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chap 3


Department
Finance
Course Code
FIN 300
Professor
Scott Anderson

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CHAPTER 3
WORKING WITH FINANCIAL
STATEMENTS
Answers to Concepts Review and Critical Thinking Questions
1. a. If 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 1.0.
b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.
c.Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.
d. As long-term 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 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current
ratio since current liabilities are not affected.
e.Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.
f.Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.
g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio
increases.
2. The firm has increased inventory relative to other current assets; therefore, assuming current liability levels
remain unchanged, liquidity has potentially decreased.
3. A current ratio of 0.50 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 short-term creditors and suppliers for immediate
payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm
has 50% more current assets than it does current liabilities. This probably represents an improvement in
liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of
15.0, 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 long-term assets or distributing the
funds to shareholders.
4. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of
inventory, generally the least liquid of the firm’s current assets.
b. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid
asset (cash).
c.Interval 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 costs.
d. Total asset turnover measures how much in sales is generated by each dollar of firm assets.
e.Equity 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 to.
f.Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt.
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g. Times interest earned ratio provides a relative measure of how well the firms operating earnings can
cover current interest obligations.
h. Profit margin is the accounting measure of bottom-line profit per dollar of sales.
i.Return on assets is a measure of bottom-line profit per dollar of total assets.
j.Return on equity is a measure of bottom-line profit per dollar of equity.
k.Price-earnings ratio reflects how much value per share the market places on a dollar of accounting
earnings for a firm.
5. 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. Common-base 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
measured.
6. 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 group.
7. Return on equity is probably the most important accounting ratio that measures the bottom-line 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 impacted.
8. The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closely followed
because it is a barometer for the entire high-tech industry where levels of revenues and earnings have been
relatively volatile.
9. 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. Same-store sales control for this by only looking
at revenues of stores open within a specific period.
10. a. For an electric utility such as Con Ed, expressing costs on a per kilowatt hour basis would be a way to
compare costs with other utilities of different sizes.
b. For a retailer such as Sears, expressing sales on a per square foot basis would be useful in
comparing revenue production against other retailers.
c.For an airline such as Southwest, expressing costs on a per passenger mile basis allows for
comparisons with other airlines by examining how much it costs to fly one passenger one mile.
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d. For an on-line service provider such as AOL, using a per call basis for costs would allow for
comparisons with smaller services. A per subscriber basis would also make sense.
e.For a hospital such as Holy Cross, revenues and costs expressed on a per bed basis would be useful.
f.For a college textbook publisher such as McGraw-Hill/Irwin, the leading publisher of finance
textbooks for the college market, the obvious standardization would be per book sold.
Solutions to Questions and Problems
NOTE: End of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.
Basic
1. Using the formula for NWC, we get:
NWC = CA – CL
CA = CL + NWC = $1,320 + 4,460 = $5,780
So, the current ratio is:
Current ratio = CA / CL = $5,780/$4,460 = 1.30 times
And the quick ratio is:
Quick ratio = (CA – Inventory) / CL = ($5,780 – 1,875) / $4,460 = 0.88 times
2. We need to find net income first. So:
Profit margin = Net income / Sales
Net income = Sales(Profit margin)
Net income = ($29M)(0.09) = $2,610,000
ROA = Net income / TA = $2.61M / $37M = 7.05%
To find ROE, we need to find total equity.
TL & OE = TD + TE
TE = TL & OE – TD
TE = $37M – 13M = $24M
ROE = Net income / TE = Net income / TE = $2.61M / $24M = 10.88%
3. Receivables turnover = Sales / Receivables
Receivables turnover = $2,873,150 / $421,865 = 6.81 times
Days sales in receivables = 365 days / Receivables turnover = 365 / 6.81 = 53.59 days
The average collection period for an outstanding accounts receivable balance was 53.59 days.
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