Chapter 04: Analysis of Financial Statements
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To keep this chapter from involving too much memorization, we provide our students with a formula sheet for use on
exams. That makes a few of the questions trivially easy, but most require some thought, and some are downright
challenging. Even the very easy ones make students think about the ratios. The challenging questions are labeled
CHALLENGING, and most students will agree with that designation.
Some of these questions are just definitions, but others require real thought about the make-up of the ratios and
relationships among the ratios. We tell our students that to answer some of these questions it is useful (1) to write out the
relevant ratio or ratios, (2) then to think about how the ratios would change if the accounting data changed, and (3)
occasionally to make up illustrative data to test their conclusions.
Note that there is some overlap between the True/False and the multiple choice questions, as some T/F statements are
used in the MC questions.
1. Ratio analysis involves analyzing financial statements to help appraise a firm’s financial position and strength.
a. True
b. False
2. The current and quick ratios 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 quick ratio measures the firm’s ability to pay off short-term obligations
without relying on the sale of inventories.
a. True
b. False
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3. 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.
a. True
b. False
4. High current and quick ratios always indicate that the firm is managing its liquidity position well.
a. True
b. False
5. 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.
a. True
b. False
Chapter 04: Analysis of Financial Statements
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13. 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.
a. True
b. False
14. The more conservative a firm’s management is, the higher the firm’s total debt to total capital ratio [measured as
(Short-term debt + Long-term debt)/(Debt + Preferred stock + Common equity)] is likely to be.
a. True
b. False
Chapter 04: Analysis of Financial Statements
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20. The profit margin measures net income per dollar of sales.
a. True
b. False
21. The return on invested capital measures the total return that a company has provided for its investors.
a. True
b. False
22. 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.
a. True
b. False
Chapter 04: Analysis of Financial Statements
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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.
a. True
b. False
28. Other things held constant, a decline in sales accompanied by an increase in financial leverage must result in a lower
profit margin.
a. True
b. False
29. Other things held constant, the more debt a firm uses, the lower the firm’s operating margin will be.
a. True
b. False
Chapter 04: Analysis of Financial Statements
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a. True
b. False
37. 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 less risky and/or more likely to enjoy higher growth in the
future.
a. True
b. False
38. 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 less risky and/or more likely to enjoy higher growth in the
future.
a. True
b. False
Chapter 04: Analysis of Financial Statements
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41. 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.
a. True
b. False
42. 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 B’s.
a. True
b. False