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P5-4 Decomposing return on common shareholders’ equity
Requirement 1:
ROCE measures a company’s performance in using capital
provided by common shareholders to generate earnings. ROCE
ROA measures the profitability of operations before considering how
Requirement 2:
Financial leverage has the effect of making ROCE more extreme.
That is, in good years (i.e., when ROA is high), ROCE is even
higher when the firm has leverage, and the more leverage, the
P5-5 Interpreting accounts receivable turnover
Requirement 1:
Accounts receivable turnover is computed as sales divided by
average accounts receivable outstanding, where average
Requirement 2:
KapStone collected its receivables somewhat more quickly in 2014
than did Packaging Corporation of America. KapStone’s 10.0
Requirement 3:
Packaging Corporation of America’s receivable turnover showed
Requirement 4:
Possible reasons for the different accounts receivable turnover
ratios include:
One company may be more aggressive in its collection
efforts;
Requirement 5:
Computing average accounts receivable outstanding by averaging
the beginning and ending balance assumes the change in the
receivables outstanding happened evenly throughout the year. If
Firms whose operations are seasonal are likely to show significantly
different receivable levels throughout the year, whereas the annual
balance sheet takes a snapshot at the same point in the seasonal
“Window dressing” refers to actions managers might take to make
the balance sheet as of the reporting date (i.e., year end) appear
more healthy than it is during the rest of the year. To the extent that
To mitigate this effect, one might take an average of quarterly
averages. The assumption now is that the change over each
12/31/16, 3/31/17, 6/30/17, 9/30/17, and 12/31/17. The weights on
the five dates, respectively, are 1/8, 1/4, 1/4, 1/4, and 1/8.
P5-6 Analyzing inventories
Danaher’s inventory turnover ratio improved from 2012 to 2014.
Inventory turnover will remain constant when cost of goods sold and
average inventory level grow at the same rate. In 2013, average
Danaher’s higher inventory turnover indicates it is servicing its
P5-7 Analyzing fixed asset turnover
Requirement 1:
Lennox International has higher turnovers (both current asset and
fixed asset) than Tecumseh Products, except in 2014 when
Requirement 2:
Because ROA = Operating profit margin x Asset turnover, it is
Operating profit margin 2012 2013 2014
Lennox’s operating margins have been positive and growing, while
Tecumseh’s have been negative the last two years. Tecumseh’s
P5-8 Determining accounting quality
Requirement 1:
Capitalizing leases increases the amount reported for both assets
and liabilities, thereby increasing both the numerator and
denominator in the long-term debt to assets ratio. For reasons
Requirement 2:
A firm’s creditworthiness represents its ability to repay its obligations
on a timely basis. Any information relevant to assessing that ability
should be considered in a determination of creditworthiness. Lease
obligations, whether treated as capital leases or operating leases
Standard and Poor’s describes the reasons it constructively
capitalizes leases as follows:
We view the accounting distinction between operating and
capital leases as substantially artificial. In both cases, the
leases, thereby:
enhancing comparability of operating and financial results
bringing financial ratios closer to the underlying economics
P5-9 Comparing profitability for three companies
Company A is Consolidated Edison. Public utilities are the most
capital intensive of the three industries. Consistent with the
significant investment in fixed assets, Company A has by far the
P5-10 Determining profitability
Note to the instructor: The following preliminary calculations provide
needed data for the remainder of the problem. Dollar amounts are
in millions.
2012 2013 2014
Average assets = (Beginning assets
Requirement 2:
Nucor experienced a slight ROA decline from 2012 to 2013. ROA
rebounded in 2014. Although some of the improved ROA in 2014
Requirement 3:
2012 2013 2014
ROCE (Net income/Average common
Note to the instructor: Nucor had no preferred stock outstanding and
Requirement 4:
Financial leverage “exaggerates” ROCE relative to ROA. That is,
P5-11 Business strategy and profit performance
Requirement 1:
Tiffany pursues a classic differentiation strategy: the particular
luxury items sold by Tiffany are simply not available elsewhere.
Requirement 2:
Tiffany generates $0.86 in sales for each asset dollar, compared to
$1.11 at Signet. This comparatively low asset turnover rate is
consistent with a Tiffany’s strategy of differentiation built around
Requirement 3:
Requirement 4:
To earn an ROA of 10.5% at the company’s current asset turnover
P5-12 Blockbuster Inc.
Requirement 1:
Cash provided by (used for) investing activities is a positive number
when the firm raises more cash from investment sales than it uses
Requirement 2:
Cash flow from operations in 2007 was -$56, and investing activities
only generated $77 million cash in that year. The cash used to pay
down debt by $329 million may have come from the company’s
Requirement 3:
Cash flow from operations in 2009 was again insufficient to cover
the company’s $846 million debt payment that year. So, the cash
Requirement 4:
The company must make sizable debt payments in each of the next
five years, but it has only generated modest cash from operations
P5-13 Analyzing why financial ratios change
(AICPA adapted)
Requirement 1:
Daley’s current liabilities are increased by the declaration of a cash
dividend. So, this transaction would reduce the current ratio.
unchanged.
Requirement 2:
Inventory increases and accounts receivable decrease. Assuming
the original transaction was profitable, the reduction in accounts
receivable exceeds the increase in inventory, thereby reducing
Requirement 3:
Current assets and current liabilities fall by equal amounts.
Because the current ratio exceeds 1, it will increase with the
Requirement 4:
Current assets increase, so the current ratio increases. There is no
change in inventory turnover. Because a loss is recorded, the
