The Iowa Electronic Markets
Financial Statement Analysis
Curriculum using the IEM
Prepared for the Fall 2000 IEM*IDEA/NSF Conference
By
Thomas A. Rietz, University of Iowa
Marilyn Dutton, North Carolina Central University
Cynthia J. Brown, University of Texas-Pan American
September 2000
Teaching Objectives
Financial Statement Analysis
Motivation
1. Financial statements are the “language” of business.
2. Financial statements show the current state of the firm.
3. Ratios are used to evaluate firm performance.
Access balance sheet and income statements from the web
Students should be able to:
1. Find financial information on publicly traded companies on the web.
Compute, understand and interpret some common ratios
Students should be able to:
1. Compute common financial ratios from a company’s financial statements.
2. Understand the performance objectives measured by the ratios.
3. Interpret the financial ratios and evaluate the company’s performance relative to industry
standards.
Use DuPont analysis to predict P/E and valuation ratios
Students should be able to:
1. Utilize financial ratios to perform DuPont analysis.
2. Use DuPont analysis to predict valuation ratios.
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Trade in IEM based on earnings and valuation predictions.
Students should be able to:
1. Use current information to form expectations on the firm’s future financial performance.
2. Combine current information with analysis of past financial performance to trade in the IEM
Computer Industry Returns market.
3. Observe the relationship between a firm’s financial performance and its share price and
returns.
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Lecture Outline
Financial Statement Analysis
1. Introduction
2. Financial Statements
a. Balance Sheet
b. Income Statement
3. Financial Ratios
a. Liquidity
b. Operating
c. Debt
d. Profitability
e. DuPont
4. Predicting valuation ratios
5. Role of Information in Share Price
6. Combining predictions and information to trade in IEM
7. Conclusion
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Financial Statement Analysis Assignment
Introduction to the IEM
The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts can
be traded (bought or sold). For this assignment, you will be using a series of contracts based on three
popular companies, Apple Computers (AAPL), IBM (IBM) and Microsoft (MSFT), and an important
index called the S&P500 index. Shares of the firms trade over the counter (NASDAQ) and on the New
York Stock Exchange (NYSE). Similarly, a daily index value is determined for the S&P500 based upon
the stock prices of the 500 companies that compose of it.
The contracts you will be using are based on the shares of Apple computers, IBM and Microsoft, and
on the value of the S&P500. These contracts are listed on the IEM under the market label “Computer
Industry Returns Market” or “Comp_Ret” for short. These contracts are described briefly later in this
note and in more depth in the IEM prospectus for the market. The prospectus and other information for
these markets are available at the IEM website:
http://www.biz.uiowa.edu/iem/markets/computer.html
Objectives
The objectives of the IEM assignments are to help you apply class concepts in a "real world,"
unstructured way to learn how to:
1. Utilize information from financial statements to predict future earnings and valuation.
2. Understand the impact of information on share prices.
3. Combine predictions and information to develop a trading strategy.
Opening an IEM Account
All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit
of ____ dollars. Funds remaining in your account are refundable at the end of the semester.
You can open an IEM account over the internet. To do so, go to the sign-up webpage:
http://iemweb.biz.uiowa.edu/signup/
and follow the instructions given to you by your instructor. (DO NOT use forms other than those given
to you by your instructor. Using other forms may result in fees or decreased deposits in your account.)
After filling out your signup forms, you may need to deposit cash with the IEM office (W283 PBAB,
phone 335-0881). Your instructor will give you details about any deposits you need to make.
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Accessing the IEM
You can access the IEM through its website address:
http://www.biz.uiowa.edu/iem/
The IEM market has several contracts trading under it. The contracts of interest for our course are the
Computer Industry Returns Market (Comp_Ret, for short).
You access your trading account from the market pages or directly at:
http://iemweb.biz.uiowa.edu/
Computer Industry Returns Contracts
The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing
contracts in the series are liquidated and payments are made as described below. Then, new
contracts are created as described below. These events occur on the Monday after the exchangetraded options for the underlying stocks expire (the Monday after the third Friday of each month).
The liquidation values for the contracts in this market are determined solely by the rates of return of
Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock
(MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified
below will payoff $1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this
market, you will need to understand what determines real stock market returns.
Contracts are designated by a ticker symbol and a letter denoting the month of contract liquidation.
Thus, the contracts traded in this market for liquidation in month “m” are:
Code
AAPLm
IBMm
MSFTm
SP500m
Underlying Asset
Apple Computers
IBM
Microsoft
S&P 500 Market Index
Liquidation Value
$1.00 if AAPL Return Highest
$1.00 if IBM Return Highest
$1.00 if MSFT Return Highest
$1.00 if SP500 Return Highest
In these contract codes, “m” refers to the month of expiration as given by the following table:
Month
January
February
March
April
Designation
a
b
c
d
Month
May
June
July
August
Designation
e
f
g
h
Month
September
October
November
December
Designation
i
j
k
l
For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing
stock prices of the underlying listed firm between the third Friday in the liquidation month and the third
Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of
the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return
on the underlying stock is computed (as the closing price on the third Friday of the liquidation month,
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minus the closing price from the third Friday of the previous month, plus any dividends on ex-dividend
dates). Then, we divide the raw return by the closing stock price from the previous month to arrive at
the dividend-adjusted rate of return.
For the SP500 contract, the return is computed as the capital gains rate of return. To do this, subtract
the closing index value on the third Friday of the previous month from the closing index value on the
third Friday of the liquidation month. Then, divide by the previous month’s closing index value.
Trading on the IEM
You can trade on the IEM in several ways. First, you can buy or sell unit portfolios (called “bundles”). A
unit portfolio is a set of all contracts in the market such as AAPLm, IBMm, MSFTm and SP500m for the
Computer Industry Returns market. You can always buy or sell such portfolios for $1.00 each. Thus,
when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to
trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market
Order” drop down menu. Enter a quantity and press the “Market Order” button.)
Second, you can buy or sell using a "market order." On the market screen, you will see that some
individuals have posted an order to buy or to sell a contract (e.g., MSFTi, the contract for September
liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted
order represents a good deal, you can buy or sell at the posted price. (To do this, select the
appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down
menu. Enter a quantity and press the “Market Order” button.)
Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to
buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone
who is willing to buy or sell at your stated price. In this manner, when your order executes, it will
execute at your stated price, not at somebody else’s. The negative is that the order may never execute
because nobody likes your price because it is too high or low. (To place a limit order, select the
appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a
price, quantity and expiration date and press the “Limit Order” button.)
Completing Your Assignments and Submitting Them
As you can see below, the IEM assignments are extensive, multi-part assignments that draw together
many concepts from the class. It would be wise to work on the various parts of the assignments as we
go over the relevant topics in class. To prepare the assignments for submission, please use the
following guidelines:
1. Each assignment must be typed. Label clearly each assignment with a cover page giving your
name, student number, and section number.
2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc.
3. Within each section, give the requested information, including sources of information gathered and
equations used to calculate results.
4. Turn in your completed assignment to your instructor on the date it is due.
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Financial Statement Analysis Assignment
Part 1: Finding Financial Information
DUE: ___________
GOAL
In this part of the assignment, you will learn where to find historical financial information about
companies and the aggregate values for the industry in which they operate.
NOTE: There are three different time periods over which people commonly calculate ratios: (1) Annual
(based on annual accounting statements), (2) Quarterly (based on quarterly financial statements) and
(3) Trailing-Twelve-Month or ttm for short (based on aggregated information for the last 12 months).
We will be looking at the most recent quarterly and trailing-twelve-month ratios. Our purpose will be to
compare and contrast these numbers. For example, we will have you compute some and compare to
others that are pre-computed for you. It is important that you keep them straight. To help, we put the
descriptive terms in bold italics.
Historical financial statements
Collect the most recent quarterly financial statements and annual information on the ratios that make
up the DuPont system (Profit Margin (PM), Asset Turnover (AT), Return on Assets (ROA), Return on
Equity (ROE) and the Equity Multiplier (EM)) as well as the debt-to-assets ratio, price-to-earnings (P/E)
ratio and market-to-book ratios for Apple Computer, IBM and Microsoft.
To get the quarterly financial statements, trailing-twelve-month ratios and industry comparisons for
Apple Computer, go to the website http://www.moneycentral.msn.com/investor, enter the ticker symbol
(e.g., AAPL) and click on the Financial Results link on the left hand side of the screen. The
Statements link allows you to select the particular financial statement of interest and view (select
quarterly) using pull-down boxes. The Key Ratios link gives lists ratios in which you can find each of
ratios needed along with industry standards. (The net profit margin, listed under “profit margins;” ROA
and ROA, listed under “investment returns;” and asset turnover, listed under “management efficiency”
are all for the trailing 12 months. The equity multiplier is also known as the “Leverage Ratio” and can
be found under “financial condition.”)
Repeat the process for IBM and MSFT.
Historical share prices
Get each stock’s closing price for the last date covered by the quarterly financial statements.
Historical share price information can also be obtained at the website
http://www.moneycentral.msn.com/investor. After entering the ticker symbol, selection the Charts link.
Selecting Export Data from the File menu will put the historical data in a spreadsheet.
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Industry Ratios
Make up a table that contains share price information and all of the above trailing-twelve-month ratios
for AAPL, IBM and MSFT and their respective industries. (Industry ratios appear with the firm’s ratios
obtained above.)
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Financial Statement Analysis Assignment
Part 2: Predicting Earnings and Valuations
DUE: ___________
GOAL
In this part of the assignment, you will analyze the trailing-twelve-month financial ratios of Apple, IBM
and Microsoft that you collected in Part 1. You will compare each company to their respective industry
and utilize this information to predict future earnings and valuations.
Analyzing Ratios
Using the trailing-twelve-month ratios you have collected for the three firms and their industries:
1. Explain what information each ratio conveys about the firms.
2. Compare the firms and analyze the performance achieved by each firm. As you do this, think
about the relationships in the DuPont system.
Firm Performance versus Industry Benchmarks
Evaluate the firms’ performance compared to others in their industry. Are your firms performing
better or worse than others in their industry? Explain how you know with reference to the ratios.
Predicting Earnings and Valuation
Based on your analysis, what predictions would you make regarding the valuation ratios (P/E and
market/book) of the firms?
Which firm would you expect to have the higher valuation ratios? Explain your reasoning with
reference to the DuPont ratios.
Do the actual valuation ratios bear out your expectations?
Discuss some reasons why the connection between the DuPont ratios and the valuation ratios
may not perfect.
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Financial Statement Analysis Assignment
Part 3: Computing Financial Ratios
DUE: ___________
GOAL
In this part of the assignment, you will learn how to compute quarterly financial ratios using recent
quarterly financial statements for Apple, IBM and Microsoft.
Computing Financial Ratios
Using the most recent quarterly financial statements obtained in Part 1, compute the ratios that
make up the DuPont system (PM, AT, ROA, ROE, EM) as well as the debt/assets, sustainable
growth rates, and P/E and market/book ratios for AAPL, IBM and MSFT.
Make up a table that contains all of the above ratios for the three firms.
Analyzing Changes in Ratios
Compare the quarterly ratios you have computed to the trailing-twelve-month ratios for each
firm. Are they the same? What kinds of possible problems or improvements within the firm are
revealed by changes in the ratios? Explain with reference to specific ratios.
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Financial Statement Analysis Assignment
Part 4: Role of Expectations in Share Price
DUE: ___________
GOAL
In this part of the assignment, you will have to use information about the company and the economic
environment to form expectations about share prices.
Letter to the Shareholders
Obtain a copy of the “management discussion” from the most recent annual reports of Apple, IBM, and
Microsoft. (You can obtain these from the annual reports. Typically, you can view annual reports from
the company’s website under “investor relations.” You can also get annual reports directly from the
Securities and Exchange Commission at their website: http://www.sec.gov. Select the link Search the
Edgar Database. Do a Quick Forms Lookup for the company’s 10-K (annual report). Finally, the
easiest way to see this discussion is to click on the “SEC filings” link on MoneyCentral, select the most
recent annual report and click on the “Mgmt Disc” link.)
What information in this discussion might influence expectations about future earnings and thus the
valuations of the companies?
News Articles
Obtain at least three recent news articles about each company.
What information in these articles might influence expectations about future earnings and thus the
valuations of the companies?
Predictions of Earnings and Valuation
Evaluate the information you gathered from the annual report and recent news articles.
Explain the impact that you expect these to have on each firm’s future earnings, its share price, its
valuation ratios (p/e and market/book) and its sustainable growth rate.
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Financial Statement Analysis Assignment
Part 5: Verifying Predictions
DUE: ___________
GOAL
In this part of the assignment, you will use historical stock price and IEM data to check your prediction
of the impact of performance and news on stock prices and the prices of contracts in the IEM.
Stock Prices and Prices in the IEM
Obtain daily closing stock prices for AAPL, IBM and MSFT for the period during which you gathered
news on the three firms. You can obtain closing prices as discussed in Part 1.
Obtain daily closing price history for the contracts in IEM’s Computer Industry Returns Market. You can
obtain prices from the IEM website for the Computer Industry Returns Market at
http://www.biz.uiowa.edu/iem by selecting the link Computer Returns followed by Data and IEM Daily
Price History.
Comparison
Look at the stock price on the days surrounding each news event. Did you correctly predict the change
in the stock price change in response to the news event?
Did the contract price in the IEM change in the same direction as the stock price?
Discussion
Discuss possible reasons why prices may not have responded to the news in the way you expected.
Discuss possible reasons why the IEM contracts may not have moved in the same direction as the
stock prices.
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Financial Statement Analysis Assignment
Part 6: Implications and Actions
DUE: ___________
GOAL
In this part of the assignment, you will use financial ratios and information to forecast returns for stocks
and turn those forecasts into actions on the IEM.
Prediction
Given all of your analysis in parts 1 to 5, predict what each stock's return and the SP&500 return will be
for the next month. Justify these predictions using the analysis techniques developed in class and in
this assignment.
Which of the securities do you predict will have the highest return? How confident are you of your
prediction?
Implication
Given your predictions above, which IEM contract (AAPLm, IBMm, MSFTm or SP500m) should be
priced the highest at the beginning of trading during the current trading month. Justify your prediction.
(Recall that the contract with the highest actual monthly return will liquidate at $1. The others will expire
worthless. Thus, you need to predict which stock will have the highest monthly return in order to
determine which IEM contract will have the greatest likelihood of payoff. This contract should be priced
the highest.)
Action
Make at least one additional trade in the IEM Computer Industry Returns market between ________
and ________. Log your trades. For each trade, report the date of the trade, the contract traded and
the prices. Attach a printout showing your trading activity. (You can either submit a “Processed
Orders” report or an ‘Order History” report. To get the first report, make sure that the “confirm” box is
checked on the trading screen. You will be asked to “execute” the order. Upon execution, the
“Processed Orders” report will appear. To get the second report, go to “My Account” information select
“view order history” and print the resulting report.)
Justify each trade you make using:
1.
2.
3.
4.
Your forecast returns
The actual returns do date
IEM prices at that time and
Any other information and analysis you wish to include.
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Student Evaluation
Multiple Choice Questions
General on the IEM in general and trading on the IEM
1. What kinds of assets are traded on the IEM?
a. Fixed income
b. Equity
c. Derivative
d. All three
e. None of the above
2. The contracts you trade on the IEM for this class are based on:
a. the returns for entertainment industry stocks.
b. the returns for computer industry stocks.
c. the outcomes of elections.
d. the level of prices in the economy.
3. Ratios can help in IEM trading because they:
a. can help explain past returns for stocks.
b. can help predict future returns for stocks.
c. determine completely the current price of a stock.
d. are based on past accounting numbers.
4. Contracts are created on the IEM through the following procedure:
a. Each trader gets contracts when he or she opens an account.
b. Contracts are created each time you make a purchase.
c. Contracts are created when traders buy bundles.
d. The number of contracts in the market is fixed and, therefore, no contracts are ever created.
5. If you think that AAPL is in the best financial shape and will have the highest return over the next month
among AAPL, IBM, MSFT and the S&P500, you should:
a. Try to buy AAPLm by placing an ask.
b. Try to buy AAPLm by placing a bid.
c. Try to sell AAPLm by placing an ask.
d. Try to sell AAPLm by placing a bid.
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Questions on computing common financial ratios
Answer the questions 6-14 based on the following simplified financial statement from IBM (source: MSN
Investor 10/30/00):
Annual Income Statement
(in Millions)
Sales
Cost of Sales
Selling, General & Admin. Expense
Dep. & Amort.
Other Income, Net
Interest Expense
Pre-tax Income
Income Taxes
Net Income
Assets
Cash and Equivalents
Receivables
Inventories
Other Current Assets
Total Current Assets
Property, Plant
& Equipment, Net
Intangibles
Other Non-Current Assets
Total Non-Current Assets
Total Assets
Dec-99
87,548.00
49,034.00
20,002.00
6,585.00
557
727
11,757.00
4,045.00
7,712.00
Dec-99
Dec-98
5,043.00 5,375.00
27,618.00 26,781.00
4,868.00 5,200.00
5,626.00 5,004.00
43,155.00 42,360.00
17,590.00 19,631.00
0
945
26,750.00 23,164.00
44,340.00 43,740.00
87,495.00 86,100.00
Liabilities & Equity
Accounts Payable
Short Term Debt
Other Current Liabilities
Total Current Liabilities
Dec-99
Dec-98
6,400.00 6,252.00
14,230.00 13,905.00
18,948.00 16,670.00
39,578.00 36,827.00
Long Term Debt
14,124.00 15,508.00
Deferred Income Taxes
Other Non-Current Liabilities
Total Non-Current Liabilities
1,354.00 1,514.00
11,928.00 12,818.00
27,406.00 29,840.00
Total Liabilities
Shareholder's Equity
Total Liabilities & Stock Equity
66,984.00 66,667.00
20,511.00 19,433.00
87,495.00 86,100.00
6. The ROE (measured on an end-of-year basis) for IBM in 1999 was:
a. 8.81%
b. 37.60%
c. 38.62%
d. 57.32%
7. The ROA (measured on an end-of year basis) for IBM in 1999 was:
a. 8.81%
b. 8.89%
c. 8.96%
d. 37.60%
8. The current ratio for IBM in 1999 was:
a. 0.917
b. 1.000
c. 1.090
d. 1.306
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9. The quick ratio for IBM in 1999 was:
a. 0.123
b. 0.967
c. 1.034
d. 1.618
10. The total debt ratio for IBM in 1999 was:
a. 0.306
b. 0.324
c. 0.766
d. 3.266
11. The net profit margin for IBM in 1999 was:
a. 8.81%
b. 13.43%
c. 14.25%
d. 42.99%
12. If the EPS was $4.10 and the dividend was $0.52, the retention ratio for IBM in 1999 was:
a. 0.123
b. 0.873
c. 1.000
d. 1.145
13. The total asset turnover ratio (based on end-of-year numbers) for IBM in 1999 was:
a. 0.506
b. 0.991
c. 0.999
d. 11.345
14. The inventory turnover ratio (based on sales and end-of-year numbers) for IBM in 1999 was:
a. 0.056
b. 1.060
c. 17.984
d. 20.295
Questions on the performance objectives measured by the ratios
15. Liquidity ratios measure the firm’s:
a. ability to cover current obligations.
b. ability to cover long-term debt obligations.
c. activity level relative to amount of resources used.
d. profits relative to amount of resources used.
e. market price relative to assets or earnings.
16. Leverage ratios measure the firm’s:
a. ability to cover current obligations.
b. ability to cover long-term debt obligations.
c. activity level relative to amount of resources used.
d. profits relative to amount of resources used.
e. market price relative to assets or earnings.
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17. Turnover ratios measure the firm’s:
a. ability to cover current obligations.
b. ability to cover long-term debt obligations.
c. activity level relative to amount of resources used.
d. profits relative to amount of resources used.
e. market price relative to assets or earnings.
18. Profitability ratios measure the firm’s:
a. ability to cover current obligations.
b. ability to cover long-term debt obligations.
c. activity level relative to amount of resources used.
d. profits relative to amount of resources used.
e. market price relative to assets or earnings.
19. Valuation ratios measure the firm’s:
a. ability to cover current obligations.
b. ability to cover long-term debt obligations.
c. activity level relative to amount of resources used.
d. profits relative to amount of resources used.
e. market price relative to assets or earnings.
Questions on the interpretation of financial ratios and evaluation the company’s
performance
20. Which of the following would cause Net Worth to increase?
a. One of the firm’s customers pays an outstanding bill with cash.
b. The firm uses cash to pay off a bank note.
c. The firm pays a cash dividend to its stockholders.
d. The firm sells inventory for a profit.
21. If IBM’s quick ratio exceeds 1, then:
a. IBM can pay off all its current obligations if it liquidates its inventory.
b. IBM can pay off all its current obligations even if sales cease.
c. IBM has more current liabilities than current assets.
d. IBM has more current liabilities than current assets if you subtract inventories.
22. If you find that a company’s ratio for a particular item (for example, the company’s debt ratio) is higher
than the industry average, this is:
a. good for the company.
b. bad for the company.
c. can be either of the above.
d. none of the above.
23. The fraction of a firm owned by equity holders is given by:
a. 1/(debt ratio)
b. 1-(debt ratio)
c. (equity ratio)/(debt ratio)
d. cannot be determined by the debt ratio.
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24. All else constant, a surprise announcement that shows a higher ROE for a firm that is expected to
remain after it is announced should:
a. result in a higher than expected return for the company’s stock.
b. result in a lower than expected return for the company’s stock.
c. not affect the company’s stock.
d. lead to the invalidation of the DuPont method.
25. A higher retention ratio should lead to:
a. lower current dividends.
b. higher sustainable growth.
c. higher future dividends.
d. all of the above.
26. A higher profit margin results from:
a. lower assets.
b. lower expenses.
c. lower taxes
d. lower interest.
27. All else constant, a higher asset turnover ratio should lead to:
a. less efficient operations.
b. lower profits.
c. more assets required.
d. all of the above.
e. none of the above.
Questions on DuPont analysis
28. DuPont analysis shows:
a. how profit margin, asset turnover ratio, and equity multiplier determine ROE
b. how expense control, efficient use of assets in production and capital structure affect return on
equity.
c. production and financing aspects of firm are tied together
d. all of the above.
e. none of the above.
29. According to DuPont analysis, an increase in the profit margin (all else constant) should:
a. increase both ROE and ROA.
b. increase ROE but not ROA.
c. increase ROA but not ROE.
d. increase neither ROA nor ROE.
30. According to DuPont analysis, an increase in asset turnover (all else constant) should:
a. increase both ROE and ROA.
b. increase ROE but not ROA.
c. increase ROA but not ROE.
d. increase neither ROA nor ROE.
31. According to DuPont analysis, an increase in the equity multiplier (all else constant) should:
a. increase both ROE and ROA.
b. increase ROE but not ROA.
c. increase ROA but not ROE.
d. increase neither ROA nor ROE.
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32. In 1999, IBM’s equity multiplier was 4.266, its asset turnover was 0.999 and its net profit margin was
0.088. According to the DuPont method, the ROE should be:
a. 8.791%.
b. 37.503%.
c. 37.541%.
d. 426.173%.
33. In 1999, IBM’s equity multiplier was 4.266, its asset turnover was 0.999 and its net profit margin was
0.088. According to the DuPont method, the ROA should be:
a. 8.791%.
b. 37.503%.
c. 37.541%.
d. 426.173%.
Short Answer Questions
1. If you purchase one IBMm contract in the Computer Industry Returns Market for $0.595 and hold until
liquidation, what will be your return if the contract liquidates at $1.00? If it liquidates at $0?
2. Explain how historical information such as financial ratios can be used to help predict returns.
3. Describe your IEM investment objective and trading strategy.
4. Suppose that firm X has a 5% profit margin while firm Z has a 15% profit margin. Both firms are in the
same industry. Which firm is doing a better job of controlling expenses? Carefully explain what the profit
margin measures and how you reached your conclusion.
5. As a financial troubleshooter, you have been given the following information on two firms.
Firm A
Firm B
Return on Assets
10%
10%
Return on Equity
25%
15%
Using the Dupont system, tell why the firms have different Returns on Equity when their Returns on Assets
are identical. Which firm uses more debt? Carefully explain how you reached this conclusion.
6. Why is it useful to use ratios? Why not use the values taken directly from the financial statements? In your
answer be sure to explain what ratios are used for.
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Questions 7-14 are based on the following information for Doric Corporation:
THE DORIC CORP.'S BALANCE SHEETS FOR 1998 AND 1999
Thousands of Dollars
1999
1998
Cash
$ 150
$ 180
Receivables
310
200
Inventories
740
620
Total current assets
$1,200
$1000
Net fixed assets
$1,450
$1,450
Total assets
$2,650
$2,450
Accounts payable
Notes payable
Accruals
Total current liabilities
Long-term debt
Common stock (200,000 shrs)
Retained earnings
Total long-term capital
Total liabilities and equity
$ 370
150
180
$ 700
250
550
1,150
$1,950
$2,650
$ 330
110
160
$ 600
400
550
900
$1,850
$2,450
THE DORIC CORP.'S 1999 INCOME STATEMENT
Thousands of Dollars
Sales
$5,000
Cost of goods sold
2,400
General expenses
1,700
EBIT
$ 900
Interest
50
EBT
$ 850
Taxes
200
Net income
$ 650
Compute the following.
7. Net Worth
_______
8. P/E if stock trades at $81.25 per share
_______
9. Market/Book if stock trades at $39.75 per share
_______
10. Return on Assets
_______
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You are in charge of evaluating the performance of Doric Inc. by comparing it to the industry leader, Trion Corp.
You have obtained the following information for Trion.
Profit Margin
Trion
Doric
10%
_____
Asset Turnover 2.5
_____
Debt/Assets
_____
60%
11. Compared to Trion, how is Doric doing in terms of expense control? Explain how you know.
12. Compared to Trion, how is Doric doing in efficient use of assets? Explain how you know.
13. Based on what you see here, which stock is likely to be more risky? Explain how you know.
14. Based on what you see here, which stock has the higher return on equity? Explain how you know.
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