SMG AC 221 Lecture Notes - Lecture 10: Financial Statement, Cash Flow, Capital Structure

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14 May 2018

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Solvency/Leverage Ratios

- Leverage is using borrowed funds to generate returns for stockholders

- May want leverage b/c can help create returns for shareholders WITHOUT using any of

company’s money

- Higher leverage means more risk b/c company will have future obligations. Even if companies is

in financial trouble, they must pay for the $$ they borrowed

- Total-debt-to-total-asset ratio - compares liabilities to asset; is a measure of capital structure

leverage

- Explains how reliant a company is on liabilities for financing

- Look at TOTAL liabilities and not just debt/bonds

- Higher ratio = less solvency and more risk

- Higher ratio means more liabilities than asset = less solvency (less ability

to pay back debt)

- Low earnings (before tax), want a low ratio

Total-debt-to-total-equity - how reliant a company is on liabilities for financing compared with

equity financing

- Higher ratio = less solvency and more risk

- “Total liabilities” includes other liabilities besides debt

- The more profitability you have → more likely for others to lend you

- More risky → industries are less willing to lend

- Intangible assets and goodwill (amount paid in excess of assets) are hard to sell → not

attractive for lending

- Interest Coverage (times interest earned) - how much profit before interest+taxes is available

to cover interest expense

- Denominator may be understated

- Are they generating earning that is sufficient to pay back the loan

- NOTE: If only given Net Interest Expense and not Interest Expense → use the

Net Interest Expense number

- Interest Coverage - How much cash flow from ops is enough to cover interest

expense

- Negative: you are using accrual numbers and may not good analysis so….use

cash flow coverage

- Cash flow Coverage - analyzes how much cash flow from operations is available to cover

interest expense

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Document Summary

Leverage is using borrowed funds to generate returns for stockholders. May want leverage b/c can help create returns for shareholders without using any of company"s money. Higher leverage means more risk b/c company will have future obligations. Even if companies is in financial trouble, they must pay for the 32541 they borrowed. Total-debt-to-total-asset ratio - compares liabilities to asset; is a measure of capital structure leverage. Explains how reliant a company is on liabilities for financing. Look at total liabilities and not just debt/bonds. Higher ratio means more liabilities than asset = less solvency (less ability to pay back debt) Low earnings (before tax), want a low ratio. Total-debt-to-total-equity - how reliant a company is on liabilities for financing compared with equity financing. Higher ratio = less solvency and more risk. The more profitability you have more likely for others to lend you. More risky industries are less willing to lend.

Related Questions

I am having a problem getting my memo right for this math done already class, I have the math done. Heres the directions and Ill post the memo outline they gave us and the math I have doneI have to tell them yes on the loan as you will see in my answer to Part 3

Precision company wishes to expand but needs a $300,000 loan. The bank requests that Precision prepare a balance sheet and key financial ratios. Precision has kept formal records and is able to provide financial statements as of December 31, 2017. The industry debt ratio averages 45.00%. The industry return on assets is 2.0%.

You represent Ideal Bank and will present your findings in a memo to report the ratios for Precision, and identify the conclusion of your opinion reached from your analysis of the companyâs financials. The memo is to be copied and distributed to the VP of Ideal Bank, so a well-written and detailed memo is crucial. Your memo will be crucial to bank leadersâ decision to lend Precision the $300,000.

Make sure you use complete sentences. Check your work for proper spelling, grammar and punctuation.

Part 1(a) - Return on Total assets

Return on Total Assets = (Earning Before Income And Taxes)/Total Assets*100

Total Assets = $1684000

Earning before Interest and Taxes = $185000

Return on Total Assets = ($185000/$1684000)*100 = 10.99%

Part 1(b) - Its Building Block is Profitability. Profitability ratios measure the how effectively company uses its assets in generating revenue. The ratio explain the relationship between income and Resources.

Company is generating more return on total assets than the industry average. Industry average is 2% and company's return on total assets is 10.99%

Also company is having the very high profit Margin, High Return on Equity. Hence overall Position regarding Profitability is Higher than Industry's average

Part 2(a) - Debt Ratio = Total Debts/Shareholders Equity

Total Debts = $400000

Shareholders Equity = $1019000

Debt Ratio = ($400000/$1019000)*100 = 39.25%

Part 2(b) - Its Building Block is Solvency. Solvency ratio determines the ability of company to meet the liabilities of long term debts. It analyses that whether company has sufficient cash flows to repay the long term debts.

Company debt ratio is 39% which is lesser than Industry Average ratio. It says that company better manages its long term debt financing. Lower debt equity ratio is better. And debt equity ratio of more than 50% is considered unhealthy. Hence company is very much performing better than its Industries sector.

Part 3- Yes, Company is highly able to get the loan of $300000. Company is performing better than Industry averages in terms of profitability and Solvency. Also Company has current ratio of more than 2.0 which says that company has high liquidity. Hence company is Growing in business and has strong financials better than industry average. Hence Company can get the loan of $300000 for expansion

Precision Company

Memorandum

To: Recipient Name

From: Your Name

CC: CC Name

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rosecoyote597

Complete one paragraph, profiling each company's business, including information such as brief histories, where each company is located, number of employees, the products each company sells, and so forth. Please reference any websites that you used for the profiles on the Bibliography tab.

Tootsie Roll Industries began in a small candy store in New York in 1896. Tootsie Roll is now headquartered in Chicago and primarily sells its products in the United States, Canada, and Mexico. According to Yahoo! Finance, Tootsie Roll has 2,000 full-time employees. Tootsie Roll sells the following branded candy: Tootsie Roll, Tootsie Roll Pop, Charms Blow Pop, Mason Dots, Andes, Sugar Daddy, Charleston Chew, Double Bubble, Razzles, Caramel Apple Pop, and Junior Mints. Tootsie Roll had 2014 net product sales of $539.9 million.

Hershey Company was founded by Milton S. Hershey in 1893 and is headquartered in Hershey, Pennsylvania. According to Yahoo! Finance, Hershey has 20,800 full-time employees. Hershey is famous for Good & Plenty, Hershey Bar, Hershey's Kisses, Hershey's Bliss, Reese's, Rolo, Twizzlers, Almond Joy, Kit Kat, and Ice Breakers. Hershey had net product sales of $7.4 billion for 2014.

Tootsie Roll			Hershey			Interpretation and comparison between the two companies' ratios (reading Chapter 13 will help you prepare the commentary)
						The comparison of the ratios is an important part of the project. A good approach is to briefly explain what the ratio tells us. Indicate whether a higher or lower ratio is better. Then compare the two companies on this basis. Remember that each ratio below requires a comparison.
		$ 1.05			$ 3.91


$264,621	=	4.11	$2,247,047	=	1.16
$64,459			$1,935,647


$198,962	=	36.9%	$3,336,166	=	45.0%
$539,895			$7,421,768


$63,298	=	11.7%	$846,912	=	11.4%
$539,895			$7,421,768


$340,933		5.2	$4,085,602		5.6
$66,118		times	$730,289		times


365	=	71	365	=	65
5.2		days	5.6		days


$539,895	=	12.9	$7,421,768	=	13.8
$41,987			$537,426

365	=	28.4	365	=	26.4
12.9		days	13.8		days


$539,895	=	0.60	$7,421,768	=	1.35
$899,398			$5,493,502


	=	7.0%		=	15.4%



$219,250	=	24.1%	$4,109,986	=	73.0%
$910,386			$5,629,516


$83,923	=	847.7	1,389,575	=	16.6
$99			83,532


$0.36	=	1.1%	$2.33	=	2.6%
$32.04			$90.32

$63,298	=	9.2%	$846,912	=	54.0%
$685,721			$1,567,791


	=	$78,065			$ 492,274
		$78,065		=


$30.65	=	29	$103.93	=	27
$1.05			$3.91

You all get the chance to play the role of financial analyst below. The summary should be a comparison of each company's performance for each major category of ratios listed below. Focus on major differences as you compare each company's performance. A nice way to conclude is to state which company you feel is the better investment and why.

Measuring Ability to Pay Current Liabilities: Tootsie Roll has the advantage for the current ratio. Tootsie Roll has $4.11 in current assets for every dollar in current liabilities, while Hershey has only $1.16 in current assets for every dollar in current liabilities.

Measuring Turnover: Hershey has the advantage for the inventory turnover and accounts receivable turnover ratios. Hershey turns over its inventory 5.6 times to Tootsie Roll's 5.2 times, and Hershey turns over its accounts receivable 13.8 times to Tootsie Roll's 12.9 times.

Measuring Leverage - Overall Ability to Pay Debts: Tootsie Roll has significantly less debt than Hershey as evidenced by Tootsie Roll's 24.1% debt-to-asset ratio as compared to Hershey's 73% debt-to-asset ratio. Tootsie Roll can cover its interest expense 847.7 times with income before interest and taxes, while Hershey can only cover its interest expense 16.6 times with their income before interest and taxes. Tootsie Roll has the advantage for each of these ratios.

Measuring Profitability: Hershey has the advantage for 4 of the 5 profitability ratios. Hershey has a significant edge in return on common stockholders' equity, with a 54% return on common stockholders' equity, as compared to Tootsie Roll's 9.2% return on common stockholders' equity. Hershey has a higher gross profit rate (45.0%â36.9%), while Tootise Roll has a higher net profit margin ratio (11.7%â11.4%). Hershey also has a significant advantage for asset turnover (1.35â.60) and rate of return on total assets (15.4%â7.0%).

Analyzing stock as an investment: Hershey returns a 2.6% dividend yield to its investors, while Tootsie Roll's yield is 1.1%. Hershey has positive free-cash flow of $492.2 million, whereas Tootsie Roll has positive free-cash flow of $78.1 million. Free-cash flow can be used to undertake acquisitions, pay additional dividends, pay down debt, or buy back stock.

Conclusion: Tootsie Roll is the safer investment when you examine the ability to pay current liabilities and overall liabilities, but Hershey has the advantage for the turnover and profitability ratios. For the conservative investor, Tootsie Roll looks like the way to go because of its strong current and times interestâearned ratios. For the growth-oriented investor, Hershey is the way to go because of its stronger profitability ratios and large amount of free-cash flow.

1. Which of the following statements is true about apartnership?

a. One capital and one drawings account is used for eachpartnership.

b. The capital account is used to record each partner'sinvestment and that partner's designated share of the earnings.

c. Partnerships are subject to separate income taxes.

d. The drawings account is closed to retained earnings at theend of the period.

2. Which of the followingstatements does not correctly describe preferred stock?

a. Preferred shareholders have a preference with respect todividend payments.

b. Preferred shareholders have a preference with respect toassets in the event of dissolution.

c. Preferred shareholders have voting rights on a per sharebasis.

d. Preferred stock typically has a fixed dividend rate.

3. Which of the followingstatements is false?

a. Common stockholders have a residual claim on assets in theevent of liquidation.

b. Shares of stock held in the treasury are subtracted from thenumber of issued shares in the determination of the number ofoutstanding shares.

c. Common stockholders have voting rights at annual stockholdermeetings.

d. Corporations are governed by their stockholders.

4. Which of the following would not be reportedas a financing activities cash flow?

a. Issuing common stock for cash.

b. Cash dividend payments.

c. Purchasing treasury stock.

d. Purchase of a building by signing a note payable.

5. Which of the following is not reported as acash flow from investing activities?

a. Sale of a depreciable asset for cash.

b. Purchasing land in exchange for common stock.

c. Selling a long-term investment at a loss for cash.

d. Purchase of a patent in exchange for cash.

6. Which of the following transactions would be reported withinthe investing section of the cash flow statement?

a. The cash sale of land at a loss.

b. The purchase of a building in exchange for common stock.

c. The receipt of a stock dividend from a stock investment.

d. The cash receipt of a dividend from a stock investment.

7. Which of the following would be subtracted from net incomewhen determining cash flows from operating activities under theindirect method?

a. A decrease in utilities payable.

b. Patent amortization expense.

c. A decrease in prepaid rent.

d. A loss on the sale of a depreciable asset.

7. Which of the following would be added to net income whendetermining cash flows from operating activities under the indirectmethod?

a. A decrease in accounts payable.

b. Patent amortization expense.

c. An increase in prepaid insurance.

d. A gain on the sale of a depreciable asset.

8. Which of the following would not be a cashflow from financing activities?

a. Issuance of common stock for cash.

b. Borrowing cash on a long-term note payable.

c. Collection of a cash dividend.

d. Repayment of principal on a long-term note payable.

9. The cash payment of a previously declared dividend increaseswhich of the following ratios?

a. Debt-to-equity.

b. Earnings per share.

c. Price/earnings ratio.

d. Asset turnover.

10. The debt-to-equity ratio measures which of thefollowing?

a. Liquidity.

b. Solvency.

c. Profitability.

d. Market strength.

11. Negative financial leverage occurs when the:

a. Average net (after tax) interest rate on borrowed funds isless than the company's earnings rate on its assets.

b. Return on assets is more than return on equity.

c. Return on equity is more than return on assets.

d. Operating expenses exceed gross profit.

12. Which of the following ratios is notconsidered to be a test of profitability?

a. Current ratio.

b. Profit margin.

c. Return on assets.

d. Earnings per share.

13. Home Depot's operating strategy is to offer a broadassortment of high-quality merchandise and services at competitiveprices using highly knowledgeable service-oriented personnel andaggressive advertising. Which of the following isnot as critical to achieving Home Depot'sstrategy?

a. Cost control

b. Product differentiation

c. High level of customer service

d. High sales volume

13. Which of the following ratios is not partof the DuPont model?

a. Asset turnover.

b. Debt-to-equity.

c. Net profit margin.

d. Return on equity.

Which of the following statements is notcorrect?

Purchasing fixed assets through debt financing decreases thefinancial leverage ratio.

Accruing an expense will affect the net profit margin ratio.

Return on equity may increase even when the financial leverageratio decreases.

Purchasing treasury stock results in a decrease in assetturnover.

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SMG AC 221 Lecture Notes - Lecture 10: Financial Statement, Cash Flow, Capital Structure

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