LAO JESSA Q.

BSACC 2-YB-1

Exercises page 111 of Chapter 4.

4-1. Financial ratio analysis is conducted by three main groups of analysts: credit
analysts, stock analysts, and managers. What is the primary emphasis of each group,
and how would that emphasis affect the ratios they focus on?

Answer: Financial ratio analysis is conducted by three primary types of analysts: credit
analysts, stock analysts, and managers. Each group concentrates on different aspects of financial
ratios.

Credit analysts focus on a company's creditworthiness and utilize profitability ratios, liquidity,
and leverage to assess the likelihood of a company repaying its debts. They emphasize certain
factors in a company's business, with current and fast ratios being essential for lenders.

Stock analysts aim to determine a company's intrinsic worth and utilize various ratios to do so,
with profitability and forward-looking growth ratios being the most crucial. They also consider
gross and operating margin ratios when searching for undervalued companies.

Managers are primarily concerned with operating a business in line with the company's mission
and long-term plan. They utilize profitability, solvency, and liquidity ratios to achieve this, as
well as efficiency measurements to ensure that assets are utilized efficiently. Return on assets
and return on investment are also significant metrics for managers.

4-2. Why would the inventory turnover ratio be more important for someone
analyzing a grocery store chain than an insurance company?

Answer: A grocery store is a commercial enterprise that specializes in buying and selling groceries. In
order to meet customer needs, it stocks a diverse range of grocery items and must calculate its inventory
turnover ratio. This ratio is more crucial for a grocery store than an insurance company because the
latter does not maintain any stock of the goods it sells.

4-3. Over the past year, M. D. Ryngaert & Co. had an increase in its current ratio and a
decline in its total assets turnover ratio. However, the company’s sales, cash and
equivalents, DSO, and fixed assets turnover ratio remained constant. What balance
sheet accounts must have changed to produce the indicated changes?

Answer: We understand that the fixed asset turnover ratio remains steady, along with business sales,
cash, and DSO. Based on this information, we can infer that there were no changes in either sales or
fixed assets. The sole alteration was an upsurge in the current ratio within current assets.
4-4. Profit margins and turnover ratios vary from one industry to another. What
differences would you expect to find between the turnover ratios, profit margins, and
DuPont equations for a grocery chain and a steel company?

Answer: Grocery stores tend to have faster inventory turnover rates since they quickly buy and sell
their goods. As a result of their often low operating expenses, grocery stores may have higher profit
margins than steel companies. Grocery stores usually have higher returns on equity than steel
companies due to their higher asset turnover ratios, greater profit margins, and lower debt levels.
Conversely, steel companies tend to have lower turnover rates due to their lengthy production processes
and significant investments in machinery.

4-5. How does inflation distort ratio analysis comparisons for one company over time
(trend analysis) and for different companies that are being compared? Are only
balance sheet items or both balance sheet and income statement items affected?

Answer: Higher earnings can be achieved due to inflation, even if sales volume does not increase. Even
though the annual depreciation expense and the book value of the assets used to generate revenue
remain unchanged, they do not accurately reflect the cost of replacing those assets. As a result, financial
ratios that compare current values with historical values become distorted over time. For instance, the
ROA may increase even though the same assets are generating the same amount of revenue. When
comparing different companies, the ratios will be significantly affected by the age of the assets.
Businesses that purchased assets earlier will have lower asset valuations than those who bought assets
later at inflated prices due to inflation.

4-6. If a firm’s ROE is low and management wants to improve it, explain how using
more debt might help.

Answer: To calculate ROE, the equity multiplier is added to the return on assets. The equity multiplier
is a measure of how much debt a company employs, and it is computed by dividing total assets by
common equity. The higher the amount of debt a company uses, the lower its equity and the greater the
equity multiplier. Consequently, employing additional debt will increase the equity multiplier, which in
turn will boost the ROE.

4-7. Give some examples that illustrate how (a) seasonal factors and (b) different
growth rates might distort a comparative ratio analysis. How might these problems be
alleviated?

Answer:

a. Companies with seasonal sales patterns experience changes in cash, receivables,

inventories, and current liabilities throughout the year. As a result, financial ratios that
assess balance sheet figures will fluctuate unless averages are used. Monthly averages
are suggested.
B. Common equity is determined as of a specific date, such as December 31, 2016. Earnings are
accumulated over time, such as during 2016. If a company is growing rapidly, the calculated
return on equity will vary depending on whether end-of-year, beginning-of-year, or average
common equity is used as the denominator. End-of-year equity will be significantly greater than
beginning-of-year equity. In theory, the most appropriate figure to use is the average common
 equity. People have supposedly deliberately used end-of-year or beginning-of-year equity in
public utility rate cases to either overstate or understate returns on equity.

4-8. Why is it sometimes misleading to compare a company’s financial ratios with

those of other firms that operate in the same industry?

Answer: Comparing financial ratios between companies in the same industry can be difficult due to the
use of various accounting methods. Moreover, comparisons may be misleading if companies have
differing investments. For example, comparing PepsiCo and Coca-Cola might be inaccurate since
PepsiCo also owns other businesses, such as Frito-Lay and Quaker, in addition to their soft drink
operation.

4-9. Suppose you were comparing a discount merchandiser with a high-end

merchandiser. Suppose further that both companies had identical ROEs. If you
applied the DuPont equation to both firms, would you expect the three components
to be the same for each company? If not, explain what balance sheet and income
statement items might lead to the component differences.

Answer: The DuPont equation is composed of three components: profit margin, assets turnover, and
equity multiplier. Even if two companies, such as a low-cost and high-end merchandiser, have the same
ROE, their three components may not be the same. This is because the low-cost merchandiser may have
a higher assets turnover ratio but a lower profit margin than the high-end merchandiser.

4-10. Indicate the effects of the transactions listed in the following table on total
current assets, current ratio, and net income. Use (+) to indicate an increase, (−) to
indicate a decrease, and (0) to indicate either no effect or an indeterminate effect. Be
prepared to state any necessary assumptions and assume an initial current ratio of
more than 1.0.

Total current Current ratio Effect on Net

asset Income
A Cash is acquired through
issuance of additional common + + 0
stock
B Merchandise is sold for cash.
+ + +
C Federal income tax due for the
previous year is paid.
- + 0
D A fixed asset is sold for less
than book value. + + -
E A fixed asset is sold for more
than book value + + +
F Merchandise is sold on credit.
+ + +
G Payment is made to trade
creditors for previous
- + 0
purchases.
H A cash dividend is declared and
paid
- - 0

I
Cash is obtained through
shortterm bank loans. + - 0

J
Short-term notes receivable are
sold at a discount.
- - -
K
Marketable securities are sold
below cost.
- - -
Advances are made to
L employees. 0 0 0

M
Current operating expenses are
paid.
- - -
Short-term promissory notes
N are issued to trade creditors in
0 0 OR - 0 OR -
exchange for past due accounts
payable.
10-year notes are issued to pay
O off accounts payable. 0 + 0 OR -
A fully depreciated asset is
P retired. 0 0 0
Accounts receivable are
Q collected.
0 OR - 0 OR - 0 OR -

R
Equipment is purchased with
short-term notes 0 - 0

S
Merchandise is purchased on
credit. + - 0

T
The estimated taxes payable
are increase 0 - -