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Unformatted text preview: Chapter 3 Discussion Questions 3-1. If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons? Short-term lenders–liquidity ratios because their concern is with the firm’s ability to pay short-term obligations as they come due. Long-term lenders–leverage ratios because they are concerned with the relationship of debt to total assets. They also will examine profitability to insure that interest payments can be made. Stockholders–profitability ratios, with secondary consideration given to debt utilization, liquidity, and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment. S3-1 3-2. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity. The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover. Return on Assets = Profit Margin × Asset Turnover assets Total Sales Sales income Net assets Total income Net × = 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 form of the Du Pont formula shows: ( 29 ( 29 Return on assets investment Return on equity = 1 Debt/Assets-This indicates that return on stockholders’ 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 stockholders’ equity that is influenced by large amounts of debt. 3-3. If the accounts receivable turnover ratio is decreasing, what will be happening to the average collection period? If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer period of time. This means the average collection period will be increasing. 3-4. What advantage does the fixed charge coverage ratio offer over simply using times interest earned? 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. Is there any validity in rule-of-thumb ratios for all corporations, for example, a current ratio of 2 to 1 or debt to assets of 50 percent?...
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This note was uploaded on 04/10/2011 for the course ADM 474 taught by Professor Stewart during the Spring '10 term at Indiana Wesleyan.
- Spring '10