CHAPTER 2—ANALYSIS OF FINANCIAL STATEMENTS
TRUE/FALSE
1. The income statement measures the flow of funds into (i.e. revenue) and out of (i.e. expenses) the
firm over a certain time period. It is always based on accounting data.
2. The balance sheet is a financial statement measuring the flow of funds into and out of various
accounts over time while the income statement measures the progress of the firm at a point in
time.
3. An increase in an asset account is a source of cash, whereas an increase in a liability account is a
use of cash.
4. Depreciation, as shown on the income statement, is regarded as a use of cash because it is an
expense.
5. When a firm pays off a loan using cash, the source of funds is the decrease in the asset account,
cash, while the use of funds involves a decrease in a liability account, debt.
6. Non-cash assets are expected to produce cash over time but the amount of cash they eventually
produce could be higher or lower than the values at which the assets are carried on the books.
7. Taxes, payment patterns, and reporting considerations, as well as credit sales and non-cash costs,
are reasons why operating cash flows can differ from accounting profits.
8. Ratio analysis involves a comparison of the relationships between financial statement accounts so
as to analyze the financial position and strength of a firm.
9. The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio
measures the relation of a firm’s current assets to its current liabilities and the inventory turnover
ratio measures how rapidly a firm turns its inventory back into a “quick” asset or cash.
10. If a firm has high current and quick ratios, this always is a good indication that a firm is managing
its liquidity position well.
11. A decline in the inventory turnover ratio suggests that the firm’s liquidity position is improving.
Chapter 2 Analysis of Financial Statements 11
12. The degree to which the managers of a firm attempt to magnify the returns to owners’ capital
through the use of financial leverage is captured in debt management ratios.
13. Profitability ratios show the combined effects of liquidity, asset management, and debt
management on operations.
14. Determining whether a firm’s financial position is improving or deteriorating requires analysis of
more than one set of financial statements. Trend analysis is one method of measuring a firm’s
performance over time.
15. The information contained in the annual report is used by investors to form expectations about
future earnings and dividends.
16. The balance sheet presents a summary of the firm’s revenues and expenses over an accounting
period.
17. On the balance sheet, total assets must equal total liabilities plus stockholders equity.
18. One of the biggest noncash items on the income statement is depreciation which needs to be
subtracted from net income to determine cash flows for the firm.
19. A firm’s net income reported on its income statement must equal the operating cash flows on the
statement of cash flows.
20. A statement reporting the impact of a firm’s operating, investing, and financing activities on cash
flows over an accounting is the statement of cash flows.
21. When a firm conducts a seasoned equity offering, it increases an equity account which is an
example of a source of funds.
22. When a firm conducts a stock repurchase, it increases an equity account which is an example of a
source of funds.
23. A liquid asset is an asset that can be easily converted into cash without a significant loss of its
original value.
12 Chapter 2 Analysis of Financial Statements
24. Genzyme Corporation has seen its days sales outstanding (DSO) decline from 38 days last year to
22 days this implying that more of the firm’s suppliers are being paid on time.
25. Funds supplied by common stockholders mainly includes capital stock, paid-in capital, and
retained earnings, while total equity is comprised of common equity plus preferred stock.
26. Retained earnings is the cash that has been generated by the firm through its operations which has
not been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash
accounts and thus, these cash accounts, when added together, will always be equal to the total
retained earnings of the firm.
27. The financial position of companies whose business is seasonal can be dramatically different
depending upon the time of year chosen to construct financial statements. This time sensitivity is
especially true with respect to the firm’s balance sheet.
28. In order to accurately estimate cash flow from operations, depreciation must be added back to net
income. The reason for this is that even though depreciation is deducted from revenue it is really
a non-cash charge.
29. In accounting, emphasis is placed on determining net income. In finance, the primary emphasis
also is on net income because that is what investors use to value the firm. However, a secondary
consideration is cash flow because that’s what is used to run the business.
30. Current cash flow from existing assets is highly relevant to the investor. However, the value of
the firm depends primarily upon its growth opportunities. As a result, profit projections from
those opportunities are the only relevant future flows with which investors are concerned.
31. If the current ratio of Firm A is greater than the current ratio of Firm B, we cannot be sure that the
quick ratio of Firm A is greater than that of Firm B. However, if the quick ratio of Firm A
exceeds that of Firm B, we can be assured that Firm A’s current ratio also exceeds B’s current
ratio.
32. The inventory turnover and current ratios are related. The combination of a high current ratio and
a low inventory turnover ratio relative to the industry norm might indicate that the firm is
maintaining too high an inventory level or that part of the inventory is obsolete or damaged.
33. We can use the fixed asset turnover ratio to legitimately compare firms in different industries as
long as all the firms being compared are using the same proportion of fixed assets to total assets.
Chapter 2 Analysis of Financial Statements 13
34. Suppose two firms with the same amount of assets pay the same interest rate on their debt and
earn the same rate of return on their assets, and that ROA is positive. However, one firm has a
higher debt ratio. Under these conditions, the firm with the higher debt ratio will also have a
higher rate of return on common equity.
35. Suppose a firm wants to maintain a specific TIE ratio. If the firm knows the level of its debt, the
interest rate it will pay on that debt and the applicable tax rate, the firm can then calculate the
earnings level required to maintain its target TIE ratio.
36. The fixed charge coverage ratio recognizes that firms often lease equipment under contract and
thus, some firms must meet more than just their scheduled interest payments out of earnings.
Therefore, the fixed charge coverage is more inclusive than the TIE ratio.
37. If sales decrease and financial leverage increases, we can say with certainty that the profit margin
on sales will decrease.
38. Selling new stock is an equity transaction; it does not affect any asset or liability account and
therefore, does not appear on the statement of cash flows.
MULTIPLE CHOICE
1. Other things held constant, which of the following will not affect the quick ratio? (Assume that
current assets equal current liabilities.)
a.
Fixed assets are sold for cash.
b.
Cash is used to purchase inventories.
c.
Cash is used to pay off accounts payable.
d.
Accounts receivable are collected.
e.
Long-term debt is issued to payoff a short-term bank loan.
14 Chapter 2 Analysis of Financial Statements
2. Changes in balance sheet accounts are necessary for
a.
A typical ratio analysis.
b.
Pro forma balance sheet construction.
c.
Statement of cash flows construction.
d.
Profit and loss analysis.
e.
Pro forma income statement construction.
3. All of the following represent cash outflows to the firm except
a.
Taxes.
b.
Interest payments.
c.
Dividends.
d.
Purchase of plant and equipment.
e.
Depreciation.
4. Other things held constant, if a firm holds cash balances in excess of their optimal level in a non-
interest bearing account, this will tend to lower the firm‘s
a.
Profit margin.
b.
Total asset turnover.
c.
Return on equity.
d.
All of the above.
e.
Answers b and c above.
5. Other things held constant, which of the following will not affect the current ratio, assuming an
initial current ratio greater than 1.0?
a.
Fixed assets are sold for cash.
b.
Long-term debt is issued to pay off current liabilities.
c.
Accounts receivable are collected.
d.
Cash is used to pay off accounts payable.
e.
A bank loan is obtained, and the proceeds are credited to the firm’s checking account.
6. The annual report contains all of the following financial statements except
a.
income statement.
b.
statement of changes in long-term financing.
c.
statement of cash flows.
d.
balance sheet.
e.
statement of retained earnings.
Chapter 2 Analysis of Financial Statements 15
7. Which of the following financial statements shows a firm’s financing activities (how funds were
generated) and investment activities (how funds were used) over a particular period of time?
a.
balance sheet
b.
income statement
c.
statement of retained earnings
d.
statement of cash flows
e.
proxy statement
8. Which of the following statements shows the portion of the firm’s earnings that has been saved
rather than paid out as dividends?
a.
balance sheet
b.
income statement
c.
statement of retained earnings
d.
statement of cash flows
e.
proxy statement
9. Which of the following financial statements includes information about a firm’s assets, equity,
and liabilities?
a.
Income statement
b.
Cash flow statement
c.
Balance sheet
d.
Statement of retained earnings
e.
All of the above
10. When constructing a Statement of Cash Flows, which of the following actions would be
considered a source of funds?
a.
increase in the cash account
b.
decrease in accounts payable
c.
increase in inventory
d.
increase in long-term bonds
e.
increase in fixed assets
11. Which of the following groups probably would not be interested in the financial statement
analysis of a firm?
a.
creditors
b.
management of the firm
c.
stockholders
d.
Internal Revenue Service
e.
All of the above would be interested in the financial statement analysis.
16 Chapter 2 Analysis of Financial Statements
12. Which of the following ratios measures how effectively a firm is managing its assets?
a.
quick ratio
b.
times interest earned
c.
profit margin
d.
inventory turnover ratio
e.
price earnings ratio
13. If your goal is determine how effectively a firm is managing its assets, which of the following
sets of ratios would you examine?
a.
profit margin, current ratio, fixed charge coverage ratio
b.
quick ratio, debt ratio, time interest earned
c.
inventory turnover ratio, days sales outstanding, fixed asset turnover ratio
d.
total assets turnover ratio, price earnings ratio, return on total assets
e.
time interest earned, profit margin, fixed asset turnover ratio
14. Which of the following ratios measures the extent to which operating income can decline before
the firm is unable to meet its annual interest costs
a.
fixed charge coverage ratio
b.
debt ratio
c.
times-interest-earned ratio
d.
return on equity
e.
profit margin
15. An analysis of a firm’s financial ratios over time that is used to determine the improvement or
deterioration in its financial situation is called
a.
sensitivity analysis
b.
DuPont chart
c.
ratio analysis
d.
progress chart
e.
trend analysis
16. Which of the following statements is most correct?
a.
An increase in a firm’s debt ratio, with no changes in its sales and operating costs, could be
expected to lower its profit margin on sales.
b.
An increase in DSO, other things held constant, would generally lead to an increase in the
total asset turnover ratio.
c.
An increase on the DSO, other things held constant, would generally lead to an increase in
the ROE.
d.
In a competitive economy, where all firms earn similar returns on equity, one would
expect to find lower profit margins for airlines, which require a lot of fixed assets relative
to sales, than for fresh fish markets.
e.
It is more important to adjust the Debt/Asset ratio than the inventory turnover ratio to
account for seasonal fluctuations.
Chapter 2 Analysis of Financial Statements 17
17. Which of the following statements is correct?
a.
The annual report contains four basic financial statements: the income statement; balance
sheet; statement of cash flows; and statement of changes in long-term financing.
b.
Although the annual report is geared toward the average stockholder, it represents
financial analysts’ most complete source of financial information about the firm.
c.
The key importance of annual report information is that it is used by investors when they
form their expectations about the firm’s future earnings and dividends and the riskiness of
those cash flows.
d.
The annual report provides no relevant information for use by financial analysts or by the
investing public.
e.
None of the above statements is correct.
18. A firm’s current ratio has steadily increased over the past 5 years, from 1.9 five years ago to 3.8
today. What would a financial analyst be most justified in concluding?
a.
The firm’s fixed assets turnover probably has improved.
b.
The firm’s liquidity position probably has improved.
c.
The firm’s stock price probably has increased.
d.
Each of the above is likely to have occurred.
e.
The analyst would be unable to draw any conclusions from this information.
19. Which of the following actions will cause an increase in the quick ratio in the short run?
a.
$1,000 worth of inventory is sold, and an account receivable is created. The receivable
exceeds the inventory by the amount of profit of the sale, which is added to retained
earnings.
b.
A small subsidiary which was acquired for $100,000 two years ago and which was
generating profits at the rate of 10 percent is sold for $100,000 cash. (Average company
profits are 15 percent of assets.)
c.
Marketable securities are sold at cost.
d.
All of the above.
e.
Answers a and b above.
20. Which of the following statements is correct?
a.
In the text, depreciation is regarded as a use of cash because it reduces fixed assets, which
then must be replaced.
b.
If a company uses some of its cash to pay off short-term debt, then its current ratio will
always decline, given the way ratio is calculated, other things held constant.
c.
During a recession, it is reasonable to think that most companies inventory turnover ratios
will change while their fixed asset turnover ratio will remain fairly constant.
d.
During a recession, we can be confident that most companies’ DSOs (or ACPs) will
decline because their sales will probably decline.
e.
Each of the above statements is false.
18 Chapter 2 Analysis of Financial Statements
21. As a short-term creditor concerned with a company’s ability to meet its financial obligation to
you, which one of the following combinations of ratios would you most likely prefer?
Current
Debt
ratio
TIE
ratio
a.
0.5 0.5 0.33
b.
1.0 1.0 0.50
c.
1.5 1.5 0.50
d.
2.0 1.0 0.67
e.
2.5 0.5 0.71
22. Which of the following statements about ratio analysis is incorrect?
a.
Classifying a large, well-diversified firm into a single industry often is difficult because
many of the firm’s divisions are involved with different products from different industries.
b.
As a rule of thumb, it is safe to conclude that any firm with a current ratio greater than 1.0
should be able to meet its current obligations—that is, pay bills that come due in the
current period. [Current ratio = (Current assets) / (Current liabilities)]
c.
Sometimes firms attempt to use “window dressing” techniques to make their financial
statements look better than they actually are in the current period.
d.
Computing the values of the ratios is fairly simple; the toughest and most important part of
ratio analysis is interpretation of the values derived from the computations.
e.
General conclusions about a firm should not be made by examining one or a few ratios—
ratio analysis should be comprehensive.
23. Yesterday, Bicksler Corporation purchased (and received) raw materials on credit from its
supplier. All else equal, if Bicksler’s current ratio was 2.0 before the purchase, what effect did
this transaction have on Bicksler’s current ratio?
a.
increased
b.
decreased
c.
stayed the same
d.
There is not enough information to answer this question.
e.
None of the above is a correct answer.
24. Bubbles Soap Corporation has a quick ratio of 1.0 and a current ratio of 2.0 implying that
a.
the value of current assets is equal to the value of inventory.
b.
the value of current assets is equal to the value of current liabilities.
c.
the value of current liabilities is equal to the value of inventory.
d.
All of the above.
e.
None of the above.
25. Which of the following statements is most correct?
a.
firms with relatively low debt ratios have higher expected returns when the business is
good.
b.
firms with relatively low debt ratios are exposed to risk of loss when the business is poor.
c.
firms with relatively high debt ratios have higher expected returns when the business is
bad.
d.
firms with relatively high debt ratios have higher expected returns when the business is
good.
e.
none of the above.
26. All other things constant, an increase in a firm’s profit margin would
a.
increase the additional funds needed for financing a growth in operations.
b.
decrease the additional funds needed for financing a growth in operations.
c.
have no effect on the additional funds needed for financing a growth in operations.
d.
decrease its taxes.
e.
none of the above.
27. Which of the following statements is correct?
a.
If Company A has a higher debt ratio that Company B, then we can be sure that A will
have a lower times-interest-earned ratio than B.
b.
Suppose two companies have identical operations in terms of sales, cost of goods sold,
interest rate on debt, and assets. However, Company A used more debt than Company B;
that is, Company A has a higher debt ratio. Under these conditions, we would expect B’s
profit margin to be higher than A’s.
c.
The ROE of any company which is earning positive profits and which has a positive net
worth (or common equity) must exceed the company’s ROA.
d.
Statements a, b, and c are all true.
e.
Statements a, b, and c are all false.
28. Pepsi Corporation’s current ratio is 0.5, while Coke Company’s current ratio is 1.5. Both firms
want to “window dress” their coming end-of-year financial statements. As part of their window
dressing strategy, each firm will double its current liabilities by adding short-term debt and
placing the funds obtained in the cash account. Which of the statements below best describes the
actual results of these transactions?
a.
The transactions will have no effect on the current ratios.
b.
The current ratios of both firms will be increased.
c.
The current ratios of both firms will be decreased.
d.
Only Pepsi Corporation’s current ratio will be increased.
e.
Only Coke Company’s current ratio will be increased.
20 Chapter 2 Analysis of Financial Statements
29. The Charleston Company is a relatively small, privately owned firm. Last year the company had
after-tax income of $15,000, and 10,000 shares were outstanding. The owners were trying to
determine the market value for the stock, prior to taking the company public. A similar firm
which is publicly traded had a price/earnings ratio of 5.0. Using only the information given,
estimate the market value of one share of Charleston’s stock.
a.
$10.00
b.
$7.50
c.
$5.00
d.
$2.50
e.
$1.50
30. If Boyd Corporation has sales of $2 million per year (all credit) and days sales outstanding of 35
days, what is its average amount of accounts receivable outstanding (assume a 360 day year)?
a.
$194,444
b.
$57,143
c.
$5,556
d.
$97,222
e.
$285,714
31. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has debt of
$7,500,000, total assets of $22,500,000, and an after-tax interest cost on total debt of 5 percent,
what is the firm’s ROA?
a.
8.4%
b.
10.9%
c.
12.0%
d.
13.3%
e.
15.1%