FNCE 3010 (Durham). HW2 (Financial ratios)

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1 FNCE 3010 (Durham). HW2 (Financial ratios) 1. What effect would the following actions have on a firms net working capital and current ratio (assume NWC is positive and current ratio is initially greater than 1)? (a) Inventory is purchased. (b) A supplier is paid. (c) A short-term bank loan is repaid. (d) A long-term debt is paid off early. (e) A customer pays off a credit account. (f) Inventory is sold at cost. (g) Inventory is sold for a profit. (a) NWC is unchanged. 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) NWC is unchanged. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. (c) NWC is unchanged. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0. (d) NWC and current ratio decrease. (e) NWC and current ratio are unchanged. (f) NWC and current ratio are unchanged. (g) NWC and current ratio increase. 2. Explain what peer group analysis means. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a peer group different from an aspirant group? Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm s operations, finances, or investment activities are out of line 1

2 with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group. 3. Why is the Du Pont identity a valuable tool for analyzing the performance of a firm? Discuss the types of information it reveals as compared to ROE considered by itself. Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the role of a firm s profitability, asset utilization efficiency, and financial leverage in achieving an ROE figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm s margins were to erode slightly, the ROE would be heavily impacted. 4. Bellevue Corp. had additions to retained earnings for the year just ended of $310,000. The firm paid out $160,000 in cash dividends, and it has ending total equity of $6.5 million. If Bellevue currently has 180,000 shares of common stock outstanding, what are earnings per share? Dividends per share? Book value per share? If the stock currently sells for $78 per share, what is the market-to-book ratio? The price-earnings ratio? Net income = Addition to RE + Dividends = $310K + 160K = $470K Earnings per share = NI / Shares = $470K / 180K = $2.61 per share Dividends per share = Dividends / Shares = $160K / 180K = $0.89 per share Book value per share = TE / Shares = $6.5M / 180K = $36.11 per share Market-to-book ratio = Share price / BVPS = $78 / $36.11 = 2.16 times P/E ratio = Share price / EPS = $78 / $2.61 = times 5. You want to examine the financial ratios for Dell Computer Corporation. Go to and type in the ticker symbol for the company (DELL). Next, go to the financial ratios link. You should find financial ratios for Dell and the industry, sector, and S&P 500 averages for each ratio. (a) What do TTM and MRQ mean? 2

3 (b) Look at Dell s valuation ratios and growth rates. Discuss briefly Dell s ratios relative to the comparison groups. (a) TTM is trailing twelve months. These values are computed over the average of the last 4 quarters. MRQ means most recent quarter. (b) Dell s PE is substantially lower than comparable firms. Dell and the comparable firms are all near their five year low and well off their five year highs. Dell s price-to-sales is also substantially lower than the industry average. On the other hand, Dell s price-to-book is higher than the industry average, suggesting that Dell has been successful at creating value historically. Dell s growth rates substantially lag the rest of the industry. But, this largely reflects Dell s past success. 3

4 6. Polly s Paper Products (PPP) has 100,000 shares of stock outstanding. The shares are trading at $10 each. Use these financial statements for the following questions: Assets Polly s Paper Products (PPP) (in thousands of $ s) Balance sheet (2005) Liabilities and Owners Equity Cash 150 Accounts payable 225 Accounts Receivable 300 Notes payable 125 Inventory 75 Current liabilities 350 Current assets 525 Long-term Debt 700 Fixed assets 1850 Owners equity 800 Retained earnings 525 Total assets 2375 Total liabilities and owners equity 2375 Income statement (2005) (in thousands of $ s) Net sales 1000 Cost of goods sold 600 Depreciation 100 EBIT 300 Interest paid 60 Taxable income 240 Taxes 82 Net income 158 Dividends 40 Addition to retained earnings 118 Compute the following financial ratios using 2005 data and describe briefly what each ratio tells us about the firm: (a) Current ratio (b) Quick ratio (c) Cash ratio (d) Total asset turnover (e) Debt-equity ratio (f) Equity multiplier (g) Total debt ratio (h) Long-term debt ratio (i) Profit margin 4

5 (j) Return on assets (k) Return on equity (l) EPS (m) PE ratio (n) Market-to-book ratio (a) Current ratio = CA / CL = 525 / 350 = 1.5 A positive current ratio indicates that the firm probably has sufficient liquidity to meet short-term needs. However, if it is too high, the firm may not be managing its NWC efficiently (a higher return could be obtained if assets were put to better use). (b) Quick ratio = (CA - Inventory) / CL = (525-75) / 350 = 1.29 Similar to current ratio. The firm does not have an unusually large part of its current assets tied up in inventory. (c) Cash ratio = Cash / CL = 150 / 350 =.43 The firm seems to have a reasonable amount of cash on hand. It is hard to say more without knowing more about the business. (d) Total asset turnover = Sales / Total assets = 1000 / 2375 =.42 A high value for TAT indicates that the firm is using its assets efficiently. If the same level of sales can be obtained using less assets, ROA (and ROE) will be increased. (e) Debt-equity ratio = Debt / Equity = 1050 / 1325 =.79 A high debt-equity ratio means the firm is highly levered. ROE, but at the cost of greater risk of financial distress. This can increase (f) Equity multiplier = Total Assets / Equity = 2375 / 1325 = 1.79 Same information as debt-equity ratio. Note that ROE = EM x ROA. (g) Total debt ratio = D/A = 1050 / 2375 =.442 (h) Long-term debt ratio = LTD / (LTD + equity) = 700 / 2025 =.346 (i) Profit margin = NI / Sales = 158 / 1000 =.158 Profit margin shows how efficient the firm is at generating earnings from sales. It is one of the three components of ROE in the Du Pont identity. (j) Return on assets = NI / TA = 158 / 2375 =.067 Return on assets measures the returns earned by the entire firm (debt and equity). This firm is earning a moderate return. Depending on how risky the firm s earnings are, the stock may trade at a slight discount to book value. Much depends on expectations for the firm s future earnings. (k) Return on equity = NI / Equity = 158 / 1325 =.119. Measures the return on capital earned by shareholders. ROE is higher than ROA due to the firm s leverage. This is respectable though not spectacular ROE. 5

6 (l) EPS = / = 1.58 (m) PE = 10 / 1.58 = 6.33 (n) Market to book = 1M / = 0.75 PPP is a value stock. 6

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