FIN 320: Chapter Four (Analysis of Financial Statements)

Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the industry. ROE is considered a very important measure, and managers strive to make the company's ROE numbers look good. An increase in ROE would ___ imply an increase in shareholder wealth.

sometimes

If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the ___ , the ___ ratio, and the ___ .

1. net profit margin 2. total asset turnover ratio 3. equity multiplier

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 ___ .

1. use of debt versus equity financing 2. control over its expenses

Monroe Manufacturing has a quick ratio of 2.00x, $28,125 in cash, $15,625 in accounts receivable, some inventory, total current assets of $62,500, and total current liabilities of $21,875. The company reported annual sales of $200,000 in the most recent annual report. Over the past year, how often did Monroe Manufacturing sell and replace its inventory?

10.67x

One year later, Cute Camel's shares are trading at $54.56 per share, and the company reports the value of its total common equity as $39,228,000. Given this information, Cute Camel's market-to-book (M/B) ratio is ___.

11.68x

Net Fixed Assets: Like Games = 110,000 | Our Play = 160,000 | Industry = 433,500

2. Like Games's fixed assets turnover ratio is higher 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 higher amount for its fixed assets.

Net Fixed Assets: Like Games = 110,000 | Our Play = 160,000 | Industry = 433,500

2. Our Play's fixed assets turnover ratio is lower than that of Like Games. This could be because Our Play is a relatively new company, so the acquisition cost of its fixed assets is higher than the recorded cost of Like Games's net fixed assets.

Total Assets: Like Games = 190,000 | Our Play = 250,000 | Industry = 469,200

3. Like Games's total assets turnover ratio is 1.05x , which is lower than the industry's average total assets turnover ratio. In general, a higher total assets turnover ratio indicates greater efficiency.

Total Assets: Like Games = 190,000 | Our Play = 250,000 | Industry = 469,200

3. The average total assets turnover in the electronic toys industry is 1.09x , which means that $1.09 of sales is being generated with every dollar of investment in assets. A higher total assets turnover ratio indicates greater efficiency. Both companies' total assets turnover ratios are lower than the industry average.

Which of the following is considered a financially leveraged firm?

A company that uses debt to finance some of its assets

You work for a brokerage firm. Your boss asked you to analyze Blue Parrot Manufacturing's performance for the past three years and to write a report that includes a benchmarking of the company's performance. Which of the following components would be best for you to include in your financial statement analysis?

A comparison of the firm's performance with other firms in the same industry based on their financial ratios

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:

Analyze the firm's financial ratios over time

As a result of targeting by unethical product liability attorneys, Southern, a small manufacturer of a revolutionary crawfish steamer, currently has a multimillion-dollar class action lawsuit pending. Although the steamer is completely reliable and safe, one person was injured as a result of using it inappropriately. Other purchasers have joined the lawsuit in an effort to collect "free" funds. How would you expect this situation to affect the assessment of Southern's financial condition and performance?

Being small, Southern may lack the financial resources and media-management expertise to successfully defend itself in the lawsuit and the media. This could jeopardize Southern's current and future sales and profits.

A liquid asset can be converted to cash quickly without significantly impacting the asset's value. Which of the following asset classes is generally considered to be the most liquid?

Cash

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 comparative analysis for the current year, you would:

Compare the firm's financial ratios with other firms in the industry for the current year

N&B Equipment Company's quick ratio is 0.7467

Current Asses - Inventory / Current Liabilities $900 - $396 / $675 = 0.7467

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

False

The inventory turnover ratio across companies in the aerospace industry is 9.108x. Based on this information, which of the following statements is true for Franklin Aerospace?

Franklin Aerospace is holding more inventory per dollar of sales compared with the industry average.

Based on your understanding of the uses and limitations of ROE, a rational investor is likely to prefer an investment option that has:

High ROE and low risk

OK, so given your knowledge of the component ratios used in the DuPont equation, which of the following strategies should improve the company's ROE?

Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases 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.

Which of the following statements represent a weakness or limitation of ratio analysis?

Inflation can distort balance sheet data. A firm's ratios can lead to conflicting conclusions—some ratios might be "good" and some "bad."

Northern assembles computers in the owner's garage from parts the owner orders over the Internet. This industry is characterized by low barriers to entry, including few operating licenses or governmental approvals, and small investments in productive equipment or facilities. How would you expect this situation to affect the assessment of Northern's financial condition and performance?

Its low barriers to entry expose Northern to increased risk of competition, which could negatively affect the predictability of its expected future sales revenues.

Which of the following statements are true?

Jing Foodstuffs Corporation has a better ability to meet its short-term liabilities than N&B Equipment Company. If a company's current liabilities are increasing faster than its current assets, the company's liquidity position is weakening. An increase in the quick ratio over time usually means that the company's liquidity position is improving and that the company is managing its short-term assets well.

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 ___ debt ratios.

Low

____ ratios examine the market value of a company's share price, its profits and cash dividends, and the book value of the firm's assets and relate them to other data items to determine how the firm is perceived in the stock market.

Market value or market based

The following shows Dernham Inc. 's income statement for the last two years. The company had assets of $11,750 million in the first year and $18,796 million in the second year. Common equity was equal to $6,250 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 = 77.35% Profit margin = 50.48% Return on total assets = 17.64% Return on common equity = 53.06% Basic earning power = 32.00%

___ ratios help measure a company's ability to generate income and profits based on its invested capital.

Profitability

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

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 OR = Net Income/Sales × Sales/Total Assets × Total Assets/Total Common Equity

Which of the following statements does NOT represent a weakness or limitation of ratio analysis?

Ratio analysis is conducted using benchmarking techniques.

Equity Multiplier: Company A = 2.14 Company B = 2.61 Company C = 3.60 Referring to these data, which of the following conclusions will be true about the companies' ROEs?

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.

What is the most commonly used base item for a common size balance sheet?

Total assets

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

These ratios, which help determine how efficiently a firm is using its assets to generate sales are called ___ ratios.

asset management or activity

Ratios that help assess a company's ability to service the interest and repayment obligations on its long-term debt and the degree to which it uses borrowed versus invested financial capital are called ___ ratios.

debt or financial leverage management

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 less competition is considered to be ___ risky than companies with multiple competitors.

less

Ratios that help determine whether a company can access its cash and pay its debts that mature in less than a year are called ___ ratios.

liquidity

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 product is considered to be ___ risky than companies with a wide range of products.

more

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

not necessarily

Cute Camel Woodcraft Company just reported earnings after tax (also called net income) of $9,750,000 and a current stock price of $28.50 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 2,900,000 new shares of stock (raising its shares outstanding from 5,500,000 to 8,400,000). If Cute Camel'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?

$23.35 per share

Accounts Receivable: Like Games = 5,400 | Our Play = 7,800 | Industry = 7,700

1. A low days of sales outstanding represents an efficient credit and collection policy. Between the two companies, Like Games is collecting cash from its customers faster than Our Play , but both companies are collecting their receivables less quickly than the industry average.

Accounts Receivable: Like Games = 5,400 | Our Play = 7,800 | Industry = 7,700

1. Our Play has 14.24 days of sales tied up in receivables, which is much higher than the industry average. It takes Our Play more time to collect cash from its customers than it takes Like Games.

Franklin Aerospace has a quick ratio of 2.00x, $36,225 in cash, $20,125 in accounts receivable, some inventory, total current assets of $80,500, and total current liabilities of $28,175. The company reported annual sales of $200,000 in the most recent annual report. Over the past year, how often did Franklin Aerospace sell and replace its inventory?

8.28x

Which of the following statements does NOT represent a weakness/limitation of ratio analysis?

A firm's financial statements show only one period of financial data.

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.

A higher operating margin than the industry average indicates either lower operating costs, higher product pricing, or both. If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.

Based on the preceding information, your calculations, and your assumptions, which of the following statements can be included in your analysis report?

A plausible reason why Cold Goose Metal Works Inc.'s price-to-cash-flow ratio has increased is that investors expect higher cash flow per share in the future. Cold Goose Metal Works Inc.'s ability to meet its debt obligations has worsened since its debt-to-equity ratio increased from 0.30 to 0.38. An improvement in the inventory turnover ratio could likely be explained by the new sales-forecasting strategies that led to better inventory management.

Which of the following statements is true about market value ratios?

Companies with high research and development (R&D) expenses tend to have high P/E ratios.

Jing Foodstuffs Corporation's quick ratio is 0.9289

Current Asses - Inventory / Current Liabilities $1,400 - $616 / $844 = 0.9289

Jing Foodstuffs Corporation's current ratio is 1.6588

Current Asses / Current Liabilities $1,400 / $844 =1.6588

N&B Equipment Company's current ratio is 1.3333

Current Asses / Current Liabilities $900 / $675 = 1.3333

Blue Sky Drone Company has a total asset turnover ratio of 3.50x, net annual sales of $40 million, and operating expenses of $18 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $2.50 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 Blue Sky Drone's debt management ratios?

Debt ratio = 21.87% Times-interest-earned ratio = 80.00x

Which of the following statements represent a weakness or limitation of ratio analysis?

Different firms may use different accounting practices. A firm may operate in multiple industries.

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

The inventory turnover ratio across companies in the manufacturing industry is 9.0695x. Based on this information, which of the following statements is true for Monroe Manufacturing?

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

Which of the following factors directly affect a company's ROE?

Net Income / Sales & Total Assets / Total Common Equity

What is the most commonly used base item for a common size income statement?

Net Sales

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

Which of the following is true about the leveraging effect?

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