University of Tunis Q5. Which of the following statements is False?

Tunis Business School a. The use of debt lower the ROA but also could raise the ROE
b. If a company is financed only with common equity, the return on assets (ROA) and the return on
Principles of Finance equity (ROE) are the same
c. Higher M/B ratios are generally associated with firms with relatively high rates of return on
common equity
Tutorial n°7 : Financial Statement Analysis d. Generally, firms with high profit margins have high asset turnover ratios and firms with low profit margins
Professor: Dr. Ridha Esghaier have low turnover ratios; this result is exactly as predicted by the extended Du Pont equation.
e. The Basic Earning Power ratio is useful for comparing firms with different tax situations and
(Spring 2021) different degrees of financial leverage

Q6.
Multiple Choice Questions:
Q1. A high current ratio is always a good indication of a well-managed liquidity position
a. True b. False

False. Current Ratio = (Cash + Receivables + inventory) / Current Liabilities

Excess cash resulting from poor management could produce a high current ratio. Similarly, if accounts receivable are not
collected promptly, this could also lead to a high current ratio. In addition, excess inventory which might include
obsolete inventory could also lead to a high current ratio. Based only on the information above, the most appropriate conclusion is that, over the period FY13 to FY15,
the company’s:
Q2. In order to assess a company’s ability to fulfill its long-term obligations, an analyst would most likely a. net profit margin and financial leverage have decreased.
examine: b. net profit margin and financial leverage have increased.
a. activity ratios. c. net profit margin has decreased but its financial leverage has increased.
b. liquidity ratios.
c. solvency ratios. C is correct. The company’s net profit margin has decreased and its financial leverage has increased. ROA = Net
d. profitability ratios. profit margin × Total asset turnover. ROA decreased over the period despite the increase in total asset turnover;
therefore, the net profit margin must have decreased.
Q3. Which of the following is NOT CORRECT? ROE = Return on assets × Financial leverage. ROE increased over the period despite the drop in ROA; therefore,
financial leverage must have increased.
a. a Low inventory turnover ratio suggests that firm might have old inventory or its control might be poor
b. The equity multiplier can be expressed as 1 – (Debt/Assets)
c. a high DSO means that firm collects on sales is too slowly Exercise n°1: Target Debt ratio
d. Firms with low debt ratios are less risky, but also forgo the opportunity to leverage up their return on equity
e. Stockholders may want more leverage because it magnifies expected earnings A company’s assets are $500,000, and its total debt outstanding is $200,000. The new CFO (Chief
Financial Officer) wants to employ a debt ratio of 60%. How much debt must the company add or
Q4. Which of the following statements is most correct? subtract to achieve the target debt ratio?

a. Having a high current ratio is always a good indication that a firm is managing its liquidity position well. Solution 1:
b. A decline in the inventory turnover ratio suggests that the firm’s liquidity position is improving.
c. If a firm’s times-interest-earned (TIE) ratio is relatively high, then this is one indication that the firm Debt Ratio: measures the percentage of funds provided by creditors.
should be able to meet its debt obligations.
d. Since ROA measures the firm’s effective utilization of assets (without considering how these assets are Total assets = $500,000
financed), two firms with the same EBIT must have the same ROA.
Present debt = $200,000 initial Debt Ratio = initial Debt / Tot.assets
e. If, through specific managerial actions, a firm has been able to increase its ROA, then, because of the
fixed mathematical relationship between ROA and ROE, (ROE = ROA × Assets/Equity) it must also have = $200,000 / $500,000 = 40%
increased its ROE.
Target Debt Ratio = 60%
Excess cash resulting from poor management could produce a high current ratio; thus statement a is false. A decline in the
inventory turnover ratio suggests that either sales have decreased or inventory has increased, which suggests that the firm’s Target amount of debt: 60% x $500,000 = $300,000
liquidity position is not improving; thus statement b is false. ROA = Net income/Total assets, and EBIT does not equal net
income. Two firms with the same EBIT could have different financing and different tax rates resulting in different net Debt that must be added = (300,000 – 200,000) = $100.000
incomes. Also, two firms with the same EBIT do not necessarily have the same total assets; thus, statement d is false. ROE
= ROA × Assets/Equity. If ROA increases because total assets decrease, then the equity multiplier decreases, and
depending on which effect is greater, ROE may or may not increase; thus, statement e is false. Statement c is correct; the
TIE ratio is used to measure whether the firm can meet its debt obligation, and a high TIE ratio would indicate this is so.
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Exercise n°2: Return on Assets & return on Equity Exercise n°4: EPS, DPS, and Payout
An investor is considering starting a new business. The company would require $500,000 of assets A company’s latest net income was $1 million, and it had 200,000 shares outstanding. The
and would be financed with 30% debt and 70% common equity. The investor will go forward only if company wants to pay out 40% of its income. Compute the earnings per share and the dividend per
she thinks the firm can provide a 15% return on equity. share that the company should declare.
a. How much net income must be expected to warrant starting the business?
b. What would be the expected ROA of the company? Solution 4:
Net income = $1,000,000
Solution 2: Shares outstanding = 200,000 shares EPS = Net income / Nber of shares
= $1,000,000 / 200,000 = $5
a. ROE= Net income / Total common equity
For each share the company earns $5 as net income
ROE: measures the rate of return on common stockholder’s investment. It reveals how Payout Ratio = Total Dividend / Net income = 40%
much profit a company generates with the money shareholders have invested.
Total Dividend = 40% x $1,000,000 = $400,000
Target ROE = 15% For each $1 invested by stockholders the firm earns $0.15 of net income
DPS = $400,000 / 200,000 = $2 or DPS = 40% EPS = 40% x $5 = $2
Assets = $500,000 Tot. common equity = 70% assets = 70% x 500,000 = $350,000
For each share, shareholders earn $2 as dividend
Required Net Income = Tot. common equity x ROE
Exercise n°5: book value and debt ratio
= $350,000 x 15% = $52,500
A company’s book value per share was $20, it had 200,000 shares outstanding, and its debt ratio
was 20%. How much debt was outstanding?
b. ROA = Net income/Total assets
= 52,500/500,000 = 10.5%% Solution 5:
ROA: measures the return on assets after interest and taxes and shows how effectively
Debt ratio 20% % of Equity =80% Total Equity Total assets Total debt
the firm is converting the money it invests (its assets) into net income.
For each $1 invested in assets, the firm earns $0.105 of net income Earnings per Share = $4
Book Value per Share = $20 Book Value/share = Total Equity / Nber of Shares
Shares outstanding : 200,000
Exercise n°3: Market value ratios
A company’s has 200,000 common equity with total book value of $4,000,000. Its stock price at Total Equity = $20 x 200,000
the end of the last year was $30.5 and its earnings per share for the year were $2.5. What were its = $4,000,000 = (100% - 20%) : 80% of Total assets
Price earnings ratio and its market to book ratio?
Solution 3: Total assets = $4,000,000 / 80% = $5,000,000

Stock Price (P) = $30.5 Total debt = 20% Total assets = 20% x $5,000,000 = $1,000,000
Earnings per share (E) = $2.5
Exercise n°6: Profit Margin and ROE
Stock Price/Earnings Ratio = (P/E) = 30.5/2.5 = 12.2
A company has $500,000 of assets, and it uses only common equity capital (zero debt). Its sales
P/E Ratio: shows how much investors accept to pay per Dollar of profit per share for the last year were $600,000, and its net income after taxes was $25,000. Stockholders recently
For each 1$ of earning per share, the investors are willing to pay $12.2 to buy a share. voted in a new management team that has promised to lower costs and get the return on equity up to
15%.
a. Calculate the current profit margin and current ROE of the firm.
Market to book ratio = Market price / book value per share b. What profit margin would the company need in order to achieve the 15% ROE, holding
everything else constant?
Book value per share = $4,000,000/2,000,000 = $20

Market to book ratio = 30.5/20 = 1.525 >1

For each 1$ of book value equity, the investors are willing to pay $1.525 to buy a share. They
accept to pay more for a stock than its accounting book value.
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Solution 6: Profit Margin, Return On Equity
Total assets (= Common Equity) = $500,000 Solution 8:
Sales = $600,000
Net income = $25,000 BEP= EBIT/Tot.ass = 15% EBIT = 15% x Tot.ass = 15% x $12M = $1.8M
EBITDA = EBIT + Depreciation = $1.8M + $1.28M = $3.08M
a. ROE= Net income / Total common equity
ROE: measures the rate of return on common stockholder’s investment. TIE = EBIT/interest charges = 4 interest charges = EBIT/4 = $1.8M /4 = $0.45M
+
current ROE = net income / total common Equity = $25,000 / $500,000 = 5% =
. + +

(for each 1$ invested by stockholders, the company earns $0.05 of net income) =
. .
= #. "
.!" . .!

current Profit Margin = Net income / Sales = $25,000 / $500,000 = 4.17% The CFs available cover 2.35 times the fixed financial charges of the firm
(for each 1$ of sales the company earns $0.0417 of net income)
Exercise n°9: Du Pont Equation: Effect of increasing debt ratio on the ROE
b. Target ROE : 15% A company’s ROE last year was 2.5%, but its management has developed a new operating plan
designed to improve things. The new plan calls for a total asset of $5,000 that would be financed with
Target Net income = Target ROE x Total Common Equity 50% debt, which will result in interest charges of $240 per year. Management projects an EBIT of $800
= 15% x $500,000 = $75,000 on sales of $8,000. Under these conditions, the federal-plus-state tax rate will be 40%. If the changes
are made, what return on equity will the company earn?
Target Profit Margin = Target net income / Sales
= $75,000 / $600,000 = 12.5% Solution 9:
The company needs a 12.5% profit margin to achieve a 15% ROE ROE = Net income/Sales x Sales/Assets x Assets/Common Equity
Profit Margin Total assets TurnOver equity multiplier
Exercise n°7: The Du Pont System Net income = (EBIT – interest charges) (1- 40%)
During the latest year a corporation had sales of $300,000 and a net income of $20,000, and its year- = (800 – 240) (1- 40%) = $336
end assets were $200,000. The firm's debt ratio was 40%.
Based on the Du Pont equation, what was the firm's Return on Equity? Profit Margin = Net income / Sales = 336 / 8,000 = 0.042
Total asset turnover = Sales/Tot. Assets = 8,000/5,000 = 1.6
Solution 7:
Equity multiplier = 1/ (1- debt ratio) = 1/ (1-0.5) = 2
Debt/tot. Assets = 40% Equity/tot. Assets = 60% Equity = 60% x $200,000 = $120,000
ROE = 0.042 x 1.6 x 2 = 13.44%
Or Equity multiplier = Tot.Ass/Equity = 1/(1-debt ratio) = 1.67

ROE = Net income/Sales x Sales/Assets x Assets/Common Equity

Profit Margin Total assets TurnOver equity multiplier
= 20,000/300,000 x 300,000/200,000 x 200,000/120,000
= 0.67 x 1.5 x 1.67 = 16.67%

Exercise n°8: Debt management Ratios

A Company has $12 million in total assets. Its basic earning power (BEP) is 15%, and its times-
interest-earned ratio (TIE) is 4. The company’s depreciation and amortization expense totals $1.28
million. It has $0.8 million in lease payments and $0.4 million must go towards principal payments on
outstanding loans and long-term debt. What is its EBITDA coverage ratio?

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