Question 1

Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. Under these conditions, then firms that have 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

Asset turnover ratio is a measure of how efficiently a company uses its assets to generate sales, and it is not directly correlated with profit margins. A firm can have a high profit margin with a low asset turnover if it sells high-margin products less frequently, or a low profit margin with a high asset turnover if it sells low-margin products more frequently.

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 current and quick ratios are commonly used as quick measures of a firm's liquidity position without requiring a full cash budget analysis.

Question 3

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 and market-to-book ratio, reflect investors' expectations about the future performance of the firm and its ability to generate profits and growth. These ratios are used by management to assess the company's attractiveness and competitiveness in the market.

Question 4

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. A company whose sales are seasonal may have a high apparent financial position during the peak season but a low apparent financial position during the off-season. This can be misleading if the financial statements are only based on a certain time period, and it is important to take into account the seasonal variations in sales when analyzing a company's financial position.

Question 5

Firms A and B have the same current ratio, 0.75, the same amount of sales, and the same amount of current liabilities. However, Firm A has a higher inventory turnover ratio than B. Therefore, we can conclude that A's quick ratio must be smaller than B's.

Accepted Answer

The inventory turnover ratio is calculated as sales divided by inventory. If Firm A has a higher inventory turnover ratio, it means that their inventory is selling faster than Firm B's. This could be an indication of better sales or more efficient inventory management.

However, the quick ratio only takes into account the most liquid assets (cash and accounts receivable) and excludes inventory. If Firm A has more inventory, but also has more cash and accounts receivable than Firm B, their quick ratio could still be higher. Therefore, we cannot conclude that A's quick ratio must be smaller than B's based solely on the information given.

Question 6

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 that of B.

Accepted Answer

The quick ratio excludes inventory from current assets, focusing on more liquid assets, whereas the current ratio includes all current assets. It's possible for Firm A to have a higher quick ratio due to more liquid assets but still have a lower current ratio if Firm B has significantly more inventory or other current assets.

Question 7

The current ratio and inventory turnover ratios 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 inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash.

Accepted Answer

The statement accurately describes the current ratio and inventory turnover ratio as measures of a firm's liquidity.

Question 8

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 comparing financial data from multiple time periods to identify patterns and changes in a firm's performance over time. This allows for a more comprehensive assessment of a firm's financial position and whether it is improving or deteriorating.

Question 9

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 should be used with caution in comparing firms that do not have the same proportion of fixed assets to total assets, as firms with a higher proportion of fixed assets will generally have a lower turnover ratio. Comparing firms with different proportions of fixed assets would require additional analysis to accurately evaluate their effectiveness in managing fixed assets.

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, specifically measure a firm's use of financial leverage to generate returns for owners. Therefore, the statement is true.

Question 11

The basic earning power ratio (BEP) reflects 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 without considering the impact of financial leverage and tax effects; it is calculated before interest and taxes.

Question 12

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 means that the firm is holding more inventory for a longer period of time, which can tie up its cash and reduce its liquidity position. Therefore, it suggests that the firm is managing its inventory less efficiently and becoming less liquid.

Question 13

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

Accepted Answer

Ratio analysis is a technique used to evaluate the financial performance of a company by analyzing different financial ratios, which are calculated based on information from the financial statements. It helps in assessing a firm's financial position, profitability, liquidity, activity, and solvency. Therefore, the statement is true.

Question 14

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

Accepted Answer

Profitability ratios take into account the operating results and how they are influenced by the company's liquidity, asset management, and debt management.

Question 15

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 ROA if they have different levels of investment in assets. A firm with a lower investment in assets will have a higher ROA than a firm with a higher investment in assets, even if both firms have the same EBIT.

Question 16

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 ratio is one way to assess a firm's ability to meet its debt obligations, but it is not the only factor to consider. Other factors include cash flow, liquidity, and overall financial health.

Question 17

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

Accepted Answer

High current and quick ratios alone do not necessarily indicate effective management of liquidity. Other factors, such as cash flow and debt management, must also be considered.

Question 18

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 days sales outstanding (DSO) measures how quickly a company is able to collect payment from its customers. Both ratios are used to assess the effectiveness of a company's asset management.

Question 19

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

This is true because differences in accounting methods can result in different values for certain financial metrics and ratios, making it harder to compare performance between companies using different methods. For example, one company may use the LIFO method for inventory valuation, while another may use FIFO, leading to different cost of goods sold and inventory values. This can impact financial ratios such as gross margin and inventory turnover, making it harder to make meaningful comparisons between the two companies.

Question 20

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

A high current ratio indicates that a company has enough current assets to pay off its current liabilities, but if the inventory turnover ratio is low, it suggests that the company may be carrying too much inventory or that some of it may be obsolete or damaged. Therefore, a high current ratio and low inventory turnover ratio, relative to industry norms, can suggest that the firm is carrying excess inventory, which may lead to decreased profitability and increased costs.

Quiz 3: Analysis of Financial Statements