Chapter 04: Analysis of Financial Statements
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Taxable income 9.0 Taxable income 15.0
Taxes 2.25 Taxes 3.75
46. If a firm’s ROE is equal to 9% and its ROA is equal to 6%, its equity multiplier must be 1.5.
a. True
b. False
47. A firm’s ROE is equal to 9% and its ROA is equal to 6%. The firm finances only with short-term debt, long-term debt,
and common equity, so assets equal total invested capital. The firm’s total debt to total capital ratio must be 50%.
a. True
b. False
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Multiple Choice: Conceptual
50. 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.
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55. Which of the following actions is an example of “window dressing?”
a. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt.
b. Borrowing on a long-term basis and using the proceeds to retire short-term debt.
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.
d. Using some of the firm’s cash to reduce long-term debt.
e. Any action that does not improve a firm’s fundamental long-run position and thus increases its intrinsic value.
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
occurred 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 total debt to total capital ratio increased.
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57. A firm’s new president wants to strengthen the company’s financial position. Which of the following actions would
make the company 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.
58. If the CEO of a large and 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 total debt to total capital 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 days, whereas the average for its competitors is 30 days.
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59. 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 total debt to total capital ratio increases.
c. The profit margin declines.
d. The times-interest-earned ratio declines.
e. The current and quick ratios both increase.
60. If a bank loan officer were considering a company’s loan request, which of the following statements would be
CORRECT, other things held constant?
a. The lower the company’s inventory turnover ratio, the lower the interest rate the bank should charge.
b. The higher the days sales outstanding ratio, the lower the interest rate the bank should charge.
c. The lower the total debt to total capital ratio, the lower the interest rate the bank should charge.
d. The lower the company’s TIE ratio, the lower the interest rate the bank should charge.
e. The lower the current ratio, the lower the interest rate the bank should charge.
61. 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.
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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. Other things held constant, increasing the total debt to total capital ratio will increase the ROA.
62. 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.
63. Amram Company’s current ratio is 2.0. Considered alone, which of the following actions would lower the current
ratio?
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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.
64. 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
trending still higher, this would be interpreted as a sign of strength.
b. A high average DSO indicates that none of the firm’s 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 its days’ sales outstanding will
decline, other things held constant.
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65. Which of the following statements is CORRECT?
a. If one firm has a higher total debt to total capital ratio than another, we can be certain that the firm with the higher
total debt to total capital 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, identical total invested capital, sales,
operating costs, interest rates on their debt, and tax rates—but one firm has a higher total debt to total capital ratio, then
the firm that uses more debt will have a lower profit margin on sales and a lower return on assets.
d. The total debt to total capital 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, identical total invested capital,
operating costs, and tax rates—but one firm has a higher total debt to total capital ratio, then the firm that uses more debt
will have a higher operating margin and return on assets.
66. 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, then 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.
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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.
67. 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%. The firm finances using only debt and common equity,
and total assets equal total invested capital. 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%. The firm finances using only debt and common equity,
and total assets equal total invested capital. 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 total debt to total capital 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%. The firm finances using only debt and common equity,
and total assets equal total invested capital. Under these conditions, the ROE will decrease.
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68. You observe that a firm’s ROE is above the industry average, but both its profit margin and equity multiplier are
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.
69. Companies HD and LD are both profitable, and they have the same total assets (TA), total invested capital, sales (S),
return on assets (ROA), and profit margin (PM). Both firms finance using only debt and common equity. However,
Company HD has the higher total debt to total capital ratio. Which of the following statements is CORRECT?
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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.
70. 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.
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e. Company HD has a lower times-interest-earned (TIE) ratio.
75. Which of the following statements is CORRECT?
a. If a firm has high current and quick ratios, then it must be managing its liquidity position well.
b. If a firm sold some inventory for cash and left the funds in its bank account, then its current ratio would probably
not change much, but its quick ratio would decline.
c. If a firm sold some inventory on credit, then 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, then 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.
76. Which of the following statements is CORRECT?
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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 the average for its industry, then it could be that
the firm uses its fixed assets very efficiently or is operating at over capacity and should probably add fixed assets.
d. The more conservative a firm’s management is, the higher the firm’s total debt to total capital 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.
77. 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 total debt to total capital 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 total debt to total capital ratio, the lower the risk.
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78. 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 considered 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 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 total debt to total capital 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.
79. Which of the following statements is CORRECT?
a. In general, if investors regard a company as 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 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.
