61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 2 – FINANCIAL STATEMENTS ANALYSIS

There are two parts in this tutorial:

- Part 1: Additional exercises that are essential for those who want to refresh their accounting
practices.
- Part 2: Required exercises that provide practices for financial statement analysis and free cash
flow calculation. Part 1: Additional exercises

Question 1: Identify whether the following statements are True or False. Correct the false statement.

1. The income statement measures the flow of funds into (i.e. revenue) and out of (i.e. expenses) the
firm over a certain time period. It is always based on accounting data.

2. The balance sheet is a financial statement measuring the flow of funds into and out of various
accounts over time while the income statement measures the progress of the firm at a point in time.

3. An increase in an asset account is a source of cash, whereas an increase in a liability account is a use of
cash.

4. Depreciation, as shown on the income statement, is regarded as a use of cash because it is an

5. When a firm pays off a loan using cash, the source of funds is the decrease in the asset account, cash,
while the use of funds involves a decrease in a liability account, debt.

6. Non-cash assets are expected to produce cash over time but the amount of cash they eventually
produce could be higher or lower than the values at which the assets are carried on the books.

7. Taxes and reporting considerations, as well as credit sales and non-cash costs, are reasons why
operating cash flows can differ from accounting profits.

8. The balance sheet presents a summary of the firm’s revenues and expenses over an accounting
period.

9. On the balance sheet, total assets must equal total liabilities plus stockholders equity.

Page 1 of 10
10. One of the biggest noncash items on the income statement is depreciation which needs to be
subtracted from net income to determine cash flows for the firm.

F
Question 2. Complete the below Balance Sheet

375,1000,1060,810,

Question 3. Complete the income statement

Question 4. Given the answers in question 1 and 2 above, calculate Earnings per share, Dividend per
share, and Book value per share for the company.

Page 2 of 10
Part 2: Required exercises and questions

Question 1. Indicate whether each of the following statement is TRUE or FALSE. Correct the false
statements.

1. Ratio analysis involves a comparison of the relationships between financial statement accounts so as
to analyze the financial position and strength of a firm.

2. If a firm has high current and quick ratios, this always is a good indication that a firm is managing its
liquidity position well.

3. The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio
measures the relation of a firm's current assets to its current liabilities and the inventory turnover
ratio measures how rapidly a firm turns its inventory back into a "quick" asset or cash.

4. A decline in the inventory turnover ratio suggests that the firm's liquidity position is improving.

5. The degree to which the managers of a firm attempt to magnify the returns to owners' capital through
the use of financial leverage is captured in debt management ratios.

6. Profitability ratios show the combined effects of liquidity, asset management, and debt management
on operations.

7. A liquid asset is an asset that can be easily converted into cash without a significant loss of its original
value.

8. Suppose two firms with the same amount of assets pay the same interest rate on their debt and earn
the same rate of return on their assets, and that ROA is positive. However, one firm has a higher debt
ratio. Under these conditions, the firm with the higher debt ratio will also have a higher rate of return
on common equity.

Question 2. Name five categories of financial ratios.

Liquidity and Solvency Ratios

Page 3 of 10
Financial Leverage Ratios
Turnover Ratios
Profitability Ratios
Market Value Ratios

Question 3. Write the Dupont equation and discuss its components.

DuPont analysis is a multi-step financial equation that provides insight into a

ROE=ROA x Equity Multiplier

Question 4. Why would the inventory turnover ratio be more important for someone analyzing a grocery
store chain than an insurance company?

The inventory turnover ratio is important to a grocery store because of the much larger inventory
required and because some of that inventory is perishable. An insurance company would have no
inventory to speak of since its line of business is selling insurance policies or other similar financial
products—contracts written on paper and entered into between the company and the insured. This
question demonstrates that the student should not take a routine approach to financial analysis but
rather should examine the business that he or she is analyzing before conducting a ratio analysis.

Question 5. Profit margins and turnover ratios vary from one industry to another. What differences
would you expect to find between the turnover ratios, profit margins, and DuPont equations for a
grocery chain and a steel company?

Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover
ratios to vary among industries. For example, a steel company needs a greater number of dollars in
assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and
turnover ratios may vary due to differences in the amount of expenses incurred to produce sales.
For example, one would expect a grocery store chain to spend more per dollar of sales than does a
steel company. Often, a high turnover will be associated with a low profit margin, and vice versa.

Page 4 of 10
Exercise 1. Bartley Barstools has an equity multiplier of 2.4, and its assets are financed with some
combination of long-term debt and common equity. What is its debt-to-assets ratio?

DA= 1 / (1 / AE)
= 1 / (1 / 2.4)=58.33%

Exercise 2. Doublewide Dealers has an ROA of 10%, a 2% profit margin, and an ROE of 15%. What is its
total assets turnover? What is its equity multiplier?
ROA= 10%, PM= 2%, ROE= 15%
ROA= NI / TA, PM= NI / S, ROE= NI / E
ROA= PM * S/TA
10= 2 * TATO
TATO= 5
ROE= PM TATO EM
15= 2 5 EM
EM= 1.5

Exercise 3. A firm has a profit margin of 2% and an equity multiplier of 2.0. Its sales are $100 million, and
it has total assets of $50 million. What is its ROE?

PM= 2%, EM= 2, sales= $100 million, TA= $50 million

Exercise 4. Midwest Packaging’s ROE last year was only 3%; but its management has developed a new
operating plan that calls for a debt-to-assets ratio of 60%, which will result in annual interest charges of
$300,000. The firm has no plans to use preferred stock. Management projects an EBIT of $1,000,000 on
sales of $10,000,000, and it expects to have a total assets turnover ratio of 2.0. Under these conditions,
the tax rate will be 34%. If the changes are made, what will be the company’s return on equity?

Page 5 of 10
Tax= (EBIT - I) * Tax Rate
= (1000000 - 300000) * .34= 238000
NI= EBIT - I - Taxes
= 1000000 - 300000 - 238000= 462000
EA= 1- DA
= 1- .6= .4
ROE= PM TATO Equity Multiplier
= (NI / Sales) TATO (TA / Equity)
= (462000/10000000) 2 (1 / EA)
= .0924 * (1 / EA)
=.0924 * (1 / .4)= 23.1%

Exercise 5. Based on the below financial statement, do the following tasks.

a. What was net operating working capital for 2010 and 2011?

b. What was Bailey’s 2011 free cash flow?

Page 6 of 10
 FCF= (sales revenue-operating cost – taxes) – required investment
FCF=[EBIT(1-T)+Depreciation and amortization] - [Capital expenditures +change in operating working
capital]

Capex= Change in gross fixed asset = change in depreciation + change in net NA = 3000 + 5000
Gross FA= net NA + depreciation
change in Gross FA = change in net NA+ change in depreciation
NWC= CA - CL
NOWC= CA – (CL – Notes payable )

Exercise 6.

Page 7 of 10
Page 8 of 10
Exercise 7.

a. Calculate corresponding ratios for the firm and compare them with industry average.
b. Construct a DuPont equation and compare the company’s ratios to the industry average ratios.

Page 9 of 10
c. Do the balance sheet accounts or the income statement figures seem to be primarily responsible
for the low profits?

Page 10 of 10