Chapter 6
Ratio Analysis
P6-4.
The junior analyst adopted a needlessly simplistic approach and thereby reached an erroneous conclusion based on that analysis. Receivables turnover is designed to assess Credit Sales/Accounts Receivable. The data provided can be used to derive AC’s credit sales for input to this ratio. Instead, the analyst used total sales, which perturbs this longitudinal comparison.
We are told that 1/3 of AC’s 20X2 sales are through its own stores and that 1/2 of these sales are cash transactions. Thus, 1/6 of AC’s total sales are cash and 5/6 are credit sales. Accordingly, AC’s A/R turnover in 20X2 = 5/6 (8.4) = 7.0 This indicates that management of this component of AC’s working capital is deteriorating rather than improving.
P6-5.
Choice A is correct.
The times-interest-earned ratio is in the category of solvency measure. This specific ratio is designed to capture the company’s ability to meet its fixed interest cost obligations. Even when a company is able to capitalize some of its interest cost (i.e., treat this portion of interest as an asset rather than as a period cost), it still incurs the cash outflow. Likewise, the unadjusted ratio of times interest earned would overestimate the solvency of a company relative to a competitor that did not capitalize any interest cost.
P6-6.
Both long-term debt and equity are represented on the balance sheet at historical cost. Consequently, the result obtained by computing Long-term Debt/Total Equity is likely to overestimate the ratio of the market value of these respective claims on the firm.
The reason is that the ratio of Market Value/Book Value of Equity (or Price-to-Book ratio) greatly exceeds 1.0 for most established profitable firms. A typical P/B in recent years for such a firm has been in the range of 3.0-6.0. Therefore, the firm appears to be more heavily financed with debt than is actually the case.
One should also note that the market value of debt may also be underestimated since interest rates have declined for most of the 1990s and early 2000s. However, this understatement will probably be much less severe than the preceding one (so the conclusion remains true in the vast majority of cases).
P6-7.
Choice C is correct.
For any firm with substantial depreciation expense, the ratio of cash flow from operations to income will exceed 1.0 since depreciation is a noncash charge (i.e., it affects income but not cash flow). A is incorrect since rent associated with operating leases affects cash flow and income. B is incorrect since a firm need not be highly leveraged for income to exceed cash flow. D is incorrect since income will exceed cash flow for many growing firms that require increasing working capital.
P6-8.
Choice B is correct.
The condition that is necessary for leverage to result in higher ROE is that EBIT/Assets exceeds the pre-tax cost of debt. If this is not the case then the increased interest expense results in a lower level of income and ROE declines.
P6-9.
EBIT - Interest Expense – Taxes = Net Income
900,000 – 400,000 – 150,000 = 350,000 = Net Income
Total Assets = Debt + Equity = 5 million + 5 million = 10 million
ROE = 350,000/5,000,000 = .07 = 7%
ROE = ROA X Leverage
ROE = 350,000/10,000,000 X 10 million/5 million
ROE = .035 X 2 = .07 or 3.52 X 2 = 7%
P6-10
PAL’s ROE remains 7%.
ROE = Profit margin X Asset Turnover X Leverage
ROE = 350,000/50 million X 50 million/10 million X 10 million/5 million = 0.7% X 5 X 2 = 7%
P6-11. Company A is better. The cash management cycle examines inventory turnover, receivable turnover, and accounts payable turnover to determine the number of days that a company has cash in use for these combined activities.
Cash Cycle = Days Inventory + Days Receivable – Days Payable
For Company A: 365/10 + 365/20 – 365/4 = 36.5 + 18.25 – 91.25 = -36.5
For Company B: 365/20 + 365/25 – 365/6 = 18.25 + 14.60 –
60.833 = - 27.983
For this combined measure of the cash management cycle, a smaller number is indicative of better performance. In this case, both companies are managing exceptionally well (with negative scores). Company A is superior despite the fact that Company B is better on 2 of the 3 components.
P6-12.
Asset Turnover is a measure of the amount of revenue that a company is able to generate for each dollar (or other currency unit) of assets.
In this case:
20x020x120x2
Asset Turnover:2.502.001.55
Wireless Technology has doubled its assets while its revenues have increased by 24% during this period. As a result we see a significant decline in asset turnover. While Wireless Technology decreased the rate of growth in assets somewhat, it appears to have planned on a much greater increase in sales in 20x2.
P6-13.
Current Ratio = 3.25 billion = .9286
3.5 billion
Quick Ratio excludes inventory and pre-paid expenses from current assets.
Thus, Quick Ratio = 3.1 billion = .8857
3.5 billion
As noted in the text, use of a ratio adjusts for size. If a difference measure were used to gauge a firm’s liquidity (e.g., current assets minus current liabilities) it would be difficult to interpret the absolute number obtained. Moreover, a difference of any given amount (say, $10 million) might indicate excellent liquidity for a very small firm and very poor liquidity condition for a similar firm that is much larger in absolute size and daily use of cash.
P6-14.
Luxury.com has a Debt-to-Asset ratio of 1.25.
Since Total Assets = Total Debt + Total equity, it will usually be the case that this debt ratio will be less than one. Luxury.com appears to have negative equity, which results when accumulated losses in retained earnings exceed other stockholders’ equity capital.
P6-15.
Recall that the purpose of the times-interest-earned ratio is to gauge a firm’s ability to meet its obligation to pay out cash as interest payments are due. Accordingly, an analyst might adjust the numerator of this ratio to reflect any difference between a firm’s EBIT and its cash flow before interest and taxes. The denominator is intended to measure the annual cash outflow for interest expense. If a firm has capitalized a significant amount of interest expense, then the reported interest expense will understate the actual outflow (since the outflow is unaffected by whether the interest is treated as a period cost or capitalized). Thus, it may be useful to increase the denominator for any capitalized interest.
P6-16.
Choice A is correct.
The current ratio would increase, and the asset turnover ratio would also increase.