(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
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 HARD, 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 T/F and the multiple choice questions, as
some T/F statements are used in the MC questions. See the preface for information on the
AACSB letter indicators (F, M, etc.) on the subject lines.
Multiple Choice: True/False
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
CHAPTER 4
ANALYSIS OF FINANCIAL STATEMENTS
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
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 debt ratio
is likely to be.
a. True
b. False
15. Other things held constant, the higher a firm’s debt ratio, the higher
its TIE ratio will be.
a. True
b. False
16. The times-interest-earned ratio is one, but not the only, indication of a
firm’s ability to meet its long-term and short-term debt obligations.
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 “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
22. 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
23. 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
24. 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
25. Other things held constant, the more debt a firm uses, the lower its
profit margin will be.
a. True
b. False
26. 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 debt
ratio 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
27. 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
28. Other things held constant, the more debt a firm uses, the lower its
operating margin will be.
a. True
b. False
29. 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
30. Other things held constant, the more debt a firm uses, the lower its
return on total assets will be.
a. True
b. False
31. 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
32. 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
33. 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
34. 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
35. 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
36. 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
37. 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
38. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover
ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier
of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow
money, use it to buy back stock, and raise the debt ratio to 50% and the
equity multiplier to 2.0. 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
39. 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
40. 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
41. 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
42. 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
43. Suppose Firms A and B have the same amount of assets, pay the same
interest rate on their debt, have the same basic earning power (BEP), and
have the same tax rate. However, Firm A has a higher debt 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
44. If a firm finances with only debt and common equity, and if its equity
multiplier is 3.0, then its debt ratio must be 0.667.
a. True
b. False
45. 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
46. 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
Multiple Choice: Conceptual
47. 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.
48. 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.
49. 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.
50. 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.
51. 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.
52. 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.
53. 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 debt ratio increased.
54. 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.
55. 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 debt 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, whereas the
average for its competitors is 30.
56. 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 debt ratio increases.
c. The profit margin declines.
d. The times-interest-earned ratio declines.
e. The current and quick ratios both increase.
57. 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 debt 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.
58. 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 debt ratio will increase the ROA.
59. 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.
60. 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.
61. 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.
62. Which of the following statements is CORRECT?
a. If one firm has a higher debt ratio than another, we can be certain
that the firm with the higher debt 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, sales, operating costs, interest rates on their
debt, and tax rates–but one firm has a higher debt ratio, the firm
that uses more debt will have a lower profit margin on sales and a
lower return on assets.
d. The debt 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, sales, operating costs, and tax rates–but one
firm has a higher debt ratio, the firm that uses more debt will have
a higher operating margin and return on assets.
63. 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.
64. 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%. 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%. 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 debt 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%. Under these
conditions, the ROE will decrease.
65. You observe that a firm’s ROE is above the industry average, but its
profit margin and debt ratio are both 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.
66. Companies HD and LD are both profitable, and they have the same total
assets (TA), Sales (S), return on assets (ROA), and profit margin (PM).
However, Company HD has the higher debt 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.
67. 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.