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Solutions for Web Chapter 19: Questions and Problems
WEB CHAPTER 19
ANALYSIS OF FINANCIAL STATEMENTS
Answers to Questions
1.
The kind of decisions that require the analysis of financial statements include whether to
lend money to a firm, whether to invest in the preferred or the common stock of a firm,
and whether to acquire a firm. To properly make such decisions, it is necessary to
understand what financial statements are available, what information is included in the
different types of statements, and how to analyze this financial information to arrive at a
rational decision.
2.
Analysts employ financial ratios simply because numbers in isolation are typically of
little value. For example, a net income of $100,000 has little meaning unless analysts
know the sales figure that generated the income and the assets or capital employed in
generating these sales or this income. Therefore, ratios are used to provide meaningful
relationships between individual values in the financial statements. Ratios also allow
analysts to compare firms of different sizes.
3.
A major problem with comparing a firm to its industry is that you may not feel
comfortable with the measure of central tendency for the industry. Specifically, you may
feel that the average value is not a very useful measure because of the wide dispersion of
values for the individual firms within the industry. Alternatively, you might feel that the
firm being analyzed is not “typical,” that it has a strong “unique” component. In either
case, it might be preferable to compare the firm to one or several other individual firms
within the industry that are considered comparable to the firm being analyzed in terms of
size or clientele. For example, within the computer industry it might be optimal to
compare IBM to Dell and/or Hewlett-Packard rather than to some total industry data that
might include numerous small firms.
4.
In general, jewellery stores have very high profit margins but low asset turnover. It could
take them months to sell a 1-carat diamond ring, but once it is sold, the profit could be
tremendous. On the other hand, grocery stores usually have very low profit margins but
very high asset turnover. Assuming the business risk of the firms are equal, the ROA’s
should likewise be equal.
5.
Business risk is measured by the relative variability (i.e., the coefficient of variation) of
operating earnings for a firm over time. In turn, the variability of operating earnings is a
function of sales volatility and the amount of operating leverage (i.e., fixed costs of
production) employed by the firm. Sales variability is the prime determinant of earnings
volatility. In addition, the greater the firm’s operating leverage, the more variable the
operating earnings series will be relative to the sales variability.
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Solutions for Web Chapter 19: Questions and Problems
6.
The steel company would be expected to have greater business risk. As discussed in
Question #5, sales variability and operating leverage are the two components of business
risk. We expect the steel mill to have the greater operating leverage because of fixed
costs (unionized labour costs, amortization) in its operating structure. But even if both
the steel and the retail food chain have high operating leverage, the steel firm is more
sensitive to the business cycle than the retail food chain. That is, the steel firm will have a
very volatile sales pattern over the business cycle. Therefore, the steel firm should have
higher business risk than the retail food chain.
7.
When examining a firm’s financial structure, we would also be concerned with its
business risk. Since financial risk is the additional uncertainty of returns faced by equity
holders because the firm uses fixed-obligation debt securities, the acceptable level of
financial risk usually depends on the firm’s business risk. For a firm with low business
risks, investors are willing to accept higher financial risk. On the other hand, if the firm
has very high business risk, investors probably would not feel comfortable with high
financial risk also.
8.
The total debt/total asset ratio is a balance sheet ratio that indicates the stock of debt as
compared to the stock of equity. While the total debt/total asset ratio is a common
measure of financial risk, many analysts prefer to employ the fixed charge coverage ratio,
which reflects the flow of funds from earnings that are available to meet fixed-payment
debt obligations.
A cash flow ratio represents the cash available to service the debt issue, whereas a
proportion of debt ratio simply indicates the amount of debt outstanding. For example, a
large amount of debt (i.e. high proportion of debt indicating greater financial risk) could
be issued with a low coupon rate, thereby requiring only a small amount of cash to
service the debt. Generally, when these two types of debt ratios diverge, one should
concentrate on the cash flow ratios since they represent the firm's ability to make its debt
obligations.
9.
Growth analysis is important to common shareholders because the future value of the
firm is heavily dependent on future growth in earnings and dividends. The present value
of a firm with a growing dividends payment is:
V
Dividend Next Period
Required Rate of Return - Growth Rate
Therefore, an estimation of expected growth of earnings and dividends on the basis of the
variables that influence growth is obviously crucial. Growth analysis is also important to
debt investors because the major determinant of the firm’s ability to pay an obligation is
the firm’s future success which, in turn, is influenced by its growth.
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Solutions for Web Chapter 19: Questions and Problems
10.
The rate of growth of any economic unit depends on the amount of resources retained and
reinvested in the entity and the rate of return earned on the resources retained. The more
reinvested, the greater the potential for growth. In general:
Growth = Retention Rate × Return on Equity
= (1- dividend payout ratio) × Net Income/Sales × Sales/Total Assets × Total Assets/Equity
The dividend payout ratio is the proportion of earnings distributed to shareholders as
dividends so the complement of this ratio is the proportion of earnings retained. The
profit margin (Net Income/Sales) shows the firm’s ability to generate profits and to
control costs. The total asset turnover (Sales/Total Assets) is a measure of operating
efficiency. The equity multiplier (Total Assets/Equity) indicates the firm’s use of
financial leverage.
11.
Assuming the risk of the firm is not abnormally high, a 24% ROE is quite high and
probably exceeds the return that the equity investor could earn on the funds. Therefore,
the firm should retain their earnings and invest them at this rate.
Alternatively, if this firm has excess cash and expects to continue generating excess cash
(such as Microsoft in 2003) it may decide to initiate or increase a cash dividend.
12.
Growth, as predicted by the sustainable growth rate (retention ratio × ROE) has two
components: the proportion of earnings retained by the firm and its return on equity. No
information is provided regarding the firm’s retention rate, so we cannot ascertain growth
potential.
13.
External market liquidity is the ability to buy or sell an asset quickly with little change in
price (from prior transaction), assuming no new information has been obtained. The two
components of external market liquidity are: (1) the time it takes to sell (or buy) the asset,
(2) the selling (or buying) price as compared to recent selling (buying) prices.
Real estate is considered an illiquid asset because it can take months to find a buyer (or
seller), and the price can vary substantially from the last transaction or comparable
transactions.
14.
Some internal corporate variables such as the total market value of outstanding securities
and the number of security owners are good indicators of market liquidity. If the firm has
a fairly large number of shareholders, it would be very likely that, at any point in time,
some of these investors will be buying or selling for a variety of purposes. Therefore, the
firm’s security would enjoy a liquid secondary market. On the other hand, a small
number of security holders would probably indicate an illiquid secondary market. The
ultimate indicator is the volume of trading in the security either in absolute terms or
relative turnover (shares traded as a percent of outstanding shares).
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Solutions for Web Chapter 19: Questions and Problems
15.
Student exercise, so answers will depend upon what limitations the student chooses to
discuss. Some possibilities are:
 Flexibility in choosing which GAAP to use and how to apply them
 Comparing firm’s ratios to industry averages when there is wide variation among
individual firm’ ratios within the industry or when the firm under analysis has a
unique component.
 Firms are multi-product and operate in different industries
 Averaging values over time can hide time series up-trends and down-trends in ratios.
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Solutions for Web Chapter 19: Questions and Problems
WEB CHAPTER 19
Answers to Problems
1(a).
Return on Total Equity 
Net Income
400,000

 34.5% or using the 3 components :
Equity
1,160,000
Net Income
Sales
Total Assets
x
x
Sales
Total Assets
Equity
400,000 6,000,000 4,000,000

x
x
 34.5%
6,000,000 4,000,000 1,160,000
 0.067 x 1.5 x .3.448
ROE 
 34.65% (slight difference is due to rounding)
1(b).
Growth Rate = (retention rate) × (return on equity)
= [1 – (160,000/400,000)] × .345
= (1 - .40) × .345
= .60 × .345
= 20.7%
1(c).
0.04 × $6,000,000 = $240,000 (profit margin × sales)
240,000
ROE 
 20.7%
1,160,000
ROE  0.04 x 1.5 x 3.45  20.7%
1(d).
Using the ROE of 20.7 in part c) and a net income of $240,000, we have
Growth Rate = .60 × .207 = 12.42%
If dividends were $40,000, then RR = 1 – ($40,000/240,000)
= 1 - .167 = .833
Then growth rate = .833 × .207 = 17.25%
2(a).
ROE = Net profit margin × Total asset turnover × Total assets/equity
Company K: ROE = 0.04 × 2.2 × 2.4 = .2112
Company L: ROE = 0.06 × 2.0 × 2.2 = .2640
Company M: ROE = 0.10 × 1.4 × 1.5 = .2100
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Solutions for Web Chapter 19: Questions and Problems
2(b).
Growth Rate = Retention Rate × ROE
= (1 - Payout Rate) × ROE
Company K: Growth Rate = 1 – (1.25/2.75) × .2112
= .545 × .2112 = .1151
Company L: Growth Rate = 1 – (1.00/3.00) × .2640
= .67 × .2640 = .1769
Company M: Growth Rate = 1 – (1.00/4.50) × .2100
= .778 × .21 = .1634
3.
Current ratio = 650/350 = 1.857
Quick ratio = 320/350 = 0.914
Receivables turnover = 3500/195 = 17.95x
Average collection period = 365/17.95 = 20.33 days
Total asset turnover = 3500/2182.5 = 1.60x
Inventory turnover = 2135/280 = 7.625x
Capital asset turnover = 3500/1462.5 = 2.39x
Equity turnover = 3500/1035 = 3.382x
Gross profit margin = (3500 - 2135)/3500 = .39
Operating profit margin = 258/3500 = .074
Return on capital (130 + 62)/1922.5 = .099 (invested capital: 2050 for 20X9, 1795 for
20X8)
Return on equity = 130/1185 = .109
Return on common equity = 115/1035 = .110
Debt/equity ratio = 725/1225 = .59
Debt/total capital ratio = 725/1850 = .372
Interest coverage = 258/62 = 4.16x
Fixed charge coverage = 258/[62 + (15/.66)] = 3.045x (preferred stock dividends are
computed on a before-tax basis)
Cash flow/long-term debt = (130 + 125 - 150)/625 = .168
= Net Income + non-cash charges (change in amortization) - change in net working
capital (excl. cash)
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Solutions for Web Chapter 19: Questions and Problems
Cash flow/total debt = (130 + 125 - 150)/975 = .108
Retention rate = 1 - (40/115) = .65
The firm’s current performance appears in line with its historical performance and the
industry average except in the areas of profitability (measured by return on capital and
return on common equity) and leverage (cash flow to long-term debt and cash flow to
total debt ratios). Its retention rate has increased markedly and its inventory turnover has
fallen.
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