Chapter 3 - Analysis of Financial Statements: True/False
Chapter 3 - Analysis of Financial Statements: True/False
Chapter 3 - Analysis of Financial Statements: True/False
TRUE/FALSE
1. Ratio analysis involves analyzing financial statements to help appraise a firm's financial position and
strength.
2. The current and inventory turnover ratios both help us measure a firm's liquidity. The current ratio
measures the relationship of the 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.
3. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide
fast and easy-to-use estimates of a firm's liquidity position.
4. High current and quick ratios always indicate that the firm is managing its liquidity position well.
ANS: F
It might have too much liquidity. Liquid assets generally provide low returns.
5. 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.
6. If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick
ratio would increase.
7. 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.
ANS: F
The quick ratio would increase as receivables replaced inventory.
8. 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.
9. 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.
10. In general, it's better to have a low inventory turnover ratio than a high one, as a low ratio 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.
11. The days sales outstanding 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.
12. If a firm's fixed assets turnover ratio is significantly higher 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.
13. 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.
14. The more conservative a firm's management is, the higher its debt ratio is likely to be.
15. Other things held constant, the higher a firm's debt ratio, the higher its TIE ratio will be.
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.
17. Profitability ratios show the combined effects of liquidity, asset management, and debt management on
a firm's operating results.
18. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving
consideration to financial leverage and tax effects.
ANS: F
BEP = EBIT/Assets. This is before the effects of leverage (interest) and taxes, so the statement is
false.
19. The operating margin measures operating income per dollar of assets.
20. The profit margin measures net income per dollar of sales.
21. 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.
ANS: T
Many of the ratios show sales over some past period such as the last 12 months divided by an asset
such as inventories as of a specific date. Assets like inventories vary at different times of the year for a
seasonal business, thus leading to big changes in the ratio.
22. 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.
23. 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.
ANS: T
A high current ratio is consistent with a lot of inventory. A low inventory turnover is also consistent
with a lot of inventory. If the CR exceeds industry norms and the turnover is below the norms, then
the firm has more inventory than most other firms, given its sales. It could just be carrying a lot of
good inventory, but it might also have a normal amount of "good" inventory plus some "bad"
inventory that has not been written off. So the statement is true.
24. 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.
ANS: F
The FA turnover is Sales/FA, and it gives an indication of how effectively the firm utilizes its FA. The
proportion of FA to TA is not relevant to this usage.
25. Other things held constant, the more debt a firm uses, the lower its profit margin will be.
26. 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 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.
ANS: F
A's higher debt ratio would tend to lower its profit margin. Since its margin is already higher, this
indicates that A is the better managed company.
27. Other things held constant, the more debt a firm uses, the lower its operating margin will be.
ANS: F PTS: 1 DIF: MEDIUM
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
28. 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.
29. Other things held constant, the more debt a firm uses, the lower its return on total assets will be.
30. 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.
ANS: F
Two firms could have identical EBITs but different amounts of interest, tax rates, and different
amounts of assets, and thus different ROAs.
Example: A B
EBIT = Sales revenues - Operating costs = EBIT $ 100.0 $ 100.0
Interest differs. B has more debt: Interest 10.0 20.0
EBT $ 90.0 $ 80.0
Both have 35% rate: Taxes 31.5 28.0
AT Inc. $ 58.5 $ 52.0
Assets differ: Assets $ 200.0 $ 500.0
ROA 29.3 % 10.4 %
31. Other things held constant, a decline in sales accompanied by an increase in financial leverage must
result in a lower profit margin.
ANS: F
PM = NI / Sales. A decline in sales would, other things held constant, increase the PM. An increase in
financial leverage would lead to higher interest charges, which would decrease net income, which
would decrease the PM. So, the net effect could be an increase or a decrease in the PM, or no change.
32. 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).
ANS: F
Stockholders should--and generally do--consider the ROE as being probably the single most important
ratio based strictly on the financial statements.
PTS: 1 DIF: MEDIUM NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
33. Market value ratios provide management with an indication of how investors view the firm's past
performance and especially its future prospects.
34. 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.
35. 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.
36. 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.
37. 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 examining changes in a firm's
performance over time.
38. 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.
ANS: F
Think about the DuPont equation: ROE = PM TATO Equity multiplier. Similar financing
policies will lead to similar Equity multipliers. Moreover, competition in the capital markets will
cause ROEs to be similar, because otherwise capital would flow to industries with high ROEs and
drive returns down toward the average, given similar risks. To have similar ROEs, firms with
relatively high PMs must have relatively low TATOs, and vice versa. Therefore, the statement is false.
39. 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 be a good move, as it would increase the ROE from 7.5%
to 13.5%.
ANS: T
DuPont equation: ROE = PM TATO Equity multiplier. Given the data, the statement is true.
40. 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.
ANS: F
This question can be answered by thinking carefully about the ratios:
The key is inventory, which is in the CR but not in the QR. The firm with more inventory can have the
ANS: F
Firm A has the higher inventory turnover, S/I. So, given the same sales, A must have less inventory.
Since the two firms have the same CR, A must have the higher QR, not the lower one. Therefore, the
statement is false.
42. 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.
ANS: T
TIE = EBIT / Interest = (Sales - Op Cost) / (Debt Interest Rate). If we know the op. costs, the
amount of debt, and the interest rate, then we can solve for the sales level required to achieve the target
TIE.
43. 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.
ANS: T
The easiest way to think about this problem is to realize that if you can borrow at a cost of 10% and
invest the proceeds to earn 11%, you'll earn a surplus. If you were previously earning an ROE of
10%, then after raising and investing additional funds at 11%, your income will be higher, your equity
will be the same, and thus your ROE will increase. Similarly, if a firm earns more on assets than the
interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus
increasing the ROE. So, if BEP > rd, then the firm can increase its expected ROE by using more debt
leverage.
The answer can also be seen by working out an example. The one below shows that leverage
increases ROE if BEP > rd, but it could be varied to show no difference in ROE if interest rates and
BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP.
44. 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.
ANS: T
Equity multiplier = Assets/Equity = 3.0 , so Equity/Assets = 1/3.0 = 0.333.
By definition, Equity/Assets + Debt/Assets = 1.00, so
0.333 + Debt/Assets = 1.0.
Therefore, Debt/Assets = 1.0 - 0.333 = 0.667. Thus, the statement is true.
45. One problem with ratio analysis is that relationships can sometimes 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.
ANS: F
The key here is to recognize that if the CR is greater than 1.0, then a given increase in both current
assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial
CR were less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a short-term basis to
build the cash account would lower the CR. For example:
46. 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.
ANS: F
The key here is to recognize that if the CR is less than 1.0, then a given reduction in both current assets
and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR
were greater than 1.0. In the question, the initial CR is less than 1.0, so using cash to reduce current
liabilities would lower the CR. If the CR were greater than 1.0, the statement would have been true.
Here's an illustration:
MULTIPLE CHOICE
1. 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.
e. An increase in accounts payable.
ANS: D PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
3. A firm wants to strengthen its financial position. Which of the following actions would INCREASE
its current ratio?
a. Reduce the company’s days’ sales outstanding to the industry average and use the resulting
cash savings to purchase plant and equipment.
b. Use cash to repurchase some of the company’s own stock.
c. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of
more than one year.
d. Issue new stock, then use some of the proceeds to purchase additional inventory and hold
the remainder as cash.
e. Use cash to increase inventory holdings.
ANS: D PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
5. 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.
b. Company E is probably judged by investors to be riskier.
c. Company E must have a higher market-to-book ratio.
d. Company E must pay a lower dividend.
e. Company E trades at a higher P/E ratio.
ANS: E PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
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. Which of the following effects would occur as a result of this action?
a. The company’s current ratio increased.
b. The company’s times interest earned ratio decreased.
c. The company’s basic earning power ratio increased.
d. The company’s equity multiplier increased.
e. The company’s debt ratio increased.
ANS: A PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
8. A firm’s new president wants to strengthen the company’s financial position. Which of the following
actions would make it FINANCIALLY stronger?
a. Increase accounts receivable while holding sales constant.
b. Increase EBIT while holding sales and assets constant.
c. Increase accounts payable while holding sales constant.
d. Increase notes payable while holding sales constant.
e. Increase inventories while holding sales constant.
ANS: B PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
9. 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.
e. The division’s DSO (days’ sales outstanding) is 40, whereas the average for its competitors
is 30.
ANS: A PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
10. Which of the following would indicate an IMPROVEMENT in a company’s financial position,
holding other things constant?
a. The inventory and total assets turnover ratios both decline.
b. The debt ratio increases.
c. The profit margin declines.
d. The times-interest-earned ratio declines.
e. The current and quick ratios both increase.
ANS: E PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
11. If a bank loan officer were considering a company’s loan request, which of the following statements
would you consider to be CORRECT?
a. The lower the company’s inventory turnover ratio, other things held constant, the lower the
interest rate the bank would charge the firm.
b. Other things held constant, the higher the days sales outstanding ratio, the lower the
interest rate the bank would charge.
c. Other things held constant, the lower the debt ratio, the lower the interest rate the bank
would charge.
d. The lower the company’s TIE ratio, other things held constant, the lower the interest rate
the bank would charge.
e. Other things held constant, the lower the current ratio, the lower the interest rate the bank
would charge the firm.
ANS: C PTS: 1 DIF: EASY
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
13. A firm wants to strengthen its financial position. Which of the following actions would INCREASE
its quick ratio?
a. Offer price reductions along with generous credit terms that would (1) enable the firm to
sell some of its excess inventory and (2) lead to an increase in accounts receivable.
b. Issue new common stock and use the proceeds to increase inventories.
c. Speed up the collection of receivables and use the cash generated to increase inventories.
d. Use some of its cash to purchase additional inventories.
e. Issue new common stock and use the proceeds to acquire additional fixed assets.
ANS: A PTS: 1 DIF: EASY | MEDIUM
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
14. Amram Company’s current ratio is 2.0. Considered alone, which of the following actions would
LOWER the current ratio?
a. Borrow using short-term notes payable and use the proceeds to reduce accruals.
b. Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
c. Use cash to reduce accruals.
d. Use cash to reduce short-term notes payable.
e. Use cash to reduce accounts payable.
ANS: B PTS: 1 DIF: MEDIUM
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
20. 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.
ANS: D
Rule out all answers except d because they are false.
Alternative answer using the DuPont equation:
ROE = PM x TATO x Eq multiplier
ROE = NI/S x S/TA x TA/Equity
The first two terms are the same, but HD has a higher equity multiplier due to its higher debt, hence
higher ROE.
21. 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.
ANS: C PTS: 1 DIF: MEDIUM
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
23. 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.
ANS: D PTS: 1 DIF: MEDIUM
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
24. 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.
ANS: A
Under the stated conditions, HD would have more interest charges, thus lower taxable income and
taxes.
25. 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.
ANS: E
HD has higher interest charges. Basic earning power equals EBIT/Assets, and since assets and BEP
are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, HD's higher interest charges
means that its TIE must be lower.
31. 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.
ANS: A PTS: 1 DIF: HARD
NAT: Analytic skills | Reflective thinking
LOC: Students will acquire knowledge of financial analysis and cash flows.
32. 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.
ANS: B
The key here is to recognize that if the CR is less than 1.0, then a given increase to both current assets
and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater than
1.0. Thus, the transactions would make Risco look stronger but Safeco look weaker. Here's an
illustration:
Original New
CA/CL Plus $10 CA/CL Old CR New CR
Safeco 20 10 30 2.00 1.50 CR falls because initial
10 10 20 CR is greater than 1.0
Original New
CA/CL Plus $10 CA/CL Old CR New CR
Risco 10 10 20 0.50 0.67 CR rises because initial
20 10 30 CR is less than 1.0
33. 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.
ANS: E
The companies have the same EBIT and assets, hence the same BEP ratio. If the interest rate is less
than the BEP, then using more debt will raise the ROE. Therefore, statement e is correct. The others
are all incorrect.
35. Ryngard Corp's sales last year were $27,000, and its total assets were $16,000. What was its total
assets turnover ratio (TATO)?
a. 1.57
b. 1.64
c. 1.49
d. 1.94
e. 1.69
ANS: E
Sales $27,000
Total assets $16,000
TATO = Sales/Total assets = 1.69
36. Beranek Corp has $665,000 of assets, and it uses no debt--it is financed only with common equity.
The new CFO wants to employ enough debt to raise the debt/assets ratio to 40%, using the proceeds
from borrowing to buy back common stock at its book value. How much must the firm borrow to
achieve the target debt ratio?
a. $303,240
b. $266,000
c. $324,520
d. $250,040
e. $252,700
ANS: B
Total assets $665,000
Target debt ratio 40%
Debt to achieve target ratio = Amount borrowed = Target% Assets = $266,000
37. Ajax Corp's sales last year were $460,000, its operating costs were $362,500, and its interest charges
were $12,500. What was the firm's times-interest-earned (TIE) ratio?
a. 7.80
b. 7.18
c. 8.19
d. 7.72
e. 9.75
ANS: A
Sales $460,000
Operating costs $362,500
Operating income $97,500
(EBIT)
Interest charges $12,500
TIE ratio = EBIT/Interest = 7.80
38. Royce Corp's sales last year were $260,000, and its net income was $23,000. What was its profit
margin?
a. 7.61%
b. 7.25%
c. 8.85%
d. 8.58%
e. 10.97%
ANS: C
Sales $260,000
Net income $23,000
Profit margin = NI/Sales = 8.85%
39. River Corp's total assets at the end of last year were $380,000 and its net income was $32,750. What
was its return on total assets?
a. 6.98%
b. 7.15%
c. 8.62%
d. 10.77%
e. 10.43%
ANS: C
Total assets $380,000
Net income $32,750
ROA = NI/Assets = 8.62%
40. X-1 Corp's total assets at the end of last year were $380,000 and its EBIT was 52,500. What was its
basic earning power (BEP) ratio?
a. 11.88%
b. 11.19%
c. 16.44%
d. 16.16%
e. 13.82%
ANS: E
Total assets $380,000
EBIT $52,500
BEP = EBIT / Assets = 13.82%
41. Zero Corp's total common equity at the end of last year was $430,000 and its net income was $70,000.
What was its ROE?
a. 14.98%
b. 16.28%
c. 12.70%
d. 15.79%
e. 12.21%
ANS: B
Common equity $430,000
Net income $70,000
ROE = NI/Equity = 16.28%
42. Your sister is thinking about starting a new business. The company would require $380,000 of assets,
and it would be financed entirely with common stock. She will go forward only if she thinks the firm
can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of
13.5%. How much net income must be expected to warrant starting the business?
a. $58,482
b. $45,144
c. $52,326
d. $51,300
e. $39,501
ANS: D
Assets = Equity $380,000
Target ROE 13.5%
Required net income = Target ROE Equity = $51,300
43. Song Corp's stock price at the end of last year was $27.75 and its earnings per share for the year were
$1.30. What was its P/E ratio?
a. 20.28
b. 26.47
c. 20.07
d. 21.35
e. 24.12
ANS: D
Stock price $27.75
EPS $1.30
P/E = Stock price / EPS 21.35
44. Hoagland Corp's stock price at the end of last year was $22.50, and its book value per share was
$25.00. What was its market/book ratio?
a. 0.85
b. 0.90
c. 0.86
d. 0.97
e. 1.00
ANS: B
Stock price $22.50
Book value per share $25.00
M/B ratio = Stock price / Book value per share = 0.90
45. Precision Aviation had a profit margin of 4.75%, a total assets turnover of 1.5, and an equity multiplier
of 1.8. What was the firm's ROE?
a. 14.88%
b. 13.59%
c. 15.52%
d. 13.47%
e. 12.83%
ANS: E
Profit margin 4.75%
TATO 1.50
Equity multiplier 1.80
ROE = PM TATO Eq. Multiplier = 12.83%
46. Meyer Inc's assets are $745,000, and its total debt outstanding is $185,000. The new CFO wants to
establish a debt ratio of 55%. The size of the firm does not change. How much debt must the
company add or subtract to achieve the target debt ratio?
a. $168,563
b. $224,750
c. $191,038
d. $211,265
e. $271,948
ANS: B
Total assets $745,000
Old debt $185,000
Target debt ratio 55%
Target amount of debt = Target debt% Total assets = $409,750
Change in amount of debt outstanding = Target debt - Old debt = $224,750
47. Helmuth Inc's latest net income was $1,210,000, and it had 225,000 shares outstanding. The company
wants to pay out 45% of its income. What dividend per share should it declare?
a. $2.49
b. $2.06
c. $2.11
d. $2.69
e. $2.42
ANS: E
Net income $1,210,000
Shares outstanding 225,000
Payout ratio 45%
EPS = NI / shares outstanding = $5.38
DPS = EPS Payout% = $2.42
48. Garcia Industries has sales of $167,500 and accounts receivable of $18,500, and it gives its customers
25 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company
changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and
if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming
other things are held constant?
a. $508.32
b. $405.68
c. $488.77
d. $386.13
e. $518.09
ANS: C
Rate of return on cash generated 8.0%
Sales $167,500
A/R $18,500
Days in Year 365
Sales/day = Sales / 365 = $458.90
Company DSO = Receivables / Sales per day = 40.3
Industry DSO 27.0
Difference = Company DSO - Industry DSO = 13.3
Cash flow from reducing the DSO = Difference Sales/day = $6,109.59
Additional Net Income = Return on cash Added cash flow = $488.77
Alternative Calculation:
A/R at industry DSO $12,390.41
Change in A/R $6,109.59
Additional Net Income $488.77
50. Han Corp's sales last year were $395,000, and its year-end receivables were $52,500. The firm sells
on terms that call for customers to pay 30 days after the purchase, but some delay payment beyond
Day 30. On average, how many days late do customers pay? Base your answer on this equation:
DSO - Allowed credit period = Average days late, and use a 365-day year when calculating the DSO.
a. 15.92
b. 15.18
c. 13.88
d. 18.51
e. 14.07
ANS: D
Sales $395,000
Sales/day = Sales / 365 = $1,082.19
Receivables $52,500
Company DSO = Receivables / Sales per day = 48.51
Credit period 30
DSO - Credit period = Days late 18.51
51. Wie Corp's sales last year were $365,000, and its year-end total assets were $355,000. The average
firm in the industry has a total assets turnover ratio (TATO) of 2.4. The firm's new CFO believes the
firm has excess assets that can be sold so as to bring the TATO down to the industry average without
affecting sales. By how much must the assets be reduced to bring the TATO to the industry average,
holding sales constant?
a. $202,917
b. $221,179
c. $213,063
d. $160,304
e. $184,654
ANS: A
Sales $365,000
Actual total assets $355,000
Target TATO = Sales / Total assets = 2.40
Target assets = Sales / Target TATO = $152,083
Asset reduction = Actual assets - Target assets = $202,917
52. A new firm is developing its business plan. It will require $635,000 of assets, and it projects $450,000
of sales and $355,000 of operating costs for the first year. Management is reasonably sure of these
numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the
bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level the bank will call in
the loan and the firm will go bankrupt. What is the maximum debt ratio the firm can use? (Hint: Find
the maximum dollars of interest, then the debt that produces that interest, and then the related debt
ratio.)
a. 50.87%
b. 59.34%
c. 49.87%
d. 62.34%
e. 42.89%
ANS: C
Assets $635,000
Sales $450,000
Operating costs $355,000
Operating income (EBIT) $95,000
Target TIE 4.00
Maximum interest expense = EBIT / Target TIE $23,750
Interest rate 7.50%
Max. debt = Max interest expense/Interest rate $316,667
Maximum debt ratio = Debt/Assets 49.87%
53. Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for
the last year were $520,000, and its net income was $25,000. Stockholders recently voted in a new
management team that has promised to lower costs and get the return on equity up to 15.0%. What
profit margin would the firm need in order to achieve the 15% ROE, holding everything else constant?
a. 10.71%
b. 9.41%
c. 10.82%
d. 8.11%
e. 12.66%
ANS: C
Total assets = Equity because zero debt $375,000
Sales $520,000
Net income $25,000
Target ROE 15.00%
Net income req'd to achieve target ROE = Target ROE Equity = $56,250
Profit margin needed to achieve target ROE = NI / Sales = 10.82%
54. Last year Ann Arbor Corp had $300,000 of assets, $305,000 of sales, $20,000 of net income, and a
debt-to-total-assets ratio of 37.5%. The new CFO believes a new computer program will enable it to
reduce costs and thus raise net income to $33,000. Assets, sales, and the debt ratio would not be
affected. By how much would the cost reduction improve the ROE?
a. 5.34%
b. 5.82%
c. 6.59%
d. 8.67%
e. 6.93%
ANS: E
Assets $300,000
Debt ratio 37.5%
Debt = Assets Debt% = $112,500
Equity = Assets - Debt = $187,500
Sales $305,000
Old net income $20,000
New net income $33,000
New ROE = New NI / Equity = 17.600%
Old ROE = Old NI / Equity = 10.667%
Increase in ROE = New ROE - Old ROE = 6.93%
55. Brookman Inc's latest EPS was $2.75, its book value per share was $22.75, it had 280,000 shares
outstanding, and its debt ratio was 44%. How much debt was outstanding?
a. $4,704,700
b. $5,355,350
c. $5,205,200
d. $4,054,050
e. $5,005,000
ANS: E
EPS $2.75
BVPS $22.75
Shares outstanding 280,000
Debt ratio 44.0%
Total equity = Shares outstanding BVPS = $6,370,000
Total assets = Total equity / (1 - Debt ratio) = $11,375,000
Total debt = Total assets - Equity = $5,005,000
57. Last year Rennie Industries had sales of $240,000, assets of $175,000, a profit margin of 5.3%, and an
equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $51,000
without affecting either sales or costs. Had it reduced its assets by this amount, and had the debt ratio,
sales, and costs remained constant, how much would the ROE have changed?
a. 3.55%
b. 3.19%
c. 3.66%
d. 3.01%
e. 3.59%
ANS: E
Old New
Sales $240,000 $240,000
Original assets $175,000
Reduction in assets $51,000
New assets = Old assets - Reduction = $124,000
TATO = Sales / Assets = 1.37 1.94
Profit margin 5.30% 5.30%
Equity multiplier 1.20 1.20
ROE = PM TATO Eq Multiplier = 8.72% 12.31%
Change in ROE 3.59%
59. Last year Jandik Corp. had $325,000 of assets, $18,750 of net income, and a debt-to-total-assets ratio
of 37%. Now suppose the new CFO convinces the president to increase the debt ratio to 48%. Sales
and total assets will not be affected, but interest expenses would increase. However, the CFO believes
that better cost controls would be sufficient to offset the higher interest expense and thus keep net
income unchanged. By how much would the change in the capital structure improve the ROE?
a. 2.19%
b. 1.67%
c. 1.57%
d. 1.94%
e. 2.17%
ANS: D
Assets $325,000
Old debt ratio 37%
Old debt = Assets Old debt% = $120,250
Old equity $204,750
New debt ratio 48%
New debt = Assets New debt% = $156,000
New Equity = Assets - New debt = $169,000
Net income $18,750
New ROE = New income / New Equity 11.09%
Old ROE = Old income / Old Equity 9.16%
Increase in ROE 1.94%
61. Jordan Inc has the following balance sheet and income statement data:
The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the
current ratio to equal the industry average, 2.10, without affecting either sales or net income.
Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and
that the funds generated are used to buy back common stock at book value, by how much would the
ROE change?
a. 28.16%
b. 20.93%
c. 24.28%
d. 32.29%
e. 25.83%
ANS: E
Original balance sheet and income statement data:
Cash $14,000 Accounts payable $42,000
Receivables 70,000 Other current liabilities 28,000
Inventories 280,000 Total CL $70,000
Total CA $364,000 Long-term debt 140,000
Net fixed assets 126,000 Common equity 280,000
Total assets $490,000 Total liab. and equity $490,000
Sales $280,000
Net income 21,000
62. Last year Hamdi Corp. had sales of $500,000, operating costs of $450,000, and year-end assets of
$355,000. The debt-to-total-assets ratio was 17%, the interest rate on the debt was 7.5%, and the
firm's tax rate was 35%. The new CFO wants to see how the ROE would have been affected if the
firm had used a 50% debt ratio. Assume that sales, operating costs, total assets, and the tax rate would
not be affected, but the interest rate would rise to 8.0%. By how much would the ROE change in
response to the change in the capital structure?
a. 3.17%
b. 3.42%
c. 3.48%
d. 3.08%
e. 2.99%
ANS: D
O N
ld ew
Interest rate 7.5% 8.0%
Tax rate 35% 35%
Assets $355,000 $355,000
Debt ratio 17% 50%
Debt = Assets Debt ratio = $60,350 $177,500
Equity = Assets - Debt = $294,650 $177,500
66. What is the firm's days sales outstanding? Assume a 365-day year for this calculation.
a. 55.27
b. 66.46
c. 80.45
d. 57.37
e. 69.96
ANS: E
DSO = Accounts receivable/(Sales/365) = 69.96