Solutions

Chapter 1

Solutions to review questions

  1. Knowing how much a company is worth is very useful. There are two major valuation approaches: cash flow and asset valuation. If one considers a business to be a going concern, the cash flow approach is appropriate.
  2. Owners of businesses need valuation techniques to know their net worth, especially in cases where the business is up for sale. Obviously, potential owners need to know the value of a business. Security analysts use valuation techniques to recommend “buy and sell” to their clients. CPAs may be called upon to help their clients find a company’s value.
  3. The cash flow approach to valuation is appropriate in all cases of going concern. Asset valuation approaches are appropriate when a company is to be liquidated. These approaches provide a valuation “floor.”
  4. Value of a firm images

    FCF1 is the cash flow producing ability of the company after taxes, that is, its effective dividend.

    R is the company’s risk adjusted rate of return. As a firm’s risk increases, its cost of capital increases.

    G is the growth rate of the firm’s earnings.

  5. Free cash flow is the excess cash flows of a business. Many businesses do not pay dividends, but they still have value. Do not think of free cash flow as the actual dividend. Instead, think of it as the dividend that could be paid.
  6. We are speaking of growth in cash earnings. The larger the expected growth rate, the greater the value of the firm. Financial statement analysis can help us determine growth rates.

Knowledge check solutions

    1. Correct. An increase in profitability will cause firm value to increase. This makes intuitive sense because people should be willing to pay more for ownership rights in a company if it is more profitable.
    2. Incorrect. Decrease is not correct because value is positively related to a company’s earnings.
    3. Incorrect. This is incorrect because value is positively related to a company’s earnings.
    4. Incorrect. Decrease is not correct because value is positively related to a company’s earnings.
    1. Correct. Expected growth and firm value are positively related so value will increase as growth increases. You can also observe this in the valuation equation in the chapter. Growth has a negative sign in the denominator which will make the fraction (value) increase as “g” increases.
    2. Incorrect. Decrease is not correct because investors are generally willing to pay more for a company that is expected to grow than they would if it were not expected to grow.
    3. Incorrect. Decrease is not correct because investors are generally willing to pay more for a company that is expected to grow than they would if it were not expected to grow.
    4. Incorrect. This is incorrect because investors are generally willing to pay more for a company that is expected to grow than they would if it were not expected to grow.
    1. Incorrect. Increase is not correct because value and risk are inversely related. That is, investors are generally willing to pay less for a riskier company.
    2. Correct. An increase in risk causes the cost of capital to increase. When the cost of capital, R, increases, firm value will decrease. Therefore, an increase in risk will be associated with a decrease in value.
    3. Incorrect. Increase is not correct because value and risk are inversely related. That is, investors are generally willing to pay less for a riskier company.
    4. Incorrect. This is incorrect because value and risk are inversely related. That is, investors are generally willing to pay less for a riskier company.
    1. Correct. The correct solution would be $1,250,000. Using the valuation formula from the chapter, value would be
      images
    2. Incorrect. Proper application of the valuation formula would not yield this result.
    3. Incorrect. We would improperly obtain this answer if we did not consider the firm’s expected growth rate. Proper application of the valuation formula would not yield this result.
    4. Incorrect. We are able to prepare an estimate from these figures. See answer a.
    1. Incorrect. Proper application of the valuation formula would not yield this result.
    2. Correct. Risk and value are inversely related, so the value would decrease. In this case, value would fall to
      images
    3. Incorrect. This is not correct because a change in the cost of capital will impact company value.
    4. Incorrect. We are able to prepare an estimate from these figures. See answer b.
    1. Correct. Free cash flow is the company’s cash flow after all necessary investments have been made. Some people call it “dividend paying ability.”
    2. Incorrect. Total cash flow is the cash flow before making investments.
    3. Incorrect. The cash flow left over after all investments have been made could be either positive or negative.
    4. Incorrect. The cash flow left over after all investments have been made could be either positive or negative.

Chapter 2

Solutions to review questions

  1. The current ratio is a measure of the quantity of a company’s liquidity. It is generally considered an effect ratio because managers do not decide to have a liquidity problem. Instead, a manager will make a decision that changes one of the causal ratios, which, in turn, causes the current ratio to decline. It is, therefore, an effect ratio.
  2. If the collection period rises, generally current liabilities rise, causing the ratio of current liabilities to net worth to increase.
  3. The debt to asset ratio is a measure of the proportion of assets that are financed with debt. A large debt ratio means the firm is deeply in debt and may have exhausted its debt capacity.
  4. The times interest earned ratio is a measure of the number of times that a firm could have paid its interest charges. The fixed charge ratio is a measure of the number of times the firm could have paid not only interest, but also lease payments and preferred stock dividends.
  5. The inventory to working capital ratio is a measure of the quality of liquidity. A firm can have a “good” current ratio and still have poor quality. The more inventory a firm has relative to working capital, the poorer its quality of liquidity is.
  6. Receivables to working capital is a quality measure of liquidity. If this ratio rises, the firm’s liquidity has decreased in terms of quality. The collection period measures the credit and collection efficiency of the firm. This ratio may indicate the existence of poor quality receivables that may never by collected.
  7. The net profit to net worth ratio is the return on equity. This ratio can be increased by the profits. The most common but more dangerous method for increasing the ratio is to use debt rather than equity financing to decrease the denominator.
  8. Sales obviously affect profitability. Therefore, if the ratio of sales to fixed assets rises, the return on fixed assets will often increase. On the other hand, if fixed assets to net worth rises because fixed assets have increased, then the return on fixed assets will fall.
  9. The net sales to working capital ratio is a measure of liquidity or the demands made on working capital to support the sales volume of a firm. It is affected by all of the six causal ratios described in a later section, which affect the components of this ratio.

Knowledge check solutions

    1. Incorrect. The current ratio is a commonly used liquidity measure.
    2. Incorrect. Defensive interval is a commonly used liquidity measure.
    3. Correct. This ratio is a measure of leverage. It shows the ability of a company to afford its debt. See the ratio list and the discussion of the ratio in the chapter.
    4. Incorrect. This is not correct because the current ratio and defensive interval are liquidity measures but times interest is not.
    1. Incorrect. A good value for the current ratio implies good quantity of liquidity, but a company can still have problems with other aspects of liquidity (for example, quality or timing of liquidity).
    2. Correct. The current ratio measures the “quantity” of a company’s liquidity. If the ratio is at a good level, it means the quantity of liquidity is okay but not other aspects of liquidity.
    3. Incorrect. This statement incorrect because only answer a. above is false. Answer b. is true and the correct answer.
    4. Incorrect. This statement incorrect because only answer a. above is false. Answer b. is true and the correct answer.
    1. Correct. Because the only difference between the current and quick ratios is inventory, the decrease in the quick ratio would have to be caused by an increase in inventory.
    2. Incorrect. This cannot be correct because a decrease in inventory would not allow a stable current ratio and a decreasing quick ratio.
    3. Incorrect. The difference between the current and the quick ratio has nothing to do with receivables. The biggest difference is caused by inventory.
    4. Incorrect. The difference between the current and quick ratios has nothing to do with cash.
    1. Incorrect. Quantity is not correct because the inventory to working capital ratio does not tell us how much liquidity a company has. Quantity of liquidity is measured by the current and the quick ratios.
    2. Incorrect. The inventory to working capital ratio does not measure the timing of liquidity. The timing of liquidity is measured by the defensive interval.
    3. Correct. The inventory to working capital ratio measures the “quality” of liquidity. Because inventory is generally the least liquid current asset, as it grows relative to other working capital items, we argue that the quality of liquidity has decreased.
    4. Incorrect. When this ratio changes, it tells us nothing about the dollar amount of liquidity.
    1. Incorrect. Increased is not correct because an increase in receivables to working capital means that the quality of liquidity has decreased.
    2. Correct. Because receivables are less liquid than cash and securities, an increase in receivables relative to other working capital items means that liquidity quality has decreased.
    3. Incorrect. Not changed is incorrect because an increase in receivables to working capital means that the quality of liquidity has decreased.
    4. Incorrect. The quality of liquidity has decreased when receivables to working capital increases.
    1. Incorrect. The current ratio measures the quantity of liquidity and is useful at any point in time, but is no more useful than normal when sales grow rapidly.
    2. Correct. While all liquidity measures are useful to watch during sales growth, the most important is the ratio of net sales to net worth. This ratio shows whether the growth in sales has been supported by growth in working capital.
    3. Incorrect. The quick ratio measures the quantity of liquidity and is useful at any point in time, but is no more useful than normal when sales grow rapidly.
    4. Incorrect. The debt to assets ratios is not a measure of liquidity.
    1. Correct. To compute the tangible debt to asset ratio, we deduct the intangible assets from total assets in the ratio’s denominator. Therefore, the intangible debt ratio will be larger as its denominator is smaller.
    2. Incorrect. Tangible debt ratios are never smaller than ordinary debt ratios.
    3. Incorrect. Tangible debt ratios and ordinary debt ratios are only the same when there are no intangible assets.
    4. Incorrect. The tangible debt ratio and the debt ratio are related. To compute the tangible debt to asset ratio, we deduct the intangible assets from total assets in the ratio’s denominator. Therefore, the intangible debt ratio will be larger as its denominator is smaller.
    1. Correct. Because short-term debt has to be rolled-over more often than long-term debt, it has a greater chance of having a rollover problem.
    2. Incorrect. Long-term debt is an incorrect answer because its rollover risk is smaller, not larger.
    3. Incorrect. Bonds are a type of long-term debt, and long-term debt has smaller roller risk than short-term debt.
    4. Incorrect. Mortgages of fixed assets are generally long-term debt and would have low rollover risk.
    1. Incorrect. This statement is true, but because answer b. is also true, the correct answer will be answer c. Short-term debt increases rollover risk because short-term debt must be continually renegotiated when used as permanent financing.
    2. Incorrect. This statement is true, but because answer a. is also true, the correct answer will be answer c. Because a company must take what-ever the market rate of interest is at the time of loan renewal, short-term debt used as permanent financing increases interest rate risk.
    3. Correct. Because both answers a. and b. are true, this is the best answer. Short-term debt used as permanent financing increases both rollover and interest rate risk for the borrowing company.
    4. Incorrect. Both a. and b. are true statements.
    1. Correct. The fixed charge coverage and times interest earned ratios are similar, except the former includes financial obligations other than interested payments.
    2. Incorrect. The fixed charge coverage ratio is extremely important for companies that lease instead of borrow because it adjusts for leasing costs.
    3. Incorrect. This is not correct because the fixed charge coverage ratio adjusts for leases is different from times interest earned.
    4. Incorrect. The fixed charge coverage ratio and the times interest earned ratio measure the ability to afford debt.
    1. Correct. Although these two ratios have the same numerator, the quick ratio measures the quantity of liquidity without inventory. The defensive interval is the ratio that measures survival time.
    2. Incorrect. The quick ratio is incorrect because it is not a timing measure of liquidity; it is a quantity measure.
    3. Incorrect. The net sales to working capital ratio is an overall liquidity measure that shows whether the company has sufficient working capital (liquidity) given its level of sales.
    4. Incorrect. The debt to assets ratio measures debt usage or leverage; it does not measure survival time.

Chapter 3

Solutions to review questions

  1. The DuPont system allows the analyst to determine whether profitability problems result from inadequate cost control, inadequate sales, or from a too conservatively financed balance sheet.
  2. The profit margin shows the number of pennies left from each sales dollar after deducting expenses. When expenses rise proportionately more than sales, the profit margin will decline. Remember, a decrease in sales usually is also accompanied by a reduced profit margin.
  3. Debt “levers-up” the ROA into a bigger ROE. If a lot of debt is in use, then equity, the denominator of the ROE, is small. This increases the ROE.

Knowledge check solutions

    1. Correct. The DuPont system divides the ROE into three ratios: the profit margin, the asset turnover, and the equity multiplier.
    2. Incorrect. The debt to asset ratio measures the same thing as the equity multiplier but uses a different scale of measurement. It is not multiplied by the ROA to achieve the ROE.
    3. Incorrect. The asset turnover is multiplied by the profit margin to determine the ROA, not the ROE.
    4. Incorrect. We do not multiply by a constant such as 3 to find the ROE.
    1. Incorrect. This is incorrect because the ROE is the product of the ROA and the equity multiplier. When we multiply the two numbers, their product does not equal 7.5 percent or 15 percent.
    2. Incorrect. This is incorrect because the ROE is the product of the ROA and the equity multiplier. When we multiply the two numbers, their product does not equal 15 percent.
    3. Correct. The ROE is the product of the ROA and Equity multiplier. So, 15% × 2 = 30%.
    4. Incorrect. See answer c., we can compute the ROE.
    1. Incorrect. When an equity multiplier increases, the ROE will increase, not decrease.
    2. Correct. The equity multiplier increases when debt usage increases. As long as the ROA is positive, the ROE will increase as well, and the increase is only the result of the increased debt. The ROE will be 45 percent.
    3. Incorrect. This is incorrect because we know the ROE must increase if the equity multiplier increases and because the product of 15 percent times 3 is not 22.5 percent.
    4. Incorrect. It would increase to 45 percent.
    1. Correct. The profit margin measures cost control. A low profit margin signals the need to control costs.
    2. Incorrect. The asset turnover is an incorrect answer because it measures the ability of a company to use its assets to produce sales.
    3. Incorrect. Only the profit margin measures cost control; the asset turnover does not.
    4. Incorrect. This is incorrect because the asset turnover does not measure cost control.
    1. Incorrect. The change in the asset turnover, does not suggest anything about leverage or debt usage.
    2. Incorrect. This is incorrect because it is the profit margin, not the asset turnover that measures the need to cut costs.
    3. Correct. The asset turnover measures how well a company is using its assets to produce sales.
    4. Incorrect. Decreasing sales will not likely change the asset turnover.
    1. Incorrect. We cannot conclude that this is correct because, although the company has a larger ROE than average, its ROA is below average due to a low profit margin. Although the ROE for the company is larger than the industry average, it is larger because of leverage (equity multiplier).
    2. Incorrect. The statement is correct because ROE for the company is larger than the industry average. However, answer d. is the best answer because it includes answers b. and c.
    3. Incorrect. The statement is correct because the ROA for the company is 15 percent while the ROA for the industry is 18 percent. However, answer d. is the best answer because it includes answers b. and c.
    4. Correct. Answers b. and c. are correct. Because this company has a below average profit margin, it should investigate cost control and/or price increases.
    1. Correct. The ROE is the product of the profit margin, the asset turnover, and the equity multiplier. In this case, we must first compute the equity multiplier from the debt to asset ratio. If debt to assets is 50 percent, then the equity to asset ratio is also 50 percent (because assets = liabilities + equity). If equity to assets is 50 percent, its inverse is assets to equity, which is the equity multiplier, and is 2 in this case. Therefore, the ROE = 5% × 2 × 2 = 20%.
    2. Incorrect. The product of the three numbers does not equal 10 percent.
    3. Incorrect. You must first convert debt to assets of 50 percent into the equity multiplier of 2. Then multiply this by the other two numbers.
    4. Incorrect. This is incorrect because the ROE is 20 percent.
    1. Incorrect. This answer cannot be correct because the ROE measures the quantity, not the quality, of earnings.
    2. Correct. Earnings quality is the perceived ability of a company to continue earning. Therefore, if we believe that a company can continue earning at its current level or better, we argue that it has “good” earnings quality.
    3. Incorrect. This cannot be correct because the ROE measures the quantity, not the quality, of earnings and therefore answer a. is incorrect.
    4. Incorrect. The current ratio measures liquidity and has no direct relationship with earnings quality.
    1. Correct. Having good liquidity and low debt ratios gives a company the ability to continue in operation in troubled times. Therefore, a strong balance sheet implies good earnings quality.
    2. Incorrect. This is incorrect because a strong balance sheet likely allows a company to continue earnings in the future and would not signal poor earnings quality.
    3. Incorrect. This is incorrect because a strong balance sheet implies good earnings quality and, therefore, has a relationship with earnings quality.
    4. Incorrect. A strong balance sheet implies good earnings quality.
    1. Incorrect. When the ratio increases it is a sign of “poor” earnings quality. As assets get older, earnings quality decreases.
    2. Correct. The ratio of accumulated depreciation to depreciation expense estimates asset age. When the ratio increases it is a sign of “poor” earnings quality. Short-term earnings may be increased, but later earnings may fall when the overdue replacement occurs.
    3. Incorrect. When the ratio increases it is a sign of “poor” earnings quality.
    4. Incorrect. The ratio of accumulated depreciation to depreciation expense is one measure of earnings quality.
    1. Correct. When all senior managers are nearing retirement age, they may have incentives to manage the company’s earnings. Therefore, this would be a sign of poor earnings quality.
    2. Incorrect. This is incorrect because when all senior managers are nearing retirement age it is a sign of poor earnings quality.
    3. Incorrect. Poor earnings quality may be evidenced by the fact that all senior managers are nearing retirement age.
    4. Incorrect. Manager age is related to earnings quality. See answer a.
    1. Correct. The extraordinary gain cannot be repeated, so earnings quality (the perceived ability to continue earning at the current rate) would be questioned.
    2. Incorrect. An increase in the relative R&D expenditure would be considered good earnings quality and would generally improve long-term earnings, therefore, this is incorrect.
    3. Incorrect. When the age of a company’s assets decreases, this is evidence of good earnings quality.
    4. Incorrect. A wide range of manager ages is a sign of good earnings quality.
    1. Incorrect. When companies change auditors, there may be good reasons to do so. However, some companies switch auditors to find a more lenient auditor. Not changing an auditor does not hurt earnings quality.
    2. Incorrect. By using the same auditor for ten years, it is unlikely that the company is “audit opinion shopping.” So keeping the same auditor for long periods is unlikely related to earnings quality.
    3. Correct. It is unlikely that keeping the same auditor for an extended period of time will impact earnings quality. However, changing auditors frequently may be a cause for concern.
    4. Incorrect. An auditor with a good reputation may enhance earnings quality but it is most likely unrelated.

Chapter 4

Solutions to review questions

  1. A causal ratio measures an action taken by a company that “causes” debt, liquidity, or profitability problems. For example, if there is a change to one part of a balance sheet, other areas will be affected.
  2. If the ratio of fixed assets to net worth increases, then fixed assets are rising faster than net worth. Either debt must increase or working capital decrease (increase current liabilities or decrease current assets). Thus a rise in the ratio of fixed assets to net worth can impair a firm’s liquidity.
  3. If this ratio rises because the company is expanding fixed assets, then liquidity, debt, and/or profitability problems can occur. When one of these three problems exists, look for an over-investment in fixed assets as a possible cause.
  4. If a firm’s collection period rises, accounts receivable has risen as well. These new receivables must be financed. Generally, some form of debt is used to finance the increase in receivables. Thus, debt problems can be caused by a rise in the collection period.
  5. The net sales to inventory ratio is often called the inventory turnover. It is an indicator of the efficiency of inventory management. If this ratio is small or has decreased, then inventory may be a problem. Perhaps obsolete inventory exists and should be written off. Too much inventory hurts liquidity because inventory is generally financed with short-term debt.
  6. Overtrading occurs when the trading ratio (net sales to net worth) is large. The overtrader is a company that has grown too rapidly and has not financed the growth with equity. This problem is deceptive because overtraders are generally profitable but have poor liquidity and large amounts of debt. An overtrader must have optimum internal and external conditions to exist.
  7. Overtraders have maximum sales growth with no new equity to support growth. Overtraders have poor liquidity and large amounts of debt. Overtrading sets a company up for a fall by reducing its capacity to withstand external shocks. Companies that encounter temporary problems may not survive if liquidity is poor and the firm is deeply in debt. Excessive growth can be fatal to a company. Overtrading may be cured by obtaining longer credit terms, raising outside equity, reducing owner’s compensation, improving cost control, and raising prices to reduce demand.
  8. If the net profit to net sales ratio is negative, then net worth is declining. Debt and liquidity problems result.
  9. Miscellaneous assets include the cash value of life insurance, non-trade receivables, long-term receivables, and prepaid expenses. Excessive investments in these assets require debt financing or reduced liquidity. In addition, these assets tend to earn below average rates of return, so profits may suffer.

Knowledge check solutions

    1. Correct. When the fixed asset to net worth ratio increases in a profitable company, fixed assets are increasing faster than equity. These assets are financed with either debt and/or working capital. So, generally, the debt ratios increase.
    2. Incorrect. The increase in fixed assets is never associated with a decrease in debt, so this answer cannot be correct.
    3. Incorrect. Generally when this ratio increases, the increased fixed assets are financed with debt. However, if a company financed the increase in fixed assets through its existing cash balance, then and only then would this answer be correct.
    4. Incorrect. Debt ratios tend to increase when fixed assets to net worth increases. So they are related to this causal ratio.
    1. Incorrect. If fixed assets to net worth increases, the company’s current ratio cannot increase because neither have current assets increased nor current liabilities decreased.
    2. Incorrect. When fixed assets to net worth increases, the short-run effect will be a decrease in the company’s liquidity if the company pays for the assets with cash or borrows short-term. However, answer d. is the best answer because it includes answers b. and c.
    3. Incorrect. There will be no direct effect on liquidity if long-term debt financing is utilized. However, answer d. is the best answer because it includes answers b. and c.
    4. Correct. Answers b. and c. are correct.
    1. Incorrect. Because costs such as insurance, property taxes, and interest increase, profits do not generally increase.
    2. Correct. If the increase in fixed assets occurs, interest expense, property taxes, and insurance costs may increase before the new assets become profitable. Therefore, profits may decrease in the short-run.
    3. Incorrect. Because costs such as insurance, property taxes, and interest increase, profits do not generally stay the same.
    4. Incorrect. There is a relationship between fixed assets to net worth and profit. They are negatively related in the short-run.
    1. Incorrect. Raising equity capital will allow debt to be repaid. Therefore, this is a reasonable correction strategy. However, answer c. is the best answer because it includes answers a. and b.
    2. Incorrect. Restricting further investment allows the company to retain earnings and retire debt over a period of time. Therefore, this is a reasonable correction strategy. However, answer c. is the best answer because it includes answers a. and b.
    3. Correct. Answers a. and b. are reasonable corrections strategies.
    4. Incorrect. Since both answer a. and b. are solutions for a company with a large fixed assets to net worth ratio, this answer cannot be correct.
    1. Correct. The collection period measures average collection time from customers. If the ratio increases, customers are taking longer to pay.
    2. Incorrect. This is incorrect because the collection period has no direct effect on or is affected by inventory.
    3. Incorrect. Rapidly increasing inventory has no impact on the collection period.
    4. Incorrect. The collection period is not directly related to fixed assets growth.
    1. Incorrect. Increase is not correct because the increase in short-term debt causes the current ratio to decrease.
    2. Correct. Decrease is correct because the increase in short-term debt causes the current ratio to decrease. For example if current assets are 200 and current liabilities are 100, the current ratio is 2. So if receivables increase by 50, current assets will be 250 and current liabilities will be 150 if the increased receivables have been financed with short-term debt. The current ratio will be less than 2, so it will have decreased.
    3. Incorrect. This is incorrect because the increase in short-term debt causes the current ratio to decrease.
    4. Incorrect. Since we can determine the change as in answer b., this answer cannot be correct.
    1. Correct. Shortening selling terms will reduce the collection period (it may also decrease sales).
    2. Incorrect. Eliminating discounts, such as 2/10 net 30, will probably increase the collection period because these discounts would have encouraged faster payment.
    3. Incorrect. Reducing inventory has no direct impact on a company’s collection period.
    4. Incorrect. Increasing sales will not likely shorten the collection period.
    1. Incorrect. This is common sense. Generally, when a company selects customers that pay on time and discourages sales to companies that pay slowly, its collection period will decrease not increase.
    2. Correct. Selecting customers with better credit histories will generally reduce the collection period.
    3. Incorrect. Selecting customers with better credit histories will generally reduce the collection period.
    4. Incorrect. Answer b. is the correct solution so this answer must be incorrect.
    1. Incorrect. Receivables write-off can negatively impact profits as the collections period increases. This is correct, but so are two other responses.
    2. Incorrect. Increased collection costs can negatively impact profits as the collection period increases. This answer is correct, but so are two other responses.
    3. Incorrect. Higher interest costs can negatively impact profits as the collection period increases. This answer is correct, but so are two other responses.
    4. Correct. Each of these things can negatively impact profits as the collection period increases. Therefore, answers a., b., and c. are correct, but because they all are, the correct response has to be d.
    1. Incorrect. This cannot be correct because the product of the divisions does not equal 25.6.
    2. Correct. See the collection period formula in the chapter. The collection period is 32 days [800,000/(9,000,000/360)].
    3. Incorrect. This cannot be correct because the product of the divisions does not equal 25.6.
    4. Incorrect. There is sufficient information to compute the collection period. See answer b. above.
    1. Correct. The inventory is 10.0 times ($9,000,000/900,000).
    2. Incorrect. This is not correct because inventory turnover is 10.0 times.
    3. Incorrect. This is not correct because inventory turnover is 10.0 times.
    4. Incorrect. There is sufficient information to compute the inventory turnover. See answer a. above.
    1. Incorrect. This cannot be correct because an increasing inventory turnover does not occur when inventory increases relative to sales.
    2. Correct. A large or increasing inventory turnover ratio signals that a company is moving its inventory very well. Therefore, inventory is generally decreasing relative to sales.
    3. Incorrect. While it may be related to sales growth (indirectly), it is not a sign of excessive sales growth.
    4. Incorrect. The inventory turnover does not provide any direct information about a company’s receivables.
    1. Correct. As inventory increases relative to sales, the inventory turnover ratio will fall.
    2. Incorrect. A decreasing turnover cannot be caused by falling inventory.
    3. Incorrect. The decreasing inventory turnover is not directly related to sales changes.
    4. Incorrect. A decreasing turnover cannot be caused by falling inventory.
    1. Incorrect. Because a slow inventory turnover implies increased inventory, this will decrease the quick ratio most of the time.
    2. Correct. Because a slow inventory turnover implies increased inventory, this will decrease the quick ratio most of the time. This is simple arithmetic. Inventory is deducted from current assets when computing the numerator of the quick ratio.
    3. Incorrect. We can determine the answer as in answer b. above.
    4. Incorrect. Because the quick ratio will not increase when inventory turnover falls, this answer cannot be correct.
    1. Correct. Perpetual inventory records permit buying in smaller quantities. This reduces the average inventory and increases the inventory turnover.
    2. Incorrect. Because perpetual records allow for smaller levels of inventory, inventory turnover will increase.
    3. Incorrect. Inventory turnover will not decrease when companies switch to perpetual records.
    4. Incorrect. The inventory turnover will generally increase when a company establishes perpetual inventory records.
    1. Incorrect. Studying which items in inventory are the problems will help to determine why inventory turnover has fallen. However, answer c. is the best answer because it includes both answers a. and b.
    2. Incorrect. Reviewing the turnover rate of inventory components will help to determine why inventory turnover has fallen. However, answer c. is the best answer because it includes both answers a. and b.
    3. Correct. Correcting inventory problems needs to begin with determining what part of inventory is the problem. Because both answers a. and b. would be ways to determine the source of the inventory problem, answer c. is the best response.
    4. Incorrect. Both answers a. and b. are correct.
    1. Incorrect. An increasing fixed assets to net worth ratio can cause liquidity to drop.
    2. Incorrect. An increasing collection period can cause liquidity to drop.
    3. Incorrect. A decreasing inventory turnover can cause liquidity to drop.
    4. Correct. The idea of causality is that an action (or lack of an action) can cause unanticipated problems. The examples in the chapter show that when each of these three ratios deteriorate, liquidity will suffer. Because answers a., b., and c. are all correct, the best response would be d.
    1. Incorrect. Because undertraders generally have small ratios of sales to net worth, because their sales growth is less than the growth in equity.
    2. Correct. Undertraders are companies with slow or no sales growth. Although they may be profitable in the short-run, if sales begin to fall, they can have trouble. Hence they will generally have small trading ratios.
    3. Incorrect. Undertraders have small trading ratios not average sized trading ratios.
    4. Incorrect. Undertraders have small trading ratios as discussed above.
    1. Incorrect. The solutions to the overtrading and undertrading problems are completely different.
    2. Incorrect. The undertrader needs to increase sales and the overtrader has excessive sales.
    3. Correct. This is clearly false. The undertrader needs to increase sales. The overtrader is burdened with excessive sales growth.
    4. Incorrect. Answer c. is correct.
    1. Incorrect. Overtraders have weak balance sheets because they tend to borrow a lot of money and have poor liquidity.
    2. Correct. The typical overtrader has growing sales and profits, but has a weak balance sheet with excessive debt and inadequate liquidity.
    3. Incorrect. Overtraders generally have weak balance sheets.
    4. Incorrect. Overtrading generally has a very negative impact on a company’s balance sheet.
    1. Correct. Overtraders are companies that generally attempt to maximize sales and sales growth.
    2. Incorrect. Overtraders generally do not focus on their balance sheet and often do not plan their liquidity.
    3. Incorrect. They tend to be sales maximizers.
    4. Incorrect. Overtraders generally have a lot of debt, but that is not their goal; the excessive debt is a byproduct of the sales growth.
    1. Incorrect. Dividing the sales by net worth does not produce a trading ratio of 1.5, so a cannot be correct.
    2. Correct. Total assets would be $4,000,000. Total liabilities would be $1,500,000, so net worth would be $2,500,000. Dividing sales of $9,000,000 by the net worth produces a trading ratio of 3.6 times.
    3. Incorrect. Dividing sales by net worth does not produce a trading ratio of 5.55.
    4. Incorrect. Dividing the sales by net worth produces a trading ratio of 3.6 times.
    1. Correct. Bringing in external equity will strengthen the balance sheet of the overtrader. Improving equity corrects one of the big problems for an overtrader.
    2. Incorrect. Because overtraders have excessive sales relative to net worth, an increase in equity will improve the situation.
    3. Incorrect. Raising external equity will improve an overtrader’s financial condition.
    4. Incorrect. Only answer a. is correct.
    1. Correct. Reducing payout improves equity and strengthens the balance sheet. This corrects the problem of an overtrader.
    2. Incorrect. Decreasing prices would further stimulate sales growth and would hurt the overtrading company.
    3. Incorrect. Answer b. is incorrect.
    4. Incorrect. Answer b. is correct.
    1. Correct. Improving cost control makes each sale more profitable. Retaining these earnings improves the overtrader’s balance sheet.
    2. Incorrect. The overtrader has a weak balance sheet, so more short-term debt would hurt the company by weakening its balance sheet further.
    3. Incorrect. Answer b. is incorrect, so all of the above cannot be correct.
    4. Incorrect. Answer a. is correct, so none of the above cannot be correct.
    1. Correct. When profits are negative, net worth decreases. The debt ratios will increase as a result. See the example in the chapter.
    2. Incorrect. Debt ratios do not ever decrease simply because a company has negative net income, so “decrease” is not correct.
    3. Incorrect. Debt ratios will increase, so this is incorrect.
    4. Incorrect. Debt ratios will increase, so this is incorrect.
    1. Incorrect. If sales cannot be restored, then the company must downsize to become profitable at the lower level of sales. However, answer c. is the best answer because it includes both answers a. and b.
    2. Incorrect. Decreasing sales can cause a profit margin problem. Restoring the sales would fix the profit margin problem if there is a way to increase the sales. However, answer c. is the best answer because it includes both answers a. and b.
    3. Correct. Because both a. and b. are good solutions, the best response has to be c.
    4. Incorrect. Raising prices when sales are decreasing will generally cause sales to decrease further.
    1. Correct. By cutting costs or by increasing prices the profit margin will increase. The price increase will only work if competition is not too severe.
    2. Incorrect. Downsizing would be a good solution if the company’s profit margin problems were caused by falling sales.
    3. Incorrect. This cannot be correct because downsizing is not a recommended solution.
    4. Incorrect. Answer a. is correct.
    1. Incorrect. The growth in these assets must be financed. Therefore, liquidity does not improve when these assets increase.
    2. Correct. When this ratio has grown, the “other” assets must be financed. Because they are often financed with short-term debt or a reduction in the cash balance, liquidity ratios will suffer.
    3. Incorrect. They will generally deteriorate.
    4. Incorrect. An increasing miscellaneous assets to net worth ratio will have an impact on a company’s liquidity.

Chapter 5

Solutions to review questions

  1. This approach not only details a company’s financial problems, but it also determines the underlying causes. Knowing the cause lets the analyst recommend the appropriate solution. For example, one does not cure a cold with a box of tissue—instead one must attack the underlying virus. In correcting a company’s financial problem, knowing the cause rather than just the symptoms provides direction for a solution.
  2. An industry analysis lets the analyst show where a company differs from similar companies. It does not make sense to compare a computer software store to a dental clinic. Industry comparisons improve the analyst’s ability to identify problems.

Knowledge check solutions

    1. Incorrect. Time series cannot be correct because comparing a company to similar companies is called an industry comparison, not a time series comparison.
    2. Correct. The time series analysis compares the company’s current results with those in prior years.
    3. Incorrect. The term ratio analysis is too general to be correct.
    4. Incorrect. Time series is incorrect; see above.
    1. Incorrect. The industry and time series comparison provide the analyst with more complete information than just an industry analysis.
    2. Incorrect. The industry and time series comparison provide the analyst with more complete information than just a time series analysis.
    3. Correct. Doing both an industry comparison and a time series analysis will provide the analyst with a more complete analysis.
    4. Incorrect. A company should do a time series and an industry comparison for a complete ratio analysis.
    1. Correct. Robert Morris and Associates Annual Statement Studies and The Almanac of Business and Industrial Financial Ratios each provide the industry averages and a “size” breakdown of the averages.
    2. Incorrect. This is not correct because Industry Norms and Key Business Ratios and Financial Studies of the Small Business do not provide a size breakdown of the ratios.
    3. Incorrect. These two sources do not generally provide ratio averages with a size breakdown.
    4. Incorrect. Robert Morris and Associates Annual Statement Studies and The Almanac of Business and Industrial Financial Ratios each provide the industry averages and a “size” breakdown of the averages.
    1. Incorrect. Poor cannot be correct because a company that matches the averages is at least as good as the average company in the industry.
    2. Correct. Industry averages are not goals, they are averages. So a company that matches the averages is “average.”
    3. Incorrect. A company that matches industry averages is not in great shape, they are average within the industry.
    4. Incorrect. If a company matches the averages, the company is simply average.
    1. Incorrect. If a company is a conglomerate, there may be a problem when using industry averages.
    2. Incorrect. If the company uses different accounting procedures than the industry, there may be a problem when using industry averages.
    3. Incorrect. If industry data is not available at year-end, there may be a problem when using industry averages.
    4. Correct. Each of these things in answers a., b., and c. is a problem to consider when using industry averages making the best response, d.
    1. Correct. It is the cause of the problem, rather than the symptoms, that should be attacked.
    2. Incorrect. When conducting an analysis of financial statements, it is important to take corrective action by attacking the root cause of the problem rather than the symptoms. Attacking the symptoms will provide only temporary solutions.
    3. Incorrect. Focusing on profits is always a good idea, but to correct a company’s problems one should examine the causes of the problems.
    4. Incorrect. While sometimes we can blame problems on bankers, fixing a company’s problems will rarely be helped by antagonizing their bankers.

Chapter 6

Solutions to cases

Case study 1:

Four of the six causal ratios are out of normal bounds. The next step should be to reexamine them more closely.

Fixed asset to net worth ratio

  • In 20X0 the company was average. Something happened over the next three years to cause a change.
  • Fixed assets actually declined over the period.
  • The decline in this ratio is caused by the reduction in net worth.
  • Fixed asset investment is not this company’s major problem.

The net profit to net sales ratio appears to be a real problem.

  • The company has lost money on sales for the last three years.
  • The effect of these losses is to distort all of the other ratios.
  • Net worth has been cut in half over the period.
  • Clearly, corrective steps must be taken immediately: You can develop a discussion of this by using the list of corrective actions that were associated with the net-profit to net-sales ratio in the causal ratio chapter.

The net sales to net worth ratio also appears out of line.

  • Sales have actually decreased over this period, but net worth has declined by a greater amount.
  • Overtrading is not one of this company’s greatest problems.

The miscellaneous assets to net worth ratio is a problem.

  • Even in 20X0 it was higher than the industry average.
  • However, miscellaneous assets have declined so that the reduction in net worth is still the major culprit.

This company’s basic problems come from (1) a loss on sales and (2) a decline in sales volume. This case shows that it is easy to over interpret ratios. The whole picture must be examined.

Case study 2:
  • Liquidity – The company’s quantity of liquidity, as measured by the current ratio, has declined over this three-year period and is well below the industry average of 1.36. This pattern can also be seen in the sales to the current asset ratio, which is considerably above the industry average.
  • Debt – The company’s debt ratios each year are very large and considerably above average.
  • Profits – The return on equity is very high in 20Y7 and 20Y8. However, a recession hits in 20Y9, and the company loses a lot of money.
  • Causes – This is a classic case of a company that has grown too quickly. The fixed assets to net worth ratio and the trading ratio are considerably larger than the industry averages.
Case study 3:

Fixed assets to net worth

  • From 200V to 200Y it grew 91 percent.
  • In 200Z it went way out of sight.
  • Fixed assets actually fell from 200Y to 200Z, but net worth fell even more. (The effect ratios can highlight some of the effects of the drop in net worth.)
  • The decrease in net worth has caused long-term liabilities to increase dramatically.
  • A rise in fixed assets is not the problem.

Collection period

  • Declines since 200X.
  • Receivables are declining faster than credit sales.
  • There is no real receivables problem for the firm.

Net sales to inventory

  • Has increased since 200X.
  • Inventory is declining faster than sales.
  • Inventory is not a major problem for the firm.

Net sales to net worth (trading)

  • Rises generally since 200V.
  • Sales are actually declining, but net worth is declining even more.
  • Costs are rising (particularly interest costs).
  • This appears to be an overtrader, but overtrading is not the real problem.
  • The problem is net worth. However, this company still has all of the problems of an overtrader.

Net profit to net sales

  • Has declined since 200X.
  • Decreasing sales and increasing interest costs are part of the reason.
  • This is the real problem for Firm A.

Miscellaneous assets to net worth

  • Has also increased, but once again, the problem is net worth.

Conclusion: Firm A has suffered major losses since 200Y. This has caused rising debt and a slight drop in liquidity. The losses have put the firm in an overtrading position.

Case study 4:

Liquidity looks sound, except that receivables/working capital is a little high.

Debt is well beyond the industry norms and is rising as measured by total liabilities to equity. Current debt is only slightly above average, but times interest earned is below average.

Profitability is below average.

Causes

  • Excessive fixed assets without equity financing
  • Excessive receivables
  • Excessive inventory
  • Overtrading
  • Inadequate cost control low profit margin during sales growth
  • Excessive miscellaneous assets
Discussion case 1

Overall, this is an example of a company with a large fixed asset to net worth and trading ratio. Similarly, its profit margin is low and profits are below average. Its debt ratios are large. This is an example of an overtrader.

Discussion case 2

This company is in the apparel business with factories in the U.S., Hong Kong, and Honduras. They operate in all phases of the apparel market up to, but not including, retail sales.

The loss in 200Z can be explained by rising expenses (see DuPont analysis), the rising collection period in 200Y, and falling inventory turnover.

Knowledge check solutions

    1. Incorrect. This answer cannot be correct because these two ratios have decreased.
    2. Correct. The current ratio and quick ratio have both decreased over this 5-year period, from 2.58 to 1.90 and 0.71 to 0.32, respectively. These two ratios measure the quantity of liquidity. Therefore, the liquidity decreased.
    3. Incorrect. This answer cannot be correct because these two ratios have decreased.
    4. Incorrect. The answer can be determined. See answer b.
    1. Correct. The ratios of receivable and inventory to working capital have both increased. An increase in these ratios implies a worsening of the quality of liquidity.
    2. Incorrect. This statement cannot be correct because these two ratios have increased, and they are the measures of the quality of liquidity. Quality decreases when these two ratios decrease.
    3. Incorrect. This statement cannot be correct because these two ratios have increased, and they are the measures of the quality of liquidity. Quality decreases when these two ratios decrease.
    4. Incorrect. The company’s liquidity has changed.
    1. Correct. Best Buy is an overtrader, so answer a. is correct. The trading ratio has increased from 7.75 to 9.65 in an industry that has a trading ratio of 4.56. Other evidence of overtrading is a large and growing ratio of fixed assets to net worth and a small profit margin.
    2. Incorrect. Because the trading ratio has increased, Best Buy is not an undertrader. An undertrader has a decreasing trading ratio.
    3. Incorrect. Because the collection period has not grown, there does not seem to be a collection period problem.
    4. Incorrect. A company cannot be an overtrader and an undertrader at the same time.
    1. Correct. The company’s debt to equity ratio is 2.11 in an industry that averages 1.00. Part of the reason for this ratio being large is the loss in year 200Z, but the ratio was still larger than average the year before the loss.
    2. Incorrect. Large debt ratios imply excessive leverage.
    3. Incorrect. Large debt ratios imply excessive leverage.
    4. Incorrect. I am not sure what the wrong kind of leverage would be in this case. So, this answer is incorrect because it makes no sense.
    1. Incorrect. This is not correct because sales growth has occurred and the lack of sales does not seem to be a problem. Increasing sales will only fix financial problems caused by the lack of sales.
    2. Correct. Biscayne’s profit margin has dropped from 6 percent to –6 percent. The industry average is four percent. This is clearly a problem. When sales are increasing (they increased from $65,258 to $100,294), a profit margin problem can be fixed by increasing prices or cutting costs. It is doubtful that in an industry that is as competitive as the apparel industry that a price increase would work. Cutting costs would be the best solution.
    3. Incorrect. Downsizing would work only when sales are decreasing. In this case, sales are increasing.
    4. Incorrect. Cutting costs would likely fix the problem. Therefore, neither of the above cannot be a solution.

Chapter 7

Solutions to review questions

  1. Lenders look very carefully at a firm’s balance sheet for short-term loan applications. This is because the firm will use its liquidity to pay off a short-term loan. A longer term loan will be paid off by the future cash flows that the firm will generate. Thus, for a long-term loan application, cash flow producing ability of a firm is crucial to a bank.
  2. In each of these cases the lender will need to know all of the details. The lender will ask the questions, “when?, where?, and, how?” Creditors will want to know the age and collectability of the receivables. They will need to know if the intangible assets can be converted to cash to repay debt if needed. Creditors will be particularly interested in the terms of the long-term debt and must know the nature and extent to which assets serve as collateral. Often contingent liabilities exist that could severely damage the liquidity of the firm.
  3. Owners and managers are more interested in profit ratios. Owners often try to increase profits at the expense of the balance sheet. Creditors are more interested in the balance sheet ratios. They are concerned about the borrower’s ability to pay the debt and the security available if the borrowers should default.

Knowledge check solutions

    1. Incorrect. Profit is not correct on a short-term loan, but would be if the loan life was longer.
    2. Correct. Bankers always place considerable importance on balance sheet ratios. For short-term loan applications, liquidity ratios are considered most important.
    3. Incorrect. Stock market ratios are rarely used in a bank’s loan analysis.
    4. Incorrect. The most important ratios for short-term loans are balance sheet ratios.
    1. Correct. The two ratios that most likely appear in a loan agreement are debt/equity and current ratio.
    2. Incorrect. This is incorrect because while profit margin and ROE may appear in a loan agreement, they are less likely to do so.
    3. Incorrect. Stock market ratios are rarely used in a bank’s loan analysis.
    4. Incorrect. These two ratios are not the most common ratios in a loan agreement.

Chapter 8

Knowledge check solutions

    1. Correct. Anything that improves the ability of a company to make and retain profits will increase sustainable growth.
    2. Incorrect. Increasing profits will never hurt a company’s ability to sustain growth.
    3. Incorrect. The direction of the change can be determined See answer a.
    4. Incorrect. Increasing profits will never hurt a company’s ability to sustain growth and should increase it.
    1. Correct. Adding equity improves sustainable growth.
    2. Incorrect. Increasing equity will always increase sustainable growth, not decrease it.
    3. Incorrect. We can determine the expected change to sustainable growth.
    4. Incorrect. Increasing equity will always improve sustainable growth, not cause it to remain unchanged.

Chapter 9

Solutions to review questions

  1. The Z-score is calculated by computing the five primary ratios, multiplying by the coefficients, and summing all the terms. See the manual for the equation.
  2. The working capital to assets ratio is a liquidity measure. Retained earnings to assets is a measure of whether the firm has retained a sufficient amount of profits over the years. EBIT to assets is a measure of the sufficiency of current profits. Equity to debt is a measure of debt usage. Sales to assets is a measure of sales productivity. Each of these ratios was constructed so that a large value implies financial health and a small value implies a problem. For a Z-score to be low several of these primary ratios must be small.
  3. A Z-score of less than 1.81 implies that bankruptcy is near. A ratio of greater than 2.99 implies relative financial health. In between these values is a grey area. These were determined by use of a statistical procedure called discriminant analysis.

Knowledge check solutions

    1. Correct. This variable is working capital divided by total assets and is a liquidity measure.
    2. Incorrect. This variable measures another aspect of a company’s financial condition.
    3. Incorrect. This variable measures another aspect of a company’s financial condition.
    4. Incorrect. This variable measures another aspect of a company’s financial condition.
    1. Correct. The correct answer is 4.0.
    2. Incorrect. Using the decimal form would understate the Z-score, so b cannot be correct. This is true for each of the first four X-variables. The fifth X-variable uses the decimal form of the number. See the computational note in the chapter.
    3. Incorrect. You do not multiply the dollar amount of retained earnings by the coefficient.
    4. Incorrect. You do not multiply the dollar amount of retained earnings by the coefficient.
    1. Correct. In general this is true. A large Z-score (above 2.99) implies good financial health.
    2. Incorrect. Altman suggested that Z-scores above 2.99 would make bankruptcy very unlikely in the near future, so false cannot be correct.
    3. Incorrect. Altman suggested that Z-scores above 2.99 would make bankruptcy very unlikely in the near future, so false cannot be correct.
    4. Incorrect. A single year’s Z-score does not tell us anything about the trend in financial health. It only shows financial health at one moment in time.
    1. Correct. The Z-score measures overall financial health. Because the Perfect Company’s Z-score dropped from 3.55 to 1.45 over a 3-year period we can conclude that Perfect’s overall financial health had deteriorated.
    2. Incorrect. While the conclusion that “Perfect is too deeply in debt” might be correct under some circumstances, we have no way to know given the information provided.
    3. Incorrect. We can determine the poor financial health of the company but not its leverage position.
    4. Incorrect. Because we can conclude that Perfect’s overall financial health has deteriorated, answer c. is not correct.