Question

2. 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.

a. 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.





b. 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.

c. 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.

d. 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.

Answer 1

Answer (a):

The selected answers are ticked as below:

Explanation:

Island is an Electric Utility company.

Burger is fast food company

Fink is a software company and

Roland is an automobile company

These companies are from different companies. These are mix of service and motor companies. Their operating charactistics differ. As such comparison of ratios of companies across different industries and deriving conclusions would be erroneous.

Although software industries are exposed to higher volatility, it would not prudent to state that financial ratios from software companies are never very reliable

Answer (b):

The selected answers are ticked as below:

Explanation:

Utilitites and Fastfood companies would not have any finished goods inventory. These companies would have lower inventory, lower receivables. These two industries operate primarily on a cash basis.

The current and quick ratios are lower due to reasons as stated above and it would be erroneous to conclude that the lower ratios are due to poor management performance.

Answer (c):

The selected answers are ticked as below:

Explanation:

Utility companies are highly capital intensive and carry large amount of debt. Utility company can maintain high level of debt since it has a large, predictable, and steady cash flow. Utilities tend to have steady cash flow requirements.

Answer (d):

The selected answers are ticked as below:

Explanation:

Although the software industry has potentially high profits and investment return performance, it is also exposed to higher volatility and risk. As such it is important to diversify and invest in companies which may have less profit but they are stable.