Question

Analyzing ratios

One of the most important applications of ratio analysis is to compare a company’s performance with that of other players in the industry or to compare its own performance over a period of time. Such analyses are referred to as comparative analysis and trend analysis, respectively.

Common size analysis requires the representation of financial statements in relation to a single financial statement item or base.

What is the most commonly used base item for a common size balance sheet in the analysis?

Net sales

Total assets

Net income

Earnings before interest and taxes

Suppose you are conducting an analysis of Hungry Hamster Food Services’s past three years’ performance.

Hungry Hamster did not issue new shares during these three years and has faced some operational difficulties. The company has thus piloted some new forecasting strategies to improve its operations management. You have collected the relevant data, made reasonable assumptions based on the information available, and calculated the following ratios.

Ratios Calculated
	Year 1	Year 2	Year 3
Price to cash flow	2.40	3.12	3.49
Inventory turnover	4.80	5.76	6.45
Debt to equity	0.40	0.42	0.50

Based on the preceding information, your calculations, and your assumptions, which of the following statements can be included in your analysis report? Check all that apply.

Hungry Hamster’s ability to meet its debt obligations has worsened since its debt-to-equity ratio increased from 0.40 to 0.50.

The market value of Hungry Hamster’s common shares declined over the three years.

An improvement in the inventory turnover ratio could likely be explained by the new sales-forecasting strategies that led to better inventory management.

A plausible reason why Hungry Hamster’s price-to-cash-flow ratio has increased is that investors expect higher cash flow per share in the future.

Answer 1

What is the most commonly used base item for a common size balance sheet in the analysis?
Net sales
Total assets	Correct	The common figure for a common size balance sheet analysis is total assets.
Net income
Earnings before interest and taxes
Suppose you are conducting an analysis of Hungry Hamster Food Services’s past three years’ performance.
Hungry Hamster did not issue new shares during these three years and has faced some operational difficulties. The company has thus piloted some new forecasting strategies to improve its operations management. You have collected the relevant data, made reasonable assumptions based on the information available, and calculated the following ratios.
Ratios Calculated
	Year 1	Year 2
Price to cash flow	2.4	3.12
Inventory turnover	4.8	5.76
Debt to equity	0.4	0.42
Based on the preceding information, your calculations, and your assumptions, which of the following statements can be included in your analysis report? Check all that apply.
Hungry Hamster’s ability to meet its debt obligations has worsened since its debt-to-equity ratio increased from 0.40 to 0.50.	Correct	If Debt equity ratio is increasing, the company is being financed by creditors rather than from its own financial sources which may be a dangerous trend.
The market value of Hungry Hamster’s common shares declined over the three years.	incorrect	The market value of Hungry Hamster’s common shares increasing over the three years.
An improvement in the inventory turnover ratio could likely be explained by the new sales-forecasting strategies that led to better inventory management.	Correct	Higher inventory turnover ratios are considered a positive indicator of effective inventory management.
A plausible reason why Hungry Hamster’s price-to-cash-flow ratio has increased is that investors expect higher cash flow per share in the future.	Correct	High P/CF ratios are common for companies in their early stages of development when the share price is mostly valued based on their future growth prospects while a small amount of cash is generated.