BBMF3013 Equity Analysis
Tutorial 3 (Valuation Principle – Analysis of Financial Statements)
1. Why would the inventory turnover ratio be more important for someone analyzing a
grocery store chain than an insurance company?
The inventory turnover ratio is important to a grocery store because of the much larger
inventory required and because some of that inventory is perishable. An insurance
company would have no inventory to speak of since its line of business is selling
insurance policies or other similar financial products—contracts written on paper and
entered into between the company and the insured. The inventory turnover ratio is very
useful to identify whether a company efficient to sell their product, but this ratio cannot
justify every business such as insurance business since their sales do not relate to
inventory. This question demonstrates that the student should not take a routine approach
to financial analysis but rather should examine the business that he or she is analyzing
before conducting a ratio analysis.
2. How does inflation distort ratio analysis comparison for one company over time
(trend analysis) and for different companies that are being compared? Are only balance
sheet items or both balance sheet and income statement items affected?
• Inflation will cause earnings to increase, even if there is no increase in sales volume. Yet,
the book value of the assets that produced the sales and the annual depreciation expense
remain at historic values and do not reflect the actual cost of replacing those assets.
• Thus, ratios that compare current flows with historic values become distorted over time.
For example, ROA will increase even though the same assets are generating the same sales
volume.
• When comparing different companies, the age of the assets will greatly affect the ratios.
Companies with assets that were purchased earlier will reflect lower asset values than
those that purchased assets later at inflated prices.
• Two firms with similar physical assets and sales could have significantly different ROAs.
Under inflation, ratios will also reflect differences in the way firms treat inventories. As
can be seen, inflation affects both income statement and balance sheet items.
3. If a firm’s ROE is low and management wants to improve it, explain how using more
debt might help.
• ROE is calculated as the return on assets multiplied by the equity multiplier. The equity
multiplier, defined as total assets divided by common equity, is a measure of debt
utilization; the more debt a firm use, the lower its equity, and the higher the equity
multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher
ROE.
• If a firm’s ROE is low, management can leverage debt in order to increase the ROE.
ROE is defined as net income over common equity. In order to leverage debt a company
decreases its common equity, so that the liabilities match the company’s assets. Due to
the interest on the debt, the earnings before taxes (EBT) is lowered making the net
income lower. However, this lower net income to lower common equity results in a
higher ROE.
• ROE(%) = net profit after tax / shareholder equities
