CH 3: Analysis of Financial Statements

Which of the following statements is CORRECT?

"Window dressing" is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value.

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."

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."

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."

Using some of the firm's cash to reduce long-term debt is an example of "window dressing."

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."

Considered alone, which of the following would increase a company's current ratio?

An increase in accounts payable.

An increase in net fixed assets.

An increase in accrued liabilities.

An increase in notes payable.

An increase in accounts receivable.

An increase in accounts receivable.

Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant?

The total assets turnover decreases.

The TIE declines.

The DSO increases.

The EBITDA coverage ratio increases.

The current and quick ratios both decline.

The EBITDA coverage ratio increases.

A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio?

Use cash to increase inventory holdings.

Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment.

Use cash to repurchase some of the company's own stock.

Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.

Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio?

Issue new common stock and use the proceeds to acquire additional fixed assets.

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.

Issue new common stock and use the proceeds to increase inventories.

Speed up the collection of receivables and use the cash generated to increase inventories.

Use some of its cash to purchase additional inventories.

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.

Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio?

Use cash to reduce accounts payable.

Borrow using short-term notes payable and use the proceeds to reduce accruals.

Borrow using short-term notes payable and use the proceeds to reduce long-term debt.

Use cash to reduce accruals.

Use cash to reduce short-term notes payable.

Borrow using short-term notes payable and use the proceeds to reduce long-term debt.

Lincoln Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio?

Use cash to reduce long-term bonds outstanding.

Borrow using short-term notes payable and use the cash to increase inventories.

Use cash to reduce accruals.

Use cash to reduce accounts payable.

Use cash to reduce short-term notes payable.

Borrow using short-term notes payable and use the cash to increase inventories.

Lofland's has $20 million in current assets and $10 million in current liabilities, while Smaland's current assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so each plans to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions?

The transaction would improve both firms' financial strength as measured by their current ratios.

The transactions would raise Lofland's financial strength as measured by its current ratio but lower Smaland's current ratio.

The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio.

The transaction would have no effect on the firm' financial strength as measured by their current ratios.

The transaction would lower both firm' financial strength as measured by their current ratios.

The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio.

Which of the following statements is CORRECT?

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.

A reduction in inventories held would have no effect on the current ratio.

An increase in inventories would have no effect on the current ratio.

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.

A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

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.

Which of the following statements is CORRECT?

If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

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.

If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase.

There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things.

A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

Other things held constant, which of the following alternatives would increase a company's cash flow for the current year?

Increase the number of years over which fixed assets are depreciated for tax purposes.

Pay down the accounts payables.

Reduce the days' sales outstanding (DSO) without affecting sales or operating costs.

Pay workers more frequently to decrease the accrued wages balance.

Reduce the inventory turnover ratio without affecting sales or operating costs.

Reduce the days' sales outstanding (DSO) without affecting sales or operating costs.

Arshadi Corp.'s sales last year were $52,000, and its total assets were $22,000. What was its total assets turnover ratio (TATO)?

2.03

2.13

2.25

2.36

2.48

2.36

TATO = Sales/Total Assets

Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant?

$267.34

$281.41

$296.22

$311.81

$328.22

$328.22

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.

True

False

True

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.

True

False

True

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?

Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.

The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm.

Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm.

Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.

The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.

Which of the following statements is CORRECT?

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.

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.

A firm's use of debt will have no effect on its profit margin on sales.

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.

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.

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.

Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.

True

False

True

The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects.

True

False

False

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.

True

False

True

A firm's new president wants to strengthen the company's financial position. Which of the following actions would make it financially stronger?

Increase inventories while holding sales and cost of goods sold constant.

Increase accounts receivable while holding sales constant.

Increase EBIT while holding sales constant.

Increase accounts payable while holding sales constant.

Increase notes payable while holding sales constant.

Increase EBIT while holding sales constant.

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.

The division's DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30.

The division's basic earning power ratio is above the average of other firms in its industry.

The division's total assets turnover ratio is below the average for other firms in its industry.

The division's debt ratio is above the average for other firms in the industry.

The division's inventory turnover is 6, whereas the average for its competitors is 8.

The division's basic earning power ratio is above the average of other firms in its industry.

Which of the following would indicate an improvement in a company's financial position, holding other things constant?

The current and quick ratios both increase.

The inventory and total assets turnover ratios both decline.

The debt ratio increases.

The profit margin declines.

The EBITDA coverage ratio declines.

The current and quick ratios both increase.

Cordelion Communications 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 Cordelion pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue?

The times interest earned ratio will decrease.

The ROA will decline.

Taxable income will decrease.

The tax bill will increase.

Net income will decrease.

The tax bill will increase.

Which of the following statements is CORRECT?

An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio.

If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.

An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio.

An increase in the DSO, other things held constant, could be expected to increase the ROE.

An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT?

If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE.

Given this information, Leaudy must have the higher ROE.

Company Leaudy has a higher basic earning power ratio (BEP).

Company Heidee has a higher basic earning power ratio (BEP).

If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE.

If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE.

Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects.

True

False

True

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?

Company A trades at a higher P/E ratio.

Company A probably has fewer growth opportunities.

Company A is probably judged by investors to be riskier.

Company A must have a higher market-to-book ratio.

Company A must pay a lower dividend.

Company A trades at a higher P/E ratio.

Which of the following statements is CORRECT?

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.

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.

Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be.

The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).

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.

The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).

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?

The company's debt ratio increased.

The company's current ratio increased.

The company's times interest earned ratio decreased.

The company's basic earning power ratio increased.

The company's equity multiplier increased.

The company's current ratio increased.

Which of the following statements is CORRECT?

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.

If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same.

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.

If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio.

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.

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.

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.

True

False

True

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 have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios.

True

False

False

Which of the following statements is CORRECT?

All else equal, increasing the debt ratio will increase the ROA.

The use of debt financing will tend to lower the basic earning power ratio, other things held constant.

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.

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.

Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock.

 

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.

Which of the following statements is CORRECT?

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.

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.

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.

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.

Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.

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.

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?

Its total assets turnover must equal the industry average.

Its total assets turnover must be above the industry average.

Its return on assets must equal the industry average.

Its TIE ratio must be below the industry average.

Its total assets turnover must be below the industry average.

Its total assets turnover must be above the industry average.

Companies Heidee and Leaudy are virtually identical in that they are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company Heidee has the higher debt ratio. Which of the following statements is CORRECT?

Heidee has lower operating income (EBIT) than Leaudy.

Heidee has a lower total assets turnover ratio than Leaudy.

Heidee has a lower equity multiplier than Leaudy.

Heidee has a higher fixed assets turnover ratio than Leaudy.

Heidee has a higher ROE than Leaudy.

Heidee has a higher ROE than Leaudy.

Heidee Corp. and Leaudy Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, Heidee uses more debt than Leaudy. Which of the following statements is CORRECT?

Heidee would have higher net income as shown on the income statement than Leaudy.

Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income.

Heidee would have a lower equity multiplier for use in the DuPont equation than Leaudy.

Heidee would have to pay more in income taxes than Leaudy.

Heidee would have lower net income as shown on the income statement than Leaudy.

Heidee would have lower net income as shown on the income statement than Leaudy.

Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?

Heidee has more net income than Leaudy.

Heidee pays less in taxes than Leaudy.

Heidee has a lower equity multiplier than Leaudy.

Heidee has a higher ROA than Leaudy.

Heidee has a higher times interest earned (TIE) ratio than Leaudy.

Heidee pays less in taxes than Leaudy.

Companies Heidee and Leaudy have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?

Heidee has a lower times interest earned (TIE) ratio than Leaudy.

Heidee has a lower equity multiplier than Leaudy.

Heidee has more net income than Leaudy.

Heidee pays more in taxes than Leaudy.

Heidee has a lower ROE than Leaudy.

Heidee has a lower times interest earned (TIE) ratio than Leaudy.

Please elaborate on the Du Pont Equation.

The DuPont equation is a formula demostrating that the profit margin multiplied by the product of total assets turnover and the equity multiplier may be used to calculate the rate of return on equity. The three factors influencing shareholder return in this DuPont equation breakdown of ROE are profit margin, asset utilization (total asset turnover), and financial leverage (equity multiplier). 

The DuPont Equation is a useful tool for managers because it helps them look into the financial numbers more. It can show which areas a company is performing well and areas where they can improve.