Deck 7: Introduction to Financial Statement Analysis

Question 1

The term financial leverage describes financing with debt and preferred stock to increase the potential return to the residual common shareholders' equity.

Answer 1

True

Question 2

A quick ratio approximately one-half of the current ratio is typical, although this varies by industry.

Answer 2

True

Question 3

If the firm offers terms of "net 45 days," a days receivable outstanding of 45 days indicates that the firm handles accounts receivable well.

Answer 3

True

Question 4

Theoretical and empirical research has shown that the expected return from investing in a firm relates, in part, to the expected profitability of the firm.

Question 5

The rate of return on common shareholders' equity (ROCE) measures a firm's performance in using and financing assets to generate earnings.

Question 6

In theory, the numerator of the accounts receivable turnover ratio should include only sales made on account if the objective is to measure how quickly a firm collects its accounts receivable.

Question 7

ROA has particular relevance to the lenders, or creditors, of a firm.

Question 8

Most firms want to extend their payables as long as they can, but they also want to maintain their relations with suppliers.Businesses, therefore, negotiate hard for favorable payment terms and then delay paying until just before the last agreed moment.

Question 9

Some analysts find the reciprocal of the fixed asset turnover ratio helpful in comparing the operating characteristics of different firms, because it measures dollars of fixed assets required to generate one dollar of sales.

Question 10

Total assets turnover reflects the effects of turnover ratios for accounts receivable, inventory, and fixed assets.

Question 11

The accounts receivable turnover ratio indicates how quickly a firm collects its accounts receivable.

Question 12

Three measures of profitability for a firm engaging in operations selling merchandise in its stores, to generate net income are: (1) Rate of return on assets, (2) Rate of return on common shareholders' equity, and (3) Earnings per share of common stock.

Question 13

Common shareholders have a residual claim on all income after creditors and preferred shareholders receive amounts contractually owed them.

Question 14

Inventory turnover equals cost of goods sold divided by the average inventory during the period.

Question 15

Financial statement ratios alone provide direct indicators of good or poor management.

Question 16

When a firm has securities outstanding that, if exchanged for shares of common stock, would decrease basic earnings per share by 30% or more, generally accepted accounting principles require a dual presentation: basic earnings per share and diluted earnings per share.

Question 17

Some analysts calculate the inventory turnover ratio by dividing sales, rather than cost of goods sold, by the average inventory.Using sales in the numerator will lead to correct measures of the inventory turnover ratio for calculating the average number of days that inventory is on hand until sale.

Question 18

To study changes in ROA, the analyst can disaggregate ROA into the product of two other ratios: the profit margin for ROA ratio and the total assets turnover ratio.

Question 19

The return from investing in the shares of common stock has two components: cash dividends and the change in the market price of the common stock.

Question 20

Four measures for assessing short-term liquidity risk are (1) Current ratio, (2) Quick ratio, (3) Cash flow from operations to current liabilities ratio, and (4) Working capital turnover ratios.

Question 21

What affect(s) the market price of common stock shares?

A)changes in international tensions
B)economy-wide factors
C)specific industry factors
D)changes in exchange rates
E)all of the above

Question 22

Most individuals prefer _____ to _____ and they will want a _____ expected return if they purchase common stock shares than if they invest in a certificate of deposit.

A)more risk; less risk; higher
B)less risk; more risk; higher
C)more risk; less risk; lower
D)less risk; more risk; lower
E)none of the above

Question 23

An analyst examines changes in a firm's ratios over the three-year period-a so-called cross-section analysis.

Question 24

The typical steps in financial statement analysis and valuation include all of the following, except

A)obtain all published reports from other financial analysts.
B)identify the industry economic characteristics and firm's strategy.
C)calculate and interpret profitability and risk ratios.
D)prepare pro forma, or projected financial statements.
E)value the firm.

Question 25

Ratios provide little information unless the analyst places them in a context.After calculating the ratios, the analyst must compare them with some standard.Which of the following is/are possible standard(s)?

A)The planned ratio for the period.
B)The corresponding ratio during the preceding period for the same firm.
C)The corresponding ratio for a similar firm in the same industry.
D)The average ratio for other firms in the same industry.
E)All of the above are possible standards.

Question 26

Most financial statement analysis explores some aspect of a firm's

A)profitability, only.
B)risk, only.
C)value, only.
D)profitability, or its risk, or both.
E)employee turnover.

Question 27

Ratios provide little information unless the analyst places them in a context.After calculating the ratios, the analyst must compare them with some standard.Which of the following is not a possible standard?

A)The planned ratio for the period.
B)The corresponding ratio during the preceding period for the same firm.
C)The corresponding ratio for a similar firm in the same industry.
D)The average ratio for other firms in the same industry.
E)The corresponding ratio during the succeeding period for the same firm.

Question 28

The typical first step in financial statement analysis and valuation (after selecting assumptions) is:

A)Understand the Purpose and Content of the Principal Financial Statements and Related Notes.
B)Identify the Industry Economic Characteristics and Firm's Strategy.
C)Calculate and Interpret Profitability and Risk Ratios.
D)Prepare Pro Forma, or Projected, Financial Statements.
E)Value the Firm.

Question 29

Analysts use measures of long-term liquidity risk to evaluate a firm's ability to meet interest and principal payments on long-term debt and similar obligations as they come due.If a firm cannot make the payments on time, it becomes insolvent and may have to reorganize or liquidate.

Question 30

The following ratio relates the results of operating performance to the investments (assets) of a firm without regard to how the firm financed those investments. $\frac{\text { Net Income + Interest Expense Net of Income Tax Savings}}{\text {Average Total Assets }}$

The ratio is called a rate of return on:

A)assets.
B)long-term investments.
C)shareholders' equity.
D)net income.
E)net income and interest expense net of income tax savings.

Question 31

Analysis of the Return on Assets has particular relevance to the

A)lenders.
B)employees.
C)lower-level managers.
D)government regulators.
E)unions.

Question 32

As a practical matter, most firms report segment information by _____ indicating that most firms appear to be organized on these same lines.

A)geographical markets
B)products and services
C)major customers
D)resource inputs
E)production methods

Question 33

Which of the following is/are limitations of ratio analysis?

A)use of acquisition cost for assets rather than current replacement cost or net realizable value
B)latitude firms have in selecting from among various generally accepted accounting principles
C)changes in many ratios correlate with each other
D)must recognize conditions that have changed between the periods being compared when comparing the size of a ratio between periods for the same firm
E)all of the above

Question 34

Measures of profitability for a firm engaging in operations selling merchandise in its stores to generate net income do not include:

A)rate of return on assets.
B)rate of return on common shareholders' equity.
C)earnings per share of common stock.
D)inventory turnover ratio.
E)none of the above.

Question 35

The return from investing in the shares of common stock include(s):

A)change in the market price of the common stock.
B)cash dividends.
C)interest income.
D)choices a and b.
E)all of the above.

Question 36

The typical last step in financial statement analysis and valuation (after selecting assumptions) is:

A)Understand the Purpose and Content of the Principal Financial Statements and Related Notes.
B)Identify the Industry Economic Characteristics and Firm's Strategy.
C)Calculate and Interpret Profitability and Risk Ratios.
D)Prepare Pro Forma, or Projected, Financial Statements.
E)Value the Firm.

Question 37

The value of common stock investments will likely change between the time the shares are purchased and the time in the future when they are sold.The difference between the eventual selling price and the purchase price, is often called

A)speculative returns.
B)enrichment.
C)inflation.
D)price appreciation (or price depreciation, if negative).
E)deflation.

Question 38

The rate of return on assets relates the results of operating performance to the investments of a firm without regard to how the firm financed those investments.The ratio is calculated as follows:

A) $\frac{\text {Net Income + Interest Expense Net of Income Tax Savings }}{\text {Average Total Assets }}$
B) $\frac{\text { Net Income}}{\text {Average Total Assets }}$
C) $\frac{\text {Net Income + Interest Expense }}{\text {Average Total Assets }}$
D) $\frac{\text {Net Income + Interest Expense Net of Income Tax Savings }}{\text { Ending Total Assets}}$
E) $\frac{\text {Net Income }}{\text { Ending Total Assets}}$

Question 39

Many analysts use a common-size balance sheet, which expresses each balance sheet item as a percentage of total assets.

Question 40

The typical steps in financial statement analysis and valuation include(s):

A)value the firm.
B)identify the industry economic characteristics and firm's strategy.
C)calculate and interpret profitability and risk ratios.
D)prepare pro forma, or projected financial statements.
E)all of the above.

Question 41

Using lower cost borrowed funds and earning a higher rate of return on those funds than their cost

A)increases the return to the common shareholders.
B)is a phenomenon called financial leverage.
C)requires the common shareholders to take on more risk in their investment.
D)all of the above
E)none of the above

Question 42

A small leverage ratio may indicate that a company is

A)well managed.
B)financed with a relatively large amount of common shareholders' equity.
C)financed with a relatively large number of shares of common and preferred stock.
D)financed with a relatively large amount of debt.
E)financed with a relatively large amount of debt and preferred stock.

Question 43

The rate of return on common shareholders' equity

A)will exceed the rate of return on assets whenever the rate of return on assets exceeds the after-tax cost of borrowing and any dividends required for preferred shareholders.
B)will not exceed the rate of return on assets whenever the rate of return on assets exceeds the after-tax cost of borrowing and any dividends required for preferred shareholders.
C)will always exceed the rate of return on assets.
D)will never exceed the rate of return on assets.
E)none of the above

Question 44

Financial leverage

A)increases the return to the common shareholders during good earnings years.
B)uses lower cost borrowed funds to earn a higher rate of return on those funds than their cost.
C)decreases the return to the common shareholders during bad earnings years.
D)all of the above
E)none of the above

Question 45

The numerator of the rate of return on common shareholders' equity

A)is the amount of earnings assignable to common shareholders' equity after subtracting all amounts required to compensate other providers of financing for the use of their funds.
B)subtracts from net income any earnings allocable to preferred stock equity, usually the dividends on preferred stock declared during the period.
C)does not subtract the dividends on common stock because such dividends represent distributions to common shareholders of a portion of the returns generated for them during the period.
D)all of the above
E)none of the above

Question 46

The capital provided by common shareholders during the period used for calculating the return on common equity equals

A)the average par value of common stock, capital contributed in excess of par value on common stock, retained earnings, and any other common shareholders' equity accounts for the period.
B)average preferred shareholders' equity less average total shareholders' equity.
C)the ending par value of common stock, capital contributed in excess of par value on common stock, retained earnings, and any other common shareholders' equity accounts for the period.
D)ending preferred shareholders' equity less ending total shareholders' equity.
E)choices a and b

Question 47

ROCE disaggregates into the following components:

A)Profit Margin for ROCE Ratio x Inventory Turnover Ratio x Debt Ratio
B)Profit Margin for ROCE Ratio x Total Assets Turnover Ratio x Debt Ratio
C)Profit Margin for ROCE Ratio x Inventory Turnover Ratio x Capital Structure Leverage Ratio
D)Profit Margin for ROCE Ratio x Total Assets Turnover Ratio x Capital Structure Leverage Ratio
E)Profit Margin x Total Assets Turnover Ratio x Debt Ratio

Question 48

ROCE will exceed ROA whenever ROA exceeds the after-tax cost of borrowing plus any dividends required for preferred shareholders.Which of the following is/are true?

A)The bond holders earn a higher return, but they undertook more risk in their investment.
B)The preferred shareholders earn a lower return, but they undertook more risk than the common shareholders in their investment.
C)The common shareholders earn a higher return, but they undertook more risk in their investment.
D)Using lower-cost borrowed funds and then earning a rate of return on those funds higher than their cost increases the return to the common shareholders.
E)Choices c and d.

Question 49

The term _____ describes financing with debt and preferred stock to increase the potential return to the residual common shareholders' equity.

A)trading on the debt
B)trading on the equity
C)financial leverage
D)equity financing
E)none of the above

Question 50

The capital provided by common shareholders during the period include(s):

A)the average par value of common stock.
B)capital contributed in excess of par value on common stock.
C)retained earnings.
D)other common shareholders' equity accounts.
E)all of the above.

Question 51

The calculation of Rate of Return on Common Shareholders' Equity (ROCE) is as follows: Rate of Return on Common = Shareholders' Equity

A) $\frac{\text {Net Income - Dividends on Preferred Stock }}{\text {Ending Common Shareholders' Equity }}$
B) $\frac{\text { Net Income}}{\text { Average Common Shareholders' Equity}}$
C) $\frac{\text { Net Income + Dividends on Preferred Stock}}{\text {Average Common Shareholders' Equity }}$
D) $\frac{\text {Net Income - Dividends on Preferred Stock }}{\text {Average Common Shareholders' Equity }}$
E) $\frac{\text {Net Income + Dividends on Preferred Stock }}{\text { Ending Common Shareholders' Equity}}$

Question 52

Financial leverage

A)may increase the return to the common shareholders.
B)uses lower cost borrowed funds and earns a higher rate of return on those funds than their cost.
C)requires the common shareholders to take on more risk in their investment.
D)all of the above
E)none of the above

Question 53

Which of the following ratios is not a measure of profitability?

A)rate of return on assets
B)rate of return on common stockholders' equity
C)earnings per share of common stock
D)rate of return on preferred stockholders' equity
E)all of the above

Question 54

Rate of return on common shareholders' equity (ROCE)

A)measures a firm's performance in using and financing assets to generate earnings and explicitly considers financing costs.
B)a measure of profitability that incorporates the results of operating, investing, and financing activities.
C)equals net income (less dividends on preferred stock, if any) divided by average common shareholders' equity.
D)all of the above
E)none of the above

Question 55

A firm computes ROA, profit margin for ROA, and total assets turnover for each segment using the segment disclosures.The amounts for these ratios computed at a segment level differ from those at a corporate level for which of the following reason(s)?

A)The numerator of ROA at a firm-wide level includes all revenues and expenses except interest expense net of taxes, whereas the numerator of ROA using the segment data includes operating revenues and expenses only.
B)The denominator of ROA at a firm-wide level is the average of assets at the beginning and end of the year, whereas total assets at the end of the year are used in computing segment ROAs.
C)The denominator of ROA at a firm-wide level is the total assets at the end of the year, whereas the average of assets at the beginning and end of the year, are used in computing segment ROAs.
D)choices a and b
E)choices a and c

Question 56

The higher the capital structure leverage ratio, the _____ is the proportion of financing that common shareholders provide and the _____ is the proportion that creditors and preferred shareholders provide.Thus, the _____ the capital structure leverage ratio, the _____ is financial leverage.

A)higher; lower; higher; higher
B)lower; higher; higher; higher
C)higher; lower; higher; lower
D)lower; higher; higher; lower
E)lower; higher; lower; lower

Question 57

The capital structure leverage ratio indicates

A)the sales generated from each dollar of assets.
B)the portion of the sales dollar left over for the common shareholders after covering all operating costs and subtracting claims of creditors and preferred shareholders.
C)the portion of the sales dollar left over for the preferred shareholders after covering all operating costs and subtracting claims of creditors and common shareholders.
D)the proportion of total assets, or total financing, provided by common shareholders contrasted with the financing provided by creditors and preferred shareholders.
E)the proportion of total assets, or total financing, provided by preferred shareholders contrasted with the financing provided by creditors and common shareholders.

Question 58

Which ratio measures a firm's performance in using assets to generate earnings independent of how the firm financed acquisition of those assets?

A)rate of return on assets
B)rate of return on common stockholders' equity
C)earnings per share of common stock
D)rate of return on preferred stockholders' equity
E)none of the above

Question 59

The rate at which accounts receivable turnover

A)indicates how quickly a firm collects cash.
B)equals sales revenue divided by average accounts receivable.
C)is often expressed in terms of the average number of days that elapse between the time the firm makes the sale and the time it later collects the cash.
D)all of the above
E)none of the above

Question 60

If the rate of return on assets for the year is 15%, a general interpretation of the ratio would be

A)the assets generated $0.15 cash per dollar of cash invested.
B)15% of the assets produced income while the remainder were at break-even for the year.
C)before payment for use of capital, $0.15 was earned for each dollar of assets used by the company.
D)dividends of $0.15 per share were paid.
E)before payment for use of capital, $0.15 was earned for each dollar of cash used by the company.

Question 61

Igor Corporation's accounts receivable, net of allowance for uncollectibles, were $250,000 at December 31, Year 3, and $350,000 at December 31, Year 4.Net cash sales for Year 4 were $300,000.The accounts receivable turnover was 6.0.Igor's net sales for Year 4 were

A)$1,500,000
B)$1,800,000
C)$2,000,000
D)$2,100,000
E)$2,200,000

Question 62

What is calculated as follows? $\begin{array} { l }?&=&\begin{array} { l } \text {Profit Margin for ROA }\\ \text {(before interest expense }\\ \text {and related income }\\ \text {tax savings) Ratio }\\\end{array}&\times&\begin{array} { l } \text {Total Assets }\\ \text {Turnover}\\ \text {Ratio }\\\end{array}\\\end{array}$

A)return on net assets
B)return on sales margin
C)return on gross margin
D)return on assets
E)return on net income

Question 63

The accounts receivable turnover ratio equals

A)profit margin divided by average accounts receivable at the end of the period.
B)gross margin divided by average accounts receivable at the end of the period.
C)sales revenue divided by ending accounts receivable at the end of the period.
D)sales revenue divided by average accounts receivable during the period.
E)gross margin divided by average accounts receivable during the period.

Question 64

Some analysts calculate the inventory turnover ratio by dividing sales, rather than cost of goods sold, by the average inventory. Which of the following regarding the inventory turnover ratio is/are not true?

A)Using sales in the numerator, will lead to incorrect measures of the inventory turnover ratio for calculating the average number of days that inventory is on hand until sale.
B)As long as the ratio of selling price to cost of goods sold remains relatively constant, either measure will identify changes in the trend of the inventory turnover ratio.
C)Using sales in the numerator, will lead to correct measures of the inventory turnover ratio for calculating the average number of days that inventory is on hand until sale.
D)Choices a and b.
E)None of the above.

Question 65

Analysts deciding between investments must consider the comparative risks.Which of the following factors affect the risk of business firms?

A)Economy-wide factors, such as increased inflation or interest rates, unemployment, and recessions.
B)Industry-wide factors, such as increased competition, lack of availability of raw materials, changes in technology, and increased government regulatory actions, such as anti-trust or clean environment policies.
C)Firm-specific factors, such as labor strikes, loss of facilities due to fire or other casualty, and poor health of key managerial personnel.
D)The amount of liquid resources available to the firm to run smoothly and effectively.
E)all of the above

Question 66

Analysts deciding between investments must consider the comparative risks.Which of the following is/are economy-wide factors that affect the risk of business firms?

A)increased inflation
B)increased interest rates
C)unemployment
D)recessions
E)all of the above

Question 67

_____ measures the amount of sales generated from a particular level of investments in fixed assets.

A)Fixed asset ratio
B)Fixed asset turnover ratio
C)Asset ratio
D)Fixed asset ratio
E)Inventory turnover ratio

Question 68

Managing inventory turnover involves balancing which of the following consideration(s) in setting the optimum level of inventory and, thus, the rate of inventory turnover?

A)For a given amount of gross margin on the goods, firms prefer to sell as many goods as possible with a minimum of assets tied up in inventories.
B)An increase in the rate of inventory turnover between periods indicates reduced costs of financing the investment in inventory.
C)Management does not want to have so little inventory on hand that shortages result in lost sales.
D)Increases in the rate of inventory turnover caused by inventory shortages could signal a loss of customers.
E)All of the above.

Question 69

To calculate the amount of net income assignable to common shareholders' equity, the analyst does not

A)subtract all amounts required to compensate other providers of financing for the use of their funds.
B)make any further adjustment for interest.
C)subtract from net income any earnings allocable to preferred stock equity usually the dividends on preferred stock declared during the period.
D)subtract dividends on common stock.
E)none of the above

Question 70

Analysts deciding between investments must consider the comparative risks.Which of the following is/are not economy-wide factors that affect the risk of business firms?

A)increased inflation
B)increased interest rates
C)unemployment
D)recessions
E)increased competition

Question 71

The profit margin ratio for ROCE indicates

A)the sales generated from each dollar of assets.
B)the portion of the sales dollar left over for the common shareholders after covering all operating costs and subtracting claims of creditors and preferred shareholders.
C)the portion of the sales dollar left over for the preferred shareholders after covering all operating costs and subtracting claims of creditors and common shareholders.
D)the proportion of total assets, or total financing, provided by common shareholders contrasted with the financing provided by creditors and preferred shareholders.
E)the proportion of total assets, or total financing, provided by preferred shareholders contrasted with the financing provided by creditors and common shareholders.

Question 72

The rate which indicates how quickly a firm collects cash is the _____ turnover ratio.

A)cash
B)accounts receivable
C)sales receipts
D)inventory
E)asset

Question 73

The rate at which _____ turn(s) over measures how quickly a firm collects cash.

A)accounts receivable
B)assets turnover
C)inventory
D)accounts payable
E)notes receivable

Question 74

Most firms that sell to other businesses, as opposed to consumers, sell on account and collect within 30 to 90 days.Interpreting any particular firm's accounts receivable turnover and days receivable outstanding requires knowing the terms of sale.If a firm's terms of sale are "net 30 days" and the firm collects its accounts receivable in 45 days, then the

A)collections are not in accord with the stated terms.
B)situation warrants a review of the credit and collection activity to ascertain the cause.
C)situation warrants a review of the credit and collection activity to guide corrective action.
D)situation indicates that the firm handles accounts receivable well.
E)choices a, b and c

Question 75

To study changes in ROA, the analyst can disaggregate ROA into the product of two other ratios:

A)the gross profit for ROA ratio and the total assets turnover ratio.
B)the profit margin for ROA ratio and the inventory turnover ratio
C)the gross margin for ROA ratio and the inventory turnover ratio.
D)the profit margin for ROA ratio and the total assets turnover ratio
E)the gross margin for ROA ratio and the total assets turnover ratio.

Question 76

The _____ turnover ratio equals sales revenue divided by average accounts receivable during the period.

A)cash
B)accounts receivable
C)sales receipts
D)sales revenue
E)asset

Question 77

The total assets turnover ratio indicates

A)the sales generated from each dollar of assets.
B)the portion of the sales dollar left over for the common shareholders after covering all operating costs and subtracting claims of creditors and preferred shareholders.
C)the portion of the sales dollar left over for the preferred shareholders after covering all operating costs and subtracting claims of creditors and common shareholders.
D)the proportion of total assets, or total financing, provided by common shareholders contrasted with the financing provided by creditors and preferred shareholders.
E)the proportion of total assets, or total financing, provided by preferred shareholders contrasted with the financing provided by creditors and common shareholders.

Question 78

The capital structure leverage ratio

A)indicates the portion of total assets, or total financing, provided by common shareholders contrasted with the financing provided by creditors and preferred shareholders.
B)is larger when there is more financial leverage.
C)is smaller when there is less financial leverage.
D)all of the above
E)none of the above

Question 79

Which of the following could affect(s) the fixed asset turnover ratio?

A)Firms often invest in fixed assets several periods before these assets generate sales from products manufactured in their plants or sold in their stores.
B)A low or decreasing rate of fixed asset turnover may indicate expanding firms preparing for future growth.
C)Firms anticipating a decline in product sales could cut back expenditures on fixed assets and increase the fixed asset turnover ratio.
D)All of the above.
E)None of the above.

Question 80

The _____ ratio indicates how fast firms sell their inventory items, measured in terms of the rate of movement of goods into and out of the firm.

A)asset turnover
B)inventory turnover
C)asset
D)inventory
E)cost of goods sold