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Assignment in Principles of Finance

  1. Financial ratio analysis is conducted by four groups of analysts: Managers, equity investors, long-term creditors and short-term creditors. What is the primary emphasis of each of these groups in evaluation ratios?

Answer #1

Financial ratios express the relationship between data in financial statements and provide an opportunity for internal and external users to examine company’s performance through financial records and measures of activity. Managers use financial ratios to examine the efficiency of company’s performance as well as to identify areas, where improvements are needed. Equity investors need financial ratio analysis to identify and decide whether the company is a good venture to invest in, meaning whether the company can earn attractive returns on the money they invest in the development and operations of the company. Creditors, whether short-term or long-term, examine financial ratios to see if the company is reliable and whether it will be able to pay its obligations on debt in future.

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Answer #2

Since financial ratios present valuable information on measuring company’s performance, various parties use them to make their decision about making business with the company. Managers use financial ratios to evaluate overall performance of the company and decide which areas are performing well and which need some sort of improvement. Equity investors look into financial ratios to evaluate company’s potential to earn investment returns on their money. Short-term and long-term creditors examine company’s financial ratios to examine the capability of the company to return its debt in future and make decision whether they can afford lending funds to the company.

  1. Why would the inventory turnover ratio be more important when analyzing a grocery chain that an insurance company?

Answer #1

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Inventory turnover represents consumption of inventory as goods are sold. Since a grocery chain sells goods, some of which are perishable, every day, the turnover ratio represents the efficiency of inventory storage and sales as well as indicates inventory shortages or abundance. Insurance companies sell insurance policies, which are not stored physically; hence there is virtually no inventory in an insurance company. Consequently, the importance of inventory turnover is close to zero for insurance companies, while it has high significance for measuring efficiency of grocery chains.

Answer #2

The difference between grocery chain and an insurance company is not only in their business objectives, but in their operations and need for inventory as well. Grocery chains are involved in business of selling goods, which need to be stored in their inventory. Since some of the goods are perishable, grocery chains need to be efficient on selling their inventory, thus increasing their inventory turnover. Insurance companies sell insurance policies, which are contracts between the company and its clients and do not need to be stored. Consequently, inventory turnover is not applicable to insurance companies, while it has significant importance for grocery chains in terms of measuring their efficiency and capability of selling goods off their stored inventories.

  1. Over the past year, ABC Co. has realized an increase in its current ratio and a drop in its total assets turnover ratio.  However, the company’s sales, cash and marketable securities, Days sales outstanding, and fixed assets turnover ratio have remained constant. What explains these changes?

Answer #1

Drop in asset turnover when the sales remained constant implies that assets of the company increased. The fact that fixed assets turnover remained constant and total assets turnover decreased means that there was a change in current assets. Current assets usually consist of cash, marketable securities and inventory. Current ratio changed while Days sales outstanding remained unchanged, the only factor that would explain the change in current ratio and total assets turnover is increase in company’s inventories.

Answer #2

An increase in current ratio implies there was an increase in current assets or a decrease in current liabilities. Since the information is given only in regard to assets, there was a change in current assets of the company. Current assets are made up with cash, marketable securities, accounts receivable, and inventories. There was no change in sales, cash and marketable securities, and no information on accounts receivable. Consequently, to provide an increase in current ratio, accounts receivable or inventories had to increase. Accounts receivable would increase only in the case of a decrease in inventories. Thus, an increase in current assets was due to an increase in company’s inventories.

  1. If a firm’s ROE is low and management wants to improve it, explain how using more debt might help?

Answer #1

If ROE is low and management wants to improve it, management can make a decision utilize debt leverage, which provides advantage of tax deduction for interest expense. Consequently, if company utilizes more debt financing, its ROE will be proportionately higher, showing improved performance on return to shareholders.

Answer #2

Companies have two options of financing its operations – through debt and equity. Financing company’s operation through equity implies that company will need to pay back dividends, which are not tax-deductible, to equity holders. Utilizing debt will require paying back interest, which is tax deductable. Thus, if a company increases the proportion of debt in its capital structure, it will be able to increase, thus, improve its Return on Equity ratio.

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