Question 1

The magnification of risk and return introduced through the use of fixed-cost financing such as debt and preferred stock is called financial leverage.

Accepted Answer

Financial leverage refers to the use of fixed-cost financing such as debt and preferred stock, which amplifies the potential return and risk for a business or investor.

Question 2

The comparison of a particular ratio to the standard (industry average) is made in order to isolate any deviations from the norm. In the case of ratios for which higher values are preferred, as long as the firm being analyzed has a value in excess of the industry average it can be viewed favorably.

Accepted Answer

A higher ratio than the industry average is generally favorable, but it must be analyzed in context, considering other factors such as sustainability, risk, and the specific circumstances of the firm.

Question 3

The average age of inventory is viewed as the average length of time inventory is held by the firmor as the average number of days' sales in inventory.

Accepted Answer

The average age of inventory is indeed viewed as the average length of time inventory is held by the firm or as the average number of days' sales in inventory.

Question 4

If an analysis is concerned only with certain specific aspects of a firm's financial position, one or two ratios may provide sufficient information from which to make a reasonable judgement.

Accepted Answer

If the analysis is limited to a specific aspect, then one or two relevant ratios can provide adequate information for evaluation. However, if a more comprehensive analysis is required, multiple ratios and other financial indicators will need to be considered.

Question 5

In cross-sectional comparison of firms operating in several lines of business, the industry average ratios of any of the firms' product lines may be used to analyze the multiproduct firm's financial performance.

Accepted Answer

In cross-sectional comparison of firms operating in several lines of business, it is not appropriate to use industry average ratios for any of the firms' product lines to analyze the multiproduct firm's financial performance. Each product line should be analyzed separately using appropriate financial ratios to understand its performance.

Question 6

The DuPont formula allows the firm to break down its return into the net profit margin, which measures the firm's profitability on sales, and its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales.

Accepted Answer

The statement accurately describes the DuPont formula, which is a widely used tool for analyzing a company's return on equity (ROE).

Question 7

Typically, higher coverage ratios are preferred, but too high a ratio may indicate under utilization of fixed-payment obligations, which may result in unnecessarily low risk and return.

Accepted Answer

This statement is true. While high coverage ratios indicate better ability to meet financial obligations, if they are too high, it may indicate that the company is not utilizing their fixed-payment obligations effectively, leading to lower risk and return. Therefore, a balance needs to be maintained.

Question 8

The current ratio provides a better measure of overall liquidity only when a firm's inventory cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall liquidity.

Accepted Answer

The answer of The current ratio provides a better measure...

Question 9

The less fixed-cost debt, or financial leverage, a firm uses, the greater will be its risk and return.

Accepted Answer

The statement is incorrect. The less fixed-cost debt a firm uses, the lower its risk will be. When a firm has less fixed-cost debt, it has less financial leverage and is less vulnerable to bankruptcy or default. However, the return may also be lower as there is less leverage to amplify returns.

Question 10

The lower the fixed-payment coverage ratio, the lower is the firm's financial leverage.

Accepted Answer

The fixed-payment coverage ratio measures a firm's ability to meet its fixed obligations such as interest and lease payments. A lower fixed-payment coverage ratio indicates a higher level of financial leverage, as the firm may have difficulty meeting its fixed obligations if its earnings decrease.

Question 11

As a rule, the necessary inputs to an effective financial analysis include, at minimum, the income statement and the statement of cash flow.

Accepted Answer

The answer of As a rule, the necessary inputs to...

Question 12

Due to inflationary effects, inventory costs and depreciation write-offs can differ from their true values, thereby distorting profits.

Accepted Answer

Inflation can cause inventory costs and depreciation write-offs to be inaccurately reported, leading to distorted profit figures.

Question 13

The use of the audited financial statements for ratio analysis may not be preferable because there may be no reason to believe that the data contained in them reflect the firm's true financial condition.

Accepted Answer

The use of audited financial statements is preferable for ratio analysis as they are required to reflect the true financial condition of the firm. The audited financial statements are prepared by certified public accountants (CPAs) who assure that the financial statements conform to generally accepted accounting principles (GAAP) and are free from material misstatements. Therefore, the data contained in them provide a reliable basis for ratio analysis.

Question 14

If a firm has annual sales of $600,000, a gross profit margin of 40% and an average inventory balance of $60,000, the firm's inventory period is 60 days (two months).

Accepted Answer

Inventory period = (average inventory balance / cost of sales) x 365 days
Cost of sales = Annual sales x (100% - Gross profit margin)
Cost of sales = $600,000 x (100% - 40%) = $360,000
Inventory period = ($60,000 / $360,000) x 365 days = 60 days

Question 15

The higher the debt ratio, the more financial leverage a firm has and, thus, the greater will be its risk and return.

Accepted Answer

A higher debt ratio means that a firm has a larger proportion of its financing coming from debt, which increases its financial leverage. Financial leverage can increase a company's risk and return, as the interest payments on debt must be made regardless of the company's performance. Higher leverage can lead to larger profits or losses, making it riskier compared to lower debt ratios. Therefore, a higher debt ratio implies higher risk and return for a firm.

Question 16

Time-series analysis is the evaluation of the firm's financial performance in comparison to other firms at the same point in time.

Accepted Answer

Time-series analysis compares a firm's financial performance over time, rather than in comparison to other firms at the same point in time.

Question 17

The higher the value of the times interest earned ratio, the higher the proportion of the firm's interest earnings compared to its contractual interest payments.

Accepted Answer

The times interest earned ratio measures a firm's ability to meet its interest obligations, not the proportion of interest earnings. A higher ratio indicates better ability to cover interest payments, not a higher proportion of interest earnings.

Question 18

The inflationary effects typically have greater impact, the larger the differences in the age of the assets of the firms being compared. Without adjustment, inflation tends to cause older firms (older assets) to appear more efficient and profitable than newer firms (newer assets).

Accepted Answer

This is because inflation makes the value of assets decrease over time, and older assets may have a lower depreciated value compared to newer assets. Therefore, older firms may appear to have higher profits compared to newer firms even if they are similarly performing.

Question 19

The return on total assets (ROA) measures the overall effectiveness of management in generating profits with the owners' investment in the firm.

Accepted Answer

ROA measures the effectiveness of management in generating profits with the firm's total assets, not just the owners' investment.

Question 20

Benchmarking is a type of time-series analysis in which the firm's ratio values are compared to those of a key competitor or group of competitors, primarily to isolate areas of opportunity for improvement.

Accepted Answer

Benchmarking involves comparing a company's processes, performance metrics, and products to industry best practices or leading competitors, but it is not a type of time-series analysis. Time-series analysis involves analyzing data points collected or recorded at specific time intervals to identify trends, cycles, or seasonal variations over time.

Quiz 3: Financial Statement Analysis