Chapter 4 Analysis of Financial Statements Self-test Questions 1. Why are financial ratios used? List the five major categories of ratios presented in the chapter. 2. What are the characteristics of a liquid asset? 3. Which current asset is typically the least liquid? Why? 4. Identify and write out the equations for two ratios that are used to analyze a firm’s liquidity position. What do each of these ratios specifically measure? 5. Identify and write out the equations for four ratios that are used to measure how effectively a firm is managing its assets. What do each of these ratios specifically measure? (2pts) 6. If one firm is growing rapidly and another is not, how might this distort a comparison of their inventory turnover ratios? 7. If you wanted to evaluate a firm’s DSO, with what could you compare it? 8. What problem might arise when comparing different firms’ fixed assets turnover ratios? 9. How does the use of financial leverage affect current stockholders’ control position? 10. How does the decision to use debt involve a risk-versus-return trade-off? 11. Explain the following statement: “Analysts look at both balance sheet and income statement ratios when appraising a firm’s financial condition.” 12. Identify and write out the equations for two ratios that are used to measure how the firm has financed its assets as well as the firm’s ability to repay its long-term debt. What do each of these ratios specifically measure? 13. Identify and write out the equations for six profitability ratios. What do each of these ratios specifically measure? (3pts) 14. Why does the use of debt lower the profit margin and the ROA? 15. Identify and write out the equations for four market value ratios. What do each of these ratios specifically measure? (2pts) 16. What are the three primary ways the market value ratios are used? 17. If one firm’s P/E ratio is lower than that of another, what are some factors that might explain the difference? 18. Explain why book values often deviate from market values. 19. What is the equity multiplier? Is it better to have a high EM or a low EM? Explain. 20. How can management use the DuPont equation to analyze ways of improving the firm’s performance? 21. What is comparative analysis, benchmarking, and trend analysis? 22. Different groups conduct financial ratio analysis. These groups could include managers, credit analysts, and stock analysts. What is the primary emphasis of each of these groups in evaluating ratios? 23. List at least three potential problems with ratio analysis.
 

Chapter 4

Analysis of Financial Statements

Self-test Questions

1. Why are financial ratios used? List the five major categories of ratios presented in the chapter.

Financial ratios are utilized by entrepreneurs because they allow them to assess their company's performance and compare it to that of other similar businesses.

The following are the main Categories of the ratios:

 Liquidity.

Profitability.

 Debt

Activity.

Market.

2.         What are the characteristics of a liquid asset?

Characteristics of a liquid asset are Price stability, Ready marketability Price stability and Reversibility.

3.         Which current asset is typically the least liquid? Why?

Inventory is the least liquid current asset. Reason being, inventory can only be sold and converted into completed goods if there is a need for it.

4.         Identify and write out the equations for two ratios that are used to analyze a firm’s liquidity position. What do each of these ratios specifically measure?

Current Ratio and Quick Ratio are the two ratios.

On a balance sheet, the current ratio is used to find the current assets and current liabilities line items.

 C. R= Current Assets / Current Liabilities

The fast ratio is a more stringent liquidity test that only takes into account certain more liquid assets, such as cash, accounts receivables, cash, and marketable securities.

The formula is used to calculate it.

Quick Ratio= (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

5.         Identify and write out the equations for four ratios that are used to measure how effectively a firm is managing its assets. What do each of these ratios specifically measure? (2pts)

a.) The fixed asset turnover ratio assesses the firm's efficiency in utilizing its fixed assets.

Formulae can be used to calculate it.

Sales / Net Fixed Assets = Fixed Asset Turnover Ratio

b.) The ratio of total assets to total assets

measures the firm's efficiency in utilizing its assets

It can be calculated using the following formula: Sales / Total assets

DSO (c.) (Days sales outstanding)

It displays the average number of days it takes you to collect on credit sales.

DSO is typically calculated as DSO = Receivables / Annual Sales / 365).

d.) Inventory turnover percentage

The number of times a company's inventory has been sold and replenished in a given period of time.

Inventory turnover ratio = sales / inventories is a formula that can be used to calculate it.

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

Sales occur throughout the year, whereas inventory figures are for a single point in time. It is especially useful to adjust the average inventory measurement if the business is seasonal or if there has been a strong upward or downward sales trend throughout the year.

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

By comparing it to the firm's credit conditions or the industry average. You're not doing well if the credit policy requires payment within 60 days and it's been 90 days.

8.         What problem might arise when comparing different firms’ fixed assets turnover ratios?

Fixed assets are valued in the balance sheet at cost less depreciation. The value of many assets acquired in the past is highly undervalued due to inflation. When comparing the old company with depreciated assets with the new company without depreciated assets, the old company has a higher turnover rate of fixed assets.

9.         How does the use of financial leverage affect current stockholders’ control position?

Stockholders that invest in a company that has taken the risk of leveraging up will experience a higher return on investment (ROI), but there will also be a larger danger of the company going bankrupt. The larger the risk, the better the gain, and the greater the danger.

10.       How does the decision to use debt involve a risk-versus-return trade-off?

In a normal economy, firms with high debt ratios have greater predicted returns; in a recession, they have lower returns and may even go bankrupt.

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

Analysts employ two methods to assess a company's debt:  they first They look at the balance sheet to see what percentage of total funds are denoted by debt and then look at the income statement to see how much interest is covered by operational profits.

12.       Identify and write out the equations for two ratios that are used to measure how the firm has financed its assets as well as the firm’s ability to repay its long-term debt. What do each of these ratios specifically measure?

Equation 1: Time-Interest-Earned (TIE) ratio= EBIT / Interest Charges

Equation 2: Debt Ratio= Total debt / total assets

13.       Identify and write out the equations for profitability ratios. What do each of these ratios specifically measure? (3pts)

1. Return on common equity (ROE)= Net income / Common equity

2. Operating Margin= EBIT / Sales

3. Basic Earning Power (BEP)= EBIT / Total assets

4. Profit Margin=Net income / Sales

5. Return on total assets (ROA)= Net income / Total assets

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

In some cases, a low ROA is the result of intentionally taking on a large amount of debt, which results in high interest costs and therefore a low net income. A lot of ratios must be examined to see what each one suggests and then the total situation must be examined when you analyze a business' performance and think about what steps it should take to improve.

15.       Identify and write out the equations for four market value ratios. What do each of these ratios specifically measure? (2pts)

i) Book value per share.

Formulae:

Book value per share=aggregate amount of stockholders' equity,the number of shares outstanding.

 

The measure above is used as a benchmark to see if the market value per share is higher or lower, which can be used as the basis for decisions to buy or sell shares.

ii) Dividend yield;

Formulae:

Dividend yield=the total dividends paid per yeardivided by the market price of the stock

 

Dividend yield is the return on investment to investors if they were to buy the shares at the current market price.

iii) Market value per share;

Formulae:

Market value per share.=the total market value of the business, total number of shares outstanding

 

It reveals the value that the market currently assigns to each share of a company's stock.

iv)Price/earnings ratio;

Formulae:

Price/earnings ratio=the current market price of a sharethe reported earnings per share

 

It is used to evaluate whether the shares are over-priced or under-priced in comparison to the same ratio results for competing companies.

16.       What are the three primary ways the market value ratios are used?

Market/Book (M/B) Ratio, Book Value Per Share, and Earnings Per Share are the three examples of market value ratios. Analysts can compare a company's market value to its book value using the market/book ratio. The book value of a corporation, on the other hand, is the equity (excluding preferred stock) divided by the number of shares outstanding in the market. Earnings per share is a metric that measures a company's net income per outstanding share of stock, demonstrating its profitability to investors.

17.       If one firm’s P/E ratio is lower than that of another, what are some factors that might explain the difference?

When a corporation takes on more debt, the P/E ratio for its shares may decline. As a result, a lower P/E doesn't automatically imply a greater stock value. P/E ratios can sometimes fall as a result of increasing risk. This is the polar opposite of P/E ratios growing in response to future growth predictions.

18.       Explain why book values often deviate from market values.

Book values differs from market value in that it represents shareholders' equity, while market value is the real-time market price, or the amount an investor would receive if they sold the shares at the current market price.

19.       What is the equity multiplier? Is it better to have a high EM or a low EM? Explain.

The equity multiplier is the leverage ratio, which measures the proportion of a company's assets to its liabilities. A low equity ratio is desirable because it indicates that the company is not taking on excessive debt to finance its assets. Instead, the company issues equity to finance the acquisition of assets it needs to run its business and to increase its cash flow.

20.       How can management use the DuPont equation to analyse ways of improving the firm’s performance?

Marketing personnel can investigate the consequences of raising sales prices or launching new items with larger margins, for example, by focusing on the profit margin. Inventory divided by Current Liabilities equals Current Assets.

21.       What is comparative analysis, benchmarking, and trend analysis?

A comparative statement is a document that compares one financial statement to those from previous periods. Benchmarking is the process of comparing a company's performance metrics and business processes to those of other companies in the same industry. Lastly, trend analysis is the act of using historical and current market trends to forecast future movement patterns.

22.       Different groups conduct financial ratio analysis. These groups could include managers, credit analysts, and stock analysts. What is the primary emphasis of each of these groups in evaluating ratios?

The interests of various sorts of analysts are not same, and they should not be. For two reasons, management is interested in all types of indications. To begin, the ratios identify vulnerabilities that must be corrected; second, management understands that all ratios are significant to third parties and that the company's financial appearance must be maintained in order for creditors and equity investors to see it favourably. While equity investors (shareholders) are primarily concerned with profitability, they also consider other ratios when determining the risk associated with equity investments. Credit analysts place a higher premium on debt coverage ratios, EIR and EBITDA ratios, and profitability ratios. Short-term lenders place a premium on liquidity and are particularly concerned about current ratios.

23.       List at least three potential problems with ratio analysis.

Effects of inflation: If there has been inflation between periods, real prices are not represented in the financial accounts. As a result, until the figures are corrected for inflation, they are not comparable across time periods.

Changes in accounting policies: If the company's accounting policies and procedures have changed, this could have a significant impact on financial reporting.

Operational changes: When a firm undergoes significant operational changes, comparing financial data before and after the change might lead to inaccurate inferences about the company's success and future prospects.

Seasonal impacts: Failure to adjust the ratio analysis for seasonality effects may result in incorrect interpretations of the analysis results.