Question 1

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 in the future.

Accepted Answer

This statement is true. A higher M/B ratio indicates that investors are willing to pay more for each dollar of accounting book value, which suggests that they have higher expectations for the company's future growth and/or lower perceived risk. Companies with lower M/B ratios, on the other hand, may be seen as riskier or slower-growing.

Question 2

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 in the future.

Accepted Answer

This statement is true. High P/E ratios can indicate investor optimism and may suggest that the market expects the company's earnings to increase in the future. However, a high P/E ratio can also indicate that a company is overvalued and may not be a good investment.

Question 3

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

Accepted Answer

When a firm uses more debt, its cost of capital increases due to higher interest payments, which reduces the return on its assets. This is because the returns to the firm's assets must first be used to pay off its debt before being available to the equity shareholders.

Question 4

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

Accepted Answer

The answer of Other things held constant, a decline in...

Question 5

Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a profit margin of 8% 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 the cause of Firm A's higher profit margin.

Accepted Answer

The answer of Suppose you are analyzing two firms in...

Question 6

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

Accepted Answer

The return on invested capital (ROIC) is a financial metric that measures how efficiently a company uses its capital to generate profits for its investors. It takes into account both the amount of capital invested in the business and the income generated from that investment.

Question 7

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.

Accepted Answer

If investors regard a company as being relatively risky and/or having relatively poor growth prospects, then it will have relatively low P/E and M/B ratios. This is because investors are willing to pay less for each dollar of earnings or book value due to the company's perceived risk and growth prospects.

Question 8

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.

Accepted Answer

The fixed assets turnover ratio compares a company's sales to its fixed assets, regardless of the proportion of fixed assets to total assets. It is a relative measure of how well a company utilizes its fixed assets to generate revenue, but it cannot be used to directly compare firms with different asset structures.

Question 9

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

Accepted Answer

The basic earning power ratio (BEP) is calculated by dividing earnings before interest and taxes (EBIT) by total assets, and therefore does not take into account the effects of debt and taxes. In contrast, the return on total assets (ROA) includes both interest and taxes in its calculation, and as such may not be as accurate of a measure of a company's operating efficiency.

Question 10

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

Accepted Answer

Market value ratios, such as price-earnings ratio and market-to-book ratio, are used by investors to evaluate a company's future prospects and growth potential. These ratios reflect investors' expectations of the firm's future financial performance and can provide valuable insights for management.

Question 11

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.

Accepted Answer

This is because different accounting methods can result in different financial statements, which in turn can affect the calculation of financial ratios. This can make comparisons between firms less accurate or meaningful.

Question 12

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

Accepted Answer

When a firm uses debt to finance its operations, it has to pay interest on that debt. This interest expense reduces the firm's net income, which in turn lowers its profit margin. Therefore, other things held constant, the more debt a firm uses, the lower its profit margin will be.

Question 13

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.

Accepted Answer

The answer of Even though Firm A's current ratio exceeds...

Question 14

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

Accepted Answer

Increasing the equity multiplier through the use of debt can increase the ROE, as long as the interest rate on the debt is lower than the return the company is able to achieve with the borrowed funds. In this case, the proposed debt would lower the profit margin but increase the ROE, making it a good move.

Question 15

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.

Accepted Answer

This statement is true. Seasonal fluctuations in sales can affect the timing and amount of revenue, expenses, and profits reported on financial statements. Therefore, the financial position presented in financial statements may only reflect a certain point in time and may not reflect the company's overall financial health throughout the year.

Question 16

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.

Accepted Answer

The answer of Suppose all firms follow similar financing policies,...

Question 17

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.

Accepted Answer

The statement is true as a high current ratio indicates good liquidity, but a low inventory turnover ratio suggests that the inventory is not being sold quickly enough. This combination can indicate that the company is maintaining a high inventory level, which in turn can lead to excess, obsolete or damaged inventory.

Question 18

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.

Accepted Answer

As stated, ROIC is based on total invested capital and after-tax operating income, while ROA is based on total assets and net income.

Question 19

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.

Accepted Answer

While two firms with the same EBIT may have equal operating performance, their ROA can differ if they have different levels of asset financing, such as different levels of debt or equity. This is because their net income and average total assets would differ, resulting in different ROA calculations.

Question 20

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

Accepted Answer

The answer of Other things held constant, the more debt...

Quiz 4: Analysis of Financial Statements