CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
1. Ratio analysis involves analyzing financial statements in order to appraise a firm’s financial position and strength.
a.
True
b.
False
True
2. The current ratio and inventory turnover ratios both help us measure the firm’s liquidity. The current ratio measures the
relationship of a firm’s current assets to its current liabilities, while the inventory turnover ratio gives us an indication of
how long it takes the firm to convert its inventory into cash.
a.
True
b.
False
True
3. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy–
to-use measures of a firm’s liquidity position.
a.
True
b.
False
True
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
4. High current and quick ratios always indicate that a firm is managing its liquidity position well.
a.
True
b.
False
False
5. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a
firm is managing its assets.
a.
True
b.
False
True
6. A decline in a firm’s inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its
liquidity position is improving, i.e., it is becoming more liquid.
a.
True
b.
False
False
7. Debt management ratios show the extent to which a firm’s managers are attempting to magnify returns on owners’
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
capital through the use of financial leverage.
a.
True
b.
False
True
8. 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
True
9. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating
results.
a.
True
b.
False
True
10. Market value ratios provide management with an indication of how investors view the firm’s past performance and
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
especially its future prospects.
a.
True
b.
False
True
11. 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 measuring changes in a firm’s performance over time.
a.
True
b.
False
True
12. The “apparent,” but not the “true,” financial position of a company whose sales are seasonal can differ dramatically,
depending on the time of year when the financial statements are constructed.
a.
True
b.
False
True
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
13. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more
difficult than if all firms used similar accounting methods.
a.
True
b.
False
True
14. 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
False
15. 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
True
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
16. 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
False
Difficulty: Moderate
INTE.GENE.16.47 – LO: 7-3
United States – BUSPROG: Reflective Thinking
United States – OH – Default City – TBA
Fixed assets turnover
17. 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
False
Difficulty: Moderate
INTE.GENE.16.49 – LO: 7-5
United States – BUSPROG: Reflective Thinking
United States – OH – Default City – TBA
18. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in
competitive product and capital markets. Under these conditions, then firms that have high profit margins will tend to
INTE.GENE.16.47 – LO: 7-3
United States – BUSPROG: Reflective Thinking
United States – OH – Default City – TBA
Inventory turnover ratio
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios.
a.
True
b.
False
False
19. 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 that of B.
a.
True
b.
False
False
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
20. Firms A and B have the same current ratio, 0.75, the same amount of sales and cost of goods sold, 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
False
Difficulty: Challenging
INTE.GENE.16.46 – LO: 7-2
United States – BUSPROG: Reflective Thinking
United States – OH – Default City – TBA
Liquidity ratios
21. 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
True
Difficulty: Challenging
INTE.GENE.16.48 – LO: 7-4
United States – BUSPROG: Reflective Thinking
United States – OH – Default City – TBA
22. 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
United States – BUSPROG: Reflective Thinking
United States – OH – Default City – TBA
Liquidity ratios
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.
a.
True
b.
False
True
23. 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
True
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
24. One problem with ratio analysis is that relationships can 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
False
25. 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
False
1.0
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
Difficulty: Challenging
INTE.GENE.16.45 – LO: 7-1
United States – BUSPROG: Reflective Thinking
forecasting, and cash flows
United States – OH – Default City – TBA
Limitations of ratio analysis
26. Considered alone, which of the following would increase a company’s current ratio?
a.
An increase in accounts payable.
b.
An increase in net fixed assets.
c.
An increase in accrued liabilities.
d.
An increase in notes payable.
e.
An increase in accounts receivable.
Difficulty: Easy
INTE.GENE.16.46 – LO: 7-2
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Current ratio
TYPE: Multiple Choice: Conceptual
27. Which of the following would, generally, indicate an improvement in a company’s financial position, holding other
things constant?
a.
The total assets turnover decreases.
b.
The TIE declines.
c.
The DSO increases.
d.
The EBITDA coverage ratio increases.
e.
The current and quick ratios both decline.
Difficulty: Easy
INTE.GENE.16.46 – LO: 7-2
United States – BUSPROG: Analytic
forecasting, and cash flows
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
28. A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio?
a.
Use cash to increase inventory holdings.
b.
Reduce the company’s days’ sales outstanding to the industry average and use the resulting cash savings to
purchase plant and equipment.
c.
Use cash to repurchase some of the company’s own stock.
d.
Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.
e.
Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as
cash.
Difficulty: Easy
INTE.GENE.16.46 – LO: 7-2
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Current ratio
29. Which of the following statements is CORRECT?
a.
If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things
held constant, its inventory turnover ratio will decrease.
b.
A reduction in inventories held would have no effect on the current ratio.
c.
An increase in inventories would have no effect on the current ratio.
d.
If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things
held constant, its inventory turnover ratio will increase.
e.
A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.
Difficulty: Easy
INTE.GENE.16.47 – LO: 7-3
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
United States – OH – Default City – TBA
Current ratio
TYPE: Multiple Choice: Conceptual
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
30. Companies A and C each reported the same earnings per share (EPS), but Company A’s stock trades at a higher price.
Which of the following statements is CORRECT?
a.
Company A trades at a higher P/E ratio.
b.
Company A probably has fewer growth opportunities.
c.
Company A is probably judged by investors to be riskier.
d.
Company A must have a higher market-to-book ratio.
e.
Company A must pay a lower dividend.
Difficulty: Easy
INTE.GENE.16.50 – LO: 7-6
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Financial statement analysis
TYPE: Multiple Choice: Conceptual
31. Which of the following statements is CORRECT?
a.
If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this
suggests that the board of directors should fire the president.
b.
If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this
suggests that the board of directors should fire the president.
c.
Other things held constant, the higher a firm’s expected future growth rate, the lower its P/E ratio is likely to
be.
d.
The higher the market/book ratio, then, other things held constant, the higher one would expect to find the
Market Value Added (MVA).
e.
If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this
situation to continue, then its market/book ratio and MVA are both likely to be below average.
Difficulty: Easy
INTE.GENE.16.50 – LO: 7-6
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Market value ratios
TYPE: Multiple Choice: Conceptual
32. Which of the following statements is CORRECT?
a.
“Window dressing” is any action that improves a firm’s fundamental, long-run position and thus increases its
intrinsic value.
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
b.
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.”
c.
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.”
d.
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 an example of “window dressing.”
e.
Using some of the firm’s cash to reduce long-term debt is an example of “window dressing.”
Difficulty: Easy
INTE.GENE.16.45 – LO: 7-1
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Window dressing
TYPE: Multiple Choice: Conceptual
33. The Cavendish Company 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 debt ratio increased.
b.
The company’s current ratio increased.
c.
The company’s times interest earned ratio decreased.
d.
The company’s basic earning power ratio increased.
e.
The company’s equity multiplier increased.
Difficulty: Easy
INTE.GENE.16.50 – LO: 7-6
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Miscellaneous ratios
TYPE: Multiple Choice: Conceptual
34. 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 inventories while holding sales and cost of goods sold constant.
b.
Increase accounts receivable while holding sales constant.
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
c.
Increase EBIT while holding sales constant.
d.
Increase accounts payable while holding sales constant.
e.
Increase notes payable while holding sales constant.
Difficulty: Easy
INTE.GENE.16.49 – LO: 7-5
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Miscellaneous ratios
TYPE: Multiple Choice: Conceptual
35. 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 DSO (days’ sales outstanding) is 40, whereas the average for its competitors is 30.
b.
The division’s basic earning power ratio is above the average of other firms in its industry.
c.
The division’s total assets turnover ratio is below the average for other firms in its industry.
d.
The division’s debt ratio is above the average for other firms in the industry.
e.
The division’s inventory turnover is 6, whereas the average for its competitors is 8.
Difficulty: Easy
INTE.GENE.16.49 – LO: 7-5
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Miscellaneous ratios
TYPE: Multiple Choice: Conceptual
36. Which of the following would indicate an improvement in a company’s financial position, holding other things
constant?
a.
The current and quick ratios both increase.
b.
The inventory and total assets turnover ratios both decline.
c.
The debt ratio increases.
d.
The profit margin declines.
e.
The EBITDA coverage ratio declines.
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
37. If a bank loan officer were considering a company’s request for a loan, which of the following statements would you
consider to be CORRECT?
a.
Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the
firm.
b.
The lower the company’s EBITDA coverage ratio, other things held constant, the lower the interest rate the
bank would charge the firm.
c.
Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm.
d.
Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.
e.
The lower the company’s TIE ratio, other things held constant, the lower the interest rate the bank would
charge the firm.
Difficulty: Easy
INTE.GENE.16.48 – LO: 7-4
United States – BUSPROG: Analytic
forecasting, and cash flows
United States – OH – Default City – TBA
Miscellaneous ratios
TYPE: Multiple Choice: Conceptual
38. Which of the following statements is CORRECT?
a.
All else equal, increasing the debt ratio will increase the ROA.
b.
The use of debt financing will tend to lower the basic earning power ratio, other things held constant.
c.
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.
d.
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.
e.
Holding bonds is better than holding stock for investors because income from bonds is taxed on a more
favorable basis than income from stock.
Difficulty: Easy
INTE.GENE.16.52 – LO: 7-8
Difficulty: Easy
INTE.GENE.16.49 – LO: 7-5
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Miscellaneous ratios
TYPE: Multiple Choice: Conceptual
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
39. A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio?
a.
Issue new common stock and use the proceeds to acquire additional fixed assets.
b.
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.
c.
Issue new common stock and use the proceeds to increase inventories.
d.
Speed up the collection of receivables and use the cash generated to increase inventories.
e.
Use some of its cash to purchase additional inventories.
Difficulty: Moderate
INTE.GENE.16.46 – LO: 7-2
United States – BUSPROG: Analytic
forecasting, and cash flows
United States – OH – Default City – TBA
TYPE: Multiple Choice: Conceptual
40. Amram Company’s current ratio is 1.9. Considered alone, which of the following actions would reduce the company’s
current ratio?
a.
Use cash to reduce accounts payable.
b.
Borrow using short-term notes payable and use the proceeds to reduce accruals.
c.
Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
d.
Use cash to reduce accruals.
e.
Use cash to reduce short-term notes payable.
Difficulty: Moderate
INTE.GENE.16.46 – LO: 7-2
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
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Effects of leverage
TYPE: Multiple Choice: Conceptual
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
41. Which of the following statements is CORRECT?
a.
If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its
days’ sales outstanding will decline.
b.
If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the industry average and
was also increasing and trending still higher, this would be interpreted as a sign of strength.
c.
If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its
days’ sales outstanding (DSO) will increase.
d.
There is no relationship between the days’ sales outstanding (DSO) and the average collection period (ACP).
These ratios measure entirely different things.
e.
A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase
in the quick ratio.
Difficulty: Moderate
INTE.GENE.16.47 – LO: 7-3
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
Accounts receivable
TYPE: Multiple Choice: Conceptual
42. Which of the following statements is CORRECT?
a.
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 profit margin on
sales.
b.
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.
c.
A firm’s use of debt will have no effect on its profit margin on sales.
d.
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.
e.
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.
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
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Current ratio
TYPE: Multiple Choice: Conceptual
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
43. Which of the following statements is CORRECT?
a.
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.
b.
If Firms X and Y have the same P/E ratios, then their market-to–book ratios must also be the same.
c.
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.
d.
If Firms X and Y have the same earnings per share and market-to–book ratio, they must have the same price
earnings ratio.
e.
If Firm X’s P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at
a faster rate.
c
Difficulty: Moderate
INTE.GENE.16.50 – LO: 7-6
United States – BUSPROG: Analytic
forecasting, and cash flows
United States – OH – Default City – TBA
Market value ratios
TYPE: Multiple Choice: Conceptual
44. 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
decrease.
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%. Under these conditions, the ROE will
increase.
c.
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.
Difficulty: Moderate
INTE.GENE.16.48 – LO: 7-4
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
Debt management
TYPE: Multiple Choice: Conceptual
CHAPTER 7—ANALYSIS OF FINANCIAL STATEMENTS
d.
The modified DuPont equation provides information about how operations affect the ROE, but the equation
does not include the effects of debt on the ROE.
e.
Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.
Difficulty: Moderate
INTE.GENE.16.52 – LO: 7-8
United States – BUSPROG: Analytic
United States – AK – DISC: Financial statements, anal – DISC: Financial statements, analysis,
forecasting, and cash flows
United States – OH – Default City – TBA
DuPont analysis
TYPE: Multiple Choice: Conceptual
45. 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 equal the industry average.
b.
Its total assets turnover must be above the industry average.
c.
Its return on assets must equal the industry average.
d.
Its TIE ratio must be below the industry average.
e.
Its total assets turnover must be below the industry average.
Difficulty: Moderate
INTE.GENE.16.52 – LO: 7-8
United States – BUSPROG: Analytic
United States – OH – Default City – TBA
DuPont analysis