Questions and Answers
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1. What are the primary limitations of ratio analysis as a technique of financial statement analysis?
2. What is the major limitation of the current ratio as a measure of a firm’s liquidity? How may this limitation be overcome?
3. What problems may be indicated by an average collection period that is substantially above or below the industry average?
4. What problems may be indicated by an inventory turnover ratio that is substantially above or below the industry average?
5. What are the three most important determinants of a firm’s return on stock- holders’ equity?
6. How can inflation affect the comparability of financial ratios between firms?
7. The Farmers State Bank recently has been earning an “above average” (compared to the overall banking industry) return on total assets of 1.50 percent. The bank’s return on common equity is only 12 percent, compared with an industry average of 15 percent.
a. What reasons can you give for the bank’s lower turn on common equity?
b. What impact do you think this performance by the bank is having on the value of its debt and equity securities?
8. Vanity Press, Inc., has annual credit sales of $1.6 million and a gross profit margin of 35 percent.
a. If the firm wishes to maintain an average collection period of 50 days, what level of accounts receivable should it carry? (Assume a 365-day year.)
b. The inventory turnover for this industry averages six times. If all of Vanity’s sales are on credit, what average level of inventory should the firm maintain to achieve the same inventory turnover figure as the industry?
9. Clovis Industries had sales in 2013 of $40 million, 20 percent of which were cash. If Clovis normally carries 45 days of credit sales in accounts receivable, what are its average accounts receivable balances? (Assume a 365-day year.)
10. The Sooner Equipment Company has total assets of $100 million. Of this total, $40 million was financed with common equity and $60 million with debt (both long- and short-term). Its average accounts receivable balance is $20 million, and this represents an 80-day average collection period. Sooner believes it can reduce its average col- lection period from 80 to 60 days without affecting sales or the dollar amount of net income after taxes (currently $5 million). What will be the effect of this action on Sooner’s return on investment and its return on stockholders’ equity if the funds received by reducing the average collection period are used to buy back its common stock at book value? What impact will this action have on Sooner’s debt ratio?