Deck 4: Analysis of Financial Statements

Question 1

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

Answer 1

True

Question 2

The days sales outstanding tells us how long it takes, on average, to collect after a sale is made. The DSO can be compared with the firm's credit terms to get an idea of whether customers are paying on time.

Answer 2

True

Question 3

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 3

True

Question 4

The more conservative a firm's management is, the higher its debt ratio is likely to be.

Question 5

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

Question 6

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

Question 7

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

Question 8

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

Question 9

The profit margin measures net income per dollar of sales.

Question 10

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 11

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

Question 12

If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or quick ratio would change.

Question 13

The operating margin measures operating income per dollar of assets.

Question 14

If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decline.

Question 15

In general, it's better to have a low inventory turnover ratio than a high one, as a low ratio indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose sales as a result of running out of stock.

Question 16

The current and inventory turnover ratios both help us measure a firm's liquidity. The current ratio measures the relationship of the firm's current assets to its current liabilities, while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash.

Question 17

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

Question 18

Other things held constant, the higher a firm's debt ratio, the higher its TIE ratio will be.

Question 19

If a firm's fixed assets turnover ratio is significantly higher than its industry average, this could indicate that it uses its fixed assets efficiently or is operating at over capacity and should probably add fixed assets.

Question 20

If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would increase.

Question 21

Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money, use it to buy back stock, and raise the debt ratio to 50% and the equity multiplier to 2.0. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably be a good move, as it would increase the ROE from 7.5% to 13.5%.

Question 22

The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operating efficiency is that the BEP does not reflect the effects of debt and taxes.

Question 23

Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry. Under these conditions, firms with 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 24

The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as being less risky and/or more likely to enjoy higher growth in the future.

Question 25

Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's debt ratio is 70% versus one of 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A's higher profit margin.

Question 26

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

Question 27

Other things held constant, the more debt a firm uses, the lower its return on total assets will be.

Question 28

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 examining changes in a firm's performance over time.

Question 29

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 30

Other things held constant, the more debt a firm uses, the lower its profit margin will be.

Question 31

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

Question 32

Other things held constant, the more debt a firm uses, the lower its operating margin will be.

Question 33

The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value. In general, investors regard companies with higher M/B ratios as being less risky and/or more likely to enjoy higher growth in the future.

Question 34

Other things held constant, a decline in sales accompanied by an increase in financial leverage must result in a lower profit margin.

Question 35

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 36

In general, if investors regard a company as being relatively risky and/or having relatively poor growth prospects, then it will have relatively high P/E and M/B ratios.

Question 37

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

Question 38

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.
E) An increase in accounts payable.

Question 39

The return on common equity (ROE) is generally regarded as being less significant, from a stockholder's viewpoint, than the return on total assets (ROA).

Question 40

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 41

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.
B) Company E is probably judged by investors to be riskier.
C) Company E must have a higher market-to-book ratio.
D) Company E must pay a lower dividend.
E) Company E trades at a higher P/E ratio.

Question 42

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) The numerator used in the TIE ratio is earnings before taxes (EBT). EBT is used because interest is paid with post-tax dollars, so the firm's ability to pay current interest is affected by taxes.
E) All else equal, increasing the debt ratio will increase the ROA.

Question 43

Which of the following statements is CORRECT?

A) Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of "window dressing." 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 another example of "window dressing."
B) 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."
C) Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase fixed assets is an example of "window dressing."
D) Using some of the firm's cash to reduce long-term debt is an example of "window dressing."
E) "Window dressing" is any action that does not improve a firm's fundamental long-run position and thus increases its intrinsic value.

Question 44

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

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

Question 45

Which of the following statements is CORRECT?

A) A reduction in inventories 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.
E) If a firm increases its sales while holding its inventories constant, then, other things held constant, its fixed assets turnover ratio will decline.

Question 46

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. Which of the following is likely to occur if the company goes ahead with the stock issue?

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

Question 47

Which of the following statements 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 DuPont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE.
D) Other things held constant, an increase in the debt ratio will result in an increase in the profit margin.
E) 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 48

If a bank loan officer were considering a company's loan request, which of the following statements would you consider to be CORRECT?

A) The lower the company's inventory turnover ratio, other things held constant, the lower the interest rate the bank would charge the firm.
B) Other things held constant, the higher the days sales outstanding ratio, the lower the interest rate the bank would charge.
C) Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge.
D) The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge.
E) Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.

Question 49

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.
E) Its total assets turnover must equal the industry average.

Question 50

Amram Company's current ratio is 2.0. Considered alone, which of the following actions would lower the 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 accruals.
D) Use cash to reduce short-term notes payable.
E) Use cash to reduce accounts payable.

Question 51

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) A firm's use of debt will have no effect on its profit margin.
C) 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 and a lower return on assets.
D) 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.
E) 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 operating margin and return on assets.

Question 52

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 equal.
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/or be expected to grow at a faster rate.
E) If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same.

Question 53

Which of the following statements is CORRECT?

A) If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average, and was increasing and trending still higher, this would be interpreted as a sign of strength.
B) A high average DSO indicates that none of its customers are paying on time. In addition, it makes no sense to evaluate the firm's DSO with the firm's credit terms.
C) There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things.
D) A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.
E) If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

Question 54

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

A) The TIE declines.
B) The DSO increases.
C) The quick ratio increases.
D) The current ratio declines.
E) The total assets turnover decreases.

Question 55

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

A) The inventory and total assets turnover ratios both decline.
B) The debt ratio increases.
C) The profit margin declines.
D) The times-interest-earned ratio declines.
E) The current and quick ratios both increase.

Question 56

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. Which of the following effects would occur as a result of this action?

A) The company's current ratio increased.
B) The company's times interest earned ratio decreased.
C) The company's basic earning power ratio increased.
D) The company's equity multiplier increased.
E) The company's debt ratio increased.

Question 57

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.
E) Company HD has a lower operating income (EBIT) than Company LD.

Question 58

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.
E) The division's DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30.

Question 59

A firm wants to strengthen its financial position. Which of the following actions 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.
E) Issue new common stock and use the proceeds to acquire additional fixed assets.

Question 60

A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio?

A) Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment.
B) Use cash to repurchase some of the company's own stock.
C) Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.
D) Issue new stock, then use some of the proceeds to purchase additional inventory and hold the remainder as cash.
E) Use cash to increase inventory holdings.

Question 61

River Corp's total assets at the end of last year were $415,000 and its net income was $32,750. What was its return on total assets?

A) 7.89%
B) 8.29%
C) 8.70%
D) 9.14%
E) 9.59%

Question 62

Which of the following statements is CORRECT?

A) If a firm has high current and quick ratios, this always indicate that the firm is managing its liquidity position well.
B) If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decline.
C) If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would decline.
D) If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or quick ratio would change.
E) The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets.

Question 63

Which of the following statements is CORRECT?

A) Other things held constant, the more debt a firm uses, the higher its operating margin will be.
B) 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.
C) Other things held constant, the more debt a firm uses, the higher its profit margin will be.
D) Other things held constant, the higher a firm's debt ratio, the higher its TIE ratio will be.
E) Debt management ratios show the extent to which a firm's managers are attempting to reduce risk through the use of financial leverage. The higher the debt ratio, the lower the risk.

Question 64

Your sister is thinking about starting a new business. The company would require $375,000 of assets, and it would be financed entirely with common stock. She 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) $41,234
B) $43,405
C) $45,689
D) $48,094
E) $50,625

Question 65

Which of the following statements is CORRECT?

A) The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio.
B) If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.
C) An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio.
D) An increase in the DSO, other things held constant, could be expected to increase the ROE.
E) An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower its profit margin.

Question 66

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.
B) Company HD has a lower equity multiplier.
C) Company HD has a higher ROA.
D) Company HD has a higher times-interest-earned (TIE) ratio.
E) Company HD has more net income.

Question 67

Beranek Corp has $720,000 of assets, and it uses no debt--it is financed only with common equity. The new CFO wants to employ enough debt to raise the debt/assets ratio to 40%, using the proceeds from borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio?

A) $273,600
B) $288,000
C) $302,400
D) $317,520
E) $333,396

Question 68

Royce Corp's sales last year were $280,000, and its net income was $23,000. What was its profit margin?

A) 7.41%
B) 7.80%
C) 8.21%
D) 8.63%
E) 9.06%

Question 69

Zero Corp's total common equity at the end of last year was $405,000 and its net income was $70,000. What was its ROE?

A) 14.82%
B) 15.60%
C) 16.42%
D) 17.28%
E) 18.15%

Question 70

Ryngard Corp's sales last year were $38,000, and its total assets were $16,000. What was its total assets turnover ratio (TATO)?

A) 2.04
B) 2.14
C) 2.26
D) 2.38
E) 2.49

Question 71

Song Corp's stock price at the end of last year was $23.50 and its earnings per share for the year were $1.30. What was its P/E ratio?

A) 17.17
B) 18.08
C) 18.98
D) 19.93
E) 20.93

Question 72

Ajax 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) 4.72
B) 4.97
C) 5.23
D) 5.51
E) 5.80

Question 73

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) Without more information, we cannot tell if HD or LD would have a higher or lower net income.
B) HD would have the lower equity multiplier for use in the DuPont equation.
C) HD would have to pay more in income taxes.
D) HD would have the lower net income as shown on the income statement.
E) HD would have the higher operating margin.

Question 74

Which of the following statements is CORRECT?

A) Other things held constant, the less debt a firm uses, the lower its return on total assets will be.
B) The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operating efficiency is that the BEP does not reflect the effects of debt and taxes.
C) The return on common equity (ROE) is generally regarded as being less significant, from a stockholder's viewpoint, than the return on total assets (ROA).
D) The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as being more risky and/or less likely to enjoy higher future growth.
E) Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's debt ratio is 70% versus 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A's higher profit margin.

Question 75

X-1 Corp's total assets at the end of last year were $405,000 and its EBIT was 52,500. What was its basic earning power (BEP) ratio?

A) 11.70%
B) 12.31%
C) 12.96%
D) 13.61%
E) 14.29%

Question 76

Hoagland 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
E) 1.63

Question 77

Which of the following statements is CORRECT?

A) In general, if investors regard a company as being relatively risky and/or having relatively poor growth prospects, then it will have relatively high P/E and M/B ratios.
B) The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects.
C) The "apparent," but not necessarily the "true," financial position of a company whose sales are seasonal can change dramatically during a given year, depending on the time of year when the financial statements are constructed.
D) The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value. In general, investors regard companies with higher M/B ratios as being more risky and/or less likely to enjoy higher future growth.
E) 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 78

Precision Aviation had a profit margin of 6.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE?

A) 15.23%
B) 16.03%
C) 16.88%
D) 17.72%
E) 18.60%

Question 79

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.
B) Company HD has more net income.
C) Company HD pays more in taxes.
D) Company HD has a lower ROE.
E) Company HD has a lower times-interest-earned (TIE) ratio.

Question 80

Which of the following statements is CORRECT?

A) A decline in a firm's inventory turnover ratio suggests that it is improving both its inventory management and its liquidity position, i.e., that it is becoming more liquid.
B) In general, it's better to have a low inventory turnover ratio than a high one, as a low one indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose sales as a result of running out of stock.
C) If a firm's fixed assets turnover ratio is significantly lower than its industry average, this could indicate that it uses its fixed assets efficiently or is operating at over capacity and should probably add fixed assets.
D) The more conservative a firm's management is, the higher its debt ratio is likely to be.
E) The days sales outstanding ratio tells us how long it takes, on average, to collect after a sale is made. The DSO can be compared with the firm's credit terms to get an idea of whether customers are paying on time.