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BY

RANSFORD U MOLLISON
02/10/2018
GF530 -
Financial
Statement
Analysis
Unit 4 Assignment 1 Textbook Questions
GF530 - Financial Statement Analysis

Unit 4 Assignment 1 Textbook Questions


Chapter 4, Problems 4.4, 4.6, 4.7, 4.18

4.4 Profit Margin for ROA versus ROCE. Describe the difference between the profit margin for ROA

and the profit margin for ROCE. Explain why each profit margin is appropriate for measuring the

rate of ROA and the rate of ROCE, respectively

ROA profit margin doesn’t include subtractions for the cost of equity or debt financing while the

profit margin for ROCE makes subtractions for all costs of financing above common shareholders.

These profit margins are appropriate because the purpose of ROA is to provide a measure of how well a

firm uses its assets to generate earnings without worrying about how the firm financed the assets. The

purpose of ROCE is to show how well the firm has used the capital contributed by more senior sources

to generate earnings for common shareholders.

4.6 Advantages of Financial Leverage. A company president remarked, ‘‘The operations of our company

are such that we can take advantage of only a minor amount of financial leverage.’’ Explain the likely

reasoning the company president had in mind to support this statement.

Financial leverage involves using assets financed with debt and preferred equity and earning a

higher return on those assets (that is, ROA) than the cost of these sources of capital. (Wahlen pp. 261,

270) There are two possable reasons the company president would make this statement. First, the firm is

earning such a small ROA that it barely exceeds the cost of financing through debt and preferred stock.

The second option is that the firm has very little capacity to carry debt, except at an extremely high cost;

possibly because their products have very short product life cycles or the firm itself has few collateral

assets.

4.7 Disadvantages of Financial Leverage. The intuition behind the benefits of financial leverage is that a

firm can borrow funds that bear a certain interest rate but invest those funds in assets that generate

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GF530 - Financial Statement Analysis

returns in excess of that rate. Why would firms with high ROAs not keep leveraging up their firm by

borrowing and investing the funds in profitable assets?

As a firm continues to leverage up, the cost of borrowing increases. As Such, even if the current

ROA exceeds the current cost of borrowing, the increase in borrowing costs would result in interest rates

approaching or exceeding ROA. The firm may not be able to instantaneously deploy financed assets

appropriately. Many growth firms that generate high ROA tend to overinvest, only to end up realizing

that there are limits to their ability to increase operations.

4.18 Calculating and Interpreting Accounts Receivable and Inventory Turnover Ratios. Nucor and AK

Steel are steel manufacturers. Nucor produces steel in mini-mills. Mini-mills transform scrap

ferrous metals into standard sizes of rolled steel, which Nucor then sells to steel service centers and

distributors. Its steel falls on the lower end in terms of quality (strength and durability). AK Steel is

an integrated steel producer, transforming ferrous metals into rolled steel and then into various

steel products for the automobile, appliance, construction, and other industries. Its steel falls on the

higher end in terms of quality. Exhibit 4.25 sets forth various data for these two companies for two

recent years.

REQUIRED

a. Calculate the accounts receivable turnovers for Nucor and AK Steel for Year 1 and Year 2.

The accounts receivable turnovers for Nucor and AK Steel are shown in the calculations

below. Nucor’s accounts receivable turnover increased from 12.38 to 16.66 and AK Steel’s

increased from 10.21 to 13.36 over the same time.

Year1 Year 2
$23,633 $16,593
Nucor: = 16.7 = 12.4
$1,420 $1,340

AK Steel: $7,644 $7,003


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GF530 - Financial Statement Analysis

= 13.4 = 10.2
$572 $686

b. Describe the likely reasons for the differences in the accounts receivable turnovers for these

two firms.

Nucor’s faster accounts receivable turnovers are likely due to the fact that it sells to steel

service centers and distributors rather than automobile, appliance, and construction industries

like AK Steel. Nucor’s customer base has wider uses for the product and therefore there is a

wider variety of customers exist to purchase the steel. On the other hand, AK Steel has a limited

customer base and may need to provide more liberal credit terms to be able to sell their products

c. Describe the likely reasons for the trend in the accounts receivable turnovers of these two

firms during the two-year period.

The most likely reason for the trend is that the accounts receivable turnover of both

Nucor and AK Steel increased across years, but that of Nucor increased significantly. The

growth rate in sales of Nucor was considerably higher than that of AK Steel. Perhaps Nucor

offered less liberal credit terms during this time of increased sales. The increase could also be

due to customers being willing to pay more quickly for access to Nucor’s products.

d. Calculate the inventory turnovers for Nucor and AK Steel for Year 1 and Year 2.

The inventory turnovers for Nucor and AK Steel are shown in the calculations below.

Nucor’s dropped from 10.7 to 7.90 while AK Steel’s increase from 9.5 to 9.8 over the same time

frame.

Year1 Year 2
$19,612 $13,035
Ak Steeel: = 9.8 = 9.5
$2,005 $1,371

Nucor: $1,6479 $5,904


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GF530 - Financial Statement Analysis

= 10.7 = 7.9
$607 $752

e. Describe the likely reasons for the differences in the inventory turnovers of these two firms.

Based on the given information, the likely difference is probably distribution in the sense

that Nucor had higher inventory turnover than AK Steel in Year 1, but lower inventory turnover

in Year 2. Nucor is not an integrated steel producer. It ships rolled steel products directly to steel

service centers and distributors. AK Steel is an integrated steel producer. It transforms raw steel

into various steel products, resulting in a longer production process.

f. Describe the likely reasons for the trend in the inventory turnovers of these two firms during

the two-year period.

AK Steel’s decline in inventories coupled with increased sales from Year 1 to Year 2

resulted in a lower inventory turnover because the company was able to sell their inventory more

quickly. Nucor’s inventory turnover decreased because the costs of goods sold, likely due to

economies of scale, while inventory increased. The company can likely change production

capacity quickly since it is not an integrated producer and manufactures more standardized

products. The cost of goods sold to sales percentages in Year 1 were 78.6% ($13,035/$16,593)

for Nucor and 84.3% ($5,904/$7,003) for AK Steel. The corresponding percentages for Year 2

were 82.9% ($19,612/$23,663) for Nucor and 84.8% ($6,479/$7,644) for AK Steel. Increased

percentages is probably caused from a combination of lower selling prices and slightly increased

in put prices.

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GF530 - Financial Statement Analysis

Chapter 5, Problems 5.3, 5.10, 5.13

5.3 Relation between Current Ratio and Operating Cash Flow to Current Liabilities Ratio. A firm has

experienced an increasing current ratio but a decreasing operating cash flow to current liabilities

ratio during the last three years. What is the likely explanation for these results?

The difference between the current ratio and quick ratio calculations is inventory. Current

ratio includes inventory in the current asset total while the quick ratio subtracts inventory from

current assets before dividing by current liabilities. Since both ratios have the same denominator,

any difference between the two must occur in the numerator. In order for the current ratio to

decrease while the quick ratio increases, inventory must decrease. A decrease in inventory would

result in less total current assets for the current ratio and would result in less being subtracted from

current assets when calculating the quick ratio.

5.10 Interpreting Altman’s Z-score Bankruptcy Prediction Model. Altman’s bankruptcy prediction

model places a coefficient of 3.3 on the earnings before interest and taxes divided by total assets

variable but a coefficient of only 1.0 on the sales to total assets variable. Does this mean that the

earnings variable is 3.3 times as important in predicting bankruptcy as the assets turnover variable?

Explain.

There is a variation in the size of the coefficient particualy because of the usual size of

the variable measured. Earnings before interest and taxes as a percentage of total assets is usually

around 0.05 to 0.10, whereas sales divided by assets is usually greater than 1.0. (Wahlen, pp. 373

– 376) If the coefficient times the value of the variable isnviewed as a relative weight of

importance, a bigger number for any of the variables increases the size of the Z-score and

reduces the probability of bankruptcy. On the other hand, the individual variables in a

multivariable model cannot be viewed as independent of the remaining variables. These

variables may be the contributing factor to a firm’s bankruptcy.


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GF530 - Financial Statement Analysis

Problems and Cases

5.13 Calculating and Interpreting Risk Ratios. Refer to the financial statement data for Hasbro in

Problem 4.24 in Chapter 4. Exhibit 5.15 presents risk ratios for Hasbro for Year 2 and Year 3.

Exhibit 5.15

Risk Ratios for Hasbro


(Problem 5.13)
Year 4 Year 3 Year 2

Current ratio 1.1 1.6 1.5

Quick ratio 1.5 1.2 1.1

Operating cash flow to current liabilities ratio 0.344 0.479 0.548

Days accounts receivable outstanding 72 68 73

Days inventory held 53 51 68

Days accounts payable outstanding 47 47 49

Net days of working capital financing needed 78 72 91

Liabilities to assets ratio 0.494 0.556 0.621

Liabilities to shareholders’ equity ratio 0-976 1.251 1.639

Long-term debt to long-term capital ratio 0.156 0.328 0.418

Long-term debt to shareholders’ equity ratio 0.185 0.489 0.720

Operating cash flow to total liabilities ratio 0.213 0.245 0.238

Interest coverage ratio 9.1 5.6 2.3

REQUIRED

a. Calculate the amounts of these ratios for Year 4.

Revenues to Cash Ratio: $2,998/0.5($521 + $725) = 4.8

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Days Revenues in Cash: 365/4.8 = 76 days

Current Ratio: $1,718/$1,149 = 1.5

Quick Ratio: ($725 + $579)/$1,149 = 1.1

Operating Cash Flow to Current Liabilities Ratio:

$358/0.5($930 + $1,149) = 0.344

Days Accounts Receivable:

$2,998/0.5($607 + $579) = 5.1; 365/5.1 = 72 days

Days Inventory:

$1,252/0.5($169 + $195) = 6.9; 365/6.9 = 53 days

Days Accounts Payable:

($1,252 + $195 – $169)/0.5($159 + $168) = 7.8; 365/7.8 = 47 days

Net Days Working Capital: 72 + 53 – 47 = 78 days

Liabilities to Assets Ratio: $1,601/$3,241 = 0.494

Liabilities to Shareholders’ Equity Ratio: $1,601/$1,640 = 0.976

Long-Term Debt Ratio to Long-Term Capital Ratio:

$303/($303 + $1,640) = 0.156

Long-Term Debt to Shareholders’ Equity Ratio: $303/$1,640 = 0.185

Operating Cash Flow to Total Liabilities Ratio:

$358/$0.5($1,758 + $1,601) = 0.213

Interest Coverage Ratio: ($196 + $32 + $64)/$32 = 9.1

b. Assess the changes in the short-term liquidity risk of Hasbro between Year 2 and Year 4 and

the level of that risk at the end of Year 4.

The changes in the short-term liquidity risk ratios present mixed signals. Hasbro has built

up its balance in cash so that it has more days of revenue held in cash. This trend provides
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GF530 - Financial Statement Analysis

Hasbro with liquidity and reduces its short-term liquidity risk. The current and quick ratios were

steady during the three years and athealthy levels. Again, these results suggest low short-term

liquidity risk. Theoperating cash flow to current liabilities ratio declined, and by Year 4, it

wasless than the 40% found for healthy companies. The decrease in this ratio is theresult of

declining cash flow from operations and increasing current liabilities.Net income increased each

year so that the declining cash flow from operationsis the result of changes in non-cash revenues

and expenses and in operating working capital accounts. Exhibit 4.30 indicates that the addback

for depreciationand amortization decreased during the three years. Depreciation and amortization

do not affect cash flows; the smaller addback simply offsets the smaller expense. Thus, changes

in depreciation and amortization do not explain the declining cash flow from operations. It

appears that the explanation lies primarilyin a decrease in prepayments in Year 2 and a decrease

in accounts payable and other current liabilities in Year 4. The analyst would be concerned with

the decrease in current liabilities in Year 4 only if it signaled pressure from suppliers of various

goods and services to pay their amounts due. Even then, Hasbro has more than sufficient cash

and accounts receivable to cover all current liabilities. The net days of working capital declined

sharply between Year 2 and Year 3 as a result of reducing the days accounts receivable and

inventory being held, a positive sign in terms of reducing short-term liquidity risk. This occurred

in a year when sales increased. The net days of working capital increased again in Year 4, a year

in which sales decreased. It would not appear that Hasbro is unduly risky in terms of short-term

liquidity risk at the end of Year 4. Its currentand quick ratios are at healthy levels and its days

inventory and accounts payable have been steady for the past two years. The only troublesome

aspect is the declining operating cash flow to current liabilities ratio. This ratio is not at a level of

extreme concern in Year 4, but a continuation of this trend could become troublesome.

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c. Assess the changes in the long-term solvency risk of Hasbro between Year 2 and Year 4 and

the level of that risk at the end of Year 4.

Hasbro’s long-term solvency risk has decreased significantly during the threeyear period.

Debt levels have declined as Hasbro has redeemed debt. (See Hasbro’s statement of cash flow in

Exhibit 4.30.) Its interest coverage ratio has increased from a worrisome level in Year 2 to a very

healthy level in Year 4. The latter occurred because of a reduction in borrowing and an increase

in net income. Its operating cash flow to total liabilities ratio has been steady and above the 20%

threshold for a healthy company. The reduced debt offset the declining cash flow from

operations to provide a relatively stable cash flow ratio. The level of long-term solvency risk at

the end of Year 4 appears low.

Reference:

Wahlen, James M. Financial Reporting, Financial Statement Analysis and Valuation, 8th Edition. Cengage

Learning, 20140801. VitalBook file.

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