MA-303



MB 663 -Quiz #1 Answers

June 6, 2009

1. Assume a firm has the following characteristics.

Cash $ 5,000

Cash receipts from sold production 120,000

Cash operating expenses 98,000

Time and savings deposits 7,000

Other current assets 6,000

Machinery and equipment 56,500

Buildings and other improvements 14,000

Land 72,000

Allowance for income taxes 7,213

Accounts payable 1,200

Repairs and maintenance 2,700

Mortgages outstanding less current payment 49,500

Other long term liabilities 1,200

Depreciation 7,400

Interest payments on long term loans 2,500

Current payment on long term loans 7,500

Withdrawals for other uses of funds 5,000

What is your assessment of this firm’s financial structure? Include in your analysis the calculation of measures of the firm’s liquidity, solvency, profitability, efficiency and debt repayment capacity. Please include a discussion of how you interpret the values you calculated. (15 points)

(SHOW ALL CALCULATIONS FOR FULL CREDIT)

Total current assets = 5,000 + 7,000 + 6,000 = 18,000

Total current liabilities = 7,500 + 1,200 + 7,213 = 15,913

Current ratio = 18,000/15,913 = 1.13

Working capital = 18,000 – 15,913 = 2,087

Conclusion: The firm is liquid, with a current ratio above the minimum of 1.0 and positive working capital.

Total assets = total current assets + 56,500 +14,000 + 72,000 = 160,500

Total liabilities = total current liabilities + 49,500 + 1,200 = 66,613

Debt ratio = total liabilities/total assets = $66,613/160,500 = 0.42

Leverage ratio = total liabilities/equity = 66,613/93,887 = 0.71

Conclusion: The firm is solvent, but the debt ratio and leverage ratio are approaching cutoff levels typically established by lenders.

Cash receipts from sales = 120,000

Total expenses = 98,000 + 2,500 + 7,400 = 107,900

EBIT = 120,000 – 98,000 = 22,000

Net income from operations = 12,100

Provision for income taxes = 7,213

Net income = 12,100 – 7,213 = 4,887

ROA = (4,887 + 2,500)/160,500

= 7,387/160,500 = .046 or 4.6%

ROE = 4,887/(160,500 – 66,613) = 4,887/93,887 = .0521 or 5.21%

Variable expense ratio = 91,800/120,000 = 81.67%

Total asset turnover ratio = 120,000/160,500 = 74.77%

Conclusion: The firm is profitable (net income from operations, ROA and ROE are positive). Its efficiency implications associated with variable expenses and asset turnover ratio are relatively low.

2. What are the major implications of the Beaver study for financial statement analysis? (5 points)

Your answer should contain the following points:

a. No single financial statement adequately explains the economic performance and financial strength of the firm. You need all three statements at minimum.

b. A firm can fail even if it is liquid at the time of failure. The firm’s that failed in the Beaver study averaged current ratios above 2.0.

c. The buildup of carryover debt from insufficient debt repayment capacity in earlier years eventually increases interest expenses to the point where net income and rates of return are negative, further complicating a return to normalcy.

d. The leverage ratio approaches 1.0 just before failure if lenders allow weak firms to get that far. The firm’s lenders eventually “own” more of the firm than the business’s owners do.

3. Define and fully describe the major differences between historical analysis, comparative analysis and pro forma analysis. (5 points)

Historical analysis involves comparing the firm’s current performance with its past performance over the past 4-5 year. Comparative analysis involves comparing the firm’s current performance with other similar firms that serve as benchmarks. Finally, pro forma analysis involves projecting the entries in financial statements into the future.

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EBIT = 120,000 – 98,000 = 22,000

Term debt and capital lease coverage ratio (equation (15 in Handout #1):

= (22,000 – 7,213)/7,500 = 1.97

Times interest earned ratio (equation 16 in Handout #1):

= (22,000 – 7,213)/2,500 = 5.91

Debt burden ratio (equation 17 in Handout #1):

= 66,613/4,887 = 13.63

Conclusion: The firm’s debt term debt and capital lease coverage ratio is above 1.0.Its debt outstanding is high relative to net income is high however. It would take over 13 years to retire its entire debt if net income used entirely for this purpose.

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