Alejandro Escalante

Homework Chapter 3

QUESTIONS 1. Investors use the information to assess whether or not they want to put money into the company. Equity investors look for an indication of stability and the potential growth. Debt investors are concerned with the firm's ability to generate cash to make interest .Vendors who supply the firm on credit look for its ability to pay its bills in the short term. Management uses financial information to pinpoint problem areas for improvement in operations. 2. Financial information about companies comes mainly from the companies themselves. The primary source is the annual report. The numerical information is usually correct, especially with respect to prospects for the future. 3. The whole idea behind financial analysis is to be investigative and critical. The analyst is always looking for potential problems that may make the future less attractive than the past. 4. Cash in the bank is an asset that had to be put there. Putting it there uses cash that then can't be used anywhere else until it's withdrawn. Thus, increasing the cash balance uses cash. 5. The Changes in the equity accounts come from three sources, net income, dividends and the sale of new stock. Net income is included in operating activities, while dividends and new stock sales are part of financing activities. The change in the cash balance is treated as a reconciling item in the cash flow format. 6. Free cash flow is a firm's gross cash flow less necessary reinvestments. It's essentially cash available for distribution as dividends. When one company acquires another, the acquirer is interested in the future free cash flow of the acquiree as an indication of whether the parent firm will have to invest more cash after the acquisition or will be able to take some out for use elsewhere. 7. Ratios are formed by dividing sets of numbers drawn from financial statements. The magnitude of each ratio serves as a measure of the firm's performance with respect to some aspect of its business. Taken together, ratios can give an overall picture of how effectively a firm is being managed. 8. Performance on particular ratios differs a great deal between types of business. Therefore, a ratio value doesn't mean much without a comparison to some standard that indicates whether performance is good or bad. The common comparisons are with the competition, history, and budget. 9. The money flowing into and out of a firm due to normal business operations passes respectively through current assets and current liabilities that are defined to become or require cash within a year. Hence, at a point in time, anything coming in within a year is in current assets while anything going out in a year is in current liabilities. 10.Inventory is particularly subject to overstatement and may be difficult to convert to cash. Therefore, a measure of liquidity that does not depend on inventory is appropriate.

Alejandro Escalante

Homework Chapter 3

11. Probably not, since customers routinely stretch payables, and an ACP of five days over terms isn't unusual. It could, however, indicate a substantial long overdue account among a majority of customers paying on time. If that's the case, the account may be uncollectible and require a write off. 12. Sometimes debt is taken to mean long-term bonds or loans only. Another definition includes short-term interest bearing notes and loans. Still a third approach includes current liabilities, which generally don't bear interest. When dealing with debt management ratios it is important to define exactly what is meant. 13.The debt is risky because it burdens the income statement with interest that must be paid regardless of profitability. Hence a leveraged company will fail more easily in bad times than one without debt. Too much debt depends to some extent on industry practice. The TIE ratio is a good indicator of whether the interest burden is excessive relative to the firm's ability to generate earnings. The debt ratio and the debt to equity ratio are good measures relative to other firms. 14. The TIE measures the number of times EBIT covers interest. However, interest is a cash expense while EBIT does not represent cash flow. Therefore situations can exist in which TIE appears high but there isn't much cash to cover interest payments. 15. Market value ratios depend on the perceptions of investors as reflected in the price of a firm's stock. That price is influenced by the things managers do and by a number of other factors outside of management's control. Hence the ability of managers to influence market prices and therefore market value ratios is limited and imprecise. 16. Managements have the ability to manipulate financial information to make a companys performance look better than it is, and many do just that. The severity of this practice varies from interpreting accounting rules as favorably as possible to outright fraud. Auditors are supposed to prevent this kind of deception, which leads to misstated financial results, but often miss it. PROBLEMS 1. a. Waterfords current account detail is: Beginning $1,875 438 722 217 Ending $3,810 2,676 2,084 456 Change ($1,935) ( 2,238) 1,362 239 ($2,572)

Accts Rec Inventory Payables Accruals Total

Alejandro Escalante

Homework Chapter 3

b. We should be very concerned about Waterfords financial health. The increases in receivables and inventory far outstrip the gain in sales revenue. This indicates that the firm may be having trouble collecting its receivables and has likely invested in inventory it cant sell. The fact that payables have also risen dramatically indicates Waterford may be having trouble paying its bills on time. The magnitude of these increases makes it look like failure may be just around the corner. 2. Net Income is: Revenue Less: Cost/expense Net Income Current account detail is: Beginning $1,456 943 205 95 Ending $2,207 786 182 83 Change ($751) 157 ( 23) ( 12) ($629) $9,453 7,580 $1,873

Accts Rec Inventory Payables Accruals Total

Then: Cash Flows From Operating Activities Net Income $1,873 Depreciation 1,462 Change in current accts (629) Cash flow from operating activities $2,706 3. First summarize the changes in working capital as follows. Latigoe Inc. Changes in Working Capital Accounts For the period ended 12/31/X8 ($000) 20X7 20X8 Change $2,329 $13,653 ($1,245) $ 509 754 ($ 196) $1,397

Accounts Receivable $ 7,943 $ 5,614 Inventory $12,408 Accounts Payable $ 1,699 $ 2,208 Accruals $ 950 $

The Statement of Cash Flows follows.

Alejandro Escalante

Homework Chapter 3

Latigoe Inc. Statement of Cash Flows For the period ended 12/31/X8 ($000) OPERATING ACTIVITIES: Net Income Depreciation Change in WC Cash from Operating Activities INVESTING ACTIVITIES: Increase in Fixed Assets Cash from Investing Activities FINANCING ACTIVITIES: Decrease in Debt Dividends Paid New Stock Sold Cash from Financing Activities NET CASH FLOW ($7,655) ($2,900) $4,800 ($5,755) 598) $5,560 $4,268 $ 1,397 $11,225

($6,068) ($6,068)

Reconciliation Beginning Cash $3,245 Net Cash Flow ($ 598) Ending Cash $2,647 4. FITCH INC Changes in Working Capital Accounts For the period ended 12/31/X1 ($000) 20X0 20X1 Change

Accounts Receivable $4,832 $5,614 ($782) Inventory $3,217 $2,843 Accounts Payable $1,642 $1,420 ($222) Accruals $ 438 $1,228 $790

$374

Alejandro Escalante

Homework Chapter 3

$160 FITCH INC. Statement of Cash Flows For the period ended 12/31/X1 ($000) OPERATING ACTIVITIES: Net Income $4,397 Depreciation $2,212 Change in WC $ 160 Cash from Operating Activities $6,769 INVESTING ACTIVITIES: Increase in Fixed Assets ($4,273) Cash from Investing Activities ($4,273) FINANCING ACTIVITIES: Decrease in Debt ($1,414) Dividends Paid ($3,100) New Stock Sold $2,500 Cash from Financing Activities ($2,014) NET CASH FLOW $ 482

Reconciliation Beginning Cash $2,165 Net Cash Flow $ 482 Ending Cash $2,647