Financial Accounting 4e - Web Solutions

Chapter 14 Financial statement analysis

Solution outline for problem 14.1
1a Profitability: ROE has increased from 12 per cent to 13 per cent while the return on assets has fallen from 9 per cent to 8 per cent. As shown in part 3 the fall in ROA is due to the fall in asset turnover. Asset management: the average time to collect debtors has stayed constant. However, the days in inventory has increased from 55 days to 72 days, meaning that, on average, it is taking much longer to sell inventory. These extra days need to be financed by the company. The reasons for the build up in inventory should be investigated (e.g. stocking up for some large orders, as opposed to lack of demand, for the product, require very different actions). Liquidity: the current ratio has increased (mainly due to the build up in inventory, see below) while the quick ratio has dropped below 1 to 0.7 indicating the company may have problems paying their bills in the short term. Financial structure: the level of gearing has increased substantially from 1 to 1.4. The ability of the company to pay its interest bill needs to be considered, particularly given the decrease in profitability as indicated by the lower ROA. It would be useful to calculate the interest cover ratio. While ROA has decreased, ROE has increased because of the increase in gearing. Provided the extra funds borrowed earn a return higher than the cost of the debt, shareholders will benefit and the ROE will increase. You can see from the numbers that ROA = Profit Margin Asset Turnover (e.g. 0.4 20 per cent = 8 per cent for 2006). While the profit margin has increased from 18 per cent to 20 per cent, asset turnover has decreased from 0.50 to 0.40, thus overall ROA has decreased. One likely reason for the fall in asset turnover is the fall in inventory turnover. The current ratio was increased because of the build up in inventory. This can be seen because the quick ratio (which is the same as the current ratio except it excludes inventory) has dropped but the current ratio has increased.

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Financial Accounting 4e - Web Solutions

Solution outline for problem 14.2

1 Such a concept of performance relates the return to the investment required to earn it, so enabling the relative return to be calculated. This is important because returns do require investment. People usually dont make investments without expecting a return, and the sizes of each have to be related to each other in order to evaluate the quality of the result. A $1,000 return would be great if the investment required was $2,000 (a ratio of 50 per cent) but not so great if the investment were $200,000 (only 0.5 per cent). The interest earned could be compared to the $1,200 required to earn it.

2a

b
c

The consulting earnings could be compared to the $15,000 invested to earn them.
This is harder because the returns are probably non-financial, such as the fun of driving a sports car, and so are not readily comparable to the cars costhowever, this sort of ratio is implicit in many buying decisions, in which we ask ourselves if the benefits we will obtain are worth the cost, and we may well choose a cheaper car if the feeling of wind in our hair isnt all that important relative to what we have to pay for a convertible.

Solution outline for problem 14.3

1 2 Return on equity = $6,000 $45,000 = 0.133. The assets financed would earn 13.75 per cent [(6,000 + 2,000 + 3,000) 80,000], according to the above calculations. The cost of the money borrowed is 8 per cent. Therefore, leverage is positive (5.75 per cent) and the company should go ahead. This will, however, increase the companys risk, because the interest has to be paid and return on assets could decline below that rate. Some possible additional information and ratios (more can be imagined, so this is an outline only): terms and security of present debts quality of management (especially Mr A) industry and competition prospects personal guarantees Mr A might offer interest coverage ratio accounts receivable collection and inventory turnover profit margin income tax information.

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