FIN 3310 Ch. 2 questions

Which of the following transactions will not affect the quick ratio of a company? Ch.2

Which of the following transactions will not affect the quick ratio of a company? Ch.2

Accounts receivable collected

The collection of accounts receivable will increase the cash balance and decrease the accounts receivable balance. Therefore, there is no change in the balance of current assets and in turn no effect on the quick ratio of the company. See 2-3: Financial Statement (Ratio) Analysis.

Suppose a firm has a growth rate equal to 8 percent, return on assets (ROA) of 10 percent, a debt ratio of 20 percent, and a current stock price of $36. What is the firm's return on equity (ROE)? Ch.2

12.5

Debt ratio = Total liabilities ÷ Total assets = 20%, so equity = (1 – 0.20) × Total assets = 0.80 × Total assets

ROA = Net income ÷ Total assets = 10%; Net income = 10% × Total assets = 0.10 × Total assets

ROE = Net income ÷ Equity = [0.10 × Total assets] ÷ [0.80× Total assets)] = 0.10 ÷ 0.80 = 0.125 = 12.5%.

Alternate solution: ROE = ROA x Equity multiplier = 10.0% x [1/(1 – 0.2)] = 12.5%.

See 2-3: Financial Statement (Ratio) Analysis

Emerald Corporation's current ratio is 0.5, while Ruby (Emerald's competitor) Company's current ratio is 1.5. Both firms want to "window dress" their coming end-of-year financial statements. As part of their window dressing strategy, each firm will double its current liabilities by adding short-term debt and placing the funds obtained in the cash account. Which of the statements below best describes the actual results of these transactions? Ch.2

Only Emerald Corporation's current ratio will be increased.

Emerald Corporation had a current ratio of 0.50 and Ruby Company had a current ratio of 1.5. An easy way to answer this question is to make up examples for the two firms mentioned. Any numbers will work as long as Emerald's initial current ratio is 0.5 and Ruby's initial current ratio is 1.5. Let's suppose that Emerald's current assets (CA) initially equal $500. Because its initial current ratio is 0.5, Emerald's initial current liabilities (CL) must equal $1,000. Let's also suppose that Ruby's current assets (CA) initially equal $150. Because its initial current ratio is 1.5, Ruby's initial current liabilities (CL) must equal $100. If the current liabilities of both firms double when short-term debt is added, their respective current ratios (CR) will be: CREmerald = ($500 + $1,000)/($1,000 + $1,000) = 0.75; CRRuby = ($150 + $100)/($100 + $100) = 1.25. Thus, after adding the short-term debt, Emerald's current's ratio will increase to 0.75. However, the current ratio of Ruby Company will reduce to 1.25, after adding the short-term debt. See 2-4: Uses and Limitations of Ratio Analysis

If a firm's existing quick ratio is 1.2, and all other variables remain unchanged, the quick ratio can be increased by _____. Ch.2

receiving interest income

If interest income is received in the form of cash, it will increase the balance of current assets, and increase the quick ratio of the company. See 2-4: Uses and Limitations of Ratio Analysis

Alumbat Corporation has $800,000 in debt outstanding, and pays an interest rate of 10 percent annually on its bank loan. Alumbat's annual sales are $3,200,000, its average tax rate is 40 percent, and its net profit margin on sales is 6 percent. If the company does not maintain a TIE ratio of at least 4 times, its bank will refuse to renew its loan, and bankruptcy will result. What is Alumbat's current times interest earned ratio? Ch.2

5.0 times

Alumbat's current TIE is 5 times. The net income is $192,000; that is, $3,200,000 multiplied by 6 percent. The earnings before tax is $192,000 divided by 60 percent, which equals $320,000. The earnings before interest and tax is $320,000 plus 10 percent of $800,000, which equals $400,000. Therefore, the times interest earned ratio of the firm is $400,000 divided by the interest charges of $80,000, which equals 5 times. See 2-3: Financial Statement (Ratio) Analysis

The book value per share of Topaz General Ltd. is $10 per share and the company has a total of 4 million shares. Calculate the total book value of common equity of the company.

$40 million

The book value per share is calculated by dividing the value of common equity by the number of shares outstanding. Therefore, the total book value of common equity is calculated by multiplying 4 million shares by $10 per share, which is equal to $40 million. See 2-2: Financial Statements

Which of the following ratios shows the relationship between a firm's current assets and its current liabilities?

Liquidity ratios

The liquidity ratios show the relationship between a firm's current assets and its current liabilities. See 2-3: Financial Statement (Ratio) Analysis

If a company has a quick ratio of 1.0 and a current ratio of 2.0, then the value of _____.

current liabilities is equal to the value of inventory

The company has a current ratio of 2, which means that the value of current assets is twice the value of current liabilities. Similarly, the quick ratio of the company is 1, which means that the value current assets minus inventory is equal to the value of current liabilities. As the current ratio of the company is twice its quick ratio, the value of current liabilities is equal to the value of inventory. Using the formulas for the current ratio and the quick ratio to solve for Current liabilities, we have the following: (1) Current ratio = Current assets/Current liabilities = CA/CL = 2.0. Thus, CA = 2CL. (2) Quick ratio = (CA – Inventories)/CL = 1.0. (3) Substituting CA = 2CL into the quick ratio equation, we have (2CL – Inventories)/CL = 1.0. Solve for CL = Inventories. See 2-3: Financial Statement (Ratio) Analysis

Market value ratios indicate _____.

what investors think of the company's future prospects based on its past performance

Market value ratios relate the firm's stock price to its earnings and book value per share. These ratios give management an indication of what investors think of the company's future prospects based on its past performance. See 2-3: Financial Statement (Ratio) Analysis

Which of the following statements is true about net worth?

A firm's net worth is equal to total assets minus total liabilities.

Total equity is the amount that would be paid to stockholders if the firm's assets could be sold at the values reported on the balance sheet and its debt could be paid off in the amounts reported on the balance sheet. Thus, the firm's stockholders' equity, or net worth, equals total assets minus total liabilities. See 2-2: Financial Statements

Bicksler Corporation has a current ratio of 2.0 on July 21 of the current year. On July 22, Bicksler purchased (and received) raw materials on credit from its supplier. Assuming all other things are equal, how will this transaction affect the current ratio of Bicksler?

The value of the current ratio will decrease.

The purchase of raw materials on credit will increase the balance of inventory as well as the balance of accounts payable with the same amount. Therefore, the current ratio of Bicksler Corporation will decrease. For example, suppose that prior to the purchase, the value of the current assets were equal to $2,000 and the value of the current liabilities were equal to $1,000. If Bicksler purchases $200 of raw material on credit, then both current assets (inventories) and current liabilities (accounts payable) will increase by $200. After the purchase, the current ratio will equal 1.83 = $2,200/$1,200. See 2-3: Financial Statement (Ratio) Analysis

Which of the following is considered by analysts when comparing the operations of two firms that are financed differently?

Earnings before interest and taxes

When comparing the operations of two firms, analysts often examine the net operating income (NOI), also known as the earnings before interest and taxes (EBIT), because this figure represents the result of normal operations before considering the effects of the firm's financing choices. See 2-2: Financial Statements

A firm's total equity is $10 million and total liabilities is $5 million. During the year, its sales equaled $75 million. Based on the given information, what is the firm’s total assets turnover ratio?

5 times

The total assets turnover ratio is 5 times. It is calculated by dividing the firm's sales of $75 million by the sum of total equity of $10 million and total liabilities of $5 million. See 2-3: Financial Statement (Ratio) Analysis

A firm has total interest charges of $10,000 per year, sales of $1 million, a tax rate of 40 percent, and a net profit margin of 6 percent. What is the firm's times interest earned ratio? 

11 times

The net income of the firm is $60,000, calculated as 6 percent of $1 million. The earnings before taxes is $100,000, calculated by dividing $60,000 by 60 percent (= 1 – 0.40). The EBIT of the firm is $110,000, calculated by adding the earnings before taxes of $100,000 and $10,000 of total interest charges. Therefore, the times interest earned ratio is 11 times; that is, $110,000 divided by $10,000. See 2-3: Financial Statement (Ratio) Analysis

Selzer Inc. sells all of its merchandise on credit. It has a profit margin of 4 percent, days sales outstanding equal to 60 days, receivables of $150,000, total assets of $3 million, and a debt ratio of 0.64. What is the firm's return on equity (ROE)?

3.3%

(Sales per day) × (DSO) = Account receivable; (Sales ÷ 360) × (60) = $150,000; Sales = $900,000

Profit margin = Net profit after tax ÷ Sales; Net profit = 0.4 × ($900,000) = $36,000

Debt ratio = 0.64 = Total debt ÷ $3,000,000; Total debt = $1,920,000

Total equity = $3,000,000 – $1,920,000 = $1,080,000

ROE = $36,000 ÷ $1,080,000 = 3.3%. See 2-3: Financial Statement (Ratio) Analysis

Using the information below for WAM Inc., what is the market value per share?

Earnings after interest and taxes = $200,000

Earnings per share = $2.00

Stockholders' equity = $2,000,000

Market/Book ratio = 0.20

$4.00

Total number of shares of WAM = $200,000 ÷ $2.00 = 100,000 shares;

Book value per share = $2,000,000 ÷ 100,000 shares = $20

Market/Book ratio = 0.20 = Market value/$20

Market value per share = $20 × 0.20 = $4 per share. See 2-3: Financial Statement (Ratio) Analysis

Which of the following is an example of a current asset?

Inventory

Current assets generally include items that the firm expects to liquidate and thus convert into cash within one year. Thus, inventory is an example of a current asset. See 2-2: Financial Statements

Which of the following provides information about a firm's performance during the past year and also provides information regarding new developments that will affect the future performance of the firm?

The annual report

A company's annual report provides two types of information. The section that discusses the operations describes the firm's operating results during the past year and discusses new developments that will affect future operations. See 2-1: Financial Reports

The statement of retained earnings for Redwood Systems Ltd. shows a retained earnings balance of $300 million on December 31. During the year, Redwood generated net income of $60 million and paid dividends of $20 million to its stockholders. What was the beginning balance of retained earnings at the start of this year?

$260 million

The balance of retained earnings of Redwood on December 31 was $300 million, which included the change in retained earnings this year. The addition to retained earnings is computed as the $60 million income minus the $20 million dividends paid to stockholders. Thus, the change in retained earnings during the year was $40 million, which means the amount in retained earnings at the beginning of the year was $300 million - $40 million = $260 million. See 2-2: Financial Statements

Determine the increase or decrease in cash for Rinky Supply Company for last year, given the following information. (Assume no other changes occurred during the past year.)

​Dividend payment                      $25

Increase in accounts receivables           $50

Increase in notes payable                 $30

Decrease in accounts payable             $20

Increase in accrued wages and taxes        $15

Increase in inventories                   $35

Addition to retained earnings                                   $5

–$80

Statement of cash flows:

Cash Flows from Operating Activities:

Addition to retained earnings                                   $5

Additions (Sources of cash):

Increase in accrued wages and taxes     $15

Subtractions (Uses of cash):

Increase in accounts receivable               ($50)

Increase in inventories                             ($35)

Decrease in accounts payable                  ($20)

Net Cash Flows from Operations                             ($85)

​

Cash Flows from Financing Activities:

Dividend payment                   ($25)

Increase in notes payable               $30

Net Cash Flows from Financing                 $5

Net reduction in cash                         ($80)

See 2-2: Financial Statements

Other things held constant, which of the following will not affect the current ratio, assuming an initial current ratio greater than 1.0?

Accounts receivable are collected.

If the accounts receivables are collected, the balance in the accounts receivables account will fall and the balance in the cash account will increase. So, there is no change in the current assets balance and thus, the current ratio will not be affected. See 2-3: Financial Statement (Ratio) Analysis

Assume that Meyer Corporation is 100 percent equity financed, and has the following information:

(1) Earnings before taxes = $1,500;

(2) Sales = $5,000;

(3) Dividend payout ratio = 60%;

(4) Total assets turnover = 2.0;

(5) Applicable tax rate = 30%

What is the firm's return on equity?

42%

Net income = $1,500 × (1 – 0.3) = $1,050

Total assets turnover = Sales ÷ TA = 2.0

Total asset = Sales ÷ 2.0 = $5,000 ÷ 2.0 = $2,500 = Equity; (The firm is financed with equity only.)

ROE = Net income ÷ Equity = $1,050 ÷ $2,500 = 42%. See 2-3: Financial Statement (Ratio) Analysis

A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has a debt of $7,500,000, total assets of $22,500,000, and an interest cost on a total debt of 5 percent, what is the firm's return on total assets (ROA)? (Round answer to two decimal places.)

13.33%

The firm's ROA is 13.33 percent, calculated by dividing the net income of $3,000,000 (= $20,000,000 x 0.15) by the total assets of $22,500,000. See 2-3: Financial Statement (Ratio) Analysis

Pearl Automotive Ltd. has a current ratio of 2. The company wants to window dress its financial statements. Which of the following transactions will increase the current ratio of Pearl Automotive, assuming all other variables remain constant?

Repayment of short-term loan

The repayment of a short-term loan will decrease the value of current assets as well as the value of current liabilities with the same value. However, it will increase the current ratio of the firm. For example, suppose that Pearl's current assets equal $200 and its current liabilities equal $100 prior to repayment of the short-term loan. If the firm repays $50 of the short-term loan, both current assets and current liabilities will decrease by $50, and the resulting current ratio will be 3.0 = ($200 - $50)/($100 - $50). See 2-4: Uses and Limitations of Ratio Analysis

Which of the following ratios indicate how much investors are willing to pay for a firm's stock for each dollar of reported profits? CH.2

Price/earnings ratio

The price/earnings ratio shows how much investors are willing to pay for a firm's stock for each dollar of reported profits. See 2-3: Financial Statement (Ratio) Analysis