Question 1

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 2

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

Accepted Answer

Operating margin is a measure of a company's operational efficiency and profitability from its core business activities, and it is not directly affected by the amount of debt a firm uses. Debt affects financial leverage and interest expenses, which impact net income and financial ratios, but not operating margin.

Question 3

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

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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 sales...

Question 5

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 as the financial position of a seasonal company can fluctuate based on the time of year the financial statements are prepared. For example, a company that sells Halloween costumes may appear to be profitable in October but may have a negative financial position in January when sales decrease significantly.

Question 6

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 measures how efficiently a company is using its fixed assets to generate sales. However, the ratio may not be comparable between companies if they have different proportions of fixed assets to total assets. Therefore, it is not appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if the firms being compared have different proportions of fixed assets to total assets.

Question 7

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 incurs interest expenses that reduce its net profit. This, in turn, leads to a lower profit margin, which is the ratio of net profit to revenue. Therefore, holding other factors constant, increasing debt can lead to lower profit margins.

Question 8

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 asset financing (i.e. one firm may have more debt financing than the other, which affects its ROA).

Question 9

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 statement is true. Different accounting methods can lead to differences in financial reporting, which can make it difficult to accurately compare financial ratios across firms.

Question 10

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, suggesting that they perceive the company as less risky and/or having higher growth potential in the future.

Question 11

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 the firm has enough current assets to cover its current liabilities. However, a low inventory turnover ratio suggests that the firm is not efficiently selling its inventory. If the firm has an above-average inventory level, it may be experiencing a backlog of inventory that has not been sold. If part of the inventory is obsolete or damaged, this can also contribute to a low inventory turnover ratio. Overall, this combination suggests that the firm may have excess inventory that is not generating sufficient revenue.

Question 12

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

Accepted Answer

This statement is a generalization of the financial principle known as the "pecking order theory," which suggests that a firm will first use internal financing (retained earnings) before turning to debt financing. This theory postulates that debt financing is considered a "last resort" due to its associated costs (e.g., interest payments, bankruptcy risk). As a result, the more debt a firm uses, the greater its financial risk and, therefore, the lower its return on total assets.

Question 13

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 BEP ratio only considers a company's operating income and total assets, and does not factor in debt or taxes. This makes it a useful metric for evaluating a company's operating efficiency independent of financing and tax strategies. The return on total assets, on the other hand, takes into account both operating income and financing costs, and may be influenced by a company's debt and tax situation.

Question 14

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 perceive a company as risky and/or with poor growth prospects, they will typically demand a higher rate of return, resulting in lower P/E and M/B ratios. Therefore, if a company has high P/E and M/B ratios, it may indicate that investors see it as relatively safe with strong growth potential.

Question 15

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 the market's perception of a company's future earnings potential and growth prospects. Therefore, they can be used by management to assess the company's standing in the eyes of investors and to make strategic decisions about future investments and operations.

Question 16

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

By increasing the equity multiplier to 2.0, the ROE would increase from 7.5% to 15.0% [(1.5 times 5.0%)+(7.5%)]. Even though the profit margin would decrease to 4.5%, the overall effect of the leverage increase would be positive.

Question 17

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 is a correct statement. Generally, companies with higher P/E ratios are seen as more attractive to investors due to the expectation of future growth potential. However, a high P/E ratio can also indicate that the stock is overvalued and may not necessarily indicate a better investment opportunity.

Question 18

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).

Accepted Answer

The return on common equity (ROE) is actually more significant from a stockholder's viewpoint as it measures the profitability of the company from the shareholders' perspective. ROA only takes into account the profitability of the company's assets, not necessarily the returns earned by the shareholders.

Question 19

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 measure of how efficiently a company uses its capital to generate profits and return value to shareholders. It is a ratio that measures the amount of return earned per dollar of invested capital.

Question 20

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

The statement is true. ROIC is based on total invested capital rather than total assets, and it uses after-tax operating income as the numerator. ROA, on the other hand, is based on total assets and uses net income as the numerator.

Quiz 4: Analysis of Financial Statements