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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