Tutorial 3 (Valuation Principle-Analysis of Financial Statements)
1. Why would the inventory turnover ratio be more important for someone analyzing a
grocery store chain than an insurance company?
The inventory turnover ratio is important to a grocery store because of the much
larger inventory required and because some of that inventory is perishable. An
insurance company would have no inventory to speak of since its line of business is
selling insurance policies or other similar financial products—contracts written on
paper and entered into between the company and the insured. This question
demonstrates that the student should not take a routine approach to financial analysis
but rather should examine the business that he or she is analyzing.
2. How does inflation distort ratio analysis comparison 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?
Inflation will cause earnings to increase, even if there is no increase in sales volume.
Yet, the book value of the assets that produced the sales and the annual depreciation
expense remain at historic values and do not reflect the actual cost of replacing those
assets. Thus, ratios that compare current flows with historic values become distorted
over time. For example, ROA will increase even though those assets are generating
the same sales volume.
When comparing different companies, the age of the assets will greatly affect the
ratios. Companies with assets that were purchased earlier will reflect lower asset
values than those that purchased assets later at inflated prices. Two firms with similar
physical assets and sales could have significantly different ROAs. Under inflation,
ratios will also reflect differences in the way firms treat inventories. As can be seen,
inflation affects both income statement and balance sheet items.
3. If a firm’s ROE is low and management wants to improve it, explain how using more
debt might help.
ROE is calculated as the return on assets multiplied by the equity multiplier. The
equity multiplier, defined as total assets divided by common equity, is a measure of
debt utilization; the more debt a firm uses, the lower its equity, and the higher the
equity multiplier. Thus, using more debt will increase the equity multiplier, resulting
in a higher ROE.
4. 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?
a. Cash, receivables, and inventories, as well as current liabilities, vary over the year
for firms with seasonal sales patterns. Therefore, those ratios that examine balance
sheet figures will vary unless averages (monthly ones are best) are used.
b. Common equity is determined at a point in time, say December 31, 2008. Profits
are earned over time, say during 2008. If a firm is growing rapidly, year-end equity
will be much larger than beginning-of-year equity, so the calculated rate of return on
equity will be different depending on whether end-of-year, beginning-of-year, or
average common equity is used as the denominator. Average common equity is
conceptually the best figure to use. In public utility rate cases, people are reported to
have deliberately used end-of-year or beginning-of-year equity to make returns on
equity appear excessive or inadequate. Similar problems can arise when a firm is
being evaluated.
5. “In general, the two components of ROA: net profit margin and asset turnover, are
complements of each other.” Is this statement correct about measuring a company’s
performance?
ROA = Profit margin × Total asset turnover. For a given ROA, a low turnover can be
made up with a high margin and vice versa.
6. Titan Petrochem has RM6 million in sales, its ROE is 12%, and its total assets
turnover is 3.2x. The company is 50% equity financed. What is its net income?
Step 1: Calculate total assets from information given.
Sales = $6 million.
3.2 = Sales/TA
$6,000 ,000
3.2 =
Assets
Assets= $1,875,000.
Step 2: Calculate net income.
There is 50% debt and 50% equity, so Equity = $1,875,000 0.5 =
$937,500.
ROE = NI/S S/TA TA/E
0.12 = NI/$6,000,000 3.2 $1,875,000/$937,500
6.4NI
0.12 =
$6,000 ,000
$720,000 = 6.4NI
$112,500 = NI.
7. Maoye Co’s ROE last year was only 3%; but its management has developed a new
operating plan that calls for a total debt ratio of 60%, which will result in annual
interest charges of RM300,000. Management projects an EBIT of RM1,000,000 on
sales of RM10,000,000, and its expects to have a total assets turnover ratio of 2.0.
Under these conditions, the tax rate will be 34%. If the charges are made, what will
be the company’s return on equity?
ROE = Profit margin TA turnover Equity multiplier
= NI/Sales Sales/TA TA/Equity.
Now we need to determine the inputs for the DuPont equation from the data that were
given. On the left we set up an income statement, and we put numbers in it on the
right:
Sales (given) $10,000,000
– Cost na
EBIT (given) $ 1,000,000
– INT (given) 300,000
EBT $ 700,000
– Taxes (34%) 238,000
NI $ 462,000
Now we can use some ratios to get some more data:
Total assets turnover = 2 = S/TA; TA = S/2 = $10,000,000/2 = $5,000,000.
D/A = 60%; so E/A = 40%; and, therefore,
Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5.
Now we can complete the DuPont equation to determine ROE:
ROE = $462,000/$10,000,000 $10,000,000/$5,000,000 2.5 = 0.231 = 23.1%.
8. Adamp Ltd. Has RM1,312,500 in current assets and RM525,000 in current liabilities.
Its initial inventory level is RM375,000, and it will raise funds as additional notes
payable and use them to increase inventory. How much can its short-term debt (notes
payable) increase without pushing its current ratio below 2.0?
Present current ratio = $1,312,500 = 2.5.
$525,000
Minimum current ratio = $1,312,500 + NP = 2.0.
$525,000 + NP
$1,312,500 + NP = $1,050,000 + 2NP
NP = $262,500.
Short-term debt can increase by a maximum of $262,500 without violating a 2 to
1 current ratio, assuming that the entire increase in notes payable is used to
increase current assets. Since we assumed that the additional funds would be used
to increase inventory, the inventory account will increase to $637,500 and current
assets will total $1,575,000, and current liabilities will total $787,500.
9. Datang Power currently has RM750,000 in accounts receivable, and its days sales
outstanding (DSO) is 55 days. It wants to reduce its DSO to 35 days by pressuring
more of its customers to pay their bills on time. If this policy is adopted, the
company’s average sales will fall by 15%. What will be the level of accounts
receivable following the change? Assume a 365-day year.
Step 1: Solve for current annual sales using the DSO equation:
55 = $750,000/(Sales/365)
55 Sales = $273,750,000
Sales = $4,977,272.73.
Step 2: If sales fall by 15%, the new sales level will be $4,977,272.73(0.85) =
$4,230,681.82. Again, using the DSO equation, solve for the new accounts
receivable figure as follows:
35 = AR/($4,230,681.82/365)
35 = AR/$11,590.91
AR = $405,681.82 $405,682.
