Question

In: Finance

Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is now​ invested, Robert performs a ratio analysis on each one and decides to compare them to each other.

 

FIN101

Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is now​ invested, Robert performs a ratio analysis on each one and decides to compare them to each other. Some of his ratios are listed here:

 

Island

Burger

Fink

Roland

 

Ratio

Electric Utility

Heaven

Software

Motors

Current ratio

1.06

1.35

6.79

4.55

Quick ratio

0.92

0.87

5.23

3.73

Debt ratio

0.69

0.45

0.04

0.34

Net profit margin

6.25%

14.33%

28.46%

8.43%

Assuming that his uncle was a wise investor who assembled the portfolio with​ care, Robert finds the wide differences in these ratios confusing. Help him out.

  1. What problems might Robert encounter in comparing these companies to one another on the basis of their​ ratios? (Select all the answers that​ apply.) (0.25 Marks)

 

  1. The four companies are in very different industries.
  2. The operating characteristics of firms across different industries vary significantly resulting in very different ratio values.
  3. Financial ratios from software companies are never very reliable.
  4. Caution must be exercised when comparing older to newer​ firms, e.g., utility company vs. software company.
  1. Why might the current and quick ratios for the electric utility and the​ fast-food stock be so much lower than the same ratios for the other​ companies? (Select all the answers that​ apply.) (0.25 Marks)
  1. Their inventory balances are going to be very close to zero because it is impossible to stockpile electricity and burgers.
  2. The explanation for the lower current and quick ratios most likely relates to poor management performance.
  3. Their accounts receivable balances are going to be much lower than for the other two companies.
  4. The explanation for the lower current and quick ratios most likely rests on the fact that these two industries operate primarily on a cash basis.
  1. Why might it be all right for the electric utility to carry a large amount of​ debt, but not the software​ company? (Select all the answers that​ apply.) (0.25 Marks)
  1. A high level of debt can be maintained if the firm has a​ large, predictable, and steady cash flow.
  2. The software firm will have very uncertain and changing cash flow.
  3. Utilities tend to have steady cash flow requirements.
  4. The software industry is subject to greater competition resulting in more volatile cash flow.
  1. Why​ wouldn't investors invest all of their money in software companies instead of in less profitable​ companies? (Focus on risk and​ return.) (Select all the answers that​ apply.) (0.25 Marks)
  1. Software companies tend to carry large debt which represents senior claims on the​ companies' assets.
  2. Investors​ wouldn't invest all of their money in software companies because their average collection period is usually very high.
  3. By placing all of the money in one​ stock, the benefits of reduced risk associated with diversification are lost.
  4. Although the software industry has potentially high profits and investment return​ performance, it also has a large amount of uncertainty associated with the profits.

Solutions

Expert Solution

Part (a):

As per Current ratio, Fink Software needs to be selected because of a strong liquidity position.

As per the Quick Ratio, Fink Software needs to be selected because of a strong short-term solvency position.

As per the Debt Ratio, Fink Software needs to be selected because of lower risk and at the same time higher returns because of a high percentage investment in Equity.

As per the Net Profit Margin Ratio, Fink Software has the highest profitability.

Note:

The ratios are calculated using the below formulae:

1. Current Ratio = Current Assets / Current Liabilities

2. Quick Ratio = Quick Assets / Current Liabilities

3. Debt Ratio = Debt / Equity

4. Net Profit Margin Ration in % = (Net Profit / Net Sales) * 100

Part (b):

Ratio Analysis can be done within the Industry as well as between different industries.

Part (c):

  1. Their inventory balances are going to be very close to zero because it is impossible to stockpile electricity and burgers.
  2. The explanation for the lower current and quick ratios most likely relates to poor management performance.
  3. Their accounts receivable balances are going to be much lower than for the other two companies.
  4. The explanation for the lower current and quick ratios most likely rests on the fact that these two industries operate primarily on a cash basis.

Inference - The above statement given in the analysis made by Mr. Robert is correct.

Part (d):

The inference made by Robert is correct as The company which has a steady cash flow or profits can take the rish and invest in high amount of debt. This is because interest payment is a fixed cost and also an irrelevant cost for decision-making. Further, tax savings is also available. This increases the retained earnings of the company.

Part (e):

The analysis made by Mr. Robert is correct as high degree of investment in software companies gives higher return with higher risk. There is a famous saying that "Higher the risk is higher the return". This higher risk can be mitigated by diversification of portfolio.


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