Question

1.1)State the potential benchmarks that an analyst could use to compare a company’s financial ratios, and discuss the advantages and limitations of each of these alternatives.

1.2) Explain how, in a period of rising prices, would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation?

a.)Gross profit margin

b.)Current ratio

c.)Asset turnover ratio

d.)Debt-to-equity ratio

Answer 1

Q1) The potential benchmarks that an analyst could use to compare a company's financial ratios are:

1) Liquidity of company: The ratio indicate in this benchmark to judge whether company is able to pay its short term obligation or not.

Advantages: Analyst able to judge the current liabilities of the company and is able to invest for short term perspective.

Limitation: Not able to analyse the long term obligation of the company.

2) Solvency: The ratio indicate in this benchmark to judge whether company is able to pay its long term obligation or not.

Advantages: Analyst able to judge the non current liabilities of the company and is able to invest for long term perspective.

Limitation: Not able to analyse the short term obligation of the company.

3) Profitability: The ratio indicate in this benchmark to judge whether company is able to fulfill its main motive which is profitability of the company or not.

Advantages: Analyst able to judge the profitability of the copany for both short as well as long term perspective.

Limitation: Unable to analyse from perpective of liability and assets of company.

Q2) During the period of rising prices, the decision to select LIFO rather than FIFO, the accounting decision will be affected as:

1) Gross Profit margin = (Revenue-COGS)/Revenue

As we select LIFO rather than FIFO and prices increases then the last purchase goods cost is costllier than the earlier purchased goods. This lead to increase in COGS which ultimately decreases gross profit(numerator) and hence decreases the Gross profit margin.

2) Current Ratio = Current asset/current liability

As we select LIFO rather than FIFO and prices increases then the last purchase goods cost is costllier than the earlier purchased goods. Assuming that the last purchase good expenses is paid which ultimately decrease the cost or inventory value of stock directly reduce the current asset and thus reduce the ratio of current ratio.

3) Assets turnover ratio = revenue/ total assets

As we select LIFO rather than FIFO and prices increases then the last purchase goods cost is costllier than the earlier purchased goods. Assuming that the last purchase good expenses is paid which ultimately decrease the cost or inventory value of stock directly reduce the current asset and thus reduce the ratio of assets turover ratio.

4) Debt to Equity ratio = Debt/Equity

As we select LIFO rather than FIFO and prices increases then the last purchase goods cost is costllier than the earlier purchased goods. Then liability will increase but it doesn't lead to specifically say that Debt or Equity will increase or reduce. So, it doesn't affect the ratio.