Question

Q2. (30 marks)

1. What are the cash flow signs of a healthy company? (5)

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

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

4. 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

· Positive cash flow from operating activities

· Purchase of fixed assets from cash flow from operating activities

· Repayment of debt and interest on time

· A ratio of higher than 1 for cash debt service coverage

· 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 should be monitored by checking current assets and liabilities of the firm

· A higher average collection period of receivables

· A higher inventory days on hand

· A lower total assets and fixed assets turnover since it gives an indication of how efficiently the assets are deployed in business

· 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

· Higher cost of goods sold and higher Operating cost

Poor cash flow from operating activities

Lower or negative net worth

c) Advantages of high leverage and Debt ratio

· Net income of the firm increases when sales grow

· Interest 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

Disadvantages of high leverage and Debt ratio

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

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

· Affects the solvency of the firm when cash flow is poor due to higher interest payments and schedule debt repayments

· A higher ratios is not seen favorable by external parties

d) 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 EPS is one of the important ratios monitored by shareholders. 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