4.1 Why Do We Analyze Financial Statements?
1) Which of the following parties would perform an external
financial analysis?
A) A firm's compensation committee
B) A financial analyst forecasting the next period's
borrowing needs
C) A firm's creditors
D) A CFO comparing the performance of the firm's various
divisions
2) Which of the following parties would perform an internal
financial analysis?
A) A financial analyst forecasting the next period's
borrowing needs
B) A firm's competitors
C) A firm's creditors
D) Analysts for investment companies
3) Which of the following parties would be interested in an
analysis of the firm's financial statements?
A) Investors
B) Creditors
C) The firm's managers
D) all of the above
4) The analysis of a firm's financial statements can be an
important factor in the firm's ability to borrow money.
Answer: TRUE
5) The analysis of a firm's financial statements is usually
of interest only to people who do not work for the company.
Answer: FALSE
6) Individuals who do not work for a company rarely have
enough information to perform a detailed financial analysis of the company.
Answer: FALSE
4.2 Common Size Statements: Standardizing
Financial Information
1) The principal reason for preparing common size
statements is
A) to make meaningful comparisons between firms that are
not the same size.
B) to make meaningful comparisons between different fiscal
years.
C) to eliminate the effects of inflation.
D) to make meaningful comparisons between firms in
different industries.
2) Common size financial statements represent all figures
on the financial statements
A) in inflation adjusted dollars from a base year.
B) as if all companies being compared had the same total
revenue.
C) as if all companies being compared had the same total
assets.
D) as a percentage of either sales or total assets.
3) Common size income statements represent all figures on
the income statement
A) as a percentage change from the previous year.
B) percentages of the current year's sales.
C) as a percentage of some benchmark figure.
D) as a percentage of total assets.
4) Common size balance sheets represent all figures on the
balance sheet
A) as a percentage change from the previous year.
B) percentages of the current year's sales.
C) as a percentage of some benchmark figure.
D) as a percentage of total assets.
5) On a common size balance sheet, total assets are equal
to 100%.
Answer: TRUE
6) On a common size income statement, EBIT is equal to
100%.
Answer: FALSE
7) By using common size income statements, firms can
determine how various expenses as a percentage of total sales changed from
period to period.
Answer: TRUE
8) What is the purpose of using common size balance sheets
and common size income statements?
Answer: The purpose
is to allow a company to compare its performance with its own prior performance
or with the performance of other firms. It is not helpful to just compare
numbers, but with common size statements firms can compare percentages, so that
they can answer questions about how their own performance changed, and how
their performance compares to that of other firms.
4.3 Using Financial Ratios
1) If you were given the components of current assets and
of current liabilities, what ratio(s) could you compute?
A) Acid test or quick ratio
B) Average collection period
C) Current ratio
D) Both A and C
E) All of the above
2) The debt ratio is a measure of a firm's
A) leverage.
B) profitability.
C) liquidity.
D) efficiency.
3) Which of the following statements is true?
A) Current assets consist of cash, accounts receivable,
inventory, and net plant, property, and equipment.
B) The quick ratio is a more restrictive measure of a
firm's liquidity than the current ratio.
C) For the average firm, inventory is considered to be more
"liquid" than accounts receivable.
D) A successful firm's current liabilities should always be
greater than its current assets.
4) Which of the following transactions does NOT affect the
quick ratio?
A) Land held for investment is sold for cash.
B) Equipment is purchased and is financed by a long-term
debt issue.
C) Inventories are sold for cash.
D) Inventories are sold on a credit basis.
5) Given an accounts receivable turnover of 8 and annual
credit sales of $362,000, the average collection period (360-day year) is
A) 90 days.
B) 45 days.
C) 75 days.
D) 60 days.
6) The question "Did the common stockholders receive
an adequate return on their investment?" is answered through the use of
A) liquidity ratios.
B) profitability ratios.
C) coverage ratios.
D) leverage ratios.
Table 1
Smith Company Balance Sheet and selected Income Statement data
Assets:
Cash and marketable
securities $300,000
Accounts receivable 2,215,000
Inventories 1,837,500
Prepaid expenses 24,000
Total current assets $3,286,500
Fixed assets 2,700,000
Less: accumulated
depreciation 1,087,500
Net fixed assets $1,612,500
Total assets $4,899,000
Liabilities:
Accounts payable $240,000
Notes payable 825,000
Accrued taxes 42,500
Total current liabilities $1,107,000
Long-term debt 975,000
Owner's equity 2,817,000
Total liabilities and owner's
equity $4,899,000
Net sales (all credit) $6,375,000
Less: Cost of goods sold 4,312,500
Selling and administrative
expense 1,387,500
Depreciation expense 135,000
Interest expense 127,000
Earnings before taxes $412,500
Income taxes 225,000
Net income $187,500
Common stock dividends $97,500
Change in retained earnings $90,000
7) Based on the information in Table 1, the current ratio
is
A) 2.97.
B) 1.46.
C) 2.11.
D) 2.23.
8) Based on the information in Table 1, the average
collection period is
A) 71 days.
B) 84 days.
C) 64 days.
D) 127 days.
9) Based on the information in Table 1, the debt ratio is
A) 0.70.
B) 0.20.
C) 0.74.
D) 0.42.
10) Based on the information in Table 1, the net profit
margin is
A) 4.61%.
B) 2.94%.
C) 1.97%.
D) 5.33%.
11) Based on the information in Table 1, the inventory
turnover ratio is
A) 0.29 times.
B) 2.35 times.
C) 0.43 times.
D) 3.47 times.
12) Marshall Networks, Inc. has a total asset turnover of
2.5 and a net profit margin of 3.5%. The firm has a return on equity of 17.5%.
Calculate Marshall's debt ratio.
A) 30%
B) 40%
C) 50%
D) 60%
13) The DuPont method decomposes return on equity into
A) return on assets and the debt ratio.
B) return on assets and the equity multiplier.
C) operating income and inventory turnover.
D) net profit margin and fixed asset turnover.
14) A firm's average collection period has decreased
significantly from the previous year. Which of the following could possibly
explain the results?
A) Customers are paying off their accounts quicker.
B) Customers are taking longer to pay for purchases.
C) The firm has a stricter collection policy.
D) Both A and C.
15) An increase in ________ will increase common equity.
A) paid in capital
B) retained earnings
C) dividends paid
D) both A and
16) Another name for the acid test ratio is the
A) current ratio.
B) quick ratio.
C) inventory turnover ratio.
D) average collection period.
17) Which of the following financial ratios is the best
measure of the operating effectiveness of a firm's management?
A) Current ratio
B) Gross profit margin
C) Quick ratio
D) Return on investment
18) Which of the following is included in the denominator
of the times-interest-earned ratio?
A) Lease payments
B) Principal payments
C) Interest expense
D) Gross profit
19) The quick ratio is a better measure of liquidity than
the current ratio if the firm has current assets composed primarily of
A) cash.
B) inventory.
C) marketable securities.
D) accruals.
20) If a company's average collection period is higher than
the industry average, then the company might be
A) enforcing credit conditions upon its customers which are
too stringent.
B) allowing its customers too much time to pay their bills.
C) too tough in collecting its accounts.
D) too liquid.
21) Why is the quick ratio a more refined measure of liquidity
than the current ratio?
A) It measures how quickly cash and other liquid assets
flow through the company.
B) Inventories are omitted from the numerator of the ratio
because they are generally the least liquid of the firm's current assets.
C) It is a quicker calculation to make.
D) Cash is the most liquid current asset.
22) Smith Corporation has current assets of $11,400,
inventories of $4,000, and a current ratio of 2.6. What is Smith's quick or
acid test ratio?
A) 1.69
B) 0.54
C) 0.74
D) 1.35
23) Kingsbury Associates has current assets as follows:
Cash $3,000
Accounts receivable $4,500
Inventories $8,000
If Kingsbury has a current ratio of 3.2, what is its quick
ratio?
A) 2.07
B) 1.55
C) 0.48
D) 0.96
24) Water Works, Inc. has a current ratio of 1.33, current
liabilities of $540,000, and inventory of $400,000. What is Water Works, Inc.'s
quick ratio?
A) 1.11
B) 0.86
C) 1.90
D) 0.59
25) Which of the following ratios indicates how rapidly the
firm's credit accounts are being collected?
A) Debt ratio
B) Gross profit margin
C) Accounts receivable turnover ratio
D) Fixed asset turnover
26) Smart and Smiley Incorporated has an average collection
period of 74 days. What is the accounts receivable turnover ratio for Smart and
Smiley?
A) 4.93
B) 2.47
C) 2.66
D) 1.68
27) Billing's Pit Corporation has an accounts receivable
turnover ratio of 3.4. What is Billing's Pit Corporation's average collection
period?
A) 107 days
B) 102 days
C) 73 days
D) 55 days
28) Which of the following statements is true?
A) As a general rule, management would want to reduce the
firm's average collection period.
B) As a general rule, management would want to reduce the
firm's accounts receivable turnover ratio.
C) As a general rule, management would want to increase the
firm's average collection period.
D) As a general rule, a firm is not financially affected by
the amount of time required to collect its accounts receivable.
29) Millers Metalworks, Inc. has a total asset turnover of
2.5 and a net profit margin of 3.5%. The total debt ratio for the firm is 50%.
Calculate Millers's return on equity.
A) 17.5%
B) 19.5%
C) 21.5%
D) 23.5%
30) Snype, Inc. has an accounts receivable turnover ratio
of 7.3. Stork Company has an accounts receivable turnover ratio of 5.0. Which
of the following statements is correct?
A) Snype's average collection period is less than Stork's.
B) Stork's average collection period is less than Snype's.
C) Snype has a lower accounts receivable account on average
than does Stork Company.
D) Stork Company has (on average) a lower accounts
receivable account than does Snype.
31) A decrease in the return on equity ratio could be
caused by an increase in
A) tax rate.
B) cost of goods sold.
C) total assets.
D) both B and C.
32) Ortny Industries has an accounts receivable turnover
ratio of 4.3. If Ortny has an accounts receivable balance of $90,000, what is
Ortny's average daily credit sales?
A) $387,000
B) $1,548
C) $1,060
D) $3,521
33) Spinnit, Limited has a debt ratio of .57, current
liabilities of $14,000, and total assets of $70,000. What is the level of
Spinnit, Limited's total liabilities?
A) $25,900
B) $24,600
C) $39,900
D) $53,900
34) Snort and Smiley Incorporated has a debt ratio of .42,
noncurrent liabilities of $20,000, and total assets of $70,000. What is Snort
and Smiley's level of current liabilities?
A) $8,400
B) $9,400
C) $12,340
D) $10,600
35) Lorna Dome, Inc. has an annual interest expense of
$30,000. Lorna Dome's times-interest-earned ratio is 4.2. What is Lorna Dome's
operating income?
A) $96,000
B) $57,000
C) $126,000
D) $57,600
36) In 1996, Snout and Smith, Inc. had a gross profit of
$27,000 on sales of $110,000. S & S's operating expenses for 1996 were
$13,000, and its net profit margin was .0585. Snout and Smith had no interest
expense in 1996. Using this information, what was S & S's operating profit
margin for 1996?
A) 0.245
B) 0.118
C) 0.127
D) 0.157
37) Sharky's Loan Co. has an annual interest expense of
$30,000. If Sharky's times-interest-earned ratio is 2.9, what is Sharky's
Earnings Before Taxes (EBT)?
A) $87,000
B) $57,000
C) $117,000
D) $60,000
38) Skrit Corporation has a net profit margin of 15% and a
total asset turnover of 1.7. What is Skrit's return on total assets?
A) 12.3%
B) 25.5%
C) 8.8%
D) 11.1%
39) Sputter Motors has sales of $3,450,000, total assets of
$1,240,000, cost of goods sold of $2,550,000, and an inventory turnover of
6.38. What is the amount of Sputter's inventory?
A) $421,054
B) $638,112
C) $543,000
D) $399,687
40) Which of the following is the best indicator of
management's effectiveness at managing the firm's balance sheet?
A) Debt ratio
B) Total asset turnover
C) Times-interest-earned
D) Operating profit margin
41) Which of the following is the best indicator of
management's effectiveness at generating profits relative to the firm's assets?
A) Quick ratio
B) Fixed assets turnover
C) Return on assets
D) Accounts receivable turnover
42) Storm King Associates has a total asset turnover ratio
of 1.90 and a return on total assets of 7.20%. What is Storm King's net profit
margin?
A) 3.79
B) 13.68
C) 9.10
D) None of the above
43) A decrease in ________ will increase gross profit
margin.
A) cost of goods sold
B) depreciation expense
C) interest expense
D) both A and B
44) Other things held constant, an increase in ________
will decrease the current ratio. Assume an initial current ratio greater than
1.0.
A) accruals
B) common stock
C) average collection period
D) cash
45) GAAP, Inc. has total assets of $2,575,000, sales of
$5,950,000, total liabilities of $1,855,062, and a net profit margin of 2.9%.
What is GAAP's return on equity? Round to the nearest 0.1%.
A) 8.6%
B) 24.0%
C) 16.4%
D) 4.4%
46) Wireless Communications has a total asset turnover of
2.66, total liabilities of $1,004,162, and sales revenues of $7,025,000. What
is Wireless's debt ratio?
A) 38.0%
B) 14.3%
C) 26.7%
D) 81.1%
47) Which of the following will help an analyst determine
how well a firm is able to meet its debt obligations?
A) Total liability turnover
B) Times-interest-earned
C) Return on debt
D) Asset ratio
48) Heavy Load, Inc. has sales of $3,450,000, total assets
of $1,240,000, and total liabilities of $275,000, which consist strictly of
notes payable. The firm's operating profit margin is 16.1%, and it pays a 10%
rate of interest on its notes payable. How much is the firm's
times-interest-earned?
A) 15.6
B) 45.3
C) 20.2
D) 3.0
49) An increase in ________ will decrease the
times-interest-earned ratio.
A) the tax rate
B) gross profit
C) interest expense
D) common stock
50) Dew Point Dynamite, Inc. generated a 1.23 total asset
turnover in its latest fiscal year on assets of $2,112,077. The firm has total
liabilities of $950,997. The firm's net profit margin was 10.3%. What is Dew
Point's return on equity? Round to the nearest 0.1%.
A) 23.1%
B) 12.6%
C) 5.5%
D) 18.2%
51) An example of a liquidity ratio is the
A) quick ratio.
B) debt ratio.
C) times-interest-earned.
D) return on assets.
52) Kannan Carpets, Inc. has asked you to calculate the
company's current ratio for 2001. All you have is a partial balance sheet and
some assumptions. Using the information provided, calculate Kannan's current
ratio for 2001.
Gross profit margin = 50%
Inventory turnover (COGS/Inv) = 5
2001 sales = $3,000
Assets Liabilities
& Equity
Cash ? Accounts payable $50
AR $40 Accruals ?
Inventory ? Long-term debt $400
Net fixed assets $500 Equity 250
Total assets $900 Total liab. & equity ?
A) 0.3
B) 0.8
C) 1.6
D) 2.2
53) Kannan Carpets, Inc. has asked you to calculate the
company's quick ratio for 2001. All you have is a partial balance sheet and
some assumptions. Using the information provided, calculate Kannan's quick
ratio for 2001.
Gross profit margin = 50%
Inventory turnover (COGS/Inv) = 5
2001 sales = $3,000
Assets Liabilities
& Equity
Cash ? Accounts payable $50
AR $40 Accruals ?
Inventory ? Long-term debt $400
Net fixed assets $500 Equity 250
Total assets $900 Total liab. & equity ?
A) 0.2
B) 0.4
C) 0.6
D) 0.8
54) A firm that wants to know if it has enough cash to meet
its bills would be most likely to use which kind of ratio?
A) Liquidity
B) Leverage
C) Efficiency
D) Profitability
55) In the times-interest-earned ratio, dividend payments
are included in
A) the numerator.
B) the denominator.
C) both the numerator and the denominator.
D) neither the numerator nor the denominator.
56) Assume that a particular firm has a total asset
turnover ratio lower than the industry norm. In addition, this firm's current
ratio and fixed asset turnover ratio also meet industry standards. Based on
this information, we can conclude that this firm must have excessive
A) accounts receivable.
B) fixed assets.
C) debt.
D) inventory.
57) Assume that a particular firm has a total asset
turnover ratio lower than the industry norm. In addition, this firm's current
ratio and acid test ratio also meet industry standards. Based on this
information, we can conclude that this firm must have excessive
A) accounts receivable.
B) fixed assets.
C) debt.
D) inventory.
58) A firm is conducting an analysis of trends over time
and discovers that its inventory turnover has declined. This may be due to
A) an increase in sales.
B) an increase in cost of goods sold.
C) an increase in inventory purchases.
D) a decrease in inventory purchases.
59) If the total asset turnover decreases, then the return
on equity will
A) decrease.
B) increase.
C) not change.
D) change, but in an indeterminate way.
Use the following information to answer the following
question(s).
Key
Ratios for ABC, Inc. and Its Industry
ABC,
Inc. 2013 Ratios Industry Average
Ratios in 2013
Current ratio 1.2 1.4
Acid test ratio 0.89 0.94
Average collection
period 30 days 25 days
Inventory turnover 18.1 20.3
Fixed assets
turnover 4.1 4.8
Total asset
turnover 2.78 2.8
Debt ratio 50% 60%
Times-interest-earned
5.5% 4.5%
Net profit margin 1.15% 1.5%
Return on equity 5.21% 7.32%
ABC, Inc. Income Statement (in thousands)
December 31, 2014
Sales (all credit) $200,000
Cost of goods sold
140,000
Gross profit on sales 60,000
Operating expenses 56,000
Operating income 4,000
Interest expense 1,000
Earnings before tax 3,000
Income tax 1,050
Net income available to
common stockholders $1,950
ABC, Inc. Balance Sheet (in
thousands)
December
31, 2014
Assets
Cash $2,000
Accounts receivable 17,800
Inventories 8,700
Total current assets 28,500
Gross fixed assets 70,000
Accumulated depreciation 26,500
Net fixed assets 43,500
Total assets $72,000
Liabilities and Equity
Accounts payable $18,000
Accruals 13,350
Total current liabilities 31,350
Long-term debt 8,250
Total liabilities 39,600
Common stock (par value and
paid in capital) 2,000
Retained earnings 30,400
Total stockholders' equity 32,400
Total liabilities and equity $72,000
60) In 1995, ABC's average collection period is
A) 30 days.
B) 32.5 days.
C) 25 days.
D) 35 days.
61) In 2014, ABC's inventory turnover is
A) 23.9.
B) 20.3.
C) 15.5.
D) 16.1.
62) In 2014, ABC's fixed asset turnover is
A) 2.78.
B) 5.0.
C) 4.6.
D) 4.8.
63) Since 2013, ABC's efficiency at using its assets has
A) improved.
B) deteriorated.
C) remained the same.
D) been variable across components of the efficiency
measures.
64) In 2014, the improvement in ABC's return on equity
occurred because
A) ABC used more debt than in 1994.
B) ABC lowered its expenses in 1995 and was, therefore,
more profitable.
C) ABC utilized its total assets more efficiently in 1995.
D) None of the above explain the improvement in ABC's
return on equity.
65) Since 2013, ABC's liquidity has
A) improved.
B) deteriorated.
C) remained the same.
D) been variable across components of the liquidity
measures.
66) Since 2013, ABC's inventory management has
A) improved.
B) deteriorated.
C) remained the same.
D) changed but in an indeterminate manner.
67) An increase in the current ratio would indicate an
increase in
A) leverage.
B) liquidity.
C) return on investment.
D) operating income.
68) Which of the following is NOT a component of return on
assets (ROA)?
A) Total assets
B) Cost of goods sold
C) Sales
D) Leverage
69) ________ indicates management's effectiveness in
managing the firm's income statement.
A) Gross profit margin
B) Operating profit margin
C) Net profit margin
D) Return on assets
70) Holding all other variables constant, which of the
following could cause a firm's current ratio to decrease from 3.0 to 2.5? An
increase in
A) inventory.
B) long-term debt.
C) accounts receivable.
D) accounts payable.
71) A firm has a return on equity of 20% and a total asset
turnover of 4. Assuming a debt ratio of 50% and sales of $1,000,000, calculate
net income.
A) $25,000
B) $50,000
C) $75,000
D) $100,000
72) Which of the following will increase return on equity?
A) An increase in sales with a proportionate increase in
costs and expenses
B) An increase in sales relative to the asset base
C) A decrease in leverage
D) Both A and C
73) Which of the following is NOT a driving force of the
operating profit margin?
A) The average selling price for each product
B) The ability to control all of the firm's expenses
C) The ability to control general and administrative
expenses
D) The number of units of product sold
74) Corbin, Inc. had net income of $150,000 on sales of
$5,000,000 during 1995. In addition, the firm's total assets were $2,500,000,
and its capital structure is comprised of 40% debt and 60% equity. What was
Corbin's return on equity in 1995?
A) 15%
B) 2.5%
C) 10%
D) Return on equity cannot be determined with the
information provided.
75) Which of the following ratios would be the most useful
in evaluating the ability of a firm to meet its short-term obligations?
A) The quick ratio (acid test)
B) Return on equity
C) Total asset turnover
D) Operating profit margin
76) If Challenge Corporation has sales of $2 million per
year (all credit) and an average collection period of 35 days, what is its
average amount of accounts receivable?
A) $191,781
B) $57,143
C) $5,556
D) $97,222
77) Which of the following financial ratios is the best
measure of how effectively a firm's management is serving its stockholders?
A) Current ratio
B) Debt ratio
C) ACP
D) Return on equity
78) Colton Corp. has current assets of $4.5 million. The
current ratio is 1.25 and the quick ratio is 0.75. What is the amount of Colton's
current liabilities (in millions)?
A) $4.5
B) $1.8
C) $2.4
D) $2.9
E) $3.6
79) Consolidated Industries has total interest charges of
$20,000 per year. Sales of $2 million generated an operating income of $220,000
and an after-tax profit of 6% of sales. The firm has a marginal tax rate of
40%. What is the firm's times-interest-earned ratio?
A) 10
B) 11
C) 12
D) 13
80) Hi Sky Enterprises has total assets of $3 million, a
debt ratio of 30%, and an after-tax profit margin of 11.04% and sales of $2.5
million. What is Hi Sky's return on equity?
A) 15%
B) 35%
C) 27%
D) 13%
81) Paper Clip Office Supply had $24,000,000 in sales last
year. Its total asset turnover was 3.0. Interest expense was $100,000 (5% on
its $2,000,000 of debt). The company is financed entirely with debt and common
equity. What is Paper Clip's debt ratio?
A) 20%
B) 30%
C) 25%
D) 60%
E) 16%
82) Kiosk Corp. has current assets of $4.5 million and
current liabilities of $3.6 million. The current ratio is 1.25, and the quick
ratio is 0.75. How much does Kiosk have invested in inventory (in millions)?
A) $0.8
B) $1.8
C) $2.4
D) $2.9
E) $3.6
83) Champion Company has sales of $20 million, total debt
of $1.5 million, and a debt ratio of 40%. What is Champion's total asset
turnover?
A) 13.33
B) 9.11
C) 6.55
D) 5.33
84) The focus of DuPont Analysis is to provide management
information as to how the firm is using its resources to maximize returns on
owners' investments.
Answer: TRUE
85) The current ratio and the acid test ratio are both
measures of financial leverage.
Answer: FALSE
86) Ratios that examine profit relative to investment are
useful in evaluating the overall effectiveness of the firm's management.
Answer: TRUE
87) Financial ratios that are higher than industry averages
may indicate problems which are as detrimental to the firm as ratios that are
too low.
Answer: TRUE
88) According to the DuPont Analysis, an increase in net
profit margin will decrease return on assets.
Answer: FALSE
89) Financial ratios comprise the principal tool of
financial analysis since they can be used to answer a variety of questions
regarding a firm's financial condition.
Answer: TRUE
90) Financial ratios can highlight a firm's financial
performance with regard to liquidity, solvency, and profitability.
Answer: TRUE
91) Ratios are used to standardize financial information.
Answer: TRUE
92) There is no such thing as a liquidity ratio being too
high.
Answer: FALSE
93) A retailer that accepts credit cards will have a higher
accounts receivable turnover ratio than a retailer with its own credit
department.
Answer: TRUE
94) One weakness of the times-interest-earned ratio is that
it includes only the annual interest expense as a finance expense that must be
paid.
Answer: TRUE
Table
3
Financial Data for Dooley
Sportswear December 31, 2013
Inventory $206,250
Long-term debt 300,000
Interest expense 5,000
Accumulated depreciation 442,500
Cash 180,000
Net sales (all credit) 1,500,000
Common stock 800,000
Accounts receivable 225,000
Operating expenses 525,000
Notes payable-current 187,500
Cost of goods sold 937,500
Plant and equipment 1,312,500
Accounts payable 168,750
Marketable securities 95,000
Prepaid insurance 80,000
Accrued wages 65,000
Retained
earnings-current-year ?
Federal income taxes 5,750
95) From the information presented in Table 3, calculate
the following financial ratios for the Dooley Sportswear Company.
current ratio operating
profit margin
acid test ratio net
profit margin
average collection period total tangible asset turnover
inventory turnover times
interest earned
gross profit margin
Answer:
Current ratio = ($180,000 + $95,000 + $225,000 + $206,250 +
$80,000)/($168,750 + $187,500 + $65,000) = ($786,250/$421,250) = 1.87
Acid test ratio = ($180,000 + $95,000 + $225,000 +
$80,000)/($168,750 + $187,500 + $65,000) = ($580,000/$421,250) = 1.38
Average collection period = ($225,000)/($1,500,000/360
days) = 54 days
Inventory turnover = ($937,500/$206,250) = 4.55
Gross profit margin = ($562,500/$1,500,000) = 0.375
Operating profit margin = ($37,500/$1,500,000) = 0.025
Net profit margin = ($26,750/$1,500,000) = 0.0178
Total asset turnover = ($1,500,000/$1,656,250) = 0.906
Times interest earned = ($37,500/$5,000) = 7.5 times
Table 4
Hokie Corporation Comparative Balance Sheet
For the Years Ending March 31, 2013 and 2014
(Millions of Dollars)
Assets 2013
2014
Current assets:
Cash $2
$10
Accounts receivable 16 10
Inventory 22 26
Total current assets $40 $46
Gross fixed assets: $120 $124
Less accumulated
depreciation 60 64
Net fixed assets 60 60
Total assets $100
$106
Liabilities and Owners'
Equity
Current liabilities:
Accounts payable $16 $18
Notes payable 10
10
Total current
liabilities $26
$28
Long-term debt 20 18
Owners' equity:
Common stock 40 40
Retained earnings 14 20
Total liabilities and
owners' equity $100 $106
Hokie had net income of
$26 million for 1996 and paid total cash dividends of $20 million to their
common stockholders.
96) Calculate the following financial ratios for the Hokie
Corporation using the information given in Table 4 and 2014 information.
current
ratio
acid
test ratio
debt
ratio
long-term
debt to total capitalization
return
on total assets
return
on common equity
Answer:
Current ratio = ($46/$28) = 1.64
Acid test ratio = ($20/$28) = 0.71
Debt ratio = ($46/$106) = 0.43
Long-term debt to total capitalization = ($18/$78) = 0.23
Return on total assets = ($26/$106) = 0.25
Return on common equity = ($26/$60) = 0.43
97) McKinny Enterprises must raise $580,000 to pay off a
bank loan at the end of the year. The firm expects sales of $5,200,000 for the
year. Depreciation for the year is $315,000. The company's net profit margin is
5%. Can the company pay off its loan through the retention of earnings?
Answer: Net profit =
sales × net profit margin = $5,200,000 × .05 = $260,000
Internal funds generated by the firm = net profit +
depreciation = $260,000 + $315,000 = $575,000
McKinny cannot pay off its loan by using only internally
generated funds.
98) S.M., Inc. had total sales of $400,000 in 2014 (70
percent of its sales are credit). The company's gross profit margin is 10%, its
ending inventory is $80,000, and its accounts receivable is $25,000. What
amount of funds can be generated by the company if it increases its inventory
turnover ratio to 10.0 and reduces its average collection period to 20 days?
Answer: Average
collection period = (accounts receivable)/(annual credit sales/360 days)
20 days = (accounts receivable)/[(400,000)(.70)/360 days]
Accounts receivable = (20 × $280,000)/(360) = $15,556
Funds generated by reducing accounts receivable = $25,000 -
$15,556 = $9,444
Inventory turnover = (cost of goods sold)/(ending
inventory)
10.0 = [($400,000)(1 - .10)]/(ending inventory)
Ending inventory = ($360,000)/(10.0) = $36,000
Funds generated by reducing inventory = $80,000 - $36,000 =
$44,000
Total funds generated = $9,444 + $44,000 = $53,444
99) Baker & Co. has applied for a loan from the Trust
Us Bank to invest in several potential opportunities. To evaluate the firm as a
potential debtor, the bank would like to compare Baker & Co. to the
industry. The following are the financial statements given to Trust Us Bank:
Balance Sheet
12/31/13 12/31/14
Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and
equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and
Owners' Equity
Accounts payable $150 $200
Notes payable 125 0
Current liabilities 275 200
Bonds 500 500
Owners' equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners' equity 1,605 1,780
Total liabilities and
owners' equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross profit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before
taxes 256 283
Taxes 87 96
Net income $169 $187
Compute the following ratios:
2013
2014 Industry Norms
Current ratio 5.0
Acid test ratio 3.0
Inventory turnover 2.2
Average collection period 90
days
Debt ratio .33
Times interest earned 7.0
Total asset turnover .75
Fixed asset turnover 1.0
Operating profit margin 20%
Net profit margin 12%
Return on total assets 9.00%
Return on equity
10.43%
Answer: Industry
2013
2014 Norm Evaluation
Current ratio
4.3x 5.7x 5.0x Satisfactory
Acid test
(quick) ratio 2.1x 2.8x 3.0x Improving
Inventory
turnover 1.0x 1.31x 2.2x Poor
Average
collection period 90 days 78.5 days 90 days Satisfactory
Debt ratio 33% 28% 33% Satisfactory
Times
interest earned 5.0x 6.0x 7.0x Poor
Total asset
turnover .46x .54x .75x Poor
Fixed asset
turnover .92x .99x 1.00x Satisfactory
Operating
Profit Margin 29.1% 25.6% 20% Satisfactory
Net profit
margin 15.36% 14.06% 12.00%
Poor
Return on
total assets 7.1% 7.54% 9.00% Poor
Operating
income return
on investments 13.45% 13.71%
15.00% Poor
Return on
equity 10.6% 10.47% 13.43% Poor
100) Baker & Co. has applied for a loan from the Trust
Us Bank to invest in several potential opportunities. To evaluate the firm as a
potential debtor, the bank would like to compare Baker & Co. to the
industry. The following are the financial statements given to Trust Us Bank:
Balance Sheet
12/31/13 12/31/14
Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and
equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and
Owners' Equity
Accounts payable $150 $200
Notes payable 125 0
Current liabilities 275 200
Bonds 500 500
Owners' equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners' equity 1,605 1,780
Total liabilities and
owners' equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross profit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before
taxes 256 283
Taxes 87 96
Net income $169 $187
a. What are the firm's financial strengths and weaknesses?
b. Should the
bank make the loan? Why or why not?
Answer:
a. The firm's liquidity has improved significantly, as
indicated by the current ratio and the acid test ratio. However, the current
ratio is a bit deceiving since it relies on inventory in part for liquidity.
Since the inventory is not particularly liquid (low inventory turnover), the
quick ratio is a better measure of liquidity, which is still below the industry
norm. Management has done a less-than-average job of generating operating
profits on its assets (low operating income return on investment). The cause
for the low OIROI is the inefficient use of assets (low asset turnover),
especially inventory (low inventory turnover). However, this ineffectiveness is
countered by efficiencies in keeping operating expenses low (high operating
profit margin). From a balance sheet perspective, the company has less financial
risk than the average firm in the industry (slightly lower debt ratio).
However, owing to the firm's lower profitability, it is not covering its
interest charges as well as the average firm in the industry (low times
interest earned). Owing to the low return on investment, the firm's return on
assets and return on equity are low relative to its competition.
b. The answer is not an easy one. The firm has improved its
liquidity, but it is still having problems at effectively managing its
inventory. It may be that the loan is not needed to the extent thought, but
rather management should work at reducing its investment in inventories. The
bank would also want to know why the operating profit margin, which is still
high, is falling. Nevertheless, the loan decision could go either way.
4.4 Selecting a Performance Benchmark
1) Which of the following industries has the highest
average inventory turnover ratio?
A) Retail clothing stores
B) Jewelry stores
C) Automobile dealerships
D) Supermarkets
2) Which of the following would be most responsible for a
company's average collection period being higher than the industry average?
A) If a company's growth in sales is greater than the
growth of sales in the industry.
B) Being more aggressive in collecting its accounts
receivable than its competitors.
C) Having credit policy standards that are more restrictive
than its competitors.
D) Being more lenient in extending credit to its customers
than its competitors.
3) When the present financial ratios of a firm are compared
with similar ratios for another firm in the same industry, it is called trend
analysis.
Answer: FALSE
4) Firms that engage in multiple lines of business make it
difficult to assign them to an industry category for ratio analysis.
Answer: TRUE
5) A small start-up company should choose an industry
leader in the same industry as a benchmark.
Answer: FALSE
6) Companies chosen for benchmmarks should be of similar
size and in the same or a similar industry.
Answer: TRUE
4.5 Limitations of Ratio Analysis
1) Which of the following is NOT a reason why financial
analysts use ratio analysis?
A) Ratios help to pinpoint a firm's strengths.
B) Ratios restate accounting data in relative terms.
C) Ratios are ideal for smoothing out the differences that
may exist when comparing firms that use different accounting practices.
D) Some of a firm's weaknesses can be identified through
the usage of ratios.
2) Which of the following is NOT a limitation related to
the usage of ratios when reviewing a firm's performance?
A) Many firms experience seasonality in their operations.
B) Ratios cannot be used to compare firms that are in the
same industry if one firm's sales are higher than another firm's.
C) Some firms operate in a variety of business lines, which
makes it difficult to make comparisons.
D) Accounting practices differ widely among firms.
3) Which of the following statements is FALSE?
A) The calculation of the accounts receivable average
collection period (ACP) would generally produce a more realistic assessment of
how a firm is managing its accounts receivable if the analyst were to calculate
the ACP for each month and average the results, than if the analyst were to
solely use the fiscal year-end accounts receivable value.
B) If an analyst were to compare the inventory turnover of
one firm to that of another, the comparison can be distorted if the two firms
use different methods of valuing ending inventory.
C) Assume that two firms are in the same industry and one
reports a higher debt ratio than the other. We can safely say that the firm
that has the highest debt ratio is the riskier of the two firms.
D) A firm that has a current ratio that is significantly
above the industry norm will, as a direct consequence, also have a significantly
better return on assets than if its current ratio was below the industry norm.
E) All of the above statements are true.
4) Which of the following is a limitation related to the
usage of ratios when reviewing a firm's performance?
A) Ratios reveal differences in policy and performance
between years.
B) Ratios can be used to compare firms that are in the same
industry if one firm's sales are higher than another firm's.
C) Financial ratios are designed for the use of creditors,
not for managers.
D) Different accounting practices between firms can distort
comparisons.
5) A serious pitfall in the interpretation of financial
ratios arises when a company, whose business is seasonal, ends its accounting
year on March 31, while most companies in the same industry end their
accounting period on December 31.
6) Differences in accounting practices limit the use of
ratio analysis.
Answer: TRUE
7) Discuss the limitations of ratio analysis.
Answer: It is often
difficult to find adequate benchmarks to use, as companies in the same industry
can be structured quite differently. Conglomerates are difficult to classify,
as they are involved in many different businesses. Firms in different countries
use different accounting methods, so ratio analysis can be difficult when
trying to compare multinational firms. Many firms have seasonal business, which
can skew results, and one-time restructurings are difficult to account for.
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