Question

Q2. (30 marks) a. What are the cash flow signs of a healthy company? (5)

b. What are some red flags to watch out for in financial statement analysis of a company? (10)

c. What are some potential advantages and disadvantages of operating with high leverage and debt ratio? (7)

d. Explain why P/E ratio and EPS are used in determining health of a stock? Is it good to have a low EPS ratio? Why or why not? (8)

Answer 1

a) The following are the cash flow signs of a healthy company

· cash flow should be generated from operating activities

· Positive free cash flows (Purchase of fixed assets from cash flow from operating activities)

· Repayment of debt and interest on time

· cash debt service coverage ratio should be greater than 1

· A high reserve of cash and cash equivalents built over a period of time

b) Red flags to watch out for in the financial statement analysis of a company

· A lower current ratio of less than 1

· A higher average collection period of receivables compared to peers

· A higher inventory days on hand compared to peers

· A lower total assets and fixed assets turnover

· A higher debt to equity ratio than peers

· A lower interest coverage ratio for interest on debt

· Lower Gross profit margin , Lower Operating profit margin and Lower net profit margin

· Declining sales over a period of time

· Negative cash flow from operating activities

· Sale of fixed assets to fund repayment debt

· Negative net worth of the firm (Total assets- Total liabilities)

c) Potential Advantages of high leverage and debt ratio

· During sales growth the net income of the firm will increase

· Interest expense is tax deductible for income tax purpose and hence lower expenses

· The cost of debt is lower than cost of equity due to tax benefits and hence return on equity will improve

· When cash flows are healthier higher debt ratio gives higher return to shareholders

Disadvantages of high leverage and debt ratio

· High fixed costs of interest expense can have an adverse impact on profits

· Profits decline when sales are decreasing and may lead to net losses for the firm

· Interest coverage ratio will be lower due to higher interest expense when operating profits are lower

· Higher interest payments and scheduled debt repayments affects the solvency of the firm

· A higher ratios is not seen favorable by external parties

d) Earnings per share (EPS) is the net income of the firm expressed on a per share basis. It is calculated dividing the net income by average outstanding common shares. P/E ratio is the price earnings ratio which commands the market price in the market based on Earning per share. So market price per share= EPS * P/E ratio. If the P/E ratio of the firm is lower than its peers in the industry it is lower valued and hence there is potential for the firm to grow its market share price. The PE ratio and EPS are important ratios monitored by shareholders to measure their return on investment. The higher the Earnings per share it is better for shareholders since it will have direct impact on the market price of the firm. A firm should have higher EPS ratio which helps in growing the shareholders’ wealth in the long term