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
• 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
(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
(3) Reduce assets – Minimize inventories, collect accounts
receivables more quickly (this increases the turnover).
e. 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]
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%.