1 Chapter 4 Analyzing Financial Statements Critical Thinking Questions 4.1 What does it mean when a company’s return on assets (ROA) is equal to its return on equity (ROE)? When ROA equals ROE, it means that the firm does not use any leverage. For firms that do use leverage, ROE will be higher than ROA. 4.2 Why is too much liquidity not a good thing? Too much liquidity could mean that a firm is not putting its money to work as the shareholders would want it to. It could mean that the firm’s managers are being too conservative and investing in low-yield assets, or it could mean that the firm does not have enough investment opportunities and is therefore hanging onto its cash. Recently, several firms including Microsoft had several billions of dollars in cash on their books, and, ultimately, Microsoft paid a special dividend to its shareholders. Too much liquidity can also make it a takeover target for firms looking to utilize the debt capacity of the liquid firm.
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Chapter 4 Analyzing Financial Statements
Critical Thinking Questions
4.1 What does it mean when a company’s return on assets (ROA) is equal to its return on
equity (ROE)?
When ROA equals ROE, it means that the firm does not use any leverage. For firms that
do use leverage, ROE will be higher than ROA.
4.2 Why is too much liquidity not a good thing?
Too much liquidity could mean that a firm is not putting its money to work as the
shareholders would want it to. It could mean that the firm’s managers are being too
conservative and investing in low-yield assets, or it could mean that the firm does not
have enough investment opportunities and is therefore hanging onto its cash. Recently,
several firms including Microsoft had several billions of dollars in cash on their books,
and, ultimately, Microsoft paid a special dividend to its shareholders. Too much liquidity
can also make it a takeover target for firms looking to utilize the debt capacity of the
liquid firm.
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4.3 Inventory is excluded when the quick ratio or acid-test ratio is calculated because
inventory is the most difficult current asset to convert to cash without loss of value. What
types of inventory are likely to be most easily converted to cash?
For the quick ratio, one uses only the most liquid of all assets—that is, all current assets
less inventory, which is not very liquid relative to cash or receivables. While the current
ratio assumes that inventory could be sold at book value, the quick ratio assumes that
inventory has no value. Hence, this gives a more conservative estimate of a firm’s
liquidity than the current ratio, and gives a better estimate of the firm’s ability to meet its
short-term obligations.
4.4 What does a very high inventory turnover ratio signify?
This could mean a number of things, including that the firm is using up its inventory too
fast and is unable to meet the demand for its products, or it has priced its products too
low relative to its competitors, or worse, the firm is selling defective products that would
eventually be returned.
4.5 How would one explain a low receivables turnover ratio?
A low receivables turnover implies a high DSO. This could mean that the firm’s
customers are not paying on time, either because of an inefficient collection system or
because of a slowdown in their customers’ business or even in the entire economy.
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4.6 What additional information does the fixed assets turnover ratio provide over the total
assets turnover ratio? For which industries does it carry greater significance?
The total assets turnover ratio measures the level of sales per dollar invested in total
assets. The higher the number, the more efficiently the management is using the firm’s
assets. Too high a number relative to its peers could imply that the firm is reaching its full
capacity and may require an additional investment in plant and equipment to generate
additional sales. The fixed asset turnover ratio can be utilized to break down the
performance of individual manufacturing facilities or a division. This ratio provides
significant information for manufacturing firms that are capital-intensive, while it will be
of much less significance for the service industry, where there is less reliance on plant
and equipment.
4.7 How does financial leverage help shareholders?
Financial leverage implies the use of debt capital in addition to the owners’ capital to
finance the firm. With the addition of debt, the owners’ capital can go a long way in
acquiring assets for the firm. Given that creditors only get the fixed-interest payments and
do not get any share of the gains from the company, the shareholders gain from the usage
of debt. This is called the leverage multiplier effect. As the company’s revenues grow,
shareholders get all the gain and the debt holders merely receive their interest payments.
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4.8 Why do banks have a low ROA (relative to other industries) but a high ROE?
Banks have a very small equity base relative to firms in most other industries. Thus, they
are highly leveraged with borrowed funds. Since their equity base is small, this magnifies
the return on equity, but the return on assets is relatively small for the large asset base.
4.9 Why is the ROE a more appropriate proxy of wealth maximization for smaller firms
rather than for larger ones?
The basis on which any business or investment decisions are evaluated must include the
size, timing, and uncertainty in the future cash flows. ROE considers neither the risk of
the cash flows nor the size of the initial investment or future cash flows from that
investment. While the ROE and shareholder wealth are correlated, this is still a problem
in large, well-diversified companies with resources from multiple sources. Smaller firms
have fewer resources and sources and can better correlate their ROE to shareholder
wealth.
4.10 Why is it not enough for an analyst to look at just the short-term and long-term debt on a
firm’s balance sheet?
The amount of liabilities shown on a firm’s balance sheet is not the total obligation of a
firm in any given period. To get a true picture, one needs to look at the financial
footnotes that follow the financial statements. This is where you will be able to find the
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amount of debt repayment that the firm is responsible for in the coming years. In
addition, off-balance sheet items could reflect certain future liabilities of the firm that do
not have to be reported on the balance sheet. One also should look for lease obligations of
the firm that are reported off the balance sheet but nevertheless remain a fixed obligation
that the firm has to meet with its cash flows. Thus, it is important for the analyst to look
beyond the short-term and long-term debt on the balance sheet to get a true measure of
the firm’s true financial commitments in any given period.
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Questions and Problems
BASIC
4.1 Liquidity ratios: Explain why the quick ratio or acid-test ratio is a better measure of a
firm’s liquidity than the current ratio?
Solution:
The quick ratio is a better or more conservative measure of liquidity than the current
ratio. The difference in the measurement of the two is that for the quick ratio we exclude
the inventory in accounting of the short term assets. Thus the quick ratio is measured as:
sliabilitieCurreent Inventory - assetsCurrent ratio Quick =
This measure includes only the most liquid of the current assets and hence gives a better
measure of liquidity.
4.2 Liquidity ratios: Flying Penguins Corp. has total current assets of $11,845,175, current
liabilities of $5,311,020, and a quick ratio of 0.89. What is its level of inventory?