Chapter 4

Analyzing Financial Statements

LEARNING OBJECTIVES
1. Explain the three perspectives from which financial statements can be viewed. Financial statements can be viewed from the owners’, managers’, or creditors’ perspective. All three groups are ultimately interested in a firm’s profitability, but each group takes a different view. Shareholders want to know how much cash they can expect to receive for their stocks, what their return on investment will be, and/or how much their stock is worth in the market. Managers should have the same perspective as shareholders when analyzing financial statements. However, managers are concerned with maximizing the firm’s long-term value through a series of day-to-day decisions as they manage the firm; thus, they need to see the short-term impact of their decisions on the financial statements to confirm that things are indeed going as planned. Finally, creditors monitor the company’s use of debt and are particularly concerned with how much debt the firm is using: Is the firm generating enough cash to pay its short-term obligations, and will the firm have enough money to cover interest and principal payments on long-term debt as it comes due?

2. Describe common-size financial statements, explain why they are used, and be able to prepare and use them to analyze the historical performance of a firm. Common-size financial statements are financial statements in which each number has been scaled by a common measure of firm size: balance sheets are expressed as a percentage of total assets, and income statements are expressed as a percentage of net sales. Common-size financial statements are necessary when comparing firms that are significantly different in size.

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3. Discuss how financial ratios facilitate financial analysis, and be able to compute and use them to analyze a firm’s performance. A financial ratio is simply one number from a financial statement divided by another. Ratios are used in financial analysis because they eliminate the size problem when comparing two or more companies of different size or when looking at the same company over time as the size changes. Financial ratios can be divided into five categories: liquidity, efficiency, leverage, profitability, and market-value ratios. Liquidity ratios measure the ability of a company to cover its current bills. Efficiency ratios tell how efficiently the firm uses its assets and how quickly the firm converts current assets into cash. Leverage ratios tell how much debt a firm has in its capital structure and whether the firm can meet its long-term financial obligations, such as interest payments on debt or lease payments. Profitability ratios focus on the firm’s earnings. Finally, market-value indicators look at a company based on market data as opposed to historical data used in traditional financial statements.

4. Describe the DuPont system of analysis and be able to use it to evaluate a firm’s performance and identify corrective actions that may be necessary. The DuPont system of analysis is a diagnostic tool that uses financial ratios to assess a firm’s financial strength. Once the assessment is complete, management focuses on correcting the problems within the context of maximizing the firm’s ROE. For analysis, the DuPont system breaks ROE into three components: net profit margin, which measures operating efficiency; total asset turnover, which measures how efficiently the firm deploys its assets; and the equity multiplier, which measures financial leverage. Exhibit 4.5 summarizes the structure of the DuPont system of analysis and shows how it links the balance sheet and income statement together.

5. Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis.

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Once we have calculated financial ratios, we need some way to evaluate them. A benchmark provides a standard for comparison. In financial statement analysis, a number of benchmarks are used. Most often, benchmark comparisons involve competitors that are roughly the same size and that offer a similar range of products. The data for these benchmark samples may be obtained from national data banks maintained by the U.S. Department of Commerce, trade associations, or private firms, such as Dun & Bradstreet. Alternatively, the firm’s major competitors can be identified, and financial data on these firms can be collected from their annual reports. Another form of benchmarking is trend analysis, which compares a firm’s current financial ratios against the same ratios from past years. Trend analysis tells us whether a ratio is increasing or decreasing over time.

6.

Identify the major limitations in using financial statement analysis.

The major limitations of financial statement and ratio analysis are the use of historical accounting data and the lack of theory to guide the decision maker. The lack of theory explains, in part, why there are so many rules of thumb. Although rules of thumb are useful, and they may work under certain conditions, they may lead to poor decisions if circumstances or the economic environment has changed.

I.
1.

True or False Questions
Financial statement analysis can help us determine why a firm’s cash flows are increasing or decreasing

a. b.

True False

3

2.

Shareholders focus on the value of their stock but not on how much cash they can expect to receive from dividends and/or capital appreciation.

a. b.

True False

3.

Managers’ decisions regarding financing, investment, and working capital are reflected in the financial statements.

a. b.

True False

4.

A financial statement analysis conducted over a three- to five-year period is called trend analysis.

a. b.

True False

5.

A benchmark for a financial statement analysis is the performance of a multinational firm in the same industry from another country.

a. b.

True False

4

6.

A typical way common size income statement is constructed is by dividing all expense items in an income statement by net income.

a. b.

True False

7.

The most frequent method of adjusting balance sheets to a common-size basis is to divide each of the accounts by total assets, expressing each account as a percentage of total assets.

a. b.

True False

8.

Liquidity ratios are concerned with the firm’s ability to pay its current bills without putting the firm in financial difficulty.

a. b.

True False

9.

A firm’s current ratio changed from 1.4 times in the previous year to 1.6 times this year. Concluding that the firm’s liquidity improved is ___________.

5

a. b.

True False

10.

A company can improve its liquidity by increasing its accounts payable, while holding all else constant.

a. b.

True False

11.

The purchase of additional inventory by a firm should decrease a firm’s quick ratio.

a. b.

True False

12.

Turnover ratios are used by managers to identify operational inefficiencies.

a. b.

True False

13.

A firm increased its days’ sales outstanding from 35 days to 43 days. This implies the firm is more efficient.

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a. b.

True False

14.

Total asset turnover is more relevant for service industry firms, while the fixed asset turnover ratio is more relevant for manufacturing industry firms.

a. b.

True False

15.

Financial leverage refers to the use of preferred stock in a firm’s capital structure.

a. b.

True False

16.

The equity multiplier is computed by dividing equity by total assets.

a. b.

True False

17.

The higher the times interest earned ratio, the more comfortable are a firm’s creditors in the ability of the firm to meet its interest obligations.

a.

True

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b.

False

18.

A firm that has no debt will have its ROA equal to its ROE.

a. b.

True False

19.

For a given level of after-tax income, the lower the level of equity a firm has, the higher the return on equity its shareholders will earn.

a. b.

True False

20.

For a given share price of a firm’s stock, the lower the EPS the lower the price-earnings ratio.

a. b.

True False

21.

The DuPont equation relates a firm’s net profit margin, total asset turnover ratio, and equity multiplier to determine its return on equity.

a.

True

8

b.

False

22.

Firms with a lower ROA and higher leverage will always have a lower ROE than firms with a higher ROA and lower leverage.

a. b.

True False

23.

In doing an industry group analysis, you form the comparison group by choosing firms that are larger than the firm being compared.

a. b.

True False

24.

The Standard Industry Classification (SIC) system is a federal government established system in which the last two digits indicate the business or industry in which the firm is engaged.

a. b.

True False

25.

The use of inflation-adjusted balance sheets serves to correct a weakness of ratio analysis.

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a. b.

True False

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II.

Multiple-Choice Questions

26.

Financial statements can be analyzed from the following three different perspectives:

a. b. c. d.

management, regulator, and bondholder management, shareholder, and creditor regulator, shareholder, and creditor shareholder, creditor, and regulator

27.

Shareholders analyze financial statements in order to:

a. b.

assess the cash flows that the firm will generate from operations/ determine the firm’s profitability, their return for that period, and the dividend they are likely to receive.

c. d.

focus on the value of the stock they hold. All of the above.

28.

The creditors of a firm analyze financial statements so that they can focus on

a.

the firm’s amount of debt.

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b.

the firm’s ability to generate sufficient cash flows to meet all legal obligations first and still have sufficient cash flows to meet debt repayment and interest payments.

c. d.

the firm’s ability to meet its short-term obligations. All of the above.

29.

A firm’s management analyzes financial statement’s so that:

a.

they can get feedback on their investing, financing, and working capital decisions by identifying trends in the various accounts that are reported in the financial statements.

b.

similar to shareholders, they can focus on profitability, dividend, capital appreciation, and return on investment.

c. d.

they can get more stock options. a and b.

30.

Anyone analyzing a firm’s financial statements should

a. b. c. d.

use audited financial statements only. do a trend analysis. perform a benchmark analysis. All of the above.

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31.

An individual analyzing a firm’s financial statements should do all but one of the following:

a. b. c. d.

Use unaudited financial statements. Do a trend analysis. Perform a benchmark analysis. Compare the firm’s performance to that of its direct competitors.

32.

All but one of the following is true of common-size balance sheets.

a.

Each asset and liability item on the balance sheet is standardized by dividing it by total assets.

b. c.

Balance sheet accounts are represented as percentages of total assets. Each asset and liability item on the balance sheet is standardized by dividing it by sales.

d.

Common-size financial statements allow us to make meaningful comparisons between the financial statements of two firms that are different in size.

33.

All but one of the following is true of common-size income statements.

a. b. c.

Each income statement item is standardized by dividing it by total assets. Income statement accounts are represented as percentages of sales. Each income statement item is standardized by dividing it by sales.

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d.

Common-size financial statement analysis is a specialized application of ratio analysis.

34.

Common-size financial statements:

a. b.

are a specialized application of ratio analysis. allow us to make meaningful comparisons between the financial statements of two firms that are different in size.

c.

are prepared by having each financial statement item expressed as a percentage of some base number, such as total assets or total revenues.

d.

All of the above are true.

35.

Which of the following is true of ratio analysis?

a.

A ratio is computed by dividing one balance sheet or income statement item by another.

b. c.

The choice of the scale determines the story that can be garnered from the ratio. Ratios can be calculated based on the type of firm being analyzed or the kind of analysis being performed.

d.

All of the above are true.

36.

Which of the following is NOT true of liquidity ratios?

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a.

They measure the ability of the firm to meet short-term obligations with shortterm assets without putting the firm in financial trouble.

b.

There are two commonly used ratios to measure liquidity—current ratio and quick ratio.

c.

For manufacturing firms, quick ratios will tend to be much larger than current ratios.

d.

The higher the number, the more liquid the firm and the better its ability to pay its short-term bills.

37.

All but one of the following is true about quick ratios.

a.

The quick ratio is calculated by dividing the most liquid of current assets by current liabilities.

b.

Service firms that tend not to carry too much inventory will see significantly higher quick ratios than current ratios.

c.

Inventory, being not very liquid, is subtracted from total current assets to determine the most liquid assets.

d.

Quick ratios will tend to be much smaller than current ratio for manufacturing firms or other industries that have a lot of inventory.

38.

Which one of the following does NOT change a firm’s current ratio?

a.

The firm collects on its accounts receivables.

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b. c. d.

The firm purchases inventory by taking a short-term loan. The firm pays down its accounts payables. None of the above.

39.

All else being equal, which one of the following will decrease a firm’s current ratio?

a. b. c. d.

a decrease in the net fixed assets a decrease in depreciation an increase in accounts payable None of the above

40.

All but one of the following is true about the inventory turnover ratio.

a. b. c. d.

It is calculated by dividing inventory by cost of goods sold. It measures how many times the inventory is turned over into saleable products. The more times a firm can turnover the inventory, the better. Too high a turnover or too low a turnover could be a warning sign.

41.

Which one of the following statements is NOT true?

a.

The accounts receivables turnover ratio measures how quickly the firm collects on its credit sales.

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b.

One ratio that measures the efficiency of a firm’s collection policy is days’ sales outstanding.

c.

The more days that it takes the firm to collect on its receivables, the more efficient the firm is.

d.

DSO measures in days, the time the firm takes to convert its receivables into cash.

42.

One of the following statements is NOT true of asset turnover ratios.

a.

Asset turnover ratios measure the level of sales per dollar of assets that the firm has.

b.

The fixed assets turnover ratio is less significant for equipment-intensive manufacturing industry firms than the total assets turnover ratio.

c.

The higher the total asset turnover, the more efficiently management is using total assets.

d.

All of the above are true.

43.

Which one of the following statements is correct?

a. b. c. d.

The lower the level of a firm’s debt, the higher the firm’s leverage. The lower the level of a firm’s debt, the lower the firm’s equity multiplier. The lower the level of a firm’s debt, the higher the firm’s equity multiplier. The tax benefit from using debt financing reduces a firm’s risk.

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44.

If firm A has a higher equity ratio than firm B, then

a. b. c. d.

firm A has a lower equity multiplier than firm B. firm B has a lower equity multiplier than firm A. firm B has lower financial leverage than firm A. None of the above.

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45.

Which one of the following statements is NOT correct?

a. b. c. d.

A leveraged firm is more risky than a firm that is not leveraged. A leveraged firm is less risky than a firm that is not leveraged. A firm that uses debt magnifies the return to its shareholders. All of the above statements are correct.

46.

Coverage ratios, like times interest earned and cash coverage ratio, allow

a. b.

a firm’s management to assess how well they meet short-term liabilities. a firm’s shareholders to assess how well the firm will meet its short-term liabilities.

c. d.

a firm’s creditors to assess how well the firm will meet its interest obligations. a firm’s creditors to assess how well the firm will meet its short-term liabilities other than interest expense.

47.

For a firm that has no debt in its capital structure,

a. b. c. d.

ROE > ROA. ROE < ROA. ROE = ROA. None of the above.

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48.

For a firm that has both debt and equity,

a. b. c. d.

ROE > ROA. ROE < ROA. ROE = ROA None of the above.

49.

Which one of the following statements is NOT correct?

a. b.

The DuPont system is based on two equations that relate a firm’s ROA and ROE. The DuPont system is a set of related ratios that links the balance sheet and the income statement.

c.

Both management and shareholders can use this tool to understand the factors that drive a firm’s ROE.

d.

All of the above are correct.

50.

The DuPont equation shows that a firm’s ROE is determined by three factors:

a. b. c. d.

net profit margin, total asset turnover, and the equity multiplier operating profit margin, ROA, and the ROE net profit margin, total asset turnover, the ROA ROA, total assets turnover, and the equity multiplier

20

51.

Which one of the following is a criticism of equating the goals of maximizing the ROE of a firm and maximizing the firm’s shareholder wealth?

a. b. c. d.

ROE is based on after-tax earnings, not cash flows. ROE does not consider risk. ROE ignores the size of the initial investment as well as future cash flows. All of the above are criticisms of ROE as a goal.

52.

Which one of the following is NOT an advantage of using ROE as a goal?

a. b.

ROE is highly correlated with shareholder wealth maximization. ROE and the DuPont analysis allow management to break down the performance and identify areas of strengths and weaknesses.

c. d.

ROE does not consider risk. All of the above are advantages of using ROE as a goal.

53.

Which one of the following statements about trend analysis is NOT correct?

a. b.

This benchmark is based on a firm’s historical performance. It allows management to examine each ratio over time and determine whether the trend is good or bad for the firm.

c.

The Standard Industrial Classification (SIC) System is used to identify benchmark firms.

21

d.

All of the above are true statements.

54.

Peer group analysis can be performed by

a.

management choosing a set of firms that are similar in size or sales, or who compete in the same market.

b.

using the average ratios of this peer group, which would then be used as the benchmark.

c.

identifying firms in the same industry that are grouped by size, sales, and product lines in order to establish benchmark ratios.

d.

Only a and b relate to peer group analysis.

55.

Limitations of ratio analysis include all but

a. b.

Ratios depend on accounting data based on historical costs. Differences in accounting practices like FIFO versus LIFO make comparison difficult.

c. d.

Trend analysis could be distorted by financial statements affected by inflation. All of the above are limitations of ratio analysis.

56.

Liquidity ratio: Lionel, Inc., has current assets of $623,122, including inventory of $241,990, and current liabilities of 378,454. What is the quick ratio?

22

a. b. c. d.

1.65 0.64 1.01 None of the above

57.

Liquidity ratio: Bathez Corp. has receivables of $334,227, inventory of $451,000, cash of $73,913, and accounts payables of $469,553. What is the firm’s current ratio?

a. b. c. d.

1.83 0.73 1.67 None of the above

58.

Liquidity ratio: Zidane Enterprises has a current ratio of 1.92, current liabilities of $272,934, and inventory of 197,333. What is the firm’s quick ratio?

a. b. c. d.

0.72 1.20 1.92 None of the above

59.

Liquidity ratio: Ronaldinho Trading Co. is required by its bank to maintain a current ratio of at least 1.75, and its current ratio now is 2.1. The firm plans to acquire additional

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inventory to meet an unexpected surge in the demand for its products and will pay for the inventory with short-term debt. How much inventory can the firm purchase without violating its debt agreement if their total current assets equal $3.5 million?

a. b. c. d.

$0 $777,777 $1 million None of the above

60.

Efficiency ratio: If Randolph Corp. has accounts receivables of $654,803 and net sales of $1,932,349, what is its accounts receivable turnover?

a. b. c. d.

0.34 times 1.78 times 2.95 times None of the above

61.

Efficiency ratio: If Viera, Inc., has an accounts receivable turnover of 3.9 times and net sales of $3,436,812, what is its level of receivables?

a. b. c.

$881,234 $13,403,567 $1,340,357

24

d.

$81,234

62.

Efficiency ratio: Jason Traders has sales of $833,587, a gross profit margin of 32.4 percent, and inventory of $178,435. What is the company’s inventory turnover ratio?

a. b. c. d.

4.67 times 3.16 times 4.1 times None of the above

63.

Efficiency ratio: Gateway Corp. has an inventory turnover ratio of 5.6. What is the firm’s days’ sales in inventory?

a. b. c. d.

65.2 days 64.3 days 61.7 days 57.9 days

64.

Efficiency ratio: Jet, Inc., has net sales of $712,478 and accounts receivables of $167,435. What are the firm’s accounts receivables turnover and days’ sales outstanding?

a. b.

0.24 times; 4.26 times;

78.5 days 85.7 days

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c. d.

5.2 times;

61.3 days

None of the above

65.

Efficiency ratio: Ellicott City Manufacturers, Inc., has sales of $6,344,210, and a gross profit margin of 67.3 percent. What is the firm’s cost of goods sold?

a. b. c. d.

$2,074,557 $2,745,640 $274,560 None of the above

66.

Efficiency ratio: Deutsche Bearings has total sales of $9,745,923, inventories of $2,237,435, cash and equivalents of $755,071, and days’ sales outstanding of 49 days. If the firm’s management wanted its DSO to be 35 days, by how much will the accounts receivable have to change?

a. b. c. d.

$373,816.23 -$373,816.23 -$379,008.12 $379,008.12

67.

Coverage ratio: Trident Corp. has debt of $3.35 million with an interest rate of 6.875 percent. The company has an EBIT of $2,766,009. What is its times interest earned?

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a. b. c. d.

13 times 12 times 11 times None of the above

68.

Coverage ratios: Sectors, Inc., has an EBIT of $7,221,643 and interest expense of $611,800. Its depreciation for the year is $1,434,500. What is its cash coverage ratio?

a. b. c. d.

15.42 times 18.34 times 14.15 times None of the above

69.

Coverage ratios: Fahr Company had depreciation expenses of $630,715, interest expenses of $112,078, and an EBIT of $1,542,833 for the year ended June 30, 2006. What are the times interest earned and cash coverage ratios for this company?

a. b. c. d.

19.4 times; 17.3 time; 13.8 times;

12.7 times 11.4 times 19.4 times

None of the above

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70.

Leverage ratio: Your firm has an equity multiplier of 2.47. What is its debt-to-equity ratio?

a. b. c. d.

0.60 1.47 1.74 0

71.

Leverage ratio: What will be a firm’s equity multiplier given a debt ratio of 0.45?

a. b. c. d.

1.82 1.28 2.22 None of the above

72.

Leverage ratio: Dreisen Traders has total debt of $1,233,837 and total assets of $2,178,990. What are the firm’s equity multiplier and debt-to-equity ratio?

a. b. c. d.

2.31; 1.31 1.75; 0.75 0.75; 1.75 1.31; 2.31

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73.

Market-value ratio: RTR Corp. has reported a net income of $812,425 for the year. The company’s share price is $13.45, and the company has 312,490 shares outstanding. Compute the firm’s price-earnings ratio.

a. b. c. d.

4.87 times 8.12 times 5.17 times None of the above

74.

Market-value ratios: Perez Electronics Corp. has reported that its net income for 2006 is $1,276,351. The firm has 420,000 shares outstanding and a P-E ratio of 11.2 times. What is the firm’s share price?

a. b. c. d.

$34.05 $3.68 $11.20 $36.80

75.

Profitability ratio: Juventus Corp has total assets of $4,744,288, total debt of $2,912,000, and net sales of $7,212,465. Their net profit margin for the year is 18 percent. What is Juventus’s ROA?

a.

25.6%

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b. c. d.

18% 27.4% None of the above

76.

DuPont equation: GenTech Pharma has reported the following information: Sales/Total assets = 2.89; ROA = 10.74%; ROE = 20.36%

What are the firm’s profit margin and equity multiplier?

a. b. c. d.

7.1%; 0.53 7.1%; 1.90 3.7%; 0.53 3.7%; 1.90

77.

Profitability ratios: Tigger Corp. has reported the financial results for year-end 2006. Based on the information given, calculate the firm’s gross profit margin and operating profit margin.

Net sales = $4,156,700 Cost of goods sold = $2,715,334

Net income = $778,321 EBIT = $1,356,098

a. b. c.

34.7%; 32.6%; 34.7%;

32.6% 18.72% 18.72%

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d.

None of the above

78.

DuPont equation: Andrade Corp has debt of $2,834,950, total assets of $5,178,235, sales of $8,234,121, and net income of $812,355. What is the firm’s return on equity?

a. b. c. d.

7.1%t 34.7% 28.1% 43.2%

79.

DuPont equation: Saunders, Inc., has a ROE of 18.7 percent, an equity multiplier of 2.53, sales of $2.75 million, and a total assets turnover of 2.7 times. What is the firm’s net income?

a. b. c. d.

$75,281.80 $514,250.00 $51,425.00 $7,528.10

80.

DuPont equation: Sorenstam Corp has an equity multiplier of 2.34 times, total assets of $4,512,895, a ROE of 17.5 percent, and a total assets turnover of 3.1 times. Calculate the firm’s ROA.

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a. b. c. d.

6.23% 4.53% 7.48% 5.79%

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III. Essay Questions

81.

Compare how a firm’s creditor would analyze a firm’s financial statements relative to those of a firm’s shareholders.

Answer: A firm’s creditors’ primary concern is the ability of the firm to repay their loans with interest on a timely manner. Toward this end they would analyze the firm’s financial statements to gauge the ability of the firm to generate sufficient cash flows to meet not only their legal financial obligations but also their debt obligations. Shareholders, on the other hand, want to know how much cash they can expect to receive for their stocks, what their return on investment will be, and/or how much their stock is worth in the market.

82.

Explain the different ways that a firm’s ratios can be benchmarked.

Answer: Benchmark data can be obtained in one of three different ways—trend analysis, industry average analysis, and peer group analysis. Trend analysis involves evaluating a single firm’s performance over time. This sort of analysis allows management to see whether a given ratio value has increased or decreased over time and whether there has been any significant changes in the value of the ratios being analyzed. A ratio value that is changing typically is a signal to the financial manager to take a closer look at the ratio and to make decisions depending on whether the change is favorable or unfavorable to the firm.

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A second way to establish a benchmark is to conduct an industry group analysis. We do this by identifying a group of firms that have the same product line, compete in the same market, and are about the same size. The average ratio values for the group will be our benchmarks. The third way to establish benchmark information is to identify a group of firms that compete with the company you are analyzing. Ideally, the firms are in similar lines of business, are about the same size, and are direct competitors of the target firm. These firms form a peer group of firms in the same industry. Once a peer group has been identified, you can obtain their annual reports and compute average ratio values against which your firm can compare its performance.

83.

What are some of the main limitations of ratio analysis?

Answer: While financial ratio analysis can provide management with useful information to improve the firm’s performance, there are some serious limitations to its usefulness. First, ratio analysis depends on accounting data based on historical costs. Management or investors will get a truer picture of a firm’s financial condition if market value was the basis of the analysis. Second, there is no theoretical backing in making judgments based on financial statement and ratio analysis. Judgment calls made based on experience or common sense work only some of the time. Third, when doing industry or peer group analysis you are often confronted with large, diversified firms that do not fit into any one SIC code or classification. Fourth, trend analysis could be distorted by financial statements affected

34

by inflation. Finally, multinational firms deal with many accounting standards. Financial reports that are created based on different accounting standards make it difficult to compare. Even among domestic firms, differences in accounting practices, like FIFO versus LIFO, make comparison difficult.

35

IV. Answers to True or False Questions

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21.

True False True True False False True True True False True True False True False False True True True False True

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22. 23. 24. 25.

False False False True

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V.

Answers to Multiple-Choice Questions

26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46.

b d d d d a c a d d c b a c a c b b a b c

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47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69.

c a d a d c c d d c a b b c a b a b a b b c c

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70. 71. 72. 73. 74. 75. 76. 77. 78. 79. 80.

b a a c a c d a b a c

VI. Solutions to Multiple-Choice Questions
56. Solution: Current assets = $623,122 Current liabilities = $378,454 Inventory = $241,990

Quick ratio =

Current assets - Inventory Current liabilities $623,122 − $241,990 = $378,454 = 1.01

40

57.

Solution: Current assets = $73,913 + $451,000 +$334,227 = $859,140 Current liabilities = $469,553 Current ratio = Current assets Current liabilities $859,140 = $469,553 = 1.83

58.

Solution: Current ratio = 1.92 Current liabilities = $272,934 Inventory = $197,333 Current assets Current liabilites Current assets 1.92 = Current liabilites Current assets = 1.92 × $272,934 = $524,033 Current ratio = Quick ratio = Current assets - Inventory Current liabilities $524,033 − $197,333 = $272,934 = 1.20

59.

Solution:

41

Let X represent the additional borrowing against the firm’s line of credit (which also equals the addition to current assets). We can solve for that level of X that forces the firm’s current ratio to be at 1.75

$3,500,000/ Current liabilities = 2.1 Current liabilities = $1,666,667

1.75 = ($3,500,000 + X) / ($1,666,667 + X) (1.75 * $1,666,667) + 1.75X = $3,500,000 + X 0.75X = $3,500,000 - $2,916,667 X = $777,777

60.

Solution: Accounts receivables = $654,803 Net sales = $1,932,349 Accounts receivables turnover = Net sales Accounts receivables $1,932,349 = $654,803 = 2.95 times

61.

Solution:

42

Accounts receivables turnover = 3.9x Net sales = $3,436,812 Accounts receivables turnover = Net sales Accounts receivables $3,436,812 3 .9 x = Accounts receivables $3,436,812 Accounts receivables = = $881,234 3 .9

62.

Solution: Sales = $833,587 Gross profit margin = 32.4% Inventory = $178,435 Gross profit margin = Sales - Cost of goods sold Sales 833,587 − Cost of goods Sold 0.324 = 833,587 Cost of goods sold = 833,587 − (0.324 ∗ 833,587) = $563,506 Cost of goods sold $563,506 = Inventory $178,435 = 3.16x

Inventory turnover ratio =

63.

Solution:

Day' s sales in inventory =

365 = 65.2 days 5.6

43

64. Solution: Net sales = $712,478 Accounts receivables = $167,435 Accounts receivable turnover = Net sales Accounts receivable $712,478 = = 4.26 times. $167,435

DSO =

365 Net sales/Accounts recievable 365 = Accounts receivables turnover 365 = 4.26 = $85.7 days

65.

Solution: Gross profit margin = Sales - Cost of goods sold Sales $6,344,210 − Cost of Goods Sold 0.673 = $6,344,210 Cost of goods sold = $6,344,210 − (0.673 ∗ $6,344,210) = $2,074,557

66.

Solution:

44

Sales = $9,745,923; DSO = 49 Days

Inventory = $2,237,435

Cash = 755,071;

365 365 = Accounts receivable turnover Net sales/Accounts receivable 365 ∗ Accounts receivables DSO = Net sales DSO × Net sales 49 × $9,745,923 Accounts recievables = = 365 365 = $1,308,356.79 DSO = Target DSO = 35 Days DSO × Net sales 35 × 9,745,923 New accounts receivables = = 365 365 = $934,540.56 ∆ Accounts receivables = $1,308,356.79 - $934,540.56 - $373,816.23

67.

Solution: Interest expense = $3,350,000 x 0.06875 = $230,312.50 Times interest earned = EBIT $2,766,009 = Interest expense $230,312.50 = 12 times

68.

Solution: Depreciation = $1,434,500 Interest expenses = $611,800 EDIT = $7,221,643

45

Cash coverage rates =

EBITDA EBIT + Depreciati on = Interest expense Interest expense $7,221,643 + $1,434,500 = $611,800 = 14.15 times

69.

Solution: Depreciation = $630,715 Interest expenses = $112,078 EDIT= $1,542,833 Times interest earned = EBIT $1,542,833 = Interest expense $112,078 = 13.8 times

Cash coverage rates =

EBITDA EBIT + Depreciati on = Interest expense Interest expense $1,542,833 + $630,715 = $112,078 = 19.4 times

70.

Solution: Equity multiplier = 1 + Debt to equity Debt to equity = Equity multiplier –1 = 2.47 – 1 = 1.47

46

71.

Solution: Equity multiplier = Total assets 1 = Equity Equity / Total assets 1 1 = = 1 − Debt/Total assets 1 − 0.45 = 1.818

72.

Solution: Debt ratio = $1,233,837 / $2,178,990 = 0.57 Equity multiplier = Total assets 1 = Equity Equity / Total assets 1 1 = = 1 − Debt/Total assets 1 − 0.57 = 2.33

Equity multiplier = 1 + (Debt to equity) Debt to equity ratio = Equity multiplier - 1 = 2.33 - 1 = 1.33

73.

Solution: Net income = $812,425 Share price = $13.45 EPS = $812,425 / 312, 490 = $2.60

47

Price - earnings ratio =

$13.45 = 5.17 times $2.60

74.

Solution: Net income = $1,276,351 Share outstanding= 420,000 EPS = $1,276,351 / 420,000 = $3.04 P-E ratio = 11.2 times Price − earnings ratio = Price per share EPS Price per share 11.2 = $3.04 Pr ice per share = 11.2 × $3.04 = $34.05

75.

Solution: Total assets= $4,744,288; Net sales= $7,212,465; Net profit margin = Total debt= $2,912,000 Net profit margin= 18%

Net income Sales Net income = 0.18 ∗ $7,212,465 = $1,298,244

ROA =

Net income $1,298,244 = = 27.4% Total assets $4,744,288

48

76.

Solution: Total assets turnover = 2.89 ROA = 10.74% ROE = 20.36%

ROA = Profit margin x Total assets turnover

Profit margin =

ROA 0.1074 = = =3.7% Totoal assets turnover 2.89

ROE = ROA x Equity multiplier Equity multiplier = ROE 0.2036 = = 1.90 ROA 0.1074

77.

Solution: Net sales = $4,156,700 Net income = $778,321 Cost of goods sold = $2,715,334 EBIT = $1,356,098

Gross profit margin =

Net sales - Cost of goods sold Net sales $4,156,700 − $2,715,334 = = 34.6757% $4,156,700

Operating profit margin =

EBIT $1,356,098 = = 32.6243% Net sales $4,156,700 49

78.

Solution: $2,834,950 = 0.5475 $5,178,235 Equity ratio = 1 - 0.5475 = 0.4525 1 Equity multiplier = = 2.2099 0.4525 Debt ratio =

ROE = PM × TATO × EM Net income Sales = × × EM Sales Total assets $812,355 $8,234,121 = × × 2.22 $8,234,121 $5,178,235 = 0.0987 × 1.5901 × 2.2099 = 34.68%

79.

Solution: Total assets turnover = Sales $2,750,000 = Total assets Total assets $2,750,000 2.7 = Total assets $2,750,000 Total assets = = $1,018,518.52 2.7

50

Total assets Equity $1,018,518.52 2.53 = Equity $1,018,519 Equity = = $402,576.49 2.53 EM =

Net income Equity Net income = ROE × Equity = 0.187 × $402,577 ROE = = $75,281.80

80.

Solution:

Total assets turnover =

Sales Total assets Sales 3 .1 = $4,512,895 Sales = 3.1 × $4,512,895 = $13,989,975

Total assets Equity $4,512,895 2.34 = Equity $4,512,895 Equity = = $1,928,588 2.34 EM =

51

ROE =

NI Equity NI = ROE × Equity = 0.175 × $1,928,588 = $337,503

ROA =

NI $337,503 = = 7.48% Total assets $4,512,895

52

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