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ch04sm - Chapter 4 Analyzing Financial Statements Critical...

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1 Chapter 4 Analyzing Financial Statements Critical Thinking Questions 4.1 What does it mean when a company’s return on assets (ROA) is equal to its return on equity (ROE)? When ROA equals ROE, it means that the firm does not use any leverage. For firms that do use leverage, ROE will be higher than ROA. 4.2 Why is too much liquidity not a good thing? Too much liquidity could mean that a firm is not putting its money to work as the shareholders would want it to. It could mean that the firm’s managers are being too conservative and investing in low-yield assets, or it could mean that the firm does not have enough investment opportunities and is therefore hanging onto its cash. Recently, several firms including Microsoft had several billions of dollars in cash on their books, and, ultimately, Microsoft paid a special dividend to its shareholders. Too much liquidity can also make it a takeover target for firms looking to utilize the debt capacity of the liquid firm.
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2 4.3 Inventory is excluded when the quick ratio or acid-test ratio is calculated because inventory is the most difficult current asset to convert to cash without loss of value. What types of inventory are likely to be most easily converted to cash? For the quick ratio, one uses only the most liquid of all assets—that is, all current assets less inventory, which is not very liquid relative to cash or receivables. While the current ratio assumes that inventory could be sold at book value, the quick ratio assumes that inventory has no value. Hence, this gives a more conservative estimate of a firm’s liquidity than the current ratio, and gives a better estimate of the firm’s ability to meet its short-term obligations. 4.4 What does a very high inventory turnover ratio signify? This could mean a number of things, including that the firm is using up its inventory too fast and is unable to meet the demand for its products, or it has priced its products too low relative to its competitors, or worse, the firm is selling defective products that would eventually be returned. 4.5 How would one explain a low receivables turnover ratio? A low receivables turnover implies a high DSO. This could mean that the firm’s customers are not paying on time, either because of an inefficient collection system or because of a slowdown in their customers’ business or even in the entire economy.
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3 4.6 What additional information does the fixed assets turnover ratio provide over the total assets turnover ratio? For which industries does it carry greater significance? The total assets turnover ratio measures the level of sales per dollar invested in total assets. The higher the number, the more efficiently the management is using the firm’s assets. Too high a number relative to its peers could imply that the firm is reaching its full capacity and may require an additional investment in plant and equipment to generate additional sales. The fixed asset turnover ratio can be utilized to break down the performance of individual manufacturing facilities or a division. This ratio provides
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ch04sm - Chapter 4 Analyzing Financial Statements Critical...

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