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

(a): The answers will be statements “1”, “2” and “4”.

The four companies are in very different industries – one is a software company, one is an automobile company while one is a utility company.

The operating characteristics of firms across different industries vary significantly resulting in very different ratio values – For example usually utility companies carry higher amount of debts than a software company.

Caution must be exercised when comparing older to newer firms, e.g., utility company vs. Software Company this is because of differences in the operating and business metrics in the two cases.

(b): The answers will be statements “3” and “4”.

Electric utility company and fast food company quickly receives payments for their services once bill is raised and so accounts receivable amount is very low in their books.

Moreover they operate mostly on cash basis and all income is received in cash almost instantly on raising the bill and they pay their expenses also without too much delay.

(c ): Here all the statements will be applicable i.e. statements 1,2 , 3 and 4.

Electric utility company has steady and predictable cash inflows in form of regular bill payments. In contrast cash flows of a software company cannot be predicted accurately. Moreover there will be more competing firms in the software industry that will make their cash flows unsteady and hence slightly volatile as well.

(d): The answer will be statements “3” and “4”.

Only by putting money in the software company no benefit of diversification will be achieved.

Although profits are high for the software company so are the risks.