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Business Administration
BUS 251
Steve Gibson

12-4 A time-series analysis is one in which financial statement data for a single company is analyzed across time. A cross-sectional analysis is one in which financial statement data from several companies are compared. The companies may be from the same industry or they may be from various sectors of the economy. Another version of the cross-sectional analysis would be to compare the company with industry average statistics. The cross-sectional analysis could also be conducted over time for a combined time-series, cross-sectional analysis. In summary, time-series analyses are useful to study the trends of a company over time, while cross-sectional analyses are used to compare one company to others. 12-5 The ratios discussed in the chapter are divided into four general categories, but they are all related. The categories are performance, short-term liquidity, activity, and long-term solvency. Most of these ratios apply to any company regardless of the nature of its business, but some (such as inventory ratios) apply only to certain types of businesses. A fifth group of ratios applicable to equity analysis is also discussed. • Profitability Ratios – Although much can be learned from studying the statement of earnings and statement of cash flows, in both their raw data and common size forms, profitability ratios complement that understanding and also draw out some of the relationships between these statements and the statement of financial position. • Short-Term Liquidity Ratios – Liquidity refers to a company’s ability to convert assets into cash to pay liabilities. A basic understanding of the company’s short-term liquidity position should result from a consideration of the financial statements, particularly the statement of cash flows, as well as the turnover rates. • Activity Ratios – The activity ratios provide additional insight into the major decisions management makes regarding asset use and liquidity. These ratios provide some quantitative measures of the lead/lag relationships that exist between the revenue and expense recognition and the cash flows related to these items. • Solvency Ratios – Solvency, or long-term liquidity, refers to the company’s ability to pay its obligations in the long term (meaning more than one year into the future). A time-series analysis of the statement of cash flows and the patterns of cash flow over time should provide much of the insight you need to assess a company’s abilities to pay its long-term debt. • Equity Analysis Ratios – Equity analysis ratios measure the long- term risk and return of the company, as measured by many of the ratios discussed in the four above categories. Equity analysts and investors are uniquely interested in the relative value of the company’s shares. They attempt to value a share, or an entire company, and compare those values to current market prices to determine if the company is an attractive investment. 12-25HomeStar's inventory turnovers has increased each year indicating that the inventory is moving out more quickly. This means that they have to wait less to turn the inventory into cash. HomeStar gross profit margin, net profit margin, return on assets, and return on equity have been decreasing each year. When one examines the debt to equity ratio, HomeStar appears to be less leveraged each year (likely by decreasing debt and/or increasing equity). They would, therefore, have less interest expenses to service this debt (assuming debt is decreasing). The ratio that indicates positive action is the Inventory turnover; the number of days held in inventory has decreased from 69 days in 2008 to 65 days in 2010, a slight improvement. 12-28 a. The before-tax cost of the debt is 7%. The after-tax cost of debt is 4.55% [7%x(1–0.35)]. b. ROE = $13,650 / $300,000 = 4.55% ROA = ($13,650 + *$9,100) / $500,000 = 4.55% *(200,000 x 0.07) + $14,000 X 0.65 = $9,100 c. ROA = ROE because the company has a debt cost of 7%, or 4.55% after tax, which is exactly equal to the current ROE. Thus, as the company borrows more to invest in assets, neither ROA nor ROE change. d. Generally, there are three main ways to sustain or improve ROE: (1) Increase sales – May increase margin if there are any fixed expenses (even if margin stays constant, turnover increases if more sales are generated with same operating assets). (2) Cut costs – Increases net earnings and therefore, the margin. (3) Reduce assets – Minimize inventories, collect accounts receivables more quickly (this increases the turnover). e. EBIT= $35,000 EBIT $35,000 Less: Interest 14,000 Earnings Before Taxes 21,000 Less: Income Tax (rate 35%) 7,350 Net Earnings $13,650 f. EBIT 35,000 Less Interest 9% 18,000 Earnings Before Taxes 17,000 Less Tax rate 35% 5,950 Net Earnings $11,050 ROA = Net earnings + [Interest expense x (1 – tax rate)] Average total assets 0.0455 = Net Earnings + [($200,000 x 0.09) x 0.65] $500,000 ROE = $11,050 / $300,000 = 3.68% g. As determined in part b, the ROA is 4.55%. In the second set of assumptions the company’s after-tax interest cost is 5.85% (9% x 0.65). Because the company is borrowing at a cost of 5.85% to invest in assets that generate a return of only 4.55%, the ROE is reduced, to 3.68%. 12-36 a.
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