April 3, 2019

CHAPTER 3

WORKING WITH FINANCIAL

STATEMENTS

Answers to Concepts Review and Critical Thinking Questions

1. a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is

purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.

b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.

c. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.

d. As long-term debt approaches maturity, the principal repayment and the remaining interest

expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases

e. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.

f. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.

g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current

ratio increases.

2. The firm has increased inventory relative to other current assets; therefore, assuming current liability

levels remain unchanged, liquidity has potentially decreased.

3. A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in

current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and

suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A

current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This

4. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects

of inventory, generally the least liquid of the firm’s current assets.

b. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its

most liquid asset (cash).

c. Total asset turnover measures how much in sales is generated by each dollar of firm assets.

d. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures

the dollar worth of firm assets each equity dollar has a claim to.

e. Long-term debt ratio measures the percentage of total firm capitalization funded by long-term

debt.

B-16 SOLUTIONS

f. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings

can cover current interest obligations.

g. Profit margin is the accounting measure of bottom-line profit per dollar of sales.

h. Return on assets is a measure of bottom-line profit per dollar of total assets.

i. Return on equity is a measure of bottom-line profit per dollar of equity.

j. Price-earnings ratio reflects how much value per share the market places on a dollar of

accounting earnings for a firm.

5. Common size financial statements express all balance sheet accounts as a percentage of total assets

and all income statement accounts as a percentage of total sales. Using these percentage values rather

than nominal dollar values facilitates comparisons between firms of different size or business type.

6. Peer group analysis involves comparing the financial ratios and operating performance of a

particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm

to its peers allows the financial manager to evaluate whether some aspects of the firm’s operations,

finances, or investment activities are out of line with the norm, thereby providing some guidance on

7. Return on equity is probably the most important accounting ratio that measures the bottom-line

performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the

role of a firm’s profitability, asset utilization efficiency, and financial leverage in achieving an ROE

8. The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closely

9. If a company is growing by opening new stores, then presumably total revenues would be rising.

10. a. For an electric utility such as Con Ed, expressing costs on a per kilowatt hour basis would be a

way to compare costs with other utilities of different sizes.

b. For a retailer such as Sears, expressing sales on a per square foot basis would be useful in

comparing revenue production against other retailers.

c. For an airline such as Southwest, expressing costs on a per passenger mile basis allows for

comparisons with other airlines by examining how much it costs to fly one passenger one

mile.

CHAPTER 3 B-17

d. For an on-line service provider such as AOL, using a per call basis for costs would allow for

comparisons with smaller services. A per subscriber basis would also make sense.

e. For a hospital such as Holy Cross, revenues and costs expressed on a per bed basis would be

useful.

f. For a college textbook publisher such as McGraw-Hill/Irwin, the leading publisher of finance

textbooks for the college market, the obvious standardization would be per book sold.

11. Reporting the sale of Treasury securities as cash flow from operations is an accounting “trick”, and

as such, should constitute a possible red flag about the companies accounting practices. For most

12. Increasing the payables period increases the cash flow from operations. This could be beneficial for

the company as it may be a cheap form of financing, but it is basically a one time change. The

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple

steps. Due to space and readability constraints, when these intermediate steps are included in this

solutions manual, rounding may appear to have occurred. However, the final answer for each problem is

found without rounding during any step in the problem.

Basic

1. Using the formula for NWC, we get:

NWC = CA – CL

CA = CL + NWC = $3,720 + 1,370 = $5,090

So, the current ratio is:

2. We need to find net income first. So:

Profit margin = Net income / Sales

Net income = Sales(Profit margin)