MGMT 221: Managerial Finance
Solution to Financial Statement Analysis Practice Problems
1. Explain the intuition behind the DuPont approach.
Answer: DuPont argued that firm management consists of three tasks: asset management, expense management, and debt management. Success in these areas is measured by the total asset turnover, the net profit margin, and the debt ratio. These ratio determine the firm’s return on equity, which is of critical importance to shareholders.
2. Use the DuPont method to analyze the following firm. Be sure to describe any potential strengths or weaknesses of the firm.
Ratio / Firm / IndustryAverage
current assets / current liabilities / 0.70 / 0.73
(cur. assets-inventory) / cur. liabilities / 0.63 / 0.65
sales / total assets / 0.35 / 0.35
sales / cash / 1.55 / 1.55
sales / inventory / 10.33 / 9.38
sales / net fixed assets / 0.52 / 0.53
inventory / (cost of goods sold/365) / 57.6 / 64.9
receivables / (sales/365) / 58.9 / 63.3
payables / (sales/365) / 106.0 / 102.2
debt / total assets / 89.8% / 66.5%
earnings bef. interest & taxes / interest expense / 6.20 / 4.40
net income / sales / 10.06% / 6.80%
net income / equity / 34.67% / 7.18%
net income / total assets / 3.55% / 2.41%
market value of equity / book value of equity / 4.00 / 2.25
share price / earnings per share / 11.54 / 31.37
Answer: The total asset turnover and all other turnovers are in line with industry averages. This suggests that the firm is experiencing no serious asset management problems. The firm’s debt ratio is above the industry average, but the TIE, current ratio, and quick ratio show no evidence that the firm is struggling to meet its debt payments. This suggests that the firm is benefiting from the ability to maintain a higher debt ratio than others in the industry. The firm has an above average net profit margin, which suggests that the firm is not having trouble in managing its expenses. One is attempted to go further and say that the firm is doing a particularly good job in keeping its expenses down. Note, however, that the high debt ratio provides a leverage benefit that will increase the net profit margin. It is not clear from the information given whether the high net profit margin is due to high debt or some combination of high debt and good expense control.
3. You have been investigating a certain company and have calculated the following ratios for the company and average ratios for that company’s industry.
Ratio / Company / Industry Averagecurrent ratio / 2.2 / 3.1
quick ratio / 1.2 / 2.4
inventory turnover / 16.8 / 16.5
fixed asset turnover / 6.4 / 6.2
total asset turnover / 2.6 / 2.5
collection period / 25.1 / 13.4
times interest earned / 4.8 / 5.1
debt ratio / 10% / 10%
profit margin / 6.4% / 6.2%
return on equity / 18.5% / 17.2%
return on assets / 16.7% / 15.5%
price to earnings / 17.1 / 16.8
market to book / 3.8 / 3.4
Analyze the firm from the perspective of both shareholders and debtholders. What problem area is evident (be as specific as possible). Should shareholders be concerned? Should debtholders be concerned?
Answer: As always, we begin by examining the factors of the DuPont equation. Notice that the profit margin, total assets turnover, and debt ratio (and hence the equity multiplier) are close to the industry average. This suggests that the firm has no serious problems in terms of expense control, asset management, and debt management. We do notice, however, that the average collection period is unusually high and that the current and quick ratios are unusually low. Since all three ratios deal with current assets, this suggests that the firm may be having trouble managing its current assets. Both the current ratio and quick ratio are low, so it is unlikely that inventory is contributing to the problem. This leaves accounts receivable as the most likely problem. It appears that the firm may be granting too much credit and that this has somehow contributed to the low liquidity ratios. Notice, however, that the P/E ratio, the market-to-book ratio, ROA, and ROE all look fine. We conclude that although the firm may be having some trouble with receivables, the trouble does not appear to have affected the bottom line for the firm. Thus, the firm is not experiencing any major problems and debtholders and shareholders should not be overly concerned.
4. You have decided to investigate a certain company to determine its health. The company and industry average ratios are as follows:
current ratio / 4.2 / 2.8
inventory turnover / 9 / 15
collection period / 26 / 28
fixed assets turnover / 3.9 / 5.6
total assets turnover / 2.2 / 3.4
debt ratio / 65% / 65%
profit margin / 14% / 12%
return on total assets / 9% / 14%
return on equity / 18% / 20%
price to earnings / 8 / 14
market-to-book / 1.6 / 2.4
Carefully describe any problem areas for the firm. Be sure to identify the root cause of the problems to the best of your ability.
Answer: As always, we begin by examining the factors of the DuPont equation. Notice that the profit margin and the debt ratio are fine, but that the total assets turnover is below average. This suggests that the firm is having trouble managing its assets. Inventory turnover and the current ratio are in good shape, so it is unlikely to be a problem with managing inventory. The fixed assets turnover is low, however, which indicates that the firm is having trouble managing its fixed assets. One possibility, for instance, is that the firm has fixed assets that are not being used or that are not being used to their fullest capacity. Although the profit margin and ROE are okay, ROA, P/E, and market-to-book are not. This suggests that the fixed assets problem is affecting the overall profitability of the firm. Since the ROA is low, debtholders and equityholders should be concerned, although debtholders seem to be safe in the short-term (since the current ratio is high). We conclude that the firm has a relatively serious problem in managing its fixed assets and that the market has devalued the company on that basis.
5. Since you are now a financial guru, you decide to investigate a certain company to determine its quality. The company and industry average ratios are as follows:
current ratio / 4.2 / 2.8
inventory turnover / 15 / 9
collection period / 34 / 22
fixed assets turnover / 5.2 / 5.6
total assets turnover / 3.3 / 3.4
debt ratio / 65% / 65%
profit margin / 8% / 13%
return on total assets / 9% / 14%
return on equity / 15% / 20%
price to earnings / 14 / 14
market-to-book / 1.6 / 2.4
Carefully describe any problem areas for the firm. Be sure to identify the root cause of the problems to the best of your ability.
Answer: As always, we begin by examining the factors of the DuPont equation. Notice that the debt ratio and total assets turnover are fine, but that the profit margin is low. This suggests that the firm is having trouble controlling its expenses. The firm's collection period and inventory turnover are worse than the average firm in the industry. This suggests that the expense problems deal with short-term assets in general (inventory and accounts receivable). For instance, the firm may be holding excess inventory and is consequently incurring higher costs. Since the ROA and ROE are low, it seems that the trouble is affecting the overall profitability of the firm. The market-to-book ratio suggests that shareholders have taken the problem into account, but the P/E ratio shows no evidence of this. This contradictory evidence is likely the result of a misleading earnings estimate or a misleading book value of equity.
6. You have examined a firm’s financial statements and have calculated the following ratios.
current ratio / 2.9 / 2.8
quick ratio / 2.2 / 2.1
inventory turnover / 15 / 17
collection period / 24 / 22
fixed assets turnover / 4.2 / 5.6
total assets turnover / 1.6 / 2.4
debt ratio / 65% / 65%
times interest earned / 3.8 / 3.4
profit margin / 5% / 3%
return on total assets / 10% / 14%
return on equity / 23% / 21%
price to earnings / 14 / 14
Analyze the ratios from the perspective of shareholders. What problem area is evident? Analyze the ratios from the perspective of debtholders. Will the firm be able to issue additional debt if necessary?
Answer: As always, we begin by examining the factors of the DuPont equation. The profit margin and debt ratio look good, but the total assets turnover is low. This suggests that the firm is having trouble effectively managing its assets. The inventory turnover is above average, so the problem is probably not with inventory. The fixed asset turnover is below average, however. This suggests that the problem is with fixed assets. One possible explanation is that the firm is using outdated (inefficient) machinery. Another is that the firm has fixed assets that are not currently being used. The current ratio, the quick ratio, and times-interest-earned are above average. The debt ratio is average. So, there appear to be no problems as far as debtholders are concerned. If the firm needs to issue additional debt in the near future, it should have no problems doing so.
7. BRIEFLY comment on the difficulties one faces in using financial statements to analysis the health of companies.
Answer: Financial statement analysis is difficult because we never have current numbers, the numbers we do have are accounting ones and are backward looking, and financial managers have incentives to create statements that misrepresent the true status of the firm. Furthermore, companies may have different fiscal years, which makes it difficult to determine appropriate industry averages. Most importantly, firms are not identical, so finding truly comparable companies may not be possible.