CFIN4
Chapter 2 – Analysis of Financial Statements
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.
a. True
b. False
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.
a. True
b. False
3. An increase in an asset account is a source of cash, whereas an increase in a liability account is a use of cash.
a. True
b. False
4. Depreciation, as shown on the income statement, is regarded as a use of cash because it is an expense.
a. True
b. False
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Chapter 2 – Analysis of Financial Statements
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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Chapter 2 – Analysis of Financial Statements
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.
a. True
b. False
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.
a. True
b. False
11. A decline in the inventory turnover ratio suggests that the firm‘s liquidity position is improving.
a. True
b. False
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.
a. True
b. False
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Chapter 2 – Analysis of Financial Statements
13. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operations.
a. True
b. False
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.
a. True
b. False
15. The information contained in the annual report is used by investors to form expectations about future earnings and
dividends.
a. True
b. False
16. The balance sheet presents a summary of the firm’s revenues and expenses over an accounting period.
a. True
b. False
17. On the balance sheet, total assets must equal total liabilities plus stockholders equity.
a. True
b. False
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.
a. True
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Chapter 2 – Analysis of Financial Statements
b. False
19. A firm’s net income reported on its income statement must equal the operating cash flows on the statement of cash
flows.
a. True
b. False
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.
a. True
b. False
21. When a firm conducts a seasoned equity offering, it increases an equity account which is an example of a source of
funds.
a. True
b. False
22. When a firm conducts a stock repurchase, it increases an equity account which is an example of a source of funds.
a. True
b. False
23. A liquid asset is an asset that can be easily converted into cash without a significant loss of its original value.
a. True
b. False
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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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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Chapter 2 – Analysis of Financial Statements
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
37. If sales decrease and financial leverage increases, we can say with certainty that the profit margin on sales will
decrease.
a. True
b. False
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Chapter 2 – Analysis of Financial Statements
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.
a. True
b. False
39. 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.
40. One would calculate changes in balance sheet accounts 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.
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Chapter 2 – Analysis of Financial Statements
41. 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.
42. 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.
43. 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.
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Chapter 2 – Analysis of Financial Statements
44. 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.
45. 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
46. 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
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Chapter 2 – Analysis of Financial Statements
47. 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
48. 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
49. 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.
50. 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
51. 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
52. 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
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Chapter 2 – Analysis of Financial Statements
53. 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
54. 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.
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Chapter 2 – Analysis of Financial Statements
55. 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.
56. 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.
57. 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.
58. 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.
59. 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.
b.
c.
d.
e.
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Chapter 2 – Analysis of Financial Statements
60. 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.
61. 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.