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Chapter 3 EVALUATION OF FINANCIAL PERFORMANCE ANSWERS TO QUESTIONS: 1. The primary limitations of ratio analysis as a technique of financial statement analysis are: a. Ratios are retrospective and do not directly incorporate forecasts of future performance of a firm. b. Ratios only indicate potential problem areas; they do not identify causes of problems. c. A good financial analyst must select the set of ratios that is most appropriate for the type of firm being analyzed. d. Ratios do not provide absolute measures for evaluation; rather they must be analyzed against some standard. The choice of an appropriate standard for comparison can sometimes be a difficult one. 2. The major limitation of the current ratio as a measure of liquidity is the inclusion in the current assets figure of some assets that may not be highly liquid, such as inventory and, in some cases, accounts receivable. The quick ratio, which does not consider inventories, helps to offset this problem. Another limitation is the fact that it is a static (based on the balance sheet) measure of liquidity, whereas liquidity is a dynamic (flow) concept. Also, the current ratio may be easily manipulated by the firm. For example, a firm with a current ratio greater than 1 × can increase that ratio by using cash to pay off some current liabilities. End- of-year balance sheet manipulation such as this is common among firms having current ratio constraints imposed as part of their financing agreements. 3. Above: The firm is having collection problems, possibly because of too liberal a credit granting policy, inadequate collection efforts, or failure to write off uncollectable accounts. Below: The company may be unduly restrictive in granting credit and therefore it may be losing some otherwise profitable accounts to competitors. 4. Above: The company may be carrying too little inventory and thus may be subject to frequent and significant "stockout" costs. A strategy of carrying a small inventory may cause the company to lose customers. Below: The company may have a lot of slow-moving or obsolete inventory. It may also not be making use of efficient inventory management techniques. 5. The fixed asset turnover ratio is subject to four major limitations in comparative analyses. The ratio is sensitive to: a. The cost of the assets at the date of acquisition.
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Chapter 3: Evaluation of Financial Performance 3-2 3-1 b. The length of time since acquisition. c. The depreciation policies adopted. d. The extent to which fixed assets are leased rather than owned. Each of these factors will differ from firm to firm, making meaningful comparative analyses difficult. 6. The three most important determinants of a firm's return on stockholders' equity are net profit margin (earnings after tax/sales), the total asset turnover (sales/total assets), and the equity multiplier (total assets/stockholders’ equity).
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