Deck 3: Analysis of Financial Statements

Question 1

U.S. regulators are fundamentally opposed to changing from Generally Accepted Accounting Principles (GAPP) to International Financial Reporting Standards (IFRS).

Answer 1

False

Question 2

The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long-term and short-term debt obligations.

Answer 2

True

Question 3

Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods.

Answer 3

True

Question 4

Determining whether a firm's financial position is improving or deteriorating requires analyzing more than the ratios for a given year. Trend analysis is one method of measuring changes in a firm's performance over time.

Question 5

The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed.

Question 6

The average collection period tells how many days it takes a business to pay money for trade credits to its suppliers.

Question 7

Debt management ratios show the extent to which a firm's managers are attempting to magnify returns on owners' capital through the use of financial leverage.

Question 8

Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects.

Question 9

Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.

Question 10

A decline in a firm's inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid.

Question 11

"Mark to Market" is the process of adjusting the valuation of assets from their recorded accounting value to a valuation based on market prices.

Question 12

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

Question 13

Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy-to-use measures of a firm's liquidity position.

Question 14

High current and quick ratios always indicate that a firm is managing its liquidity position well.

Question 15

The basic earning power ratio (BEP) shows the earning power of a firm's assets after giving consideration to financial leverage and tax effects.

Question 16

The inventory turnover and current ratio are related. The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged.

Question 17

It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if and only if all the firms being compared have the same proportion of fixed assets to total assets.

Question 18

The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its assets.

Question 19

To take full advantage of the credit term provided, management should try to lengthen the average payables period with cautions.

Question 20

Current ratio and quick ratio both help us measure the firm's liquidity. The current ratio measures the relationship of a firm's current assets to its current liabilities, while the quick ratio subtracts inventory from other current assets.

Question 21

Companies E and P each reported the same earnings per share (EPS), but Company E's stock trades at a higher price. Which of the following statements is correct?

A) Company E probably has fewer growth opportunities than company P.
B) Company E is probably judged by investors to be riskier than company P.
C) Company E must pay a lower dividend than company P.
D) Company E trades at a higher P/E ratio than company P.

Question 22

A firm's new president wants to strengthen the company's financial position. Which action would make it financially stronger?

A) Increase accounts receivable while holding sales constant.
B) Increase EBIT while holding sales constant.
C) Increase accounts payable while holding sales constant.
D) Increase notes payable while holding sales constant.

Question 23

A firm wants to strengthen its financial position. Which action would increase its current ratio?

A) Use cash to repurchase some of the company's own stock.
B) Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than 1 year.
C) Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.
D) Use cash to increase inventory holdings.

Question 24

Even though Firm A's current ratio exceeds that of Firm B, Firm B's quick ratio might exceed that of A. However, if A's quick ratio exceeds B's, then we can be certain that A's current ratio is also larger than that of B.

Question 25

Firms A and B have the same current ratio, 0.75, the same amount of sales, and the same amount of current liabilities. However, Firm A has a higher inventory than B. Therefore, we can conclude that A's quick ratio must be smaller than B's.

Question 26

Considered alone, which of the following would increase a company's current ratio?

A) an increase in net fixed assets
B) an increase in accrued liabilities
C) an increase in notes payable
D) an increase in accounts receivable

Question 27

Casey Communications recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. What would occur as a result of this action?

A) The company's current ratio would increase.
B) The company's times-interest-earned ratio would decrease.
C) The company's basic earning power ratio would increase.
D) The company's equity multiplier would increase.

Question 28

If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667.

Question 29

Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, Firm A has a higher debt ratio. If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.

Question 30

Which statement about inventories is correct?

A) A reduction in inventories held would have no effect on the current ratio.
B) An increase in inventories would have no effect on the current ratio.
C) If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.
D) A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

Question 31

Which of the following would, generally, indicate an improvement in a company's financial position, other things held constant?

A) The TIE declines.
B) The DSO increases.
C) The EBITDA coverage ratio increases.
D) The current and quick ratios both decline.

Question 32

Other things held constant, a decline in sales and a simultaneous increase in financial leverage must result in a lower profit margin.

Question 33

One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase.

Question 34

Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio.

Question 35

One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger.

Question 36

Since the ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA.

Question 37

Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. Under these conditions, then firms that have high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios.

Question 38

If the CEO of a large, diversified firm were filling out a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant.

A) The division's basic earning power ratio is above the average of other firms in its industry.
B) The division's total assets turnover ratio is below the average for other firms in its industry.
C) The division's debt ratio is above the average for other firms in the industry.
D) The division's inventory turnover is 6, whereas the average for its competitors is 8.

Question 39

Which of the following is an example of window dressing?

A) Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of window dressing.
B) Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of window dressing.
C) Using some of the firm's cash to reduce long-term debt is an example of window dressing.
D) Window dressing is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value.

Question 40

Which of the following statements is correct?

A) If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
B) If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
C) Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be.
D) The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).

Question 41

Which of the following statements is correct?

A) If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.
B) An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio.
C) An increase in the DSO, other things held constant, could be expected to increase the ROE.
D) An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

Question 42

You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is correct?

A) Its total assets turnover must be above the industry average.
B) Its return on assets must equal the industry average.
C) Its TIE ratio must be below the industry average.
D) Its total assets turnover must be below the industry average.

Question 43

Companies HD and LD are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company HD has the higher debt ratio. Which of the following statements is correct?

A) Company HD has a lower total assets turnover than Company LD.
B) Company HD has a lower equity multiplier than Company LD.
C) Company HD has a higher fixed assets turnover than Company LD.
D) Company HD has a higher ROE than Company LD.

Question 44

If a bank loan officer were considering a company's request for a loan, which of the following statements is correct?

A) The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm.
B) Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm.
C) Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.
D) The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

Question 45

Which of the following might represent a major distortion brought about by a move to implement "mark to market" accounting?

A) A rise or fall in the market value of assets will not afford investors a better basis for assessing the future value of their investments.
B) Uncertainty regarding whether the adjusted market prices reflect temporary or permanent changes to the asset's value may result in ambiguous signals when financial ratios are prepared.
C) Financial statements represent historical information in that they reflect collective past performance (balance sheet) and the most recent past performance (income statement). As such, it is not necessary to adjust asset valuation to reflect current market values.
D) Since prices change over time, "mark to market" is inferior to current accounting methods because a move to "mark to market" asset valuation will create a disconnect between past and future financial information.

Question 46

Which of the following would indicate an improvement in a company's financial position, other things held constant?

A) The debt ratio increases.
B) The profit margin declines.
C) The EBITDA coverage ratio declines.
D) The current and quick ratios both increase.

Question 47

Taggart Technologies is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or the tax rate. What is likely to occur if the company goes ahead with the stock issue?

A) The ROA will decline.
B) The tax bill will increase.
C) Net income will decrease.
D) The times-interest-earned ratio will decrease.

Question 48

Which statement regarding the Du Pont analysis is correct?

A) Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase.
B) Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE.
C) The modified Du Pont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE.
D) Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease.

Question 49

Walter Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio?

A) Borrow using short-term notes payable and use the cash to increase inventories.
B) Use cash to reduce accruals.
C) Use cash to reduce accounts payable.
D) Use cash to reduce short-term notes payable.

Question 50

Which statement about accounts receivable is correct?

A) If a security analyst saw that a firm's DSO was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength.
B) If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its DSO will increase.
C) There is no relationship between the DSO and the ACP. These ratios measure entirely different things.
D) If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

Question 51

Amram Company's current ratio is 1.9. Considered alone, which action would reduce the company's current ratio?

A) Borrow using short-term notes payable and use the proceeds to reduce accruals.
B) Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
C) Use cash to reduce short-term notes payable.
D) Use cash to reduce accounts payable.

Question 52

HD Corp. and LD Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, HD uses more debt than LD. Which of the following statements is correct?

A) HD would have the lower equity multiplier for use in the Du Pont equation.
B) HD would have to pay more in income taxes.
C) HD would have the lower net income as shown on the income statement.
D) HD would have the higher net income as shown on the income statement.

Question 53

Many countries, including Canada, have replaced Generally Accepted Accounting Principles (GAPP) with International Financial Reporting Standards (IFRS). To date, the U.S. has not made this change. What is a major reason why the U.S. has made this decision?

A) There is a fear that such a move would distort the analysis of a firm's performance over time.
B) Moving to this new accounting standard would impose major financial costs on U.S. firms during the current period of poor performance and economic uncertainty.
C) U.S. companies are, by and large, unaffected by activities in other jurisdictions, and as such, the change in accounting practices would result in only minor adjustments to financial statements.
D) The change to IFRS practices would have a major affect on financial statements, but investors do not rely heavily on financial statement information in making future investment decisions.

Question 54

A firm wants to strengthen its financial position. Which action would increase its quick ratio?

A) Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable.
B) Issue new common stock and use the proceeds to increase inventories.
C) Speed up the collection of receivables and use the cash generated to increase inventories.
D) Use some of its cash to purchase additional inventories.

Question 55

Which of the following statements is correct?

A) If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same.
B) If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same.
C) If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio.
D) If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate.

Question 56

Companies HD and LD have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is correct?

A) Company HD has a lower equity multiplier than Company LD.
B) Company HD has more net income than Company LD.
C) Company HD pays more in taxes than Company LD.
D) Company HD has a lower times-interest-earned (TIE) ratio than Company LD.

Question 57

Which of the following statements is correct?

A) The use of debt financing will tend to lower the basic earning power ratio, other things held constant.
B) A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure.
C) If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE.
D) Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favourable basis than income from stock.

Question 58

Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is correct?

A) Company HD pays less in taxes than Company LD.
B) Company HD has a lower equity multiplier than Company LD.
C) Company HD has a higher ROA than Company LD.
D) Company HD has more net income than Company LD.

Question 59

Which of the following statements is correct?

A) If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.
B) If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales.
C) The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.
D) If two firms differ only in their use of debt-i.e., they have identical assets, sales, operating costs, and tax rates-but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales.

Question 60

Other things held constant, which of the following alternatives would increase a company's cash flow for the current year?

A) Pay down the accounts payables.
B) Reduce the days' sales outstanding (DSO) without affecting sales or operating costs.
C) Pay workers more frequently to decrease the accrued wages balance.
D) Reduce the inventory turnover ratio without affecting sales or operating costs.

Question 61

Arshadi Corp.'s sales last year were $52,000, and its total assets were $22,000. What was its total assets turnover ratio (TATO)?

A) 2.03
B) 2.13
C) 2.25
D) 2.36

Question 62

Helmuth Inc.'s latest net income was $1,250,000, and it had 225,000 shares outstanding. The company wants to pay out 45% of its income. What dividend per share should it declare?

A) $2.14
B) $2.26
C) $2.38
D) $2.50

Question 63

Nikko Corp.'s total common equity at the end of last year was $305,000, and its net income after taxes was $60,000. What was its ROE?

A) 16.87%
B) 17.75%
C) 18.69%
D) 19.67%

Question 64

Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed up by this change, how would that affect its net income, assuming other things are held constant?

A) $281.41
B) $296.22
C) $311.81
D) $328.22

Question 65

Harper Corp.'s sales last year were $395,000, and its year-end receivables were $42,500. Harper sells on terms that call for customers to pay 30 days after the purchase, but many delay payment beyond Day 30. On average, how many days late do customers pay? Base your answer on this equation: DSO - Allowed credit period = Average days late, and use a 365-day year when calculating the DSO.

A) 7.95
B) 8.37
C) 8.81
D) 9.27

Question 66

Vang Corp.'s stock price at the end of last year was $33.50 and its earnings per share for the year were $2.30. What was its P/E ratio?

A) 13.84
B) 14.57
C) 15.29
D) 16.06

Question 67

Chambliss Corp.'s total assets at the end of last year were $305,000 and its EBIT was 62,500. What was its basic earning power (BEP)?

A) 18.49%
B) 19.47%
C) 20.49%
D) 21.52%

Question 68

Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE?

A) 12.79%
B) 13.47%
C) 14.18%
D) 14.88%

Question 69

Heaton Corp. sells on terms that allow customers 45 days to pay for merchandise. Its sales last year were $425,000, and its year-end receivables were $60,000. If its DSO is less than the 45-day credit period, then customers are paying on time. Otherwise, they are paying late. By how much are customers paying early or late? Base your answer on this equation: DSO - Credit period = days early or late, and use a 365-day year when calculating the DSO. A positive answer indicates late payments, while a negative answer indicates early payments.

A) 6.20
B) 6.53
C) 6.86
D) 7.20

Question 70

Safeco's current assets total $20 million, versus $10 million of current liabilities, while Risco's current assets are $10 million, versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so they tentatively plan to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which statement below best describes the results of these transactions?

A) The transactions would raise Safeco's financial strength as measured by its current ratio but lower Risco's current ratio.
B) The transactions would lower Safeco's financial strength as measured by its current ratio but raise Risco's current ratio.
C) The transactions would lower both firms' financial strength as measured by their current ratios.
D) The transactions would improve both firms' financial strength as measured by their current ratios.

Question 71

Lindley Corp.'s stock price at the end of last year was $33.50, and its book value per share was $25.00. What was its market/book ratio?

A) 1.34
B) 1.41
C) 1.48
D) 1.55

Question 72

An investor is considering starting a new business. The company would require $475,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business?

A) $54,979
B) $57,873
C) $60,919
D) $64,125

Question 73

Bonner Corp.'s sales last year were $415,000, and its year-end total assets were $355,000. The average firm in the industry has a total assets turnover ratio (TATO) of 2.4. Bonner's new CFO believes the firm has excess assets that can be sold so as to bring the TATO down to the industry average without affecting sales. By how much must the assets be reduced to bring the TATO to the industry average, holding sales constant?

A) $164,330
B) $172,979
C) $182,083
D) $191,188

Question 74

Rappaport Corp.'s sales last year were $320,000, and its net income after taxes was $23,000. What was its profit margin on sales?

A) 6.49%
B) 6.83%
C) 7.19%
D) 7.55%

Question 75

Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times-interest-earned (TIE) ratio?

A) 4.97
B) 5.23
C) 5.51
D) 5.80

Question 76

Beranek Corp. has $410,000 of assets, and it uses no debt-it is financed only with common equity. The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio?

A) $155,800
B) $164,000
C) $172,200
D) $180,810

Question 77

ABC Inc. has a 59-day average payables period. The account payables are $2,737.50 at the beginning and $3,589.50 at the end of the covering year. What is the annual cost of goods sold? Use a 365-day year when calculating the APP.

A) $17,265
B) $18,992
C) $19,571
D) $20,123

Question 78

Branch Corp.'s total assets at the end of last year were $315,000 and its net income after taxes was $22,750. What was its return on total assets?

A) 7.22%
B) 7.58%
C) 7.96%
D) 8.36%

Question 79

Pace Corp.'s assets are $625,000, and its total debt outstanding is $185,000. The new CFO wants to employ a debt ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio?

A) $158,750
B) $166,688
C) $175,022
D) $183,773

Question 80

Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company HD has a higher debt ratio. Which of the following statements is correct?

A) Company LD has a higher basic earning power ratio (BEP) than Company HD.
B) Company HD has a higher basic earning power ratio (BEP) than Company LD.
C) If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company HD will have the higher ROE.
D) If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company HD will have the higher ROE.