Question

 

FIN101

1. 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.

2. 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.

3. 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.

4. 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

Question:1

What problems might Robert encounter in comparing these companies to one another on the basis of their​ ratios?

Answer:

Here, the four companies are different from each other in their structure, financial management and operations. Comparison should be between similar industries or sectors.

Question:2

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?

Answer:

Here, the current ratio and quick ratio give the current liquidity position of the company. It may differ from company to company and comparison cannot be between different companies. Current and quick ratio can be compared between similar industries or same sectors. Here the electric utility have few inventory but burgers cannot have inventory.The current ratio and quick ratio of these industries are less because they mostly operate on cash.

Question:3

Why might it be all right for the electric utility to carry a large amount of​ debt, but not the software​ company?

Answer:

The debt ratio basically shows the company or industry assets which are bought by debt and has to be paid in future. As,the electric utility and fink software company are two different companies or industries and are of different scale, which have different operations and cash flows. It definitely shows the difference in the debt each company has and flow of cash in the company.

Question:4

Why​ wouldn't investors invest all of their money in software companies instead of in less profitable​ companies?

Answer:

Firstly, investors always show interest in investing profitable companies, as it results in less risk and more returns and sometimes more risk and returns depending on the economy. Investing in less profitable companies is not so profitable to investors as it may have less profits.

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