$575,000
McKinny cannot pay of its loan by using only internally generated funds.
Dif: 2
AACSB: 3. Analytic thinking
Question Status: Previous edition
Objective: 4.3 Calculate and use a comprehensive set of inancial ratios to evaluate a company’s
performance.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
98) S.M., Inc. had total sales of $400,000 in 2014 (70 percent of its sales are credit). The
company’s gross proit margin is 10%, its ending inventory is $80,000, and its accounts
receivable is $25,000. What amount of funds can be generated by the company if it
increases its inventory turnover ratio to 10.0 and reduces its average collection period to
20 days?
Question Status: Revised
Objective: 4.3 Calculate and use a comprehensive set of inancial ratios to evaluate a company’s
performance.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
41
99) Baker & Co. has applied for a loan from the Trust Us Bank to invest in several potential
opportunities. To evaluate the irm as a potential debtor, the bank would like to compare
Baker & Co. to the industry. The following are the inancial statements given to Trust Us
Bank:
Balance Sheet 12/31/13 12/31/14
Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and Owners’ Equity
Accounts payable $150 $200
Notes payable 125 0
Current liabilities 275 200
Bonds 500 500
Owners’ equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners’ equity 1,605 1,780
Total liabilities and owners‘ equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross proit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before taxes 256 283
Taxes 87 96
Net income $169 $187
42
Compute the following ratios:
2013 2014 Industry Norms
Current ratio 5.0
Acid test ratio 3.0
Inventory turnover 2.2
Average collection period 90 days
Debt ratio .33
Times interest earned 7.0
Total asset turnover .75
Fixed asset turnover 1.0
Operating proit margin 20%
Net proit margin 12%
Return on total assets 9.00%
Return on equity 10.43%
Question Status: Revised
Objective: 4.3 Calculate and use a comprehensive set of inancial ratios to evaluate a company’s
performance.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
43
100) Baker & Co. has applied for a loan from the Trust Us Bank to invest in several
potential opportunities. To evaluate the irm as a potential debtor, the bank would like to
compare Baker & Co. to the industry. The following are the inancial statements given to
Trust Us Bank:
Balance Sheet 12/31/13 12/31/14
Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and Owners’ Equity
Accounts payable $150 $200
Notes payable 125 0
Current liabilities 275 200
Bonds 500 500
Owners’ equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners’ equity 1,605 1,780
Total liabilities and owners‘ equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross proit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before taxes 256 283
Taxes 87 96
Net income $169 $187
a. What are the irm’s inancial strengths and weaknesses?
b. Should the bank make the loan? Why or why not?
44
Question Status: Revised
Objective: 4.3 Calculate and use a comprehensive set of inancial ratios to evaluate a company’s
performance.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
45
4.4 Selecting a Performance Benchmark
1) Which of the following industries has the highest average inventory turnover ratio?
A) Retail clothing stores
B) Jewelry stores
C) Automobile dealerships
D) Supermarkets
Question Status: Previous edition
Objective: 4.4 Select an appropriate benchmark for use in performing a inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 4: Market Prices Relect Information
2) Which of the following would be most responsible for a company’s average collection
period being higher than the industry average?
A) If a company’s growth in sales is greater than the growth of sales in the industry.
B) Being more aggressive in collecting its accounts receivable than its competitors.
C) Having credit policy standards that are more restrictive than its competitors.
D) Being more lenient in extending credit to its customers than its competitors.
Question Status: Revised
Objective: 4.4 Select an appropriate benchmark for use in performing a inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 4: Market Prices Relect Information
3) When the present inancial ratios of a irm are compared with similar ratios for another
irm in the same industry, it is called trend analysis.
Question Status: Previous edition
Objective: 4.4 Select an appropriate benchmark for use in performing a inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 4: Market Prices Relect Information
4) Firms that engage in multiple lines of business make it diicult to assign them to an
industry category for ratio analysis.
Question Status: Previous edition
Objective: 4.4 Select an appropriate benchmark for use in performing a inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 4: Market Prices Relect Information
46
5) A small start-up company should choose an industry leader in the same industry as a
benchmark.
Question Status: New question
Objective: 4.4 Select an appropriate benchmark for use in performing a inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 4: Market Prices Relect Information
6) Companies chosen for benchmmarks should be of similar size and in the same or a
similar industry.
Question Status: New question
Objective: 4.4 Select an appropriate benchmark for use in performing a inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 4: Market Prices Relect Information
4.5 Limitations of Ratio Analysis
1) Which of the following is NOT a reason why inancial analysts use ratio analysis?
A) Ratios help to pinpoint a irm’s strengths.
B) Ratios restate accounting data in relative terms.
C) Ratios are ideal for smoothing out the diferences that may exist when comparing irms
that use diferent accounting practices.
D) Some of a irm’s weaknesses can be identiied through the usage of ratios.
Question Status: Previous edition
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
2) Which of the following is NOT a limitation related to the usage of ratios when reviewing
a irm’s performance?
A) Many irms experience seasonality in their operations.
B) Ratios cannot be used to compare irms that are in the same industry if one irm’s sales
are higher than another irm’s.
C) Some irms operate in a variety of business lines, which makes it diicult to make
comparisons.
D) Accounting practices difer widely among irms.
Question Status: Previous edition
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
47
3) Which of the following statements is FALSE?
A) The calculation of the accounts receivable average collection period (ACP) would
generally produce a more realistic assessment of how a irm is managing its accounts
receivable if the analyst were to calculate the ACP for each month and average the results,
than if the analyst were to solely use the iscal year-end accounts receivable value.
B) If an analyst were to compare the inventory turnover of one irm to that of another, the
comparison can be distorted if the two irms use diferent methods of valuing ending
inventory.
C) Assume that two irms are in the same industry and one reports a higher debt ratio than
the other. We can safely say that the irm that has the highest debt ratio is the riskier of the
two irms.
D) A irm that has a current ratio that is signiicantly above the industry norm will, as a
direct consequence, also have a signiicantly better return on assets than if its current ratio
was below the industry norm.
E) All of the above statements are true.
Question Status: Previous edition
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
4) Which of the following is a limitation related to the usage of ratios when reviewing a
irm’s performance?
A) Ratios reveal diferences in policy and performance between years.
B) Ratios can be used to compare irms that are in the same industry if one irm’s sales are
higher than another irm’s.
C) Financial ratios are designed for the use of creditors, not for managers.
D) Diferent accounting practices between irms can distort comparisons.
Question Status: New question
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
5) A serious pitfall in the interpretation of inancial ratios arises when a company, whose
business is seasonal, ends its accounting year on March 31, while most companies in the
same industry end their accounting period on December 31.
Question Status: Previous edition
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
48
6) Diferences in accounting practices limit the use of ratio analysis.
Question Status: Previous edition
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
7) Discuss the limitations of ratio analysis.
Question Status: Previous edition
Objective: 4.5 Describe the limitations of inancial ratio analysis.
Keywords: inancial ratios
Principles: Principle 2: There Is a Risk-Return Tradeof
49