Razones Financieras

Chapter 3

Discussion Questions

3-1. Short-term lenders - liquidity because their concern is with the firm's ability to pay short-term obligations as they come due.

Long-term lenders - leverage because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made.

Shareholders - profitability, with secondary consideration given to debt utilization, liquidity, and other ratios. Since shareholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.

3-2. a. Return on investment = Net income

Total assets

Inflation may cause net income to be overstated and total assets to be understated. Too high a ratio could be reported.

b. Inventory turnover = Sales or COGS

Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect "inflation-influenced" dollars and the net effect will be nil.

If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported.

c. Capital asset turnover = Sales .

Capital assets

Capital assets will be understated relative to sales and too high a ratio could be reported.

d. Debt to total assets = Total debt .

Total assets

Since both are based on historical costs, no major inflationary impact will take place in the ratio. Assets are likely understated, however, causing ratio to be overstated.

3-3. The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover.

ROA = Profit Margin × Asset Turnover

Net income = Net income × Sales .

Total assets Sales Total assets

In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a company in the capital goods industry may have a high profit margin and a low asset turnover, while a food-processing firm may suffer from low profit margins, but enjoy a rapid turnover of assets.

The modified Du Pont formula shows:

ROE = ROA × Equity multiplier

Return on equity = Return on assets (investment) × Total assets

Equity

This indicates that return on shareholders' equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on shareholders' equity that is influenced by large amounts of debt.

3-4. The fixed charge coverage ratio measures the firm's ability to meet all fixed obligations rather that interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm.

3-5. In both instances, we would not reflect a very significant cost of doing business. Of course, one could argue that, to the extent that differential tax rates of financing plans (and associated interest costs) did not reflect the operating capability of the firm, omission of these changes could provide new insights.

3-6. No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information.

3-7. Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last ten years. Trend analysis must also be compared to industry patterns of change.

3-8. Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm's income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly.

3-9. Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar. Lessening inflation also means that the required return that investors demand on financial assets will be going down, and with this lower demanded return, future earnings or interest should receive a higher current valuation.

3-10. There are many different methods of financial reporting accepted by the accounting profession as promulgated by the Canadian Institute of Chartered Accountants. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items.

Internet Resources and Questions

1. www.adviceforinvestors.com

2. www.sedar.com/search/search_form_pc_en.htm

3. www.bmo.com

www.rbc.com

Problems

3-1. Neon Light Company

a.

b.

OR

c.

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