) What are 5 ways the 5 ratio categories help a business?

1. They are necessary to continue operations 2. they keep costs low and net income high 3. they tell how risky the firm is and the amount of operating income must be paid to bondholders rather than stockholders. 4. it combines asset and debt management and shows effects on ROE 5. It shows what investors think about a company and prospects

(4.3) Write the equation for four ratios that are used to measure how effectively a firm manages its assets.

1.) Inventory turnover ratio = sales / inventories 2.) DSO (Days sales outstanding) = Receivables / Annual sales /365) 3.) Fixed assets turnover ratio = Sales / Net Fixed assets 4.) Total assets turnover ratio = Sales / Total assets

A firm has annual sales of $100 million, $20 million of inventory and $30 million of accounts receivable. What is its DSO?

109.5 days DSO (Days sales outstanding) = Receivables / Annual sales /365) 30 million / (100 million / 365 = 109.5

(b) What is its ROE?

20% Return on common equity (ROE) Net income / Common equity $1 billion / ($10/2) = .2

A firm has annual sales of $100 million, $20 million of inventory and $30 million of accounts receivable. What is its inventory turnover ratio?

5 times Inventory turnover ratio = sales / inventories 100 million / 20 million = 5

(a) A company has $20 billion of sales and $1 billion of net income. Its total assets are $10 billion, financed half by debt and half by common equity. What is its profit margin?

5% Profit Margin Net income / Sales $1 billion / $20 billion =.5

(4-7) Write the equation for the DuPoint equation.

=Profit Margin * Total assets turnover * equity multiplier = (net income / sales) * (Sales / Total Assets) * (Total assets / Total common equity)

Why does the use of debt lower the profit margin and the ROA?

A low ROA can result from a conscious decision to use a great deal of debt, in which case high interest expenses will cause net income to be relatively low. You must look at a number of ratios, see what each suggests and then look at the overall situation when you judge a performance of a company and consider what actions it should undertake to improve.

How does one do a trend analysis?

A trend analysis is a firm's financial ratios over time. You simply plot a ratio over time.

(4.2) What are the characteristics of a liquid asset?

An asset that can be converted to cash quickly without having to reduce the asset's price very much.

Explain how inflated and R&D programs might cause book values to deviate from market values.

Asset value, as reported by accountants on corporate balance sheets, do not reflect either inflation or goodwill. Assets purchased years ago at pre-inflation prices are carried at their original costs even though inflation might have caused their actual values to rise substantially; and successfully companies' values rise above their historic costs, whereas unsuccessful ones have low M/B ratios.

How is book value per share calculated?

Book value per share =common equity / Shares outstanding

Give some examples of liquid assets.

Cash on hand, current account, savings account, marketable securities. Anything that can be easily converted to cash.

Name two ratios that are used to measure financial leverage and write their equations.

Debt Ratio Total debt / total assets Time-Interest-Earned (TIE) ratio EBIT / Interest Charges

Using more debt lowers profits and thus the ROA. Why doesn't debt have the same negative effect on the ROE?

Debt lowers net income, but it also lowers the firm's equity; and the equity reduction can offset the lower net income.

How does the decision to use debt involve a risk-versus-rertun trade-off?

Firms with relatively high debt ratios typically have higher expected returns when the economy is normal but lower returns and possibly bankruptcy if the economy goes into a recession.

How might different ages distort comparisons of different firms' fixed assets turnover ratios?

Fixed assets are shown on the balance sheet at their historical costs less depreciation. Inflation has caused the value of many assets that were purchased in the past to be seriously understated. Therefore, when comparing an old firm w depreciated assets and new company with assets who aren't depreciated, the old firm will have a higher fixed asset turnover ratio.

(4.4) How does the use of financial leverage affect stockholders' control position?

If stockholders put money into a company that has taken the risk of leveraging up they will see a higher ROE but there will be a higher chance of the firm going bankrupt as well. Higher risk higher reward higher threats.

How does the U.S. tax structure influence a firm's willingness to finance with debt?

Interest is deductible so the use of debt lowers the tax bill and leaves more of the firm's operating income available to investors

Which is the least liquid of the firm's current assets?

Inventories

How can management use the DuPoint equation to analyze ways of improving the firm's performance?

It can be used to help identify ways to improve its performance by focusing in on the departments who work with the specific ratios.

Why are comparative ratio analysis useful?

It gives a good indication of a firms strengths and weaknesses relative to the average company in the industry.

What important information does a trend analysis provide?

It is great insight on why the ROE behaved as it did.

(4.1) What are the 5 ratio categories?

Liquidity ratios Asset management ratios debt management ratios profitability ratios market value ratios

If competition causes all companies to have similar ROEs in the long run, would companies with high turnovers tend to have high or low profit margins? Explain.

Low

In what sense do these market value ratios reflect investors' opinions about a stock's risk and expected future growth?

M/B ratio typically exceeds 1.0, which means that investors are willing pay more for stock than the accounting book value of the stocks.

(d) Would its ROE increase?

No

(b) If one firm's P/E ratio is lower than that of another firm, what factors might explain the difference?

P/E ratios are relatively high for firms with strong growth prospects and little risk but low for slow growing and risky firms.

(4-6) Describe two ratios that relate a firm's stock price to tis earnings and book value per share and write their equations.

Price/Earnings (P/E) ratio =Price per share / earnings per share This shows how much investors are willing to pay per dollar of reported profits Market/book (M/B) ratio =Market price per share / book value per share The ratio of a stock's market price to its book value

(4-9) Why might railroads have such low total assets turnovers and food wholesalers and grocery stores such high turnovers?

Railroads require many long-term assets; while grocery companies have more perishable products and thus higher turnovers.

If one firm is growing rapidly and another is not, how might this distort a comparison of their inventory turnover ratios?

Sales occur over the entire year, whereas inventory figure is for one point in time. If the business is seasonal or if there has been a strong upward or downward sales trend during the year, it is especially useful to make an adjustment to the average inventory measurement.

(a) What does the price/earnings (P/E) ratio show?

The dollar amount investors will pay for $1 of current earnings.

What is the equity multiplier, and why is it used?

The equity multiplier is the adjustment factor that represents how many times more your assets are worth coated to your equity. You want your equity to be higher than your assets.

If you wanted to evaluate a firm's DSO, with what could you compare it?

The industry average or by comparing it to the firm's credit terms. If the credit policy calls for payment within 30 days and its been 46 days, your not doing well.

Explain the following statement: Analysts look at both balance sheet and income statement ratios when appraising a firm's financial condition.

The two procedures that analysts use to examine a firm's debt: 1) they check the balance sheet to determine the proportion of total funds represented by debt. 2.) they review the income statement to see the extent to which interest is covered by operating profits.

What question are the two liquidity ratios designed to answer?

Will the firm be able to pay off its debts as they come due and thus remain a viable organization?

(c) Would this firm's ROA increase if it used less leverage?

Yes