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.