RANSFORD U MOLLISON
02/10/2018
GF530 -
Financial
Statement
Analysis
Unit 4 Assignment 1 Textbook Questions
GF530 - Financial Statement Analysis
4.4 Profit Margin for ROA versus ROCE. Describe the difference between the profit margin for ROA
and the profit margin for ROCE. Explain why each profit margin is appropriate for measuring the
ROA profit margin doesn’t include subtractions for the cost of equity or debt financing while the
profit margin for ROCE makes subtractions for all costs of financing above common shareholders.
These profit margins are appropriate because the purpose of ROA is to provide a measure of how well a
firm uses its assets to generate earnings without worrying about how the firm financed the assets. The
purpose of ROCE is to show how well the firm has used the capital contributed by more senior sources
4.6 Advantages of Financial Leverage. A company president remarked, ‘‘The operations of our company
are such that we can take advantage of only a minor amount of financial leverage.’’ Explain the likely
Financial leverage involves using assets financed with debt and preferred equity and earning a
higher return on those assets (that is, ROA) than the cost of these sources of capital. (Wahlen pp. 261,
270) There are two possable reasons the company president would make this statement. First, the firm is
earning such a small ROA that it barely exceeds the cost of financing through debt and preferred stock.
The second option is that the firm has very little capacity to carry debt, except at an extremely high cost;
possibly because their products have very short product life cycles or the firm itself has few collateral
assets.
4.7 Disadvantages of Financial Leverage. The intuition behind the benefits of financial leverage is that a
firm can borrow funds that bear a certain interest rate but invest those funds in assets that generate
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GF530 - Financial Statement Analysis
returns in excess of that rate. Why would firms with high ROAs not keep leveraging up their firm by
As a firm continues to leverage up, the cost of borrowing increases. As Such, even if the current
ROA exceeds the current cost of borrowing, the increase in borrowing costs would result in interest rates
approaching or exceeding ROA. The firm may not be able to instantaneously deploy financed assets
appropriately. Many growth firms that generate high ROA tend to overinvest, only to end up realizing
4.18 Calculating and Interpreting Accounts Receivable and Inventory Turnover Ratios. Nucor and AK
Steel are steel manufacturers. Nucor produces steel in mini-mills. Mini-mills transform scrap
ferrous metals into standard sizes of rolled steel, which Nucor then sells to steel service centers and
distributors. Its steel falls on the lower end in terms of quality (strength and durability). AK Steel is
an integrated steel producer, transforming ferrous metals into rolled steel and then into various
steel products for the automobile, appliance, construction, and other industries. Its steel falls on the
higher end in terms of quality. Exhibit 4.25 sets forth various data for these two companies for two
recent years.
REQUIRED
a. Calculate the accounts receivable turnovers for Nucor and AK Steel for Year 1 and Year 2.
The accounts receivable turnovers for Nucor and AK Steel are shown in the calculations
below. Nucor’s accounts receivable turnover increased from 12.38 to 16.66 and AK Steel’s
Year1 Year 2
$23,633 $16,593
Nucor: = 16.7 = 12.4
$1,420 $1,340
= 13.4 = 10.2
$572 $686
b. Describe the likely reasons for the differences in the accounts receivable turnovers for these
two firms.
Nucor’s faster accounts receivable turnovers are likely due to the fact that it sells to steel
service centers and distributors rather than automobile, appliance, and construction industries
like AK Steel. Nucor’s customer base has wider uses for the product and therefore there is a
wider variety of customers exist to purchase the steel. On the other hand, AK Steel has a limited
customer base and may need to provide more liberal credit terms to be able to sell their products
c. Describe the likely reasons for the trend in the accounts receivable turnovers of these two
The most likely reason for the trend is that the accounts receivable turnover of both
Nucor and AK Steel increased across years, but that of Nucor increased significantly. The
growth rate in sales of Nucor was considerably higher than that of AK Steel. Perhaps Nucor
offered less liberal credit terms during this time of increased sales. The increase could also be
due to customers being willing to pay more quickly for access to Nucor’s products.
d. Calculate the inventory turnovers for Nucor and AK Steel for Year 1 and Year 2.
The inventory turnovers for Nucor and AK Steel are shown in the calculations below.
Nucor’s dropped from 10.7 to 7.90 while AK Steel’s increase from 9.5 to 9.8 over the same time
frame.
Year1 Year 2
$19,612 $13,035
Ak Steeel: = 9.8 = 9.5
$2,005 $1,371
= 10.7 = 7.9
$607 $752
e. Describe the likely reasons for the differences in the inventory turnovers of these two firms.
Based on the given information, the likely difference is probably distribution in the sense
that Nucor had higher inventory turnover than AK Steel in Year 1, but lower inventory turnover
in Year 2. Nucor is not an integrated steel producer. It ships rolled steel products directly to steel
service centers and distributors. AK Steel is an integrated steel producer. It transforms raw steel
f. Describe the likely reasons for the trend in the inventory turnovers of these two firms during
AK Steel’s decline in inventories coupled with increased sales from Year 1 to Year 2
resulted in a lower inventory turnover because the company was able to sell their inventory more
quickly. Nucor’s inventory turnover decreased because the costs of goods sold, likely due to
economies of scale, while inventory increased. The company can likely change production
capacity quickly since it is not an integrated producer and manufactures more standardized
products. The cost of goods sold to sales percentages in Year 1 were 78.6% ($13,035/$16,593)
for Nucor and 84.3% ($5,904/$7,003) for AK Steel. The corresponding percentages for Year 2
were 82.9% ($19,612/$23,663) for Nucor and 84.8% ($6,479/$7,644) for AK Steel. Increased
percentages is probably caused from a combination of lower selling prices and slightly increased
in put prices.
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GF530 - Financial Statement Analysis
5.3 Relation between Current Ratio and Operating Cash Flow to Current Liabilities Ratio. A firm has
experienced an increasing current ratio but a decreasing operating cash flow to current liabilities
ratio during the last three years. What is the likely explanation for these results?
The difference between the current ratio and quick ratio calculations is inventory. Current
ratio includes inventory in the current asset total while the quick ratio subtracts inventory from
current assets before dividing by current liabilities. Since both ratios have the same denominator,
any difference between the two must occur in the numerator. In order for the current ratio to
decrease while the quick ratio increases, inventory must decrease. A decrease in inventory would
result in less total current assets for the current ratio and would result in less being subtracted from
5.10 Interpreting Altman’s Z-score Bankruptcy Prediction Model. Altman’s bankruptcy prediction
model places a coefficient of 3.3 on the earnings before interest and taxes divided by total assets
variable but a coefficient of only 1.0 on the sales to total assets variable. Does this mean that the
earnings variable is 3.3 times as important in predicting bankruptcy as the assets turnover variable?
Explain.
There is a variation in the size of the coefficient particualy because of the usual size of
the variable measured. Earnings before interest and taxes as a percentage of total assets is usually
around 0.05 to 0.10, whereas sales divided by assets is usually greater than 1.0. (Wahlen, pp. 373
– 376) If the coefficient times the value of the variable isnviewed as a relative weight of
importance, a bigger number for any of the variables increases the size of the Z-score and
reduces the probability of bankruptcy. On the other hand, the individual variables in a
5.13 Calculating and Interpreting Risk Ratios. Refer to the financial statement data for Hasbro in
Problem 4.24 in Chapter 4. Exhibit 5.15 presents risk ratios for Hasbro for Year 2 and Year 3.
Exhibit 5.15
REQUIRED
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GF530 - Financial Statement Analysis
Days Inventory:
b. Assess the changes in the short-term liquidity risk of Hasbro between Year 2 and Year 4 and
The changes in the short-term liquidity risk ratios present mixed signals. Hasbro has built
up its balance in cash so that it has more days of revenue held in cash. This trend provides
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GF530 - Financial Statement Analysis
Hasbro with liquidity and reduces its short-term liquidity risk. The current and quick ratios were
steady during the three years and athealthy levels. Again, these results suggest low short-term
liquidity risk. Theoperating cash flow to current liabilities ratio declined, and by Year 4, it
wasless than the 40% found for healthy companies. The decrease in this ratio is theresult of
declining cash flow from operations and increasing current liabilities.Net income increased each
year so that the declining cash flow from operationsis the result of changes in non-cash revenues
and expenses and in operating working capital accounts. Exhibit 4.30 indicates that the addback
for depreciationand amortization decreased during the three years. Depreciation and amortization
do not affect cash flows; the smaller addback simply offsets the smaller expense. Thus, changes
in depreciation and amortization do not explain the declining cash flow from operations. It
appears that the explanation lies primarilyin a decrease in prepayments in Year 2 and a decrease
in accounts payable and other current liabilities in Year 4. The analyst would be concerned with
the decrease in current liabilities in Year 4 only if it signaled pressure from suppliers of various
goods and services to pay their amounts due. Even then, Hasbro has more than sufficient cash
and accounts receivable to cover all current liabilities. The net days of working capital declined
sharply between Year 2 and Year 3 as a result of reducing the days accounts receivable and
inventory being held, a positive sign in terms of reducing short-term liquidity risk. This occurred
in a year when sales increased. The net days of working capital increased again in Year 4, a year
in which sales decreased. It would not appear that Hasbro is unduly risky in terms of short-term
liquidity risk at the end of Year 4. Its currentand quick ratios are at healthy levels and its days
inventory and accounts payable have been steady for the past two years. The only troublesome
aspect is the declining operating cash flow to current liabilities ratio. This ratio is not at a level of
extreme concern in Year 4, but a continuation of this trend could become troublesome.
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GF530 - Financial Statement Analysis
c. Assess the changes in the long-term solvency risk of Hasbro between Year 2 and Year 4 and
Hasbro’s long-term solvency risk has decreased significantly during the threeyear period.
Debt levels have declined as Hasbro has redeemed debt. (See Hasbro’s statement of cash flow in
Exhibit 4.30.) Its interest coverage ratio has increased from a worrisome level in Year 2 to a very
healthy level in Year 4. The latter occurred because of a reduction in borrowing and an increase
in net income. Its operating cash flow to total liabilities ratio has been steady and above the 20%
threshold for a healthy company. The reduced debt offset the declining cash flow from
operations to provide a relatively stable cash flow ratio. The level of long-term solvency risk at
Reference:
Wahlen, James M. Financial Reporting, Financial Statement Analysis and Valuation, 8th Edition. Cengage
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