Understanding Financial Statements 11th Edition By Ormiston Frasier -Test Bank

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Understanding Financial Statements 11th Edition By Ormiston Frasier -Test Bank

Chapter 5

 

True-False

 

  1. The objectives of a financial statement analysis will vary depending on the perspective of the financial statement user.

 

  1. A creditor is ultimately concerned with the ability of a firm to generate profits.

 

  1. Supplementary schedules, such as data related to the breakdown of key financial figures by operating segment, are helpful to financial statement analysts.

 

  1. Form 10-Ks and Form 10-Qs can be located through the Dun & Bradstreet Information services.

 

  1. Articles from current business periodicals should not be used in financial statement analysis as journalists are often biased.

 

  1. Financial ratios are powerful tools due to the fact that standard definitions exist and there is a set standard that should be met for each ratio.

 

  1. Three ratios that help the financial analyst assess short-term solvency are the current ratio, the quick ratio and the cash flow liquidity ratio.

 

  1. The accounts receivable turnover, inventory turnover and accounts payable turnover ratios are mathematical complements to the ratios that make up the cash conversion cycle.

 

  1. The debt ratio considers the proportion of all stockholders’ equity that is financed with debt.

 

  1. Tools used in a financial statement analysis should generally include common-size financial statements, key financial ratios, trend analysis, structural analysis, and comparison with industry competitors.

 

Fill in the Blank

 

  1. A statement contains useful information about the board of directors and executive compensation, option grants, audit-related matters, related party transactions and proposals to be voted on by shareholders.
  2. ratios measure a firm’s ability to meet cash needs as they arise.

 

  1. ratios measure the liquidity of specific assets and the efficiency of managing assets.

 

  1. ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges.

 

  1. ratios measure returns to stockholders and the value the marketplace puts on a company’s stock.

 

  1. The cycle or                          cycle is the normal operating cycle of a firm that consists of buying or manufacturing inventory, selling inventory and paying accounts payable and collecting accounts receivable.

 

  1. The ratio is a broader measure of coverage capability than the times interest earned ratio because it includes the fixed payments associated with leasing.

 

  1. The shows the relationship between cash dividends and market price.

 

  1. The helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity.

 

  1. financial statements are projections of financial statements based on a set of assumptions regarding future revenues, expenses, level of investments in assets, financing methods and costs, and working capital management.

 

Multiple Choice

 

  1. Which group of people would be the most concerned about the ability of a firm to make interest and principal payments?
  2. Auditors.
  3. Customers.
  4. Creditors.
  5. Investors.

 

  1. Which group of people would be the most concerned about the operating areas that have contributed to the success of the firm and which have not?
  2. Customers.
  3. Management.
  4. Auditors.
  5. Creditors.

 

  1. Which ratios help assess the firm’s ability to meet cash needs as they arise?
  2. Current ratio and cash flow liquidity ratio.
  3. Average collection period and net profit margin.
  4. Debt ratio and dividend payout.
  5. Operating profit margin and return on equity.

 

  1. Which ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and fixed charges?
  2. Debt ratio and price-to-earnings ratio.
  3. Cash flow adequacy and fixed charge coverage.
  4. Days payable outstanding and gross profit margin.
  5. Cash interest coverage and average collection period.

 

  1. How is the cash conversion cycle calculated?
  2. Average collection period + days inventory held + Days payable outstanding.
  3. Average collection period – days inventory held + Days payable outstanding.
  4. Average collection period – days inventory held – Days payable outstanding.
  5. Average collection period + days inventory held – Days payable outstanding.

 

  1. What does a low asset turnover compared to the industry imply?
  2. The investment in assets may be too high.
  3. Sales are higher than average.
  4. The investment in assets is too low.
  5. Net income is low relative to the investment in assets.

 

  1. All of the following are steps of a financial statement analysis except:
  2. Establish objectives of the analysis.
  3. Prepare pro forma statements.
  4. Study the industry in which the firm operates.
  5. Develop knowledge of the firm and the quality of management.

 

  1. What does a financial leverage index greater than one indicate about a firm?
  2. Return on assets exceeds the return on equity.
  3. Return on equity exceeds the return on assets.
  4. The firm is not employing debt successfully.
  5. The firm does not generate enough funds to cover interest payments.

 

  1. The Du Pont System shows which of the following series of relationships?
  2. Net profit margin x total asset turnover = Return on investment.
  3. Net profit margin x financial leverage = Return on equity.
  4. Net profit margin x total asset turnover = Return on investment and Return on investment x financial leverage = Return on equity.
  5. Net profit margin x total asset turnover = Return on equity and Return on equity x financial leverage = Return on investment.

 

  1. What is important to understand about the label “pro forma”?
  2. Pro forma refers to GAAP-based financial statements.
  3. Pro forma requires firms to present two distinct net profit amounts in their Form 10-Ks.
  4. Pro forma relates to the amount of debt in a firm’s capital structure.
  5. Pro forma earnings or financial statements are sometimes based on a firm’s own definition which is not technically a correct definition.

 

Use the following selected financial information for Wilcox Corporation to answer questions 11-20.

Wilcox Corporation

Income Statement

For the Year Ended December 31, 2015

 

Net sales                                           $2,870

Cost of goods sold                                        1,985

Gross profit                                                $   885

Operating expenses                                620

Operating profit                                $   265

Interest expense                                       40

Earnings before taxes                        $   225

Income tax expense                                  80

Net profit                                          $   145

 

Wilcox Corporation

Balance Sheet

December 31, 2015

 

Assets                                                         Liabilities and stockholders’ equity

Current assets                                            Current liabilities

Cash                              $ 25                      Accounts payable          $ 85

Short-term investments    15                      Accrued liabilities             45

Accounts receivable          70            Total current liabilities            130

Inventory                       150                      Long-term debt              240

Total current assets                  260            Total liabilities                          370

Long-term assets                                        Stockholders’ equity

Net PPE                           390                     Common stock and PIC     80

Goodwill                          210                    Retained earnings          410

Total stockholders’ equity          490

Total assets                              $860           Total liabilities and equity        $860

 

 

WilcoxCorporation

Statement of Cash Flow Information

For the Year Ended December 31, 2015

 

Cash from operating activities                    $150

 

Investing activities:

Capital expenditures                         $  60

Acquisitions                                               $  10

 

Financing activities:

Proceeds from long-term borrowing $ 50

Payments on long-term borrowing    $ 25

Payments of cash dividends              $ 20

 

Cash paid for interest                                 $ 10

Cash paid for income taxes                        $ 75

 

 

 

  1. Wilcox’s quick ratio is:
  2. 0.85
  3. 2.00
  4. 1.00
  5. 0.75

 

  1. Wilcox’s average collection period is:
  2. 5 days
  3. 9 days
  4. 13 days
  5. 15 days

 

  1. Wilcox’s days payable outstanding is:
  2. 7 days
  3. 11 days
  4. 16 days
  5. 22 days

 

  1. Wilcox’s total asset turnover ratio is:
  2. 3.98
  3. 4.22
  4. 5.91
  5. 3.34

 

  1. Wilcox’s times interest earned ratio is:
  2. 1.50
  3. 4.50
  4. 6.63
  5. 8.60

 

  1. Wilcox’s cash flow adequacy ratio is:
  2. 1.43
  3. 2.15
  4. 1.90
  5. 0.54

 

  1. Wilcox’s cash flow margin is:
  2. 5.23%
  3. 5.85%
  4. 6.24%
  5. 6.67%

 

  1. Wilcox’s effective tax rate is:
  2. 24.67%
  3. 27.36%
  4. 35.00%
  5. 35.56%

 

  1. Wilcox’s debt ratio is:
  2. 40.11%
  3. 43.02%
  4. 55.80%
  5. 56.32%

 

  1. Wilcox’s return on equity is:
  2. 20.62%
  3. 25.50%
  4. 29.59%
  5. 28.49%

 

Short Answer/Problem

 

  1. Explain the key items of interest to the following groups of people when completing a financial statement analysis: investors, creditors and management.

 

  1. What other sources of information will a financial statement analyst find useful other than the financial statements and related notes?

 

  1. List and define the five categories of ratios generally used in financial statement analysis.

 

  1. Explain the difference between the current ratio and the cash flow liquidity ratio.

 

  1. List and discuss the ratios that make up the calculation of the cash conversion cycle.

 

  1. Define cash flow adequacy and the importance of this ratio to credit rating agencies.

 

  1. The following categories of ratios are used in financial statement analysis:
  2. Liquidity
  3. Operating efficiency (also referred to as Activity)
  4. Leverage
  5. Profitability
  6. Market measures

 

Classify the following ratios according to the above categories:

 

          (1) Dividend payout

          (2) Fixed charge coverage

          (3) Cash flow margin

          (4) Days inventory held

          (5) Times interest earned

          (6) Net profit margin

          (7) Earnings per share

          (8) Fixed asset turnover

          (9) Total asset turnover

          (10) Current ratio

 

  1. Using the ratios and information given below for PepCo Company, analyze the short-term liquidity of the firm.

 

2015           2014

Current ratio                                                        .86              .80

Quick ratio                                                 .65              .61

Cash flow liquidity ratio                                      .69              .62

Average collection period                           32 days       30 days

Days inventory held                                   74 days       74 days

Days payable outstanding                          157days      163 days

Cash conversion cycle                                (51 days)    (59 days)

Cash flow from operations (in millions)     $2,508        $2,232

Net sales (in millions)                                 $13,957      $13,074

 

 

 

  1. Using the ratios and information given below for SportsOutlet.com, analyze the short-term liquidity and operating efficiency of the firm.

 

2015           2014

Current ratio                                                        1.50            1.35

Quick ratio                                                 1.15            1.08

Cash flow liquidity ratio                                      1.39            1.32

Average collection period                           10 days       7 days

Days inventory held                                   35 days       28 days

Days payable outstanding                          86 days       79 days

Cash conversion cycle                                (41 days)    (44 days)

Fixed asset turnover                                   27.36 times 22.14 times

Total asset turnover                                   1.93 times   2.21 times

Cash flow from operations (in millions)     $523           $376

Net sales (in millions)                                 $6,743        $5,187

 

  1. The following ratios have been calculated for Wholesale Appliances, Inc. Analyze the capital structure and long-term solvency of Wholesale Appliances, Inc.

 

2015       2014

</P>Debt ratio (%) 77.8 90.3
Long-term debt to total capital (%) 29.8 66.1
Times interest earned (times) (2.0) (2.8)
Cash interest coverage (times) 4.6 4.1
Fixed charge coverage (times) (0.4) (1.0)
Cash flow adequacy (times) 0.2 0.3

 

  1. The following ratios have been calculated for the Solar Tech Company. Analyze the profitability of Solar Tech Company.

2015           2014

Gross profit margin                                    37.0%         42.5%

Operating profit margin                               4.7%         21.7%

Net profit margin                                       1.3%           17.2%

Cash flow margin                                       20.4%         25.9%

 

 

  1. The following ratios have been calculated for Hi-Tech Toys. Analyze the capital structure, long-term solvency, and profitability of Hi-Tech Toys.

</P>

<UNTBL><COLHD>Financial ratios  2015   2014</COLHD>
<TB><BOLD>Leverage</BOLD>
Debt ratio (%) 65.3 57.2
Long-term debt to total capital (%) 46.8 17.6
Times interest earned (times) (1.5) 3.9
Cash interest coverage (times) 4.1 9.2
Fixed charge coverage (times) (0.4) 2.8
Cash flow adequacy (times) 0.3 0.8
Profitability    
Gross profit margin (%) 54.7 58.6
Operating profit margin (%) (2.3) 7.4
Net profit margin (%) (3.4) 4.7
Cash flow margin (%) 4.3 8.9
Return on assets (%) (3.1) 3.2
Return on equity (%) (10.7) (9.9)
Cash return on assets (%) 3.8 8.4</TB></UNTBL></Q>

 

  1. Using the following information for Tiger Inc. calculate earnings per share, the price-to earnings ratio, dividend payout and dividend yield for the firm. Analyze these market ratios.

 

2015                     2014

Net income                                                 $960 million                  $854 million

Shares of common stock outstanding                  420 million           419 million

Dividends per share                                    $ 1.75                            $ 1.60

Market price per share                               $56                       $50

 

 

 

  1. Financial ratio data is listed below for Gallery of Dreams. Construct a list of strengths and weaknesses for the firm after analyzing the ratios.

 

Gallery of Dreams

Ratios

Ratio Industry 2015 2014 2013
Current 2.50x 4.48x 4.06x 3.48x
Quick 0.80x 1.47x 1.18x 0.96x
Average collection period 11 days 16 days 15 days 9 days
Inventory turnover 2.30x 1.19x 1.24x 1.37x
Days payable outstanding 15 days 11 days 12 days 8 days
Fixed asset turnover 17.50x 9.74x 9.09x 8.85x
Total asset turnover 2.80x 1.50x 1.67x 1.82x
Debt ratio 62.00% 29.47% 34.04% 39.17%
Long term debt to

total capitalization

 

25.53%

 

14.09%

 

18.91%

 

22.33%

Times interest earned 9.93x 22.02x 19.00x 14.23x
Fixed charge coverage 8.69x 4.59x 4.47x 4.25x
Gross profit margin 31.10% 59.21% 59.39% 58.52%
Operating profit margin 8.06% 22.05% 21.86% 20.52%
Net profit margin 4.32% 11.89% 11.00% 10.97%
Return on investment 9.21% 17.97% 18.28% 18.35%
Return on equity 11.34% 24.14% 27.51% 29.88%

 

 

 

 

  1. Using the financial ratios calculated from the 2015 annual report of PVC Pipes, assess the short-term liquidity, operating efficiency, capital structure and long-term solvency and profitability of the firm.

 

Ratio 2015 2014
Current 1.52x 1.48x
Quick 1.01x 0.98x
Average collection period 65 days 58 days
Days inventory held 36 days 28 days
Days payable outstanding 61 days 47 days
Cash conversion cycle 40 days 39 days
Fixed asset turnover 4.91x 4.02x
Total asset turnover 1.70x 1.43x
Debt ratio 67.10% 63.08%
Long Term debt to

total capitalization

 

46.82%

 

42.51%

Times interest earned (5.10x) 1.65x
Fixed charge coverage (2.34x) 1.40x
Cash flow adequacy 0.32x 0.87x
Gross profit margin 10.10% 12.81%
Operating profit margin (5.93%) 2.75%
Net profit margin (4.98%) 0.91%
Cash flow margin 3.84% 7.00%
Return on investment (8.63%) 1.28%
Return on equity (25.49%) 3.51%
Cash return on assets 6.90% 9.10%

 

 

Solutions – Chapter 5

 

True-False

 

  1. T 6.  F
  2. F 7.  T
  3. T 8.  T
  4. F 9.  F
  5. F          10. T

 

Fill in the Blank

 

  1. proxy
  2. Liquidity
  3. Activity
  4. Leverage
  5. Market
  6. cash conversion, net trade
  7. fixed charge coverage
  8. dividend yield
  9. Du Pont System
  10. Pro forma

 

Multiple Choice

 

  1. c 6.  a            11.  a          16.  a
  2. b 7.  b            12.  b          17.  a
  3. a 8.  b            13.  c           18.  d
  4. b 9.  c             14.  d          19.  b
  5. d         10.  d            15.  c           20.  c

 

Short Answer/Problem

 

  1. Investors attempt to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation. The investment analyst poses such questions as:
  • What is the company’s performance record, and what are the future expectations? What is its record with regard to growth and stability of earnings? Of cash flow from operations?
  • How much risk is inherent in the firm’s existing capital structure? What are the expected returns, given the firm’s current condition and future outlook?
  • How successfully does the firm compete in its industry, and how well positioned is the company to hold or improve its competitive position?

The investment analyst also uses historical financial statement data to forecast the future. In the case of the investor, the ultimate objective is to determine whether the investment is sound.

 

Creditors are concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds. The questions raised in a credit analysis should include:

  • What is the purpose for the borrowing? What do the financial statements reveal about the reason a firm has requested a loan or the purchase of goods on credit?
  • What is the firm’s capital structure? How much debt is currently outstanding? How well has debt been serviced in the past?
  • What will be the source of debt repayment? How well does the company manage working capital? Is the firm generating cash from operations?

The credit analyst will use the historical record of the company, as presented in the financial statements, to answer such questions and to predict the potential of the firm to satisfy future demands for cash, including debt service.

 

Management is concerned with all of the questions raised by creditors and investors because these user groups must be satisfied for the firm to obtain capital as needed. Management must also consider its employees, the general public, regulators, and the financial press. Management looks to financial statement data to determine:

  • How well has the firm performed and why? What operating areas have contributed to success and which have not?
  • What are the strengths and weaknesses of the company’s financial position?
  • What changes should be implemented to improve future performance?

Financial statements provide insight into the company’s current status and lead to the development of policies and strategies for the future.

 

  1. Other sources of information that the financial statement analyst might find useful are: the proxy statement, auditor’s report, management discussion and analysis, supplementary schedules, Form 10Ks and Form 10-Qs, research materials at libraries, comparative statistical ratios, financial websites, SEC Edgar Database, articles from current periodicals.

 

  1. The five categories of ratios are:(1) liquidity ratios, which measure a firm’s ability to meet cash needs as they arise; (2) activity ratios, which measure the liquidity of specific assets and the efficiency of managing assets; (3) leverage ratios, which measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges; (4) profitability ratios, which measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity; and (5) market ratios, which measure returns to stockholders and the value the marketplace puts on a company’s stock.

 

  1. Both the current ratio and the cash flow liquidity ratio measure short-term solvency and the denominator of both ratios is current liabilities. The difference in the ratios lies in the numerator. The current ratio includes the current assets of a firm in the numerator and is limited by the nature of its components. The actual amount of liquid assets may vary considerably from the date on which the balance sheet is prepared. Further, accounts receivable and inventory may not be truly liquid. A firm could have a relatively high current ratio but not be able to meet demands for cash because the accounts receivable are of inferior quality or the inventory is salable only at discounted prices. It is necessary to use other measures of liquidity, including cash flow from operations and other financial ratios that rate the liquidity of specific assets, to supplement the current ratio. The cash flow liquidity ratio offers an alternative to the current ratio. The numerator for this ratio includes only liquid items: cash and cash equivalents, marketable securities, and cash flow from operating activities.

 

  1. The average collection period of accounts receivable is the average number of days required to convert receivables into cash. The average collection period helps gauge the liquidity of accounts receivable, the ability of the firm to collect from customers. It may also provide information about a company’s credit policies.

The days inventory held is the average number of days it takes to sell inventory to customers. This ratio measures the efficiency of the firm in managing its inventory. Generally, a low number of days inventory held is a sign of efficient management; the faster inventory sells, the fewer funds tied up in inventory. On the other hand, too low a number could indicate understocking and lost orders, a decrease in prices, a shortage of materials, or more sales than planned. A high number of days inventory held could be the result of carrying too much inventory or stocking inventory that is obsolete, slow-moving, or inferior; however, there may be legitimate reasons to stockpile inventory, such as increased demand, expansion and opening of new retail stores, or an expected strike. The type of industry is important in assessing days inventory held. It is expected that florists and produce retailers would have a relatively low days inventory held because they deal in perishable products, whereas retailers of jewelry or farm equipment would have higher days inventory held, but higher profit margins.

The days payable outstanding is the average number of days it takes to pay payables in cash. This ratio offers insight into a firm’s pattern of payments to suppliers. Delaying payment of payables as long as possible is desirable because the firm can earn a return on cash held.

 

  1. Credit rating agencies often use cash flow adequacy ratios to evaluate how well a company can cover annual payments of items such as debt, capital expenditures, and dividends from operating cash flow. Cash flow adequacy is generally defined differently by analysts; therefore, it is important to understand what is actually being measured. Cash flow adequacy in the textbook measures a firm’s ability to cover capital expenditures, debt maturities, and dividend payments each year. Companies over the long run should generate enough cash flow from operations to cover investing and financing activities of the firm. If purchases of fixed assets are financed with debt, the company should be able to cover the principal payments with cash generated by the company. A larger ratio would be expected if the company pays dividends annually because cash used for dividends should be generated internally by the company, rather than by borrowing. Borrowing each year to pay dividends and repay debt is a questionable cycle for a company to be in over the long run.

 

  1. (1) e (6) d

(2) c                               (7) e

(3) d                               (8) b

(4) a                               (9) b

(5) c                               (10) a

 

  1. PepCo’s current, quick, and cash flow liquidity ratios are all below one. The firm has fewer current assets and fewer liquid items than the current liability amounts each year. The ratios have increased slightly from 2014 to 2015. The average collection period is good and stable. The inventory days held is steady at 74 days, but without an industry average it is difficult to assess if the firm could shorten the time inventory is held. Of concern is the long time it takes PepCo to pay its suppliers. At more than five months the firm risks losing a quality supplier if they are not paying bills on time. The high days payable outstanding is the reason that the cash conversion cycle is negative. While this is beneficial to PepCo to keep their cash on hand longer, it could be a problem as mentioned if suppliers are not satisfied in a timely manner. Both sales and cash from operations are increasing which is a positive sign that the firm is able to cover debts as they come due.

 

  1. Short-term liquidity at SportsOutlet.com is good and improving from 2014 to 2015. The current and quick ratios are both above one to one, as is the cash flow liquidity ratio. The firm’s accounts receivable collection period has increased by three days but is still a very low 10 days. Days inventory held has also increased by seven days and is now at 35 days. SportsOutlet.com is taking seven days longer to pay their accounts payable.  As long as SportsOutlet.com is paying their suppliers in a timely manner, the 86 days payable outstanding is allowing the firm to collect their cash from customers before they pay their suppliers.  This is good cash management and causes the negative cash conversion cycle; however, if the firm’s suppliers expect payment sooner than 86 days, SportsOutlet.com is risking the loss of suppliers.

 

Fixed asset turnover has improved which means the level of sales growth is more than any increases in fixed assets.  Despite the increase in fixed asset turnover, total asset turnover has declined.  If the magnitude of accounts receivable and inventories is greater than fixed assets, the decline in total asset turnover can be explained by the decline in accounts receivable and inventory turnovers.  It is also possible that SportsOutlet.com has large amounts of cash, investments and goodwill which could cause the total asset turnover to be lower.

 

Overall SportsOutlet.com has good liquidity and operating efficiency.

 

  1. Wholesale Appliances has a risky capital structure, though it has improved from 2014 to 2015. The significant decrease in debt appears to be largely a decline in long-term debt. The firm is operating at a loss which has caused the times interest earned and fixed charge coverage ratios to be negative. While the firm cannot cover fixed payments with profit, they can cover these items with cash. The cash interest coverage ratio is positive both years and has improved in 2015. Cash flow adequacy is very low and has decreased from 0.3 to 0.2. This indicates that the firm cannot cover capital expenditures, debt repayments and dividends with cash from operations. It is possible that the low cash flow adequacy ratio is a result of Wholesale Appliance paying down long-term debt in the current year which is a good thing. The firm should not be paying dividends given their lack of profits and high debt.

 

  1. The Solar Tech Company is experiencing significant declines in profits. Gross profit margin has dropped 5.5% which could be a result of declining selling prices, increased cost of goods sold, or a decline in volume if fixed costs are present in cost of goods sold. The operating profit margin has dropped 17%, far greater than the drop in gross profit margin. The firm’s operating expenses have either increased or a significant drop in sales, without a corresponding drop in expenses, has caused the operating profit margin to decline. Net profit margin has followed the trend of operating profit margin. Despite the poor profitability of the firm, cash flow margin is still at 20.4%, although it has dropped 5.5%. The firm most likely has large amounts of depreciation and amortization, noncash expenses.

 

  1. Hi-Tech Toys’ capital structure is more risky in 2015 compared to 2014. The firm has increased debt from 57.2% to 65.3% of assets. The long-term debt to total capitalization ratio indicates that much of the debt added to the firm’s capital structure is long-term. As a result of increased debt and lack of profitability in 2015, the company can no longer cover interest and lease expenses with profits; however, cash generated from operations is still enough to cover the actual cash payments in 2015 for interest and leases.

 

Profitability is deteriorating at Hi-Tech Toys. The gross profit margin has declined 3.9% indicating that either costs are increasing or selling prices are being lowered. Hi-Tech Toys needs to control costs better or pass increased costs onto customers to improve the gross profit margin. Operating and net profit in 2014 have turned to losses in 2015. Further investigation of the cause of these losses is warranted. Due to the financial leverage used in the firm, the effect on return on equity has been magnified in both 2014 (positively) and in 2015 (negatively). As stated previously, despite the accrual-based losses the firm has incurred, Hi-Tech Toys still generates positive cash from operations. Cash flow margin and cash return on assets have declined from the 2014 levels but are still positive.  Hi-Tech Toys’ long-term solvency is adequate.  The increased use of debt is probably a result of the underlying causes of the profit deterioration.

 

2015           2014

Earnings per share                                               $2.29          $2.04

PE ratio                                                      24.45          24.51

Dividend payout                                         76.42%       78.43%

Dividend yield                                            3.13%         3.20%

 

The earnings per share has increased, but the market has not reacted to the change as evidenced by the stable PE ratio. The dollar amount of dividends has increased but the dividend payout and yield have declined slightly as the dividends did not go up as fast as the earnings per share and market price of stock. Given the low interest rates in 2014 and 2015, shareholders are realizing a good return of over 3% in dividends from their investment.

  1. Strengths:
  • Current and quick ratios are above industry average and increasing
  • Accounts payable are paid in a timely manner
  • Overall debt has declined significantly and is well below the industry average
  • Interest is covered by profits as are lease payments and the number of times covered has increased each year
  • Profitability is excellent with gross, operating and net profit margins above industry average and increasing all years with the exception of gross profit margin which decreased slightly in 2015

 

Weaknesses:

  • The average collection period is increasing and is now above industry average
  • Inventory turnover is below industry average and is extremely low indicating the firm does not move inventory well
  • Fixed asset turnover, while increasing, is still below industry average
  • Total asset turnover is decreasing which implies sales are declining and/or investments in assets are too high relative to sales
  • Fixed charge coverage is below industry average and implies that the firm has significant operating leases
  • Return on investment is declining due to significant investment in assets
  • Return on equity is declining, but this is also positive as it is partially due to the significant decline in debt

 

  1. Short-term liquidity

PVC Pipes current and quick ratios increased slightly and both are above one. The cash flow liquidity ratio is below one in and has dropped by half in 2015. This could be a result of a decrease in cash from operations (CFO), marketable securities and the cash balance. The cash conversion cycle is stable from 2014 to 2015, but the components that make up the cycle have not been stable. The average collection period has increased seven days, inventory days held grew by eight days, and the days payable outstanding grew 14 days, offsetting the negative effects of a deteriorating collection period and inventory turnover. The firm needs to tighten up their credit policy and monitor the increasing days inventory is held. It is also important that the days payable outstanding not increase more in the future or the firm may risk the loss of suppliers. The short-term liquidity for PVC Pipes is adequate, but the firm needs to monitor the above-mentioned items.

 

 

Operating efficiency

The fixed and total asset turnover ratios have increased as a result of sales increasing and/or fixed and total assets decreasing.

 

Capital structure and long-term solvency

The capital structure of PVC Pipes is risky. Long-term debt has increased and total debt is now 67.10% relative to total assets. The coverage ratios, both accrual and cash-based, have all declined. The accrual-based ratios are now negative as a result of a net loss in 2015. Cash interest coverage is still positive, but decreasing. The cash flow adequacy ratio is dropping rapidly and has been below one both years. The firm cannot cover capital expenditures, debt repayments and dividends with CFO. If PVC Pipes is paying dividends that would not be a good strategy given the losses and the risky capital structure. The firm needs to improve its cash flow and pay down debt to improve its balance sheet.

 

Profitability

Profitability is poor for PVC Pipes. The gross profit margin has declined and is now at 10.10%. Either costs are increasing or selling prices are being lowered. PVC Pipes needs to control costs better or pass increased costs onto customers to improve the gross profit margin. Operating and net profit in 2015 have turned to losses in 2015. Further investigation of the cause of these losses is warranted. Due to the financial leverage used in the firm, the effect on return on equity has been magnified in both 2014 (positively) and in 2015 (negatively). As stated previously, despite the accrual-based losses the firm has incurred, PVC Pipes still generates positive cash from operations. Cash flow margin and cash return on assets have declined from the 2014 levels but are still positive.  PVC Pipes’ long-term solvency is adequate. The increased use of debt is probably a result of the underlying causes of the profit deterioration.