Home work 4

ST-1. a. Liquid Asset

A liquid asset is an asset that can be quickly and easily converted into cash without significantly affecting
its value. Examples of liquid assets include cash, money market instruments, and marketable securities.
Liquid assets are important because they provide companies with the ability to meet short-term
obligations and take advantage of opportunities.

b. Liquidity Ratios

Liquidity ratios measure a company's ability to meet its short-term obligations using its most liquid
assets.

- Current Ratio= Current Assets/Current Liabilities

This ratio indicates whether the company has enough assets to cover its short-term liabilities. A ratio
above 1 indicates that the company has more current assets than current liabilities.

- Quick (Acid-Test) Ratio= {Current Assets - Inventories /Current Liabilities

This ratio is a more stringent measure than the current ratio, as it excludes inventories from current
assets. It assesses the company's ability to pay off short-term liabilities without relying on the sale of
inventories.

c. Asset Management Ratios

Asset management ratios measure how efficiently a company uses its assets to generate sales and
manage its operations.

- Inventory Turnover Ratio= Cost of Goods Sold (COGS)/{Average Inventory

This ratio measures how many times inventory is sold and replaced over a period. A higher ratio
indicates efficient inventory management.

- Days Sales Outstanding (DSO)= (Accounts Receivable/Total Credit )*Sales Number of Days

DSO measures the average number of days it takes a company to collect payment after a sale. Lower
DSO values indicate quicker collections.

- Fixed Assets Turnover Ratio= Sales/Net Fixed Assets

This ratio measures how efficiently a company generates sales from its fixed assets, such as property,
plant, and equipment (PP&E).

- Total Assets Turnover Ratio= Sales/Total Assets

This ratio measures how efficiently a company uses all of its assets to generate sales.

d. Debt Management Ratios

Debt management ratios assess a company's ability to manage its debt load and meet its financial
obligations.
- Total Debt to Total Capital= Total Debt/(Total Capital (Debt + Equity)

This ratio measures the proportion of a company’s capital that comes from debt. A higher ratio
indicates higher leverage.

- Times-Interest-Earned (TIE) Ratio= EBIT/Interest Expense

This ratio measures a company’s ability to meet its interest obligations. A higher ratio indicates a
greater ability to cover interest expenses.

e. Profitability Ratios

Profitability ratios measure a company’s ability to generate earnings relative to its revenue, assets,
equity, and other financial metrics.

- Operating Margin = Operating Income (EBIT)/ Sale

This ratio measures the proportion of revenue left after paying for variable costs of production, such as
wages and raw materials.

- Profit Margin= Net Income/Sales

This ratio measures how much of every dollar of sales is converted into profit.

- Return on Total Assets (ROA)= Net Income/Total Assets

This ratio indicates how efficiently a company uses its assets to generate profit.

- Return on Common Equity (ROE) = Net Income/Common Equity

This ratio measures how well the company generates profits from its equity financing.

- Return on Invested Capital (ROIC)= Net Operating Profit After Taxes (NOPAT/Invested Capital

This ratio measures the return earned on all capital invested in the company, including both debt and
equity.

- Basic Earning Power (BEP) Ratio:= EBIT/Total Asset

This ratio indicates the earning power of the company’s assets before the influence of taxes and
interest.

f. Market Value Ratios

Market value ratios assess a company’s market value compared to its accounting values and earnings.

- Price/Earnings (P/E) Ratio = Market Price per Share/Earnings per Share (EPS

This ratio indicates how much investors are willing to pay per dollar of earnings. A higher P/E ratio may
indicate expectations of higher future growth.

- Market/Book (M/B) Ratio= Market Value per Share/Book Value per Share

This ratio compares the market value of the company’s equity to its book value, giving insight into how
investors perceive its value compared to its accounting value.
- Enterprise Value/EBITDA Ratio = Enterprise Value (EV)/EBITDA

This ratio measures the overall value of the company (debt plus equity minus cash) relative to its
earnings before interest, taxes, depreciation, and amortization. It’s often used in valuation comparisons.

g. DuPont Equation

The DuPont equation is a formula that breaks down Return on Equity (ROE) into three
components: profit margin, asset turnover, and financial leverage. This helps in understanding
what drives a company’s ROE. The basic DuPont equation is:

ROE=Profit Margin × Asset Turnover × Equity Multiplier

Profit Margin: Measures how much profit is generated per dollar of sales

Profit Margin = Net Income / Sales

Asset Turnover: Measures how efficiently the company uses its assets to generate sales

Asset Turnover = Sales / Total Assets

Equity Multiplier: Measures the degree of financial leverage

Equity Multiplier = Total Assets / Total Equity

The extended version of the DuPont equation includes more components, such as operating
efficiency (measured by the operating margin) and interest burden, providing a deeper analysis
of ROE.

Benchmarking

Benchmarking involves comparing a company's performance metrics with those of other

companies, typically within the same industry. This helps in identifying best practices, areas of
improvement, and potential competitive advantages. Benchmarking can be done against industry
averages, leading competitors, or companies in other industries that excel in certain areas.

Trend Analysis

Trend analysis involves analyzing a company's historical financial data over time to identify
patterns or trends. This can reveal whether a company’s performance is improving, deteriorating,
or remaining stable. Trend analysis is often used for forecasting future performance based on
past trends, such as sales growth, profit margins, or return on assets.

h. Window dressing refers to actions taken by a company to make its financial statements
appear more attractive to investors, creditors, or other stakeholders, usually near the end of a
reporting period. These techniques are often legal but can be misleading. Examples include:
  Boosting Sales: Offering large discounts to customers or engaging in aggressive sales
tactics to temporarily boost sales figures.
 Delaying Expenses: Deferring necessary expenses or delaying the recognition of
liabilities until after the reporting period to improve short-term profitability.
 Reducing Debt: Temporarily paying off short-term debts just before the balance sheet
date to improve liquidity ratios or reduce the debt-to-equity ratio.
 Inflating Inventory: Overvaluing inventory by not writing down obsolete or slow-
moving stock, thereby improving the current ratio.
 Reclassifying Assets: Reclassifying long-term assets as short-term or inflating asset
values to improve financial ratios.
 Accelerating Revenue Recognition: Recognizing revenue before it is earned, such as
booking future sales in the current period.

While window dressing may enhance the appearance of a company’s financial health in the short
term, it can lead to future issues when the true financial situation becomes apparent.

ST-2. Billings worth paid $2 in dividends and retained $2 per share. Since total retained earnings
rose by $12 million, 6 million shares must be outstanding. With a book value of $40 per share,
total common equity must be $40(6 million) ¼ $240 million. Since Billings worth has $120
million of debt, its debt ratio must be 33.3%.

Debt/Assets = Debt/(Debt + Equity) = 120 million/ (120 million+240 million) = 0.3333 or

33.33%

ST-3. a) Find Kaiser’s (1) accounts receivable, (2) current assets, (3) total assets, (4) ROA, (5)
common equity, (6) quick ratio, and (7) long-term debt.

1) DSO = Accounts receivable/ (Sales/365)

40.55 = AR/ (Sales/365)

AR = 40.55($2.7397) = $111.1 million

2) Current ratio = Current assets/Current liabilities = 3.0

= Current assets/$105.5 = 3.0

Current assets = 3.0($105.5) = $316.50 million

3) Total assets = Current assets + Fixed assets

= $316.5 + $283:5 = $600 million

4) ROA = Profit margin x Total assets turnover

= (Net income/Sales) x (Sales/Total assets)

= ($50/$1,000) x ($1,000/$600) = 0.083333 or 8.3333%

5) ROE = ROA x (Assets/Equity)

12.0% = 8:3333% x ($600/Equity)

Equity = (8.3333% x $600)/ 12.0% = $416.67 million

6) Current assets = Cash and equivalents + Accounts receivable + Inventories

$316:5 = $100.0 + $111.1 + Inventories

Inventories = $105:4 million

Quick ratio = (Current assets 3 Inventories)/ Current Liabilities

= ($316.5 - $105.4)/ $105.5 = 2.0

(7) Total assets = Total claims = $600 million Current liabilities +Long-term debt + Equity

= $600 million $105.5 + Long-term debt + $416.67

= $600 million Long-term debt

= $600 - $105.5 - $416.67 = $77.83 million

b. Kaiser’s average sales per day were $1,000/365 ¼ $2.74 million. Its DSO was 40.55, so A/R =
40.55($2.74) = $111.1 million. Its new DSO of 30.4 would cause A/R = 30.4($2.74) = $83.3
million. The reduction in receivables would be $111.1 - $83.3 = $27.8 million, which would
equal the amount of cash generated.
(1) New equity = Old equity - Stock bought back
= $416.7 - $27.8 = $388.9 million
Thus, New ROE = Net income/New equity
= $50/$388.9 = 12.86% versus old ROE of 12.0%
(2) New ROA = Net income/ (Total assets - Reduction in AR)
= $50/ ($600 - $27.8) = 8.74% versus old ROA of 8.33%
(3) The old debt is the same as the new debt: Debt = Total claims - Equity = $600 - $416.7 =
$183.3 million
New total assets = Old total assets - Reduction in AR
= $600 - $27.8 = $572.2 million
Therefore, Debt/Old total assets = $183.3/ $600 = 30.6%
while New debt/New total assets = $183.3/$572.2 = 32.0%