Question 1

Which of the following statements is CORRECT?
A) Other things held constant, the less debt a firm uses, the lower its return on total assets will be.
B) 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.
C) 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).
D) 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 more risky and/or less likely to enjoy higher future growth.
E) Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's debt ratio is 70% versus 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 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. This means that the BEP only considers factors related to operating efficiency, making it a more effective measure in comparing companies within the same industry.

Question 2

Which of the following statements is CORRECT?
A) Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase.
B) Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE.
C) The DuPont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE.
D) Other things held constant, an increase in the debt ratio will result in an increase in the profit margin.
E) Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 3

Companies HD and LD have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?
A) Company HD has a lower equity multiplier.
B) Company HD has more net income.
C) Company HD pays more in taxes.
D) Company HD has a lower ROE.
E) Company HD has a lower times-interest-earned (TIE) ratio.

Accepted Answer

The answer of Companies HD and LD have the same...

Question 4

Which of the following statements is CORRECT?
A) If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average, and was increasing and trending still higher, this would be interpreted as a sign of strength.
B) A high average DSO indicates that none of its customers are paying on time. In addition, it makes no sense to evaluate the firm's DSO with the firm's credit terms.
C) There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things.
D) A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.
E) If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

Accepted Answer

A decrease in days' sales outstanding is equivalent to a shorter ACP (average collection period). If a firm increases its sales while keeping accounts receivable constant, the firm's ACP could diminish, as collections will likely increase.

Question 5

Companies HD and LD are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company HD has the higher debt ratio. Which of the following statements is CORRECT?
A) Company HD has a lower total assets turnover than Company LD.
B) Company HD has a lower equity multiplier than Company LD.
C) Company HD has a higher fixed assets turnover than Company LD.
D) Company HD has a higher ROE than Company LD.
E) Company HD has a lower operating income (EBIT) than Company LD.

Accepted Answer

Since both companies have the same total assets, sales, ROA, and PM, the only difference between the two is their debt ratio. A higher debt ratio means Company HD has a higher leverage, which leads to a higher ROE. Therefore, Company HD has a higher ROE than Company LD.

Question 6

Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?
A) Company HD pays less in taxes.
B) Company HD has a lower equity multiplier.
C) Company HD has a higher ROA.
D) Company HD has a higher times-interest-earned (TIE) ratio.
E) Company HD has more net income.

Accepted Answer

The answer of Companies HD and LD have the same...

Question 7

Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company HD has a higher debt ratio. Which of the following statements is CORRECT?
A) Given this information, LD must have the higher ROE.
B) Company LD has a higher basic earning power ratio (BEP).
C) Company HD has a higher basic earning power ratio (BEP).
D) If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company HD will have the higher ROE.
E) If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company HD will have the higher ROE.

Accepted Answer

The answer of Companies HD and LD have the same...

Question 8

HD Corp and LD Corp have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, HD uses more debt than LD. Which of the following statements is CORRECT?
A) Without more information, we cannot tell if HD or LD would have a higher or lower net income.
B) HD would have the lower equity multiplier for use in the DuPont equation.
C) HD would have to pay more in income taxes.
D) HD would have the lower net income as shown on the income statement.
E) HD would have the higher operating margin.

Accepted Answer

Since HD uses more debt than LD, it would have a higher interest expense. This would result in a lower net income for HD as compared to LD, all else being equal. Therefore, D is the correct answer. We cannot determine the equity multiplier for HD or LD without more information, and we also cannot determine which company would pay more in income taxes or have a higher operating margin based on the given information.

Question 9

Walter Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio?
A) Borrow using short-term notes payable and use the cash to increase inventories.
B) Use cash to reduce accruals.
C) Use cash to reduce accounts payable.
D) Use cash to reduce short-term notes payable.
E) Use cash to reduce long-term bonds outstanding.

Accepted Answer

The answer of Walter Industries' current ratio is 0.5. Considered...

Question 10

Safeco's current assets total to $20 million versus $10 million of current liabilities, while Risco's current assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so they tentatively plan to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions?
A) The transactions would improve Safeco's financial strength as measured by its current ratio but lower Risco's current ratio.
B) The transactions would lower Safeco's financial strength as measured by its current ratio but raise Risco's current ratio.
C) The transactions would have no effect on the firm' financial strength as measured by their current ratios.
D) The transactions would lower both firm' financial strength as measured by their current ratios.
E) The transactions would improve both firms' financial strength as measured by their current ratios.

Accepted Answer

The current ratio is calculated by dividing current assets by current liabilities.

Before borrowing, Safeco's current ratio is 2 ($20 million / $10 million) and Risco's current ratio is 0.5 ($10 million / $20 million).

After borrowing, Safeco's current assets increase to $30 million while current liabilities remain at $10 million. This results in a current ratio of 3 ($30 million / $10 million), which is an improvement in financial strength.

On the other hand, Risco's current assets also increase to $20 million, but current liabilities increase to $30 million due to the borrowing. This results in a current ratio of 0.67 ($20 million / $30 million), which is a decrease in financial strength.

Therefore, option B is the correct answer.

Question 11

Which of the following statements is CORRECT?
A) Other things held constant, the more debt a firm uses, the higher its operating margin will be.
B) 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.
C) Other things held constant, the more debt a firm uses, the higher its profit margin will be.
D) Other things held constant, the higher a firm's debt ratio, the higher its TIE ratio will be.
E) Debt management ratios show the extent to which a firm's managers are attempting to reduce risk through the use of financial leverage. The higher the debt ratio, the lower the risk.

Accepted Answer

Debt management ratios, such as debt-to-equity ratio or interest coverage ratio, show the level of financial leverage a company is using to magnify returns on owners' equity. Option A and C are incorrect because more debt does not necessarily lead to higher operating or profit margins. Option D is also incorrect because a higher debt ratio implies higher financial risk, which can result in lower TIE (times interest earned) ratio. Option E is incorrect because higher debt ratios generally lead to higher financial risk, so managers may use debt to increase returns but at the same time increase the risk.

Question 12

Which of the following statements is CORRECT?
A) The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio.
B) If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.
C) An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio.
D) An increase in the DSO, other things held constant, could be expected to increase the ROE.
E) An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower its profit margin.

Accepted Answer

An increase in a firm's debt ratio will increase its interest expense, which will lower its net income and therefore its profit margin. The other statements are either incorrect or do not have a clear relationship between the variables mentioned.

Question 13

Which of the following statements is CORRECT?
A) If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be equal.
B) If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same.
C) If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price/earnings ratio.
D) If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and/or be expected to grow at a faster rate.
E) If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same.

Accepted Answer

P/E ratio is calculated by dividing price per share by earnings per share. Therefore, if two firms have the same net income, number of shares outstanding, and price per share, they will also have the same earnings per share and thus the same P/E ratio. However, the market-to-book ratio is calculated by dividing the market value of equity by the book value of equity, and does not necessarily have a direct relationship with the P/E ratio.

Question 14

Which of the following statements is CORRECT?
A) 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.
B) The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects.
C) 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.
D) 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 more risky and/or less likely to enjoy higher future growth.
E) 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 answer of Which of the following statements is CORRECT?
A)...

Question 15

Which of the following statements is CORRECT?
A) If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses.
B) A firm's use of debt will have no effect on its profit margin.
C) If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales and a lower return on assets.
D) The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.
E) If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a higher operating margin and return on assets.

Accepted Answer

The use of debt increases a firm's financial risk, which in turn can lower its profitability. This is because interest and principal payments on debt must be made regardless of a company's revenue or profits. Therefore, if two firms have identical operations but one uses more debt, the firm with higher debt will have lower profits and return on assets. The other statements are incorrect.

Question 16

Which of the following statements is CORRECT?
A) 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.
B) In general, it's better to have a low inventory turnover ratio than a high one, as a low one 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.
C) If a firm's fixed assets turnover ratio is significantly lower 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.
D) The more conservative a firm's management is, the higher its debt ratio is likely to be.
E) The days sales outstanding ratio 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.

Accepted Answer

The statement that is correct is E. The days sales outstanding ratio (DSO) measures the average time it takes for a firm to collect a payment after a sale has been made. It can be compared to the firm's credit terms to determine if customers are paying on time. A lower DSO is generally better since it indicates that a firm is collecting payments more quickly.

Question 17

Which of the following statements is CORRECT?
A) 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.
B) Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio.
C) 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.
D) 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.
E) Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money, use it to buy back stock, and raise the debt ratio to 50% and the equity multiplier to 2.0. 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 not be a good move, as it would decrease the ROE from 7.5% to 6.5%.
Multiple Choice: Problems
A good bit of relatively simple algebra is involved in these problems, and although the calculations are simple, it will take students some time to set up the problems and do the arithmetic. We allow for this when assigning problems for a timed test. Also, note that students must know the definitions of a number of ratios to answer the questions. We provide our students with a formula sheet on exams, using the relevant sections of

Accepted Answer

This statement is correct as a firm can calculate the amount of sales required to achieve its target TIE ratio using the given information of its debt, interest rate on that debt, applicable tax rate, and operating costs. Statements A, C, D and E are incorrect as they make false assumptions or statements that are not necessarily true.

Question 18

Which of the following statements is CORRECT?
A) If a firm has high current and quick ratios, this always indicate that the firm is managing its liquidity position well.
B) If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decline.
C) If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would decline.
D) 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.
E) The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 19

You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT?
A) Its total assets turnover must be above the industry average.
B) Its return on assets must equal the industry average.
C) Its TIE ratio must be below the industry average.
D) Its total assets turnover must be below the industry average.
E) Its total assets turnover must equal the industry average.

Accepted Answer

Since the firm's ROE is above the industry average, it must be generating higher profits per dollar of equity compared to its peers. However, its profit margin is below the industry average, indicating that it has lower profitability per dollar of sales. Therefore, the only way the firm can achieve a higher ROE is by having a higher total assets turnover. This means that the firm is generating more sales per dollar of assets, which in turn boosts its ROE. The debt ratio is irrelevant to the analysis since it does not directly impact profitability or efficiency. The TIE ratio, on the other hand, relates to the firm's ability to pay interest on its debt and is also not related to profitability or efficiency.

Question 20

Taggart Technologies is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Taggart pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue?
A) The ROA will decline.
B) Taxable income will decline.
C) The tax bill will increase.
D) Net income will decrease.
E) The times-interest-earned ratio will decrease.

Accepted Answer

The answer of Taggart Technologies is considering issuing new common...

Quiz 4: Statement Analysis

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Companies HD and LD have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Companies HD and LD are both profitable, and they have the same total assets (TA) , Sales (S) , return on assets (ROA) , and profit margin (PM) . However, Company HD has the higher debt ratio. Which of the following statements is CORRECT?

Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?

Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company HD has a higher debt ratio. Which of the following statements is CORRECT?

HD Corp and LD Corp have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, HD uses more debt than LD. Which of the following statements is CORRECT?

Walter Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT?