"Financial Report":Financial Analysis
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Questions 1:
A company operating in a highly fragmented and competitive industry reported an increase in return on equity (ROE) over the prior year. Which of the following reasons for the increase in ROE is least likely to be sustainable? The company:
A 、increased the prices of its product significantly.
B、 decided to make greater use of long-term borrowing capacity.
C、 implemented a new IT system, allowing it to reduce working capital levels as a percentage of assets.
Questions 2:
The following data are available on a company:
The least likely explanation for the improvement in the cash conversion cycle is that the firm improved on its:
A、 ability to collect from customers.
B 、payments to suppliers.
C、 inventory management.
A is correct.
An increase in price is not sustainable in a fragmented and competitive industry. Fragmented industries tend to be highly price competitive because of the need to increase market share and undercut prices in an attempt to steal share.
B is incorrect. Increasing the use of long-term borrowing capacity will increase leverage and increase ROE and is sustainable as long as the company maintains that level of leverage.
C is incorrect. By lowering the amount of working capital in the business, the company lowered its average total assets and average shareholders’ equity and increased its turnover ratio. Holding all else equal, a lower average total asset will increase the ROE through the higher turnover ratio. This strategy is sustainable because it relies on an improvement in productivity generated by new technology (new IT system).
C is correct. The cash conversion cycle = DSO + DOH – Days in payables
The company’s cash conversion cycle improved. The reduction in days of sales outstanding indicates that the company improved its collections from customers and shortened the cash conversion cycle. The increase in number of days of payables indicates that the company took longer to pay suppliers, which also shortened the cash conversion cycle and indicates greater liquidity. The only metric that deteriorated is days of inventory on hand, which indicates that the company tied up more capital in inventory. Therefore, inventory management did not improve the cash conversion cycle.
A is incorrect. The reduction in days of sales outstanding indicates that the company improved its collections from customers. This also served to shorten the cash conversion cycle and indicates greater liquidity. Therefore, the response is valid as it did represent an improvement.
B is incorrect because the increase in number of days of payables indicates that the company took longer to pay suppliers, which served to shorten the cash conversion cycle and indicates greater liquidity. Therefore, the response is valid as it did represent an improvement.
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