6114 words - 25 pages

Chapter 3

Analysis of Financial Statements

ANSWERS TO END-OF-CHAPTER QUESTIONS

3-1

a. A liquidity ratio is a ratio that shows the relationship of a firm’s cash and other

current assets to its current liabilities. The current ratio is found by dividing current

assets by current liabilities. It indicates the extent to which current liabilities are

covered by those assets expected to be converted to cash in the near future. The

quick, or acid test, ratio is found by taking current assets less inventories and then

dividing by current liabilities.

b. Asset management ratios are a set of ratios that measure how effectively a firm is

managing its assets. The inventory turnover ratio ...view middle of the document...

d. Profitability ratios are a group of ratios, which show the combined effects of liquidity,

asset management, and debt on operations. The profit margin on sales, calculated by

dividing net income by sales, gives the profit per dollar of sales. Basic earning power

is calculated by dividing EBIT by total assets. This ratio shows the raw earning

power of the firm’s assets, before the influence of taxes and leverage. Return on total

assets is the ratio of net income to total assets. Return on common equity is found by

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Answers and Solutions: 3 - 1

dividing net income by common equity.

e. Market value ratios relate the firm’s stock price to its earnings and book value per

share. The price/earnings ratio is calculated by dividing price per share by earnings

per share--this shows how much investors are willing to pay per dollar of reported

profits. The price/cash flow is calculated by dividing price per share by cash flow per

share. This shows how much investors are willing to pay per dollar of cash flow.

Market-to-book ratio is simply the market price per share divided by the book value

per share. Book value per share is common equity divided by the number of shares

outstanding.

f. Trend analysis is an analysis of a firm’s financial ratios over time. It is used to

estimate the likelihood of improvement or deterioration in its financial situation.

Comparative ratio analysis is when a firm compares its ratios to other leading

companies in the same industry. This technique is also known as benchmarking.

g. The Du Pont equation is a formula, which shows that the rate of return on assets can

be found as the product of the profit margin times the total assets turnover. Window

dressing is a technique employed by firms to make their financial statements look

better than they really are. Seasonal factors can distort ratio analysis. At certain

times of the year a firm may have excessive inventories in preparation of a “season”

of high demand. Therefore an inventory turnover ratio taken at this time as opposed

to after the season will be radically distorted.

3-2

The 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 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 ratio, TIE, and fixed-charge coverage ratios, as well as the profitability ratios.

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