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# Chapter 4

## Analyzing Financial Statements

LEARNING OBJECTIVES
1. Explain the three perspectives from which financial statements can be viewed.
Financial statements can be viewed from the owners, managers, or creditors perspective. All three
groups are ultimately interested in a firms profitability, but each group takes a different view.
Shareholders want to know how much cash they can expect to receive for their stocks, what their return
on investment will be, andor how much their stock is worth in the market. !anagers should have the
same perspective as shareholders when analy"ing financial statements. #owever, managers are concerned
with maximi"ing the firms long\$term value through a series of day\$to\$day decisions as they manage the
firm% thus, they need to see the short\$term impact of their decisions on the financial statements to confirm
that things are indeed going as planned. Finally, creditors monitor the companys use of debt and are
particularly concerned with how much debt the firm is using& 's the firm generating enough cash to pay its
short\$term obligations, and will the firm have enough money to cover interest and principal payments on
long\$term debt as it comes due(
). Describe common-size financial statements, explain why they are used, and be able to prepare
and use them to analyze the historical performance of a firm.
Common\$si"e financial statements are financial statements in which each number has been scaled by a
common measure of firm si"e& balance sheets are expressed as a percentage of total assets, and income
statements are expressed as a percentage of net sales. *ommon\$si"e financial statements are necessary
when comparing firms that are significantly different in si"e.
1
+. Discuss how financial ratios facilitate financial analysis, and be able to compute and use them to
analyze a firms performance.
A financial ratio is simply one number from a financial statement divided by another. ,atios are used in
financial analysis because they eliminate the si"e problem when comparing two or more companies of
different si"e or when looking at the same company over time as the si"e changes. Financial ratios can be
divided into five categories& li-uidity, efficiency, leverage, profitability, and market\$value ratios.
.i-uidity ratios measure the ability of a company to cover its current bills. /fficiency ratios tell how
efficiently the firm uses its assets and how -uickly the firm converts current assets into cash. .everage
ratios tell how much debt a firm has in its capital structure and whether the firm can meet its long\$term
financial obligations, such as interest payments on debt or lease payments. 0rofitability ratios focus on the
firms earnings. Finally, market\$value indicators look at a company based on market data as opposed to
historical data used in traditional financial statements.
1. Describe the Duont system of analysis and be able to use it to evaluate a firms performance
and identify corrective actions that may be necessary.
2he 3u0ont system of analysis is a diagnostic tool that uses financial ratios to assess a firms financial
strength. 4nce the assessment is complete, management focuses on correcting the problems within the
context of maximi"ing the firms ,4/. For analysis, the 3u0ont system breaks ,4/ into three
components& net profit margin, which measures operating efficiency% total asset turnover, which measures
how efficiently the firm deploys its assets% and the e-uity multiplier, which measures financial leverage.
/xhibit 1.5 summari"es the structure of the 3u0ont system of analysis and shows how it links the balance
sheet and income statement together.
5. Explain what benchmar!s are, describe how they are prepared, and discuss why they are
important in financial statement analysis.
)
4nce we have calculated financial ratios, we need some way to evaluate them. A benchmark provides a
standard for comparison. 'n financial statement analysis, a number of benchmarks are used. !ost often,
benchmark comparisons involve competitors that are roughly the same si"e and that offer a similar range
of products. 2he data for these benchmark samples may be obtained from national data banks maintained
by the 6.S. 3epartment of *ommerce, trade associations, or private firms, such as 3un 7 8radstreet.
Alternatively, the firms ma9or competitors can be identified, and financial data on these firms can be
collected from their annual reports. Another form of benchmarking is trend analysis, which compares a
firms current financial ratios against the same ratios from past years. 2rend analysis tells us whether a
ratio is increasing or decreasing over time.
:. "dentify the ma#or limitations in usin\$ financial statement analysis.
2he ma9or limitations of financial statement and ratio analysis are the use of historical accounting data
and the lack of theory to guide the decision maker. 2he lack of theory explains, in part, why there are so
many rules of thumb. Although rules of thumb are useful, and they may work under certain conditions,
they may lead to poor decisions if circumstances or the economic environment has changed.
". %rue or &alse 'uestions
1. Financial statement analysis can help us determine why a firms cash flows are increasing
or decreasing
a. 2rue
b. False
+
). Shareholders focus on the value of their stock but not on how much cash they can expect
to receive from dividends andor capital appreciation.
a. 2rue
b. False
+. !anagers decisions regarding financing, investment, and working capital are reflected in
the financial statements.
a. 2rue
b. False
1. A financial statement analysis conducted over a three\$ to five\$year period is called trend
analysis.
a. 2rue
b. False
5. A benchmark for a financial statement analysis is the performance of a multinational firm
in the same industry from another country.
a. 2rue
b. False
1
:. A typical way common si"e income statement is constructed is by dividing all expense
items in an income statement by net income.
a. 2rue
b. False
;. 2he most fre-uent method of ad9usting balance sheets to a common\$si"e basis is to divide
each of the accounts by total assets, expressing each account as a percentage of total
assets.
a. 2rue
b. False
<. .i-uidity ratios are concerned with the firms ability to pay its current bills without
putting the firm in financial difficulty.
a. 2rue
b. False
=. A firms current ratio changed from 1.1 times in the previous year to 1.: times this year.
*oncluding that the firms li-uidity improved is >>>>>>>>>>>.
5
a. 2rue
b. False
1?. A company can improve its li-uidity by increasing its accounts payable, while holding all
else constant.
a. 2rue
b. False
11. 2he purchase of additional inventory by a firm should decrease a firms -uick ratio.
a. 2rue
b. False
1). 2urnover ratios are used by managers to identify operational inefficiencies.
a. 2rue
b. False
1+. A firm increased its days sales outstanding from +5 days to 1+ days. 2his implies the
firm is more efficient.
:
a. 2rue
b. False
11. 2otal asset turnover is more relevant for service industry firms, while the fixed asset
turnover ratio is more relevant for manufacturing industry firms.
a. 2rue
b. False
15. Financial leverage refers to the use of preferred stock in a firms capital structure.
a. 2rue
b. False
1:. 2he e-uity multiplier is computed by dividing e-uity by total assets.
a. 2rue
b. False
1;. 2he higher the times interest earned ratio, the more comfortable are a firms creditors in
the ability of the firm to meet its interest obligations.
a. 2rue
;
b. False
1<. A firm that has no debt will have its ,4A e-ual to its ,4/.
a. 2rue
b. False
1=. For a given level of after\$tax income, the lower the level of e-uity a firm has, the higher
the return on e-uity its shareholders will earn.
a. 2rue
b. False
)?. For a given share price of a firms stock, the lower the /0S the lower the price\$earnings
ratio.
a. 2rue
b. False
)1. 2he 3u0ont e-uation relates a firms net profit margin, total asset turnover ratio, and
e-uity multiplier to determine its return on e-uity.
a. 2rue
<
b. False
)). Firms with a lower ,4A and higher leverage will always have a lower ,4/ than firms
with a higher ,4A and lower leverage.
a. 2rue
b. False
)+. 'n doing an industry group analysis, you form the comparison group by choosing firms
that are larger than the firm being compared.
a. 2rue
b. False
)1. 2he Standard 'ndustry *lassification @S'*A system is a federal government established
system in which the last two digits indicate the business or industry in which the firm is
engaged.
a. 2rue
b. False
)5. 2he use of inflation\$ad9usted balance sheets serves to correct a weakness of ratio analysis.
=
a. 2rue
b. False
1?
"". (ultiple-Choice 'uestions
):. Financial statements can be analy"ed from the following three different perspectives&
a. management, regulator, and bondholder
b. management, shareholder, and creditor
c. regulator, shareholder, and creditor
d. shareholder, creditor, and regulator
);. Shareholders analy"e financial statements in order to&
a. assess the cash flows that the firm will generate from operations
b. determine the firms profitability, their return for that period, and the dividend
c. focus on the value of the stock they hold.
d. All of the above.
)<. 2he creditors of a firm analy"e financial statements so that they can focus on
a. the firms amount of debt.
11
b. the firms ability to generate sufficient cash flows to meet all legal obligations
first and still have sufficient cash flows to meet debt repayment and interest
payments.
c. the firms ability to meet its short\$term obligations.
d. All of the above.
)=. A firms management analy"es financial statements so that&
a. they can get feedback on their investing, financing, and working capital decisions
by identifying trends in the various accounts that are reported in the financial
statements.
b. similar to shareholders, they can focus on profitability, dividend, capital
appreciation, and return on investment.
c. they can get more stock options.
d. a and b.
+?. Anyone analy"ing a firms financial statements should
a. use audited financial statements only.
b. do a trend analysis.
c. perform a benchmark analysis.
d. All of the above.
1)
+1. An individual analy"ing a firms financial statements should do all but one of the
following&
a. 6se unaudited financial statements.
b. 3o a trend analysis.
c. 0erform a benchmark analysis.
d. *ompare the firms performance to that of its direct competitors.
+). All but one of the following is true of common\$si"e balance sheets.
a. /ach asset and liability item on the balance sheet is standardi"ed by dividing it by
total assets.
b. 8alance sheet accounts are represented as percentages of total assets.
c. /ach asset and liability item on the balance sheet is standardi"ed by dividing it by
sales.
d. *ommon\$si"e financial statements allow us to make meaningful comparisons
between the financial statements of two firms that are different in si"e.
++. All but one of the following is true of common\$si"e income statements.
a. /ach income statement item is standardi"ed by dividing it by total assets.
b. 'ncome statement accounts are represented as percentages of sales.
c. /ach income statement item is standardi"ed by dividing it by sales.
1+
d. *ommon\$si"e financial statement analysis is a speciali"ed application of ratio
analysis.
+1. *ommon\$si"e financial statements&
a. are a speciali"ed application of ratio analysis.
b. allow us to make meaningful comparisons between the financial statements of
two firms that are different in si"e.
c. are prepared by having each financial statement item expressed as a percentage of
some base number, such as total assets or total revenues.
d. All of the above are true.
+5. Bhich of the following is true of ratio analysis(
a. A ratio is computed by dividing one balance sheet or income statement item by
another.
b. 2he choice of the scale determines the story that can be garnered from the ratio.
c. ,atios can be calculated based on the type of firm being analy"ed or the kind of
analysis being performed.
d. All of the above are true.
+:. Bhich of the following is )*% true of li-uidity ratios(
11
a. 2hey measure the ability of the firm to meet short\$term obligations with short\$
term assets without putting the firm in financial trouble.
b. 2here are two commonly used ratios to measure li-uidityCcurrent ratio and -uick
ratio.
c. For manufacturing firms, -uick ratios will tend to be much larger than current
ratios.
d. 2he higher the number, the more li-uid the firm and the better its ability to pay its
short\$term bills.
+;. All but one of the following is true about -uick ratios.
a. 2he -uick ratio is calculated by dividing the most li-uid of current assets by
current liabilities.
b. Service firms that tend not to carry too much inventory will see significantly
higher -uick ratios than current ratios.
c. 'nventory, being not very li-uid, is subtracted from total current assets to
determine the most li-uid assets.
d. Duick ratios will tend to be much smaller than current ratio for manufacturing
firms or other industries that have a lot of inventory.
+<. Bhich one of the following does )*% change a firms current ratio(
a. 2he firm collects on its accounts receivables.
15
b. 2he firm purchases inventory by taking a short\$term loan.
c. 2he firm pays down its accounts payables.
d. Eone of the above.
+=. All else being e-ual, which one of the following will decrease a firms current ratio(
a. a decrease in the net fixed assets
b. a decrease in depreciation
c. an increase in accounts payable
d. Eone of the above
1?. All but one of the following is true about the inventory turnover ratio.
a. 't is calculated by dividing inventory by cost of goods sold.
b. 't measures how many times the inventory is turned over into saleable products.
c. 2he more times a firm can turnover the inventory, the better.
d. 2oo high a turnover or too low a turnover could be a warning sign.
11. Bhich one of the following statements is )*% true(
a. 2he accounts receivables turnover ratio measures how -uickly the firm collects on
its credit sales.
1:
b. 4ne ratio that measures the efficiency of a firms collection policy is days sales
outstanding.
c. 2he more days that it takes the firm to collect on its receivables, the more efficient
the firm is.
d. 3S4 measures in days, the time the firm takes to convert its receivables into cash.
1). 4ne of the following statements is )*% true of asset turnover ratios.
a. Asset turnover ratios measure the level of sales per dollar of assets that the firm
has.
b. 2he fixed assets turnover ratio is less significant for e-uipment\$intensive
manufacturing industry firms than the total assets turnover ratio.
c. 2he higher the total asset turnover, the more efficiently management is using total
assets.
d. All of the above are true.
1+. Bhich one of the following statements is correct(
a. 2he lower the level of a firms debt, the higher the firms leverage.
b. 2he lower the level of a firms debt, the lower the firms e-uity multiplier.
c. 2he lower the level of a firms debt, the higher the firms e-uity multiplier.
d. 2he tax benefit from using debt financing reduces a firms risk.
1;
11. 'f firm A has a higher e-uity ratio than firm 8, then
a. firm A has a lower e-uity multiplier than firm 8.
b. firm 8 has a lower e-uity multiplier than firm A.
c. firm 8 has lower financial leverage than firm A.
d. Eone of the above.
1<
15. Bhich one of the following statements is )*% correct(
a. A leveraged firm is more risky than a firm that is not leveraged.
b. A leveraged firm is less risky than a firm that is not leveraged.
c. A firm that uses debt magnifies the return to its shareholders.
d. All of the above statements are correct.
1:. *overage ratios, like times interest earned and cash coverage ratio, allow
a. a firms management to assess how well they meet short\$term liabilities.
b. a firms shareholders to assess how well the firm will meet its short\$term
liabilities.
c. a firms creditors to assess how well the firm will meet its interest obligations.
d. a firms creditors to assess how well the firm will meet its short\$term liabilities
other than interest expense.
1;. For a firm that has no debt in its capital structure,
a. ,4/ F ,4A.
b. ,4/ G ,4A.
c. ,4/ H ,4A.
d. Eone of the above.
1=
1<. For a firm that has both debt and e-uity,
a. ,4/ F ,4A.
b. ,4/ G ,4A.
c. ,4/ H ,4A
d. Eone of the above.
1=. Bhich one of the following statements is )*% correct(
a. 2he 3u0ont system is based on two e-uations that relate a firms ,4A and ,4/.
b. 2he 3u0ont system is a set of related ratios that links the balance sheet and the
income statement.
c. 8oth management and shareholders can use this tool to understand the factors that
drive a firms ,4/.
d. All of the above are correct.
5?. 2he 3u0ont e-uation shows that a firms ,4/ is determined by three factors&
a. net profit margin, total asset turnover, and the e-uity multiplier
b. operating profit margin, ,4A, and the ,4/
c. net profit margin, total asset turnover, the ,4A
d. ,4A, total assets turnover, and the e-uity multiplier
)?
51. Bhich one of the following is a criticism of e-uating the goals of maximi"ing the ,4/ of
a firm and maximi"ing the firms shareholder wealth(
a. ,4/ is based on after\$tax earnings, not cash flows.
b. ,4/ does not consider risk.
c. ,4/ ignores the si"e of the initial investment as well as future cash flows.
d. All of the above are criticisms of ,4/ as a goal.
5). Bhich one of the following is )*% an advantage of using ,4/ as a goal(
a. ,4/ is highly correlated with shareholder wealth maximi"ation.
b. ,4/ and the 3u0ont analysis allow management to break down the performance
and identify areas of strengths and weaknesses.
c. ,4/ does not consider risk.
d. All of the above are advantages of using ,4/ as a goal.
5+. Bhich one of the following statements about trend analysis is )*% correct(
a. 2his benchmark is based on a firms historical performance.
b. 't allows management to examine each ratio over time and determine whether the
trend is good or bad for the firm.
c. 2he +tandard "ndustrial Classification ,+"C- +ystem is used to identify
benchmark firms.
)1
d. All of the above are true statements.
51. 0eer group analysis can be performed by
a. management choosing a set of firms that are similar in si"e or sales, or who
compete in the same market.
b. using the average ratios of this peer group, which would then be used as the
benchmark.
c. identifying firms in the same industry that are grouped by si"e, sales, and product
lines in order to establish benchmark ratios.
d. 4nly a and b relate to peer group analysis.
55. .imitations of ratio analysis include all but
a. ,atios depend on accounting data based on historical costs.
b. 3ifferences in accounting practices like F'F4 versus .'F4 make comparison
difficult.
c. 2rend analysis could be distorted by financial statements affected by inflation.
d. All of the above are limitations of ratio analysis.
5:. .i/uidity ratio0 .ionel, 'nc., has current assets of I:)+,1)), including inventory of
I)11,==?, and current liabilities of +;<,151. Bhat is the -uick ratio(
))
a. 1.:5
b. ?.:1
c. 1.?1
d. Eone of the above
5;. .i/uidity ratio0 8athe" *orp. has receivables of I++1,));, inventory of I151,???, cash
of I;+,=1+, and accounts payables of I1:=,55+. Bhat is the firms current ratio(
a. 1.<+
b. ?.;+
c. 1.:;
d. Eone of the above
5<. .i/uidity ratio0 Jidane /nterprises has a current ratio of 1.=), current liabilities of
I);),=+1, and inventory of 1=;,+++. Bhat is the firms -uick ratio(
a. ?.;)
b. 1.)?
c. 1.=)
d. Eone of the above
5=. .i/uidity ratio0 ,onaldinho 2rading *o. is re-uired by its bank to maintain a current
ratio of at least 1.;5, and its current ratio now is ).1. 2he firm plans to ac-uire additional
)+
inventory to meet an unexpected surge in the demand for its products and will pay for the
inventory with short\$term debt. #ow much inventory can the firm purchase without
violating its debt agreement if their total current assets e-ual I+.5 million(
a. I?
b. I;;;,;;;
c. I1 million
d. Eone of the above
:?. Efficiency ratio0 'f ,andolph *orp. has accounts receivables of
I:51,<?+ and net sales of I1,=+),+1=, what is its accounts receivable turnover(
a. ?.+1 times
b. 1.;< times
c. ).=5 times
d. Eone of the above
:1. Efficiency ratio0 'f Kiera, 'nc., has an accounts receivable turnover of +.= times and net
sales of I+,1+:,<1), what is its level of receivables(
a. I<<1,)+1
b. I1+,1?+,5:;
c. I1,+1?,+5;
)1
d. I<1,)+1
:). Efficiency ratio& Lason 2raders has sales of I<++,5<;, a gross profit margin of +).1
percent, and inventory of I1;<,1+5. Bhat is the companys inventory turnover ratio(
a. 1.:; times
b. +.1: times
c. 1.1 times
d. Eone of the above
:+. Efficiency ratio& Mateway *orp. has an inventory turnover ratio of 5.:. Bhat is the
firms days sales in inventory(
a. :5.) days
b. :1.+ days
c. :1.; days
d. 5;.= days
:1. Efficiency ratio0 Let, 'nc., has net sales of I;1),1;< and accounts receivables of
I1:;,1+5. Bhat are the firms accounts receivables turnover and days sales outstanding(
a. ?.)1 times% ;<.5 days
b. 1.): times% <5.; days
)5
c. 5.) times% :1.+ days
d. Eone of the above
:5. Efficiency ratio0 /llicott *ity !anufacturers, 'nc., has sales of I:,+11,)1?, and a gross
profit margin of :;.+ percent. Bhat is the firms cost of goods sold(
a. I),?;1,55;
b. I),;15,:1?
c. I);1,5:?
d. Eone of the above
::. Efficiency ratio0 3eutsche 8earings has total sales of I=,;15,=)+, inventories of
I),)+;,1+5, cash and e-uivalents of I;55,?;1, and days sales outstanding of 1= days. 'f
the firms management wanted its 3S4 to be +5 days, by how much will the accounts
receivable have to change(
a. I+;+,<1:.)+
b. \$I+;+,<1:.)+
c. \$I+;=,??<.1)
d. I+;=,??<.1)
:;. Covera\$e ratio0 2rident *orp. has debt of I+.+5 million with an interest rate of :.<;5
percent. 2he company has an /8'2 of I),;::,??=. Bhat is its times interest earned(
):
a. 1+ times
b. 1) times
c. 11 times
d. Eone of the above
:<. Covera\$e ratios& Sectors, 'nc., has an /8'2 of I;,))1,:1+ and interest expense of
I:11,<??. 'ts depreciation for the year is I1,1+1,5??. Bhat is its cash coverage ratio(
a. 15.1) times
b. 1<.+1 times
c. 11.15 times
d. Eone of the above
:=. Covera\$e ratios& Fahr *ompany had depreciation expenses of I:+?,;15, interest
expenses of I11),?;<, and an /8'2 of I1,51),<++ for the year ended Lune +?, )??:.
Bhat are the times interest earned and cash coverage ratios for this company(
a. 1=.1 times% 1).; times
b. 1;.+ time% 11.1 times
c. 1+.< times% 1=.1 times
d. Eone of the above
);
;?. .evera\$e ratio0 Nour firm has an e-uity multiplier of ).1;. Bhat is its debt\$to\$e-uity
ratio(
a. ?.:?
b. 1.1;
c. 1.;1
d. ?
;1. .evera\$e ratio0 Bhat will be a firms e-uity multiplier given a debt ratio of ?.15(
a. 1.<)
b. 1.)<
c. ).))
d. Eone of the above
;). .evera\$e ratio0 3reisen 2raders has total debt of I1,)++,<+; and total assets of
I),1;<,==?. Bhat are the firms e-uity multiplier and debt\$to\$e-uity ratio(
a. ).+1% 1.+1
b. 1.;5% ?.;5
c. ?.;5% 1.;5
d. 1.+1% ).+1
)<
;+. (ar!et-value ratio0 ,2, *orp. has reported a net income of I<1),1)5 for the year. 2he
companys share price is I1+.15, and the company has +1),1=? shares outstanding.
*ompute the firms price\$earnings ratio.
a. 1.<; times
b. <.1) times
c. 5.1; times
d. Eone of the above
;1. (ar!et-value ratios& 0ere" /lectronics *orp. has reported that its net income for )??: is
I1,);:,+51. 2he firm has 1)?,??? shares outstanding and a 0\$/ ratio of 11.) times. Bhat
is the firms share price(
a. I+1.?5
b. I+.:<
c. I11.)?
d. I+:.<?
;5. rofitability ratio0 Luventus *orp has total assets of I1,;11,)<<, total debt of
I),=1),???, and net sales of I;,)1),1:5. 2heir net profit margin for the year is 1<
percent. Bhat is Luventuss ,4A(
a. )5.:O
)=
b. 1<O
c. );.1O
d. Eone of the above
;:. Duont e/uation0 Men2ech 0harma has reported the following information&
Sales2otal assets H ).<=% ,4A H 1?.;1O% ,4/ H )?.+:O
Bhat are the firms profit margin and e-uity multiplier(
a. ;.1O% ?.5+
b. ;.1O% 1.=?
c. +.;O% ?.5+
d. +.;O% 1.=?
;;. rofitability ratios& 2igger *orp. has reported the financial results for year\$end )??:.
8ased on the information given, calculate the firms gross profit margin and operating
profit margin.
Eet sales H I1,15:,;?? Eet income H I;;<,+)1
*ost of goods sold H I),;15,++1 /8'2 H I1,+5:,?=<
a. +1.;O% +).:O
b. +).:O% 1<.;)O
c. +1.;O% 1<.;)O
+?
d. Eone of the above
;<. Duont e/uation0 Andrade *orp has debt of I),<+1,=5?, total assets of I5,1;<,)+5,
sales of I<,)+1,1)1, and net income of I<1),+55. Bhat is the firms return on e-uity(
a. ;.1Ot
b. +1.;O
c. )<.1O
d. 1+.)O
;=. Duont e/uation0 Saunders, 'nc., has a ,4/ of 1<.; percent, an e-uity multiplier of
).5+, sales of I).;5 million, and a total assets turnover of ).; times. Bhat is the firms
net income(
a. I;5,)<1.<?
b. I511,)5?.??
c. I51,1)5.??
d. I;,5)<.1?
<?. Duont e/uation0 Sorenstam *orp has an e-uity multiplier of ).+1 times, total assets of
I1,51),<=5, a ,4/ of 1;.5 percent, and a total assets turnover of +.1 times. *alculate the
firms ,4A.
+1
a. :.)+O
b. 1.5+O
c. ;.1<O
d. 5.;=O
+)
""". Essay 'uestions
<1. *ompare how a firms creditor would analy"e a firms financial statements relative to
those of a firms shareholders.
1nswer0 A firms creditors primary concern is the ability of the firm to repay their loans
with interest on a timely manner. 2oward this end they would analy"e the firms financial
statements to gauge the ability of the firm to generate sufficient cash flows to meet not
only their legal financial obligations but also their debt obligations. Shareholders, on the
other hand, want to know how much cash they can expect to receive for their stocks, what
their return on investment will be, andor how much their stock is worth in the market.
<). /xplain the different ways that a firms ratios can be benchmarked.
1nswer0 8enchmark data can be obtained in one of three different waysCtrend analysis,
industry average analysis, and peer group analysis. 2rend analysis involves evaluating a
single firms performance over time. 2his sort of analysis allows management to see
whether a given ratio value has increased or decreased over time and whether there has
been any significant changes in the value of the ratios being analy"ed. A ratio value that
is changing typically is a signal to the financial manager to take a closer look at the ratio
and to make decisions depending on whether the change is favorable or unfavorable to
the firm.
++
A second way to establish a benchmark is to conduct an industry group analysis.
Be do this by identifying a group of firms that have the same product line, compete in
the same market, and are about the same si"e. 2he average ratio values for the group will
be our benchmarks.
2he third way to establish benchmark information is to identify a group of firms
that compete with the company you are analy"ing. 'deally, the firms are in similar lines
of business, are about the same si"e, and are direct competitors of the target firm. 2hese
firms form a peer group of firms in the same industry. 4nce a peer group has been
identified, you can obtain their annual reports and compute average ratio values against
which your firm can compare its performance.
<+. Bhat are some of the main limitations of ratio analysis(
1nswer0 Bhile financial ratio analysis can provide management with useful information
to improve the firms performance, there are some serious limitations to its usefulness.
First, ratio analysis depends on accounting data based on historical costs. !anagement or
investors will get a truer picture of a firms financial condition if market value was the
basis of the analysis.
Second, there is no theoretical backing in making 9udgments based on financial
statement and ratio analysis. Ludgment calls made based on experience or common sense
work only some of the time. 2hird, when doing industry or peer group analysis you are
often confronted with large, diversified firms that do not fit into any one S'* code or
classification. Fourth, trend analysis could be distorted by financial statements affected
+1
by inflation. Finally, multinational firms deal with many accounting standards. Financial
reports that are created based on different accounting standards make it difficult to
compare. /ven among domestic firms, differences in accounting practices, like F'F4
versus .'F4, make comparison difficult.
+5
"2. 1nswers to %rue or &alse 'uestions
1. 2rue
). False
+. 2rue
1. 2rue
5. False
:. False
;. 2rue
<. 2rue
=. 2rue
1?. False
11. 2rue
1). 2rue
1+. False
11. 2rue
15. False
1:. False
1;. 2rue
1<. 2rue
1=. 2rue
)?. False
)1. 2rue
+:
)). False
)+. False
)1. False
)5. 2rue
+;
2. 1nswers to (ultiple-Choice 'uestions
):. b
);. d
)<. d
)=. d
+?. d
+1. a
+). c
++. a
+1. d
+5. d
+:. c
+;. b
+<. a
+=. c
1?. a
11. c
1). b
1+. b
11. a
15. b
1:. c
+<
1;. c
1<. a
1=. d
5?. a
51. d
5). c
5+. c
51. d
55. d
5:. c
5;. a
5<. b
5=. b
:?. c
:1. a
:). b
:+. a
:1. b
:5. a
::. b
:;. b
:<. c
:=. c
+=
;?. b
;1. a
;). a
;+. c
;1. a
;5. c
;:. d
;;. a
;<. b
;=. a
<?. c
2". +olutions to (ultiple-Choice 'uestions
5:. +olution0
*urrent assets H I:)+,1))
*urrent liabilities H I+;<,151
'nventory H I)11,==?
3.43 =

=
=
151 , +;< I
==? , )11 I 1)) , :)+ I
s liabilitie *urrent
'nventory \$ assets *urrent
ratio Duick
1?
5;. +olution0
*urrent assets H I;+,=1+ P I151,??? PI++1,)); H I<5=,11?
*urrent liabilities H I1:=,55+
3.56 =
=
=
55+ , 1:= I
11? , <5= I
s liabilitie *urrent
assets *urrent
ratio *urrent
5<. +olution0
*urrent ratio H 1.=)
*urrent liabilities H I);),=+1
'nventory H I1=;,+++
I5)1,?++ I);),=+1 1.=) assets *urrent
liabilites *urrent
assets *urrent
=) . 1
liabilites *urrent
assets *urrent
ratio *urrent
= =
=
=
3.74 =

=
=
=+1 , );) I
+++ , 1=; I ?++ , 5)1 I
s liabilitie *urrent
'nventory \$ assets *urrent
ratio Duick
5=. +olution0
11
.et Q represent the additional borrowing against the firms line of credit @which also
e-uals the addition to current assetsA. Be can solve for that level of Q that forces the
firms current ratio to be at 1.;5
I+,5??,??? *urrent liabilities H ).1
*urrent liabilities H I1,:::,::;
1.;5 H @I+,5??,??? P QA @I1,:::,::; P QA
@1.;5 R I1,:::,::;A P 1.;5Q H I+,5??,??? P Q
?.;5Q H I+,5??,??? \$ I),=1:,::;
Q H I;;;,;;;
:?. +olution0
Accounts receivables H I:51,<?+
Eet sales H I1,=+),+1=
times 7.89 =
=
=
<?+ , :51 I
+1= , =+) , 1 I
s receivable Accounts
sales Eet
turnover s receivable Accounts
:1. +olution0
1)
Accounts receivables turnover H +.=x
Eet sales H I+,1+:,<1)
:553,764 = =
=
=
= . +
<1) , 1+: , + I
s receivable Accounts
s receivable Accounts
<1) , 1+: , + I
x = . +
s receivable Accounts
sales Eet
turnover s receivable Accounts
:). +olution0
Sales H I<++,5<;
Mross profit margin H +).1O
'nventory H I1;<,1+5
6.3;x =
= =
=
=

=
=
1+5 , 1;< I
5?: , 5:+ I
'nventory
sold goods of *ost
ratio turnover 'nventory
5?: , 5:+ I
A 5<; , <++ +)1 . ? @ 5<; , <++ sold goods of *ost
<++,5<;
Sold goods of *ost 5<; , <++
+)1 . ?
Sales
sold goods of *ost \$ Sales
margin profit Mross
:+. +olution0
days ;9.7 = =
5.:
+:5
inventory in sales s S 3ay
1+
:1. +olution0
Eet sales H I;1),1;<
Accounts receivables H I1:;,1+5
. times ): . 1
1+5 , 1:; I
1;< , ;1) I
receivable Accounts
sales Eet
turnover receivable Accounts
= =
=
days :59.< =
=
=
=
): . 1
+:5
turnover s receivable Accounts
+:5

recievable unts salesAcco Eet
+:5
3S4
:5. +olution0
:7,4<4,99< =
=

=
=
A )1? , +11 , : I :;+ . ? @ )1? , +11 , : I sold goods of *ost
I:,+11,)1?
Sold Moods of *ost )1? , +11 , : I
:;+ . ?
Sales
sold goods of *ost \$ Sales
margin profit Mross
::. +olution0
11
Sales H I=,;15,=)+% 'nventory H I),)+;,1+5 *ash H ;55,?;1%
3S4 H 1= 3ays
;= . +5: , +?< , 1 I
+:5
=)+ , ;15 , = I 1=
+:5
sales Eet 3S4
s recievable Accounts
sales Eet
s receivable +:5
receivable unts salesAcco Eet
+:5
turnover receivable Accounts
+:5
3S4
=

=
= =
Accounts
DSO
6 :6<6,53;.7 -
: I=+1,51?.5 \$ .;= I1,+?<,+5: s receivable
5: . 51? , =+1 I
+:5
=)+ , ;15 , = +5
+:5
sales Eet 3S4
s receivable accounts Eew
3ays +5 3S4 2arget
=
=

=
=
Accounts
:;. +olution0
'nterest expense H I+,+5?,??? x ?.?:<;5 H I)+?,+1).5?
times 3)
5? . +1) , )+? I
??= , ;:: , ) I
expense 'nterest
/8'2
earned interest 2imes
=
= =
:<. +olution0
3epreciation H I1,1+1,5??
'nterest expenses H I:11,<??
/3'2 H I;,))1,:1+
15
times 34.39 =
+
=
+
= =
<?? , :11 I
5?? , 1+1 , 1 I :1+ , ))1 , ; I
expense t 'nteres
on 3epreciati /8'2
expense 'nterest
/8'23A
rates coverage *ash
:=. +olution0
3epreciation H I:+?,;15
'nterest expenses H I11),?;<
/3'2H I1,51),<++
times 36.5 =
= =
?;< , 11) I
<++ , 51) , 1 I
expense 'nterest
/8'2
earned interest 2imes
times 38.4 =
+
=
+
= =
?;< , 11) I
;15 , :+? I <++ , 51) , 1 I
expense t 'nteres
on 3epreciati /8'2
expense 'nterest
/8'23A
rates coverage *ash
;?. +olution0
/-uity multiplier H 1 P 3ebt to e-uity
3ebt to e-uity H /-uity multiplier T1
H ).1; T 1
H 3.4<
1:
;1. +olution0
535 3.
15 . ? 1
1
assets 3ebt2otal 1
1
assets 2otal /-uity
1
/-uity
assets 2otal
multiplier /-uity
=

=
= =
;). +olution0
3ebt ratio H I1,)++,<+; I),1;<,==? H ?.5;
3.66
7.66
= =
=
+ =
=

=
= =
1 \$ ).++
1 \$ multiplier /-uity ratio e-uity 3ebt to
e-uityA @3ebt to 1 multiplier /-uity
5; . ? 1
1
assets 3ebt2otal 1
1
assets 2otal /-uity
1
/-uity
assets 2otal
multiplier /-uity
;+. +olution0
Eet income H I<1),1)5
Share price H I1+.15
/0S H I<1),1)5 +1), 1=? H I).:?
1;
times 9 1; .
:? . ) I
I1+.15
ratio earnings \$ 0rice = =
;1. +olution0
Eet income H I1,);:,+51
Share outstandingH 1)?,???
/0S H I1,);:,+51 1)?,??? H I+.?1
0\$/ ratio H 11.) times
:64.49 = =
=
=
I+.?1 11.) share per ice 0r
I+.?1
share per 0rice
) . 11
/0S
share per 0rice
ratio earnings 0rice
;5. +olution0
2otal assetsH I1,;11,)<<% 2otal debtH I),=1),???
Eet salesH I;,)1),1:5% Eet profit marginH 1<O
:3,785,744 =
=
=
1:5 , )1) , ; I 1< . ? income Eet
Sales
income Eet
margin profit Eet
7<.4= = = =
)<< , ;11 , 1 I
)11 , )=< , 1 I
assets 2otal
income Eet
,4A
1<
;:. +olution0
2otal assets turnover H ).<=
,4A H 1?.;1O
,4/ H )?.+:O
,4A H 0rofit margin x 2otal assets turnover
6.<= = = = =
<= . )
1?;1 . ?
turnover assets 2otoal
,4A
margin 0rofit
,4/ H ,4A x /-uity multiplier
3.84 = = =
1?;1 . ?
)?+: . ?
,4A
,4/
multiplier /-uity
;;. +olution0
Eet sales H I1,15:,;??
Eet income H I;;<,+)1
*ost of goods sold H I),;15,++1
/8'2 H I1,+5:,?=<
64.;<9<= =

=
=
;?? , 15: , 1 I
++1 , ;15 , ) I ;?? , 15: , 1 I
sales Eet
sold goods of *ost \$ sales Eet
margin profit Mross
67.;746= = = =
;?? , 15: , 1 I
?=< , +5: , 1 I
sales Eet
/8'2
margin profit 4perating
1=
;<. +olution0
)?== . )
?.15)5
1
multiplier /-uity
?.15)5 ?.51;5 \$ 1 ratio /-uity
51;5 . ?
)+5 , 1;< , 5 I
I),<+1,=5?
ratio 3ebt
= =
= =
= =
64.;5= =
=
=
=
=
)?== . ) 5=?1 . 1 ?=<; . ?
)) . )
)+5 , 1;< , 5 I
1)1 , )+1 , < I
1)1 , )+1 , < I
+55 , <1) I
/!
assets 2otal
Sales
Sales
income Eet
/! 2A24 0! ,4/
;=. +olution0
5) . 51< , ?1< , 1 I
).;
I),;5?,???
assets 2otal
assets 2otal
??? , ;5? , ) I
; . )
assets 2otal
??? , ;5? , ) I
assets 2otal
Sales
turnover assets 2otal
= =
=
= =
5?
1= . 5;: , 1?) I
5+ . )
51= , ?1< , 1 I
/-uity
/-uity
5) . 51< , ?1< , 1 I
5+ . )
/-uity
assets 2otal
/!
= =
=
=
:<9,753.54 =
=
=
=
5;; , 1?) I 1<; . ?
/-uity ,4/ income Eet
/-uity
income Eet
,4/
<?. +olution0
5 I1+,=<=,=; <=5 , 51) , 1 I 1 . + Sales
<=5 , 51) , 1 I
Sales
1 . +
assets 2otal
Sales
turnover assets 2otal
= =
=
=
5<< , =)< , 1 I
+1 . )
<=5 , 51) , 1 I
/-uity
/-uity
<=5 , 51) , 1 I
+1 . )
/-uity
assets 2otal
/!
= =
=
=
51
5?+ , ++; I
5<< , =)< , 1 I 1;5 . ?
/-uity ,4/ E'
/-uity
E'
,4/
=
=
=
=
<.45= = = =
<=5 , 51) , 1 I
5?+ , ++; I
assets 2otal
E'
,4A
5)