Chapter 3 Questions Foundations of Financial Management Financial Analysis and planning

1) If we divide users of ratios into short term lenders, long term lenders, and stockholders, which ratios would each group be most interested I, and for what reasons

• Short term lenders
• Will be most interested in the firm’s ability to repay debt so they would be interested in the liquidity ratios, Current ratio and Quick ratio.
• Long term lenders
• Will be most interested in
• Debt to total assets but also in
• Liquidity ratios
• Current ratio
• Quick ratio
• As they want to be sure the business can meet it’s commitments
• Profitability ratios
• Profit margin
• Return on assets
• Return on equity
• As they are interested in the long term health and thus ability to repay that the firm has.

2) Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholder’s equity.

Profit margin is Net Income / Sales

Asset Turnover is Sales / Total Assets

Return on Assets is Profit Margin * Asset turnover

Return on equity is return on assets / (1- debt / Assets)

The Du Pont system stresses that a satisfactory return on assets may be achieved through high profit margin or rapid turnover of assets or both. With the Du Pont system the use of debt is also important as this affects the return on equity.

3) If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?

The average collection period will be getting longer.

4) What advantage does the fixed charge coverage ratio offer over simply using times interest earned?

Fixed charge coverage measures the firms ability to meet all the fixed obligations rather than just interest. The assumption is that failure to meet any financial obligation will endanger the firm. We need to see if they are safely coverered.

5) Is there any validity in rule of thumb ratios for all corporations, for example, a current ratio of 2 to one or debt to assets of 50%?

These can be useful to a certain extent. For example 2to one current ratio means that you should be able to pay current liabilities as they come due. However this would be more useful if you also had some information on inventory turnover and even better on Accounts Receivable turnover. However it is best to make comparison to industry benchmarks and even better than this compare the trends of the business over time with the trends for other businesses over the same time frame.

6) Why is trend analysis helpful in analyzing ratios.

Trend analysis shows changes in a particular ratio over time and allows one to she the changes that occur in profitability, asset utilization etc. over time. This is even better when the trend analysis includes an analysis of trends within the industry. As the industry may be subject to cyclical fluctuations. Competitive pressures in the industry might change as might the general business environment.

7) Inflation can have significant effect on income statement and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios and explain the direction of the impact based on your assumptions.

• Return on investment
• Inflation will tend to make this trend higher over time as investment assets are recorded at historical old low values while income is recorded at inflated new values
• Inventory turnover
• Again inflation will make this ratio trend higher as Sales are recorded at the inflated new rate compared to the older value for Inventory. This is especially true if FIFO is used for inventory valuation but is moderated to some extent by the use of LIFO.
• Fixed Asset Turnover
• Again inflation will trend this ratio higher as sales are recorded at a lower inflated price while fixed assets are recorded at historical lower prices.
• Debt to assets ratio
• This ratio will not be greatly affected by inflation unless assets are acquired continuously while debt is constant. (This could be the case, in which case the ratio would trend lower with inflation) making the debt position appear move favorable.

8)What affect will disinflation following a highly inflationary period have on the reported income of the firm?

A great change in ratios will occur as expensive inventory is charged against softening prices.

9) Why might disinflation prove favorable to financial assets.

Softening in prices reduces the perceived need to hold real assets as a hedge against inflation. Investment shift then to financial assets

10) Comparisons of income can be very difficult for two companies even though they sell the same products at equal volume. Why?

There are many different ways of recognizing data for financial reports which can affect the profit and other ratios for example;

• Timing of recording revenue (Enron)
• Cost of goods sold (Inventory, LIFO and FIFO)
• Extraordinary gains and losses (before or after taxes)
• Depreciation methods and rates
• Reserve accounts
• Management payment methods (options or cash)
• Of balance sheet loans
• Capitalizing certain expense then amortising over a longer time e.g. AOL.
• Aggressive accounting methods may be a sign of avaricious managers alone or may be part of the competitive culture of a particular industry.

Problems:

1) Database Systems

Net Income and return on assets for the year.

Assets 500000

Sales 1200000

Profit margin 6%

Net Income = 72000 (i.e. 6% of 1200000)

Return on investment = 14.4% = 72000/500000

2) Polly Ester Dress Shops

Annual Sales of 960000

Assets turned over 2.4 times per year.

Profit Margin 7%

Net income = 67200

Assets = 400000 = 960000/2.4

Return on Assets = 16.8% = 67200/400000

3) Billy Chrystal Stores

Asset 5000000

Asset turnover = 1.2

Sales = 6000000 (5000000 * 1.2)

Return on assets = 8%

Net income = 400000 (8% of 5000000)

Profit margin = 6.67% = 400000/6000000

4) Alpha Industries

Asset turnover 1.4 times

Return on total assets 8.4 %

Profit margin? = 8.4 /1.4 = 6%

Next year same level of assets

Asset turnover = 1.2 times

Profit margin = 7 %

Return on total assets? 1.2 * 7 = 8.4% so it is the same as before.

5) King Card Company

return on assets (investment ratio) = 12%

debt to total assets ratio 40%

return on equity = 12/(1-.4) = 12/.6 = 20%

If the firm had no debt then return on equity = 12%

Notice how debt increases the return on equity

6) Lollar Corpoaration Du pont method.

Profit Margin 5%

Return on Assets (investment) 13.5%

Asset turnover ratio. = 13.5/5 = 2.7

Debt to assets ratio 60%

Return on equity = 13.5/(1-.6) = 33.75

If debt to assets decrease to 40%

Return on equity = 13.5/(1-.4) = 22.5

7) Jerry Rice and Grain Stores

Sales 4000000

Profit margin 3.5%

Turn over on Assets = 2.5

Current liabilities 100000

Long term liabilities 300000

Return on equity

First Return on Assets = 2.5* 3.5 = 8.75%

Net profit = 4000000 * 0.035 = 140000

Assets = 1400000/0.0875 = 1600000

Debt/Assets = 400000/1600000 = .25%

Return on equity = 8.75/(1-0.25) = 11.67%

If total asset turnover goes to 3.0

Sales = 4800000

Profit margin same profit = 168000

Return on assets = 3 * 3.5 = 10.5

Assets = 168000/10.5 = 1600000

Return on equity = 10.5/0.75 = 14%

8) A firm

Sales 1.2 million

10% sales are cash

year end Accounts Receivable 180000

Average collection period?

Average daily credit sales = 1.2 * .9 /360 = 3000

Avg collection period = 180000/3000 = 60 days.

9) Chamberlain Corporation

Account receivable turnover = 12 times

Accounts receivable = 90000

Credit sales = 90000 * 12 = 1080000

Average daily credit sales = 3000

10) Bryan Corporation

Sales 3040000

Credits sales = .75 * 3040000 = 2280000

Current ratio = (280000 + 240000+ 50000) / (220000+ 80000) = 1.9

Quick ratio = (280000+ 50000) / (220000+80000) = 1.1

Debt to total assets ratio = (220000+80000+118000)/950000 = 0.44 or 44%

Asset turnover = 3040000/950000 = 3.2

Average daily credit sales = 2280000 / 360 = 6333.33

Average collection Period = 280000/6333.33 = 44.2

11) Lancaster Corporation.

Times interest earned = 60000/12000 = 5

Fixed charge coverage = 84000/36000 = 2.33

12) Jason Kid’s Furniture

Times interest earned = 60000/5000 = 12

Fixed charge coverage = 110000/55000 = 2

Total assets = 160000

Profit Margin = 33000/200000 = 16.5%