cfm10eaiseIM03rev.docx

cfm10eaiseIM03rev.docx

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cfm10eaiseIM03rev

CHAPTER3

EVALUATIONOFFINANCIALPERFORMANCE

ANSWERSTOQUESTIONS:

1.Theprimarylimitationsofratioanalysisasatechniqueoffinancialstatementanalysisare:

a.Ratiosareretrospectiveanddonotdirectlyincorporateforecastsoffutureperformanceofafirm.

b.Ratiosonlyindicatepotentialproblemareas;theydonotidentifycausesofproblems.

c.Agoodfinancialanalystmustselectthesetofratiosthatismostappropriateforthetypeoffirmbeinganalyzed.

d.Ratiosdonotprovideabsolutemeasuresforevaluation;rathertheymustbeanalyzedagainstsomestandard.Thechoiceofanappropriatestandardforcomparisoncansometimesbeadifficultone.

2.Themajorlimitationofthecurrentratioasameasureofliquidityistheinclusioninthecurrentassetsfigureofsomeassetsthatmaynotbehighlyliquid,suchasinventoryand,insomecases,accountsreceivable.Thequickratio,whichdoesnotconsiderinventories,helpstooffsetthisproblem.

Anotherlimitationisthefactthatitisastatic（basedonthebalancesheet）measureofliquidity,whereasliquidityisadynamic（flow）concept.Also,thecurrentratiomaybeeasilymanipulatedbythefirm.Forexample,afirmwithacurrentratiogreaterthan1xcanincreasethatratiobyusingcashtopayoffsomecurrentliabilities.End-of-yearbalancesheetmanipulationsuchasthisiscommonamongfirmshavingcurrentratioconstraintsimposedaspartoftheirfinancingagreements.

3.Above:

Thefirmishavingcollectionproblems,possiblybecauseoftooliberalacreditgrantingpolicy,inadequatecollectionefforts,orfailuretowriteoffuncollectibleaccounts.

Below:

Thecompanymaybeundulyrestrictiveingrantingcreditandthereforeitmaybelosingsomeotherwiseprofitableaccountstocompetitors.

4.Above:

Thecompanymaybecarryingtoolittleinventoryandthusmaybesubjecttofrequentandsignificant"stockout"costs.Astrategyofcarryingasmallinventorymaycausethecompanytolosecustomers.

Below:

Thecompanymayhavealotofslow-movingorobsoleteinventory.Itmayalsonotbemakinguseofefficientinventorymanagementtechniques.

5.Thefixedassetturnoverratioissubjecttofourmajorlimitationsincomparativeanalyses.Theratioissensitiveto:

a.Thecostoftheassetsatthedateofacquisition.

b.Thelengthoftimesinceacquisition.

c.Thedepreciationpoliciesadopted.

d.Theextenttowhichfixedassetsareleasedratherthanowned.

Eachofthesefactorswilldifferfromfirmtofirm,makingmeaningfulcomparativeanalysesdifficult.

6.Thethreemostimportantdeterminantsofafirm'sreturnonstockholders'equityarenetprofitmargin（earningsaftertax/sales）,thetotalassetturnover（sales/totalassets）,andtheequitymultiplier（totalassets/stockholders’equity）.

7.Alternativeaccountingprocedurescanhaveasignificantimpactonthevalidityofcomparativefinancialanalyses.Threeofthemostsignificantareasfordisagreementbetweenfirmsareinventoryvaluation（LIFOvs.FIFO,forexample）,depreciationmethods（straightline,acceleratedorMACRSdepreciation）,andthetreatmentoffinancialleases（capitalizedornot）.Anyoneoftheseitemscanlimitcomparabilitybetweenfirms.

8.Inflationcanimpactthecomparabilityoffinancialratiosbetweenfirmsinanumberofways.Oneimportantexampleistheexistenceofinventoryprofitsinaperiodofrisingprices.IfafirmusesFIFO,itwillshowhigherprofits（andalargerbalancesheetinventoryfigure）intimesofrisingpricesthanafirmusingLIFO.Inflationalsoaffectsthecostoffixedassetsandthedepreciationchargedagainsttheseassets.Firmsthatownolderassetswilltendtoreporthigherprofitsthanfirmswithnewlyacquiredassets.Theuseofreplacementcostaccountingcanoffsettheseproblems.

9.TheP/Emultipleindicateshowmuchinvestorsarewillingtopayforeachdollarofcurrentearnings.Withagreaterlevelofrisk,investorswillofferlessforadollarofearningsbecauseofthatrisk.Also,thegreaterthegrowthprospectsofthefirm'searnings,themoreinvestorswillbewillingtopayforadollarofcurrentearnings.

10.Generallyearningsqualityisenhancedthegreaterthecashportionofearningsandthemoretheearningsarecomposedofrecurring,asopposedtonon-recurringitems.Balancesheetqualityisenhancedthegreatertheinclusionoftangible,asopposedtointangibleassets.Also,themorenearlytheassetvaluesreportedonabalancesheetarereflectiveoftheiractualmarketvalues,thehigherthebalancesheetquality.

11.AlowerP/Eratiocanbeexpectedforatypicalnaturalgasutilitythanforacomputertechnologyfirmbecausethegrowthprospectsaremuchlowerfortheutility.Offsettingthistosomeextentisalowerperceivedriskoftheutility.

12.Write-offsofnon-performingassetsshouldincreasethefutureprofitabilityratios（e.g.,returnonassetsandcommonequity）sincethefirm’stotalassetsandretainedearnings（partofcommonequity）willbelower.Italsoshouldincreasethefinancialleverageratiosbecauseretainedearnings（partofcommonequity）willbelower.Overthelongrun,thewrite-offsofnon-performingassetsshouldincreasethemarketvalueofthefirm’sequitysecurities,becauseanyproceedsfromthesalesoftheseassetscanbereinvestedinmoreprofitableassets（i.e.,assetswithhigherexpectedratesofreturn）.

13.a.Thebankmusthavealowerequitymultiplierthanotherbanksintheindustry,onaverage.Thatisthebankisemployingmoreequity（foragivenleveloftotalassets）comparedwithotherbanks.

b.Alowequitymultiplierimpliesthatthebankisfollowingafairlyconservativefinancial

leveragepolicy,whichwouldleadtolowerrequiredratesofreturnonitsdebt（kd）andequity（ke）securities,allotherthingsbeingequal.Hence,allotherthingsbeingequal,thisshouldleadtohigherbondandstockprices.However,thebankmaybeearningabove-averagereturnsonitsassetsbyinvestinginhigherriskassetscomparedwithotherbanks.Thiswouldleadtohigherrequiredratesofreturnonitsdebtandequitysecuritiesandthus,allotherthingsbeingequal,lowerbondandstockprices.Theanswercannotbedeterminedwithoutmoreinformationontherelativeriskinessofthebank’sassets.

14.MVA（marketvalueadded）isequaltothepresentvalueofexpectedfutureEVA（economicvalueadded）.EVAistheincrementalcontributionofafirm’soperationstothecreationofMVA.

SOLUTIONSTOPROBLEMS:

1.a.50days=AccountsReceivable/（$1,600,000/365days）

50days=AccountsReceivable/$4,383.56

AccountsReceivable=$219,178

b.Costofsales=（1-0.35）（$1,600,000）=$1,040,000

InventoryTurnover=6=CostofSales/AverageInventory

6=$1,040,000/AverageInventory

AverageInventory=$173,333

2.a.Returnonstockholders'equity

=（$20,000,000）/$10,000,000）x（$10,000,000/$4,000,000）0.03x

=0.15or15%

b.Returnonstockholders'equity=0.05x2.0x2.5=0.25or25%

3.Creditsales=0.8（$40million）=$32million

Averagedailycreditsales=$32million/365days/yr.

=$87,671.23

Averageaccountsreceivable=45x$87,671.23=$3,945,205

4.FromtheDuPontequation（Equation3.21）

ROE=NPMxTATxEquityMultiplier

1.22=（0.12）xTATx（1.7）

TAT=1.08

5.a.

Firm

ABCD

TotalAssetTurnover1.33x1.33x1.00x1.04x

NetProfitMargin0.150.050.150.12

EquityMultiplier1.50x1.50x1.07x2.40x

ReturnonEquity0.300.100.160.30

b.FirmAappearstohavefewproblemsincomparisonwiththeotherfirms.

FirmBhasaveryweakprofitmargin,indicatingtheneedforcorrectiveactiontocontrolcostsortochangethefirm'spricingstrategy.

FirmChasalowassetturnover,suggestingtheexistenceofexcessiveinvestmentsinfixedassetsand/orshort-termassets.Thelowequitymultipliersuggeststhatthefirmhasnotmadeasmuchuseofdebtasthecompetingfirms.ThislowturnoverandlowequitymultiplierhavecombinedtogiveFirmCalowerthanaveragereturnonequity.

FirmDhasalowerthanaverageassetturnoverandanaverageprofitmargin.Thehighreturnonequityhasdoubtlesslybeenearnedbyassumingaveryrisky（debt-heavy）capitalstructure.Thisheavyuseofdebtexposesthefirmtosubstantialfinancialrisk.

Moredetailaboutthedeterminantsofthenetprofitmarginandthetotalassetturnoverratiowouldbevaluable.ThisinformationcouldbeintheformofaDupontchart.Also,itwouldbeusefultoknowifallfirmsusesimilarfinancialreportingmethods.

6.ForecastedBalanceSheet

Cash$104,000

Accountsreceivable1,096,000Totalcurrentliabilities$1,200,000

Inventory1,200,000Longtermdebt2,800,000

Totalcurrentassets$2,400,000Totaldebt$4,000,000

Netfixedassets7,600,000Stockholders'equity6,000,000

Totalassets$10,000,000Totalliabilitiesand$10,000,000

stockholders’equity

a.Profitmarginonsales=0.05=$1,000,000/Sales

Sales=$20,000,000

b.Totalassetturnover=2=$20,000,000/Totalassets

Totalassets=$10,000,000

c.Totaldebttototalassets=0.4=Totaldebt/$10,000,000

Totaldebt=$4,000,000

d.Currentliabilitiestostockholders’equity=0.2=Currentliabilities/$6,000,000

Currentliabilities=$1,200,000

e.Currentratio=2=Currentassets/$1,200,000

Currentassets=$2,400,000

f.Fixedassets=Totalassetsminuscurrentassets

=$10,000,000-$2,400,000=$7,600,000

g.Quickratio=1=（$2,400,000-Inventories）/$1,200,000

Inventories=$1,200,000

h.Averagecollectionperiod=20days

=Accountsreceivable/（$20,000,000/365）

Accountsreceivable=$1,096,000（roundedtothenearest$1,00