Suppose an analyst reformulates financial statements to prepare the alternative
ID: 2496731 • Letter: S
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 effect the decomposition of ROCE=Operating ROA+(Leverage*spread)? How do you interpret the net borrowing rate for this firm? 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 effect the decomposition of ROCE=Operating ROA+(Leverage*spread)? How do you interpret the net borrowing rate for this firm?Explanation / Answer
Operating ROA is positive and large which suggests that the total assets are earning satisfactory results whereas the financial obligation of the firm are negative.
The effects on decomposition of ROCE by the relevant factors are as discussed below:
Operating ROA
Operating Return on Assets (ROA) is one of the important profitability ratios. Operating ROA is calculated just like Return on Assets but uses Earnings Before Interest and Taxes (EBIT) instead of Net Income.
Operating return on assets indicates the company’s operating income generated per dollar invested in total assets.
A higher operating RoA is preferred and while analyzing this ratio, the analyst must analyse the historical performance and also compare it with the peers in the industry.
Leverage
The ratio of a company's loan capital (debt) to the value of its ordinary shares (equity); gearing.
Spread
Spread is the difference between the stock price and market value
The spread for an asset is influenced by a number of factors like:
a) Supply or "float" (the total number of shares outstanding that are available to trade)
b) Demand or interest in a stock
c) Total trading activity of the stock
The Net borrowing rate for this firm would be inflated as the net financial obligations are negative and the condition of this firm is such which would be giving hih cost of borrowings.
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