LECTURE 3 ANALYSIS OF FINANCIAL STATEMENTS

(Difficulty: E = Easy, M = Medium, and T = Tough)

True-False Easy:
Ratio analysis
1

Answer: a

Diff: E

.

Ratio analysis involves a comparison of the relationships between financial statement accounts so as to analyze the financial position and strength of a firm. a. True b. False

Liquidity ratios
2

Answer: b

Diff: E

.

The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio measures the relationship of a firm's current assets to its current liabilities and the inventory turnover ratio measures how rapidly a firm turns its inventory back into a "quick" asset or cash. a. True b. False

Current ratio
3

Answer: b

Diff: E

.

If a firm has high current and quick ratios, this is always a good indication that a firm is managing its liquidity position well. a. True b. False

Asset management ratios
4

Answer: a

Diff: E

.

The inventory turnover ratio and days sales outstanding (DSO) are two ratios that can be used to assess how effectively the firm is managing its assets in consideration of current and projected operating levels. a. True b. False

Inventory turnover ratio
5

Answer: b

Diff: E

.

A decline in the inventory turnover ratio suggests that the firm's liquidity position is improving. a. True

b. False Debt management ratios
6

Answer: a

Diff: E

.

The degree to which the managers of a firm attempt to magnify the returns to owners' capital through the use of financial leverage is captured in debt management ratios. a. True b. False

TIE ratio
7

Answer: a

Diff: E

.

The times-interest-earned ratio is one indication of a firm's ability to meet both long-term and short-term obligations. a. True b. False

Profitability ratios
8

Answer: a of

Diff: E asset

.

Profitability ratios show the combined effects management, and debt management on operations. a. True b. False

liquidity,

ROA
9

Answer: b

Diff: E

.

Since 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. a. True b. False

Market value ratios
10

Answer: a

Diff: E

.

Market value ratios provide management with a current assessment of how investors in the market view the firm's past performance and future prospects. a. True b. False

Trend analysis
11

Answer: a

Diff: E

.

Determining whether a firm's financial position is improving or deteriorating requires analysis of more than one set of financial statements. Trend analysis is one method of measuring a firm's performance over time. a. True b. False

Medium:
Liquidity ratios
12

Answer: b

Diff: M

.

If the current ratio of Firm A is greater than the current ratio of Firm B, we cannot be sure that the quick ratio of Firm A is greater than that of Firm B. However, if the quick ratio of Firm A exceeds that of Firm B, we can be assured that Firm A's current ratio also exceeds B's current ratio. a. True b. False

Inventory turnover ratio
13

Answer: a

Diff: M

.

The inventory turnover and current ratios are related. The combination of a high current ratio and a low inventory turnover ratio relative to the industry norm might indicate that the firm is maintaining too high an inventory level or that part of the inventory is obsolete or damaged. a. True b. False

Fixed assets turnover
14

Answer: b

Diff: M

.

We can use the fixed assets turnover ratio to legitimately compare firms in different industries as long as all the firms being compared are using the same proportion of fixed assets to total assets. a. True b. False

BEP and ROE
15

Answer: a

Diff: M

.

Suppose two firms 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, one firm has a higher debt ratio. If BEP is greater than the interest rate on debt, the firm with the higher debt ratio will also have a higher rate of return on common equity. a. True b. False

Equity multiplier
16

Answer: a

Diff: M

.

If the equity multiplier is 2.0, the debt ratio must be 0.5. a. True b. False

the interest rate it will pay on that debt. Which of the following statements is most correct? . b. Long-term debt is issued to pay off current liabilities. c. False Multiple Choice: Conceptual Easy: Current ratio 19 Answer: c Diff: E . which of the following will not affect the current ratio. Other things held constant. e. a. d. Suppose a firm wants to maintain a specific TIE ratio. If the firm knows the level of its debt. and the applicable tax rate. Cash is used to purchase inventories. however. False Profit margin and leverage 18 Answer: b Diff: M . Answer: d Diff: E Quick ratio 20 . Cash is used to pay off accounts payable. True b. Fixed assets are sold for cash. which of the following will not affect the quick ratio? (Assume that current assets equal current liabilities. Other things held constant. we can say with certainty that the profit margin on sales will decrease. b. Fixed assets are sold for cash. e.) a. A bank loan is obtained. a. d. True b. If sales decrease and financial leverage increases. c. trades at a higher price. Answer: a Diff: E Financial statement analysis 21 . Company J’s stock. Cash is used to pay off accounts payable. Company J and Company K each recently reported the same earnings per share (EPS).0? a. Accounts receivable are collected. the firm can then calculate the earnings level required to maintain its target TIE ratio. Accounts receivable are collected. Long-term debt is issued to pay off a short-term bank loan. assuming an initial current ratio greater than 1. and the proceeds are credited to the firm's checking account.TIE ratio 17 Answer: a Diff: M .

The times interest earned ratio (TIE) will increase. Company J must have a higher market to book ratio. its current ratio must rise. e. Company J must have a higher P/E ratio. e. Answers b and c are correct. c. All of the statements above are correct. Quick ratio Answer: e Diff: M . Company J must have fewer growth opportunities.a.000 and simultaneously increases its inventories by $1. Which of the following statements is most correct? a. Company J must be riskier. Answer: e Diff: E Leverage and financial ratios 22 . Taxes paid will decline. None of the statements above is correct. Statements a and b are correct.000. Medium: Liquidity ratios 23 Answer: d Diff: M . A company’s quick ratio may never exceed its current ratio.) a. b. d.'s CFO has proposed that the company issue new debt and use the proceeds to buy back common stock. d. Use cash to purchase additional inventory. d. If a company increases its current liabilities by $1. Reduce the company’s days sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. c. Which of the following are likely to occur if this proposal is adopted? (Assume that the proposal would have no effect on the company's operating earnings. e. Issue short-term debt and use the proceeds to buy back long-term debt with a maturity of more than one year. d. Current ratio 24 Answer: e Diff: M . b. c. b. e.000 and simultaneously increases its inventories by $1. Stennett Corp. None of the statements above is correct. Which of the following actions can a firm take to increase its current ratio? a. Return on assets (ROA) will decline. None of the answers above is correct. Statements a and c are correct. b. If a company increases its current liabilities by $1. c. its quick ratio must fall.000.

None of the statements above is correct.50 0. A small subsidiary which was acquired for $100.0 e. b. One of the problems of ratio analysis is that the relationships are subject to manipulation. 0. (Average company profits are 15 percent of assets. 1. All of the answers above. Marketable securities are sold at cost.5 1. the current ratio will always increase.5 Debt ratio 0. the firm with the higher debt ratio will also have a higher rate of return on common equity.5 b.0 c.000 cash. Answers a and b above.5 TIE 0. Which of the following actions will cause an increase in the quick ratio in the short run? a. e.67 0.000 worth of inventory is sold. Ratio analysis 26 Answer: c Diff: M .25 . 2.0 1.50 0.5 1. The receivable exceeds the inventory by the amount of profit on the sale. and an account receivable is created. Generally.0 0. e. d. All of the statements above are correct. firms with high profit margins have high asset turnover ratios. d. which is added to retained earnings. Which of the following statements is most correct? a. and if that ROA is positive.000 two years ago and which was generating profits at the rate of 10 percent is sold for $100.5 d. $1.71 Answer: a Diff: M Financial statement analysis 27 . 1. this result is exactly as predicted by the extended Du Pont equation.33 0. As a short-term creditor concerned with a company's ability to meet its financial obligation to you. especially if the current ratio is weak initially. 2. we know that if we use some of our cash to pay off some of our current liabilities. which one of the following combinations of ratios would you most likely prefer? Current ratio a.) c. and firms with low profit margins have low turnover ratios. For example. c. If two firms pay the same interest rate on their debt and have the same rate of return on assets. b. .

c. other things held constant. which require a lot of fixed assets relative to sales. would generally lead to an increase in the total asset turnover ratio. . b. d. All of the answers above are correct. It is anticipated that these actions will have no effect on sales. An increase in the DSO. If the two companies have the same basic earning power (BEP). d. which has the same amount of total assets.Financial statement analysis 28 Answer: a Diff: M . where all firms earn similar returns on equity. than for fresh fish markets. Return on assets will increase. b. or on the firm’s total assets. Times interest earned will increase. Both companies have a marginal tax rate of 35 percent. Basic earning power will decrease. would generally lead to an increase in the ROE. In a competitive economy. Which of the following statements is most correct? a. Which of the following statements is most correct? a. An increase in a firm's debt ratio. Company B will have a lower profit margin. An increase in the DSO. one would expect to find lower profit margins for airlines. whereas Company B. operating income. Leverage and financial ratios 30 Answer: d Diff: M . Profit margin will decrease. If the firm does increase its debt ratio. b. Company B will have a higher return on assets. c. If the two companies have the same level of sales and basic earning power (BEP). It is more important to adjust the Debt/Assets ratio than the inventory turnover ratio to account for seasonal fluctuations. other things held constant. which of the following will occur? a. Company B will have a higher return on equity. None of the answers above is correct. Company A is financed with 90 percent debt. Leverage and financial ratios 29 Answer: a Diff: M . A firm is considering actions which will raise its debt ratio. Total assets turnover will increase. d. is financed entirely with equity. e. e. c. e. If the two companies have the same return on assets. could be expected to lower its profit margin on sales. with no changes in its sales and operating costs.

All of the statements above are correct. Answers a and b are correct. (That is. d. e. c. its timesinterest-earned (TIE) ratio and fixed charge coverage ratios must be the same. The company’s basic earning power (BEP) will fall. e. d. If Firm A has a higher market to book ratio than Firm B. common equity = total assets).) a. The company’s equity multiplier (EM) will increase. this implies that the firm is financed entirely with common equity. Miscellaneous ratios 33 Answer: e Diff: M . Which of the following statements is most correct? a. they should have the same stock price. None of the answers above is correct. they must have the same times interest earned (TIE) ratio. but that the company’s debt ratio will increase this year. Reeves Corporation forecasts that its operating income (EBIT) and total assets will remain the same as last year. All of the answers above are correct. If two companies have the same return on equity. b. c. b. e. If a firm has no lease payments or sinking fund payments. . c. Miscellaneous ratios 32 Answer: b Diff: M . If Company A and Company B have the same debt ratio. then Company A must have a higher return on assets. b. What can you conclude about the company’s financial ratios? (Assume that there will be no change in the company’s tax rate. Which of the following statements is most correct? a. d. Answers b and c are correct. The company’s return on assets (ROA) will fall. If a firm’s ROE and ROA are the same. If Company A has a higher profit margin and higher total assets turnover relative to Company B. then Firm A must also have a higher price earnings ratio (P/E).Miscellaneous ratios 31 Answer: e Diff: M . Answers b and c are correct.

Company X and Company Y. . cost of goods sold. However. and assets. and total assets. Which of the following statements is most correct? a. You have collected the following information: • • • • • The two Company Company Company Company companies have X has a higher X has a higher Y has a higher Y has a higher the same total assets. interest rate on debt. The ROE of any company which is earning positive profits and which has a positive net worth (or common equity) must exceed the company's ROA. b. Firms A and B have the same level of net income. b. we would expect B's profit margin to be higher than A's. c. Company Y must have a higher quick ratio. and c are false. Company X must have a higher net income. Under these conditions. e. its return on equity (ROE) must be greater than that of Firm B. c. b. d. Company A has a higher debt ratio. All of the answers above are correct. b. Tough: ROE and debt ratios 35 Answer: b Diff: T . that is. its basic earnings power ratio (BEP) must be greater than that of Firm B.Miscellaneous ratios 34 Answer: b Diff: M . then we can be sure that A will have a lower times-interest-earned ratio than B. d. b. Ratio analysis 36 Answer: a Diff: T . inventory turnover ratio than Company X. If Firms A and B have the same level of earnings per share. and c are true. taxes paid. You are an analyst following two companies. c. Company A uses more debt than Company B. Which of the following statements is most correct? a. total assets turnover than Company Y. Statements a. and the same market to book ratio. e. they must have the same price earnings ratio. Company X must have a higher ROE. None of the answers above is correct. Which of the following statements is most correct? a. If Company A has a higher debt ratio than Company B. If Firm A has a higher interest expense. Suppose two companies have identical operations in terms of sales. Firms A and B have the same level of net income. profit margin than Company Y. If Firm A has a higher interest expense. Statements a. current ratio than Company X.

higher times-interest-earned (TIE) ratio. and it plans to finance this increase by issuing $1 million in new debt. and its average tax rate will remain at 40 percent. d. . • The two companies have the same tax rate.d.000 $ 900. Statements a and b are correct.000 The company wants to increase its assets by $1 million. • The two companies have the same operating income (EBIT). The company’s net income will increase. The company’s income statement is summarized below: Operating Income (EBIT) Interest Expense Earnings before tax (EBT) Taxes (40%) Net Income $1. The company’s return on equity will remain the same. and $4 million of common equity. c. b. Company C has a higher debt ratio and a higher interest expense than Company D. c. All of the answers above are correct. but its operating income will remain at 20 percent of its total assets. Statements a and c are correct. lower ROA. higher basic earning power (BEP) ratio. Statements a and b are correct. The company’s assets are financed with $1 million of debt. lower ROE. You have collected the following information regarding Companies C and D: • The two companies have the same total assets.000 100. d. If the company takes this action. b. which of the following will occur: a. e. Ratio analysis 37 Answer: d Diff: T .000 360. Based on this information.000 $ 540.000. which of the following statements is most correct? a. This action will double the company’s interest expense. The company’s return on assets will fall. Blair Company has $5 million in total assets. e. Answer: d Diff: T • Leverage and financial ratios 38 . • Company C has a lower profit margin than Company D. Company Company Company Company Company C C C C C must must must must must have have have have have a a a a a higher level of sales. e.

9% 12. b. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent.000. total assets of $22. c. cut operating costs.4% 10. b. The company recently reported that its basic earning power (BEP) ratio was 15 percent and that its return on assets (ROA) was 9 percent. without affecting sales or the balance sheet (the additional profits will be paid out as dividends). what is the firm's ROA? a.000. d. and raise net income to $300. and an after-tax interest cost on total debt of 5 percent.000 $ 6. by how much would its ROE increase? a. 8.33% Sales: TIE ratio: $10.000.50% 4.00% 3.1% Answer: c Tapley Dental Supply Company has the following data: Net income: Debt ratio: BEP ratio: $240 75% 13.000 2. 3.500. What was the company’s interest expense? a.000 $18.0 Total assets: Current ratio: $6. e.000.2 Diff: E ROE 41 .000.500. e. b. If the firm has debt of $7.3% 15. e.25% 5.000 1.000 $15.000.0% 13. d. c. d. c.Multiple Choice: Problems Easy: Financial statement analysis 39 Answer: a Diff: E .00% 4.000 Answer: d Diff: E ROA 40 .000. If Tapley could streamline operations. A firm has a profit margin of 15 percent on sales of $20. $ 0 $ 2.50% .000.

Net F.000.7% Medium: Accounts receivable 43 Answer: a Diff: M R . The company's CFO estimates that if this policy is adopted the company's average sales will fall by 10 percent. Assuming that the company adopts this change and succeeds in reducing its DSO to 32 days and does lose 10 percent of its sales.4% 4.A.980 $ 9. e.000 $ 9.000 5.000 Income statement: Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net Income Debt Equity Total claims $10. c.000 in accounts receivable. what will be the level of accounts receivable following the change? a. 2. You think you can change your inventory control system so as to cause your turnover to equal the industry average.020 2.Profit margin 42 Answer: c following balance sheet and income Diff: E .000 5. b. Its days sales outstanding (DSO) is 50 days (based on a 365-day year).000 The industry average inventory turnover is 5. d. $576.000 .200 $ 800 400 $ 400 160 $ 240 $ 4. Total Assets statement $ 20 1. Ruth Company currently has $1.000 $ 6.3% 6. Your company had the information for 2003: Balance sheet: Cash A/R Inventories Total C. What will your profit margin be after the change in inventories is reflected in the income statement? a. and this change is expected to have no effect on either sales or cost of goods sold.A. The company wants to reduce its DSO to the industry average of 32 days by pressuring more of its customers to pay their bills on time. Assume a 365-day year. The cash generated from reducing inventories will be used to buy tax-exempt securities which have a 7 percent rate of return.5% 5.1% 2.000 9.

b. What is Q Corp.2. c. e. c.0% 16.000 $900.2% 13. What is the company’s return on assets (ROA)? a. and a debt ratio of 0.64.'s return on assets (ROA)? a. d. Q Corp. what is its return on total assets (ROA)? a.b.945.0% 12.5% Answer: e Diff: M ROA 46 . It has a profit margin of 4 percent. and a debt ratio of 60 percent.667 ROA 44 Answer: a Diff: M . c. its tax rate is 40 percent. d.25% Answer: c Diff: M R ROE 47 . sells all its merchandise on credit. $676. e.1% 14.56% 5. days sales outstanding equal to 60 days (based on a 365-day year).667 $776. and its basic earning power (BEP) ratio is 10 percent. Humphrey Hotels’ operating income (EBIT) is $40 million. What is the firm's return on equity (ROE)? . 8.000.7% 20.0% 10.5% 10. receivables of $147. b. Total assets are $100. The Meryl Corporation's common stock is currently selling at $100 per share. e. The company’s times-interest-earned (TIE) ratio is 8.33% 8. 7. If the firm has 100 shares of common stock outstanding.0. d.000 $976. c. total assets of $3 million.45% 5. e.0% Answer: a Diff: M ROA 45 .0% 12. which represents a P/E ratio of 10. and has a times interest earned (TIE) ratio of 6. a return on equity of 20 percent. b. has a basic earnings power (BEP) ratio of 15 percent. Selzer Inc.97% 4. d. The corporate tax rate is 40 percent. 6.

25% 30% 35% 42% 50% Earnings before taxes Sales = $5. 71.10 Total assets turnover = 2. 11% 46% 40% 20% 53% ROE 49 Answer: d Assume Meyer Corporation is 100 percent equity financed. c. b.1% b.. e.0 30% Diff: M .15).1% ROE 48 Answer: b Diff: M . 3.. new TA = old TA × 1.0% e. You expect to finance this asset growth entirely by debt.e. Calculate the .3% c.000 Dividend payout ratio Total assets turnover Applicable tax rate = = $1.00 Equity multiplier = 2.a. You are considering adding a new product to your firm's existing product line.5).00 a. b. 33. d.e. e. 7. 8. new PM = old PM × 1. If the following ratios were computed before the change. It should cause a 15 percent increase in your profit margin (i. c. return on equity.500 = 60% = 2. d. given the following information: (1) (2) (3) (4) (5) a. but it will also require a 50 percent increase in total assets (i. what will be the new ROE if the new product is added and sales remain constant? Ratios before new product Profit margin = 0.3% d.

and a quick ratio equal to 1. What is the .2 5.3 Debt ratio 51 Answer: c Diff: M . c. e.2.0. What is the company’s debt ratio? a. b. d.60 0. 2.45% e.66 Profit margin 52 Answer: a Diff: M . You are given the debt/total assets = 0.0 6. 5. The Merriam Company has determined that percent. c. 6.8.96% d.20 0. The company is financed entirely with debt and common equity.33 0.5 6. The company has $2 million in sales and its current liabilities are $1 million.000 in sales last year.0 5. 5. b.Liquidity ratios 50 Answer: a Diff: M .82% its return on equity is 15 various components that went following information: total turnover = 2.000. 12. Kansas Office Supply had $24. Its total assets turnover was 6.30 0.35 and total assets profit margin? a. 0. The company’s net income was $400. 3. d. Oliver Incorporated has a current ratio = 1.6.000. Management is interested in the into this calculation. What is the company’s inventory turnover ratio? a.48% b.42% c. e. The company’s ROE was 15 percent.

620.000 $ 360. Collins Company had the following partial balance sheet and complete annual income statement: Partial Balance Sheet: Cash A/R Inventories Total current assets Net fixed assets Total assets Income Statement: Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net Income $ 20 1. b.000 Financial statement analysis 54 Answer: e Diff: M R . c.200 $ 800 400 $ 400 160 $ 240 The industry average DSO is 30 (based on a 365-day year).000 $ 3.28% 52.20.75% 60. c.4. d. has a current ratio of 3.000 2.000 9. Harvey Supplies Inc. d.020 2.980 $ 6. What is Harvey's sales figure? a. Harvey's total assets are $1 million and its debt ratio is 0. 33. and an inventory turnover ratio of 6.0.000 $ 120. e. Collins plans to change its credit policy so as to cause its DSO to equal the industry average.000 $ 880. b. a quick ratio of 2.Sales volume 53 Answer: a Diff: M .000 $10. what will Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet? a. $ 720.33% 45. and this change is expected to have no effect on either sales or cost of goods sold.71% . The firm has no long-term debt. If the cash generated from reducing receivables is used to retire debt (which was outstanding all last year and which has a 10 percent interest rate).00% 65.000 $1. e.

4 b.000 $ 375. Thomas Corp. -$ 8. $200.2 The company’s current assets consist of cash. 4.000 200.20 1. d.667 Quick ratio 56 Answer: c Diff: M .000 d.000 175.000 Sales for the year totaled $600.493 c.333 b. 1. and its current ratio was 1. If the company follows the president's recommendation and sales remain the same.5 . has the following simplified balance sheet: Cash Inventory Accounts receivable Net fixed assets Total $ 50. and accounts receivable. The company’s current assets totaled $100 million.200.000 200. How much cash does Taft have on its balance sheet? a. b.000.000 Current liabilities Long-term debt Common equity Total $125. The company president believes the company carries excess inventory. What was the company’s quick ratio? a. and its inventory turnover ratio was 5.Financial ratios 55 Answer: b Diff: M R .55 2.8 1. e.0 c.72 0.000 $500. She would like the inventory turnover ratio to be 8× and would use the freed up cash to reduce current liabilities.000 $500.0. $316. Last year.49 Quick ratio 57 Answer: e Diff: M .000 40 4. c. inventories.000 150. $125. 4. $ 68.39 0. the new quick ratio would be: a. Quayle Energy had sales of $200 million. Taft Technologies has the following relationships: Annual sales Current liabilities Days sales outstanding (DSO) (365-day year) Inventory Turnover ratio Current ratio $1.2.000 e.000 100. 2.

000 1.27 1.200 3. Perry Technologies Inc.486 days. had the following financial information for the past year: Inventory turnover Quick ratio Sales Current ratio = = = = 8× 1.45 Current liabilities 59 Answer: a Diff: M . This additional cash would be used to reduce its notes payable. 1.417 days without reducing its sales. Under this scenario.500 The company also forecasts that its days sales outstanding (DSO) on a 365-day basis will be 35.500 $ 800 400 $1.17 2. 3.2 e.0 Current ratio 58 Answer: b Diff: M R . c. b.00 1.d. the reduction in accounts receivable would generate additional cash. Mondale Motors has forecasted the following year-end balance sheet: Assets: Cash and marketable securities Inventories Accounts receivable Total current assets Net fixed assets Total assets Liabilities and Equity: Notes payable Accounts payable Total current liabilities Long-term debt Stockholders’ equity Total liabilities and equity $ 300 500 700 $1.300 $6. Now. what would be the company’s current ratio? a.35 1. e.75 . 1.5 $860.000 2.500 5. If this scenario were to occur. d. assume instead that Mondale is able to reduce its DSO to the industry average of 30.000 $6.

00% 11. b.44% 51.000 on sales of $240. d.50% 35. Roland & Company has a new management team that has developed an operating plan to improve upon last year's ROE.000 per year. e. $430.000 per year. c.0. Southeast Packaging's ROE last year was only 5 percent. Under these conditions. d.000 $500. If the changes are made. c. 17. b.000.00% Answer: c Diff: T ROE 61 . and it expects to have a total assets turnover ratio of 3. d. e.67% 44.What were Perry’s current liabilities? a.65% 21. The average tax rate will be 40 percent. What does Roland & Company expect return on equity to be following the changes? a. EBIT is projected to be $25.000 on sales of $270.82% 26. but its management has developed a new operating plan designed to improve things. b. Management projects an EBIT of $26.500 $ 61.25% .000 $107.50% 22. and it expects to have a total assets turnover ratio of 2. c. the average tax rate will be 40 percent. 9.25% 17.000. The new plan would place the debt ratio at 55 percent which will result in interest charges of $7.0.429 $573.333 Tough: ROE 60 Answer: d Diff: T . what return on equity will Southeast earn? a. The new plan calls for a total debt ratio of 60 percent. e. which will result in interest charges of $8.

000 Income Statement: Sales Operating costs Operating income (EBIT) Interest expense Taxable income (EBT) Taxes (40%) Net income The company’s interest cost is 10 percent.) (3) Under this scenario. The CFO has noticed that the company’s inventory turnover ratio is considerably weaker than the industry average which is 6.000 $ 600. Georgia Electric reported the following income statement and balance sheet for the previous year: Balance sheet: Assets Cash Inventory Accounts receivable Current assets Net fixed assets Total assets Liabilities & Equity $ 100. b.000 $1. As an exercise.000.000 $6. So.000 400.000 1.000. (The company pays all net income as dividends. While the company’s financial performance is quite strong. so the company’s interest expense each year is 10 percent of its total debt. e.600.0.000 $4.000 $6. The company’s interest expense would have been 10 percent of the new level of total debt.ROE 62 Answer: d Diff: T .000 1.400. but was able to reduce inventory enough to achieve the industry average inventory turnover ratio.000 4.3% 31.000.400. its CFO (Chief Financial Officer) is always looking for ways to improve. the CFO asks what would the company’s ROE have been last year if the following had occurred: (1) (2) The company maintained the same level of sales.000.000 $1.000 400.000.5% 30. what would have been the company’s ROE last year? a.000 500.600. The cash that was generated from the reduction in inventory was used to reduce part of the company’s outstanding debt. the company’s total debt would have been $4 million less the cash freed up from the improvement in inventory policy. 27.0% . c.000 $1. Assume equity does not change.000 2.000.5% 33.0% 29. d.000 Total debt Total equity Total claims $3.000.

0%: Total assets turnover: 3. which is 5. d. Vance Motors has current assets of $1.22 0. e. and its inventory turnover ratio is 4. What is the company's cost of debt? (Hint: Work only with old data. Tax rate: 40%.92% 13.200 Debt ratio: .000 These data have been constant for several years. the tax rate. and the balance sheet will remain constant.Current ratio 63 Answer: c Diff: T .51% 13. What will be the company’s current ratio. b. What is Lone Star's EBIT? a.2 million. d. the following data applied: Total assets: Tax rate: EBT: $8. A company has just been taken over by new management which believes that it can raise earnings before taxes (EBT) from $600 to $1. Sales. b. Prior to the change. assuming that it is successful in improving its inventory turnover ratio to 5? a.75 2.7.200 $12. without reducing its sales. d.000 $33. The company would like to increase its inventory turnover ratio to the industry average. Any reductions in inventory will be used to reduce the company’s current liabilities. c. $ 3.67 1. 1.000.) a.0%.0%.3125% $15.000 35% $600 Debt ratio: BEP ratio: Sales: 45% 13. merely by cutting overtime pay and thus reducing the cost of goods sold. The company’s current ratio is 1. its quick ratio is 0.75% 14. b. e.26 Answer: a Diff: T Financial statement analysis 64 . Profit margin: 6. EBIT 65 12. Lone Star Plastics has the following data: Assets: $100.000 $30. e.000. Interest rate: 8.000 $18.00% Answer: e Diff: T . c. and all income is paid out as dividends.23% 13. c.33 1.2. 40.0.

LECTURE 3 ANSWERS AND SOLUTIONS .

2 = Total debt + 1.50. TIE ratio Profit margin and leverage Current ratio Quick ratio The quick ratio is calculated as follows: Current Assets – Inventories . 21. 18. The net effect is no change in the quick ratio. 16. 4. Answer: a Answer: e Diff: E Diff: E The increase in debt payments will reduce Also. 12. While this action decreases receivables (a current asset). 9. 19. 11. 8.1.0 = Total assets/Total equity = 2/1. 20. net income and hence reduce ROA. Financial statement analysis Leverage and financial ratios Statements a and c are correct. Therefore. 14. higher debt payments will result in . 15. Ratio analysis Liquidity ratios Current ratio Asset management ratios Inventory turnover ratio Debt management ratios TIE ratio Profitability ratios ROA Market value ratios Trend analysis Liquidity ratios Inventory turnover ratio Fixed assets turnover BEP and ROE Equity multiplier EM = 2. 5. 6. 22. or Total debt = 1. 2. Answer: a Answer: b Answer: b Answer: a Answer: b Answer: a Answer: a Answer: a Answer: b Answer: a Answer: a Answer: b Answer: a Answer: b Answer: a Answer: a Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: M Diff: M Diff: M 17. 3. Current Liabilities Answer: a Answer: b Answer: c Answer: d Diff: M Diff: M Diff: E Diff: E The only action that doesn't affect the quick ratio is statement d. Total debt/Total assets = 1/2 = 0. 13. it increases cash (also a current asset). 10. 7.

statement e is the correct choice. so Company B. If a firm has no lease payments or sinking fund payments.lower taxable income and less tax. and a reduction in NI. and this will lower its profit margin. TIE = EBI T . Leverage and financial ratios Miscellaneous ratios Answer: d Answer: e Diff: M Diff: M Statements b and c are correct. so the company is 100% equity financed. Thus ROA will fall. 25. statement e is the correct choice. will have a higher net income. 26. 30. there will be less equity than there would have been. 29. choice. 33 . EM = Assets/Equity. if a firm takes on more debt. Leverage and financial ratios Answer: a Diff: M Statement a is correct. statement e is the best Answer: d Answer: e Answer: e Answer: c Answer: a Answer: a Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Statement a is true because. 34. 27. which has no interest expense. Therefore. hence the ROE might rise even though the profit margin fell. Use the Du Pont equation to find that the equity multiplier equals 1. 28. I n t e r e s + L e a s eP y m t s+ t (1 . Liquidity ratios Current ratio Quick ratio Ratio analysis Financial statement analysis Financial statement analysis Therefore. 23. 32. while Inte rest Fixed charge coverage ratio = E B I T+ L e a s eP a y m e n t s SF Pymts .T) Therefore. 24. its interest expense will rise. An increase in the debt ratio will result in an increase in interest expense. Company B will have a higher ROA. thus causing the equity multiplier (EM) to increase. the amount of equity in the denominator decreases. Of course. ROA = NI/TA. Miscellaneous ratios Answer: b Diff: M . then its TIE and fixed charge coverage ratios are the same. Miscellaneous ratios Answer: e Diff: M Miscellaneous ratios Answer: b Diff: M Statements a and b are correct. 31. Both companies have the same EBIT and total assets. Therefore. As debt increases.

Statement b is correct. therefore. the others are false. and C has higher interest than D but the same EBIT. ROE = NI/EQ or ROE = ROA × Equity multiplier. X’s quick ratio would be ($200 . Y's CR = $30/$10 = 3. for Y to have a higher inventory turnover (S/I) than X. therefore. Ratio analysis Answer: d Diff: T Statement d is correct.000 Answer: d 0. Thus. Therefore.) 37. An example demonstrates this. but a lower quick ratio than X. Say X has CA = $200. So. Statement a is false. say Y has inventory of $20. Y must have less inventory than X. 36. (Note that the numbers used in the example are made up but they are consistent with the rest of the question. So. ROE and debt ratios Ratio analysis Answer: b Answer: a Diff: T Diff: T Statement a is correct. This is impossible to determine given the information in the question. If Company X has a higher total assets turnover (Sales/TA) but the same total assets. Since the two firms have the same total assets. Statement c is false. TIEC < TIED. say Y has CA = 30.200.000 $ 600. Statement b is false. which could lead it to have a higher ROE because its equity multiplier would be greater than company D's. For this statement to be correct. CL = 10. Statement c is incorrect because higher interest expense doesn’t necessarily imply greater debt. we know that Y has a higher current ratio than X. in this example Y has a higher current ratio. Company C has higher interest expense than Company D.$50)/$100 = 1. 38 .000 Diff: T . If X had inventory of $50.000 400. we cannot say that X must have a higher ROE than Y. it must have higher sales than Y. Statement c is false as TIE = EBIT/Interest. Therefore. they have the same BEP = EBIT/TA from the facts as given in this problem. Leverage and financial ratios The new income statement will Operating Income (EBIT) Interest Expense Earnings Before Tax (EBT) Taxes (40%) Net Income be as follows: $1. X has CR = $200/$100 = 2. ROA = NI/TA. A’s amount of debt would have to be greater than B’s. Y’s quick ratio = ($30 . EBIT = EBT + Interest. Statement c is false. we cannot tell what sales are. it must have lower net income. 35. therefore. Now. it must follow that X has a higher net income than Y.2 × $6.5.000. Therefore.000 $1.000 200. From the facts as stated above. ROAC < ROAD. they could be the same or different. Statement e is false.000. CL = 100. Company C must have lower equity than Company D. We also know that Y has less inventory than X because the problem states that Y has a higher inventory turnover than X and from the facts given X’s sales are higher than Y. the others are false. therefore. If X has higher sales and also a higher profit margin (NI/Sales) than Y. In either case we need to know the amount of equity that both firms have. Statement b is false. lower inventory.$20)/$10 = 1.

0%. Inv = = = $2. 5 5 Inv Freed cash = $5. $1. and ROE increases.3%.000) = $3.000 NI $540. 40 . ROAOld = ROEOld = ROE New = $600.T) EBT = $9.000 = = 10. ROA falls. Increase in NI = 0.15($20.000 ROENew = $600.NI $540. . 42.000. ROA = $3.000 .000/$22.000 EBIT = $15.500 E New ROE = $300 = 0.000.000. $6.000.000.5%. ROE Equity = 0.000 Therefore.500.500. EBT = NI/(1 . Assets $5.16% = 4%.000. Therefore interest expense = $0. ROA falls. $4. Current ROE = Answer: c Diff: E Answer: d Diff: E Answer: a Diff: E $240 NI = = 16%.000 S = = 2.6 EBT = $15. ROA = NI/TA 0. 41.20 = 20%.500 ∆ ROE = 20% . $1. Equity $4. ROA Net income = 0.000. statement d is the correct choice.07($3.000) = $210.000.000.000.000 = 15.000.000.25($6.000/0. Profit margin Current inventory turnover = Answer: c Diff: E $10.000 Since Net Income increases.000. Financial statement analysis BEP = EBIT/TA 0.000.000) = $1.000.000 = = 13.000.000 = 10%.09 = NI/$100. $5.000 S = 5. 39.000 = $3.000.000 Inv New inventory turnover = S $10.000.000.8%.000 = 13.$2.000 NI = $9.15 = EBIT/$100.

EBIT = 0.300. ROA BEP = Answer: a Diff: M Answer: a Diff: M EBIT TA = 0. $10.9) = $6.000) = $15.1.000. Accounts receivable $240 + $210 NI = = 0. the new sales level will be $7.15. 20% = (ROA)(2. 6 Calculate Net income: EBIT $15.60) = 2. 44. Again. N I T A = $7. INT = = $15.0450 = 4.5%.570.000(0.500.000 INT 2.000/365) or AR = $576.570. so now we need to find net income. ROA Equity multiplier = 1/(1 .5. ROA Step 1 We must find TA.500 = 7.000.New Profit margin = 43. by working through the income statement: Net income is found EBIT TA and TA = EBIT .500 EBT $12.000/0. ROA = 8.000.000 Answer: e Diff: M Therefore. 45 .15($100. solve for the new accounts receivable figure as follows: 32 = AR/($6.000.D/A) = 1/(1 .000/(Sales/365) to find annual sales equal to $7.500 ROA = 46.000. BEP . using the DSO equation.500 Tax (40%) 5.0. BEP = We are given BEP and EBIT.000.000 NI $ 7. ROE = ROA × Equity multiplier.000.000 Sales Answer: a Diff: M R First solve for current annual sales using the DSO equation as follows: 50 = $1.5). TIE = EBIT INT EBIT 6 = 6.5%. or $400 million.000 = $2. TA = $40. Step 2 NI/TA = ROA. $100.0%.300. If sales fall by 10%. TA = $100.

New total asset turnover: 2. Equity multiplier = 1.500(1 .000 = 5× .0) = 0.000 .Inventory + Inventory)/Current liabilities ($1.5 = 1.0) = 42%.46 = 46%.600.I)/$1.000.000/$1.0.0 since firm is 100% equity financed.T)/(Sales/2.0(1. Net income = 0.000.000. ROE: (0.0) = $1.000. 49.0)(1.000. Alternate solution: ROE = EBT(1 .33.10)(1.2 Sales = $900.33) = 0.0525 = 5.I = $1.15) = 0. ROE = $36. 51.000 = $1.2 = (CA .080.0/1.000.000) = $36.25%.4($900. 48.200.000 + Inventory)/$1. Answer: c Diff: M R (Sales per day)(DSO) = A/R (Sales/365)(60) = $147. New equity multiplier: 2. ROE = (Profit margin)(Assets turnover)(Equity multiplier) = (21%)(2. Answer: c Diff: M .000 = 3.000. Debt ratio = 0.0) = $1. ROE New profit margin: (0.EBIT Interest EBT Taxes NI Step 3 47.000.080. Profit margin = Net income/Sales.000.3))/$5. 50.115.200.000 Inventory = = = = (Current assets .920.500 = 42%.000/$400.153.050/$2.5) = 3.000 = 21%.3%. Total debt = $1. CR 1.64 = Total debt/$3.500(0. Debt ratio Debt ratio = Debt/Total assets.200.7)/($5.920.115)(1.000/2.6 $1. Liquidity ratios Answer: a Diff: M QR = (Current assets .$1.000 $1.000. ROE Answer: d Diff: M Answer: b Diff: M Profit margin = ($1.000 CA .153)(3.000 + Inventory $400.000.Inventory)/Current liabilities 1. New ROA: (0.945.000. Inventory turnover = Sales/Inventory = $2.0. ROE $40M 5M $35M 14M $21M (from TIE ratio: (40% tax rate) 8 = EBIT/Int) ROA = $21M/$400M = 0. Total equity = $3.

$2.8)(1. DSO = AR = = find the accounts receivables: AR/(Sales/365) DSO(Sales)(1/365) (40)($1.2)($1.200.000) = $200. CA = $600.000 = $68.000. Sales: S/$120.000 = 6.667.507.000 .$166.000 . Next. (TATO = 6 = Sales/Total assets.0.67. I = $120.000 = 3.  365  Answer: b Diff: M R First. 54.$131.000.$166.54.54) PM = 3.I)/$200.Inventory = $450.8 = $250.000 = 36 days. Next.000.667 = $1. find the amount of current assets: Current ratio = Current assets/Current liabilities Current assets = (Current liabilities)(Current ratio) = $375.493. $6. 52 .333/$4.000 . Financial ratios  $10.48%.10 = $4.000. Debt = Total assets .67 T D = = 65.000(1.000.000. 53. Reduce receivables by 6  Debt = $400/0. Current assets: CA/$200.666. Quick ratio Answer: c Diff: M . 56.000.333.000 .000 .000.000. Financial statement analysis Current DSO = Answer: e Diff: M R $1.AR .333.3333.67 T A 55. Debt ratio = $1. $4. Sales volume Answer: a Diff: M Answer: a Diff: M Current liabilities: (0.666.139/36 5 Industry average DSO = 30 days.Total assets = $24.000/4.000/6 = $4.) ROE = NI/Equity Equity = NI/ROE = $400.000 = 2.Equity = $4. find the inventories: Inventory turnover = Sales/Inventory Inventory = Sales/(Inventory turnover) = $1. Inventory: ($600. Profit margin Equity multiplier = 1/(1 .000.4.0.000 = 0. S = $720.000.000.200.000/0.$250.71%.15 = $2. find the amount of cash: Cash = Current assets .507 .139  = $166. $10. ROE = (Profit margin)(Assets utilization)(Equity multiplier) 15% = (PM)(2. Finally.000)(1/365) = $131.35) = 1.333.2) = $450.000.

500/CL = 1.75 .000)/$50. new current assets are $50.$107.000 = 3× . we know (CA . Current ratio Step 1 Step 2 Step 3 We must find sales using DSO of 35. Inv = $200. 000.417.000.500 . Answer: b Diff: M R If AR and AR AR/(Sales/365) = 35. 000 − $40.$107. then Sales = $7. To find the new CR (CA/CL).000 = $225. (Remember.000/8 = $75. Thus. AR/($7.000 = $75.000. notes payable were also reduced by $100. it is just ($1.$100)/($1. 333 CL they have $83. CL = $83.) Answer: a Diff: M 59. Answer: e Diff: M 57. Current inventory minus the new level of inventory reflects the amount of cash freed up or $150.000 + $100.2727. 60.75. 000 5 = $40.5. we now have 1. we reduced AR by $100.$75.5.000 na $ 26.500. S/Inv = 5. Current liabilities will be reduced to $125.$107.5. CL Find quick ratio: $100. = 30.$75.500)/CL = 1.800 Answer: d Diff: T .72. 000.000 8. ROE ROE = Profit Margin × TA Turnover × Equity Multiplier Set up an income statement: Sales (given) Cost EBIT (given) I (given) EBT Taxes (40%) NI $240.000. The new quick ratio is then: ($225. Recognizing the first term as the current ratio or 1. 000 CA − Inv = $83. is $700. 58.000.33 Step 3 = 0.000.000.000 .000 7.200/365) becomes $600.200.200 $100) = 1.000 + $75. Quick ratio If sales remain at $600. Solve this expression for CL = $430. 000.$75.200 $ 10.000. Step 2 Calculate current liabilities: From the current ratio. then for the inventory turnover ratio to be 8x inventory must be $600.000 = $50.417 Now.Step 1 Calculate inventory: Quayle Energy has $40 million in inventory because the inventory turnover ratio is equal to 5. we can conclude that million in current liabilities.33 million. 000.000 . 000 CR = = 1.000 $ 18. $100. Current liabilities We can solve for inventory (because we’re given the inventory turnover ratio) as 8 = $860. to reduce DSO to 30. We can rewrite this as CA/CL . Thus.500/CL = 1.486. 333.2.000.000 . Given the quick ratio.000/Inventory or Inventory = $107.

45($90.500.5%.1 = $350.0 ROE = (PM)(TATO)(EM).000. $1. of debt = $3.000. so E/A = 40%. To match this level: Inventory = Sales/6 $3.000/3 = $90. therefore.000/6 = $500.67%.000 = $500.000 × 40%) TATO = Sales/Total assets Total assets = Sales/TATO = $270.500.000.000 × 0.000/$120. TA/E = 1/(E/A) = 1/0. ROE Answer: d Diff: T Industry average inventory turnover = 6 = Sales/Inventory. 63. and. 62.50%.000 Tax 420.000 is to be used to reduce the debt of the Interest on this level New debt level = $4.200.000 Sales = $270.000 7. EBIT I EBT T NI $25.050.000 Int 350.000 = 0.000.000.000.0.500 = 26. Reduction in inventory = $1. 61. ROE = NI/Equity = $10.000 EBT $1.000.000 This $500.000/$48. Current ratio Step 1 Step 2 Answer: c Diff: T Solve for the current inventory level: CA/CL = 1.000.000 Interest = $7. Answer: c Diff: T Recall the Du Pont equation: ROE = (ROA)(EM).50.3150 or 31.4 = 2.000.200 $10. ROE Given: New D/A = 0. TA = S/2 = $240. D/A = 60%. Current inventory = $500.55 EBIT = $25.000 $18.000 × $240. ROE = NI/Equity. so CL = $1.000 × $120.000. Equity = [1 . Look at the income statement to get net income: EBIT $1.000 ROE = Net income/Equity = $630.800/$40.55](Total assets) Equity = 0.000) = $40.000.800 (Given) ($18.000 .045 × 2 × 2.Turnover = 2 = S/TA.5 = 0.000. Complete the Du Pont equation to determine ROE: ROE = $10.500.000/$2.(D/A)](Total assets) Equity = [1 .000 = $3.000 = 0.000.000/2 = $120.000.000 NI $ 630.000 7.800/$240.000 Tax rate = 40% TATO = 3.$500. Solve for current level of inventories: .2 and CA = $1.000. company.400.225 = 22.

000 A TA turnover = = S A = 3.000 = -$100.$600 = $465.000 .000 Taxes (40%) 12.45. S D D Debt ratio = = = 0.000 .Inv)/$1.000. So.000.000/(1 .000) = 1. Financial statement analysis Sales Cost of goods sold EBIT Interest EBT Taxes (35%) NI BEP = $15.000 Cost of goods sold ________ EBIT $ 33.T) = $30.000.45($8.EBT = $1.000. NI = $18.92%. $3.000 .200. Step 3 Step 4 Next we find the sales level using the old inventory turnover ratio: Sales/$500. S = $300.000) .000 (EBIT = EBT + Interest) ($40. Answer: a new CR = Step 5 64.000. Using the current sales level and the new target inventory turnover ratio of 5. $8.000)/($1.065 465 $ 600 210 $ 390 Diff: T EBIT = 0.000. Inv = $500.000/InvNew = 5.000 Now fill in: EBIT = $1.000(0.000 A $465 Interest Interest rate = = = 0.000 = 4.065.$100.000 . InvNew = $400.000 Now set up an income statement: Sales $300. D = 0.000 Now plug sales into profit margin ratio to find NI: NI = 0.06.000.200 EBT $ 30.600 Debt EBIT TA = 65.7. $100.08) = $3.0. EBIT Answer: e Diff: T Write down equations with given data.065. $8.133125.200) (EBT = $18.222. So sales are $2. EBIT = $1. ($1. $100. we can solve for the new inventory level: $2. then find unknowns: NI Profit margin = = 0.200 Interest 3. Solve for the new current ratio: ∆ Inv = $400.000.600. our ($1.000.000 _______ $ 1.$500.4.200.1292 = 12.7. D D = = 0.000) = $3.06.$100. D = $40.000. Interest = EBIT .000 = 0. S = 3. $300.000.Since QR = 0.065 .

000 .NI $ 18.

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