CHAPTER 04 ANALYSIS OF FINANCIAL STATEMENTS

REFERENCES: 4-2 Liquidity RatiosRDS: United States - OH - DISC.FOFM.BRIG.16.05 - Financial analysis and cash flows TOPICS: Liquidity ratios KEYWORDS: Bloom’s: Knowledge 3.. A decline i

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To keep this chapter from involving too much memorization, we provide our students with a formula sheet for use on exams That makes a few of the questions trivially easy, but most require some thought, and some are downright

challenging Even the very easy ones make students think about the ratios The challenging questions are labeled CHALLENGING, and most students will agree with that designation.

Some of these questions are just definitions, but others require real thought about the make-up of the ratios and relationships among the ratios We tell our students that to answer some of these questions it is useful (1) to write out the relevant ratio or ratios, (2) then to think about how the ratios would change if the accounting data changed, and (3) occasionally to make up illustrative data to test their conclusions.

Note that there is some overlap between the True/False and the multiple choice questions, as some T/F statements are used in the MC questions.

1 Ratio analysis involves analyzing financial statements to help appraise a firm's financial position and strength

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TOPICS: Ratio analysis

KEYWORDS: Bloom’s: Knowledge

2 The current and quick ratios both help us measure a firm's liquidity The current ratio measures the relationship of the firm's current assets to its current liabilities, while the quick ratio measures the firm's ability to pay off short-term obligations without relying on the sale of inventories

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REFERENCES: 4-2 Liquidity Ratios

RDS: United States - OH - DISC.FOFM.BRIG.16.05 - Financial analysis and cash flows

TOPICS: Liquidity ratios

3 Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and to-use estimates of a firm's liquidity position

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REFERENCES: 4-2 Liquidity Ratios

TOPICS: Liquidity ratios

4 High current and quick ratios always indicate that the firm is managing its liquidity position well

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TOPICS: Current ratio

KEYWORDS: Bloom's: Comprehension

5 If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not changemuch, but its quick ratio would decline

a True

b Fals

e

ANSWER: False

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TOPICS: Current and quick ratios

6 If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would increase

a True

b Fals

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7 If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or quick ratio would change

a True

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8 The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a

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firm is managing its current assets.

TOPICS: Asset management ratios

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9 A decline in a firm's inventory turnover ratio suggests that it is improving both its inventory management and its liquidity position, i.e., that it is becoming more liquid.

TOPICS: Inventory turnover ratio

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10 In general, it's better to have a low inventory turnover ratio than a high one, as a low ratio indicates that the firm has

an adequate stock of inventory relative to sales and thus will not lose sales as a result of running out of stock

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11 The days sales outstanding tells us how long it takes, on average, to collect after a sale is made The DSO can be compared with the firm's credit terms to get an idea of whether customers are paying on time.

TOPICS: Days sales outstanding

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12 If a firm's fixed assets turnover ratio is significantly higher than its industry average, this could indicate that it uses its fixed assets very efficiently or is operating at over capacity and should probably add fixed assets.

TOPICS: Fixed assets turnover ratio

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13 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.

TOPICS: Debt management ratios

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14 The more conservative a firm's management is, the higher its total debt to total capital ratio [measured as (Short-term debt + Long-term debt)/(Debt + Preferred stock + Common equity)] is likely to be.

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15 Other things held constant, the higher a firm's total debt to total capital ratio [measured as (Short-term debt + term debt)/(Debt + Preferred stock + common equity)], the higher its TIE ratio will be.

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16 The times-interest-earned ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs.

TOPICS: TIE ratio

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17 Profitability ratios show the combined effects of liquidity, asset management, and debt management on a firm's operating results.

TOPICS: Profitability ratios

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

a True

b Fals

e

ANSWER: False

RATIONALE: BEP = EBIT/Assets EBIT reflects earnings before the effects of leverage

(interest) and taxes, so the statement is false

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19 The operating margin measures operating income per dollar of assets

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20 The profit margin measures net income per dollar of sales

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21 The return on invested capital measures the total return that a company has provided for its investors

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22 The "apparent," but not necessarily the "true," financial position of a company whose sales are seasonal can change dramatically during a given year, depending on the time of year when the financial statements are constructed

a True

b Fals

e

ANSWER: True

RATIONALE: Many of the ratios show sales over some past period such as the last 12 months

divided by an asset such as inventories as of a specific date Assets like inventories vary at different times of the year for a seasonal business, thus leading to big changes in the ratio

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STATE STAND

ARDS:

United States - OH - DISC.FOFM.BRIG.16.05 - Financial analysis and cash flows

TOPICS: Balance sheet changes

23 Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used the same or similar accounting methods

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TOPICS: Ratio limitations

24 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 Fals

e

ANSWER: True

RATIONALE: A high current ratio is consistent with a lot of inventory A low inventory turnover is

also consistent with a lot of inventory If the CR exceeds industry norms and the turnover is below the norms, then the firm has more inventory than most other firms, given its sales It could just be carrying a lot of good inventory, but it might also have a normal amount of "good" inventory plus some "bad" inventory that has not been written off So the statement is true

POINTS: 1

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25 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 Fals

e

ANSWER: False

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RATIONALE: The FA turnover is Sales/FA, and it gives an indication of how effectively the firm

utilizes its FA The proportion of FA to TA is not relevant to this usage

TOPICS: Fixed assets turnover

26 Other things held constant, the more debt a firm uses, the lower its profit margin will be

a True

b Fals

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TOPICS: Profit margin

27 Suppose you are analyzing two firms in the same industry Firm A has a profit margin of 10% versus a profit margin of8% for Firm B Firm A's total debt to total capital ratio [measured as (Short-term debt + Long-term debt)/(Debt +

Preferred stock + Common equity)] is 70% versus one of 20% for Firm B Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be thecause of Firm A's higher profit margin

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a True

b Fals

e

ANSWER: False

RATIONALE: A's higher total debt to total capital ratio would tend to lower its profit margin

Since its margin is already higher, this indicates that A is the better managed company

KEYWORDS: Bloom's: Analysis

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28 Other things held constant, a decline in sales accompanied by an increase in financial leverage must result in a lower profit margin.

a True

b Fals

e

ANSWER: False

RATIONALE: PM = NI/Sales A decline in sales would, other things held constant, increase the

PM An increase in financial leverage would lead to higher interest charges, whichwould decrease net income, which would decrease the PM So, the net effect could be an increase or a decrease in the PM, or no change

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STATE STAND

ARDS:

29 Other things held constant, the more debt a firm uses, the lower its operating margin will be

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STATE STANDA

RDS:

TOPICS: Operating margin

30 The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operatingefficiency is that the BEP does not reflect the effects of debt and taxes

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TOPICS: BEP ratio

31 Other things held constant, the more debt a firm uses, the lower its return on total assets will be

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32 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 Fals

e

ANSWER: False

RATIONALE: Two firms could have identical EBITs but different amounts of interest, tax rates,

and different amounts of assets, and thus different ROAs

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33 The return on common equity (ROE) is generally regarded as being less significant, from a stockholder's viewpoint, than the return on total assets (ROA)

a True

b Fals

e

ANSWER: False

RATIONALE: Stockholders should, and generally do, consider the ROE as being probably the

single most important ratio based strictly on the financial statements

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ARDS: flows

TOPICS: ROE

34 The return on invested capital (ROIC) differs from the return on assets (ROA) First, ROIC is based on total invested capital rather than total assets Second, the numerator of the ROIC is after-tax operating income rather than net income

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STATE STANDA

RDS:

TOPICS: ROIC and ROA

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

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TOPICS: Market value ratios

36 In general, if investors regard a company as being relatively risky and/or having relatively poor growth prospects, then

it will have relatively high P/E and M/B ratios

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TOPICS: Market value ratios

37 The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings In general, investors regard companies with higher P/E ratios as being less risky and/or more likely to enjoy higher growth inthe future

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REFERENCES: 4-6 Market Value Ratios

TOPICS: P/E ratio

38 The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value In general, investors regard companies with higher M/B ratios as being less risky and/or more likely to enjoy higher growth

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39 Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry Under these conditions, firms with high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios

a True

b Fals

e

ANSWER: False

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RATIONALE: Think about the DuPont equation: ROE = PM × TATO × Equity multiplier Similar

financing policies will lead to similar Equity multipliers Moreover, competition in the capital markets will cause ROEs to be similar, because otherwise capital would flow to industries with high ROEs and drive returns down toward the average, given similar risks To have similar ROEs, firms with relatively high PMs must have relatively low TATOs, and vice versa Therefore, the statement is false

TOPICS: DuPont equation

40 Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and therefore an equity multiplier of 1.0, and an ROE of 7.5% The CFO recommends that the firm borrow funds using long-term debt, use the funds to buy back stock, and raise the equity multiplier to 2.0 The size of the firm (assets) would not change She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5% This would

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probably be a good move, as it would increase the ROE from 7.5% to 13.5%.

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STATE STANDA

RDS:

TOPICS: DuPont equation

KEYWORDS: Bloom's: Application

41 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 examining changes in a firm's performance over time

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TOPICS: Trend analysis

42 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 B's

a True

b Fals

e

ANSWER: False

RATIONALE: This question can be answered by thinking carefully about the ratios:

Demonstration that the first sentence is true: QR(B) > QR(A)

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