ACT 3211
ACT 3211
TUTORIAL 2 - AnswersANALYSIS OF FINANCIAL STATEMENTS
1.Text book questions: 4-1; 4-2; 4-3; 4-4; 4-7; 4-9
Q 4-1The emphasis of the various types of analysts is by no
means uniform nor should it be. Management is interested in all
types of ratios for two reasons. First, the ratios point out
weaknesses that should be strengthened; second, management
recognizes that the other parties are interested in all the ratios
and that financial appearances must be kept up if the firm is to be
regarded highly by creditors and equity investors. Equity investors
(stockholders) are interested primarily in profitability, but they
examine the other ratios to get information on the riskiness of
equity commitments. Long-term creditors are more interested in the
debt, TIE, and EBITDA coverage ratios, as well as the profitability
ratios. Short-term creditors emphasize liquidity and look most
carefully at the current ratio.
Q 4-2The inventory turnover ratio is important to a grocery
store because of the much larger inventory required and because
some of that inventory is perishable. An insurance company would
have no inventory to speak of since its line of business is selling
insurance policies or other similar financial productscontracts
written on paper and entered into between the company and the
insured. This question demonstrates that the student should not
take a routine approach to financial analysis but rather should
examine the business that he or she is analyzing.
Q 4-3Given that sales have not changed, a decrease in the total
assets turnover means that the companys assets have increased.
Also, the fact that the fixed assets turnover ratio remained
constant implies that the company increased its current assets.
Since the companys current ratio increased, and yet, its cash and
equivalents and DSO are unchanged means that the company has
increased its inventories.
Q 4-4Differences in the amounts of assets necessary to generate
a dollar of sales cause asset turnover ratios to vary among
industries. For example, a steel company needs a greater number of
dollars in assets to produce a dollar in sales than does a grocery
store chain. Also, profit margins and turnover ratios may vary due
to differences in the amount of expenses incurred to produce sales.
For example, one would expect a grocery store chain to spend more
per dollar of sales than does a steel company. Often, a large
turnover will be associated with a low profit margin, and vice
versa.
Q 4-7a.Cash, receivables, and inventories, as well as current
liabilities, vary over the year for firms with seasonal sales
patterns. Therefore, those ratios that examine balance sheet
figures will vary unless averages (monthly ones are best) are
used.
b.Common equity is determined at a point in time, say December
31, 2005. Profits are earned over time, say during 2005. If a firm
is growing rapidly, year-end equity will be much larger than
beginning-of-year equity, so the calculated rate of return on
equity will be different depending on whether end-of-year,
beginning-of-year, or average common equity is used as the
denominator. Average common equity is conceptually the best figure
to use. In public utility rate cases, people are reported to have
deliberately used end-of-year or beginning-of-year equity to make
returns on equity appear excessive or inadequate. Similar problems
can arise when a firm is being evaluated.
Q4-9The three components of the extended Du Pont equation are
profit margin, assets turnover, and the equity multiplier. One
would not expect the three components of the discount merchandiser
and high-end merchandiser to be the same even though their ROEs are
identical. The discount merchandisers profit margin would be lower
than the high-end merchandiser, while the assets turnover would be
higher for the discount merchandiser than for the high-end
merchandiser.
2.Between supermarket and hotel, which has a lower turnover on
fixed assets (Sales/Net Fixed Assets)?
Hotel is having lower turnover on fixed asset. Operations of
hotel industries are capital intensive. Large amount is invested in
fixed assets to generate sales, suggesting lower fixed assets
turnover. Supermarket is investing more in inventories (current
assets). It generates sales more by selling inventories than the
used of fixed assets.
3.Explain why it is bad, when the inventory turnover
(Sales/Inventories) of a company is too high or too low as compared
to the industry?
Too low: The company is holding more inventory than it needs to
support its sales volume. It will generate costs to the company
such as rental for storage area, insurance cost, obsolete, damage
and outdated.
Too high: The company is holding less inventory than it needs to
support customers demand. It can cause lost of sales because
customers seeking for alternative seller.4.For the past years the
current ratio of Syarikat Ardee has been on the steady increase.
But at the same time the quick ratio of this company is decreasing.
What is actually taking place? Does this scenario indicate a sign
of improvement of company liquidity?
Both current ratio and quick ratio are the measuring the
liquidity performance of a company. They evaluate companys ability
to pay its short term obligations. Current ratio is defined as
current assets divided by current liabilities. Meaning it is assume
that the company can use all current asset to pay for the current
liabilities.
It is sometimes unreasonable to use all the current assets for
that. Inventories are typically the least liquid current assets and
losses are most likely to occur from inventories in the event of
liquidation. The quick ratio [(Current Assets-Inventories)/Current
Liabilities] is the better measurement. It measures a companys
ability to pay off short term obligation without relying on the
sale of inventories.
Situation given in the question means that portion of
inventories holds by Syarikat Ardee is getting higher, compare to
current assets. It suggests that the liquidity of the company is
getting worst.
5.Which of the following company has a higher profit? Company A:
Net profit margin is 2% and total assets turnover is 10X or Company
B: Net profit margin is 10% and total assets turnover is 2X.
Explain your answer and give an example of this type of company A
and B.
Company B is having higher net profit.
Example of company B is hotel industry. It requires higher
profit margins and invests (uses) the fixed assets intensively to
generate sales and, does contributing lower assets turnover.
Example of company A is the food industry or supermarket. It can
succeed with lower profit margins and invests/uses less assets to
generate sales and, does contributing higher assets turnover.
6.Strack Houseware Supplies Inc. has RM2 billion in total assets.
The other side of its balance sheet consists of RM0.2 billion in
current liabilities, RM0.6 billion in long-term debt, and RM1.2
billion in common equity. The company has 300 million shares of
common stock outstanding, and its stock price is RM20 per share.
What is Stracks market/book ratio?
Book value per share = Common Equity / Shares Outstanding
= RM1.2 billion / 300 million unit
= RM 4 per share
Market/book ratio = Market Price Per Share / Book Value Per
Share
= RM 20 / RM 4
= RM 5 per share
7.Construct the DuPont system of analysis using the following
financial data for Malee Industries and determine which areas of
the firm need further analysis.
Key Financial Data
Malee Industries:
Sales$4,500,000
Net profits after taxes337,500
Total assets6,750,000
Total liabilities3,375,000
Industry Averages:
Total asset turnover (Sales/Assets)0.71
Debt ratio (Debts/Assets)33.00%
Financial leverage multiplier1.50
Return on total assets (ROA)6.75%
Return on equity (ROE)10.00%
Net profit margin (Net Income / Sales)9.50%
Industry Averages:
ROE (10%)
ROA (6.75%)
x Equity Multiplier (1.5 times)
Profit(9.5%)
Assets (0.71)
1 / (1-Debt Ratio) Margin
Turnover
1 / (1-33%)
Malee Industries:
ROE (10%)
ROA
x Equity Multiplier
= 7.5% x 66.67%
= 5%
= 1 / (1-Debt Ratio)
= 1 / [1-(Liabilities/Assets)]
= 1/[1-(3,375,000/6,750,000)]
Profit
Assets
= 2 times Margin
x Turnover
Net Income
Sales
Sales
Total Assets
= 337,500
= 4,500,000
4,500,000
6,750,000
= 7.5%
= 66.67%
Explanation: Malee is having same level of ROE which the
industry averages, which is 10%. However according to the DU Pont
analysis, ROA, profit margin and assets turnover for Malee are
lower compare to industry. Meaning, the profitability and turnover
ratios for Malee are not good enough. At the same time, the debt
ratio for Malee is very high (50%) compare to industry (33%).
Same ROE doesnt mean Male is performing at the same level with
the industry average. Its able to achieve the same ROE, but its
failed to achieve high profitability and turnover ratio, because it
is supported by high debt ratio. Malee is using too much debt,
which is very risky to the business.8.Given the following balance
sheet, income statement, historical ratios and industry averages,
calculate the Bazla Inc. financial ratios for the most recent year.
Analyze its overall financial situation for the most recent year.
Analyze its overall financial situation from both a crosssectional
and timeseries viewpoint. Break your analysis into an evaluation of
the firms liquidity, activity, debt, and profitability.Income
StatementBazla Inc.For the Year Ended December 31, 2005
Sales Revenue$2,080,976
Less: Cost of Goods Sold1,701,000
Gross Profits$379,976
Less: Operating Expenses273,846
Operating Profits$106,130
Less: Interest Expense19,296
Net Profits Before Taxes$86,834
Less: Taxes (40%)34,810
Net Profits After Taxes$52,024
Balance SheetBazla Inc.December 31, 2005
Assets
Cash$ 95,000
Accounts receivable237,000
Inventories243,000
Total current assets$ 575,000
Gross fixed assets500,000
Less: Accumulated depreciation75,000
Net fixed assets$ 425,000
Total assets$1,000,000
Liabilities and stockholders equity
Current liabilities
Accounts payable$ 89,000
Notes payable169,000
Accruals87,000
Total current liabilities$ 345,000
Longterm debt188,000
Total liabilities$ 533,000
Stockholders equity
Common stock255,000
Retained earnings212,000
Total stockholders equity$ 467,000
Total liabilities and stockholders equity$1,000,000
Historical and Industry Average Ratios
Bazla Inc.
Ratio200320042005Industry2005
Liquidity Ratios
Current Ratio
(Cur. Assets / Cur. Lias)1.61.7575K / 345K= 1.667 times1.6
Quick Ratio[(Cur. Assets - Inv) / Cur.Lias]0.91.0(575K-243K) /
345K= 0.96 times0.9
The liquidity ratios for Bazla, are getting better from year
2003 to 2004, however, both ratios slightly drop in 2005. Bazla is
facing liquidity problem since the acid test ratio is below two,
meaning Bazla is not able to cover all the current liabilities
within time, unless the Bazla is able to sell its inventory, within
that particular period.
Comparing with the industry averages, it seems that the Bazla is
having similar liquidity ratios with the industry.
Activity Ratios
Inventory Turnover(Sales / Inv)8.19.31,701K / 243K= 7
times8.4
Average Collection Period[ACR / (Sales/365)] 33 days 37 days237K
/ (2,080,976/365)= 41 days39 days
Total Asset Turnover(Sales / Total Assets)2.32.22,080,976 /
1,000K= 2.08 times2.2
Overall performance of Bazla in term of the asset management
(activity) is getting weak from year 2003 to year 2005. Even the
inventory turnover was increase in year 2004 it drops again in the
current year, while the total asset turnover is decreasing. Meaning
that Bazla is not using the asset effectively in generating sales.
Furthermore Bazla needs more days to collect the debts from
customers compare to the previous years.
Bazla has better inventory turnover compare to the industry,
however, the total asset turnover is still lower. Same conclusion
can be made since the collection period for the industry is lower
than Bazla.
Debt Ratios
Debt Ratio(Total Liabilities / Total Assets)60%56%533K /
1,000K
= 53.3 %58%
Times Interest Earned(EBIT / Interest Charged)2.53.5106,130 /
19,296= 5.50 times2.3
Bazla is able to manage its debt better compare to the previous
years as well as industry averages since the debt ratio is lower.
Meaning that Bazla use less debt to run the business compare to the
previous years and industries.
At the same time, Bazla is able to pay interest more frequent
due to high TIE ratio.
Historical and Industry Average Ratios
Bazla Inc.
Ratio200320042005Industry2005
Profitability Ratios
Gross Profit Margin(Gross Profit / Sales)21%19.7%379,976 /
2,080,976
= 18.26% 20.4%
Operating Profit Margin(Operating Profit / Sales) 4.7%
4.8%106,130 / 2,080,976
= 5.10% 4.7%
Net Profit Margin(Net Profit / Sales) 1.8% 1.6%52,024 /
2,080,976
= 2.50% 1.4%
Return on total assets(Net Profit / Total Assets) 4.1%
3.5%52,024 / 1,000 K
= 5.20% 3.08%
Return on Equity(Net Profit / Equity)10.3%7.9%52,024 / 467 K
= 11.14% 7.3%
Overall profitability performance for Bazla is good compare to
the previous years as well as industries. Even tough the gross
profit margin is lower, but the rest of the profitability ratios
are higher. Lower gross profit margin in the current year, is
because the cost of selling the merchandise is higher, may be due
to higher purchasing price, charged by the suppliers.
However, Bazla manage to control the operating expenses that
contribute to higher operating and net profit margins. It
contributes to higher ROA as well as ROE.
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