Share
Explore BrainMass

Financial Analysis of Companies

1. Under what circumstances might a company have a high p/e ratio even when investors are not optimistic about the company's future prospects?
2. Assume that you have several thousand dollars to invest in the stock market. Given that "people will always have to eat," you have decided to explore the possibility of investing in Wendy's and McDonald's. Your analysis of each company's financial statements reveals that both have negative working capital and both have current and quick ratios of less than 1 to 1. Assume that neither Wendy's or McDonald's accepts debit or credit cards. Based on your findings, should you be concerned about the short-term liquidity (solvency) of these two companies? Explain.
3. Assume that the net sales of a large department store have grown annually at a rate of 5% over each of the past several years. Do you think that the store is selling 5% more merchandise each year? Explain in detail.
4. Net sales at the General Store have been increasing at a reasonable rate, but net income has been declining steadily as a percentage of sales. What seems to be the problem?
5. Alpine Products experiences a considerable season variance in its business. The high point in the year's activity comes in November, the low point in July. During which month would you expect the company's current ratio to be higher? If the company were choosing a fiscal year for accounting purposes, what advice would you give?
6. Top Drawer Inc. reported 2006 earnings per share of $3.26 and had no extraordinary items. In 2007 earnings per share on income before extraordinary items was $2.99, and earnings per share on net income was $3.49. Do you consider this trend to be favorable? Why or why not?
7. Assume that you are a financial analyst and that two of your clients are requesting your advice on certain companies as potential investments. Both clients are interested in purchasing common stock. One is primarily interested in the dividends to be received from the investment. The second is primarily interested in the growth of the market value of the stock. What information would you advise your clients to focus on in their respective analyses?

Solution Preview

1. Under what circumstances might a company have a high p/e ratio even when investors are not optimistic about the company's future prospects?

Typically, the higher a price/earning ratio, the more the market is willing to pay for the company's earnings. However, investors may interpret a high price/earning ratio as an overpriced stock; or investors may be over overly enthusiastic about a company's future and bid up the stock price, leading to a high price/earning ratio. In order to determine if a price/earning ratio is reasonable it is important to make comparisons between the company's valuation and other similar companies within the same industry. Included in this analysis could be dollars per day per store, and sales per square foot. An investor might also consider if the earnings being used in the price/earning calculation are historical or projected. It would be important to consider these aspects before randomly investing in a stock due to a high price/earning ratio.

Reference:
Zacks Investment Research. How to Use the Price to Earnings Ratio. Retrieved from http://www.zacks.com/education/articles.php?id=30.

2. Assume that you have several thousand dollars to invest in the stock market. Given that "people will always have to eat," you have decided to explore the possibility of investing in Wendy's and McDonald's. Your analysis of each company's financial statements reveals that both have negative working capital and both have current and quick ratios of less than 1 to 1. Assume that neither Wendy's nor McDonald's accepts debit or credit cards. Based on your findings, should you be concerned about the short-term liquidity (solvency) of these two companies? Explain.

Working capital is a measure of a company's ability to pay off short term debt as well as finance its day to day operations. If a company has negative working capital that means the company must take on additional debt to finance its' daily operations. In addition, it must have a plan for the future to resolve this deficit, in order to survive and thrive. Companies cannot exist in the long run working with negative working capital! Current ratio of less than 1 to 1 indicates that the companies have fewer assets than their debt. Assets might be real estate, inventory or pre-paid debt (credit/debit cards). Quick ratio is similar to current ratio but without the inventory or prepaid assets. In other words, could the companies meet their obligations (immediate liabilities) with their current assets? Since both companies reveal a negative working capital and both have ...

Solution Summary

This solution discusses under what circumstances might a company have a high p/e ratio even when investors are not optimistic about the company's future prospects. It also discusses reviewing financial statements with negative working capital and current and quick ratios of less than 1 to 1 and the concern of short-term liquidity (solvency). In addition, it discusses how companies choose what month to start a fiscal year, and how to evaluate if a company had a favorable year based on earnings per share.
Also, the solution reviews purchasing stock based on growth of market value of stock compared to purchasing for dividends. Examples and links are given for each of the various scenarios.

$2.19