solutions manual and testbank for Chapter
3 - Foundations of Financial Management
11th Canadian edition
Introduction to Finance (Concord University)
,Discussion Questions
3-1. Short-term lenders - liquidity because their concern is with the firm's ability to pay
shortterm obligations as they come due.
Long-term lenders - leverage because they are concerned with the relationship of debt to total
assets. They also will examine profitability to ensure that interest payments can be made.
Shareholders - profitability, with secondary consideration given to debt utilization,
liquidity, and other ratios. Since shareholders are the ultimate owners of the firm, they are
primarily concerned with profits or the return on their investment.
3-2.
a. Return on investment = Net income
Total assets
Inflation may cause net income to be overstated and total assets to be understated.
Too high a ratio could be reported.
b. Inventory turnover = Sales or COGS
Inventory
*Sales may be used when COGS is not available (rival private firms).
Inflation may cause sales to be overstated. If the firm uses FIFO accounting,
inventory will also reflect "inflation-influenced" dollars and the net effect will be
nil.
If the firm uses LIFO accounting, inventory will be stated in old dollars and too
high a ratio could be reported.
c. Capital asset turnover = Sales Capital assets
Capital assets will be understated relative to sales and too high a ratio could be
reported.
d. Debt to total assets = Total debt
Total assets
, lOMoARcPSD|1541887
Chapter 3
Since both are based on historical costs, no major inflationary impact will take
place in the ratio. Assets are likely understated, however, causing ratio to be
overstated.
3-3. The Du Pont system of analysis breaks out the return on assets between the profit margin
and asset turnover.
ROA = Profit Margin × Asset Turnover
Net income = Net income × Sales .
Total assets Sales Total assets
In this fashion, we can assess the joint impact of profitability and asset turnover on the
overall return on assets. This is a particularly useful analysis because we can determine
the source of strength and weakness for a given firm. For example, a company in the
capital goods industry may have a high profit margin and a low asset turnover, while a
food-processing firm may suffer from low profit margins, but enjoy a rapid turnover of
assets.
The modified Du Pont formula shows:
ROE = ROA × Equity multiplier
Return on equity = Return on assets (investment) × Total assets
Equity
This indicates that return on shareholders' equity may be influenced by return on assets,
the debt-to-assets ratio or a combination of both. Analysts or investors should be
particularly sensitive to a high return on shareholders' equity that is influenced by large
amounts of debt.
3-4. The fixed charge coverage ratio measures the firm's ability to meet all fixed obligations
rather than interest payments alone, on the assumption that failure to meet any financial
obligation will endanger the position of the firm.
3-5. In both instances, we would not reflect a very significant cost of doing business. Of course,
one could argue that, to the extent that differential tax rates of financing plans (and
associated interest costs) did not reflect the operating capability of the firm, omission of
these changes could provide new insights.
3-6. No rule-of-thumb ratio is valid for all corporations. There is simply too much difference
between industries or time periods in which ratios are computed. Nevertheless, rules-
, ofthumb ratios do offer some initial insight into the operations of the firm, and when used
with caution by the analyst can provide information.
3-7. Trend analysis allows us to compare the present with the past and evaluate our progress
through time. A profit margin of 5 percent may be particularly impressive if it has been
running only 3 percent in the last ten years. Trend analysis must also be compared to
industry patterns of change. The change in accounting rules with the use of IFRS for
public companies and ASPE for private enterprises results in financial statements being
significantly different with those prepared before January 1, 2011 which makes trend
analysis inappropriate for decision making. However, the conversion of previous years’
statements will make the years prior to 2011 comparative and useful for trend analysis.
3-8. Disinflation tends to lower reported earnings as inflation-induced income is squeezed out
of the firm's income statement resulting in decreased net income. This is particularly true
for firms in highly cyclical industries, such as oil based products, where prices tend to
rise and fall quickly.
3-9. Because it is possible that prior inflationary pressures will no longer seriously impair the
purchasing power of the dollar. Lower inflation also means that the required return that
investors demand on financial assets will be lower, and with this lower demanded return,
future earnings or interest should receive a higher current valuation.
3-10. There are many different methods of financial reporting accepted by the accounting
profession as promulgated by the Canadian Institute of Chartered Accountants (now CPA
Canada). The implementation of IFRS (public firms) and ASPE (private firms) should
result in better comparison of statements among companies using the same rules of
accounting. Though the industry has continually tried to provide uniform guidelines and
procedures, many options remain open to the reporting firm. Every item on the income
statement and balance sheet must be given careful attention. Two apparently similar firms
may show different values for sales, research and development, extraordinary losses, and
many other items.
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller BRAINBOOSTERS. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $27.99. You're not tied to anything after your purchase.