Management Chapter 19 Income sales Shows The Firms Ability Generate Profits

Solutions for Web Chapter 19: Questions and Problems

WEB CHAPTER 19

ANALYSIS OF FINANCIAL STATEMENTS

Answers to Questions

1. The kind of decisions that require the analysis of financial statements include whether to

lend money to a firm, whether to invest in the preferred or the common stock of a firm,

2. Analysts employ financial ratios simply because numbers in isolation are typically of

little value. For example, a net income of $100,000 has little meaning unless analysts

3. A major problem with comparing a firm to its industry is that you may not feel

comfortable with the measure of central tendency for the industry. Specifically, you may

feel that the average value is not a very useful measure because of the wide dispersion of

4. In general, jewellery stores have very high profit margins but low asset turnover. It could

take them months to sell a 1-carat diamond ring, but once it is sold, the profit could be

5. Business risk is measured by the relative variability (i.e., the coefficient of variation) of

operating earnings for a firm over time. In turn, the variability of operating earnings is a

Solutions for Web Chapter 19: Questions and Problems

6. The steel company would be expected to have greater business risk. As discussed in

Question #5, sales variability and operating leverage are the two components of business

7. When examining a firm’s financial structure, we would also be concerned with its

business risk. Since financial risk is the additional uncertainty of returns faced by equity

8. The total debt/total asset ratio is a balance sheet ratio that indicates the stock of debt as

compared to the stock of equity. While the total debt/total asset ratio is a common

measure of financial risk, many analysts prefer to employ the fixed charge coverage ratio,

9. Growth analysis is important to common shareholders because the future value of the

firm is heavily dependent on future growth in earnings and dividends. The present value

of a firm with a growing dividends payment is:

Solutions for Web Chapter 19: Questions and Problems

10. The rate of growth of any economic unit depends on the amount of resources retained and

reinvested in the entity and the rate of return earned on the resources retained. The more

reinvested, the greater the potential for growth. In general:

11. Assuming the risk of the firm is not abnormally high, a 24% ROE is quite high and

probably exceeds the return that the equity investor could earn on the funds. Therefore,

12. Growth, as predicted by the sustainable growth rate (retention ratio × ROE) has two

13. External market liquidity is the ability to buy or sell an asset quickly with little change in

price (from prior transaction), assuming no new information has been obtained. The two

14. Some internal corporate variables such as the total market value of outstanding securities

and the number of security owners are good indicators of market liquidity. If the firm has

a fairly large number of shareholders, it would be very likely that, at any point in time,

Solutions for Web Chapter 19: Questions and Problems

– 148 –

15. Student exercise, so answers will depend upon what limitations the student chooses to

discuss. Some possibilities are:

• Flexibility in choosing which GAAP to use and how to apply them

Solutions for Web Chapter 19: Questions and Problems

– 149 –

WEB CHAPTER 19

Answers to Problems

1(a).

1(c). 0.04 × $6,000,000 = $240,000 (profit margin × sales)

1(d). Using the ROE of 20.7 in part c) and a net income of $240,000, we have

:components 3 theusingor %5.34

000,160,1

000,400

Equity

IncomeNet

Equity Totalon Return

===

20.7% 3.45 x 1.5 x 0.04 ROE

20.7%

1,160,000

240,000

ROE

==

Solutions for Web Chapter 19: Questions and Problems

– 150 –

2(b). Growth Rate = Retention Rate × ROE

= (1 – Payout Rate) × ROE

3. Current ratio = 650/350 = 1.857

Quick ratio = 320/350 = 0.914

Receivables turnover = 3500/195 = 17.95x

Return on equity = 130/1185 = .109

Return on common equity = 115/1035 = .110

Debt/equity ratio = 725/1225 = .59

Debt/total capital ratio = 725/1850 = .372

Interest coverage = 258/62 = 4.16x

Solutions for Web Chapter 19: Questions and Problems

– 151 –

Cash flow/total debt = (130 + 125 – 150)/975 = .108