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Chapter 03: Financial Analysis
Chapter 3
Financial Analysis
Discussion Questions
3-1.
If we divide users of ratios into short-term lenders, long-term lenders, and
stockholders, in which ratios would each group be most interested, and for what
reasons?
Short-term lenders–liquidity ratios because their concern is with the firm’s
ability to pay short-term obligations as they come due.
Long-term lenders–leverage ratios 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 ratios, 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.
Chapter 03: Financial Analysis
3-2
3-2.
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
assets Total
Sales
Sales
incomeNet
assets Total
incomeNet =
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 food processing 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 assets investment
Return on equity = 1 Debt/Assets−
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.
Chapter 03: Financial Analysis
3-4.
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.
3-5.
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.
3-6.
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.
Chapter 03: Financial Analysis
3-4
3-7.
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.
a.
assets Total
incomeNet
investmenton Return =
Inflation may cause net income to be overstated and total assets to be
understated causing an artificially high ratio that is misleading.
b.
Inventory
Sales
turnoverInventory =
Inflation may cause sales to be overstated. If the firm uses FIFO accounting,
inventory will also reflect “inflation-influenced” dollars and the net effect
will be nil.
If the firm uses LIFO accounting, inventory will be stated in old dollars and
too high a ratio could be reported.
c.
assets Fixed
Sales
overasset turn Fixed =
Fixed assets will be understated relative to their replacement cost and to
sales and too high a ratio could be reported.
d.
assets Total
debt Total
assets totalDebt to =
Since both are based on historical costs, no major inflationary impact will
take place in the ratio.
Chapter 03: Financial Analysis
3-8.
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.
3-9.
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.
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.
Chapter 3
Problems
1. Profitability ratios (LO2) Low Carb Diet Supplement, Inc., has two divisions. Division A
has a profit of $100,000 on sales of $2,000,000. Division B is only able to make $25,000
on sales of $300,000. Based on the profit margins (returns on sales), which division is
superior?
Chapter 03: Financial Analysis
3-1. Solution:
Low Carb Diet Supplements
Division A Division B
Net income $100,000 $25,000
5% 8.33%
Sales 2,000,000 $300,000
==
2. Profitability ratios (LO2) Database Systems is considering expansion into a new product
line. Assets to support expansion will cost $500,000. It is estimated that Database can
3-2. Solution:
Database Systems
Net income = Sales profit margin
= $1,200,000 0.06
= $72,000
Return on assets Net income
(investment) Total assets
$72,000
$500,000
14.4%
=
=
=
Chapter 03: Financial Analysis
3. Profitability ratios (LO2) Polly Esther Dress Shops, Inc., can open a new store that will
do an annual sales volume of $960,000. It will turn over its assets 2.4 times per year. The
profit margin on sales will be 7 percent. What would net income and return on assets
(investment) be for the year?
3-3. Solution:
Polly Esther Dress Shops, Inc.
Sales
Assets Total asset turnover
$960,000 $400,000
2.4
Net income Sales Profit Margin
$960,000 0.07 = $67,200
Net income
Return on assets (investment) Total assets
$67,200 16.8%
$400,000
=
==
=
=
=
==
4. Profitability ratios (LO2) Billy’s Chrystal Stores, Inc., has assets of $5,000,000 and turns
over its assets 1.2 times per year. Return on assets is 8 percent. What is the firm’s profit
margin (return on sales)?
Chapter 03: Financial Analysis
3-4. Solution:
Billy Crystal Stores, Inc.
Sales Assets total asset turnover
$6,000,000 $5,000,000 1.2
Net income Assets Return on assets
$400,000 $5,000,000 8%
Net income $400,000/$6,000,000 = 6.67%
Sales
=
=
=
=
=
5. Profitability ratios (LO2) Elizabeth Tailors, Inc., has assets of $8,000,000 and turns over
its assets 2.5 times per year. Return on assets is 9.5 percent. What is the firm’s profit
margin (returns on sales)?
3-5. Solution:
Elizabeth Tailors, Inc.
Sales Assets total asset turnover
$20,000,000 $8,000,000 2.5
Net income Assets Return on assets
$760,000 $8,000,000 9.5%
Net Income $760,000 / $20,000,000 3.8%
Sales
=
=
=
=
==
Chapter 03: Financial Analysis
3-9
6. Profitability ratios (LO2) Dr.Zhivago Diagnostics Corp. income statements for 2010 is as
follows:
Sales ................................................................................... $2,000,000
Cost of goods sold .............................................................. 1,400,000
Gross profit ........................................................................ 600,000
Selling and administrative expense ..................................... 300,000
Operating profit .................................................................. 300,000
Interest expense .................................................................. 50,000
Income before taxes ............................................................ 250,000
Taxes (30%) ....................................................................... 75,000
Income after taxes............................................................... $ 175,000
a. Compute the profit margin for 2010.
b. Assume in 2011, sales increase by 10 percent and cost of goods sold increases by 20
percent. The firm is able to keep all other expenses the same. Once again, assume a tax
rate of 30 percent on income before taxes. What are income after taxes and the profit
margin for 2011?
3-6. Solution:
Dr. Zhivàgo Diagnostics
a. Profit margin for 2010
Net income $175,000 8.75%
Sales $2,000,000
==
b. Sales ............................................................ $2,200,000*
Cost of goods sold ....................................... 1,680,000**
Chapter 03: Financial Analysis
3-6. (Continued)
* $2,000,000 × 1.10 = $2,200,000
