Chapter 4

Question 1

why are ratios useful?

Answer 1

• standardize numbers and facilitate comparisons***
• used to highlight weaknesses and strengths
• ration comparisons should be made through time and with competitors (industry analysis, bench mark analysis, trend analysis)

Question 2

liquidity

Answer 2

can we make required payments?

how well can the compnay cover short term obligations

Question 3

assets management

Answer 3

right amount of assets vs sales?

how effective are we employing assets to maximize performance?

Question 4

debt management

Answer 4

right mix of debt and equity?

how are we financing assets? debt? equity?

Question 5

profitability

Answer 5

do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?
how well are we managing cost? how much of our net income do we actually get to keep?

Question 6

effects of dent on ROA and ROE

Answer 6

if debt increases

• equity declines
• interest expense increases (which leads to a reduction in NI)

ROA declines (due to the reduction in Net Income)

ROE may increase or decrease (since both NI and equity decline)

Question 7

problems with ROE

Answer 7

ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of performance because

• roe does not consider risk
• roe does not consider the amount of capital invested

Question 8

ratio analysis can be done using the ___ equation

Answer 8

DuPont

Question 9

DuPont Equation

Answer 9

• allows us to analyze a company’s performance

- through this systematic approach, we find why ROE changed and how it did

Question 10

potential uses of freed up cash

Answer 10

• repurchase stock
• expand business
• reduce debt
• all these actions would likely improve the stock price

Question 11

potential problems and limitations of financial ratio analysis

Answer 11

• comparisons with industry averages is difficult for a conglomerate firm that operates in many different divisions
• different operating and accounting practices can distort comparisons
• sometimes it is hard to tell if a ratio is good or bad
• difficult to tell whether a company is, on balance, in a strong or weak position
• “average” performance is not necessarily good, perhaps the firm should aim higher
• seasonal factors can distort ratios
• “window dressing” techniques can make statements and ratios look better than they actually are
• inflation has distorted many firms’ balance sheets, so analyses must be interpreted with judment

Question 12

consider qualitative factors when evaluating a company’s future financial performance

Answer 12

• are the firm’s revenue tied to one key customer, product, or supplier?
• what percentage of the firm’s business is generated overseas?
• firm’s competitive environment
• future prospects
• legal and regulatory environment