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Published by Taleb Alsumain

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Published by: Taleb Alsumain on Mar 04, 2013
Copyright:Attribution Non-commercial


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Chapter 4Analyzing Financial Statements
Critical Thinking Questions
What does it mean when a company’s return on assets (ROA) is equal to its return onequity (ROE)?When ROA equals ROE, it means that the firm does not use any leverage. For firms thatdo use leverage, ROE will be higher than ROA.
Why is too much liquidity not a good thing? Too much liquidity could mean that a firm is not putting its money to work as theshareholders would want it to. It could mean that the firms managers are being tooconservative and investing in low-yield assets, or it could mean that the firm does nothave enough investment opportunities and is therefore hanging onto its cash. Recently,several firms including Microsoft had several billions of dollars in cash on their books,and, ultimately, Microsoft paid a special dividend to its shareholders. Too much liquiditycan also make it a takeover target for firms looking to utilize the debt capacity of theliquid firm.
Inventory is excluded when the quick ratio or acid-test ratio is calculated becauseinventory is the most difficult current asset to convert to cash without loss of value. Whattypes of inventory are likely to be most easily converted to cash?For the quick ratio, one uses only the most liquid of all assets—that is, all current assetsless inventory, which is not very liquid relative to cash or receivables. While the currentratio assumes that inventory could be sold at book value, the quick ratio assumes thatinventory has no value. Hence, this gives a more conservative estimate of a firmsliquidity than the current ratio, and gives a better estimate of the firm’s ability to meet itsshort-term obligations.
What does a very high inventory turnover ratio signify? This could mean a number of things, including that the firm is using up its inventory toofast and is unable to meet the demand for its products, or it has priced its products toolow relative to its competitors, or worse, the firm is selling defective products that wouldeventually be returned.
How would one explain a low receivables turnover ratio?A low receivables turnover implies a high DSO. This could mean that the firmscustomers are not paying on time, either because of an inefficient collection system orbecause of a slowdown in their customers’ business or even in the entire economy.
What additional information does the fixed assets turnover ratio provide over the totalassets turnover ratio? For which industries does it carry greater significance? The total assets turnover ratio measures the level of sales per dollar invested in totalassets. The higher the number, the more efficiently the management is using the firm’sassets. Too high a number relative to its peers could imply that the firm is reaching its fullcapacity and may require an additional investment in plant and equipment to generateadditional sales. The fixed asset turnover ratio can be utilized to break down theperformance of individual manufacturing facilities or a division. This ratio providessignificant information for manufacturing firms that are capital-intensive, while it will beof much less significance for the service industry, where there is less reliance on plantand equipment.
How does financial leverage help shareholders?Financial leverage implies the use of debt capital in addition to the owners’ capital tofinance the firm. With the addition of debt, the owners’ capital can go a long way inacquiring assets for the firm. Given that creditors only get the fixed-interest payments anddo not get any share of the gains from the company, the shareholders gain from the usageof debt. This is called the leverage multiplier effect. As the company’s revenues grow,shareholders get all the gain and the debt holders merely receive their interest payments.

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