) Suppose an analyst reformulates financial statements to prepare the alternativ
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Question
) Suppose an analyst reformulates financial statements to prepare the alternative decomposition of ROCE for a firm with no debt. The analyst determines that the company holds excess cash as large marketable equity securities. The result will be net financial obligations that are negative. Assume that operating ROA is positive and large. How will this affect the decomposition of ROCE=Operaring ROA+(LeveragexSpread)? How do you interpret the net borrowing rate for this firm? A firm has experienced a decrease in its current ratio but an increase in its quick ratio during the last three years. What is the likely explanation for these results?Explanation / Answer
The resulting Debt from the findings of the analyst is negative the decomposition of ROCE becomes Operating ROA-(LeveragexSpread)= Operating ROA-(Debt/Equity)x(ROA+borrowing rate) where Leverage=Debt/Equity and Spread=ROA-borrowing rate ,as Leverage is negative=Debt/Equity because of the negative Debt.With no Debt initially before findings ROCE=Operating ROA-(0/Equity)x(ROA-0)=Operating ROA but after the finding Operating ROA is reduced by (Debt/Equity)x(ROA+borrowing rate) ,The resulting ROCE shall be negatively affected by the new findings of a negative financial obligations (negative Debt) therefore we subtract the LeveragexSpread from ROA to arrive at a reduced ROCE.The net borrowing rate for this firm would be negative due to negative financial obligations.
current ratio =Current Assets/Current Liabilities
quick ratio=(Current Assets-Inventory)/Current Liabilities
A decrease in its current ratio but an increase in its quick ratio could be the result of a decreasing inventory over the last three years.Suppose the Current Assets are 3,2,1.8 in years 1 ,2 and 3 with Current Liabilities remaining same as 1 for all the years with decreasing current ratio of 3,2,1.8 in years 1 ,2 and 3.Inventory decreases as 1.5,.4,.1 in years 1,2,3 respectively thus the quick ratio in years 1,2,3 are 3-1.5=1.5 in yr 1,2-.4=1.6 in year 2 and 1.8-.1=1.7 in year 3 therefore we see that the quick ratio is infact increasing in last 3 years whereas the current ratio is decreasing.The most likely explanation is that the inventory levels are going down over the years.
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