Chapter 4: Analysis of Financial Statements
72.
HD Corp and LD Corp have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. Both
firms finance using only debt and common equity and total assets equal total invested capital. However, HD
uses
more debt than LD. Which of the following statements is CORRECT?
a.
Without more information, we cannot tell if HD or LD would have a higher or lower net income.
b.
HD would have the lower equity multiplier for use in the DuPont equation.
c.
HD would have to pay more in income taxes.
d.
HD would have the lower net income as shown on the income statement.
e.
HD would have the higher operating margin.
73.
Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning
power. Both firms finance using only debt and common equity and total assets equal total invested capital.
Both
companies have positive net incomes. Company HD has a higher total debt to total capital ratio and,
therefore, a
higher interest expense. Which of the following statements is CORRECT?
a.
Company HD pays less in taxes.
b.
Company HD has a lower equity multiplier.
c.
Company HD has a higher ROA.
d.
Company HD has a higher times-interest-earned (TIE) ratio.
e.
Company HD has more net income.
74.
Companies HD and LD have the same tax rate, sales, total assets, and basic earning power. Both companies
have
positive net incomes. Both firms finance using only debt and common equity and total assets equal total
invested
capital. Company HD has a higher total debt to total invested capital ratio and, therefore, a higher
interest expense.
Which of the following statements is CORRECT?
a.
Company HD has a lower equity multiplier.
b.
Company HD has more net income.
c.
Company HD pays more in taxes.
d.
Company HD has a lower ROE.
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, this always indicate that the firm is managing its liquidity
position
well.
b.
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.
c.
If a firm sold some inventory on credit, 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, 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?
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 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.
d.
The more conservative a firm’s management is, the higher its 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.
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 regarded as being 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 being 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 being 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 being 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.
80.
Walter Industries’ current ratio is 0.5. Considered alone, which of the following actions would increase the
company’s current ratio?
a.
Borrow using short-term notes payable and use the cash to increase inventories.
b.
Use cash to reduce accruals.
c.
Use cash to reduce accounts payable.
d.
Use cash to reduce short-term notes payable.
e.
Use cash to reduce long-term bonds outstanding.
81.
Safeco’s current assets total to $20 million versus $10 million of current liabilities, while Risco’s current
assets are $10 million versus $20 million of current liabilities. Both firms would like to “window dress” their
end-of-year
financial statements, and to do so they tentatively plan to borrow $10 million on a short-term
basis and to then hold
the borrowed funds in their cash accounts. Which of the statements below best
describes the results of these
transactions?
a.
The transactions would improve Safeco’s financial strength as measured by its current ratio but lower
Risco’s current ratio.
b.
The transactions would lower Safeco’s financial strength as measured by its current ratio but raise Risco’s
current ratio.
c.
The transactions would have no effect on the firm’ financial strength as measured by their current ratios.
d.
The transactions would lower both firm’ financial strength as measured by their current ratios.
e.
The transactions would improve both firms’ financial strength as measured by their current ratios.
82.
Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same
interest rate on their debt. Both firms finance using only debt and common equity and total assets equal total
invested capital. However, company HD has a higher total debt to total capital ratio. Which of the following
statements is CORRECT?
a.
Given this information, LD must have the higher ROE.
b.
Company LD has a higher basic earning power ratio (BEP).
c.
Company HD has a higher basic earning power ratio (BEP).
d.
If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then
Company HD will have the higher ROE.
e.
If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then
Company HD will have the higher ROE.
83.
Which of the following statements is CORRECT?
a.
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.
b.
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.
c.
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.
d.
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.
e.
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 not be a good move, as it would
decrease the
ROE from 7.5% to 6.5%.
Chapter 4: Analysis of Financial Statements
Multiple Choice: Problems
A good bit of relatively simple algebra is involved in these problems, and although the calculations are
simple, it will take students some time to set up the problems and do the arithmetic. We allow for this when
assigning problems for a timed test. Also, note that students must know the definitions of a number of ratios
to answer the questions. We provide our students with a formula sheet on exams, using the relevant sections
of Appendix C at the then of the text. Otherwise, they spend too much time trying to memorize thing rather
than trying to understand the issues.
The difficulty of the problems depends on (1) whether or not students are provided with a formula sheet
and (2) the amount of time they have to work the problems. Out difficulty assessments assume that they have
a formula sheet and a “reasonable” amount of time for the test. Note that a few of the problems are trivially
easy if students have formula sheets.
To work some of the problems, students must transpose equations and solve for items that are normally
inputs. For example, the equation for the profit margin is given as Profit margin = Net income/Sales. We
might have a problem where sales and the profit margin are given and then require students to find the
firm’s net income. We explain to our students in class before the exam that they will have to transpose terms
in the formulas to work some problems.
Problems 84 through 114 are all stand-along problems with individualized data. Problems 115 through
133 are all based on a common set of financial statements, and they require students to calculate ratios and
find items like EPS, TIE, and the like using this data set. The financial statements can be changed
algorithmically, and this changes the calculated ratios and other items.
84.
Ryngard Corp’s sales last year were $38,000, and its total assets were $16,000. What was its total assets
turnover
ratio (TATO)?
a. 2.04
b. 2.14
c. 2.26
d. 2.38
e. 2.49
85.
Beranek Corp has $720,000 of assets (which equal total invested capital), and it uses no debt—it is financed
only
with common equity. The new CFO wants to employ enough debt to raise the total debt to total capital
ratio to
40%, using the proceeds from borrowing to buy back common stock at its book value. How much
must the firm
borrow to achieve the target debt ratio?
a. $273,600
b. $288,000
c. $302,400
d. $317,520
e. $333,396
86.
Ajax Corp’s sales last year were $435,000, its operating costs were $362,500, and its interest charges were
$12,500. What was the firm’s times-interest-earned (TIE)
ratio?
a. 4.72
b. 4.97
c. 5.23
d. 5.51
e. 5.80
87.
Royce Corp’s sales last year were $280,000, and its net income was $23,000. What was its profit margin?
a. 7.41%
b. 7.80%
c. 8.21%
d. 8.63%
e. 9.06%
88.
River Corp’s total assets at the end of last year were $415,000 and its net income was $32,750. What was its
return
on total assets?
a. 7.89%
b. 8.29%
c. 8.70%
d. 9.14%
e. 9.59%
89.
X-1 Corp’s total assets at the end of last year were $405,000 and its EBIT was 52,500. What was its basic
earning
power (BEP) ratio?
a. 11.70%
b. 12.31%
c. 12.96%
d. 13.61%
e. 14.29%
90.
Zero Corp’s total common equity at the end of last year was $405,000 and its net income was $70,000. What
was
its ROE?
a. 14.82%
b. 15.60%
c. 16.42%
d. 17.28%
e. 18.15%
91.
Your sister is thinking about starting a new business. The company would require $375,000 of assets, and it
would
be financed entirely with common stock. She will go forward only if she thinks the firm can provide a
13.5% return
on the invested capital, which means that the firm must have an ROE of 13.5%. How much net
income must be
expected to warrant starting the business?
a. $41,234
b. $43,405
c. $45,689
d. $48,094
e. $50,625
92.
Herring Corporation has operating income of $225,000 and a 40% tax rate. The firm has short-term debt of
$120,000, long-term debt of $330,000, and common equity of $450,000. What is its return on invested
capital?
a. 13.75%
b. 14.33%
c. 15.00%
d. 16.25%
e. 17.10%
93.
Song Corp’s stock price at the end of last year was $23.50 and its earnings per share for the year were $1.30.
What was its P/E ratio?
a. 17.17
b. 18.08
c. 18.98
d. 19.93
e. 20.93
94.
Hoagland Corp’s stock price at the end of last year was $33.50, and its book value per share was $25.00.
What
was its market/book ratio?
a. 1.34
b. 1.41
c. 1.48
d. 1.55
e. 1.63
95.
Precision Aviation had a profit margin of 6.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8.
What
was the firm’s ROE?
a. 15.23%
b. 16.03%
c. 16.88%
d. 17.72%
e. 18.60%
96.
Meyer Inc’s total invested capital is $625,000, and its total debt outstanding is $185,000. The new CFO wants
to
establish a total debt to total capital ratio of 55%. The size of the firm will not change. How much debt
must the
company add or subtract to achieve the target debt to capital ratio?
a. $158,750
b. $166,688
c. $175,022
d. $183,773
e. $192,962
97.
Helmuth Inc’s latest net income was $1,250,000, and it had 225,000 shares outstanding. The company wants
to pay
out 45% of its income. What dividend per share should it declare?
a. $2.14
b. $2.26
c. $2.38
d. $2.50
e. $2.63
98.
Garcia Industries has sales of $200,000 and accounts receivable of $18,500, and it gives its customers 25 days
to
pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and
collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash
freed-
up by this change, how would that affect its net income, assuming other things are held constant?
a. $241.45
b. $254.16
c. $267.54
d. $281.62
e. $296.44
99.
Faldo Corp sells on terms that allow customers 45 days to pay for merchandise. Its sales last year were
$325,000,
and its year-end receivables were $60,000. If its DSO is less than the 45-day credit period, then
customers are
paying on time. Otherwise, they are paying late. By how much are customers paying early or
late? Base your
answer on this equation: DSO − Credit Period = Days early or late, and use a 365-day year
when calculating the
DSO. A positive answer indicates late payments, while a negative answer indicates early
payments.
a. 21.27
b. 22.38
c. 23.50
d. 24.68
e. 25.91
100.
Han Corp’s sales last year were $425,000, and its year-end receivables were $52,500. The firm sells on terms
that
call for customers to pay 30 days after the purchase, but some delay payment beyond Day 30. On
average, how
many days late do customers pay? Base your answer on this equation: DSO − Allowed credit
period = Average
days late, and use a 365-day year when calculating the DSO.
a. 12.94
b. 13.62
c. 14.33
d. 15.09
e. 15.84
101.
Wie Corp’s sales last year were $315,000, and its year-end total assets were $355,000. The average firm in
the
industry has a total assets turnover ratio (TATO) of 2.4. The firm’s new CFO believes the firm has excess
assets
that can be sold so as to bring the TATO down to the industry average without affecting sales. By how
much must
the assets be reduced to bring the TATO to the industry average, holding sales constant?
a. $201,934
b. $212,563
c. $223,750
d. $234,938
e. $246,684
102.
A new firm is developing its business plan. It will require $615,000 of assets (which equals total invested
capital),
and it projects $450,000 of sales and $355,000 of operating costs for the first year. Management is
reasonably sure
of these numbers because of contracts with its customers and suppliers. It can borrow at a rate
of 7.5%, but the
bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level the bank
will call in the loan and
the firm will go bankrupt. The firm will use only debt and common equity for
financing. What is the maximum debt
to capital ratio (measured as debt/total invested capital) the firm can
use? (Hint: Find the maximum dollars of
interest, then the debt that produces that interest, and then the related
debt to capital ratio.)
a. 41.94%
b. 44.15%
c. 46.47%
d. 48.92%
e. 51.49%