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.

terpsichorefan

thanks for sharing

Gypsy

Patch Grove Nursery uses the LIFO inventory accounting method. Maria Huff, president, wants to determine the financial statement impact of changing to the FIFO accounting method. Selected company information follows:

• Year-end inventory: $22,000
• LIFO reserve: $4,000
• Change in LIFO reserve: $1,000
• LIFO cost of goods sold: $18,000
• After-tax income: $2,000
• Tax rate: 40%

Under FIFO, the nursery’s ending inventory and after-tax profit for the year would have been:

FIFO ending inventory

FIFO after-tax profit

A) $18,000 $2,600

B) $26,000 $2,600

C) $26,000 $1,400

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FIFO ending inventory = LIFO ending inventory + LIFO reserve = 22,000 + 4,000 = $26,000
FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 − t) = $2,000 + ($1,000)(1 − 0.4) = $2,000 + $600 = $2,600

Gypsy

At the end of 2007, Decatur Corporation reported last-in, first-out (LIFO) inventory of $20 million, cost of goods sold (COGS) of $64 million, and inventory purchases of $58 million. If the LIFO reserve was $6 million at the end of 2006 and $16 million at the end of 2007, compute first-in, first-out (FIFO) inventory at the end of 2007 and FIFO COGS for the year ended 2007.

FIFO Inventory

FIFO COGS

A) $36 million $54 million

B) $26 million $54 million

C) $36 million $74 million

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2007 FIFO inventory was $36 million ($20 million LIFO inventory + $16 million reserve). 2007 FIFO COGS was $54 million ($64 million LIFO COGS – $10 million increase in LIFO reserve).

Gypsy

Falcon Financial Group is considering the purchase of Company A or Company B based on a low price-to-book investment strategy that also considers differences in solvency. Selected financial data for both firms, as of December 31, 20X7, follows:

in millions, except per-share data	Company A	Company B
Current assets	$3,000	$5,500
Fixed assets	$5,700	$5,500
Total debt	$2,700	$3,500
Common equity	$6,000	$7,500
Outstanding shares	500	750
Market price per share	$26.00	$22.50

The firms’ financial statement footnotes contain the following:

• Company A values its inventory using the first in, first out (FIFO) method.
• Company B’s inventory is based on the last in, first out (LIFO) method. Had Company B used FIFO, its inventory would have been $700 million higher.
• Company A leases its manufacturing plant. The remaining operating lease payments total $1,600 million. Discounted at 10%, the present value of the remaining payments is $1,000 million.
• Company B owns its manufacturing plant.

To make the firms financials ratios comparable, calculate the adjusted price-to-book ratios for Company A and Company B.

Company A

Company B

A) $2.17 $2.81

B) $1.63 $2.06

C) $2.17 $2.06

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Company A should be adjusted for the operating lease liability and the related assets; however, adding the present value of the lease payments to both assets and liabilities does not change equity (book value). Thus, Company A’s adjusted P/B ratio is 2.17 = [$26 price / ($6,000 million equity / $500 million shares)]. Company B’s inventory should be adjusted back to FIFO by adding the LIFO reserve to both assets and equity. Thus, Company B’s P/B ratio is 2.06 = $22.50 / [($7,500 million equity + $700 million LIFO reserve) / 750 million shares].

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.

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

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

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

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.