Financial Management

Financial Management--Assignment #5 Questions and Answers

Using the current ratio, discuss what conclusions you can make about the ability of each company to pay current liabilities (debt). The liquidity ratio compares the liquid assets to its short-term liabilities (Loth, 2010). One of the liquidity ratios is the current ratio, and it is commonly explained as a measure of the ability of a company to pay its current debt liabilities (The Strategic CFO, LLC., 2010). The current ratio formula is current assets divided by current liabilities (Loth, 2010). Also, a ratio under one suggests that a company would be unable to pay off its obligations if they came due (Loth, 2010).

Current assets represent cash and other assets that will be converted into cash within one year (The Strategic CFO, LLC., 2010). In addition, current assets normally include cash, marketable securities, accounts receivable, and inventories (The Strategic CFO, LLC., 2010). In contrast, current liabilities represent financial obligations that come due within one year (The Strategic CFO, LLC., 2010). Current liabilities normally include accounts payable, notes payable, short-term loans, current portion of term debt, accrued expenses, and taxes (The Strategic CFO, LLC., 2010).

Current ratio is very helpful to determine whether a company has a sufficient level of liquidity to pay liabilities (The Strategic CFO, LLC., 2010). Shareholders would prefer a high current ratio since it reduces the risk of a company and determines the weakness in the financial position of a company (The Strategic CFO, LLC., 2010. A company with a low current ratio can raise a red flag as it may be a sign that the company will have difficulty running its operations, as well as meetings its obligations (Loth, 2010).

Every industry has its own norms of current ratio, and the better way to evaluate current ratio is to check it against its industry average (The Strategic CFO, LLC., 2010). More importantly, investors should look at the trend of the current ratio of the company, types of current assets the company has, and how quickly these can be converted into cash to meet the current liabilities (The Strategic CFO, LLC., 2010). Also, a lack of cash is one of the main reasons why companies fail (The Strategic CFO, LLC., 2010). As shown in the Appendix, PepsiCo, Inc. is in a better liquidity position as its current ratio was 1.4, and Coca-Cola Enterprises, Inc. was 1.1. This comparison means that for every dollar in current liabilities, there was $1.40 in current assets for PepsiCo, Inc.

Buildings, real estate, equipment and furniture are fixed assets (Loth, 2010). Long-term liabilities are leases, bond repayments, and other items due in more than one year (Loth, 2010).

Using the profitability ratios, discuss what conclusions you can make about the profits of each company over the past three years. The profitability indicator ratio measures how well the company utilized its resources in generating profit and shareholder value (Loth, 2010). The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders (Loth, 2010). Out of several profitability ratios, return on equity and return on assets is used to measure the profitability of a company. Over the past three years, PepsiCo, Inc. and Coca-Cola Enterprises, Inc. generally stayed in the same profitability range.

Return on assets measures how well management is employing the total assets of a company to make a profit (Loth, 2010). Return on assets is net income divided by average total assets, and the higher the return, the more efficient management is in utilizing its asset base (Loth, 2010). Net income is the total earnings of a company (Loth, 2010). Investors like to see the return on assets for a company at no less than 5% (Loth, 2010). As shown in the Appendix, PepsiCo, Inc. had 15% and Coca-Cola Enterprises, Inc. had 4%. Since PepsiCo, Inc. had a return asset of 15%, which means that the company earned $0.15 for each dollar in assets, so it was more profitable then Coca-Cola Enterprises, Inc.

Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet of a company (Kennon, 2010). Return on equity is net income divided by the shareholder equity (Loth, 2010). Shareholder equity represents the amount by which a company is financed through common and preferred shares (Loth, 2010). A business that has a high return on equity is more likely to be one that is capable of generating cash internally (Kennon, 2010). As shown in the Appendix, PepsiCo, Inc. had a return on equity ratio of 35%, and Coca-Cola Enterprises, Inc. had 85% in 2009. PepsiCo, Inc. has earned more but Coca-Cola Enterprises, Inc. has been more profitable and makes it more attractive to investors. Also, Coca-Cola Enterprises, Inc. has a globally appreciated product and has shifted costs to other resources in order to keep their prices low.

Using the cash flow indicator and investment valuation ratios, discuss which company is more likely to have satisfied stockholders. Cash flow indicator ratio measures how much cash that companies are generating from their sales, the amount of cash they are generating that is free and clear, and the amount of cash they have to cover obligations (Loth, 2010). The dividend payout ratio is one of the cash flow indicators, and it identifies the percentage of earnings per share of common stock allocated to paying cash dividends to shareholders (Loth, 2010). The equation is dividends per common share divided by earnings per share (Loth, 2010). The higher the dividend payout ratio, the less profits are invested back into the business to create future growth (Loth, 2010). As shown in the Appendix, PepsiCo, Inc. had a dividend payout ratio of 48% while Coca-Cola Enterprises, Inc. was 20%.

The investment valuation ratio is an attempt to simplify the evaluation process by comparing relevant data that help investors gain an estimate of valuation (Loth, 2010). Price/earnings ratio is the best known of the investment valuation indicators, and it is the current share price of a company divided by its basic per share earnings (Loth, 2010). A high price/earnings ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower one (Loth, 2010). As shown in the Appendix, PepsiCo, Inc. had a 16.4 price/earnings ratio, and Coca-Cola Enterprises, Inc. was 38.3. Based on the dividend payout ratio and the price/earnings ratio, Coca-Cola Enterprises, Inc. was in a better position for stock options and earnings growth