Financial Reporting and Analysis 【Reading 35】Sample customers, companies, quality, motorcycle

Gypsy

National Scooter Company and Continental Chopper Company are motorcycle manufacturing companies. National’s target market includes consumers that are switching to motorcycles because of the high cost of operating automobiles and they compete on price with other manufacturers. The average age of National’s customers is 24 years. Continental manufactures premium motorcycles and aftermarket accessories and competes on the basis of quality and innovative design. Continental is in the third year of a five-year project to develop a customized hybrid motorcycle. Which of the two firms would most likely report higher gross profit margin, and which firm would most likely report higher operating expense stated as a percentage of total cost?

Higher gross profit margin

Higher percentage operating expense

A) Continental National

B) National Continental

C) Continental Continental

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Continental likely has the highest gross profit margin percentage since it is selling a customized product and does not compete primarily based on price. Because of the research and development costs of developing a new hybrid motorcycle, Continental likely has the higher operating expense stated as a percentage of total cost.

Gypsy

According to the Management Discussion and Analysis section of Frankfurt Supply Company’s annual report, Frankfurt recently decreased the sales prices of its products in order to increase market share. In addition, Frankfurt recently lowered its requirements for credit customers and increased the credit limits of some customers. What is the most likely impact on Frankfurt’s accounts receivable turnover and inventory turnover as a result of these changes?

A) Only one will decrease.

B) Both will decrease.

C) Both will increase.

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Accounts receivable turnover will likely decrease as a result of offering credit to customers with weak credit histories. Collections will likely slow down and bad debt expense will likely increase. Inventory turnover is likely to increase as sales of Frankfurt’s products increase from more liberal credit terms and the decrease in price.

Gypsy

Sterling Company is a start-up technology firm that has been experiencing super-normal growth over the past two years. Selected common-size financial information follows:

	2007 Actual % of Sales	2008 Forecast % of Sales
Sales	100%	100%
Cost of goods sold	60%	55%
Selling and administration expenses	25%	20%
Depreciation expense	10%	10%
Net income	5%	15%
Non-cash operating working capital a	20%	25%
a Non-cash operating working capital = Receivables + Inventory – Payables

For the year ended 2007, Sterling reported sales of $20 million. Sterling expects that sales will increase 50% in 2008. Ignoring income taxes, what is Sterling’s forecast operating cash flow for the year ended 2008, and is this forecast likely to be as reliable as a forecast for a large, well diversified, firm operating in mature industries?

Operating cash flow

Reliable forecast

A) $4.5 million No

B) $4.0 million No

C) $4.0 million Yes

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2008 sales are expected to be $30 million ($20 million 2007 sales × 1.5) and 2008 net income is expected to be $4.5 million ($30 million 2008 sales × 15%). 2007 non-cash operating working capital was $4 million ($20 million 2007 sales × 20%) and 2008 non-cash operating working capital is expected to be $7.5 million ($30 million 2008 sales × 25%). 2008 operating cash flow is expected to be $4 million ($4.5 million 2008 net income + $3 million 2008 depreciation – $3.5 million increase in non-cash operating working capital). Forecasts for small firms, start-ups, or firms operating in volatile industries may be less reliable than a forecast for a large, well diversified, firm operating in mature industries.

Gypsy

Would projecting future financial performance based on past trends provide a reliable basis for valuation of the following firms?Firm #1 – A rapidly growing company that has made numerous acquisitions and divestitures.

Firm #2 – A large, well-diversified, company operating in a number of mature industries.

Firm #1

Firm #2

A) Yes No

B) No Yes

C) No No

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Using past trends to project future financial performance would be reliable for a well-diversified firm operating in a number of mature industries. The diversified firm would likely have relatively predictable earnings. Using past trends to project future financial performance would not likely be reliable for the rapidly growing firm involved in numerous acquisitions and divestitures. Such a firm would likely have high earnings volatility.

Gypsy

For 2007, Morris Company had 73 days of inventory on hand. Morris would like to decrease its days of inventory on hand to 50. Morris’ cost of goods sold for 2007 was $100 million. Morris expects cost of goods sold to be $124.1 million in 2008. Assuming a 365 day year, compute the impact on Morris’ operating cash flow of the change in average inventory for 2008.

A) $6.3 million source of cash.

B) $3.0 million source of cash.

C) $3.0 million use of cash.

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2007 inventory turnover was 5 (365 / 73 days in inventory). Given inventory turnover and COGS, 2007 average inventory was $20 million ($100 million COGS / 5 inventory turnover). 2008 inventory turnover is expected to be 7.3 (365 / 50 days in inventory). Given expected inventory turnover, 2008 average inventory is $17 million ($124.1 million COGS / 7.3 expected inventory turnover). To achieve 50 days of inventory on hand, average inventory must decline $3 million ($20 million 2007 average inventory – $17 million 2008 expected inventory). A decrease in inventory is a source of cash.

Gypsy

Statement #1 – From a lender’s perspective, higher volatility of a borrower's profit margins is undesirable for floating-rate debt but not for fixed-rate debt.Statement #2 – Product and geographic diversification should lower a borrower's credit risk.
With respect to these statements:

A) only one is correct.

B) both are incorrect.

C) both are correct.

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Margin stability is desirable from the lender’s perspective for both floating-rate and fixed-rate debt. Higher volatility will increase credit risk. Product and geographic diversification should lower credit risk as the borrower is less sensitive to adverse events and conditions.

Gypsy

When assessing credit risk, which of the following ratios would best measure a firm’s tolerance for additional debt and a firm’s operational efficiency?Ratio #1 – Retained cash flow (CFO – dividends) divided by total debt.
Ratio #2 – Current assets divided by current liabilities.
Ratio #3 – Earnings before interest, taxes, depreciation, and amortization divided by revenues.

Tolerance for leverage

Operational efficiency

A) Ratio #1 Ratio #3

B) Ratio #2 Ratio #3

C) Ratio #3 Ratio #1

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A firm’s tolerance for additional debt can be measured by its capacity to repay debt. Retained cash flow divided by total debt is one of several measures that can be used. Operational efficiency refers to the firm’s cost structure and can be measured by the “margin” ratios. EBITDA divided by sales is one version of an operating margin ratio. The current ratio is a measure of short-term liquidity.

Gypsy

Selected financial information gathered from Alpha Company and Omega Corporation follows:

	Alpha	Omega
Revenue	$1,650,000	$1,452,000
Earnings before interest, taxes,   depreciation, and amortization	69,400	79,300
Quick assets	216,700	211,300
Average fixed assets	300,000	323,000
Current liabilities	361,000	404,400
Interest expense	44,000	58,100

Which of the following statements is most accurate?

A) Omega uses its fixed assets more efficiently than Alpha.

B) Omega has less tolerance for leverage than Alpha.

C) Alpha is more operationally efficient than Omega.

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Using the EBITDA coverage (EBITDA / Interest expense) to measure leverage tolerance, Omega has less tolerance for leverage. Omega’s EBITDA coverage is 1.4 ($79,300 EBITDA / $58,100 interest expense) and Alpha’s EBITDA coverage is 1.6 ($69,400 EBITDA / $44,000 interest expense). Using EBITDA margin to measure operational efficiency, Alpha is less operationally efficient than Omega. Alpha’s EBITDA margin is 4.2% ($69,400 EBITDA / $1,650,000 revenue) and Omega’s EBITDA margin is 5.5% ($79,300 EBITDA / $1,452,000 revenue). Using fixed asset turnover to measure the efficiency of fixed assets, Omega uses its fixed assets less efficiently than Alpha. Alpha’s fixed asset turnover is 5.5 ($1,650,000 revenue / $300,000 average fixed assets) and Omega’s fixed asset turnover is 4.5 ($1,452,000 revenue / $323,000 average fixed assets).

Gypsy

Cody Scott would like to screen potential equity investments to identify value stocks and selects firms that have low price-to-sales ratios. Unfortunately, screening stocks based only on this criterion may result in stocks that have poor profitability or high financial leverage, which are undesirable to Scott. Which of the following filters could be added to the stock screen to best control for poor profitability and high financial leverage?
Filter #1 – Include only stocks with a debt-to-equity ratio that is above a certain benchmark value.Filter #2 – Include only dividend paying stocks.
Filter #3 – Include only stocks with an assets-to-equity ratio that is below a certain benchmark value.
Filter #4 – Include only stocks with a positive return-on-equity.

Poor profitability

High financial leverage

A) Filter #4 Filter #1

B) Filter #4 Filter #3

C) Filter #2 Filter #3

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Firms that have poor profitability are more likely to be non-dividend paying. Selecting only dividend paying stocks can serve as a check on poor profitability. Using positive ROE to control for poor performance can result in bogus results without additional filters. For example, if both the numerator (net income) and the denominator (average equity) are negative, ROE will be positive. The higher the assets-to-equity ratio, the higher the leverage. Selecting only stocks with an assets-to-equity ratio below a certain cut-off point will eliminate stocks with high leverage. Debt-to-equity above a certain point would include firms with higher, not lower, financial leverage.

Gypsy

Comet Corporation is a capital intensive, growing firm. Comet operates in an inflationary environment and its inventory quantities are stable. Which of the following accounting methods will cause Comet to report a lower price-to-book ratio, all else equal?

Inventory method

Depreciation method

A) First-in, First-out Accelerated

B) Last-in, First-out Accelerated

C) First-in, First-out Straight-line

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FIFO results in higher assets and higher equity in an inflationary environment as compared to LIFO. Equity is higher because COGS is lower (and inventory higher) under FIFO. Straight-line depreciation will result in greater assets and equity compared to accelerated depreciation for a stable or growing firm. Equity is greater because depreciation expense is less with straight-line depreciation. Greater equity will result in greater book value per common share, the denominator of the price-to-book ratio. Greater book value per share will result in a lower price-to-book ratio.