Steven has just won a significant amount of money from the state lottery. He has decided to use the funds to create an investment portfolio containing stocks from different industries. Steven has learned financial ratio analysis is a tool that he can use to help make his investment decisions. Some of the companies and ratios are:
South Regional CheapO Quality Heavy Duty
Electric Burger Software Machinery
Current Ratio 0.9 1.4 7.1 3.9
Quick Ratio 0.8 0.9 5.2 2.8
Debt Ratio 71% 50% 0% 36%
Net Profit Margin 6.5% 13.2% 26.9% 9.0%
What are the difficulties in comparing the ratios of these companies to one another?
Why are the liquidity ratios for the utility and fast food companies so much different from the software and machinery manufacturing company?
Would it be advisable for the software company to carry the same debt ratio as the utility company? Why or why not?
Make a recommendation to Steven regarding these investment choices. Based on these ratios, what is your advice? If another student makes different suggestions, challenge them to justify their choices.
Steven has just won a significant amount of money from the state lottery. He has decided to use the funds to create an investment portfolio containing stocks from different industries. Steven has learned financial ratio analysis is a tool that he can use to help make his investment decisions. Some of the companies and ratios are:
South Regional CheapO Quality Heavy Duty
Electric Burger Software Machinery
Current Ratio 0.9 1.4 7.1 3.9
Quick Ratio 0.8 0.9 5.2 2.8
Debt Ratio 71% 50% 0% 36%
Net Profit Margin 6.5% 13.2% 26.9% 9.0%
What are the difficulties in comparing the ratios of these companies to one another?
Why are the liquidity ratios for the utility and fast food companies so much different from the software and machinery manufacturing company?
Would it be advisable for the software company to carry the same debt ratio as the utility company? Why or why not?
Make a recommendation to Steven regarding these investment choices. Based on these ratios, what is your advice? If another student makes different suggestions, challenge them to justify their choices.
Related questions
- Classify the following changes in each of the accounts as either an outflow or an inflow of cash. (1 Mark – 0.2 each)
a. Is a decrease in land and buildings an inflow or an outflow of cash?
b. Is an increase in accounts payable an inflow or an outflow of cash?
c. Is a decrease in vehicles an inflow or an outflow ofcash?
d. Is an increase in accounts receivable an inflow or an outflow ofcash?
e) Is the payment of dividends an inflow or an outflow ofcash?
- Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is nowinvested, Robert performs a ratio analysis on each one and decides to compare them to each other. Some of his ratios are listed here:
|
Island |
Burger |
Fink |
Roland |
|
|
|
Ratio |
Electric Utility |
Heaven |
Software |
Motors |
|
|
Current ratio |
1.06 |
1.35 |
6.79 |
4.55 |
|
|
Quick ratio |
0.92 |
0.87 |
5.23 |
3.73 |
|
|
Debt ratio |
0.69 |
0.45 |
0.04 |
0.34 |
|
|
Net profit margin |
6.25% |
14.33% |
28.46% |
8.43% |
Assuming that his uncle was a wise investor who assembled the portfolio with care, Robert finds the wide differences in these ratios confusing. Help him out.
a. What problems might Robert encounter in comparing these companies to one another on the basis of theirratios? (Select all the answers that) (0.25 Marks)
- The four companies are in very different industries.
- The operating characteristics of firms across different industries vary significantly resulting in very different ratio values.
- Financial ratios from software companies are never very reliable.
- Caution must be exercised when comparing older to newerfirms,g., utility company vs. software'
b. Why might the current and quick ratios for the electric utility and thefast-food stock be so much lower than the same ratios for the other companies? (Select all the answers that) (0.25 Marks)
- Their inventory balances are going to be very close to zero because it is impossible to stockpile electricity and burgers.
- The explanation for the lower current and quick ratios most likely relates to poor management performance.
- Their accounts receivable balances are going to be much lower than for the other two companies.
- The explanation for the lower current and quick ratios most likely rests on the fact that these two industries operate primarily on a cash basis.
c. Why might it be all right for the electric utility to carry a large amount ofdebt, but not the software company? (Select all the answers that) (0.25 Marks)
- A high level of debt can be maintained if the firm has alarge, predictable, and steady cash flow.
- The software firm will have very uncertain and changing cash flow.
- Utilities tend to have steady cash flow requirements.
- The software industry is subject to greater competition resulting in more volatile cash flow.
d. Why wouldn't investors invest all of their money in software companies instead of in less profitable companies? (Focus on risk and) (Select all the answers that apply.) (0.25 Marks)
1. Software companies tend to carry large debt which represents senior claims on thecompanies'
2.Investorswouldn't invest all of their money in software companies because their average collection period is usually very high.
3. By placing all of the money in onestock, the benefits of reduced risk associated with diversification are lost.
4. Although the software industry has potentially high profits and investment returnperformance, it also has a large amount of uncertainty associated with the profits.
3.You have $5,100 to invest today at 11% interest compounded annually. Find how much you will have accumulated in the account at the end of: (0.5 Marks each)
(1)4years,
(2) 8 years, and
(3) 12 years.
4.Using the values below, answer the questions that follow:
|
Amount of annuity |
Interest rate |
Deposit period (years) |
|
|
$500 |
9% |
10 |
- Calculate the future value of theannuity, assuming that it is
- An ordinary annuity. (0.5 marks)
- An annuity due. (0.5 marks)
- Compare your findings in parts a(1) and a(2). All else beingidentical, which type of annuity—ordinary or annuity due—is preferable as an investment? Explain why. (0.5 Marks)