978-0324651140 Test Bank Chapter 6 Part 4

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Three ratios that address how profitable a company might be include the total assets turnover, net profit

margin, and inventory turnover. The total assets turnover ratio measures the efficiency of resource use,

i.e., the ability to generate sales through the use of assets. The net profit margin ratio measures the net

income generated by each dollar of sales. The net profit margin ratio provides some indication of the

ability of the firm to absorb cost increases or sales declines. The inventory turnover ratio measures how

quickly inventory is sold as well as how effectively investment in inventory is used and managed. All

three ratios delve into how the company is doing operationally, which is a significant factor in its

profitability.

Three ratios that address how risky (liquid) a company might be include the current ratio, times interest

earned, and total debt to net worth. The current ratio measures the ability to meet short-term obligations

using short-term assets. The times interest earned ratio measures the ability to meet interest

commitments from current earnings. The higher the ratio, the more safety there is for long-term

creditors. The total debt to net worth ratio measures the level of protection creditors have in the case of

possible insolvency. This ratio also measures the degree of financial leverage and whether or not the

firm will be able to obtain additional financing through borrowing.

154. Ratio analysis is one tool management may use to examine a firm’s profitability and risk. Another tool

often used by management are pro forma financial statements.

Required:

Describe the purpose of pro forma financial statements.

Describe how pro forma financial statements may be constructed.

The purpose of pro forma financial statements is to examine the impact potential management plans and

assumptions may have on the accounts within the statements. They are often future oriented, though

based on past financial information and assumed relationships that remain stable.

Constructing pro forma financial statements begins with an articulated plan or set of assumptions that

management would like to explore. Such plans may include raising the sales price of the firm’s product

or increasing advertising. The most recent period’s financial statements, often beginning with the

income statement (operating revenues and expenses), are then altered to reflect the potential plans or

altered assumptions. The balance sheet is then changed to reflect the new information, as well as the

remaining items on the income statement that reflect financing changes. A pro forma statement of cash

flows may then be created to reflect the cash flow implications of the plans or assumptions.

Management can then compare the pro forma statements (and ratios built from these statements) with its

plans or assumptions to test their viability.

155. Discuss how investors base their investment decisions on the return anticipated from each investment and

the risk associated with that return.

156. Describe the relation between financial statement analysis and investment decisions.

Relation Between Financial Statement Analysis and Investment Decisions

157. Why are ratios useful?

USEFULNESS OF RATIOS

Readers cannot easily answer questions about a firm’s profitability and risk from the raw information in

1. The planned ratio for the period.

2. The corresponding ratio during the preceding period for the same firm.

3. The corresponding ratio for a similar firm in the same industry.

4. The average ratio for other firms in the same industry.

158. A measure of profitability for a firm engaging in operations selling merchandise in its stores to generate

net income includes the rate of return on assets. Discuss the rate of return on assets.

RATE OF RETURN ON ASSETS

The rate of return on assets (ROA) measures a firm’s performance in using assets to generate net income

independent of how the firm financed the acquisition of those assets. The rate of return on assets relates the

results of operating performance to the investments (assets) of a firm without regard to how the firm financed

those investments.

The calculation of ROA is as follows:

159. Discuss how the analyst can disaggregate ROA into the product of two other ratios to study changes in

ROA.

DISAGGREGATING THE RATE OF RETURN ON ASSETS

assets, or alternatively, to control the amount of assets it uses to generate a particular level of sales. The smaller

the amount of assets the firm needs to generate a given level of sales, the better (larger) its assets turnover and

the more profitable the firm.

Firms improve their ROA by increasing the profit margin for ROA ratio, the rate of assets turnover, or both.

Some firms, however, have limited flexibility to alter one or the other of these components. For example, a firm

160. Discuss the accounts receivable turnover ratio.

Accounts Receivable Turnover

The rate at which accounts receivable turn over indicates how quickly a firm collects cash. The accounts

receivable turnover ratio equals sales revenue divided by average accounts receivable during the period. In

161. Describe the inventory turnover ratio.

Inventory Turnover

The inventory turnover ratio indicates how fast firms sell their inventory items, measured in terms of the rate of

movement of goods into and out of the firm. Inventory turnover equals cost of goods sold divided by the

162. Describe the fixed asset turnover ratio.

Fixed Asset Turnover

The fixed asset turnover ratio measures the relation between sales and the investment in fixed assets—property,

plant, and equipment. You will likely have more difficulty understanding the notion that fixed assets “turn over”

163. Both U.S. GAAP and IFRS require firms to report certain information about each of their operating

segments. What segment information and disclosures are required?

ANALYSIS OF SEGMENT DATA

Both U.S. GAAP and IFRS require firms to report certain information about each of their operating

segments. These disclosures permit analysis of profitability at an additional level of depth.

Required Segment Information

Authoritative guidance requires firms to disclose information on their operating segments. The definition of

the business.

Firms must reconcile data for their operating segments with total revenues, operating income, and assets at a

firm-wide level. Segment revenues usually sum to firm-wide revenues. Segment operating income will not

We can compute ROA, profit margin for ROA, and total assets turnover for each segment using the segment

disclosures. The amounts for these ratios computed at a segment level differ from those at a corporate level for

at least two reasons:

1. The numerator of ROA at a firm-wide level includes all revenues and expenses except interest expense net

164. Discuss how the rate of return on common shareholders’ equity is calculated..

RATE OF RETURN ON COMMON SHAREHOLDERS’ EQUITY

The rate of return on common shareholders’ equity (ROCE) measures a firm’s performance in using and

financing assets to generate earnings. Unlike ROA, the rate of return on shareholders’ equity considers

financing costs. Thus, this measure of profitability incorporates the results of operating, investing, and financing

decisions. The calculation of ROCE is as follows:

165. Describe the relationship between return on assets and return on common shareholders’ equity.

RELATION BETWEEN RETURN ON ASSETS AND RETURN ON COMMON SHAREHOLDERS’

EQUITY

For profitable firms, it is common for ROCE to exceed ROA. ROA measures the profitability of a firm before

any payments to the suppliers of financing. Each of the various providers of financing has a claim on some

portion of the income in the numerator of ROA. Creditors receive the contractual interest to which they have a

166. What is financial leverage?

FINANCIAL LEVERAGE

The term financial leverage describes financing with debt and preferred stock to increase the potential return to

the residual common shareholders’ equity. Financial leverage works as follows:

1. A firm obtains funds from creditors, preferred shareholders, and common shareholders.

167. Describe the disaggregation of the rate of return on common shareholders’ equity.

DISAGGREGATING THE RATE OF RETURN ON COMMON SHAREHOLDERS’ EQUITY

ROCE disaggregates into several components (in a manner similar to the disaggregation of ROA):

Thus,

The profit margin ratio for ROCE ratio indicates the portion of the sales dollar left over for the common

shareholders after covering all operating costs and subtracting claims of creditors and preferred shareholders. It