#1. Holding all factors constant, indicate whether each of the following changes generally signals good or bad news about a company. What is rational behind your choice?
a)Increase in profit margin: Good symbol as it denotes increase in the profitability of the company.
b)Decrease in inventory turnover: Bad, as it denotes decrease in the number of turnovers of inventory during a specific period and it means that there is inefficiency in the management of assets of the company.
c)Increase in current ratio: It is good symbol as it denotes improvement in the liquidity position of the company.
d)Increase in average collection period for receivables: Bad for the company as there will be decrease in the cash inflows of the company.
e)Decease in earnings per share: Bad symbol as it will affect the wealth maximization of the company negatively
f)Increase in debt to total assets ratio: Bad, as it will denote increase in the debts and time interest earned of the company which means increase in fixed obligations in the form of increased interests on debts
g)Decrease in times interest earned: Bad, as this will lead to decrease in the net income due to higher taxation.
For example: A) = good news because profit margin is a profitability ratio and increase in profits for a firm is always good.
#2. A number of you have already referenced the different ratio types. So let see how well you really understand them with the following questions:
What are the broad ratio categories of financial performance and describe eachwith a specific example:
Ans.
The various types of financial ratios used to analyze financial performance are broadly classified into the following:
Liquidity ratios
Activity (Asset utilization) ratios
Leverage (Solvency) ratios
Profitability ratios
Market Value ratios
Liquidity ratios: Liquidity is the company’s ability to convert non-cash assets into cash or to obtain cash in order to meet current liabilities. Liquidity applies to the short-term, which is typically viewed as a time span of one year or less.
Activity (Asset utilization) ratios: These ratios are used to determine how quickly various accounts are converted into sales or cash. Overall liquidity ratios do not give an adequate picture of a company’s real liquidity, due to differences in kinds of current assets and liabilities the company holds. Thus, it is necessary to evaluate the activity or liquidity of specific current accounts. Various ratios exist to measure the activity of receivables, inventory and total assets. The various ratios that are calculated under it include: accounts receivable, inventory turnover, average collection period etc. are calculated under it.
Leverage (Solvency) ratios: Solvency is a company is a company’s ability to meet its long-term obligations as they become due. An analysis of solvency concentrates on the long-term financial and operating structure of the business. The degree of long-term debt in the capital structure is also considered. Further, solvency is dependent upon profitability since in the long run a firm will not be able to meet its debts unless it is profitable. Various ratios calculated under it include: debt ratio, time interest earned ratio etc.
Profitability ratios: An indication of good financial health is the company’s ability to earn a satisfactory profit and return on its investments. Investors will be reluctant to associate themselves with an entity that has poor earning potential since the market price of stock and dividend potential will be adversely affected. Creditors will shy away from companies with deficient profitability since the amounts owed to them may not be paid. Some of the ratios calculated under it are: profit margin, return on equity (ROE), return on investment (ROI) etc.
Market Value Ratios: This group of ratio relates to firm’s stock price to its earnings (or book value) per share. It also includes dividend-related ratios.
#3. Now that we have identifying what the different ratio types are, you are ready to answer
the following question:
Financial ratio analysisis conducted by four groups of analysts (listed below). What is the primary emphasis of each of these groups in selecting ratios to make assessment & what is the reason? (Hint: focus on purpose of different ratio types)
1. Managers: All the ratios are important as they need to know all ratios to judge and improve the overall financial position of the company. They are the part of management of the company, so they have the responsibility of improving and strengthening the financial position of the company.
2. Equity Investors: For investors profitability ratios are more important as compared to other ratios. Investors will be reluctant to associate themselves with an entity that has poor earning potential since the market price of stock and dividend potential will be adversely affected.
3. Long-Term creditors: For long term creditors, the solvency ratios are important because the ratios under this category indicate the long term financial position of the company in terms of its solvency.
4.Short-term creditors: For short term creditors liquidity ratios are more important. Analyzing corporate liquidity is especially important to creditors. If a company has poor liquidity position, it may lead to delay in receiving interest and principal payments or even losses on the amounts due. It includes various ratios such as current ratio, liquid ratio, working capital etc.
#4. In your reading of the different financial statements you came acrossthe accounting steps used to arrive at these financials. Thus, I liketo get your feedback on the following question:
What are required steps in the accounting cycle?
Ans.
The accounting process (or cycle) is a series of routine steps (major steps):
1) occurrence of the transaction,
2) classification of each transaction in chronological order (journalizing),
3) recording the classified data in ledger accounts (posting),
4) preparation of financial statements, and
5) closing of nominal accounts.