ACC501 All Assignment2

Question 1
(i)
Ratios make financial analysis easier because it allow you to figure out what is happening on the
financial statements. They also allow you to compare your firm to others in your industry.
Five major categories of ratios
1 Financial Liquidity ratio Show the ability of the company to pay off its short-term debt
obligation. It focuses on the relationship of a firm's current assets to
its currents liability (Investopedia, 2015).
2 Financial Leverage

Show the ability of the company to pay off its long-term debt
obligation. It focuses on the firm long-term liabilities.

3 Asset Efficiency ratio

Show how efficiently a company manages the asset under its control.

4 Profitability ratio

Show the ability of the company to manages overall operations. It

focuses on overall income and profit that firm generated.

5 Market Value ratio

Show the market current perception of the company in regard to

future profit potential.

(ii)
Current Ratio = Current Assets / Current Liabilities
Current ratio2015 = 1.85:1
Quick Ratio = (Current Assets Inventory) / Current Liabilities
Quick ratio2015 = 1.00:1
In 2014, although the firm has improve in increasing its current asset, but its current liabilities is
increasing also. This make company's liquidity positions fall to below the industry average.
However, the company projected that their will be improve to meet the industry average in 2015.
2015

2014

2013

Industry Average

Current ratio

1.85:1

1.78:1

2.02:1

1.85:1

Quick ratio

1.00:1

0.87:1

1.14:1

1.0:1

Different types of analysts have a different interest in the liquidity ratios. Since the liquidity ratios
measure the ability of the company to pay short-term debt obligations, so short-term creditors such
as bankers are more interested in liquidity assessment than managers because they have to be sure
that the company have the short-term debt-paying ability.

(iii)
Inventory Turnover = Cost of goods sold/ Average inventory
Inventory turnover2015 = 1.78 times
Days Sales Outstanding = Account receivables / (Annual sales/365)
Days sales outstanding2015 = 155 days
Fixed Assets Turnover = Net sales / Average fixed assets
Fixed assets turnover2015 = 7.18 times
Total Assets Turnover = Net sales / Average total assets
Total asset turnover2015 = 0.94 times
Everelite
Inventory turnover

Days sales outstanding

1.78 times

Industry
6.10 times Everelite stores inventories extremely longer
than the other firms in its industry.
Consequently, a lot of money has tied up in
inventory and the more chance a company
has of inventory obsolescence.

155 days

56 days Everelite collect money from sales in

extremely longer than the industry average.
Implying, they are facing a problem in money
collection or its collection policy should be
adjusted.

Fixed asset turnover

7.18 times

9.30 times Everelite's fixed asset turnover is lower than

industry average. It mean they are less
efficiency than industry average in using their
fixed assets to product the sales.

Total asset turnover

0.94 times

2.10 times The firm's total asset turnover is below the

industry average. It mean they are less
efficiency than industry average in using their
total assets to product the sales.

(iv)
Debt Ratio = Total liabilities / Total assets
Debt ratio2015 = 0.75
Times-Interest-Earned = EBIT / Interest expense
Time Interest Earned ratio2015 = 5.90
Everelite
Debt ratio
Time Interest Earned ratio

Industry
75%

50%

5.90 times

6.20 times

In conclusion, The Everelite's debt ratio and time interest earned ratio is lower than the
industry average. It show that the company fund most of their money from the debt to operate their
business, as well as company is in the lower position to pay its interest obligations and so more
default risk. This is a bad sign for the company, so they should try to minimize the debt.

(v)
Operating Margin = EBIT / Net sales
Operation margin2015 = 8%
Profit Margin = Net income / Net sales
Profit margin2015 = 4%
Basic Earning Power = EBIT / Average total assets
Basic earning power2015 = 7%
Return on Assets = Net income / Average total assets
Return on assets2015 = 4%
Return on Equity = Net income / Average common stockholder's equity
Return on equity2015 = 13%
2015

2014

2013

Industry
Average

Operation margin

8%

6%

12%

13% Everelite' operating margin is

below industrial average. Though
Everelite has improved the sales in
2014, but they cannot control the
operating costs. Hence, its
operation margin drop drastically.

Profit margin

4%

3%

7%

9% Everelite' profit margin is below

industrial average. Though
Everelite has improved the sales in
2014, but they cannot control the
operating costs as well as obviously
increase in interest expense. Hence,
its profit margin drop drastically.

Basic earning
power

7%

7%

14%

15% Everelite's basic earning power is

below industrial average. Though
total assets increase from 2013, but
they do not have ability to use
added assets to generate income
efficiently.

Return on asset

4%

3%

8%

6.5% Everelite's 2013 return of asset is

more than the industrial average,
but its drop distinctly to below the
industrial average in 2014 and still
under the industrial average in
2015. Meaning, firms do not have
the efficiency of asset usage
comparing to other firms in its
industry.

Return on equity

13%

10%

23%

12% Everelite's 2013 return of equity is

more than the industrial average,
but its drop distinctly to below the
industrial average in 2014.
However, it is projected that its will
recover to a little above the
industrial average in 2015. It mean

the firm do better performance

based on its average shareholders'
equity outstanding.
(vi)
Price/Earning Ratio = Market price per share / Earning per share
Price/earnings ratio2015 = 23.70 times
Market/Book ratio = Market price per share / Book value per share
Market/book ratio2015 = 3.37 times
2015

2014

2013

Industry Average

Price/earnings ratio

23.70 times

23.38 times

14.53 times

10.00 times

Market/book ratio

3.37 times

2.36 times

3.34 times

3.00 times

The very high price per earning ratio compared to the industry average show that investors
expect the company's earning will improve dramatically in future.
(vii)
Improvement in the Day Sales Outstanding would tend to affect the stock because it increase
cash flow in operating business.
To illustrate of this, assumed that the company adjust the collection policy and improve its
collection procedures from 155 days to 56 days (at industrial average). As the table below, the cash
from collection increase $ 237,841.30 after adjust new cash collection procedures.

Old cash
collection policy
(155 days)

Adjusted cash
collection policy
(56 days)

Cash collected from credit sales*

$ 372,380.92
$ 134,537.62
*Cash collected from credit sales = Sales Per Day x Day Sales Outstanding
= 876,897/365 x Day Sales Outstanding

Net cash increase

$ 237,843.30

The amount of increased cash could be used to expend the business, improve the firm's
operation, and pay off the debt that is the major risk of the company.
(viii)
Everelite's inventory turnover ratio is very low compare to the other firms in its industry
throughout 3 years period. Hence, a lot of money has tied up in inventory and the more chance a
company has of inventory obsolescence. Additionally, it can imply that company have a problem in
sale forecast or a problem in selling the product.
If the company could increase the inventory turnover, this would improve company's
financial liquidity, financial leverage and efficiency which culminate in better company's
profitability and stock price.

(ix)
As a credit manager, I would not continue to sell to Everelite on credit even if the firm's
projected ratio is improving, the firm debt ratio is very high, at 75%. It is too risk to continue to
sell on credit with Everelite.
Similarly, if I was the bank loan officer, I would recommend Everelite not renewing the loan
because the firm debt is very high and Everelite should try to lower the firm's debt to make the
company more stable financial position.
(x)
Some potential problems and limitations of financial ratio analysis are:
1. The ratio analyze the company at a point of time, therefore inflation and deflation could deviate
the ratio.
2. Supply and demand of some goods and services is affected by seasonal factors. This could distort
the ratio.
3. It is difficult to conclude from the ratio analysis' results that company are good or bad company
4. Many firms have subdivisions that operate in different industries, so it is hard to find the average
ratio that is appropriate to compare with.
5. Each company has different policies for recording the same accounting transaction. For example,
some use LIFO method in managing inventory, some use FIFO method or some use accelerate
depreciation method, some use straight-line depreciation method.
6. Each company has different company strategy. For example, discount store use low cost strategy,
so they have low gross margin. On the contrary, luxury brand shop use differentiation strategy, so
they have higher gross margin.
(xi)
To evaluating a company's likely future financial performance, some qualitative factors
analysts should consider are:
1. How many customers does the firm have? Firm that most of its sale hinge on one customer are
riskier than the firms that have various customers.
2. How many products does the firm have? Firm that focus on manufacturing or selling a single
product tend to have lower cost of good sold and higher profit margin than the firm that its product
is various.
3. How many suppliers does the firm have? Firm that most of its sale rely on one supplier are riskier
than the firms that have many supplier.
4. What percentage of the firm's business is generate oversea? The firm that most of its income
originate from oversea could expect the higher growth in sales and higher profit margin. On the
other hand, they confront with the higher risk in international business management
5. What is the competitive situation? The more strongly competition, the more competition in
discount. It mean the average profit margin of its industry is lower.
6. What does the future has in store? Firm that the key success factor in operating business is
inventing or evolving the new product to the market tent to have high product research and
development cost.
7. What is the company's legal and regulatory environment? The change in legal and regulatory
effect the way that firm operating in the future.

Question 2
The capital of a company is composed of common equity, preferred stock and the debt. The
cost of each component is called its component cost. These cost are then combined to form a
Weighted Average Cost of Capital (Brigham et al., 2011). The weighted average cost of capital is
affected by a number of factors Some are beyond the firms control, but others can be influenced by
its financing and investment decisions (Brigham and Houston, 2004).
The factors affecting the cost of capital that the firm cannot control
1. The level of Interest Rates
The interest rates affect the supply and demand of the capital in the economy (Petty and Petty,
2009). If interest rates in the economy increase, the demand of the capital increase, the expected
return on investment of the investors or banker is increase. Consequently, the cost of both debt and
equity capital increase because firms have to pay more to obtain the capital.
2. The level of Stock Prices.
If the stock prices in general decline, pulling the firm's stock price down, its cost of equity will rise
(Brigham and Houston, 2004).
3. Market Risk Premium
The perceived risk in stocks determine the market risk premium. It effects the cost of equity and,
thought a substitution effect, the cost of debt, and thus the Weighted Average Cost of Capital
(Brigham and Ehrhardt, 2014).
4. Tax Rates
Tax rates have an important effect on the cost of capital because they affect the after-tax cost of
debt that is used in the calculation of the component cost of debt (Brigham and Houston, 2004). As
tax rates increase, the cost of debt decreases, decreasing the cost of capital.

The factors affecting the cost of capital that the firm can control]
1. Capital structure policy
A firm could directly control its cost of capital by changing its capital structure. If the firm make a
decision to use more debt and less common equity, this change in the Weighted Average Cost of
Capital equation will tent to lower the Weighted Average Cost of Capital (Brigham and Houston,
2004).
2. Dividend policy
The dividend policy set out the percentage of earning paid out in dividends. This policy affects the
stock's required rate of return. If the firm's pay out ratio is so high that it must issue new stock to
fund its capital budget, this will force it to incur flotation cost, and this too will affect its cost of
capital (Brigham and Houston, 2004).

3. Investment policy
When the firms make investment decision, the company determine the investment that meet the
existing firm required rate of return and similar level of risk. If a company changes its investment
policy relative to its required rate of return and risk, both the cost of debt and cost of equity will
change (Investopedia, 2008).

Question 3
Maximization of shareholder, in other word maximization of the market value of the firm's
common stock, is long-term goal. Therefore, we need not focus on every stock price change,
particularly short-term price changes, and emphasize on the long-term growth instead.
For example, if one action increases a firms stock price from a current level of $20 to $25
in 6 months and then to $30 in 5 years but another action keeps the stock at $20 for several years
but then increases it to $40 on 5 years. From this example, the second action would be better
because second action increase the wealth of shareholder than the first action in the long run (as you
can see from the table below).
Present Value of the first action
Present Value of the second action

5
(1+0.1)0.5

15

+ (1+0.1)5= $ 7.8719

20
(1+0.1)5

= $ 12.418

However, there is some firms that too focus on short-term profits and generating attractive
short-term return. They ignore future risks and wider consequent (Adetunji, 2011).
A recently example is the Volkswagen emissions scandal. Volkswagen, the number 1 car company
by sales in the world (USA TODAY, 2015), has shocked the world by cheating the car' software to
reduce emissions while testing to meet the requirement of the stringent emissions laws of the US,
and allowed the car to breathe freely producing more power, with improved fuel efficiency, and
of course increased toxic emissions when not testing (Mathiesen and Neslen, 2015). Additionally,
the further investigation of US find out that Volk also cheat in the other previous car's models
(EWING, 2015). From this case, despite Volkswagen could reduce the cost of testing and finetuning its cars in the short term, but in the long term they lost consumer trust and are fine the
billions of dollars. Including, the stock price plunge nearly 30% after admitting emission cheat
(Kresge and Weiss, 2015).

References

Adetunji, J. (2011). Short-term profit can be dwarfed by longer-term losses. [online] the Guardian.
Available at: http://www.theguardian.com/sustainable-business/short-term-profit-long-term-losses
[Accessed 12 Oct. 2015].
Brigham, E. and Ehrhardt, M. (2014). Financial management. Mason, Ohio: South-Western.
Brigham, E., Houston, J., Chiang, Y., Lee, H. and Ariffin, B. (2011). Core concepts of financial
management. Singapore: Cengage Learning.
Brigham, E. and Houston, J. (2004). Fundamentals of financial management. Mason, Ohio:
Thomson/South-Western.
EWING, J. (2015). Volkswagen Says 11 Million Cars Worldwide Are Affected in Diesel Deception.
[online] Nytimes.com. Available at:
http://www.nytimes.com/2015/09/23/business/international/volkswagen-diesel-carscandal.html?_r=0 [Accessed 16 Oct. 2015].
Investopedia, (2008). Factors Affecting the Cost of Capital - CFA Level 1 | Investopedia. [online]
Available at: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/factorsaffecting-cost-of-capital.asp [Accessed 11 Oct. 2015].
Investopedia, (2015). Why should sunk costs be ignored in future decision making?. [online]
Available at: http://www.investopedia.com/ask/answers/042115/why-should-sunk-costs-beignored-future-decision-making.asp [Accessed 15 Oct. 2015].
Kresge, N. and Weiss, R. (2015). Volkswagen Drops 23% After Admitting Diesel Emissions Cheat.
[online] Bloomberg.com. Available at: http://www.bloomberg.com/news/articles/2015-0921/volkswagen-drops-15-after-admitting-u-s-diesel-emissions-cheat [Accessed 11 Oct. 2015].
Mathiesen, K. and Neslen, A. (2015). VW scandal caused nearly 1m tonnes of extra pollution,
analysis shows. [online] the Guardian. Available at:
http://www.theguardian.com/business/2015/sep/22/vw-scandal-caused-nearly-1m-tonnes-of-extrapollution-analysis-shows [Accessed 10 Oct. 2015].
Petty, J. and Petty, J. (2009). Financial management. Frenchs Forest, N.S.W.: Pearson Education
Australia.
USA TODAY, (2015). VW surpasses Toyota as world's largest automaker in first half of 2015.
[online] Available at: http://www.usatoday.com/story/money/2015/07/28/volkswagen-surpassestoyota-worlds-largest-automaker-first-half-2015/30772509/ [Accessed 10 Oct. 2015].

Bibliography

Besley, S. and Brigham, E. (2008). Essentials of managerial finance. Mason, OH: Thomson/Southwestern.
Block, S. (2013). Foundations of financial management with time value of money card. [Place of
publication not identified]: Mcgraw Hill Higher Educat.
Garrison, R., Noreen, E. and Brewer, P. (2014). Managerial accounting. New York: McGraw-Hill
Education.
Weygandt, J., Kimmel, P. and Kieso, D. (2015). Managerial accounting. Singapore: Wiley.