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Financial Statement AnalysisFinancial Statement Analysis

Chapter 4

Foundations of Ratios and Financial Analysis

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Problem 10

By calculating some ratios based on the average of opening and closing balances, we make the implicit assumption that changes in these accounts, occurred uniformly throughout the year. Sometimes, however, the actual change occurs unevenly, perhaps due to an acquisition. In such cases, ratios based on averages will be distorted. Discuss how you would calculate the return on assets ratio if the growth in assets occurred:

• At the beginning of the year

• At the end of the first quarter

• At the end of the second quarter

• At the end of the fourth quarter

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Problem 10 - Answer

– At the beginning of the year• Use the average of end of year and end of

first quarter assets in denominator, or alternatively, use end of year assets at the end of the first quarter

– At the end of the first quarter• Use weighted average: .25 x opening assets

+ .75 closing assets; this matches the numerator that reflects a return on the additional assets for 3/4 of the year. Alternatively, use end of first quarter assets

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Problem 10 - Answer

– At the end of the second quarter• Average of opening and closing assets is

weighted average

– At the end of the fourth quarter• Use weighted average: 0.75 x opening assets

+ 0.25 closing assets. If assets added at the end of the fourth quarter, use opening assets.

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Problem 11

Company F’s and Company O’s financial and operating leverage differ. Explain how it is possible for the two companies to have the same total leverage. In you answer, be sure to define financial, operating and total leverage.

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Problem 11 - Answer

• Operating leverage (OL) measures the effect of fixed operating costs on income whereas financial leverage (FL) measures effects of fixed financing costs.

• Total leverage is the product of operating and financial leverage (TL = OL x FL), measuring the effect of all fixed costs. That amount ‘TL’ can be equal for both companies even if the individual components (OL and FL) are not.

• One company may have high fixed operating costs, whereas the second may have high fixed interest costs, but overall total fixed costs may be identical.

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Problem 12

Using the following financial ratios for the RAMI Company, calculate the return on equity:

• Net profit margin 5.5%

• Asset turnover 2.0

• Dividend payout ratio 31.8%

• Equity turnover (sales/equity) 4.2

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Problem 13

You have been asked to project next year’s working capital requirements of the OB Company. The company’s sales forecast for next year is $12 million. OB’s target ratios are:

• Gross profit margin 45%

• Inventory turnover 6 times

• Receivables turnover 12 times

• Cash ratio 1.2 times

• Cash cycle 45 days

Use the sales forecast and target ratios to forecast each of the following elements of OB’s balance sheet:1.Inventory 2. Accounts receivables

3.Accounts payable 4. Cash 5. Current ratioAssume that beginning and ending A/R, A/P and inventory are equal (The latter also implies COGS equals purchases). Furthermore, assume A/P is the company’s only current liability.

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Problem 14

You have been provided with the following ratios and other indicators of RSEF Inc:

• Assets turnover (sales/ assets) 3.5

• Return on equity 56.3%

• Tax rate 20%

• Net income/ sales 10%

• Accounts payable turnover 13.5

• Accounts receivable turnover 6

• Interest/sales 4%

• Operating cycle 80 days

Using the data provided above, compute RSEF’s:

1. Inventory turnover 2. Cash cycle

3. Financial leverage (assets/equity) 4. Return on assets

5. Interest coverage ratio

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Problem 15

The working capital accounts of Queen Chana, a retailer, are as follows:Year 2001 2002 2003

Cash $1,000 $1,500 $2,000

A/R 2,000 4,000 6,000

Inventory 2,000 4,500 8,000

Current assets 5,000 10,000 16,000

A/P 2,000 3,500 4,500

Short term debt 500 1,500 3,500

Current Liabilities 2,500 5,000 8,000a) For years 2001 to 2003 calculate Queen Chana’s

i) Current ratio ii) Quick ratio iii) Cash ratio

b) Describe the other useful indicators of the firm’s liquidity that can be calculated from the data given.

c) Using the results of parts a and b, discuss the limitations of the current ratio as a measure of liquidity

d) List other ratios that would be useful to confirm your analysis. State what you would expect theses ratios to show

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Problem 15 - Answer

Year 2001 2002 2003

Current Ratio 2.00 2.00 2.00

Quick Ratio 1.20 1.10 1.00

Cash Ratio 0.40 0.30 0.25

b) Common size statements would show that cash as a percentage of (current) assets is declining; accounts receivable and inventory are growing. Similarly, current liabilities would show the proportion of (bank) borrowing growing relative to credit granted by suppliers.

c) Although the current ratio has remained constant over the 2001- 2003 period, its components have not. The quick and cash ratios have deteriorated. The firm's liquidity position has weakened over the period as its current assets are less liquid (more inventory and receivables, less cash). At the same time its debt financing relative to trade credit has grown.

d) The CFO to current liabilities and turnover ratios would be used to measure the length of the operating and cash cycle. We would expect slower turnover and therefore longer operating and cash cycles. Similarly, CFO and the CFO to current liabilities ratio would be expected to decline.

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Problem 16

The following information was taken from Amazon’s 1999-2000 annual reports. Like many e-commerce retails, Amazon.com has had difficulty in generating profits and/or operating cash flows (all amounts in $million). Years Ended December 311998 1999 2000

Inventory $30 $221 $171

Accounts payable 113 463 485

Cost of goods sold 1,349 2,106

Note: Amazon.com has no accounts receivable.

• Calculate purchases for the years 1999 and 2000.

• Calculate the company’s operating and cash cycles for the years 1999-2000.

• Describe the effects of the company’s operating and cash cycles on its cash from operations.

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Problem 17

Ann Taylor and The Limited compete in the market for apparel for the fashion consious professional woman. Ann Taylor targets the “better price” and “upper moderate price” categories whereas the Limited has a broader target audience. Financial data of the two companies is presented (Note: the amounts are in $million for one column and $10 million for the other).Company 1 Company 2

Sales S1,084 $977

Costs of goods sold (536) (644)

Gross margin $548 $333

Operating expenses (414) (241)

Operating income $134 $92

Total assets $765 $413

a) Prepare common-size income statements for Company 1 and Company 2.

b) Calculate ROA for each company and disaggregate the ROA into profitability and activity components.

c) Using the information from parts a and b, identify which company is Ann Taylor and which is The Limited . Justify your choice.

d) Explain how the financial data computed in parts a and b refelct the companies’ competitive strategies.

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Problem 18

The following data were taken from Teaco’s 1997-1999 annual reports:

Selected Data for Texaco,m 1997-1999 ($million)

1997 1998 1999

Sales $45,187 $30,910 $34,975

EBIT 3,847 1,124 2,083

Pretax income 3,327 701 1,779

Net income 2,664 603 1,177

Assets 29,600 28,570 28,972

Equity 12,766 11,833 12,042

a) Calculate Texaco’s ROE for 1997-1999.

b) Disaggregate Texaco’s 1997-1999 ROE into its five components and analyze the factor(s) responsible for the changes in ROE over the period.

c) Using 1997 as your base, estimate the operating leverage effect fora) 1998

b) 1999

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Problem 22

The Vac Company has an ROA of 10%. The company has no debt and (not even trade liabilities). Its total assets are $1 million and its tax rate is 20%. The company is considering borrowing some money and using the proceeds to buy back outstanding stock. The bank has stated that the interest rate charged will depend on the level of bank debt according to the following schedule:Debt to Equity Interest Rate

(1) 0.25 6%

(2) 0.50 8%

(3) 1.00 10%

(4) 1.50 12%

(5) 2.00 15%

a) Compute the company’s current ROE.

b) Using the formula in the chapter that related ROE to ROA and interest costs. Calculate the expected ROE for each level of debt.

c) Confirm your calculation of cases (1) and (5) by completing the following for each case (i) Debt in dollars, (ii) Equity in dollars, (iii) Income before interest and taxes, (iv) interest expense, (v) Tax expense, (vi) Net income (vii) Return on equity

d) Discuss the implications of this table regarding ‘optimal’ levels of debt and limits to the use of leverage.

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Test Question 1

The ABC Company reports the following balance sheet data:

Current liabilities $280,000

Bonds payable 120,000

Preferred stock, 14%, $100 par value 200,000

Common stock, $25 par value, 16,800 shares 420,000

Paid-in capital on common stock 240,000

Retained earnings 180,000

Income before taxes is $160,000. The tax rate is 40%. Common stockholders’ equity in the previous year was $800,000. The market price per share of common stock is $35. Calculate

(a)Net income

(b)Preferred dividends

(c)Return on common stock

(d)Times interest earned

(e)Earnings per share

(f) price/earning ratio

(g)Book value per share

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Test Question 2

Industry A has three companies whose income statements and balance sheets are summarized below:

Company X Company Y Company Z

Sales $500,000 (d) (g)

Net income $25,000 $30,000 (h)

Total assets $100,000 (e) $250,000

Total asset turnover (a) (f) 0.4

Profit margin (b) 0.4% 5%

Return on total assets (ROA) (c) 2% (i)

First supply the missing data in the table above. Then comment on the relative performance of each company

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Assignment No. II Due Date October 21, 2011

• Visit the link: http://www.gharibwalcement.com/financials2009-2010.html and http://www.gharibwalcement.com/financials2007-2008.html and download financial statements.

• Conduct Horizontal and Vertical Analysis of four years i.e. 2007, 2008, 2009 and 2010

• Provide ten points of each analysis by giving solid reasons to justify the results

• Distinct points and reasons will result excellent marks

• Do not copy the interpretations, it will be negativity on account of your assignment

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G R O U P P R O J E C T

• Maximum 5 members and minimum 3 members

• List of group members – submission date is October 21, 2011

• Guidelines in this regard will be provided in the forthcoming lecture

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Q U I Z II

• Chapter 2 and Chapter 4

• Numerical based questions

• Quiz start exactly at 9.30 am and every one has to attempt

• No excuse regarding absentees and no re-quiz