BFM 1014 FUNDAMENTALS OF FINANCE Trimester 2, 2016-2017
CHAPTER 3: UNDERSTANDING FINANCIAL STATEMENTS AND CASH FLOW CRITICAL THINKING AND CONCEPT REVIEW
1. What effect would the following actions have on a firm’s current ratio? Assume that net working capital is positive. a. inventory purchase b. a supplier paid c. a short term loan bank is repaid d. a long term debt is paid off early e. a customer pays off a credit account 1.
If inventory is purchased with with cash, then there there is no change change in the current current ratio. If inventory inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0. a.
b. Reducing accounts accounts payable payable with cash cash increases the current ratio ratio if it was was initially greater than 1.0. c.
Reducing short-term short-term debt with cash increases increases the current current ratio if it was initially greater than 1.0.
d. As long-term debt approaches approaches maturity, the principal principal repayment and the remaining remaining interest
expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. e.
Reduction of accounts receivables receivables and an increase increase in cash leaves the current current ratio unchanged.
f.
Inventory sold sold at cost reduces reduces inventory inventory and raises cash, cash, so the current ratio is unchanged.
g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio
increases.
4. Fully explain the kind of information the following financial ratios provide about a firm.
4.
a.
Quick ratio
b.
Cash ratio
c.
Capital intensity ratio
d.
Total asset turnover
e.
Equity multiplier
f.
Times interest earned ratio
g.
Profit margin
h.
Return on assets
i.
Return on equity
j.
Price earnings ratio
Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm’s current assets. a.
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b. Cash ratio represents the ability of the firm to completely pay off its current liabilities balance with
its most liquid asset (cash). c. The capital intensity ratio tells us the dollar amount investment in assets needed to generate one
dollar in sales. d. Total asset turnover measures how much in sales is generated by each dollar of firm assets. e. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the
dollar worth of firm assets each equity dollar has a claim to. f. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings
can cover current interest obligations. g. Profit margin is the accounting measure of bottom-line profit per dollar of sales. h. Return on assets is a measure of bottom-line profit per dollar of total assets. i.
Return on equity is a measure of bottom-line profit per dollar of equity.
j. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting
earnings for a firm.
7. Why is DuPont identity a valuable tool for analysing the performance of a firm? Discuss the types of information it reveals as compared to ROE considered by itself. Return on equity is probably the most important accounting ratio that measures the bottomline performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the role of a firm’s profitability, asset utilization efficiency, and financial leverage in achieving a ROE figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were a marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm’s margins were to erode slightly, the ROE would be heavily impacted.
QUESTIONS AND PROBLEM
1. SDJ. Inc has net working capital of $1,730, current liabilities of $5,140 and inventory of $2,170. What is the current ratio? What is the quick ratio? To find the current assets, we must use the net working capital equation. Doing so, we find: NWC = Current assets – Current liabilities $1,730 = Current assets – $5,140 Current assets = $6,870 2
Now, use this number to calculate the current ratio and the quick ratio. The current ratio is: Current ratio = Current assets / Current liabilities Current ratio = $6,870 / $5,140 Current ratio = 1.34 times And the quick ratio is: Quick ratio = (Current assets – Inventory) / Current liabilities Quick ratio = ($6,870 – 2,170) / $5,140 Quick ratio = .91 times
2. Remi, Inc has sales of $15 million, total assets of $9 million and total debt of $3.7 million. If the profit margin is 7% what is the net income? What is the ROA? What is the ROE? To find the return on assets and return on equity, we need net income. We can calculate the net income using the profit margin. Doing so, we find the net income is: Profit margin = Net income / Sales .07 = Net income / $15,000,000 Net income = $1,050,000 Now we can calculate the return on assets as: ROA = Net income / Total assets ROA = $1,050,000 / $9,000,000 ROA = .1167, or 11.67% We do not have the equity for the company, but we know that equity must be equal to total assets minus total debt, so the ROE is: ROE = Net income / (Total assets – Total debt) ROE = $1,050,000 / ($9,000,000 – 3,700,000) ROE = .1981, or 19.81%
3. Pujols Lomber Yard has a current accounts receivable balance of $527,167. Credit sales for the year ended were $5,938,261. What is the receivables turnover? The days’ sales in receivables? How long did it take on average for credit customers to pay off their accounts during the past year? 3
Receivables turnover = Credit sales / Receivables Receivables turnover = $5,938,261 / $527,167 Receivables turnover = 11.26 times Using the receivables turnover, we can calculate the days’ sales in receivables as: Days’ sales in receivables = 365 days / Receivables turnover Days’ sales in receivables = 365 days / 11.26 Days’ sales in receivables = 32.40 days The average collection period, which is the same as the days’ sales in receivables, was 32.40 days.
4. Allen Inc has a total debt ratio of 0.34. What its debt-equity ratio? What is its equity multiplier? To find the debt-equity ratio using the total debt ratio, we need to rearrange the total debt ratio equation. We must realize that the total assets are equal to total debt plus total equity. Doing so, we find: Total debt ratio = Total debt / Total assets .34 = Total debt / (Total debt + Total equity) .66(Total debt) = .34(Total equity) Total debt / Total equity = .34 / .66 Debt-equity ratio = .52 And the equity multiplier is one plus the debt-equity ratio, so: Equity multiplier = 1 + D/E Equity multiplier = 1 + .52 Equity multiplier = 1.52
5. Rossdale Inc had additional to the retained earnings for the year just ended of $575,000. The firm paid out $140,000 in cash dividends, and it has ending total equity of $7.3 million. If the company currently has 490,000 shares of common stock outstanding, what are the earning per share? Dividend per share? What is the book value per share? If the stock currently sells for $47 per share, what is the market to book ratio? The price earnings ratio? If the total sales were $15.4 million, what is the price sales ratio? We need to calculate the net income before we calculate the earnings per share. The sum of dividends and addition to retained earnings must equal net income, so net income must have been: 4
Net income = Addition to retained earnings + Dividends Net income = $575,000 + 140,000 Net income = $715,000 So, the earnings per share were: EPS = Net income / Shares outstanding EPS = $715,000 / 490,000 EPS = $1.46 per share The dividends per share were: Dividends per share = Total dividends / Shares outstanding Dividends per share = $140,000 / 490,000 Dividends per share = $.29 per share The book value per share was: Book value per share = Total equity / Shares outstanding Book value per share = $7,300,000 / 490,000 Book value per share = $14.90 per share The market-to-book ratio is: Market-to-book ratio = Share price / Book value per share Market-to-book ratio = $47 / $14.90 Market-to-book ratio = 3.15 times The P/E ratio is: P/E ratio = Share price / EPS P/E ratio = $47 / $1.46 P/E ratio = 32.21 times Sales per share are: Sales per share = Total sales / Shares outstanding Sales per share = $15,400,000 / 490,000 Sales per share = $31.43 The P/S ratio is: P/S ratio = Share price / Sales per share 5
P/S ratio = $47 / $31.43 P/S ratio = 1.50 times
6. Bobaflex Corporation has ending inventory of $426,163 and cost of goods sold for the year ended was $6,238,615. What is the inventory turnover? The days’ sales in inventory? How long on average did a unit of inventory sit on the shelf before it was sold? The inventory turnover for the company was: Inventory turnover = COGS / Inventory Inventory turnover = $6,238,615 / $426,163 Inventory turnover = 14.64 times Using the inventory turnover, we can calculate the days’ sales in inventory as: Days’ sales in inventory = 365 days / Inventory turnover Days’ sales in inventory = 365 days / 14.64 Days’ sales in inventory = 24.93 days On average, a unit of inventory sat on the shelf 24.93 days before it was sold.
7. If JPhone Inc. has an equity multiplier of 1.65, total asset turnover of 1.8 and a profit margin of 6%, what is its ROE? With the information given, we must use the Du Pont identity to calculate return on equity. Doing so, we find: ROE = (Profit margin)(Total asset turnover)(Equity multiplier) ROE = (.06)(1.80)(1.65) ROE = .1782, or 17.82%
10. Rainbow Company has debt equity ratio of 0.95. Return on assets is 7.5% and total equity if $735,000. What is the equity multiplier, Return on Equity? Net Income? With the information provided, we need to calculate the return on equity using an extended return on equity equation. We first need to find the equity multiplier which is: Equity multiplier = 1 + Debt-equity ratio Equity multiplier = 1 + .95 Equity multiplier = 1.95 6
Now we can calculate the return on equity as: ROE = (ROA)(Equity multiplier) ROE = .075(1.95) ROE = .1463, or 14.63% The return on equity equation we used was an abbreviated version of the Du Pont identity. If we multiply the profit margin and total asset turnover ratios from the Du Pont identity, we get: (Net income / Sales)(Sales / Total assets) = Net income / Total assets = ROA With the return on equity, we can calculate the net income as: ROE = Net income / Total equity .1463 = Net income / $735,000 Net income = $107,494
11. If Nuber Inc. has an ROA of 8% and a payout ratio of 25%, what is its internal growth rate? To find the internal growth rate, we need the plowback, or retention, ratio. The plowback ratio is: b = 1 – .25 b = .75 Now, we can use the internal growth rate equation to find: Internal growth rate = [(ROA)(b)] / [1 – (ROA)(b)] Internal growth rate = [.08(.75)] / [1 – .08(.75)] Internal growth rate = .0638, or 6.38%
12. If the Crash Davis Driving School has an ROE of 14.5% and a payout ratio 30%, what is its sustainable growth rate?
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To find the sustainable growth rate we need the plowback, or retention, ratio. The plowback ratio is: b = 1 – .30 b = .70 Now, we can use the sustainable growth rate equation to find: Sustainable growth rate = [(ROE)(b)] / [1 – (ROE)(b)] Sustainable growth rate = [.145(.70)] / [1 – .145(.70)] Sustainable growth rate = .1130, or 11.30%
15. Prepare 2013 and 2014 common size balance sheet for Bethesda Mining Company.
To calculate the common-size balance sheet, we divide each asset account by total assets, and each liability and equity account by total liabilities and equity. For example, the common-size cash percentage for 2013 is: Cash percentage = Cash / Total assets Cash percentage = $21,396 / $917,617 Cash percentage = .0233, or 2.33% Repeating this procedure for each account, we get:
2013
2014
Assets Current assets Cash Accounts receivable Inventory
$21,396 51,552 121,807
2.33% 5.62% 13.27%
$24,385 58,318 143,615
2.48% 5.93% 14.60%
$194,755
21.22%
$226,318
23.01%
Fixed assets Net plant and equipment
$722,862
78.78%
$757,328
76.99%
Total assets
$917,617
100%
$983,646
100%
Total
Liabilities and owners' equity 8
Current liabilities Accounts payable
$214,414
23.37%
$192,480
19.57%
99,022
10.79%
134,508
13.67%
$313,436
34.16%
$326,988
33.24%
Long-term debt
$271,700
29.61%
$285,300
29.00%
Owners' equity Common stock and paid-in surplus
$200,000
21.80%
$200,000
20.33%
132,481
14.44%
171,358
17.42%
$332,481
36.23%
$371,358
37.75%
$917,617
100%
$983,646
100%
Notes payable Total
Accumulated retained earnings Total Total liabilities and owners' equity
16. Based on the balance sheets given for Bethesda Mining, calculate the following ratios for each year. a. Current ratio b. Quick ratio c. Cash ratio d. Debt equity ratio and equity multiplier e. Total debt ratio a.
The current ratio is calculated as: Curent ratio = Current assets / Current liabilities Current ratio2013 = $194,755 / $313,436 Current ratio2013 = .62 times Current ratio2014 = $226,318 / $326,988 Current ratio2014 = .69 times
b.
The quick ratio is calculated as: Quick ratio = (Current assets – Inventory) / Current liabilities Quick ratio2013 = ($194,755 – 121,807) / $313,436 Quick ratio2013 = .23 times Quick ratio2014 = ($226,318 – 143,615) / $326,988 Quick ratio2014 = .25 times
c.
The cash ratio is calculated as: Cash ratio = Cash / Current liabilities Cash ratio2013 = $21,396 / $313,436 Cash ratio2013 = .07 times
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Cash ratio2014 = $24,385 / $326,988 Cash ratio2014 = .07 times d.
The debt-equity ratio is calculated as: Debt-equity ratio = Total debt / Total equity Debt-equity ratio = (Current liabilities + Long-term debt) / Total equity Debt-equity ratio2013 = ($313,436 + 271,700) / $332,481 Debt-equity ratio2013 = 1.76 times Debt-equity ratio2014 = ($326,988 + 285,300) / $371,358 Debt-equity ratio2014 = 1.65 times And the equity multiplier is: Equity multiplier = 1 + Debt-equity ratio Equity multiplier2013 = 1 + 1.76 Equity multiplier2013 = 2.76 times Equity multiplier2014 = 1 + 1.65 Equity multiplier2014 = 2.65 times
e.
The total debt ratio is calculated as: Total debt ratio = Total debt / Total assets Total debt ratio = (Current liabilities + Long-term debt) / Total assets Total debt ratio2013 = ($313,436 + 271,700) / $917,617 Total debt ratio2013 = .64 times Total debt ratio2014 = ($326,988 + 285,300) / $983,646 Total debt ratio2014 = .62 times
17. Suppose that the Bethesda Mining Company had sales of $2,945,376 and net income of $89,351 for the year ending December 31,2014. Calculate the DuPont identity. Using the Du Pont identity to calculate ROE, we get: ROE = (Profit margin)(Total asset turnover)(Equity multiplier) ROE = (Net income / Sales)(Sales / Total assets)(Total asset / Total equity) ROE = ($89,351 / $2,945,376)($2,945,376 / $983,646)($983,646 / $371,358) ROE =.2406, or 24.06%
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