8% of X’s income comes from investment in associate and is accounted by equity method. Assoc. was financed by 30% debt. X’s capital structure is 25 debt, 75% equity. in adjusting analyst will most likely increase: a.net profit margine b. Financial leverage ratio c. Total asset turnover ratio please explain briefly the answer
without fully thinking it through, first blush would be “b”. If we go proportionate consolidate as the adjustment, we would be adding additional deb.t Assoc is more levered (30 vs 25%) so this should increase my leverage ratio? i haven’t fully thought it through - have a meeting in 15 minutes and will see if this still makes sense after that…
B If you remove the affects of the equity investment, assets and equity will drop by equal amounts and net income will also decrease. Liabilities will make up a greater proportion of your total assets so leverage ratio will increase. Now that I think of it though, total asset turnover will also increase. Sales will be held constant in the numerator, and assets will be smaller in the denominator.
i thought as much but the answer given in Stall pass master was C. i didn’t quite understand even the explanation.
I think the answer is A. The investor, X, will report its pro-rata share of NI in its income statement while its sales will remain unchanged. B is incorrect because debt is unaffected by an investment in an associate. The investment is kept on the BS so Assets and Equity increase (I’m not sure about that last part). So financial leverage would decrease. C is incorrect because Sales remain unchanged and Assets increase. Thus Total Asset Turnover will decrease.
lol I’m confused.
under the equity method it would be a noncurrent asset, if we remove it we decrease the total asset and the ratio increases since it was financed with d/e and NOT cash, a cash outflow does not occur so when we remove the noncurrent asset we dont even need to reverse the cash outflow
Oh wait. What ADJUSTMENTS would an analyst make? Let me think. Ok A is out. If anything that would be adjusted downward. I can see why C is correct. Sales should be increased to reflect proportionate consolidation. No adjustment is necessary for Equity or Assets. So TAT would increase. B also seems correct.
C is correct A is wrong. When you adjust, sales will remain unchanged because Equity method doesn’t affect sales. Net income will decrease though. Net Profit Margin (Net Income / Sales) will decrease. For B, the investment was financed with both Equity (70%) and Debt (30%) but the capital structure of the company is 75% equity and 25% debt. By removing the asset from the balance sheet, equity will make up a greater % of total assets. Think about the marginal affects of removing it. C is correct as I stated above. Sales remains constant. Assets will decrease because you remove the investment. Total Asset Turnover (Sales/Assets) will increase.
These would be my adjustments: -Remove income from affiliate and add the proportionate revenues and expenses to income statement. -Remove investment in affiliate and add the proportionate percentage of the associate’s assets and liabilities. According to the Stalla guide, assets would increase when going from equity method to proportionate consolidation. Revenues would also increase. Using the example that they provided, asset turnover AND the financial leverage ratio would increase. I’d like the question code so I can look it over before I send them an e-mail regarding this question.
bpdulog - not sure why you are adjusting the Liabilities, revenues, expenses due to an equity method investment. It is a single line adjustment, right? And you are going from having an investment in associates, to NO investment in associates here, not from Equity to Prop. Consolidation in my mind. My adjustments: equity method investment you would reduce the Investment in Associates. So Assets would reduce. No Change in Debt. So Equity would reduce. You would reduce the Net Income from Associates. No change to Sales. Net Profit Margin -> Lower - since Net Income is lower, Sales no change Leverage -> Total Assets would Reduce, Equity would reduce. But Total Assets would reduce MORE. So Leverage would reduce. Sales are the same, Total Assets reduced - so Net Sales / Total Assets = Total Asset Turnover would be the only one that increased.
cpk123 Wrote: ------------------------------------------------------- > bpdulog - not sure why you are adjusting the > Liabilities, revenues, expenses due to an equity > method investment. It is a single line adjustment, > right? And you are going from having an investment > in associates, to NO investment in associates > here, not from Equity to Prop. Consolidation in my > mind. > > My adjustments: > equity method investment > > you would reduce the Investment in Associates. So > Assets would reduce. No Change in Debt. So Equity > would reduce. > You would reduce the Net Income from Associates. > > No change to Sales. > > Net Profit Margin -> Lower - since Net Income is > lower, Sales no change > Leverage -> Total Assets would Reduce, Equity > would reduce. But Total Assets would reduce MORE. > So Leverage would reduce. > > Sales are the same, Total Assets reduced - so Net > Sales / Total Assets = Total Asset Turnover would > be the only one that increased. Because proportionate consolidation reflects “economic reality” as Peter Olinto would say. It even mentions it on page 5-31. If we wanted to see what the standalone company net income was, then we would do exactly as you described. But the question doesn’t specify what outcome they are looking for, so I assumed they wanted to keep the investment in associate intact.