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168. 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
169. What factors affect the risk of business firms?
ANALYSIS OF RISK
Analysts deciding between investments must consider the comparative risks. Various factors affect the risk of
business firms:
Assessing liquidity requires a time horizon. Consider the three questions that follow:
1. Does a firm have sufficient cash to repay a loan due tomorrow?
170. Discusses the four measures for assessing short-term liquidity risk.
MEASURES OF SHORT-TERM LIQUIDITY RISK
Four measures for assessing short-term liquidity risk are (1) Current ratio, (2) Quick ratio, (3) Cash flow
from operations to current liabilities ratio, and (4) Working capital turnover ratios.
Current Ratio
The current ratio equals current assets divided by current liabilities. Current assets comprise cash and assets that
Furthermore, management can take deliberate steps to produce a financial statement that presents a better
current ratio at the balance sheet date than the average, or normal, current ratio during the rest of the year. For
example, near the end of its accounting period a firm might delay normal purchases on account. Or, it might
hasten the collections of a loan receivable, classified as noncurrent assets, and use the proceeds to reduce
current liabilities. Such actions will increase the current ratio. Analysts refer to such actions as window
dressing.
Some analysts criticize the current ratio and the quick ratio to measure short-term liquidity risk because these
ratios use balance sheet amounts at a specific time. If financial statement amounts at that time are unusually
example, using cash to pay off a current liability (reducing both numerator and denominator) or acquiring
inventory on account (increasing both numerator and denominator).
The cash flow from operations to current liabilities ratio overcomes these deficiencies. The numerator of this
of days that a firm’s accounts payable remain outstanding (that is, 365 days/accounts payable turnover ratio)
indicates the length of the period between the purchase of inventory on account and the payment of cash to
suppliers during each operating cycle. The accounts payable turnover ratio equals purchases on account divided
by average accounts payable. Although firms do not disclose their purchases, the analyst can derive the amount
as follows:
171. Discuss measures of long-term liquidity risk.
MEASURES OF LONG-TERM LIQUIDITY RISK
Analysts use measures of long-term liquidity risk to evaluate a firm’s ability to meet interest and principal
total liabilities ratio, and the interest coverage ratio.
1. Liabilities to Assets Ratio = Total Liabilities/Total Assets
Because several variations of the debt ratio appear in corporate annual reports, the analyst should take care
when comparing debt ratios among firms.
Cash Flow from Operations to Total Liabilities Ratio
172. What are the limitations of ratio analysis?
LIMITATIONS OF RATIO ANALYSIS
firms have in selecting from among various generally accepted accounting principles.
particular dimension of profitability or risk.
3. When comparing the size of a ratio between periods for the same firm, the analyst must recognize conditions
173. What are pro forma financial statements?
Accountants use the term pro forma financial statements to refer to financial statements prepared under a
particular set of assumptions. One set of assumptions might be that some transactions, actually reported in the
firm’s income statement for the year under generally accepted accounting principles, had not occurred. Such
174. What are the steps in preparing pro forma financial statements?
PREPARING PRO FORMA FINANCIAL STATEMENTS
The preparation of pro forma financial statements requires the analyst to make assumptions about the future.
The usefulness of the pro forma financial statements depends on the reasonableness of those assumptions.
come directly from the pro forma income statement and comparative balance sheets.
The following are the steps in preparing pro forma financial statements:
1. Project operating revenues.
175. Discuss any ethical issues raised by the following actions.
General Hospital is subject to a constraint in its short-term borrowing agreement with its bank. General Hospital
must have a year-end current ratio that is greater than 1.5. On December 30 of the current year, it projects that
its current ratio will be only 1.4 as of the close of business on December 31. General Hospital has a long-term
176. Discuss any ethical issues raised by the following actions.
Big Store’s rate of return on assets (ROA) has fallen below analysts’ expectations in recent years because the
firm, a retailer, has added a significant number of new stores (increasing assets in the denominator of ROA)
prior to these stores generating earnings (ultimately increasing the numerator of ROA). Big Store decides to
177. Discuss any ethical issues raised by the following actions.
Lamb Inc. has a debt-equity ratio of 30 percent, which is considerably lower than most of its competitors. Lamb
Inc. has become the target of a takeover by a group of outside investors. This takeover group feels that Lamb
Inc. could service debt up to 60 percent of its financing. They plan to borrow the necessary cash to finance the
takeover and then have Lamb Inc. assume the debt. This action will result in a debt-equity ratio for Lamb Inc. of
60 percent after the takeover. The current management desires to defend Lamb Inc. against this takeover
attempt. It sells off a profitable division of the business and uses the cash proceeds to buy back outstanding
