Question 1

Since 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.

Accepted Answer

Two firms with the same EBIT may have different levels of assets and thus different ROA. For example, if Firm A has $1 million in assets and earns $100,000 in EBIT, its ROA would be 10%. If Firm B has $2 million in assets and also earns $100,000 in EBIT, its ROA would be 5%. Therefore, the two firms do not have the same ROA even though they have the same EBIT.

Question 2

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

Accepted Answer

The statement is true. The current and quick ratios are commonly used measures of liquidity, but a cash budget provides more comprehensive information.

Question 3

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

Accepted Answer

Profitability ratios reflect the efficiency of a company's operations in generating profits by considering its liquidity, asset management, and debt management. Therefore, they show the combined effects of these factors on the business's profitability.

Question 4

A decline in the inventory turnover ratio suggests that the firm's liquidity position is improving.

Accepted Answer

A decline in the inventory turnover ratio means that the firm is taking more time to sell its inventory, indicating that its liquidity position may be worsening. An increase in the inventory turnover ratio suggests better liquidity as the firm is selling inventory at a faster pace.

Question 5

The degree to which the managers of a firm attempt to magnify the returns to owners' capital through the use of financial leverage is captured in debt management ratios.

Accepted Answer

Debt management ratios are used to measure how much a company is relying on debt to finance its operations and investments. These ratios help to determine the degree to which managers attempt to increase returns to owners by using financial leverage. Therefore, the statement is true.

Question 6

The inventory turnover ratio and days sales outstanding (DSO) are two ratios that can be used to assess how effectively the firm is managing its assets in consideration of current and projected operating levels.

Accepted Answer

The inventory turnover ratio and days sales outstanding (DSO) are indeed two ratios that are useful in measuring how well a company is managing its assets based on its current and projected operating levels.

Question 7

If sales decrease and financial leverage increases, we can say with certainty that the profit margin on sales will decrease.

Accepted Answer

A decrease in sales and an increase in financial leverage do not necessarily guarantee a decrease in profit margin, as other factors like cost management and pricing strategies can influence the profit margin.

Question 8

If a firm has high current and quick ratios, this is always a good indication that a firm is managing its liquidity position well.

Accepted Answer

High current and quick ratios indicate liquidity, but excessively high values may suggest inefficient use of assets or excessive inventory, not necessarily good management.

Question 9

Determining whether a firm's financial position is improving or deteriorating requires analysis of more than one set of financial statements. Trend analysis is one method of measuring a firm's performance over time.

Accepted Answer

Trend analysis is a method of analyzing a firm's performance over time by comparing financial statements from different periods to identify trends and changes in key financial metrics. Therefore, it is true that determining whether a firm's financial position is improving or deteriorating requires analysis of more than one set of financial statements, and trend analysis is one such method of analysis.

Question 10

Suppose two firms 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, one firm has a higher debt ratio. If BEP is greater than the interest rate on debt, the firm with the higher debt ratio will also have a higher rate of return on common equity.

Accepted Answer

This is because the higher debt ratio firm has a lower amount of equity financing, which means that the profits will be divided among fewer shareholders. This will result in a higher return on equity for the remaining shareholders. However, if BEP is lower than the interest rate on debt, the higher debt ratio firm may face financial distress and a lower return on equity.

Question 11

If the current ratio of Firm A is greater than the current ratio of Firm B, we cannot be sure that the quick ratio of Firm A is greater than that of Firm B. However, if the quick ratio of Firm A exceeds that of Firm B, we can be assured that Firm A's current ratio also exceeds B's current ratio.

Accepted Answer

The quick ratio excludes inventory from current assets, so a higher quick ratio does not guarantee a higher current ratio, as the current ratio includes inventory.

Question 12

The fixed charge coverage ratio recognizes that firms often lease equipment under contract and thus, some firms must meet more than just their scheduled interest payments out of earnings. Therefore, the fixed charge coverage is more inclusive than the TIE ratio.

Accepted Answer

The statement accurately describes the purpose and advantages of using the fixed charge coverage ratio over the traditional TIE ratio.

Question 13

The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio measures the relationship of a firm's current assets to its current liabilities and the inventory turnover ratio measures how rapidly a firm turns its inventory back into a "quick" asset or cash.

Accepted Answer

The inventory turnover ratio measures how efficiently a firm manages its inventory, not its liquidity. The current ratio is a liquidity measure, but the inventory turnover ratio is more about operational efficiency.

Question 14

The times-interest-earned ratio is one indication of a firm's ability to meet both long-term and short-term obligations.

Accepted Answer

The times-interest-earned ratio measures a company's ability to meet its interest payments on debt. It is calculated by dividing earnings before interest and taxes (EBIT) by interest expenses. A higher ratio indicates that a company is more capable of covering its interest expenses and suggests that it has a lower risk of defaulting on its debts. Therefore, the times-interest-earned ratio can be used as an indicator of a firm's ability to meet both its long-term and short-term obligations.

Question 15

Suppose a firm wants to maintain a specific TIE ratio. If the firm knows the level of its debt, the interest rate it will pay on that debt, and the applicable tax rate, the firm can then calculate the earnings level required to maintain its target TIE ratio.

Accepted Answer

The TIE (Times Interest Earned) ratio is calculated as EBIT (Earnings before Interest and Taxes) divided by Interest Expense. If a firm wants to maintain a specific TIE ratio, it can calculate the required EBIT by rearranging the formula. Specifically, EBIT = TIE x Interest Expense. By knowing the level of debt, interest rate, and tax rate, the firm can calculate its Interest Expense and then use the desired TIE ratio to solve for the required EBIT.

Question 16

The inventory turnover and current ratios are related. The combination of a high current ratio and a low inventory turnover ratio relative to the industry norm might indicate that the firm is maintaining too high an inventory level or that part of the inventory is obsolete or damaged.

Accepted Answer

A high current ratio indicates that a company has enough current assets to pay off its current liabilities, while a low inventory turnover ratio suggests that the company is not efficiently selling its inventory. When these two ratios are analyzed together, a high current ratio and low inventory turnover ratio could suggest that there is excess inventory that is not being sold, which could be due to obsolescence, damage, or just overstocking. Therefore, the statement is true.

Question 17

Ratio analysis involves a comparison of the relationships between financial statement accounts so as to analyze the financial position and strength of a firm.

Accepted Answer

Ratio analysis does involve a comparison of the relationships between financial statement accounts in order to evaluate the financial health of a company.

Question 18

Two firms have the same current ratio, 0.75, and the same amount of sales. However, Firm A has a higher inventory turnover ratio than Firm B. Therefore, we can conclude that the quick ratio of Firm A will be smaller than that of Firm B.

Accepted Answer

The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory. Therefore, if Firm A has a higher inventory turnover ratio, it means that their average inventory is lower than that of Firm B. This would result in a higher quick ratio for Firm A, as the quick ratio excludes inventory from current assets. Therefore, the statement is false.

Question 19

We can use the fixed assets turnover ratio to legitimately compare firms in different industries as long as all the firms being compared are using the same proportion of fixed assets to total assets.

Accepted Answer

The fixed assets turnover ratio is calculated by dividing sales by fixed assets. However, different industries may have different proportions of fixed assets to total assets, which makes it difficult to use this ratio to compare firms in different industries. Therefore, it is not necessary for all the firms being compared to use the same proportion of fixed assets to total assets.

Question 20

Market value ratios provide management with a current assessment of how investors in the market view the firm's past performance and future prospects.

Accepted Answer

Market value ratios, such as price-to-earnings ratio and market-to-book ratio, reflect the market's perception of a company's current and future performance. This information can be used by management to evaluate their strategies and make decisions about the company's future direction.

Quiz 8: Analysis of Financial Statements