10) The ________ ratio indicates whether a firm will be able to meet interest obligations due on
outstanding debt.
A) debt-to-equity
B) interest turnover
C) total assets turnover
D) times interest earned
11) The higher, the value of the ________ ratio, the better able a firm is to fulfill its interest
obligations.
A) dividend payout
B) average collection period
C) times interest earned
D) average payment period
12) When assessing the fixed-payment coverage ratio, ________.
A) the lower its value the more risky is the firm
B) the lower its value, the higher is the firm’s financial leverage
C) preferred stock dividend payments can be disregarded
D) the higher its value, the more difficult it is for a firm to pay its debts
13) The magnification of risk and return introduced through the use of fixed-cost financing, such
as debt and preferred stock is called financial leverage.
14) The financial leverage multiplier is the ratio of a firm’s total assets to common stock equity.
1) The gross profit margin measures the percentage of each sales dollar left after a firm has paid
for its goods and operating expenses.
43
2) Key Financial Data
Income Statement, Dreamscape, Inc.
For the Year Ended December 31, 2020
Prepare a common-size income statement for Dreamscape, Inc. for the year ended December 31,
2020. Evaluate the company’s performance against industry average ratios and against last year’s
results.
44
Copyright © 2019 Pearson Education, Inc.
Answer: Common-Size Income Statement
Dreamscape, Inc.
For the Year Ended December 31, 2020
Dreamscape, Inc. performs significantly below industry average. All profitability ratios
(gross profit margin, operating profit margin, and net profit margin) trail the industry norms. In
2019 expenses as a percent of sales were high.
Dreamscape, Inc. improved the management of operating expenses in 2020 meeting industry
averages. However, cost of goods sold as a percent of sales increased and is a full 5 percent
above the industry average, further reducing the gross profit margin. Interest expense is two
times the average indicating high cost of debt or a high debt level. The firm must concentrate on
reducing the cost of goods sold and interest expense to improve performance.
Diff: 2
Topic: Common Size Income Statements
Learning Obj.: LG 5
Learning Outcome: F-02
AACSB: Analytical Thinking
3) Two frequently cited ratios of profitability that can be read directly from the common-size
income statement are ________.
A) the earnings per share and the return on total assets
B) the gross profit margin and the earnings per share
C) the gross profit margin and the return on total assets
D) the gross profit margin and the net profit margin
4) The ________ is a popular approach for evaluating profitability in relation to sales by
expressing each item on the income statement as a percent of sales.
A) retained earnings statement
B) common-size balance sheet
C) common-size income statement
D) profit and loss statement
5) In 2018, Walmart reported sales of $500.3 billion, gross profits of $126.9 billion, EBIT of
$20.4 billion, and net income of $9.9 billion. The company’s cost of goods sold that year
equalled ________.
A) 2%
B) $373.4 billion
C) $353 million
D) 4.1%
6) In 2017, Apple Inc. reported sales of $229.2 billion, cost of goods sold of $141 billion, and
net income of $48.4 billion. Apple’s gross profit margin that year was ________.
A) 38.4%
B) 21.1%
C) 61.5%
D) 17.4%
7) In 2018, Target Corp. reported sales of $71.9 billion, cost of goods sold of $51.1 billion,
operating profit of $4.3 billion, and net income of $2.9 billion. Target has no preferred stock
outstanding. It’s net profit margin that year was ________.
A) 6%
B) 28.9%
C) 4%
D) 5.7%
8) In 2018, Target Corp. reported sales of $71.9 billion, cost of goods sold of $51.1 billion,
operating profit of $4.3 billion, and net income of $2.9 billion. Target has no preferred stock
outstanding. It’s operating profit margin that year was ________.
A) 20.7%
B) 8.4%
C) 4.0%
D) 6.0%
9) The ________ indicates the percentage of each sales dollar remaining after the firm has paid
for its goods.
A) net profit margin
B) operating profit margin
C) gross profit margin
D) earnings available to common shareholders
10) The ________ measures the percentage of profit earned on each sales dollar before interest
and taxes but after all costs and expenses.
A) net profit margin
B) operating profit margin
C) gross profit margin
D) earnings available to common shareholders
11) A firm with a gross profit margin which meets industry standard and a net profit margin
which is below industry standard may have excessive ________.
A) general and administrative expenses
B) cost of goods sold
C) dividend payments
D) principal payments
12) The ________ measures the percentage of each sales dollar remaining after all costs and
expenses, including interest, taxes, and preferred stock dividends, have been deducted.
A) net profit margin
B) operating profit margin
C) gross profit margin
D) earnings available to common shareholders
13) The ________ measures the overall effectiveness of management in generating profits with
its available assets.
A) total asset turnover
B) price/earnings ratio
C) return on equity
D) return on total assets
14) The ________ ratio measures the return earned on the common stockholders’ investment in
the firm.
A) net profit margin
B) price/earnings
C) return on equity
D) return on total assets
15) A firm with sales of $1,000,000, net profits after taxes of $30,000, total assets of $1,500,000,
and common stockholders’ investment of $750,000 has a return on equity of ________.
A) 2 percent
B) 15 percent
C) 3 percent
D) 4 percent
16) The net profit margin measures the percentage of each sales dollar remaining after all costs
and expenses, including interest, taxes, and common stock dividends, have been deducted.
17) If a firm has no liabilities or debt of any kind on its balance sheet, then which of the
following is TRUE?
A) ROE > ROA
B) ROE < ROA
C) ROE = ROA
D) ROA = net profit margin
18) If a firm uses any debt at all and if the firm generates positive earnings for common
stockholders, then which of the following below is TRUE?
A) ROE > ROA
B) ROE < ROA
C) ROE = ROA
D) Gross profit margin < net profit margin
19) Return on total assets (ROA) measures the overall effectiveness of management in
generating profits with its available assets.
20) The more money a firm borrows ________.
A) the lower is its ROE because more interest expense reduces earnings
B) the larger is the gap between its ROA and its ROE
C) the lower is its operating profit margin
D) the higher is its gross profit margin
21) The ________ ratios are primarily used as measures of return.
A) liquidity
B) activity
C) debt
D) profitability
1) A firm’s P/E ratio tends to be higher if ________.
A) its risk and its growth prospects are lower
B) its risk is higher and its growth prospects are lower
C) its risk and its growth prospects are higher
D) its risk is lower and its growth prospects are higher
2) All other things being equal, a firm’s P/E ratio will be lower if investors think the firm’s
growth prospects are very good.
3) Earnings per share represents the dollar amount earned and distributed to shareholders.
4) The ________ ratio reflects how much investors are willing to pay for a company’s stock per
dollar of earnings that the company generates.
A) debt
B) price/earnings
C) return on equity
D) return on total assets
5) Holding all other factors constant, a higher price/earnings (P/E) ratio indicates that investors
have more confidence in a firm’s future performance.
6) Suppose a firm that is normally very profitable barely does better than breaking even this year,
i.e., it earns a very small profit. That firm’s P/E ratio is likely to be ________.
A) very high
B) zero
C) negative
D) the lowest among all firms in its industry
7) The P/E ratio measures the ________.
A) market value of the stock relative to earnings per share
B) intrinsic value of the stock relative to earnings per share
C) book value of the stock relative to earnings per share
D) market price of the stock relative to retained earnings
8) Book value per share is the ratio of ________.
A) common stock equity to number of outstanding common shares
B) retained earnings to number of outstanding common shares
C) fixed assets to number of outstanding common shares
D) total liabilities to number of outstanding common shares
9) During the 2008-2009 recession, the average P/E ratio of firms in the U.S. stock market
reached an extraordinarily high level because ________.
A) investors believed short-term growth prospects for U.S. firms were extraordinarily good at
that time
B) stock prices generally boomed during the recession
C) earnings per share were unusually low during the recession
D) investors believed long-term growth prospects coming out of the recession were not very
good
10) Over long periods of time, the average P/E ratio of firms in the U.S. stock market is closest
to ________.
A) 0.2
B) 2.0
C) 20
D) 200
11) In its 2018 fiscal year, the data storage company, NetApp Inc., reported that it had 267.9
million shares of common stock outstanding, trading at a price of about $68 per share. On the
firm’s balance sheet, the value of common stock equity was reported as $2.067 billion. NetApp’s
market/book ratio was ________.
A) 8.8
B) 7.7
C) 68
D) greater than 100
12) Which of the following is TRUE?
A) For most companies the market/book ratio is less than 1.0 because book value is a
conservative estimate of what a firm’s equity is really worth.
B) For most companies the market/book ratio is greater than 1.0 because the stock market tends
to overvalue things.
C) For most companies the market/book ratio is greater than 1.0 because book value is a
backward-looking measure based largely on historical costs, whereas market value is forward
looking and depends on how investors believe the company will perform in the future.
D) For most companies the market/book ratio is very close to 1.0 because on average, book value
provides a good estimate of the market value of a firm’s equity.
13) In early 2018, Facebook’s market/book ratio was close to 7.0. A market/book ratio that much
greater than 1.0 for Facebook means that ________.
A) Facebook has a huge number of common shares outstanding
B) the book value of Facebook’s equity is far less than the total market value of the company’s
stock
C) Facebook’s stock is overvalued
D) Facebook’s book value is inflated because so many of its assets are intangible
14) For most companies we would expect the market/book ratio to be greater than 1.0.
15) Market ratios only measure a firm’s risk.
1) Earnings per share represents the dollar amount earned and distributed to shareholders.
2) The DuPont formula allows a firm to break down its return into the net profit margin, which
measures the firm’s profitability on sales, and its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
3) The DuPont system allows a firm to break its return on equity into a profit-on-sales
component, an efficiency-of-asset-use component, and a liquidity component.
4) According to the basic DuPont equation, a firm’s ROA is the product of what other two ratios?
A) net profit margin and return on equity
B) net profit margin and total asset turnover
C) net profit margin and the financial leverage multiplier
D) ROE and the financial leverage multiplier
5) The ________ is used by financial managers as a structure for dissecting a firm’s financial
statements to assess its financial condition.
A) statement of cash flows
B) DuPont system of analysis
C) break-even analysis
D) technical analysis
6) The modified DuPont formula relates the firm’s return on total assets (ROA) to its ________.
A) return on equity (ROE)
B) operating leverage multiplier
C) net profit margin
D) total asset turnover
7) In the DuPont system of analysis, the return on equity is equal to ________.
A) (net profit margin) × (total asset turnover)
B) (stockholders’ equity) × (financial leverage multiplier)
C) (return on total assets) × (financial leverage multiplier)
D) (return on total assets) × (total asset turnover)
8) A firm with a low net profit margin can improve its return on total assets by ________.
A) increasing its debt ratio
B) increasing its total asset turnover
C) decreasing its fixed asset turnover
D) decreasing its total asset turnover
9) Other things being equal, a decrease in total asset turnover will result in ________ in the
return on total assets.
A) an increase
B) a decrease
C) no change
D) an undetermined change
10) The modified DuPont equation says that a firm with a low return on total assets can improve
its return on equity, all else remaining the same, by ________.
A) financing more of its assets with debt
B) increasing its total asset turnover
C) using less debt
D) decreasing its total asset turnover
11) The three basic ratios used in the DuPont system of analysis are ________.
A) net profit margin, total asset turnover, and return on investment
B) net profit margin, total asset turnover, and return on equity
C) net profit margin, total asset turnover, and financial leverage multiplier
D) net profit margin, financial leverage multiplier, and return on equity
12) The financial leverage multiplier is an indicator of how much ________ a corporation is
utilizing.
A) operating leverage
B) long-term debt
C) total debt
D) total assets