Part 2 Financial Analysis Tools
CHAPTER 4
FINANCIAL STATEMENT ANALYSIS AND FORECASTING
CHAPTER LEARNING OBJECTIVES
4.1 Identify the issues to consider in applying consistent financial analysis.
4.2 Explain why return on equity is a key financial ratio used to assess a firm’s
performance.
4.3 Calculate, interpret, and evaluate the key ratios relating to financial leverage.
4.4 Calculate, interpret, and evaluate the key ratios relating to financial efficiency.
4.5 Calculate, interpret, and evaluate the key ratios relating to financial
4.6 Calculate, interpret, and evaluate the key ratios relating to financial liquidity.
4.7 Calculate, interpret, and evaluate the key ratios relating to the valuation of a
4.8 Explain how to prepare financial forecasts using the percentage of sales
method.
4.9 Explain how external financing requirements are related to sales growth,
4.10 Apply financial forecasting to a real company.
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MULTIPLE CHOICE QUESTIONS
1. Ratios should not be used to compare two companies in different industries since
wide variations across industries can occur. But even within an industry, sometimes
comparisons can be problematic. Which of the following is/are a reason(s) for concern?
a) Methods of calculating ROE may differ between analysts
b) Company choice between weighted average and FIFO inventory valuations
c) Companies are based in different countries
d) All of these are reasons for concern.
2. What problem arises for comparing Exxon Mobil Corporation (United States) and BP
PLC (United Kingdom) financial statements?
a) Different accounting standards between the two countries
b) Different reporting currencies between the two countries
c) Different tax rates between the two countries
d) Exxon Mobil Corporation and BP PLC are each listed on the stock exchange in their
respective country
3. What is the risk of comparing financial ratios reported by different companies?
a) Financial ratios have multiple formulations.
b) Financial ratios have only one formulation.
c) Financial ratios all produce the same answer.
d) Financial ratios are disallowed by some companies.
4. The International Financial Reporting Standards apply to Canadian public companies.
How does that affect comparability of financial statements across countries?
a) It achieves greater comparability in the short term only.
b) It achieves greater comparability in the long term.
c) IFRS is not intended to improve comparability.
d) IFRS coordinates only a few changes in financial reporting standards.
5. Which of the following people would be likely to calculate financial ratios for a
company?
a) Bondholders
b) Equity holders
c) Suppliers
d) All of these would calculate ratios on a company.
6. Which of the following people would be least likely to calculate financial ratios for a
company?
a) Bondholders
b) Equity holders
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c) Suppliers
d) Customers
7. Which of the following are not components in the DuPont analysis?
a) Leverage ratios
b) Efficiency ratios
c) Liquidity ratios
d) Productivity ratios
8. Why is the DuPont system used by analysts?
a) The DuPont system provides information about the sources of a company’s ROE.
b) The DuPont system is easier to calculate than the standard ROE.
c) The DuPont system produces different ROE results than the standard ROE formula.
d) The DuPont system excludes leverage, which can distort the calculation of ROE.
9. Financial ratios are used to perform analysis of:
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a) a company’s historical performance
b) a company’s performance relative to its peers
c) a company’s historical performance and its relative performance to its peers
d) a company using only a single ratio
10. What is a pure financial ratio?
a) A financial ratio that does not include non-cash items
b) A financial ratio for the same year
c) A financial ratio that involves items from the same financial statement
d) A financial ratio using the same GAAP
11. Which of the following is not true?
a) Financial analysis can be fully standardized.
b) Effective analysis requires identification of the most appropriate ratios for the
particular objective, as all ratios will not give the same information.
c) The output from financial analysis can often provide only general clues.
d) Some financial ratios will not be appropriate for firms of different sizes.
12. Return on equity can be calculated by: Net Income / Average Shareholders’ Equity.
The reasoning for this method is:
a) net income is earned over the year and shareholder’s equity measures invested
capital at the end of the year. Average shareholder’s equity gives a measure of capital
invested throughout the year.
b) net income is measured at the end of the year and shareholder’s equity is measured
at the beginning of the year. Averaging the shareholder’s equity will result in a better
match between the timing of the net income measure and the measure of the invested
capital (equity).
c) to reduce the number of observations.
d) to increase ROE as average shareholders’ equity is usually lower than ending
shareholders’ equity.
13. If GUW and BFG have the same return on equity, then:
I. The two companies must have the same operating performance.
II. If GUW has higher leverage than BFG, it must also have higher operating
performance.
III. If BFG has lower operating performance than GUW, it must have higher leverage.
a) Only I is true
b) Only III is true
c) Only II and III are true
d) Only I and III are true
14. Which one of the following is TRUE?
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a) Stand-alone ratios do not provide much information about the company.
b) Ratios are comparative measures over time or across firms.
c) Ratios are forward-looking measures.
d) Analyzing historical ratios is not useful.
15. Toronto Skaters Company earned a net profit margin of 6% in 2015. Their turnover
ratio is 5 and the firm had a leverage ratio of 3. The return on equity earned by Toronto
Skaters in 2015 is:
a) 0.90%
b) 9%
c) 10%
d) 90%
16. Igor the intern has obtained the following financial data for PDQ Corporation:
PDQ Financial Data
for fiscal year end:
2015
Net income $125,000
Sales $475,000
Total assets $285,000
Shareholders’ equity $145,000
The turnover ratio for 2015 is:
a) 1.6667
b) 1.9655
Financial Analysis Tools 6 – 8
c) 26.32%
d) 86.21%
17. Igor the intern has obtained the following financial data for PDQ Corporation:
PDQ Financial Data
for fiscal year end:
2015
Net income $125,000
Sales $475,000
Total assets $285,000
Shareholders’ equity $145,000
The leverage ratio for 2015 is:
a) 1.6667
b) 1.9655
c) 26.32%
d) 86.21%
18. Igor the intern has obtained the following financial data for PDQ Corporation:
PDQ Financial Data
for fiscal year end:
2015
Net income $125,000
Sales $475,000
Total assets $285,000
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Shareholders’ equity $145,000
The return on equity for 2015 is:
a) 1.6667
b) 1.9655
c) 26.32%
d) 86.21%
19. Igor the intern has obtained the following financial data for PDQ Corporation:
PDQ Financial Data
for fiscal year end:
2015
Net income $125,000
Sales $475,000
Total assets $285,000
Shareholders’ equity $145,000
The net profit margin for 2015 is:
a) 1.6667
b) 1.9655
c) 26.32%
d) 86.21%
20. Which of the following ratios are “flow ratios”?
a) Debt / equity ratio
b) Times interest covered
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c) Leverage ratio
d) None of the above
21. Why are leverage ratios important?
a) Low ROA can generate high ROE if the company is highly levered.
b) Leverage magnifies losses which increases risk.
c) Leverage ratios measure a firm’s ROA.
d) High ROE can only be generated with high leverage.
22. What does a coverage ratio measure?
a) The company’s ability to pay the interest on its debt
b) The company’s ability to pay the principal amount of its debt
c) The company’s ability to “cover” (pay) its operating expenses
d) The company’s ability to “cover” (meet) shareholder return expectations
23. Which one of the following is FALSE?
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a) A high leverage ratio increases ROE.
b) A low leverage ratio decreases the risk of bankruptcy.
c) A leverage ratio is a stock ratio.
d) A low leverage ratio reduces the size of the balance sheet.
24. Which of the following ratios are “stock ratios”?
a) Debt / equity ratio
b) Leverage ratio
c) Debt / asset ratio
d) All of the above
25. Which of the following ratios would be most useful for evaluating a firm’s degree of
leverage?
a) Earnings-power ratio
b) Debt-to-equity ratio
c) Current ratio
d) Asset turnover ratio
26. The only debt a firm has outstanding is a $10 million, 8 percent bond issue. If their
earnings before taxes are $5.2 million, then their times-interest-earned ratio would be:
a) 5.5
b) 6.5
c) 7.5
d) None of the above
27. Montreal Brewing Company has an outstanding debt of $20 million. 10 percent of
the company debt bears an interest cost of 8 percent and the rest costs 6 percent. If
their earnings before taxes are $5.2 million, then their times-interest-earned ratio would
be:
a) 3.2
b) 4.2
c) 5.2
d) None of the above
28. On the balance sheet, a company reports total assets of $8 million, common shares
(book value) of $4 million, and retained earnings of $2 million. The debt–to-asset ratio
is:
a) 0.25
b) 0.50
c) 0.75
d) None of the above
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29. On the balance sheet, a company reports total assets of $8 million, common shares
(book value) of $4 million, and retained earnings of $2 million. The debt–to-equity ratio
is:
a) 0.33
b) 1.00
c) 2.00
d) 3.00
30. On the balance sheet of last year, a company reports total assets of $8 million,
common shares (book value) of $4 million, and retained earnings of $2 million. At the
end of the current year, the net income was $ 1 million, and the whole amount was
retained by the firm. Everything else (each of the aforementioned amounts other than
retained earnings) was held constant. The debt-to-equity ratio at the end of the current
year is:
a) 0.17
b) 0.14
c) 0.25
d) 0.33
31. On the balance sheet of last year, a company reports total assets of $8 million,
common shares (book value) of $4 million, and retained earnings of $2 million. At the
end of the current year, the net income was $ 1 million, and the whole amount was
retained by the firm. Everything else (each of the aforementioned amounts other than
retained earnings) was held constant. The debt-to-assets ratio at the end of the current
year is:
a) 0.25
b) 0.125
c) 0.75
d) 0.5
32. Which of the following class(es) of ratios examines the relationship of borrowed
funds to funds contributed by the equity holders and the ability of the firm to service its
existing borrowings?
a) Profitability and activity ratios
b) Leverage and coverage ratios
c) Liquidity ratios
d) All of the above
33. Which of the following class(es) of ratios examines the ability of the firm to meet its
short-term obligations?
4 – 15 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
a) Profitability and activity ratios
b) Leverage and coverage ratios
c) Liquidity ratios
d) All of the above
34. Charles invested $3 million in the bonds of Toys & Tots Company eight years ago.
Recent recalls of the toys produced by Toys & Tots has Charles worried about whether
he will receive his annual interest cheque from the firm. Which ratio(s) will most directly
address Charles’ concern?
I. Debt / asset
II. Debt / equity
III. Times interest earned
a) I only
b) I and II only
c) III only
d) II and III only
35. Marie invested $3 million in 10-year bonds of Abitibi Mills Company nine years ago.
Recent changes in the industry have Marie worried about whether she will receive her
principal at the end of next year. Which ratio(s) will most directly address Marie’s
concern?
I. Debt / asset
II. Debt / equity
III. Times interest earned
a) I only
b) I and II only
Financial Analysis Tools 6 – 16
c) III only
d) II and III only
36. Two firms, STM and VPL, have the same contribution margin but VPL’s fixed costs
(including interest) are greater than STM’s. The sales and tax rates of the two firms are
the same. We would expect:
a) VPL’s income to have the same variability as STM
b) VPL’s income to be less variable than STM
c) VPL’s income to be more variable than STM
d) Can’t determine with the information provided
37. To produce chewing gum, DryFruit Gum Company pays $100,000 per year for rent
on a long-term lease and $25 per kilogram for sorbitol and other ingredients. The firm
pays zero taxes. These are the only costs associated with making DryFruit Gum. During
the year, the firm sells 30,000 kilograms of chewing gum at $45 per kilogram. The net
profit margin for DryFruit is closest to:
a) 120.00%
b) 55.56%
c) 44.44%
d) 37.04%
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38. What is the best description of an efficiency ratio?
a) A measure of how well a company converts revenue into earnings
b) A measure of how quickly a company processes accounts receivables
c) A measure of a firm’s return on assets (ROA)
d) A measure of the efficiency of a company’s logistics
39. What does the contribution margin measure?
a) The amount that can be contributed to bond repayment
b) The incremental change in revenue from an additional unit sold
c)The amount available to pay fixed costs and contribute to profits
d) The incremental change in revenue from an additional dollar spent on advertising
40. To produce chewing gum, DryFruit Gum Company pays $100,000 per year for rent
on a long-term lease and $25 per kilogram for sorbitol and other ingredients. The firm
pays zero taxes. These are the only costs associated with making DryFruit Gum. During
Financial Analysis Tools 6 – 18
the year, the firm sells 30,000 kilograms of chewing gum at $45 per kilogram. The
degree of total leverage for DryFruit is closest to:
a) 120.00%
b) 55.56%
c) 44.44%
d) 37.04%
41. Which one of the following is NOT an efficiency ratio?
a) Operating margin
b) Break-even point
c) Times interest earned
d) Degree of total leverage
42. To produce chewing gum, DryFruit Gum Company pays $100,000 per year for rent
on a long-term lease and $25 per kilogram for sorbitol and other ingredients. The firm
pays zero taxes. These are the only costs associated with making DryFruit Gum. During
the year, the firm sells 30,000 kilograms of chewing gum at $45 per kilogram. The
break-even point for DryFruit is closest to:
a) 225,000 kilograms
b) 40,000 kilograms
c) 5,000 kilograms
d) 60,000 kilograms
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43. Given the following information extracted from the income statement of Widget
Company ( Widget Company has no depreciation or amortization expenses),
Extract from Widget Company’s income statement
Sales:
Units sold 150,000
Price per unit $15
Variable cost per unit $8
Fixed factory operating costs $450,000
Total gross profit margin $600,000
Non-operating fixed costs $200,000
Fixed interest costs $100,000
Taxes $75,000
The gross profit margin and operating margin for Widget Company are closest to:
a) GPM = 26.67%; OM = 17.78%
b) GPM = 17.78%; OM = 26.67%
c) GPM = 53.33%; OM = 14.44%
d) GPM = 14.44%; OM = 53.33%
44. Given the following information extracted from the income statement of Widget
Company ( Widget Company has no depreciation or amortization expenses),
Extract from Widget Company’s income statement
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Sales:
Unit sold 150,000
Price per unit $15
Variable cost per unit $8
Fixed factory operating costs $450,000
Total gross profit margin $600,000
Non-operating fixed costs $200,000
Fixed interest costs $100,000
Taxes $75,000
The degree of total leverage of Widget Company is closest to:
a) 2.80
b) 3.25
c) 3.50
d) 4.00
45. Given the following information extracted from the income statement of Widget
Company ( Widget Company has no depreciation or amortization expenses),
Extract from Widget Company’s income statement
Sales:
Unit sold 150,000
Price per unit $15
Variable cost per unit $8
Fixed factory operating costs $450,000
Total gross profit margin $600,000
Non-operating fixed costs $200,000
Fixed interest costs $100,000
Taxes $75,000
The break-even point for Widget Company is:
a) 64,286 units
b) 107,135 units