Question 1

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to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged.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 inventory turnover ratio measures how efficiently a company manages its inventory by dividing the cost of goods sold by average inventory. A low inventory turnover ratio indicates that a company is not selling its inventory quickly enough, which can lead to higher holding costs, storage costs, and potential obsolescence. On the other hand, the current ratio measures a company's ability to pay off its short-term liabilities with its current assets. A high current ratio indicates that a company has enough current assets to cover its short-term obligations. However, a high current ratio combined with a low inventory turnover ratio suggests that the company may have excess inventory, obsolete or damaged items, which could negatively impact overall profitability.

Question 2

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

Two firms with the same EBIT can have different ROAs if they have different levels of assets. ROA is calculated as EBIT divided by total assets, so if two firms have the same EBIT but one has more assets than the other, the one with fewer assets will have a higher ROA.

Question 3

Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods.

Accepted Answer

When firms use different accounting methods, their financial statements may not be directly comparable. This can make it difficult to accurately compare ratios between firms and draw meaningful conclusions about their relative financial health.

Question 4

High current and quick ratios ALWAYS indicate that a firm is managing its liquidity position well.

Accepted Answer

While high current and quick ratios may indicate that a firm has good liquidity, it does not necessarily mean that the firm is managing its liquidity position well. High ratios could be due to factors such as low levels of inventory or a large amount of cash reserves, but these may not necessarily be managed effectively in the long term. Effective liquidity management involves not only having high liquidity ratios, but also using the liquidity effectively to generate profits and grow the business.

Question 5

To take full advantage of the credit term provided, management should try to lengthen the average payables period with cautions.

Accepted Answer

Lengthening the payables period means delaying payments to suppliers, which can improve cash flow and allow for more time to use funds for other purposes. However, caution must be taken to not damage relationships with suppliers or negatively affect the company's credit score.

Question 6

Determining whether a firm's financial position is improving or deteriorating requires analyzing more than the ratios for a given year. Trend analysis is one method of measuring changes in a firm's performance over time.

Accepted Answer

Trend analysis involves comparison of financial ratios and other data over several years to determine changes in a firm's financial position and performance. This is necessary to understand whether the firm is improving or declining in its financial health over time.

Question 7

The basic earning power ratio (BEP) shows the earning power of a firm's assets after giving consideration to financial leverage and tax effects.

Accepted Answer

The basic earning power (BEP) ratio measures a firm's earning power from its assets before the influence of financial leverage and taxes, focusing solely on its operational efficiency.

Question 8

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-to-earnings ratio (P/E ratio) and market-to-book ratio provide insights into how investors perceive a company's potential for growth and profitability in the future, based on its current market price and book value. Therefore, these ratios can help management evaluate the effectiveness of their strategies and identify areas for improvement to enhance the company's market perception and value.

Question 9

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 as quick measures of a firm's liquidity position, but a more comprehensive analysis would require a cash budget to fully evaluate a company's ability to meet financial obligations.

Question 10

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.

Accepted Answer

Debt management ratios, such as debt to equity ratio and interest coverage ratio, reflect a firm's use of financial leverage to maximize returns on owners' capital. Therefore, the statement is true.

Question 11

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

Accepted Answer

Ratio analysis is a tool used to evaluate the financial performance of a company by comparing information from its financial statements. It involves calculating and interpreting key ratios such as liquidity, profitability, efficiency, and solvency. The results are used to assess the company's financial position, performance, and potential for growth.

Question 12

The average collection period tells how many days it takes a business to pay money for trade credits to its suppliers.

Accepted Answer

The average collection period actually refers to how long it takes a business to collect payment for goods or services it has sold to customers. It is measured in days.

Question 13

The times-interest-earned ratio is one, but not the only, indication of a firm's ability to meet its long- term and short-term debt obligations.

Accepted Answer

The times-interest-earned (TIE) ratio measures a company's ability to meet its interest payments on its debt. While it is an important indicator, it should not be the only factor considered when evaluating a firm's ability to meet its debt obligations. Other factors like cash flow, debt-to-equity ratio, and overall financial health should also be taken into account.

Question 14

Current ratio and quick ratio both help us measure the firm's liquidity. The current ratio measures the relationship of a firm's current assets to its current liabilities, while the quick ratio subtracts inventory from other current assets.

Accepted Answer

This is a true statement.

Question 15

The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed.

Accepted Answer

This statement is true. Since the sales of a seasonal company vary throughout the year, their financial position may appear strong during peak seasons and weak during off-seasons. Therefore, the financial statements of a seasonal company need to be analyzed considering the seasonality effect.

Question 16

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 is calculated by dividing a company's sales by its fixed assets. It is used to determine how effectively a company is using its fixed assets to generate revenue. However, this ratio should not be used to compare companies with different proportions of fixed assets to total assets as it may be skewed. For example, a company with a higher proportion of fixed assets may have a lower fixed assets turnover ratio but can still be generating more revenue from its fixed assets. Therefore, it is not appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if they have different proportions of fixed assets to total assets.

Question 17

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

Accepted Answer

Profitability ratios take into account a company's ability to generate profits based on its liquidity, asset management, and debt management. By measuring the return on investment, profit margins, and other metrics, these ratios provide a comprehensive picture of a company's financial health and performance.

Question 18

A decline in a firm's inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid.

Accepted Answer

A decline in inventory turnover ratio indicates that a firm is selling its inventory less frequently, which can be a sign of poor inventory management and potentially decreased liquidity.

Question 19

The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its assets.

Accepted Answer

The inventory turnover ratio measures how efficiently a company is managing its inventory, while the DSO measures how long it takes for the company to collect cash from its sales. Both ratios are used to evaluate a company's asset management.

Question 20

Other things held constant, a decline in sales and a simultaneous increase in financial leverage must result in a lower profit margin.

Accepted Answer

A decline in sales would typically lead to lower profits, but an increase in financial leverage does not directly affect profit margins. Financial leverage amplifies the returns (or losses) on equity but does not inherently change the profit margin, which is calculated before the effects of financing are considered.

Quiz 3: Analysis of Financial Statements