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ACT 3211

TUTORIAL 2 - Answers
ANALYSIS OF FINANCIAL STATEMENTS
1.

Text book questions: 4-1; 4-2; 4-3; 4-4; 4-7; 4-9


Q 4-1 The emphasis of the various types of analysts is by no means uniform nor
should it be. Management is interested in all types of ratios for two reasons. First,
the ratios point out weaknesses that should be strengthened; second, management
recognizes that the other parties are interested in all the ratios and that financial
appearances must be kept up if the firm is to be regarded highly by creditors and
equity investors. Equity investors (stockholders) are interested primarily in
profitability, but they examine the other ratios to get information on the riskiness of
equity commitments. Long-term creditors are more interested in the debt, TIE, and
EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors
emphasize liquidity and look most carefully at the current ratio.
Q 4-2 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 productscontracts 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.
Q 4-3 Given that sales have not changed, a decrease in the total assets turnover
means that the companys assets have increased. Also, the fact that the fixed
assets turnover ratio remained constant implies that the company increased its
current assets. Since the companys current ratio increased, and yet, its cash and
equivalents and DSO are unchanged means that the company has increased its
inventories.
Q 4-4 Differences in the amounts of assets necessary to generate a dollar of sales
cause asset turnover ratios to vary among industries. For example, a steel company
needs a greater number of dollars in assets to produce a dollar in sales than does a
grocery store chain. Also, profit margins and turnover ratios may vary due to
differences in the amount of expenses incurred to produce sales. For example, one
would expect a grocery store chain to spend more per dollar of sales than does a
steel company. Often, a large turnover will be associated with a low profit margin,
and vice versa.
Q 4-7 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,
2005. Profits are earned over time, say during 2005. 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.
Q 4-9 The three components of the extended Du Pont equation are profit margin,
assets turnover, and the equity multiplier. One would not expect the three
components of the discount merchandiser and high-end merchandiser to be the
same even though their ROEs are identical. The discount merchandisers profit
margin would be lower than the high-end merchandiser, while the assets turnover
would be higher for the discount merchandiser than for the high-end merchandiser.
2.

Between supermarket and hotel, which has a lower turnover on fixed


assets (Sales/Net Fixed Assets)?
Hotel is having lower turnover on fixed asset. Operations of hotel industries are
capital intensive. Large amount is invested in fixed assets to generate sales,
suggesting lower fixed assets turnover. Supermarket is investing more in
inventories (current assets). It generates sales more by selling inventories than
the used of fixed assets.

3.

Explain why it is bad, when the inventory turnover (Sales/Inventories) of a


company is too high or too low as compared to the industry?
Too low: The company is holding more inventory than it needs to support its
sales volume. It will generate costs to the company such as rental for storage
area, insurance cost, obsolete, damage and outdated.
Too high: The company is holding less inventory than it needs to support
customers demand. It can cause lost of sales because customers seeking for
alternative seller.

4.

For the past years the current ratio of Syarikat Ardee has been on the steady
increase. But at the same time the quick ratio of this company is decreasing.
What is actually taking place? Does this scenario indicate a sign of
improvement of company liquidity?
Both current ratio and quick ratio are the measuring the liquidity performance of a
company. They evaluate companys ability to pay its short term obligations.
Current ratio is defined as current assets divided by current liabilities. Meaning it
is assume that the company can use all current asset to pay for the current
liabilities.
It is sometimes unreasonable to use all the current assets for that. Inventories
are typically the least liquid current assets and losses are most likely to occur
from inventories in the event of liquidation. The quick ratio [(Current AssetsInventories)/Current Liabilities] is the better measurement. It measures a
companys ability to pay off short term obligation without relying on the sale of
inventories.

Situation given in the question means that portion of inventories holds by


Syarikat Ardee is getting higher, compare to current assets. It suggests that the
liquidity of the company is getting worst.
5.

Which of the following company has a higher profit? Company A: Net profit
margin is 2% and total assets turnover is 10X or Company B: Net profit margin is
10% and total assets turnover is 2X. Explain your answer and give an
example of this type of company A and B.
Company B is having higher net profit.
Example of company B is hotel industry. It requires higher profit margins and
invests (uses) the fixed assets intensively to generate sales and, does
contributing lower assets turnover.
Example of company A is the food industry or supermarket. It can succeed with
lower profit margins and invests/uses less assets to generate sales and, does
contributing higher assets turnover.

6.

Strack Houseware Supplies Inc. has RM2 billion in total assets. The other side of its
balance sheet consists of RM0.2 billion in current liabilities, RM0.6 billion in longterm debt, and RM1.2 billion in common equity. The company has 300 million
shares of common stock outstanding, and its stock price is RM20 per share. What
is Stracks market/book ratio?
Book value per share = Common Equity / Shares Outstanding
= RM1.2 billion / 300 million unit
= RM 4 per share
Market/book ratio

= Market Price Per Share / Book Value Per Share


= RM 20 / RM 4
= RM 5 per share

7.

Construct the DuPont system of analysis using the following financial data
for Malee Industries and determine which areas of the firm need further
analysis.
Key Financial Data
Malee Industries:
Sales
Net profits after taxes
Total assets
Total liabilities
Industry Averages:
Total asset turnover (Sales/Assets)
Debt ratio (Debts/Assets)
Financial leverage multiplier
Return on total assets (ROA)
Return on equity (ROE)
Net profit margin (Net Income / Sales)

$4,500,000
337,500
6,750,000
3,375,000
0.71
33.00%
1.50
6.75%
10.00%
9.50%

Industry Averages:
ROE (10%)
ROA (6.75%)
Profit (9.5%)
Margin
Malee Industries:

Equity Multiplier (1.5 times)

Assets (0.71)
Turnover

1 / (1-Debt Ratio)
1 / (1-33%)
ROE (10%)

ROA
= 7.5% x 66.67%
= 5%
Profit
Margin

Assets
Turnover

Net Income
Sales

Sales
Total Assets

= 337,500
4,500,000

= 4,500,000
6,750,000

= 7.5%

= 66.67%

Equity Multiplier
= 1 / (1-Debt Ratio)
= 1 / [1-(Liabilities/Assets)]
= 1/[1-(3,375,000/6,750,000)]
= 2 times

Explanation: Malee is having same level of ROE which the industry averages,
which is 10%. However according to the DU Pont analysis, ROA, profit margin
and assets turnover for Malee are lower compare to industry. Meaning, the
profitability and turnover ratios for Malee are not good enough. At the same time,
the debt ratio for Malee is very high (50%) compare to industry (33%).
Same ROE doesnt mean Male is performing at the same level with the industry
average. Its able to achieve the same ROE, but its failed to achieve high
profitability and turnover ratio, because it is supported by high debt ratio. Malee
is using too much debt, which is very risky to the business.
8.

Given the following balance sheet, income statement, historical ratios and
industry averages, calculate the Bazla Inc. financial ratios for the most
recent year. Analyze its overall financial situation for the most recent year.
Analyze its overall financial situation from both a cross-sectional and
time-series viewpoint. Break your analysis into an evaluation of the firms
liquidity, activity, debt, and profitability.
Income Statement
Bazla Inc.
For the Year Ended December 31, 2005
Sales Revenue
$2,080,976
Less: Cost of Goods Sold
1,701,000
Gross Profits
$379,976
Less: Operating Expenses
273,846
Operating Profits
$106,130
Less: Interest Expense
19,296
Net Profits Before Taxes
$86,834
Less: Taxes (40%)
34,810
Net Profits After Taxes
$52,024

Balance Sheet
Bazla Inc.
December 31, 2005
Assets
Cash
Accounts receivable
Inventories
Total current assets
Gross fixed assets
Less: Accumulated depreciation
Net fixed assets
Total assets
Liabilities and stockholders equity
Current liabilities
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Total liabilities
Stockholders equity
Common stock
Retained earnings
Total stockholders equity
Total liabilities and stockholders equity

$ 95,000
237,000
243,000
$ 575,000
500,000
75,000
$ 425,000
$1,000,000

$ 89,000
169,000
87,000
$ 345,000
188,000
$ 533,000
255,000
212,000
$ 467,000
$1,000,000

Historical and Industry Average Ratios


Bazla Inc.
Ratio
Liquidity Ratios
Current Ratio
(Cur. Assets / Cur. Lias)
Quick Ratio
[(Cur. Assets - Inv) / Cur.Lias]

2003

2004

2005

1.6

1.7

0.9

1.0

575K / 345K
= 1.667 times
(575K-243K) / 345K
= 0.96 times

Industry
2005
1.6
0.9

The liquidity ratios for Bazla, are getting better from year 2003 to 2004, however,
both ratios slightly drop in 2005. Bazla is facing liquidity problem since the acid test
ratio is below two, meaning Bazla is not able to cover all the current liabilities within
time, unless the Bazla is able to sell its inventory, within that particular period.
Comparing with the industry averages, it seems that the Bazla is having similar
liquidity ratios with the industry.
Activity Ratios
Inventory Turnover
(Sales / Inv)
Average Collection Period
[ACR / (Sales/365)]
Total Asset Turnover
(Sales / Total Assets)

8.1

9.3

33
days

37
days

2.3

2.2

1,701K / 243K
= 7 times
237K / (2,080,976/365)
= 41 days
2,080,976 / 1,000K
= 2.08 times

8.4
39 days
2.2

Overall performance of Bazla in term of the asset management (activity) is getting


weak from year 2003 to year 2005. Even the inventory turnover was increase in
year 2004 it drops again in the current year, while the total asset turnover is
decreasing. Meaning that Bazla is not using the asset effectively in generating
sales. Furthermore Bazla needs more days to collect the debts from customers
compare to the previous years.
Bazla has better inventory turnover compare to the industry, however, the total
asset turnover is still lower. Same conclusion can be made since the collection
period for the industry is lower than Bazla.
Debt Ratios
Debt Ratio
(Total Liabilities / Total Assets)
Times Interest Earned
(EBIT / Interest Charged)

60%

56%

2.5

3.5

533K / 1,000K
= 53.3 %
106,130 / 19,296
= 5.50 times

58%
2.3

Bazla is able to manage its debt better compare to the previous years as well as
industry averages since the debt ratio is lower. Meaning that Bazla use less debt to
run the business compare to the previous years and industries.
At the same time, Bazla is able to pay interest more frequent due to high TIE ratio.

Historical and Industry Average Ratios


Bazla Inc.
Industry
Ratio
2003 2004
2005
2005
Profitability Ratios
Gross Profit Margin
21% 19.7
379,976 / 2,080,976
20.4%
%
(Gross Profit / Sales)
= 18.26%
Operating Profit Margin
4.7
4.8
106,130 / 2,080,976
4.7%
%
%
(Operating Profit / Sales)
= 5.10%
Net Profit Margin
1.8
1.6
52,024 / 2,080,976
1.4%
%
%
(Net Profit / Sales)
= 2.50%
Return on total assets
4.1
3.5
52,024 / 1,000 K
3.08
%
%
%
(Net Profit / Total Assets)
= 5.20%
Return on Equity
10.3 7.9%
52,024 / 467 K
7.3%
%
(Net Profit / Equity)
= 11.14%
Overall profitability performance for Bazla is good compare to the previous years as
well as industries. Even tough the gross profit margin is lower, but the rest of the
profitability ratios are higher. Lower gross profit margin in the current year, is
because the cost of selling the merchandise is higher, may be due to higher
purchasing price, charged by the suppliers.
However, Bazla manage to control the operating expenses that contribute to higher
operating and net profit margins. It contributes to higher ROA as well as ROE.