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FIN 300
Scott Anderson

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 theratioent 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 firms 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. 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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