P83 CONCEPTS REVIEW AND CRITICAL THINKING QUESTIONS

1. Current Ratio [LO2] What effect would the following actions have on a firm's current ratio?
Assume that net working capital is positive.

a. Inventory is purchased.
If inventory is purchased with cash, then there is no change in the current ratio. If inventory is
purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.

b. A supplier is paid.
Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.

c. A short-term bank loan is repaid.

Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.

d. A long-term debt is paid off early.

As long-term debt approaches maturity, the principal repayment and the remaining interest
expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it
was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will
reduce the current ratio since current liabilities are not affected.

e. A customer pays off a credit account.

Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.

f. Inventory is sold at cost.

Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.

g. Inventory is sold for a profit.

Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current
ratio increases.

4.Financial Ratios [LO2] Fully explain the kind of information the following financial ratios provide
about a firm:
a. Quick ratio.
Quick ratio provides a measure of the short-term liquidity of the firm, after
removing the effects of inventory, generally the least liquid of the firm’s current
assets.

b. Cash ratio.
Cash ratio represents the ability of the firm to completely pay off its current
liabilities balance with its most liquid asset (cash).

c. Total asset turnover.

Total asset turnover measures how much in sales is generated by each dollar of
firm assets.

d. Equity multiplier.
Equity multiplier represents the degree of leverage for an equity investor of the
firm; it measures the dollar worth of firm assets each equity dollar has a claim to.

e. Long-term debt ratio.

Long-term debt ratio measures the percentage of total firm capitalization funded
by long-term debt.

f. Times interest earned ratio.

Times interest earned ratio provides a relative measure of how well the firm’s
operating earnings can cover current interest obligations.
g. Profit margin.
Profit margin is the accounting measure of bottom-line profit per dollar of sales.

h. Return on assets.
Return on assets is a measure of bottom-line profit per dollar of total assets

i. Return on equity.
Return on equity is a measure of bottom-line profit per dollar of equity.

j. Price- earnings ratio.

Price-earnings ratio reflects how much value per share the market places on a
dollar of accounting earnings for a firm.

7. DuPont Identity [LO3] Why is the DuPont identity a valuable tool for analyzing the performance of a
firm? Discuss the types of information it reveals compared to ROE considered by itself.

The DuPont identity breaks ROE down into three parts, which are profit margin, asset turnover, and
financial leverage. Profit margin is a measure of profitability, and an indicator of a company’s pricing
strategies and how well the company controls costs. It is calculated by finding the net profit as a
percentage of the total revenue. If the profit margin of a company increases, every sale will bring
more money to a company’s bottom line, resulting in a higher overall return on equity.

Asset turnover is a financial ratio that measures how efficiently a company uses its assets to generate
sales revenue or sales income for the company. Companies with low profit margins tend to have high
asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit
margin, if asset turnover increases, a company will generate more sales per asset owned, once again
resulting in a higher overall return on equity.

The third part, financial leverage, refers to the amount of debt that a company utilizes to finance its
operations, as compared with the amount of equity that the company utilizes. Increased financial
leverage leads to an increase in return on equity. This is because the increased use of debt as
financing will cause a company to have higher interest payments, which are tax deductible. Because
dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s
capital structure leads to a higher return on equity.

By splitting ROE into three parts, the DuPont identity allows companies to more easily understand
changes in their ROE over time. Some industries may rely on a single factor of the DuPont equation
more than others. In this way, the equation allows analysts to determine which of the factors is
dominant in relation to a company’s return on equity. For example, some high turnover industries,
such as retail stores, may have very low profit margins on sales and relatively low financial leverage.
In such industries, the measure of asset turnover is much more important.

On the other hand, high margin industries , such as fashion, may derive a large portion of their
competitive advantage from selling at a higher margin. For them, increasing sales without sacrificing
margin may be critical. Other industries, such as those in the financial sector, mainly rely on high
leverage to generate an acceptable return on equity. While a high level of leverage could be seen as
too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with
other financial elements that can determine a company’s return on equity.

In comparison, ROE is best used to compare companies in the same industry. The ROE simply
measures the rate of return on shareholders’ equity of the common stock owners. It measures a
company’s efficiency at generating profits using the shareholders’ stake of equity in the business. It is
therefore an indication of how well a company uses investment funds to generate earnings growth.
The limitation with ROE is that a high calculated value does not mean that a company will see
immediate benefits. Stock prices are most strongly determined by earnings per share (EPS) as
opposed to return on equity. The true benefit of a high return on equity comes from a company’s
earnings being reinvested into the business or distributed as a dividend. In some cases, ROE is
presumably irrelevant if earnings are not reinvested or distributed.

P84 QUESTIONS AND PROBLEMS

8. DuPont Identity [L04] Kindle Fire Prevention Corp. has a profit margin of 4.6 percent, total asset
turnover of 2.3, and ROE of 19.14 percent. What is this firm's debt- equity ratio?

ROE = Profit Margin x Total Asset Turnover x Equity Multiplier

0.1914 = (.046)(2.3)(EM)

EM = 1.81

(D+E)/E = 1.81

D = 0.81E

D/E = 0.81

Debt equity ratio = 0.81 2d.p.

9. Sources and Uses of Cash [LO4] Based only on the following information for Shinoda Corp., did
cash go up or down? By how much? Classify each event as a source or use of cash.

Decrease in inventory $430

Decrease in accounts payable $165
Increase in notes payable $150
Increase in accounts receivable $180

Decrease in inventory is a source of cash.

Decrease in accounts payable is a use of cash.

Increase in notes payable is a source of cash.

Increase in accounts receivable is a use of cash.

Changes in cash = sources – uses

= $430 – 165 + 150 – 180

= $235

Cash increased by $235.