spartan1

How would the collection of accounts receivable most likely affect the current and cash ratios?

Current ratio

Cash ratio

A) Increase Increase

B) No effect No effect

C) No effect Increase

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Collecting receivables increases cash and decreases accounts receivable. Thus, current assets do not change and the current ratio is unaffected. Because the numerator of the cash ratio only includes cash and marketable securities, collecting accounts receivable increases the cash ratio.

spartan1

What would be the impact on a firm’s return on assets ratio (ROA) of the following independent transactions, assuming ROA is less than one?
Transaction #1 – A firm owned investment securities that were classified as available-for-sale and there was a recent decrease in the fair value of these securities.
Transaction #2 – A firm owned investment securities that were classified as trading securities and there was recent increase in the fair value of the securities.

Transaction #1

Transaction #2

A) Higher Lower

B) Higher Higher

C) Lower Higher

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Available-for-sale securities are reported on the balance sheet at fair value and any unrealized gains and losses bypass the income statement and are reported as an adjustment to equity. Thus, a decrease in fair value will result in a higher ROA ratio (lower assets). Trading securities are also reported on the balance sheet at fair value; however, the unrealized gains and losses are recognized in the income statement. Therefore, an increase in fair value will result in higher ROA. In this case, both the numerator and denominator are higher; however, since the ratio is less than one, the percentage change of the numerator is greater than the percentage change of the denominator, so the ratio will increase.

spartan1

Given the following income statement and balance sheet for a company:

Balance Sheet
Assets	Year 2006	Year 2007
Cash	200	450
Accounts Receivable	600	660
Inventory	500	550
Total CA	1300	1660
Plant, prop. equip	1000	1580
Total Assets	2600	3240
Liabilities
Accounts Payable	500	550
Long term debt	700	1052
Total liabilities	1200	1602
Equity
Common Stock	400	538
Retained Earnings	1000	1100
Total Liabilities & Equity	2600	3240
Income Statement
Sales		3000
Cost of Goods Sold		(1000)
Gross Profit		2000
SG&A		500
Interest Expense		151
EBT		1349
Taxes (30%)		405
Net Income		944

Which of the following is closest to the company's return on equity (ROE)?

A) 0.62.

B) 0.29.

C) 1.83.

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There are several ways to approach this question but the easiest way is to recognize that ROE = NI / average equity thus ROE = 944 / 1,519 = 0.622.
If using the traditional DuPont, ROE = (NI / Sales) × (Sales / Assets) × (Assets / Equity):
ROE = (944 / 3,000) × (3,000 / 2,920) × (2,920 / 1,519) = 0.622
The 5-part Dupont formula gives the same result:
ROE = (net income / EBT)(EBT / EBIT)(EBIT / revenue)(revenue / total assets)(total assets / total equity)
Where EBIT = EBT + interest = 1,349 + 151 = 1,500
ROE 2007 = (944 / 1,349)(1,349 / 1,500)(1,500 / 3,000)(3,000 / 2,920)(2,920 / 1,519) = 0.622

spartan1

Income Statements for Royal, Inc. for the years ended December 31, 20X0 and December 31, 20X1 were as follows (in $ millions):

	20X0	20X1
Sales	78	82
Cost of Goods Sold	(47)	(48)
Gross Profit	31	34
Sales and Administration	(13)	(14)
Operating Profit (EBIT)	18	20
Interest Expense	(6)	(10)
Earnings Before Taxes	12	10
Income Taxes	(5)	(4)
Earnings after Taxes	7	6

Analysis of these statements for trends in operating profitability reveals that, with respect to Royal’s gross profit margin and net profit margin:

A) gross profit margin decreased but net profit margin increased in 20X1.

B) gross profit margin increased in 20X1 but net profit margin decreased.

C) both gross profit margin and net profit margin increased in 20X1.

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Royal’s gross profit margin (gross profit / sales) was higher in 20X1 (34 / 82 = 41.5%) than in 20X0 (31 / 78 = 39.7%), but net profit margin (earnings after taxes / sales) declined from 7 / 78 = 9.0% in 20X0 to 6 / 82 = 7.3% in 20X1.

spartan1

Kellen Harris is a credit analyst with the First National Bank. Harris has been asked to evaluate Longhorn Supply Company’s cash needs. Harris began by calculating Longhorn’s turnover ratios for 2007. After a discussion with Longhorn’s management, Harris decides to adjust the turnover ratios for 2008 as follows:

	2007 Actual Turnover	Expected Increase / (Decrease)
Accounts receivable	5.0	10%
Fixed asset	3.0	7%
Accounts payable	6.0	(20%)
Inventory	4.0	(5%)
Equity	5.5	—
Total asset	2.3	8%

Longhorn’s expected cash conversion cycle for 2008, based on the expected changes in turnover and assuming a 365 day year, is closest to:

A) 82 days.

B) 46 days.

C) 86 days.

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2008 expected days of sales outstanding is 66 [365 / (5.0 × 1.1)], 2008 days of inventory on hand is 96 [365 / (4.0 × 0.95)], and 2008 days of payables is 76 [365 / (6.0 × 0.8)]. Expected cash conversion cycle is 86 days [66 days of sales outstanding + 96 days of inventory on hand – 76 days of payables].

spartan1

Selected financial information gathered from the Matador Corporation follows:

	2007	2006	2005
Average debt	$792,000	$800,000	$820,000
Average equity	$215,000	$294,000	$364,000
Return on assets	5.9%	6.6%	7.2%
Quick ratio	0.3	0.5	0.6
Sales	$1,650,000	$1,452,000	$1,304,000
Cost of goods sold	$1,345,000	$1,176,000	$1,043,000

Using only the data presented, which of the following statements is most correct?

A) Leverage has declined.

B) Gross profit margin has improved.

C) Return on equity has improved.

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Leverage increased as measured by the debt-to-equity ratio from 2.25 in 2005 to 3.68 in 2007. Gross profit margin declined from 20.0% in 2005 to 18.5% in 2007. Return on equity has improved since 2005. One measure of ROE is ROA × financial leverage. Financial leverage (assets / equity) can be derived by adding 1 to the debt-to-equity ratio. In 2005, ROE was 23.4% [7.2% ROA × (1 + 2.25 debt-to-equity)]. In 2007, ROE was 27.6% [5.9% ROA × (1 + 3.68 debt-to-equity)].

spartan1

Assume that Q-Tell Incorporated is in the communications industry, which has an average receivables turnover ratio of 16 times. If the Q-Tell’s receivables turnover is less than that of the industry, Q-Tell’s average receivables collection period is most likely:

A) 20 days.

B) 25 days.

C) 12 days.

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Average receivables collection period = 365 / receivables turnover, which is 22.81 days for the industry (= 365 / 16). If Q-Tell’s receivables turnover is less than 16, its average days collection period must be greater that 22.81 days.

spartan1

Comparative income statements for E Company and G Company for the year ended December 31 show the following (in $ millions):

	E Company	G Company
Sales	70	90
Cost of Goods Sold	(30)	(40)
Gross Profit	40	50
Sales and Administration	(5)	(15)
Depreciation	(5)	(10)
Operating Profit	30	25
Interest Expense	(20)	(5)
Earnings Before Taxes	10	20
Income Taxes	(4)	(8)
Earnings after Taxes	6	12

The financial risk of E Company, as measured by the interest coverage ratio, is:

A) higher than G Company's because its interest coverage ratio is less than G Company's, but at least one-third of G Company's.

B) higher than G Company's because its interest coverage ratio is less than one-third of G Company's.

C) lower than G Company's because its interest coverage ratio is at least three times G Company's.

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E Company’s interest coverage ratio (EBIT / interest expense) is (30 / 20) = 1.5.
G Company’s interest coverage ratio is (25 / 5) = 5.0. Higher interest coverage means greater ability to cover required interest and lease payments. Note that 1.5 / 5.0 = 0.30, which means the interest coverage for E Company is less than 1/3 that of G Company.

spartan1

An analyst has gathered the following information about a company:

Balance Sheet
Assets
	Cash	100
	Accounts Receivable	750
	Marketable Securities	300
	Inventory	850
	Property, Plant & Equip	900
	Accumulated Depreciation	(150)
Total Assets		2750
Liabilities and Equity
	Accounts Payable	300
	Short-Term Debt	130
	Long-Term Debt	700
	Common Equity	1000
	Retained Earnings	620
Total Liab. and Stockholder's equity		2750
Income Statement
Sales		1500
COGS		1100
Gross Profit		400
SG&A		150
Operating Profit		250
Interest Expense		25
Taxes		75
Net Income		150

What is the ROE?

A) 10.7%.

B) 9.9%.

C) 9.3%.

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ROE = 150(NI) / [1000(common) + 620(RE)] = 150 / 1620 = 0.0926 or 9.3%

spartan1

What is the net income of a firm that has a return on equity of 12%, a leverage ratio of 1.5, an asset turnover of 2, and revenue of $1 million?

A) $360,000.

B) $36,000.

C) $40,000.

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The traditional DuPont system is given as:
ROE = (net profit margin)(asset turnover)(leverage ratio)
Solving for the net profit margin yields:
0.12 = (net profit margin) × (2) × (1.5)
0.04 = (net profit margin)
Recognizing that the net profit margin is equal to net income / revenue we can substitute that relationship into the above equation and solve for net income:0.04 = net income / revenue = net income / $1,000,000  
$40,000 = net income.