Chapter 4: Analysis of Financial Statements
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 out 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 both 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
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
6.
If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio
would
increase.
a.
True
b.
False
7.
If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or
quick
ratio would change.
a.
True
b.
False
8.
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.
a.
True
b.
False
9.
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.
a.
True
b.
False
10.
In general, it’s better to have a low inventory turnover ratio than a high one, as a low ratio 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.
a.
True
b.
False
11.
The days sales outstanding 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.
a.
True
b.
False
12.
If a firm’s fixed assets turnover ratio is significantly higher than its industry average, this could indicate that it
uses
its fixed assets very efficiently or is operating at over capacity and should probably add fixed assets.
a.
True
b.
False
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 its 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
15.
Other things held constant, the higher a firm’s total debt to total capital ratio [measured as (Short-term debt +
Long-
term debt)/(Debt + Preferred stock + common equity)], the higher its TIE ratio will be.
a.
True
b.
False
16.
The times-interest-earned ratio measures the extent to which operating income can decline before the firm is
unable to meet its annual interest costs.
a.
True
b.
False
17.
Profitability ratios show the combined effects of liquidity, asset management, and debt management on a
firm’s
operating results.
a.
True
b.
False
18.
The basic earning power ratio (BEP) reflects the earning power of a firm’s assets after giving consideration to
financial leverage and tax effects.
a.
True
b.
False
19.
The operating margin measures operating income per dollar of assets.
a.
True
b.
False
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
23.
Significant variations in accounting methods among firms make meaningful ratio comparisons between firms
more
difficult than if all firms used the same or similar accounting methods.
a.
True
b.
False
24.
The inventory turnover and current ratio are related. The combination of a high current ratio and a low
inventory
turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory
level and/or that
part of the inventory is obsolete or damaged.
a.
True
b.
False
25.
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.
a.
True
b.
False
26.
Other things held constant, the more debt a firm uses, the lower its profit margin will be.
a.
True
b.
False
27.
Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a profit
margin of 8% for Firm B. Firm A’s total debt to total capital ratio [measured as (Short-term debt + Long-term
debt)/(Debt + Preferred stock + Common equity)] is 70% versus one of 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.
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 its operating margin will be.
a.
True
b.
False
30.
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.
a.
True
b.
False
31.
Other things held constant, the more debt a firm uses, the lower its return on total assets will be.
a.
True
b.
False
32.
Since the ROA measures the firm’s effective utilization of assets without considering how these assets are
financed, two firms with the same EBIT must have the same ROA.
a.
True
b.
False
ROA
29.3%
10.4%
33.
The return on common equity (ROE) is generally regarded as being less significant, from a stockholder’s
viewpoint,
than the return on total assets (ROA).
a.
True
b.
False
34.
The return on invested capital (ROIC) differs from the return on assets (ROA). First, ROIC is based on total
invested capital rather than total assets. Second, the numerator of the ROIC is after-tax operating income
rather
than net income.
a.
True
b.
False
35.
Market value ratios provide management with an indication of how investors view the firm’s past
performance and
especially its future prospects.
a.
True
b.
False
36.
In general, if investors regard a company as being relatively risky and/or having relatively poor growth
prospects,
then it will have relatively high P/E and M/B ratios.
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 being 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 being less risky and/or more likely to
enjoy higher
growth in the future.
a.
True
b.
False
39.
Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and
operate in
competitive product and capital markets. However, firms face different operating conditions
because, for example,
the grocery store industry is different from the airline industry. Under these conditions,
firms with high profit
margins will tend to have high asset turnover ratios, and firms with low profit margins
will tend to have low turnover
ratios.
a.
True
b.
False
40.
Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and therefore
an
equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow funds using
long-term
debt, use the funds to buy back stock, and raise the equity multiplier to 2.0. The size of the firm
(assets) would not
change. She thinks that operations would not be affected, but interest on the new debt
would lower the profit
margin to 4.5%. This would probably be a good move, as it would increase the ROE
from 7.5% to 13.5%.
a.
True
b.
False
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
43.
Firms A and B have the same current ratio, 0.75, the same amount of sales, and the same amount of current
liabilities. However, Firm A has a higher inventory turnover ratio than B. Therefore, we can conclude that A’s
quick ratio must be smaller than B’s.
a.
True
b.
False
44.
Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that
debt,
the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount
of sales
required to achieve its target TIE ratio.
a.
True
b.
False
45.
Suppose Firms A and B have the same amount of assets, total assets are equal to total invested capital, pay the
same interest rate on their debt, have the same basic earning power (BEP), finance with only debt and
common
equity, and have the same tax rate. However, Firm A has a higher debt to capital ratio. If BEP is
greater than the
interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.
a.
True
b.
False
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
48.
One problem with ratio analysis is that relationships can sometimes be manipulated. For example, if our
current
ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash
account
would cause the current ratio to INCREASE.
a.
True
b.
False
49.
One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our
current
ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause
the current
ratio to increase and thus make the firm look stronger.
a.
True
b.
False
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.
51.
Which of the following would, generally, indicate an improvement in a company’s financial position, holding
other
things constant?
a.
The TIE declines.
b.
The DSO increases.
c.
The quick ratio increases.
d.
The current ratio declines.
e.
The total assets turnover decreases.
52.
A firm wants to strengthen its financial position. Which of the following actions would increase its current
ratio?
a.
Reduce the company’s days’ sales outstanding to the industry average and use the resulting cash savings to
purchase plant and equipment.
b.
Use cash to repurchase some of the company’s own stock.
c.
Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.
d.
Issue new stock, then use some of the proceeds to purchase additional inventory and hold the remainder as
cash.
e.
Use cash to increase inventory holdings.
53.
Which of the following statements is CORRECT?
a.
A reduction in inventories would have no effect on the current ratio.
b.
An increase in inventories would have no effect on the current ratio.
c.
If a firm increases its sales while holding its inventories constant, then, other things held constant, its
inventory turnover ratio will increase.
d.
A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.
e.
If a firm increases its sales while holding its inventories constant, then, other things held constant, its fixed
assets turnover ratio will decline.
54.
Companies E and P each reported the same earnings per share (EPS), but Company E’s stock trades at a
higher
price. Which of the following statements is CORRECT?
a.
Company E probably has fewer growth opportunities.
b.
Company E is probably judged by investors to be riskier.
c.
Company E must have a higher market–to-book ratio.
d.
Company E must pay a lower dividend.
e.
Company E trades at a higher P/E ratio.
55.
Which of the following statements is CORRECT?
a.
Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an
example of “window dressing.” Offering discounts to customers who pay with cash rather than buy on
credit
and then using the funds that come in quicker to purchase additional inventories is another example
of
“window dressing.”
b.
Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current
ratio and thus could be considered to be an example of “window dressing.”
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 is an example of “window dressing.”
d.
Using some of the firm’s cash to reduce long-term debt is an example of “window dressing.”
e.
“Window dressing” is 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 would occur 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.
57.
A firm’s new president wants to strengthen the company’s financial position. Which of the following actions
would
make it 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, 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.
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
you
consider to be CORRECT?
a.
The lower the company’s inventory turnover ratio, other things held constant, the lower the interest rate the
bank would charge the firm.
b.
Other things held constant, the higher the days sales outstanding ratio, the lower the interest rate the bank
would charge.
c.
Other things held constant, the lower the total debt to total capital ratio, the lower the interest rate the bank
would charge.
d.
The lower the company’s TIE ratio, other things held constant, the lower the interest rate the bank would
charge.
e.
Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the
firm.
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.
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.
All else equal, 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?
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 was increasing and trending still higher, this would be interpreted as a sign of strength.
b.
A high average DSO indicates that none of its 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, other things held constant,
its
days’ sales outstanding will decline.
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, 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, 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, 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.
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.
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?
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.
71.
Which of the following statements is CORRECT?
a.
The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either
the
DSO or the inventory turnover ratio.
b.
If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.
c.
An increase in the DSO, other things held constant, could be expected to increase the total assets turnover
ratio.
d.
An increase in the DSO, other things held constant, could be expected to increase the ROE.
e.
An increase in a firm’s total debt to total capital ratio, with no changes in its sales or operating costs, could
be
expected to lower its profit margin.