Chapter 3
Discussion Questions
3-1.
If we divide users of ratios into short-term lenders, long-term lenders, and
stockholders, which ratios would each group be most interested in, and for what reasons?
Short-term lenders–liquidity because their concern is with the firm's ability to pay short-term obligations as they come due.
Long-term lenders–leverage because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made.
Stockholders–profitability, with secondary consideration given to debt utilization, liquidity, and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.
Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders' equity.
The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover.
Return on Assets = Profit Margin Asset Turnover
Net incomeTotal assets?Net incomeSales?SalesTotal assets 3-2.
In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a company in the capital goods industry may have a high profit
margin and a low asset turnover, while a foodprocessing firm may suffer from low profit margins, but enjoy a rapid turnover of assets.
The modified form of the Du Pont formula shows:
Return on equity?Return on assets ?investment??1?Debt/Assets?
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Copyright ? 2005 by The McGraw-Hill Companies, Inc.
3-3.
3-4.
3-5.
3-6.
3-7.
This indicates that return on stockholders' equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on stockholders' equity that is influenced by large amounts of debt.
If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period?
If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer period of time. This means the average collection period will be increasing.
What advantage does the fixed charge coverage ratio offer over simply using times interest earned?
The fixed charge coverage ratio measures the firm's ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.
Is there any validity in rule-of-thumb ratios for all corporations, for example, a current ratio of 2 to 1 or debt to assets of 50 percent?
No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into the
operations of the firm, and when used with caution by the analyst can provide information.
Why is trend analysis helpful in analyzing ratios?
Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last ten years. Trend analysis must also be compared to industry patterns of change.
Inflation can have significant effects on income statements 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.
a. Return on investment. b. Inventory turnover. c. Fixed asset turnover. d. Debt-to-assets ratio.
Copyright ? 2005 by The McGraw-Hill Companies, Inc.
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a. Return on investment
b. Inventory turnover?
c. Fixed asset turnover?
d. Debt to total assets?
3-8.
?Net incomeTotal assets
Inflation may cause net income to be overstated and total assets to be understated causing an artificially high ratio that is misleading.
SalesInventory
Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect \will be nil.
If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported.
SalesFixed assets
Fixed assets will be understated relative to sales and too high a ratio could be reported.
Total debtTotal assets
Since both are based on historical costs, no major inflationary impact will take place in the ratio.
3-9.
What effect will disinflation following a highly inflationary period have on the reported income of the firm?
Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm's income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly.
Why might disinflation prove to be favorable to financial assets?
Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar, lessening inflation also means that the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current evaluation.
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Copyright ? 2005 by The McGraw-Hill Companies, Inc.
3-10.
Comparisons of income can be very difficult for two companies even though they sell the same products in equal volume. Why?
There are many different methods of financial reporting accepted by the
accounting profession as promulgated by the Financial Accounting Standards Board. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items.
Copyright ? 2005 by The McGraw-Hill Companies, Inc.
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Problems
3-1.
Griffey Junior Wear, Inc., has $800,000 in assets and $200,000 of debt. It reports net income of $100,000.
a. What is the return on assets?
b. What is the return on stockholders' equity?
Solution:
Griffey Junior Wear
a.
Return on assets ?investment??Net incomeTotal assets
$100,000$800,000?12.5%
b.
Return on equity?Net incomeStockholders' equityStockholders' equity?total assets?total debt?$800,000?$200,000?$600,000
Net incomeStockholder's equity?$100,000$600,000?16.67%%OR
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Copyright ? 2005 by The McGraw-Hill Companies, Inc.