LDP 3.4 Analyzing combined BS and IS

Question 1

Financial productivity

Answer 1

• Company’s ability to generate profit from its assets and its measures are often referred to as rates of return.
• It relates profit to assets and net worth and provides another method for evaluating profitability.
• Measured through ROA or ROE

Question 2

ROA

Answer 2

Profit before or after tax / average assets

• measures management’s overall effectiveness in using a company’s total resources to make a profit
• How many pennies of profit were generated from each dollar of assets?

Question 3

Basic measure of ROA has two limitations

Answer 3

1) after-tax profit version can be distorted by tax strategies. Can be reduced by using before-tax profit.
2) related to total assets. When a company’s assets grow or shrink significantly during the year, using a figure for year-end assets can give a misleading indication of ROA. Use 2-year average

Question 4

ROE

Answer 4

Net income / NW

• expresses net income for a year as a percentage of year-end net worth
• expressing profit as a percentage of net worth
• To eliminate distortions caused by large changes during the year in the amount of net worth, use return on average equity.
• A third variation: divide profit before taxes by tangible net worth –> used to compare with RMA Annual Statement Studies

Question 5

If a company has an abnormally high sales-to-assets ratio, it may result from several causes.

Answer 5

• It may mean the company is on the verge of needing additional investments in assets
• it depreciates assets faster than the industry average
• it is leasing more of its assets under operating leases than the industry average
• it uses an inventory accounting method that understates inventory in relation to the industry.

Question 6

STUDY JOB AID 3.4

Answer 6

For asset turnover, A/R efficiency, Inv turnover efficiency, AP efficiency, Working capital turnover

Question 7

Asset Turnover

Answer 7

= Sales / Total Assets

• measures the total asset turnover by analyzing the relationship of annual net sales to total assets.
• In order for a company to use its assets efficiently, it must increase its asset turnover throughout the year.

Question 8

Limitations of Turnover Ratios

Answer 8

Turnover ratios are not as useful in analyzing service companies and other companies that have low investment in assets.

They can obscure or be obscured by seasonal fluctuations in sales or asset levels.

They imply, incorrectly, that all members of the asset category turn over with the same frequency.

They do not distinguish between assets of good or poor quality.

Question 9

Usefulness of Turnover Ratios

Answer 9

Useful in discovering borrowing causes and repayment sources and in evaluating management actions, because turnover ratios measure a company’s need for assets in relation to its sales.

Question 10

Accounts Receivable Efficiency

Answer 10

A/R Turnover = Nets Sales / AR

Days Sales O/S in AR = 365 / AR Turnover

Question 11

Inventory Turnover Efficiency

Answer 11

Inventory Turnover = COGS / Inventory

Days’ COGS in Inventory = 365 / Inventory Turnover

Question 12

Accounts Payable Efficiency

Answer 12

AP Turnover = COGS or Payables / AP

Days’ COGS or Purchases in AP = 365 / AP Turnover

Question 13

Working Capital Turnover

Answer 13

= Net Sales / Working Capital