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ECON 4400

CHAPTER 3WORKING WITH FINANCIAL STATEMENTSLearning ObjectivesLO1The sources and uses of a firms cash flowsLO2How to standardize financial statements for comparison purposesLO3How to compute and more importantly interpret some common ratiosLO4The determinants of a firms profitabilityLO5Some of the problems and pitfalls in financial statement analysisAnswers to Concepts Review and Critical Thinking Questions1LO2aIf inventory is purchased with cash then there is no change in the current ratio If inventory is purchased on credit then there is a decrease in the current ratio if it was initially greater than 10bReducing accounts payable with cash increases the current ratio if it was initially greater than 10cReducing shortterm debt with cash increases the current ratio if it was initially greater than 10dAs longterm debt approaches maturity the principal repayment and the remaining interest expense become current liabilities Thus if debt is paid off with cash the current ratio increases if it was initially greater than 10 If the debt has not yet become a current liability then paying it off will reduce the current ratio since current liabilities are not affectedeReduction of accounts receivables and an increase in cash leaves the current ratio unchangedfInventory sold at cost reduces inventory and raises cash so the current ratio is unchangedgInventory sold for a profit raises cash in excess of the inventory recorded at cost so the current ratio increases2LO2 The firm has increased inventory relative to other current assets therefore assuming current liability levels remain unchanged liquidity has potentially decreased3LO2 A current ratio of 050 means that the firm has twice as much in current liabilities as it does in current assets the firm potentially has poor liquidity If pressed by its shortterm creditors and suppliers for immediate payment the firm might have a difficult time meeting its obligations A current ratio of 150 means the firm has 50 more current assets than it does current liabilities This probably represents an improvement in liquidity shortterm obligations can generally be met completely with a safety factor built in A current ratio of 150 however might be excessive Any excess funds sitting in current assets generally earn little or no return These excess funds might be put to better use by investing in productive longterm assets or distributing the funds to shareholdersS314LO2aQuick ratio provides a measure of the shortterm liquidity of the firm after removing the effects of inventory generally the least liquid of the firms current assetsbCash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset cashcInterval measure estimates how long a company could continue operating by depleting its existing current assets at a rate that is consistent with its average daily operating costsdTotal asset turnover measures how much in sales is generated by each dollar of firm assetseEquity multiplier represents the degree of leverage for an equity investor of the firm it measures the dollar worth of firm assets each equity dollar has a claim tofLongterm debt ratio measures the percentage of total firm capitalization funded by longterm debtgTimes interest earned ratio provides a relative measure of how well the firms operating earnings can cover current interest obligationshProfit margin is the accounting measure of bottomline profit per dollar of salesiReturn on assets is a measure of bottomline profit per dollar of total assetsjReturn on equity is a measure of bottomline profit per dollar of equitykPriceearnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm5LO1 Common size financial statements express all balance sheet accounts as a percentage of total assets and all income statement accounts as a percentage of total sales Using these percentage values rather than nominal dollar values facilitates comparisons between firms of different size or business type Commonbase year financial statements express each account as a ratio between their current year nominal dollar value and some reference year nominal dollar value Using these ratios allows the total growth trend in the accounts to be measured6LO2 Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firms operations finances or investment activities are out of line with the norm thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate An aspirant group would be a set of firms whose performance the company in question would like to emulate The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm some managers are evaluated by how well they match the performance of an identified aspirant group7LO3 Return on equity is probably the most important accounting ratio that measures the bottomline performance of the firm with respect to the equity shareholders The Du Pont identity emphasizes the role of a firms profitability asset utilization efficiency and financial leverage in achieving an ROE figure For example a firm with ROE of 20 would seem to be doing well but this figure may be misleading if it were marginally profitable low profit margin and highly levered high equity multiplier If the firms margins were to erode slightly the ROE would be heavily impacted8LO2 The booktobill ratio is intended to measure whether demand is growing or falling It is closely followed because it is a barometer for the entire hightech industry where levels of revenues and earnings have been relatively volatile 9LO2 If a company is growing by opening new stores then presumably total revenues would be rising Comparing total sales at two different points in time might be misleading Samestore sales control for this by only looking at revenues of stores open within a specific period10LO1aFor an electric utility such as Ontario Hydro expressing costs on a per kilowatt hour basis would be a way to compare costs with other utilities of different sizesbFor a retailer such as Sears expressing sales on a per square foot basis would be useful in comparing revenue production against other retailersS32
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