Chapter 14 Company Analysis RQ Flashcards
Identify the ratio an analyst would use to assess a company’s ability to meet the fixed charges on its debt payments.
A. Asset coverage ratio.
B. Operating cash flow ratio.
C. Interest coverage ratio.
D. Acid test ratio.
C. Interest coverage ratio.
The interest coverage ratio reveals the ability of a company to pay the interest charges on its debt and indicates how well these charges are covered, based upon earnings available to pay them. This ratio indicates a margin of safety, since a company’s inability to meet its interest charges could result in bankruptcy.
Karim is interested investing in a company which has high returns. Identify the group of ratios that he should use to evaluate his purchase.
A. Value Ratios.
B. Risk Analysis Ratios.
C. Profitability Ratios.
D. Profit Ratios.
A. Value Ratios.
Value Ratios show the investor the worth of the company’s
shares or the return on owning them. An example is the price/earnings ratio which links the market price of a common share to earnings per common share, and thus allows investors to rate the shares of companies within the same industry.
Select the correct statements about the current ratio.
A current ratio less than 2 indicates that the company is in financial distress.
Companies with high amounts of non-marketable inventories will likely have high current ratios.
The lower the current ratio the lower the prospect of liquidity problems, but it may indicate too much inventory.
The current ratio is a measure of how well a company can deal with its short-term debt obligations.
A. 1 and 2.
B. 2 and 3.
C. 3 and 4.
D. 2 and 4.
D. 2 and 4.
Is a current ratio of 2:1 good or bad or mediocre? It depends on many factors such as type of industry and business, composition of current assets, inventory turnover rate and credit terms. A current ratio of 2:1 is good, but not exceptional, because it means there are $2 cash or equivalents to pay each $1 of debt. However, if Company A had 50% cash in its current assets and Company B had 90% inventories and each had a current ratio of 2:1, Company A would be better than B because it would be more liquid and could pay its current debts more easily and quickly. Also, if a current ratio of 2:1 is good, is 20:1 ten times as good? No. If a company’s current ratio exceeds 5:1 and consistently maintains such a high level, the company may have an unnecessary accumulation of funds which could indicate sales problems (too much inventory) or financial mismanagement. Current ratios can be industry dependent. An industry that typically carries a great deal of inventory would naturally have a higher ratio than an industry that was more service oriented.
Calculate the trend for Year 3 for the following Earnings Per Share. Round your answer to two decimal places.
Year 1 Year 2 Year 3 Year 4 Year 5 1.10 1.80 0.90 1.20 1.10 A. 0.50. B. 0.82. C. 0.90. D. 1.22.
B. 0.82.
The Trend Ratio for a year is calculated by dividing the year in question by the base year. In this example, the trend ratio would be calculated as: (0.90/1.10) = 0.82.
Select the company that is likely suffering from financial mismanagement. Assume the companies are all members of the retail grocery industry.
Current Ratio Quick Ratio Company A 2.1:1 0.9:1 Company B 1.2:1 1.0:1 Company C 3.1:1 1.7:1 Company D 7.0:1 3.9:1 A. Company A. B. Company B. C. Company C. D. Company D.
D. Company D.
A current ratio that exceeds 5 may signify that the company has an unnecessary accumulation of funds which could indicate sales problems or financial mismanagement.
Why do analysts exclude goodwill as an asset when calculating the asset coverage ratio?
A. Goodwill cannot be sold or converted into cash to make debt payments.
B. Goodwill represents money paid when the company was purchased and is a liability.
C. Goodwill represents money owed for purchasing the good name of the company.
D. Goodwill is already being amortized annually so it is already included as an expense.
A. Goodwill cannot be sold or converted into cash to make debt payments.
The Asset Coverage ratio is calculated using net tangible assets. As a result, intangible assets such as Goodwill are excluded from the calculation. Intangible assets include items that cannot be converted easily into cash to make debt payments.
Identify the correct statements regarding the Debt/Equity Ratio.
The debt/equity ratio is a risk analysis ratio.
The debt/equity ratio measures a company’s ability to meet its short-term obligations.
The higher the debt/equity ratio the higher the financial risk.
The higher a company’s equity position the higher its debt/equity ratio.
A. 2 and 4.
B. 2 and 3.
C. 1 and 4.
D. 1 and 3.
D. 1 and 3.
This ratio pinpoints the relationship of debt to equity and can be a warning that a company’s
borrowing is excessive. The higher the debt/equity ratio, the higher the financial risk. Too large a debt burden reduces the margin of safety behind the debt holder’s capital, increases the company’s fixed charges, reduces earnings available for dividends and, in times of recession or high interest rates, could cause a financial crisis.
Select the item considered a positive indicator in estimating the possibility for dividends for a common stock.
A. Planned expansion of operations.
B. Volatility of profits.
C. High working capital.
D. Decrease in retained earnings.
C. High working capital.
Estimating the dividend possibilities of a stock may take into account the amount of profit for the current fiscal year; the stability of profit over a period of years; the amount of retained earnings and the rate of return on those earnings; the company’s working capital; the policy of the board of directors; plans for expanding (or contracting) operations; and government dividend restraints (if any). Before a company can pay a dividend, it must have sufficient earnings and working capital. A, B, and D would all be warning flags for reduction or elimination of dividends.
Markian is considering investing in one of two companies. ABC is highly leveraged, while DEF is unleveraged. Canada is experiencing an upswing in the economy. What impact will this upswing have on the two companies?
A. ABC would see their earnings grow slower than DEF.
B. ABC would see their earnings grow faster than DEF.
C. DEF would see faster earnings growth during an upswing, but slower earnings growth during a downturn in the economy.
D. The amount of leverage has no impact on the growth of earnings per share, when the economy is growing.
B. ABC would see their earnings grow faster than DEF.
The earnings of a company are leveraged if the capital structure contains debt and/or preferred shares. The presence of senior securities accelerates any cyclical rise or fall in earnings. The earnings of leveraged companies show a larger and faster increase during an upswing in the business cycle than earnings of companies without leverage. Conversely, earnings of a leveraged company collapse more quickly in response to deteriorating economic conditions.
Two companies of equal status in the same industry have similar prospects but different P/E ratios. Identify the correct statement regarding the company with the lower P/E ratio.
A. It is an overvalued company.
B. It is the higher priced company.
C. It is the more profitable company.
D. It is a better buy.
D. It is a better buy.
The logic is that if two similar companies have the same prospects it makes sense to choose the one that recovers the price of the security in the shortest time.
An analyst has identified that the cost of sales as a percentage of revenue has been increasing over the last 5 years. What does this indicate to the analyst?
A. The company has improved its gross margin, which is an indicator of increasing potential profit.
B. Gross profit margin is improving but net profit margin is declining, indicating a problem in managing the administrative costs of the company.
C. The company is having difficulty keeping overall costs under control and may be losing potential profits.
D. The company has increased sales over the 5-year period, indicating a likelihood that profits will increase.
C. The company is having difficulty keeping overall costs under control and may be losing potential profits.
By calculating cost of sales as a percentage of revenue, you can determine whether costs are rising, stable, or falling in relation to sales. A rising trend over several years may indicate that a company is having difficulty keeping overall costs under control and is therefore losing potential profits. A falling trend suggests that a company is operating cost effectively and is likely to be more profitable in the future.
An analyst notes that XYZ Corporation’s 4% corporate bonds, currently comprising 15% of the capital structure are coming due in 3 months. Interest rates for corporate bonds are currently 8.5%. How will the analyst likely perceive the trend of interest coverage if XYZ refinances using corporate bonds?
A. Improving, as interest coverage will be lower.
B. Improving, as interest coverage will be higher.
C. Worsening, as interest coverage will be lower.
D. Worsening, as interest coverage will be higher.
C. Worsening, as interest coverage will be lower.
Refinancing at a higher rate will result in higher interest costs for XYZ Corporation. As a result, the interest coverage will worsen. A weakening or declining pattern in interest coverage is usually a danger signal and would be considered unfavourably by the analyst.
ABC Corporation has a debt/equity ratio of 33%. Other things being equal, what impact will the issue of additional common shares have on the ratio?
A. The ratio will likely fall as there will be an increase in the equity component of the capital structure.
B. The ratio will likely rise as there will be an increase in the equity component of the capital structure.
C. The issue of additional common shares does not impact the equity component of the company as the additional shares are already included in authorized shares.
D. The ratio remains unchanged as the increase in the equity component is offset by the increase in the company’s current liabilities.
A. The ratio will likely fall as there will be an increase in the equity component of the capital structure.
Since the denominator of the ratio increases, the ratio as a whole will fall. Issuing additional shares of equity will affect the equity component of the company. Issuing additional shares does not affect the company’s liabilities.
Company XYZ Inc. has a policy to maintain the same dividend payment year after year. A high XYZ Inc. dividend payout rate may be the result of which factors?
Declining earnings. Cyclical peak. Stable earnings. Growing earnings. A. 1 and 2. B. 1 and 3. C. 2 and 3. D. 2 and 4.
B. 1 and 3.
A company that maintains a steady dividend payment while experiencing declining earnings could have a high payout ratio (the numerator remains unchanged but the denominator of the ratio is falling). A company may also maintain a high payout ratio because they have stable earnings and can therefore afford to make high dividend payments. Companies that maintain a steady dividend payment will see the payout ratio decline when earnings are growing or when earnings are typically high at a cyclical peak.
The P/E ratio for a particular industry is 9.5. Rosalita is considering investing in a company in this industry. Based on the P/E ratios below, which company would likely provide Rosalita with the best value?
Company P/E Company A 10.4 Company B 9.2 Company C 11.5 Company D 6.3 A. Company A. B. Company B. C. Company C. D. Company D.
D. Company D.
There are many factors to consider in the buying decision. While P/E is not the absolute standard for making an investment decision, typically a lower P/E would indicate that a stock may be undervalued. In this particular case, D is lower than both the other companies and the industry. An analyst would need to further examine if Company D has similar prospects to the other 3 companies, or if there is a problem with this particular company that is contributing to a lower P/E and thus making it a poor investment choice. But based solely on the P/E ratio, Company D is selling for a lower price relative to the other companies and offers the best value.
