978-0134083285 Chapter 4 Part 1

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Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 4 Evaluating a Firm’s Financial Performance

Learning Objective 4.1

1) When the present financial ratios of a firm are compared with similar ratios for another firm in the

same industry it is called trend analysis.

Keywords: Trend Analysis, Bases of Comparison

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

2) Theoretically, market values of assets are better for evaluating the creation of shareholder wealth than

accounting numbers, but accounting numbers are used because they are more readily available.

Keywords: Shareholder Value, Market Value, Accounting Information

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

3) Financial ratios are often reported by industry or line of business because differences in the type of

business can make ratio comparisons uninformative or even misleading.

Keywords: Ratio Analysis

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

4) Financial ratios are useful for evaluating performance but should not be used for making financial

projections.

Keywords: Ratio Analysis, Financial Projections

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

5) Financial ratios are used by managers inside the company and by lenders, credit-rating agencies, and

investors outside of the company.

Keywords: Ratio Analysis, Usefulness

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

6) Financial ratios cannot be used to evaluate the creation of shareholder wealth because they are based

on accounting numbers that reflect historical cost and not current market values.

Keywords: Ratio Analysis, Shareholder Wealth

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

7) Common stockholders may use financial ratios to monitor manager actions to help lessen agency

problems.

Keywords: Agency Problems, Use of Ratio Analysis

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

8) Accounting information is used in financial ratio analysis because it is theoretically the best data to

guide financial decision-making.

Keywords: Ratio Analysis, Market Value, Historical Cost

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

9) Ratios of almost all companies are easily comparable because all public companies prepare their

financial reports based upon generally accepted accounting principles.

Keywords: Ratio Comparability, GAAP

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

10) Common-size balance sheets are balance sheets of companies with almost identical total assets (within

2% of each other).

Keywords: Common-Sized Balance Sheet

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

11) Financial ratios that are higher than industry averages may indicate problems that are as detrimental

to the firm as ratios that are too low.

Keywords: Ratio Analysis, Interpretation of Ratios

Learning Obj.: L.O. 4.1

AACSB: Analytical Thinking

12) Ratios are used to standardize financial information, thereby making it easier to interpret.

Keywords: Ratio Analysis

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

13) Trend analysis is the forecasting of the firm’s financial ratios for a future time period by using its own

ratios from previous periods.

Keywords: Trend Analysis

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

14) How managers choose to finance the business affects the company’s risk, and as a result, the rate of

return stockholders receive on their investments.

Keywords: Risk Requires a Reward, Risk-Return Trade-off

Learning Obj.: L.O. 4.1

AACSB: Analytical Thinking

15) Financial analysis

A) uses historical financial statements and is thus useful only to assess past performance.

B) relies on generally accepted accounting principles to make comparisons between companies valid.

C) uses historical financial statements to measure a company‘s performance and in making financial

projections of future performance.

D) is accounting record-keeping using generally accepted accounting principles.

Keywords: Financial Analysis, Financial Performance, Financial Projections

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

16) Common-sized balance sheets

A) show data for companies in the same industry.

B) show data for companies with approximately the same amount of assets.

C) show each balance sheet account as a percentage of total sales.

D) show each balance sheet account as a percentage of total assets.

Keywords: Common-Sized Balance Sheet

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

17) Common-sized income statements

A) assist in the comparison of companies of different sizes.

B) show each income statement account as a percentage of total assets.

C) compare companies with the same level of total sales.

D) compare companies with the same level of net income.

Keywords: Common-Sized Income Statement

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

18) In an ideal world, which of the following would be used to evaluate firm performance?

A) book value of assets

B) corporate retained earnings from the day of incorporation

C) accounting assets and profits

D) market value of assets

Keywords: Financial Analysis, Market Value

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

19) How does a firm use financial ratios? Who else might use financial ratios and why?

Keywords: Ratio Analysis

Learning Obj.: L.O. 4.1

AACSB: Reflective Thinking

Learning Objective 4.2

1) A company with a current ratio higher than industry average must also have a quick ratio higher than

industry average because both ratios measure liquidity.

Keywords: Liquidity, Current Ratio, Quick Ratio

Learning Obj.: L.O. 4.2

AACSB: Analytical Thinking

2) Return on equity is driven by (1) the spread between the operating return on assets and the interest

rate, and (2) changes in the debt ratio.

Keywords: Return on Equity, Operating Return on Assets, Debt Ratio

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

3) Borrowing money causes a corporation’s return on operating assets to decrease because of the interest

that must be paid.

Keywords: Operating Return on Assets, Debt

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

4) Borrowing more money will always increase a company‘s return on equity because the company is

using financial leverage, but it also adds to the riskiness of the company.

Keywords: Return on equity, Financial Leverage

Learning Obj.: L.O. 4.2

AACSB: Analytical Thinking

5) Operating return on assets is equal to the operating profit margin times total asset turnover.

Keywords: Operating Return on Assets, Operating Profit Margin, Total Asset Turnover

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

6) Total asset turnover is equal to accounts receivable turnover plus inventory turnover plus fixed asset

turnover.

Keywords: Total Asset Turnover, Accounts Receivable Turnover, Inventory Turnover, Fixed Asset Turnover

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

7) Financial ratios are useful for measuring performance because maximizing the return on equity for

common shareholders is the primary goal of financial managers.

Keywords: Ratio Analysis, Goal of the Firm, ROE

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

8) If company A has a lower average collection period than company B, then company A will have a

higher accounts receivable turnover.

Keywords: Average Collection Period, Accounts Receivable Turnover, Liquidity

Learning Obj.: L.O. 4.2

AACSB: Analytical Thinking

9) Net income is the best measure to use for evaluating a firm’s profits on assets because it includes the

effect of financing as well as the effect of operations.

Keywords: Net Income, Asset Management

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

10) Operating profits or EBIT is used to measure a firm’s profits on assets because it does not include the

firm’s cost of debt financing.

Keywords: Operating Profits, Asset Management

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

11) Operating return on assets (OROA) is equal to operating profit margin times fixed assets turnover.

Keywords: Operating Return on Assets, Operating Profit Margin, Total Asset Turnover

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

12) Lower asset turnover ratios are generally indicative of more efficient asset management.

Keywords: Asset Turnover Ratios, Asset Management

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

13) A high debt ratio can be favorable because higher leverage may result in a higher return on equity.

Keywords: Debt Ratio, Leverage, Return on Equity

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

14) A common method of evaluating a firm’s financial ratios is to compare the current values of the firm‘s

ratios to its own ratios from prior periods. This is referred to as trend analysis.

Keywords: Trend Analysis

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

15) The current ratio and the acid test ratio both measure financial leverage.

Keywords: Current Ratio, Quick Ratio

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

16) Ratios that examine profit relative to investment are useful in evaluating the overall effectiveness of

the firm’s management.

Keywords: Ratio Analysis

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

17) The astute financial manager will seek to attain the highest current ratio possible.

Keywords: Current Ratio

Learning Obj.: L.O. 4.2

AACSB: Ethical understanding and reasoning

18) One weakness of the times interest earned ratio is that it includes only the annual interest expense as a

finance expense and ignores other financing items such as lease payments that must be paid.

Keywords: Times Interest Earned

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

19) DuPont analysis indicates that the return on equity may be boosted above the return on assets by

using leverage (debt).

Keywords: DuPont Analysis, Return on Equity, Return on Assets

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

20) Economic Value Added attempts to measure a firm‘s economic profit rather than its accounting profit.

Keywords: Economic Value Added

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

21) Economic value added includes a charge for the cost of equity that is not included on financial

statements prepared according to GAAP.

Keywords: Economic Value Added, Cost of Equity

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

22) Economic value added is calculated by taking (net income less the cost of all capital) times total assets.

Keywords: Economic Value Added

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

23) How managers choose to finance the business does not affect the rate of return to shareholders

because the rate of return is based on how the company uses the assets it has, not whether or not they

paid for the assets with debt or equity.

Keywords: Risk Requires a Reward, Risk-Return Trade-off

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

24) The computation of return on equity, or ROE, does not include retained earnings as part of common

equity because retained earnings includes all net income for the company since its inception and analysts

are trying to calculate the return for just the current year.

Keywords: Return on Equity, Retained Earnings

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

25) Operating return on assets captures the effect of taxes and financing costs, and hence provides the

broadest possible measure of profitability.

Keywords: Operating Return on Assets

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

26) The goal of most financial managers is to reduce the amount of long-term debt to zero, thus

maximizing shareholder wealth.

Keywords: Debt Ratio, Financial Leverage

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

27) Ratio analysis enhances our understanding of three basic attributes of performance: liquidity,

profitability, and the ability to create shareholder value.

Keywords: Ratio Analysis, Liquidity, Profitability, Shareholder Value

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

28) Which of the following transactions will increase a corporation’s operating return on assets?

A) sell stock and use the money to pay off some long-term debt

B) sell 10-year bonds and use the money to pay off current liabilities

C) negotiate a new contract that lowers raw material costs by 10%

D) increase sales by 10%

Keywords: Operating Return on Assets

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

29) Asset efficiency ratios for Fischer, Inc. are given in the table below. Based on this information, Fischer,

Inc.’s fixed asset turnover ratio is likely to be ________.

Fischer, Inc.

Peer Group

Total Asset Turnover

1.58X

2.05X

Accounts Receivable Turnover

17.55X

14.35X

Inventory Turnover

6.34X

5.22X

Fixed Asset Turnover

?????

3.50X

A) equal to 3.50

B) less than 3.50

C) greater than 3.50

D) negative

Keywords: Asset Efficiency Ratios, Fixed Asset Turnover

Learning Obj.: L.O. 4.2

AACSB: Analytical Thinking

30) An analyst is evaluating two companies, A and B. Company A has a debt ratio of 50% and Company

B has a debt ratio of 25%. In his report, the analyst is concerned about Company B’s debt level, but not

about Company A’s debt level. Which of the following would best explain this position?

A) Company B has much higher operating income than Company A.

B) Company A has a lower times interest earned ratio and thus the analyst is not worried about the

amount of debt.

C) Company B has a higher operating return on assets than Company A, but Company A has a higher

return on equity than Company B.

D) Company B has more total assets than Company A.

Keywords: Operating Return on Assets, Debt Ratio, Return on Equity

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking

31) Smith Corporation has earned a return on capital invested of 10% for the past two years, but an

investment analyst reviewing the company has stated the company is not creating shareholder value.

This may be due to the fact that

A) the risk-free rate of interest is 3%.

B) the corporation’s inventory turnover is high.

C) investors’ required rate of return is 8%.

D) investors’ required rate of return is 12%.

Keywords: Economic Value Added, Required Return

Learning Obj.: L.O. 4.2

AACSB: Analytical Thinking

32) All of the following measure liquidity EXCEPT

A) current ratio.

B) inventory turnover.

C) acid-test ratio.

D) operating return on assets.

Keywords: Liquidity, Current Ratio, Acid-test Ratio, Inventory Turnover

Learning Obj.: L.O. 4.2

AACSB: Reflective Thinking