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Chapter 04: 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 our 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 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-
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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.
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
DATE MODIFIED:
6/23/2015 3:24 PM
27. 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 [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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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 money, 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
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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.
Chapter 04: Analysis of Financial Statements
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
Chapter 04: Analysis of Financial Statements
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
