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(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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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

e. None of the statements above is correct. d. b. c.a. b.'s CFO has proposed that the company issue new debt and use the proceeds to buy back common stock. Issue short-term debt and use the proceeds to buy back long-term debt with a maturity of more than one year. All of the statements above are correct. Return on assets (ROA) will decline. e. Company J must be riskier. its quick ratio must fall. If a company increases its current liabilities by $1. Answer: e Diff: E Leverage and financial ratios 22 . Use cash to purchase additional inventory. The times interest earned ratio (TIE) will increase. d. Company J must have fewer growth opportunities. A company’s quick ratio may never exceed its current ratio. c. Statements a and c are correct. Taxes paid will decline. None of the statements above is correct. Company J must have a higher P/E ratio. Current ratio 24 Answer: e Diff: M . d.) a. Which of the following actions can a firm take to increase its current ratio? a. If a company increases its current liabilities by $1. Answers b and c are correct. b. its current ratio must rise. 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. Company J must have a higher market to book ratio. None of the answers above is correct. Which of the following statements is most correct? a.000. c. b. Medium: Liquidity ratios 23 Answer: d Diff: M . c. Stennett Corp. Statements a and b are correct.000 and simultaneously increases its inventories by $1.000 and simultaneously increases its inventories by $1. e. d. Reduce the company’s days sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. e. Quick ratio Answer: e Diff: M .000.

b. None of the statements above is correct.000 two years ago and which was generating profits at the rate of 10 percent is sold for $100. the current ratio will always increase. firms with high profit margins have high asset turnover ratios. $1. especially if the current ratio is weak initially.0 e. As a short-term creditor concerned with a company's ability to meet its financial obligation to you.5 Debt ratio 0.5 1. d.71 Answer: a Diff: M Financial statement analysis 27 . the firm with the higher debt ratio will also have a higher rate of return on common equity.000 worth of inventory is sold.25 . b.50 0. All of the answers above. c. 2.67 0. we know that if we use some of our cash to pay off some of our current liabilities.0 c. One of the problems of ratio analysis is that the relationships are subject to manipulation. Ratio analysis 26 Answer: c Diff: M .33 0.000 cash. Which of the following actions will cause an increase in the quick ratio in the short run? a. A small subsidiary which was acquired for $100. d. 2. which is added to retained earnings.5 b. 0. and an account receivable is created. 1. All of the statements above are correct. (Average company profits are 15 percent of assets. . e. Answers a and b above. Which of the following statements is most correct? a.0 1. Marketable securities are sold at cost. which one of the following combinations of ratios would you most likely prefer? Current ratio a. 1. If two firms pay the same interest rate on their debt and have the same rate of return on assets. For example. and firms with low profit margins have low turnover ratios. The receivable exceeds the inventory by the amount of profit on the sale.) c.50 0. and if that ROA is positive.5 TIE 0. Generally. e.5 1. this result is exactly as predicted by the extended Du Pont equation.0 0.5 d.

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

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

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

which of the following will occur: a.000 The company wants to increase its assets by $1 million. higher basic earning power (BEP) ratio. b. c. b. The company’s assets are financed with $1 million of debt. The company’s return on equity will remain the same. Ratio analysis 37 Answer: d Diff: T . c. If the company takes this action. The company’s return on assets will fall.000 360. You have collected the following information regarding Companies C and D: • The two companies have the same total assets. e. The company’s income statement is summarized below: Operating Income (EBIT) Interest Expense Earnings before tax (EBT) Taxes (40%) Net Income $1. lower ROE. which of the following statements is most correct? a.000 $ 900. Based on this information. Blair Company has $5 million in total assets. Answer: d Diff: T • Leverage and financial ratios 38 .000. and it plans to finance this increase by issuing $1 million in new debt.000 100. lower ROA. but its operating income will remain at 20 percent of its total assets. d. and its average tax rate will remain at 40 percent. Statements a and c are correct. Statements a and b are correct. All of the answers above are correct. • The two companies have the same tax rate. e. . This action will double the company’s interest expense.000 $ 540. Company C has a higher debt ratio and a higher interest expense than Company D. higher times-interest-earned (TIE) ratio. and $4 million of common equity. Statements a and b are correct. d. • The two companies have the same operating income (EBIT). 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. The company’s net income will increase.d. • Company C has a lower profit margin than Company D. e.

A firm has a profit margin of 15 percent on sales of $20.25% 5. without affecting sales or the balance sheet (the additional profits will be paid out as dividends). If the firm has debt of $7. b.000. d.000.000. e. e.0% 13. 3. and raise net income to $300.Multiple Choice: Problems Easy: Financial statement analysis 39 Answer: a Diff: E . b.000.000 Answer: d Diff: E ROA 40 . Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent.500.000 $15. cut operating costs. $ 0 $ 2.000.3% 15. c.00% 4. and an after-tax interest cost on total debt of 5 percent. c. The company recently reported that its basic earning power (BEP) ratio was 15 percent and that its return on assets (ROA) was 9 percent.500. If Tapley could streamline operations.000.9% 12. d.00% 3.33% Sales: TIE ratio: $10. what is the firm's ROA? a.000 $ 6.000.50% 4.4% 10.000 $18. What was the company’s interest expense? a.000 1. c. b. 8.2 Diff: E ROE 41 .1% Answer: c Tapley Dental Supply Company has the following data: Net income: Debt ratio: BEP ratio: $240 75% 13. total assets of $22.000. by how much would its ROE increase? a.0 Total assets: Current ratio: $6. e.000 2.50% . d.

The company's CFO estimates that if this policy is adopted the company's average sales will fall by 10 percent.000 9. You think you can change your inventory control system so as to cause your turnover to equal the industry average. d.980 $ 9. e.000 $ 9. b.5% 5.1% 2. $576.Profit margin 42 Answer: c following balance sheet and income Diff: E . Your company had the information for 2003: Balance sheet: Cash A/R Inventories Total C.000 Income statement: Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net Income Debt Equity Total claims $10.200 $ 800 400 $ 400 160 $ 240 $ 4. Assume a 365-day year. 2.000 The industry average inventory turnover is 5.000 5. Assuming that the company adopts this change and succeeds in reducing its DSO to 32 days and does lose 10 percent of its sales. and this change is expected to have no effect on either sales or cost of goods sold. Net F. 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.A. Ruth Company currently has $1. Total Assets statement $ 20 1.A.000 .4% 4. what will be the level of accounts receivable following the change? a. c. Its days sales outstanding (DSO) is 50 days (based on a 365-day year).000.020 2. What will your profit margin be after the change in inventories is reflected in the income statement? a.3% 6.000 in accounts receivable. The cash generated from reducing inventories will be used to buy tax-exempt securities which have a 7 percent rate of return.000 5.7% Medium: Accounts receivable 43 Answer: a Diff: M R .000 $ 6.

7% 20. Selzer Inc.45% 5.5% 10. c.25% Answer: c Diff: M R ROE 47 . Q Corp. d. c.2% 13. and a debt ratio of 0. Total assets are $100.0. sells all its merchandise on credit.1% 14. e. has a basic earnings power (BEP) ratio of 15 percent. 7.667 ROA 44 Answer: a Diff: M . The Meryl Corporation's common stock is currently selling at $100 per share. e. total assets of $3 million.97% 4. What is Q Corp. The corporate tax rate is 40 percent.0% Answer: a Diff: M ROA 45 . a return on equity of 20 percent.0% 10.667 $776.5% Answer: e Diff: M ROA 46 . days sales outstanding equal to 60 days (based on a 365-day year). Humphrey Hotels’ operating income (EBIT) is $40 million. $676.'s return on assets (ROA)? a. what is its return on total assets (ROA)? a.64. d. 6. What is the firm's return on equity (ROE)? .0% 16.945.2. If the firm has 100 shares of common stock outstanding.000 $976. The company’s times-interest-earned (TIE) ratio is 8.000. and its basic earning power (BEP) ratio is 10 percent.000 $900.33% 8. receivables of $147. and has a times interest earned (TIE) ratio of 6. d. 8. b. It has a profit margin of 4 percent. which represents a P/E ratio of 10. What is the company’s return on assets (ROA)? a. e. c. and a debt ratio of 60 percent.0% 12. c. its tax rate is 40 percent. e. b. b.0% 12.56% 5. d.b.

71. b. c. 3.3% c..5). 11% 46% 40% 20% 53% ROE 49 Answer: d Assume Meyer Corporation is 100 percent equity financed.500 = 60% = 2. e. c.000 Dividend payout ratio Total assets turnover Applicable tax rate = = $1. 8.a.e.1% ROE 48 Answer: b Diff: M . d. It should cause a 15 percent increase in your profit margin (i.00 a. 25% 30% 35% 42% 50% Earnings before taxes Sales = $5.10 Total assets turnover = 2. d. Calculate the . what will be the new ROE if the new product is added and sales remain constant? Ratios before new product Profit margin = 0. 33. but it will also require a 50 percent increase in total assets (i.e. b. You are considering adding a new product to your firm's existing product line. new TA = old TA × 1. e.00 Equity multiplier = 2. given the following information: (1) (2) (3) (4) (5) a.0 30% Diff: M .. 7. new PM = old PM × 1.15). You expect to finance this asset growth entirely by debt. If the following ratios were computed before the change.1% b.0% e. return on equity.3% d.

e. The company’s ROE was 15 percent. d. and a quick ratio equal to 1.0 6. 2. What is the company’s debt ratio? a. The Merriam Company has determined that percent. Management is interested in the into this calculation.0. 12.82% its return on equity is 15 various components that went following information: total turnover = 2. 5. The company’s net income was $400. The company has $2 million in sales and its current liabilities are $1 million.60 0.2. 3. The company is financed entirely with debt and common equity. 0.2 5.6. b. You are given the debt/total assets = 0. What is the . Its total assets turnover was 6.66 Profit margin 52 Answer: a Diff: M . b. c. Kansas Office Supply had $24.42% c. 5. e.0 5.5 6.Liquidity ratios 50 Answer: a Diff: M .3 Debt ratio 51 Answer: c Diff: M . What is the company’s inventory turnover ratio? a.33 0.30 0. d. c.35 and total assets profit margin? a. Oliver Incorporated has a current ratio = 1.20 0.45% e. 6.96% d.48% b.000.000.8.000 in sales last year.

Sales volume 53 Answer: a Diff: M . e.000 $ 360.000 $ 120.20.33% 45. c. Collins plans to change its credit policy so as to cause its DSO to equal the industry average.4. and this change is expected to have no effect on either sales or cost of goods sold. The firm has no long-term debt. 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. a quick ratio of 2. 33.000 2. $ 720.000 $ 880.000 $ 3. Harvey Supplies Inc. has a current ratio of 3.000 $10.620. Harvey's total assets are $1 million and its debt ratio is 0.000 9.71% .000 Financial statement analysis 54 Answer: e Diff: M R . What is Harvey's sales figure? a. b.000 $1.200 $ 800 400 $ 400 160 $ 240 The industry average DSO is 30 (based on a 365-day year). and an inventory turnover ratio of 6.980 $ 6. e. b.00% 65. d.020 2.75% 60.28% 52. c. 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).0. d. what will Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet? a.

$316. 2.0 c.000 $500. If the company follows the president's recommendation and sales remain the same. 4. $ 68. inventories. e.493 c. 4.2.333 b.000 d. has the following simplified balance sheet: Cash Inventory Accounts receivable Net fixed assets Total $ 50.72 0.000. and its current ratio was 1.000 175.8 1.Financial ratios 55 Answer: b Diff: M R .20 1.39 0.000 Sales for the year totaled $600.49 Quick ratio 57 Answer: e Diff: M . Quayle Energy had sales of $200 million.000 e. How much cash does Taft have on its balance sheet? a.667 Quick ratio 56 Answer: c Diff: M .5 . Taft Technologies has the following relationships: Annual sales Current liabilities Days sales outstanding (DSO) (365-day year) Inventory Turnover ratio Current ratio $1. The company’s current assets totaled $100 million. She would like the inventory turnover ratio to be 8× and would use the freed up cash to reduce current liabilities. 1.4 b. c.000 $ 375. and accounts receivable. Thomas Corp.000 200. and its inventory turnover ratio was 5. -$ 8. Last year.2 The company’s current assets consist of cash.200.0. The company president believes the company carries excess inventory.000 40 4. $200. What was the company’s quick ratio? a.000 $500. b.000 150.000 100.000 200. $125. d.000 Current liabilities Long-term debt Common equity Total $125. the new quick ratio would be: a.55 2.

300 $6.d. the reduction in accounts receivable would generate additional cash. Under this scenario.000 1.500 $ 800 400 $1.486 days. 3. what would be the company’s current ratio? a.5 $860. e.17 2.200 3.000 $6. 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 $1.500 The company also forecasts that its days sales outstanding (DSO) on a 365-day basis will be 35.75 .00 1. Now. had the following financial information for the past year: Inventory turnover Quick ratio Sales Current ratio = = = = 8× 1.500 5.45 Current liabilities 59 Answer: a Diff: M .27 1.0 Current ratio 58 Answer: b Diff: M R . 1. assume instead that Mondale is able to reduce its DSO to the industry average of 30. d. b. This additional cash would be used to reduce its notes payable.2 e.35 1. Perry Technologies Inc.417 days without reducing its sales.000 2. 1. If this scenario were to occur. c.

333 Tough: ROE 60 Answer: d Diff: T . c. Under these conditions. EBIT is projected to be $25.000 per year. c. The average tax rate will be 40 percent.000 on sales of $240. 17.0.65% 21. and it expects to have a total assets turnover ratio of 3. Southeast Packaging's ROE last year was only 5 percent. d.00% 11. The new plan calls for a total debt ratio of 60 percent. e.000 $500.44% 51.000 on sales of $270. b. the average tax rate will be 40 percent.500 $ 61.50% 22. c. but its management has developed a new operating plan designed to improve things. d.00% Answer: c Diff: T ROE 61 . Management projects an EBIT of $26.000. e. What does Roland & Company expect return on equity to be following the changes? a. and it expects to have a total assets turnover ratio of 2.25% 17.000.82% 26.What were Perry’s current liabilities? a. b.429 $573. e. b. If the changes are made.0.67% 44. which will result in interest charges of $8. $430.000 $107. d.25% . what return on equity will Southeast earn? a. The new plan would place the debt ratio at 55 percent which will result in interest charges of $7. 9.50% 35. Roland & Company has a new management team that has developed an operating plan to improve upon last year's ROE.000 per year.

While the company’s financial performance is quite strong.) (3) Under this scenario.000 1. As an exercise.000 $6.5% 30. the company’s total debt would have been $4 million less the cash freed up from the improvement in inventory policy. 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. (The company pays all net income as dividends.000.000 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.000 Total debt Total equity Total claims $3.000 500.600.5% 33.000 400.000 2. d.000. So. The company’s interest expense would have been 10 percent of the new level of total debt. Assume equity does not change.000. so the company’s interest expense each year is 10 percent of its total debt. 27.000 $1.600.000 $ 600.0.000.000 $1.000 $4.000 $6.3% 31.0% . but was able to reduce inventory enough to achieve the industry average inventory turnover ratio.400.ROE 62 Answer: d Diff: T . 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 $ 100.000. what would have been the company’s ROE last year? a.000 400. e. The cash that was generated from the reduction in inventory was used to reduce part of the company’s outstanding debt.400. The CFO has noticed that the company’s inventory turnover ratio is considerably weaker than the industry average which is 6. its CFO (Chief Financial Officer) is always looking for ways to improve.000 4.000. b.000.000 1.000 $1.0% 29. c.

b.0.000 $30. A company has just been taken over by new management which believes that it can raise earnings before taxes (EBT) from $600 to $1. b.000. c. Tax rate: 40%. assuming that it is successful in improving its inventory turnover ratio to 5? a. Sales. e.75 2. What is the company's cost of debt? (Hint: Work only with old data.2 million.67 1. Any reductions in inventory will be used to reduce the company’s current liabilities.000.) a. Lone Star Plastics has the following data: Assets: $100.51% 13. d.0%: Total assets turnover: 3. e.26 Answer: a Diff: T Financial statement analysis 64 . Profit margin: 6. and its inventory turnover ratio is 4.0%.200 $12.2. e.Current ratio 63 Answer: c Diff: T . The company would like to increase its inventory turnover ratio to the industry average. the following data applied: Total assets: Tax rate: EBT: $8. EBIT 65 12. Prior to the change. c. d.00% Answer: e Diff: T .200 Debt ratio: . What will be the company’s current ratio.000 35% $600 Debt ratio: BEP ratio: Sales: 45% 13. and all income is paid out as dividends. 40.000 $18. What is Lone Star's EBIT? a.0%. c. the tax rate. b.33 1. which is 5.7. and the balance sheet will remain constant. 1.3125% $15. The company’s current ratio is 1. $ 3.22 0. its quick ratio is 0.000 These data have been constant for several years.23% 13. without reducing its sales. Interest rate: 8. merely by cutting overtime pay and thus reducing the cost of goods sold.000 $33. Vance Motors has current assets of $1. d.92% 13.75% 14.

LECTURE 3 ANSWERS AND SOLUTIONS .

2 = Total debt + 1. 13. 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. 7. While this action decreases receivables (a current asset). 10. 18. 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. 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. 20. Therefore.50. Total debt/Total assets = 1/2 = 0. 15. net income and hence reduce ROA. 14. 8.1. The net effect is no change in the quick ratio. higher debt payments will result in . 6. it increases cash (also a current asset). 9. 12. 3. TIE ratio Profit margin and leverage Current ratio Quick ratio The quick ratio is calculated as follows: Current Assets – Inventories . 19. 4. 16. 22. 11. 5. Financial statement analysis Leverage and financial ratios Statements a and c are correct. 2. Answer: a Answer: e Diff: E Diff: E The increase in debt payments will reduce Also. 21. or Total debt = 1.0 = Total assets/Total equity = 2/1.

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

but a lower quick ratio than X.2 × $6. ROE and debt ratios Ratio analysis Answer: b Answer: a Diff: T Diff: T Statement a is correct. it must have higher sales than Y. Therefore. for Y to have a higher inventory turnover (S/I) than X. say Y has CA = 30. Statement b is false. Y must have less inventory than X. in this example Y has a higher current ratio. 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. lower inventory. Statement c is false. (Note that the numbers used in the example are made up but they are consistent with the rest of the question.000 $1. If X had inventory of $50. we know that Y has a higher current ratio than X.000 200. therefore. Statement b is false. In either case we need to know the amount of equity that both firms have. This is impossible to determine given the information in the question.$20)/$10 = 1. we cannot say that X must have a higher ROE than Y. 38 . therefore. Now. From the facts as stated above.000 Diff: T . 35. Thus.5. TIEC < TIED. Therefore. CL = 100. If X has higher sales and also a higher profit margin (NI/Sales) than Y. X’s quick ratio would be ($200 . Statement c is incorrect because higher interest expense doesn’t necessarily imply greater debt.000 400.000. which could lead it to have a higher ROE because its equity multiplier would be greater than company D's.) 37. Company C has higher interest expense than Company D. ROA = NI/TA. they could be the same or different. Ratio analysis Answer: d Diff: T Statement d is correct. Y's CR = $30/$10 = 3. they have the same BEP = EBIT/TA from the facts as given in this problem. the others are false. therefore. it must have lower net income. Y’s quick ratio = ($30 . A’s amount of debt would have to be greater than B’s. we cannot tell what sales are. So. ROAC < ROAD. An example demonstrates this. Since the two firms have the same total assets. the others are false. X has CR = $200/$100 = 2. EBIT = EBT + Interest.Statement b is correct. ROE = NI/EQ or ROE = ROA × Equity multiplier.$50)/$100 = 1. therefore. Statement a is false. CL = 10.000 $ 600. 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. Therefore. and C has higher interest than D but the same EBIT. If Company X has a higher total assets turnover (Sales/TA) but the same total assets. Company C must have lower equity than Company D. 36.200. Say X has CA = $200. Statement c is false as TIE = EBIT/Interest. So. Statement c is false. it must follow that X has a higher net income than Y. For this statement to be correct.000 Answer: d 0. say Y has inventory of $20.000. Statement e is false.

Profit margin Current inventory turnover = Answer: c Diff: E $10.000/0.500.500 ∆ ROE = 20% .000 Inv New inventory turnover = S $10. 42.3%.000.000 = = 13.000.000. Assets $5.500 E New ROE = $300 = 0.000.15($20. 5 5 Inv Freed cash = $5.000 = 10%.500. Increase in NI = 0.$2. $1. $5.07($3.0%.000) = $1.000 Therefore.000. ROA falls. $6. Financial statement analysis BEP = EBIT/TA 0.000.000. ROA = NI/TA 0. ROAOld = ROEOld = ROE New = $600. 41. 4 40 .000 = 13. and ROE increases.000 S = = 2.000.000.000 = $3.000.NI $540.000 ROENew = $600.000 .09 = NI/$100.000. 39. $4. ROE Equity = 0. ROA Net income = 0.000 EBIT = $15. statement d is the correct choice.000. Current ROE = Answer: c Diff: E Answer: d Diff: E Answer: a Diff: E $240 NI = = 16%.8%.000 NI $540.000 S = 5.6 EBT = $15.16% = 4%.000) = $3. ROA = $3. . Therefore interest expense = $0.000.5%.25($6.20 = 20%.000. ROA falls.000 NI = $9.000. EBT = NI/(1 .000.000 Since Net Income increases.000.000.000) = $210.T) EBT = $9.15 = EBIT/$100.000 = 15. Equity $4.000 = = 10. Inv = = = $2.000. $1.000/$22.

$100. Accounts receivable $240 + $210 NI = = 0.5). TA = $40.000. using the DSO equation.D/A) = 1/(1 .000(0.000 Answer: e Diff: M Therefore. ROA = 8.570. the new sales level will be $7.500 Tax (40%) 5. Step 2 NI/TA = ROA.15. or $400 million. ROA BEP = Answer: a Diff: M Answer: a Diff: M EBIT TA = 0. TIE = EBIT INT EBIT 6 = 6.15($100. ROE = ROA × Equity multiplier.000. ROA Equity multiplier = 1/(1 .000/0. BEP .000/(Sales/365) to find annual sales equal to $7. 44.500 ROA = 46.1.500 EBT $12.300. 45 .5.300. INT = = $15.000.000 NI $ 7. by working through the income statement: Net income is found EBIT TA and TA = EBIT . solve for the new accounts receivable figure as follows: 32 = AR/($6.0%.000 Sales Answer: a Diff: M R First solve for current annual sales using the DSO equation as follows: 50 = $1. 6 Calculate Net income: EBIT $15.5%.000) = $15.000 INT 2.000/365) or AR = $576.0450 = 4. TA = $100. Again.000.570.9) = $6.5%.000.500. If sales fall by 10%.000. BEP = We are given BEP and EBIT. EBIT = 0.500 = 7.000.0.60) = 2.New Profit margin = 43. so now we need to find net income. ROA Step 1 We must find TA. 20% = (ROA)(2. $10.000 = $2. N I T A = $7.

6 $1.000/2.0) = $1.0/1.0525 = 5. Inventory turnover = Sales/Inventory = $2.000 .200.15) = 0.64 = Total debt/$3.33) = 0.945.000. ROE New profit margin: (0. 51.200.000.080.000.153.920.000/$1.0 since firm is 100% equity financed. Total equity = $3. New total asset turnover: 2.050/$2.080.000 + Inventory)/$1.920. 49.153)(3. Liquidity ratios Answer: a Diff: M QR = (Current assets .500(0.500 = 42%.000.000 = 21%. ROE $40M 5M $35M 14M $21M (from TIE ratio: (40% tax rate) 8 = EBIT/Int) ROA = $21M/$400M = 0. ROE Answer: d Diff: M Answer: b Diff: M Profit margin = ($1. New equity multiplier: 2.0) = 42%. Net income = 0.000) = $36. Debt ratio = 0.5) = 3. Profit margin = Net income/Sales.0) = $1.33.000 = 5× .Inventory)/Current liabilities 1.I = $1.2 = (CA .000/$400.000 CA .7)/($5.25%.000. ROE = $36.0) = 0. ROE = (Profit margin)(Assets turnover)(Equity multiplier) = (21%)(2.3%.EBIT Interest EBT Taxes NI Step 3 47. Answer: c Diff: M . Debt ratio Debt ratio = Debt/Total assets. Answer: c Diff: M R (Sales per day)(DSO) = A/R (Sales/365)(60) = $147.000 Inventory = = = = (Current assets .000.000 + Inventory $400.000.T)/(Sales/2.115)(1.000.2 Sales = $900.115.$1. Alternate solution: ROE = EBT(1 . ROE: (0.0(1.4($900. 48. Total debt = $1.000 $1.10)(1.5 = 1.I)/$1.000. New ROA: (0.46 = 46%.600. CR 1.Inventory + Inventory)/Current liabilities ($1.0)(1.000.200.000. 50.000.000 = $1.500(1 .000 = 3.3))/$5.0. Equity multiplier = 1.0.

000 = 0.8 = $250.4. S = $720. find the amount of cash: Cash = Current assets .000) = $200. 56. Financial ratios $10. Quick ratio Answer: c Diff: M .139 = $166.667 = $1.71%. find the inventories: Inventory turnover = Sales/Inventory Inventory = Sales/(Inventory turnover) = $1.0. (TATO = 6 = Sales/Total assets.000.000)(1/365) = $131.000 = 36 days.000.333/$4.139/36 5 Industry average DSO = 30 days.000 .$250. $4.$2. CA = $600.Total assets = $24.54.AR . $6.35) = 1.000 = 6. Financial statement analysis Current DSO = Answer: e Diff: M R $1.000. Reduce receivables by 6 Debt = $400/0.333.48%.000.$166.000 .333.Inventory = $450.10 = $4.333.2) = $450.) ROE = NI/Equity Equity = NI/ROE = $400.54) PM = 3.200.000.507 .67 T D = = 65. Profit margin Equity multiplier = 1/(1 .000. Next.200.0. Current assets: CA/$200.3333.67.666.667. Sales: S/$120.000/0.000/6 = $4. DSO = AR = = find the accounts receivables: AR/(Sales/365) DSO(Sales)(1/365) (40)($1.000 . Inventory: ($600.000.000 .000 = 2. Debt ratio = $1. 365 Answer: b Diff: M R First.000/4. Next.$131.000.000. 52 . 54.000 . I = $120. Debt = Total assets .507. Finally.000. find the amount of current assets: Current ratio = Current assets/Current liabilities Current assets = (Current liabilities)(Current ratio) = $375.000 = 3.$166. 53.I)/$200.Equity = $4.000(1.8)(1. $10.15 = $2.000.2)($1.666.000 = $68.000.67 T A 55.000. Sales volume Answer: a Diff: M Answer: a Diff: M Current liabilities: (0. ROE = (Profit margin)(Assets utilization)(Equity multiplier) 15% = (PM)(2.493.

Answer: b Diff: M R If AR and AR AR/(Sales/365) = 35.200. it is just ($1.75 . 000 − $40. then for the inventory turnover ratio to be 8x inventory must be $600.000.000.000 = $225.000/8 = $75.Step 1 Calculate inventory: Quayle Energy has $40 million in inventory because the inventory turnover ratio is equal to 5. 000 5 = $40.000 + $100.000 = $75. = 30.33 Step 3 = 0.417 Now.500)/CL = 1.000 = 3× . Current liabilities will be reduced to $125.000 8. 000.$75. 000. 333 CL they have $83. 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)/$50.000 . Recognizing the first term as the current ratio or 1. S/Inv = 5. Step 2 Calculate current liabilities: From the current ratio.000 . new current assets are $50.500 .000. (Remember. CL = $83.000 + $75.417.2727. 58. Current liabilities We can solve for inventory (because we’re given the inventory turnover ratio) as 8 = $860.5.000.$107.75. 000 CA − Inv = $83.200/365) becomes $600.33 million. CL Find quick ratio: $100.000. Quick ratio If sales remain at $600.500/CL = 1.$107.800 Answer: d Diff: T .) Answer: a Diff: M 59.200 $100) = 1. notes payable were also reduced by $100.$75.72. 000.000 . Inv = $200. Solve this expression for CL = $430. to reduce DSO to 30. $100.000 = $50. then Sales = $7. we can conclude that million in current liabilities. 60.000. AR/($7.$100)/($1.000/Inventory or Inventory = $107.486.5.$107. Thus. we now have 1.000 7. we reduced AR by $100.5. Current ratio Step 1 Step 2 Step 3 We must find sales using DSO of 35. is $700.000 na $ 26.000 $ 18. The new quick ratio is then: ($225. 333.500.000.$75.000.500/CL = 1. we know (CA . Thus. Given the quick ratio. We can rewrite this as CA/CL . Answer: e Diff: M 57. Current inventory minus the new level of inventory reflects the amount of cash freed up or $150. 000.2.200 $ 10. To find the new CR (CA/CL). 000 CR = = 1.

000 Int 350.67%. ROE = NI/Equity.0.Turnover = 2 = S/TA.000.000 Interest = $7.000.45($90.000.000/$2.000 ROE = Net income/Equity = $630.200 $10. so CL = $1.000 × $240.800 (Given) ($18.50. EBIT I EBT T NI $25.000 = $3.000 EBT $1.000.(D/A)](Total assets) Equity = [1 . 63.55 EBIT = $25.2 and CA = $1.0 ROE = (PM)(TATO)(EM). ROE = NI/Equity = $10.050.000.000 × $120.1 = $350. Current inventory = $500.000.000 = 0.500. company.$500. $1.045 × 2 × 2. Reduction in inventory = $1. ROE Given: New D/A = 0.000.000/$120. 62. Current ratio Step 1 Step 2 Answer: c Diff: T Solve for the current inventory level: CA/CL = 1.000 Tax rate = 40% TATO = 3.000/$48.000 NI $ 630.400.000.000 Sales = $270.000 is to be used to reduce the debt of the Interest on this level New debt level = $4.500. of debt = $3.800/$240.000.3150 or 31.000.5 = 0.800/$40. Answer: c Diff: T Recall the Du Pont equation: ROE = (ROA)(EM). Complete the Du Pont equation to determine ROE: ROE = $10.000/6 = $500. ROE Answer: d Diff: T Industry average inventory turnover = 6 = Sales/Inventory. so E/A = 40%. Solve for current level of inventories: .55](Total assets) Equity = 0.200.000. therefore. Equity = [1 .000.000.000. 61. Look at the income statement to get net income: EBIT $1.000 7.225 = 22. D/A = 60%.000 × 0.4 = 2.5%.000/3 = $90.000/2 = $120.000 × 40%) TATO = Sales/Total assets Total assets = Sales/TATO = $270.50%. TA/E = 1/(E/A) = 1/0.000 = 0.000 Tax 420.000 $18.000.000) = $40.000 7. and. To match this level: Inventory = Sales/6 $3.500 = 26.500.000 = $500.000 . TA = S/2 = $240.000 This $500.

$500.200) (EBT = $18.065 465 $ 600 210 $ 390 Diff: T EBIT = 0. D = $40. $100.06.000.000(0.000. S = $300.000 = -$100. D = 0.000 Taxes (40%) 12.000) = $3.222. Financial statement analysis Sales Cost of goods sold EBIT Interest EBT Taxes (35%) NI BEP = $15.000 . EBIT Answer: e Diff: T Write down equations with given data.000) .45.45($8.08) = $3.000 A TA turnover = = S A = 3.000 = 4.1292 = 12.0.600 Debt EBIT TA = 65.600.000 Cost of goods sold ________ EBIT $ 33.4. Answer: a new CR = Step 5 64.000 . Interest = EBIT . our ($1.000.Since QR = 0.$100.T) = $30. ($1. D D = = 0. S D D Debt ratio = = = 0. $8.000 .000 Now fill in: EBIT = $1. then find unknowns: NI Profit margin = = 0.000 Now set up an income statement: Sales $300.000 Now plug sales into profit margin ratio to find NI: NI = 0.000.000 . Solve for the new current ratio: ∆ Inv = $400. So sales are $2.7.$100. we can solve for the new inventory level: $2.133125. $300.000.000.000) = 1.000 _______ $ 1.065 .06.200 EBT $ 30.200.000. EBIT = $1. So.000)/($1.200 Interest 3.000. NI = $18.000 = 0. $8.000 (EBIT = EBT + Interest) ($40.065.000.000.000 A $465 Interest Interest rate = = = 0. $3.$600 = $465.200.EBT = $1.7.000/(1 .000/InvNew = 5. S = 3. Step 3 Step 4 Next we find the sales level using the old inventory turnover ratio: Sales/$500.92%. Using the current sales level and the new target inventory turnover ratio of 5.000.Inv)/$1. Inv = $500. $100.065. InvNew = $400.

NI $ 18.000 .

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