Tutorial 1

Question 1

Ratios for activity analysis: Long-term (investment) activity ratios
Explain the problems in this area.

Answer 1

 Sales growth is continuous, investments in capacity are discrete. That gives management discretionary power over timing, form, and financial reporting of the acquisition of incremental capacity.

 Accumulation of depreciation expense improves turnover ratio without corresponding improvement in efficiency.

 Newer assets are generally more efficient (new technology) but might decrease the turnover ratio because inflation makes them more expensive.

Question 2

Liquidity analysis: Length of cash cycle

What is meant by operating cycle of a merchandising firm?
What is meant by the cash cycle?

Differentiate between merchandising and manufacturing firm.

Answer 2

 Operating cycle of a merchandising firm: number of days it takes to sell inventory + number of days until the resulting receivables are converted to cash
 Cash cycle: Number of days a company’s cash is tied up by its current operating cycle
 Merchandising firm ► only finished goods inventory
 Manufacturing firm ► inventory held through three stages:
 raw material
 work in progress
 finished goods

Question 3

Draw the operating cycle diagram.

Answer 3

Acquire inventory–>Pay for inventory –> sale of product –> cash collection

Step 1-3:inventory holding period
Step 2-4: operating cash cycle

Question 4

Review: Purpose and use of ratio analysis
 Financial ratios are used to compare the risk and return of different firms
 Ratios can also provide a profile of a firm, its economic characteristics and competitive strategies, and its unique operating, financial, and investment characteristics

Explain the purpose of activity analysis.

Answer 4

Activity analysis
 Evaluates revenue/output generated by the firm’s assets
 Describes relationship
between operations and assets

Question 5

Review: Purpose and use of ratio analysis
 Financial ratios are used to compare the risk and return of different firms
 Ratios can also provide a profile of a firm, its economic characteristics and competitive strategies, and its unique operating, financial, and investment characteristics

Explain the purpose of liquidity analysis.

Answer 5

Measures the adequacy of a firm’s cash resources to meet its near- term cash obligations

Question 6

Differentiate between long-term debt/solvency analysis and profitability analysis.

Answer 6

Solvency: Examines the firm’s capital structure, financing sources and the ability of the firm to satisfy its long-term debt

Profitability: Measures the income of the firm relative to its revenues/expenses and invested capital