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Asset Turnover, ROE, Ethical issues, highly leveraged

A.
Fixed assets total............100,000
Accum depr total.............(50,000)

Net Assets....................50,000 (assume this is the average assets)
Net Sales.....................100,000

1. What is the Asset Turnover Ratio of this firm?
2. If you were buying this company would you perceive this to be good or bad?
3. Is this ratio reliable to make a buying decision? Tell me why or why not.

B.
If a business owner buys a 200,000 home for cash, and the market goes up 3% then the gain is 6,000 or 3%. This is very safe but not a stellar return.

If we put down 100,000 and borrow a 100,000 our rate of return doubles to 6%. A still very safe investment but it is still not considered stellar.

Now if we put down 5% our return jumps to 60%. We put down 10,000 and the value of the investment increased 6,000. Now that is a return to brag about. Another way to look at this is for every 1 dollar we put in we borrowed 19.

This easy example underscores the risk often taken on Wall Street takes. The most recent catastrophe was MF Global. They invested 1 dollar for every 40 borrowed! This was not uncommon with Lehman Brothers and the likes of Merrill Lynch.

1. There is a play between your ROE and your debt ratios. The more debt the higher your ROE is but it will lower your debt performance ratios. How do you believe a company should manage this?

2. What is a good ROE?

3. Should we even care about the ROE ratio? If all the other ratios are healthy and the profit is good should we really care?

4. Do you see any ethical issues with Wall Street investors, such as MF Global, with such highly leveraged investments?

Solution Preview

A.
Fixed assets total............100,000
Accum depr total.............(50,000)

Net Assets....................50,000 (assume this is the average assets)
Net Sales.....................100,000

1. What is the Asset Turnover Ratio of this firm?

Asset turnover: sales / assets
100,000 / 50,000 = 2.0

2. If you were buying this company would you perceive this to be good or bad?

It is hard to know in a vacuum. Some firms have a high profit margin and low turns (like Tiffanys) or a low profit margin and high turns (like Costco). It is the combination of turns and profit margins that result in return on assets. Without information on profit margins, it is hard to say. However, asset turnover over 2 is pretty good (Costco being closer to 3 and being the top of the turnover game).

3. Is this ratio reliable to make a buying decision? Tell me why or why not.

No, this ratio is without context. Only knowing the asset turnover you know about assets and sales but nothing about costs and profits. All buying decisions should reflect an understanding of costs and profit impact. Without knowing the return on assets and return on equity you cannot reasonably compare this choice to another. It is not the asset turnover that shows whether the ...

Solution Summary

Your tutorial is 391 words and explains why asset turnover is not enough to make a buying decision and how ROE is important as a measure of performance. Other comments address the questions posed.

$2.19