Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 4 Evaluating a Firm’s Financial Performance
4.1 Learning Objective 1
1) When the present financial ratios of a firm are compared with similar ratios for another firm in
the same industry it is called trend analysis.
2) Ratio analysis enhances our understanding of three basic attributes of performance: liquidity,
profitability, and the ability to create shareholder value.
3) Theoretically, market values of assets are better for evaluating the creation of shareholder
wealth than accounting numbers, but accounting numbers are used because they are more readily
available.
4) Financial ratios are often reported by industry or line of business because differences in the
type of business can make ratio comparisons uninformative or even misleading.
5) Financial ratios are useful for evaluating performance but should not be used for making
financial projections.
6) Financial ratios are used by managers inside the company and by lenders, credit-rating
agencies, and investors outside of the company.
7) Financial ratios cannot be used to evaluate the creation of shareholder wealth because they are
based on accounting numbers that reflect historical cost and not current market values.
8) Common stockholders may use financial ratios to monitor manager actions to help lessen
agency problems.
9) Accounting information is used in financial ratio analysis because it is theoretically the best
data to guide financial decision-making.
10) Ratios of almost all companies are easily comparable because all public companies prepare
their financial reports based upon generally accepted accounting principles.
11) Common-size balance sheets are balance sheets of companies with almost identical total
assets (within 2% of each other).
12) Financial ratios that are higher than industry averages may indicate problems that are as
detrimental to the firm as ratios that are too low.
13) Ratios are used to standardize financial information, thereby making it easier to interpret.
14) Trend analysis is the forecasting of the firm’s financial ratios for a future time period by
using its own ratios from previous periods.
15) How managers choose to finance the business affects the company’s risk, and as a result, the
rate of return stockholders receive on their investments.
16) Financial analysis
A) uses historical financial statements and is thus useful only to assess past performance.
B) relies on generally accepted accounting principles to make comparisons between companies
valid.
C) uses historical financial statements to measure a company’s performance and in making
financial projections of future performance.
D) is accounting record-keeping using generally accepted accounting principles.
17) Common-sized balance sheets
A) show data for companies in the same industry.
B) show data for companies with approximately the same amount of assets.
C) show each balance sheet account as a percentage of total sales.
D) show each balance sheet account as a percentage of total assets.
18) Common-sized income statements
A) assist in the comparison of companies of different sizes.
B) show each income statement account as a percentage of total assets.
C) compare companies with the same level of total sales.
D) compare companies with the same level of net income.
4.2 Learning Objective 2
1) A company with a current ratio higher than industry average must also have a quick ratio
higher than industry average because both ratios measure liquidity.
2) Return on equity is driven by (1) the spread between the operating return on assets and the
interest rate, and (2) changes in the debt ratio.
3) Borrowing money causes a corporation’s return on operating assets to decrease because of the
interest that must be paid.
4) Borrowing more money will always increase a company’s return on equity because the
company is using financial leverage, but it also adds to the riskiness of the company.
5) Operating return on assets is equal to the operating profit margin times total asset turnover.
6) Total asset turnover is equal to accounts receivable turnover plus inventory turnover plus fixed
asset turnover.
7) Financial ratios are useful for measuring performance because maximizing the return on
equity for common shareholders is the primary goal of financial managers.
8) If company A has a lower average collection period than company B, then company A will
have a higher accounts receivable turnover.
9) Net income is the best measure to use for evaluating a firm’s profits on assets because it
includes the effect of financing as well as the effect of operations.
10) Operating profits or EBIT is used to measure a firm’s profits on assets because it does not
include the firm’s cost of debt financing.
11) Operating return on assets (OROA) is equal to operating profit margin times total asset
turnover.
12) Lower asset turnover ratios are generally indicative of more efficient asset management.
13) A high debt ratio can be favorable because higher leverage may result in a higher return on
equity.
14) A common method of evaluating a firm’s financial ratios is to compare the current values of
the firm’s ratios to its own ratios from prior periods. This is referred to as trend analysis.
15) The current ratio and the acid test ratio both measure financial leverage.
16) Ratios that examine profit relative to investment are useful in evaluating the overall
effectiveness of the firm’s management.
17) The astute financial manager will seek to attain the highest current ratio possible.
18) One weakness of the times interest earned ratio is that it includes only the annual interest
expense as a finance expense and ignores other financing items such as lease payments that must
be paid.
19) DuPont analysis indicates that the return on equity may be boosted above the return on assets
by using leverage (debt).
20) Economic Value Added attempts to measure a firm’s economic profit rather than its
accounting profit.
21) Economic value added includes a charge for the cost of equity that is not included on
financial statements prepared according to GAAP.
22) Economic value added is calculated by taking (net income less the cost of all capital) times
total assets.
23) How managers choose to finance the business does not affect the rate of return to
shareholders because the rate of return is based on how the company uses the assets it has, not
whether or not they paid for the assets with debt or equity.
24) The computation of return on equity, or ROE, does not include retained earnings as part of
common equity because retained earnings includes all net income for the company since its
inception and analysts are trying to calculate the return for just the current year.
25) Operating return on assets captures the effect of taxes and financing costs, and hence
provides the broadest possible measure of profitability.
26) The goal of most financial managers is to reduce the amount of long-term debt to zero, thus
maximizing shareholder wealth.
27) Which of the following transactions will increase a corporation’s operating return on assets?
A) sell stock and use the money to pay off some long-term debt
B) sell 10-year bonds and use the money to pay off current liabilities
C) negotiate a new contract that lowers raw material costs by 10%
D) increase sales by 10%
28) Asset efficiency ratios for Fischer, Inc. are given in the table below. Based on this
information, Fischer, Inc.’s fixed asset turnover ratio is likely to be ________.
Fischer, Inc. Peer Group
Total Asset Turnover 1.58X 2.05X
Accounts Receivable Turnover 17.55X 14.35X
Inventory Turnover 6.34X 5.22X
Fixed Asset Turnover ????? 3.50X
A) equal to 3.50
B) less than 3.50
C) greater than 3.50
D) negative
29) An analyst is evaluating two companies, A and B. Company A has a debt ratio of 50% and
Company B has a debt ratio of 25%. In his report, the analyst is concerned about Company B’s
debt level, but not about Company A’s debt level. Which of the following would best explain
this position?
A) Company B has much higher operating income than Company A
B) Company A has a lower times interest earned ratio and thus the analyst is not worried about
the amount of debt
C) Company B has a higher operating return on assets than Company A, but Company A has a
higher return on equity than Company B
D) Company B has more total assets than Company A
30) Smith Corporation has earned a return on capital invested of 10% for the past two years, but
an investment analyst reviewing the company has stated the company is not creating shareholder
value. This may be due to the fact that
A) the risk free rate of interest is 3%
B) the corporation’s inventory turnover is high
C) investors’ required rate of return is 8%
D) investors’ required rate of return is 12%
31) In an ideal world, which of the following would be used to evaluate firm performance?
A) book value of assets
B) corporate retained earnings from the day of incorporation
C) accounting assets and profits
D) market value of assets
32) All of the following measure liquidity except:
A) current ratio.
B) inventory turnover.
C) acid-test ratio.
D) operating return on assets.
33) Baker Corp. is required by a debt agreement to maintain a current ratio of at least 2.5, and
Baker’s current ratio now is 3. Baker wants to purchase additional inventory for its upcoming
Christmas season, and will pay for the inventory with short-term debt. How much inventory can
Baker purchase without violating its debt agreement if their total current assets equal $15
million?
A) $0.50 million
B) $1.67 million
C) $4.50 million
D) $6.00 million
34) Williams Inc. has a current ratio equal to 3, a quick ratio equal to 1.8, and total current assets
of $6 million. William’s inventory balance is
A) $2,000,000.
B) $2,400,000.
C) $4,000,000.
D) $4,800,000.
35) Jones, Inc. has a current ratio equal to 1.40. Which of the following transactions will increase
the company’s current ratio?
A) The company collects $500,000 of its accounts receivable
B) The company sells $1 million of inventory on credit
C) The company pays back $50,000 of its long-term debt
D) The company writes a $30,000 check to pay off some existing accounts payable
36) For a retailer with inventory to sell, the acid-test ratio will be
A) less than the current ratio, thus providing a more stringent measure of liquidity.
B) greater than the current ratio, thus providing a more stringent measure of liquidity.
C) greater than the current ratio, thus providing a less stringent measure of liquidity.
D) unimportant because it doesn’t include inventory.
37) Company A has a higher day’s sales outstanding ratio than Company B. Therefore,
A) Company A sells more on credit than Company B
B) Company A has a higher percentage of cash to credit sales than Company B
C) Company A must be collecting its accounts receivable faster than Company B, on average
D) Other things being equal, Company B has a cash flow advantage over Company A
38) When comparing inventory turnover ratios, other things being equal,
A) a lower inventory turnover is preferred in order to keep inventory costs low.
B) a higher inventory turnover is preferred to improve liquidity.
C) higher inventory turnover results from old or obsolete inventory increasing the inventory
balance on the balance sheet.
D) highe rinventory turnover results from an increase in the selling price of the product.
39) Company A and Company B have the same gross profit margin and the same total asset
turnover, but company A has a higher return on equity. This may result from
A) Company B has more common stock .
B) Company A has a lower debt ratio.
C) Company A has lower selling and administrative expenses, resulting in a higher net profit
margin.
D) Company A has lower cost of goods sold, resulting in a higher net profit margin.
40) Nelson Industries has a higher debt ratio than Butler, Inc., and Nelson also has a higher times
interest earned ratio than Butler. If Nelson and Butler both have the same amount of total assets,
then
A) Nelson must have higher operating income than Butler.
B) if both companies have the same operating income, Butler must be paying a higher interest
rate on its long-term debt than Nelson is paying.
C) Nelson may have more non-interest bearing liabilities, such as accounts payable, than Butler
has.
D) if both companies have the same operating income, a mistake was made in the calculations
because the company with a higher debt ratio must have a lower times interest earned ratio.
41) HighLev Incorporated borrows heavily and uses the leverage to boost its return on equity to
30% this year, nearly 10% higher than the industry average. However, HighLev’s stock price
decreases relative to its industry counterparts. How is this possible?
A) Markets are inefficient and fail to recognize the benefits of leverage
B) The increased debt resulted in interest payments that made HighLev’s operating income drop
even though return on equity increased
C) Shareholders are not interested in return on equity
D) the high levels of debt increased the riskiness of HighLev relative to its competitors
42) Benkart Corporation has sales of $5,000,000, net income of $800,000, total assets of
$2,000,000, and 100,000 shares of common stock outstanding. If Benkart’s P/E ratio is 12, what
is the company’s current stock price?
A) $60 per share
B) $96 per share
C) $240 per share
D) $360 per share
43) Which of the following statements concerning Economic Value Added (EVA) is most
correct?
A) The higher the cost of capital, the higher the EVA, other things being held constant
B) EVA can be negative even if operating profits are positive
C) A company with positive net income will have positive EVA
D) HIgher operating return on assets will result in lower EVA for a company with a debt ratio
over 50%
44) The acid-test ratio of a firm would be unaffected by which of the following?
A) accounts payable are reduced by obtaining a short-term loan
B) common stock is sold and the money is invested in marketable securities
C) inventories are sold for cash
D) inventories are sold on a short-term credit basis
45) The acid-test ratio of a firm would be unaffected by which of the following?
A) several short-term loans are consolidated and paid off using long-term debt
B) equipment is purchased, financed by a long-term debt issue
C) additional inventory is purchased for cash
D) large accounts receivable balances are collected
46) The current ratio of a firm would be increased by which of the following?
A) land held for investment is sold for cash
B) equipment is purchased, financed by a long-term debt issue
C) inventories are sold for cash
D) inventories are sold on a credit basis
47) The current ratio of a firm would be decreased by which of the following?
A) land held for investment is sold for cash
B) equipment is purchased, financed by a long-term debt issue
C) inventories are sold for cash
D) inventories are sold on a long-term credit basis
48) The current ratio of a firm would equal its quick ratio whenever
A) the firm has no inventory.
B) the firm’s inventory is equal to its other current assets.
C) the firm’s inventory is equal to its current liabilities.
D) the firm’s current ratio is equal to one.
49) Given an accounts receivable turnover of 10 and annual credit sales of $900,000, the average
collection period is
A) 18.25 days.
B) 36.50 days.
C) 90 days.
D) 40.56 days.
Please refer to Table 4-1 for the following questions.
Table 4-1
Stewart Company
Balance Sheet
Assets:
Cash and marketable securities
$600,000
Accounts receivable
900,000
Inventories
1,500,000
Prepaid expenses
75,000
Total current assets
$3,075,000
Fixed assets
8,000,000
Less: accum. depr.
(2,075,000)
Net fixed assets
$5,925,000
Total assets
$9,000,000
Liabilities:
Accounts payable
$800,000
Notes payable
700,000
Accrued taxes
50,000
Total current liabilities
$1,550,000
Long-term debt
2,500,000
Owner’s equity (1 million
shares of common stock
outstanding)
4,950,000
Total liabilities and owner’s
equity
$9,000,000
Net sales (all credit)
$10,000,000
Less: Cost of goods sold
(3,000,000)
Selling and administrative
expense
(2,000,000)
Depreciation expense
(250,000)
Interest expense
(200,000)
Earnings before taxes
4,550,000
Income taxes
(1,820,000)
Net income
$2,730,000
50) Based on the information in Table 4-1, the current ratio is
A) 1.92.
B) 1.98.
C) 2.86.
D) 2.88.
51) Based on the information in Table 4-1, the acid-test ratio is
A) 1.71.
B) 1.67.
C) 1.02.
D) 0.98.
52) Based on the information in Table 4-1, the average collection period is
A) 36.50 days.
B) 32.85 days.
C) 46.34 days.
D) 29.85 days.
53) Based on the information in Table 4-1, the accounts receivable turnover is
A) 10.00.
B) 11.11.
C) 8.11.
D) 9.50.
54) Based on the information in Table 4-1, the debt ratio is
A) 24.1%.
B) 32.6%.
C) 45.0%.
D) 55.2%.
55) Based on the information in Table 4-1, the OROA is
A) 24.73%.
B) 39.50%.
C) 46.54%.
D) 52.78%.
56) Based on the information in Table 4-1, the times interest earned ratio is
A) 32.33 times.
B) 23.75 times.
C) 19.00 times.
D) 12.33 times.
57) Based on the information in Table 4-1, assuming that no preferred dividends were paid, the
return on common equity is
A) 55.15%.
B) 44.86%.
C) 38.83%.
D) 17.56%.
58) Based on the information in Table 4-1, the fixed asset turnover ratio is
A) 1.69.
B) 2.17.
C) 4.39.
D) 4.80.
59) Based on the information in Table 4-1, the total asset turnover ratio is
A) 1.11.
B) 1.41.
C) 2.33.
D) 4.45.
60) Based on the information in Table 4-1, the operating profit margin is
A) 47.5%.
B) 37.5%.
C) 26.4%.
D) 32.8%.
61) Based on the information in Table 4-1, and assuming the company’s stock price is $30 per
share, the P/E ratio is
A) 3.09.
B) 4.83.
C) 9.85.
D) 10.99.
62) XYZ Corporation has a P/E ratio of 20 and EFG Corporation has a P/E ratio of 10. It is likely
that
A) XYZ’s earnings per share are twice the earnings per share of EFG.
B) investors expect XYZ’s earnings to grow faster than EFG’s earnings.
C) investors believe that for the same level of earnings growth, XYZ is a higher risk company.
D) investors believe XYZ stock is overvalued.
Please refer to Table 4-2 for the following questions.
Table 4-2
Drummond Company
Balance Sheet
Assets:
Cash and marketable securities
$400,000
Accounts receivable
1,415,000
Inventories
1,847,500
Prepaid expenses
24,000
Total current assets
3,686,500
Fixed assets
2,800,000
Less: accum. depr.
(1,087,500)
Net fixed assets
1,712,500
Total assets
$5,399,000
Liabilities:
Accounts payable
$600,000
Notes payable
875,000
Accrued taxes
92,000
Total current liabilities
$1,567,000
Long-term debt
900,000
Common Stock (100,000 shares)
700,000
Retained Earnings
2,232,000
Total liabilities and owner’s
equity
$5,399,000
Net sales (all credit)
$6,375,000
Less: Cost of goods sold
(4,375,000)
Selling and administrative
expense
(1,000,000)
Depreciation expense
(135,000)
Interest expense
(100,000)
Earnings before taxes
$765,000
Income taxes
(306,000)
Net income
$459,000
63) Based on the information in Table 4-2, the current ratio is
A) 2.97.
B) 2.46.
C) 2.35.
D) 2.23.
64) Based on the information in Table 4-2, the acid-test ratio is
A) 1.17.
B) 1.33.
C) 1.39.
D) 2.15.
65) Based on the information in Table 4-2, the average collection period is
A) 70 days.
B) 81 days.
C) 89 days.
D) 127 days.
66) Based on the information in Table 4-2, the debt ratio is
A) 28.12%.
B) 34.74%.
C) 45.69%.
D) 42.03%.
67) Based on the information in Table 4-2, the return on equity is
A) 19.33%.
B) 18.47%.
C) 16.66%.
D) 15.65%.
68) Based on the information in Table 4-2, and assuming the company’s stock price is $50 per
share, the P/E ratio is
A) 10.89.
B) 14.33.
C) 24.44.
D) 27.50.
69) Based on the information in Table 4-2, the times interest earned ratio is
A) 11.48.
B) 5.25.
C) 4.88.
D) 8.65.
Please refer to Table 4-3 for the following questions.
Table 4-3
Emery Corporation
Balance Sheet
Income Statement
Assets:
Cash
$250,000
Sales (all credit)
$8,000,000
Accounts receivable
450,000
Cost of goods sold
(4,000,000)
Inventory
500,000
Operating expense
(2,900,000)
Net fixed assets
2,100,000
Interest expense
(150,000)
Total assets
$3,300,000
Income taxes
(380,000)
Net income
$570,000
Liabilities and owners’ equity:
Accounts payable
$100,000
Notes payable
450,000
Long-term debt
1,050,000
Owners’ Equity
1,700,000
Total liabilities and owner’s equity
$3,300,000
70) Based on the information in Table 4-3, the average collection period is
A) 38.01 days.
B) 27.36 days.
C) 20.53 days.
D) 17.49 days.
71) Based on the information in Table 4-3, the operating return on total assets is
A) 55.62%.
B) 10.06%.
C) 44.74%.
D) 33.33%.
72) Based on the information in Table 4-3, the operating profit margin is
A) 13.75%.
B) 18.59%.
C) 25.80%.
D) 33.33%.
73) Based on the information in Table 4-3, the total asset turnover is
A) 2.10 times.
B) 2.42 times.
C) 2.87 times.
D) 3.25 times.
74) Based on the information in Table 4-3, the debt ratio is
A) 18.38%.
B) 40.24%.
C) 48.48%.
D) 53.43%.
75) Based on the information in Table 4-3, the current and acid-test ratios are, respectively
A) 2.37 and 1.39.
B) 2.37 and 1.27.
C) 2.18 and 1.39.
D) 2.18 and 1.27.
76) Based on the information in Table 4-3, assuming that the firm has no preferred stock, and
paid $300,000 in common dividends, the firm’s return on equity was
A) 79.43%.
B) 61.89%.
C) 43.34%.
D) 33.53%.