Question 1

Companies E and P each reported the same earnings per share (EPS), but Company E's stock trades at a higher price. Which of the following statements is correct?
A) Company E probably has fewer growth opportunities than company P.
B) Company E is probably judged by investors to be riskier than company P.
C) Company E must pay a lower dividend than company P.
D) Company E trades at a higher P/E ratio than company P.

Accepted Answer

Since the two companies have the same EPS but Company E is trading at a higher price, this means that Company E is probably trading at a higher P/E ratio than Company P. This suggests that investors are willing to pay more for each dollar of Company E's earnings compared to Company P, indicating that Company E is perceived to have better growth prospects or less risk.

Question 2

A firm's new president wants to strengthen the company's financial position. Which action would make it financially stronger?
A) Increase accounts receivable while holding sales constant.
B) Increase EBIT while holding sales constant.
C) Increase accounts payable while holding sales constant.
D) Increase notes payable while holding sales constant.

Accepted Answer

Increasing EBIT (earnings before interest and taxes) while holding sales constant would make the company financially stronger. This means the company is generating more profit from its operations, which can be used to pay off debts or invest in growth opportunities. Increasing accounts receivable, accounts payable, or notes payable would not necessarily make the company stronger, as it could indicate an increase in debt or slower collection of cash from customers.

Question 3

A firm wants to strengthen its financial position. Which action would increase its current ratio?
A) Use cash to repurchase some of the company's own stock.
B) Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than 1 year.
C) Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.
D) Use cash to increase inventory holdings.

Accepted Answer

The current ratio is calculated as current assets divided by current liabilities. Issuing new stock increases cash (a current asset) without immediately increasing current liabilities, thus improving the current ratio. Using some of the proceeds to purchase additional inventory also increases current assets, further improving the ratio. Holding the remainder as cash maintains the improved ratio.

Question 4

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 current ratio and quick ratio measure different aspects of a company's liquidity. It's possible for Firm A to have a higher quick ratio than Firm B while still having a lower current ratio, as these ratios consider different sets of assets in their calculations. The quick ratio excludes inventory and other less liquid current assets, focusing on those assets that can be quickly converted to cash.

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 than B. Therefore, we can conclude that A's quick ratio must be smaller than B's.

Accepted Answer

The quick ratio only considers assets that can be easily converted into cash, such as accounts receivable and cash equivalents. Inventory is not considered in the quick ratio calculation. Since Firm A has a higher inventory, it will have a higher current ratio but this does not necessarily means that its quick ratio will be smaller than B's. Therefore, the statement is false.

Question 6

Considered alone, which of the following would increase a company's current ratio?
A) an increase in net fixed assets
B) an increase in accrued liabilities
C) an increase in notes payable
D) an increase in accounts receivable

Accepted Answer

Current ratio is calculated by dividing current assets by current liabilities. Increasing accounts receivable (a current asset) would increase the numerator without affecting the denominator, leading to an increase in the current ratio. The other options would either decrease the numerator or increase the denominator, leading to a decrease in the current ratio.

Question 7

Casey Communications recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. What would occur as a result of this action?
A) The company's current ratio would increase.
B) The company's times-interest-earned ratio would decrease.
C) The company's basic earning power ratio would increase.
D) The company's equity multiplier would increase.

Accepted Answer

When Casey Communications pays off some of its short-term notes payable with new common stock, the company's current ratio, which measures the company's ability to pay off its current liabilities with its current assets, would increase. This is because the company's current assets would remain the same, but its current liabilities would decrease, resulting in a higher current ratio. The other options (B, C, D) are not affected by this action.

Question 8

If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667.

Accepted Answer

Debt ratio = Total Debt / Total Assets
Equity multiplier = Total Assets / Total Equity
We can rearrange the equation for equity multiplier to get:
Total Equity = Total Assets / Equity multiplier

Substituting this in the debt ratio equation:
Debt ratio = Total Debt / (Total Assets / Equity multiplier)

Debt ratio = (Total Debt / Total Assets) x Equity multiplier

Given that equity multiplier = 3.0, we can solve for debt ratio:

3.0 x Debt ratio = 1
Debt ratio = 1 / 3.0
Debt ratio = 0.333

Therefore, the firm's debt ratio is 0.333 and its equity multiplier is 3.0, consistent with the statement in the question.

Question 9

Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, Firm A has a higher debt ratio. If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.

Accepted Answer

This is because debt amplifies the returns, both positive and negative. When BEP is greater than the interest rate, the returns earned by the firm on the funds generated by debt are higher than the cost of debt, resulting in a higher ROE. However, this relationship may not hold true when BEP is less than the interest rate on debt.

Question 10

Which statement about inventories is correct?
A) A reduction in inventories held would have no effect on the current ratio.
B) An increase in inventories would have no effect on the current ratio.
C) If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.
D) A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

Accepted Answer

If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. This is because the inventory turnover ratio is calculated as cost of goods sold divided by average inventory, and if sales increase while inventories remain constant, the cost of goods sold will increase, leading to a higher inventory turnover ratio. Option A, B, and D are incorrect because A reduction in inventories held would increase the current ratio, an increase in inventories would decrease the inventory turnover ratio, and a reduction in the inventory turnover ratio will generally lead to a decrease in the ROE.

Question 11

Which of the following would, generally, indicate an improvement in a company's financial position, other things held constant?
A) The TIE declines.
B) The DSO increases.
C) The EBITDA coverage ratio increases.
D) The current and quick ratios both decline.

Accepted Answer

An increase in the EBITDA coverage ratio indicates that the company is generating more earnings before interest, taxes, depreciation, and amortization, which can be used to cover its debt payments. This suggests a stronger financial position. The other options indicate a decline in financial position.

Question 12

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.

Question 13

One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase.

Accepted Answer

The answer of One problem with ratio analysis is that...

Question 14

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.

Accepted Answer

This is true. The TIE ratio (times interest earned ratio) is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses. By knowing the amount of debt, interest rate, and tax rate, the company can calculate its interest expenses and calculate the amount of EBIT required to achieve a specific TIE ratio. It can then use its operating costs to determine the amount of sales necessary to achieve that level of EBIT.

Question 15

One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger.

Accepted Answer

The answer of One problem with ratio analysis is that...

Question 16

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 may have different levels of assets, and thus different ROAs. ROA is calculated as EBIT divided by average total assets, so the size of the asset base matters in determining the ROA.

Question 17

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 ratios and profit margins are not directly correlated in this manner. 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. The conditions described do not inherently lead to a correlation between profit margins and asset turnover ratios.

Question 18

If the CEO of a large, diversified firm were filling out a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant.
A) The division's basic earning power ratio is above the average of other firms in its industry.
B) The division's total assets turnover ratio is below the average for other firms in its industry.
C) The division's debt ratio is above the average for other firms in the industry.
D) The division's inventory turnover is 6, whereas the average for its competitors is 8.

Accepted Answer

The CEO would likely give the division manager a better grade if the division's basic earning power ratio is above the average of other firms in its industry. This measure indicates the efficiency with which the division is using its assets to generate operating income, which is a key performance indicator for any manager. The other options suggest that the division is underperforming compared to its peers, which would likely result in a lower grade.

Question 19

Which of the following is an example of window dressing?
A) Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of window dressing.
B) Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of window dressing.
C) Using some of the firm's cash to reduce long-term debt is an example of window dressing.
D) Window dressing is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value.

Accepted Answer

Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of window dressing. Window dressing refers to any action taken by a company to improve its financial ratios or appearance, without actually changing the underlying economic reality. In this case, while the current ratio may improve, the company's cash flows and debt payments may actually be worsened in the long run.

Question 20

Which of the following statements is correct?
A) If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
B) If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
C) Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be.
D) The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).

Accepted Answer

A higher market/book ratio indicates that the market values the company more highly compared to its book value, which often correlates with a higher Market Value Added (MVA).

Quiz 3: Analysis of Financial Statements

Companies E and P each reported the same earnings per share (EPS) , but Company E's stock trades at a higher price. Which of the following statements is correct?

A firm's new president wants to strengthen the company's financial position. Which action would make it financially stronger?

A firm wants to strengthen its financial position. Which action would increase its current ratio?

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.

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 than B. Therefore, we can conclude that A's quick ratio must be smaller than B's.

Considered alone, which of the following would increase a company's current ratio?

Casey Communications recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. What would occur as a result of this action?

If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667.

Which statement about inventories is correct?

Which of the following would, generally, indicate an improvement in a company's financial position, other things held constant?

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

One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase.

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.

One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger.

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.

If the CEO of a large, diversified firm were filling out a fitness report on a division manager (i.e., "grading" the manager) , which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant.

Which of the following is an example of window dressing?

Which of the following statements is correct?