rage and profitability ratios Typically, items in the balance sheets are ranked and classified in the order of their levels of...

W5E1.Leverage and profitability ratios

Typically, items in the balance sheets are ranked and classified in the order of their levels of liquidity. This protocol is rooted in the use of accounting numbers for credit analysis. However, it is often more useful in financial analysis to reclassify assets and liabilities based on the business activities they are associated with.

Assets can be classified into operating assets (OA) and financial assets (FA). Operating assets are asset items that are essentially associated with the current operating activities of the business. Financial assets include cash, short-term and long-term investments, loan to other entities, etc. They are not directly associated with dealing with customers, suppliers and internal production and management processes. Rather, they are “resources” temporarily “stored” by the firm in order to meet requirement of future operating and investing activities or debt obligations.

For instance, trade receivables are operating assets because they arise from dealing with customers, but loan receivables are typically financial assets because they arise from the firm’s acting as a lender, which is not part of its main operating activities (unless the firm is a financial institution).

Similarly, liabilities can be classified into operating liabilities (OL) and financial liabilities (FL). For example, accounts payables are operating liabilities, while bond payables are financial liabilities.Net operating assets (NOA) is defined as the difference between operating assets and operating liabilities, and net financial debt, and net financial liability (NFL) is defined as the difference between financial liabilities and financial assets:NOA=OA-OL and NFL = FL-FAUnder a similar vein, income statement items can be classified to form operating income (OI) and net financing expense (NFE). NFE is equal to interest expenses minus interest income, OI equals total comprehensive income minus NFE.

Required1. Use the balance sheet date to calculate Wesfarmers’ net operating assets (NOA) and net financial debt (ND) as of the end of fiscal year 2016. [Hint: You need to check the notes to the financial statements to determine the nature of some line items. Derivatives as hedging instruments are classified as operating items.]2. Compute Wesfarmers’ return on net operating asset (RNOA), return on equity (ROE), financial leverage (FLEV), and net borrowing cost (NBC) for fiscal year 2016. [Hint:RNOA = OI/NOA; ROE=comprehensive income/Equity; FLEV= NFL/Equity; NBC=NFE/NFL.]3. Holding RNOA and NBC constant, what would ROE be if FLEV is 10%, 20%, and 30%higher than its current level as of the end of fiscal year 2016?This exercise tests your ability to migrate your financial analysis skills. The link to an onlinecopy of the company’s annual report: https://www.wesfarmers.com.au/docs/defaultsource/reports/2016-annual-report.pdf?sfvrsn=4