# Problem set 3

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Problem set #3 1. The primary emphasis is evaluating financial ratios for management, equity investors, and long-term potential creditors. - Management: management uses financial ratios to identify areas of strength and weakness within the firm, providing insights into where attention is needed - Equity investors: For equity investors, financial ratios are crucial in predicting future earnings, dividends, and free cash flow - Long-term potential creditors: Long-term potential creditors utilize ratios to determine the company's creditworthiness. 2. Profitability ratios for Hemingway Corporation for 2020: i. Operating profit margin = EBIT/Sales = 1478/7000 ≈ 21.1% ii. Return on assets (ROA) = Net income/Total assets = 1028/4946 ≈ 20.8% iii. Return on equity (ROE) = Net income/total common equity = 1028/2924 ≈ 35.2% iv. Basic earning power (BEP) = EBIT/total assets = 1478/4946 ≈ 29.9% 3. Asset management ratios for Hemingway Corporation for 2020: i. Total assets turnover = Net sales/ total assets = 7000/4946 ≈ 1.4 ii. Fixed assets turnover = Net sales/net fixed assets = 7000/3520 ≈ 2.0 iii. Inventory turnover = (Cost of goods sold + depreciation)/Inventories = (4800 + 322)/840 ≈ 6.1 4. Liquidity and debt management ratios for Hemingway Corporation in 2020:
i. Current ratio = total current assets/total current liabilities = 1426/922 ≈ 1.5 ii. Quick ratio = (total current assets - inventories) / total current liabilities = (1426 - 840) / 922 ≈ 0.6 iii. Debt ratio = total debt/total assets = notes payable + long-term bonds/total assets = (252 +1100) /4946 ≈ 27.3% 5. - Trend analysis: the technique that reveals the financial conditions of a firm are improving or deteriorating. Profitability ratios for Hemingway Corporation for 2021: - Net profit margin = net income /sales = 1049/7600 ≈ 13.8% - Operating profit margin = EBIT/Sales = 1498/7600 ≈ 19.7% - Gross profit margin = (Sales - cost of goods including depreciation) / sales = (7600 - 5320 + 372)/7600 ≈ 25.1% - Basic earning power (BEP) = EBIT/total assets = 1498/5036 ≈ 29.7% - Return on total assets (ROA) = Net income/total assets = 1049/5036 ≈ 20.8% - Return on common equity = net income/common equity = 1049/3216 ≈ 32.6% 6. The trend analysis indicates that Hemingway Corporation's financial performance worsened from 2019 to 2020. However, it is projected to improve in 2021. Ratio 2019 2020 2021 Est. Operating profit margin 22.3% 21.1% 19.7% ROA 25% 20.78% 20.8% ROE 39% 35.15% 32%
BEP 35% 29.9% 29.7% Total asset turnover 1.58 1.4 1.51 Fixed asset turnover 2.2 1.99 2.04 Inventory turnover 7.3 6.09 8.37 Current ratio 1.44 1.55 1.74 Quick ratio 0.79 0.6 0.84 Debt ratio 23.8% 27.3% 24.2% 7. Benchmarking: a technique in which companies compare their financial ratios with a select group of peers, often industry leaders known for efficient management. Ratio 2019 2020 2021 Est. Industry Average Total asset turnover 1.58 1.4 1.51 1.6 Fixed asset turnover 2.2 1.99 2.04 2.3 Inventory turnover 7.3 6.09 8.37 6.0 Using this analysis reveals that the total and fixed asset turnover have declined over the years relative to the industry average. However, the inventory turnover, although it worsened from 2019-2020, is expected to surpass the industry average in 2021. 8. ROE for Hemingway Corporation for 2022 = Profit margin * total asset turnover * equity multiplier = 16% * 1.6* 1.7 = 43.52% 9. Four limitations of ratio analysis that Mike is addressing: - Industry variability: ratios can vary widely across industries due to differences in business models, capital requirements, and market dynamics. This makes ratios less reliable for analysis. - Manipulation and window dressing: A company can manipulate its financial statements to present a more favorable picture. This also would make ratios less reliable for analysis. - Lack of context: ratios provide number values, but they don't provide context or any explanation for why certain ratios have specific values. - Inflation effects: ratios are based on financial statements, which can be affected by inflation. 10. Five qualitative factors that the financial statement users should consider when evaluating the company's future financial performance. - The company's management team's competence, experience, and track record can significantly influence its ability to navigate challenges and seize opportunities. Experienced and capable leadership is often indicative of a well-managed company.