Which of the following statements is correct?

a. A reduction in inventories would have no effect on the current ratio.

b. An increase in inventories would have no effect on the current ratio.
c. If a firm increases its sales while holding its inventories constant, then, other things held
constant, its inventory turnover ratio will increase.
d. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

AR Communications recently issued new common stock and used the proceeds to pay off some of its
short-term notes payable. This action had no effect on the company’s total assets or operating
income. Which of the following effects would occur as a result of this action?
a. The company’s current ratio increased.
b. The company’s times interest earned ratio decreased.
c. The company’s basic earning power ratio increased.
d. The company’s debt ratio increased.

If a bank loan officer were considering a company’s loan request, which of the following statements
would you consider to be correct?
a. The lower the company’s inventory turnover ratio, other things held constant, the lower the
interest rate the bank would charge the firm.
b. Other things held constant, the higher the days sales outstanding ratio, the lower the
interest rate the bank would charge.
c. Other things held constant, the lower the debt ratio, the lower the interest rate the bank
would charge.
d. The lower the company’s TIE ratio, other things held constant, the lower the interest rate
the bank would charge.

A firm wants to strengthen its financial position. Which of the following actions would increase its
quick ratio?
a. Offer price reductions along with generous credit terms that would (1) enable the firm to
sell some of its excess inventory and (2) lead to an increase in accounts receivable.
b. Issue new common stock and use the proceeds to increase inventories.
c. Speed up the collection of receivables and use the cash generated to increase inventories.
d. Use some of its cash to purchase additional inventories.

Which of the following statements is correct?

a. If one firm has a higher debt ratio than another, we can be certain that the firm with the
higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a
firm uses.
b. A firm’s use of debt will have no effect on its profit margin.
c. If two firms differ only in their use of debt—i.e., they have identical assets, sales,
operating costs, interest rates on their debt, and tax rates—but one firm has a higher debt ratio,
the firm that uses more debt will have a lower profit margin on sales and a lower return on assets.
d. If two firms differ only in their use of debt—i.e., they have identical assets, sales, operating
costs, and tax rates—but one firm has a higher debt ratio, the firm that uses more debt will have a
higher operating margin and return on assets.
Companies HD and LD are both profitable, and they have the same total assets (TA), Sales (S), return
on assets (ROA), and profit margin (PM). However, Company HD has the higher debt ratio. Which of
the following statements is correct?
a. Company HD has a lower total assets turnover than Company LD.
b. Company HD has a lower equity multiplier than Company LD.
c. Company HD has a higher fixed assets turnover than Company LD.
d. Company HD has a higher ROE than Company LD.

Which of the following statements is correct?

a. A decline in a firm's inventory turnover ratio suggests that it is improving both its inventory
management and its liquidity position, i.e., that it is becoming more liquid.
b. In general, it's better to have a low inventory turnover ratio than a high one, as a low one
indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose
sales as a result of running out of stock.
c. If a firm's fixed assets turnover ratio is significantly lower than its industry average, this
could indicate that it uses its fixed assets very efficiently or is operating at over capacity and should
probably add fixed assets.
d. The days sales outstanding ratio tells us how long it takes, on average, to collect after a
sale is made. The DSO can be compared with the firm's credit terms to get an idea of whether
customers are paying on time.

Tom’s current assets total to $20 million versus $10 million of current liabilities, while Jerry’s current
assets are $10 million versus $20 million of current liabilities. Both firms would like to “window
dress” their end-of-year financial statements, and to do so they tentatively plan to borrow $10
million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of
the statements below best describes the results of these transactions?
a. The transactions would improve Tom’s financial strength as measured by its current ratio
but lower Jerry’s current ratio.
b. The transactions would lower Tom’s financial strength as measured by its current ratio but
raise Jerry’s current ratio.
[The key here is to recognize that if the CR is less than 1.0, then a given increase to both current
assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater
than 1.0. Thus, the transactions would make Jerry look stronger but Tom look weaker.]
c. The transactions would have no effect on the firm’ financial strength as measured by their
current ratios.
d. The transactions would lower both firm’ financial strength as measured by their current
ratios.

Your sister is thinking about starting a new business. The company would require $380,000 of
assets, and it would be financed entirely with common stock. She will go forward only if she thinks
the firm can provide a 13.5% return on the invested capital, which means that the firm must have an
ROE of 13.5%. How much net income must be expected to warrant starting the business?
a. $58,482
b. $45,144
c. $52,326
d. $51,300
XY Inc's assets are $745,000, and its total debt outstanding is $185,000. The new CFO wants to
establish a debt ratio of 55%. The size of the firm does not change. How much debt must the
company add or subtract to achieve the target debt ratio?
a. $168,563
b. $224,750
c. $191,038
d. $211,265

N-Corp's sales last year were $395,000, and its year-end receivables were $52,500. The firm sells on
terms that call for customers to pay 30 days after the purchase, but some delay payment beyond
Day 30. On average, how many days late do customers pay? Base your answer on this equation:
DSO - Allowed credit period = Average days late, and use a 365-day year when calculating the DSO.
a. 15.92
b. 15.18
c. 13.88
d. 18.51

A-Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the
last year were $520,000, and its net income was $25,000. Stockholders recently voted in a new
management team that has promised to lower costs and get the return on equity up to 15.0%. What
profit margin would the firm need in order to achieve the 15% ROE, holding everything else
constant?
a. 10.71%
b. 9.41%
c. 10.82%
d. 8.11%

Solution:
Total assets = Equity (because zero debt) $375,000
Sales $520,000
Net income $25,000
Target ROE 15.00%
Net income req'd to achieve target ROE = Target ROE x Equity = $56,250
Profit margin needed to achieve target ROE = NI / Sales = 10.82%

Last year ABC Industries had sales of $240,000, assets of $175,000, a profit margin of 5.3%, and an
equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $51,000
without affecting either sales or costs. Had it reduced its assets by this amount, and had the debt
ratio, sales, and costs remained constant, how much would the ROE have changed?
a. 3.19%
b. 3.66%
c. 3.01%
d. 3.59%
Solution:
Old New
Sales $240,000 $240,000
Original assets $175,000
Reduction in assets $51,000
New assets = Old assets - Reduction = $124,000
Cont …
TATO = Sales / Assets = 1.37 1.94
Profit margin 5.30% 5.30%
Equity multiplier 1.20 1.20
ROE = PM TATO Eq Multiplier = 8.72% 12.31%
Change in ROE 3.59%

N-Corp.’s CFO has proposed that the company issue new debt and use the proceeds to buy back
common stock. 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 income.)
a. Return on assets (ROA) will decline.
b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.

Company A and Company B have the same total assets, return on assets (ROA), and profit margin.
However, Company A has a higher debt ratio and interest expense than Company B. Which of the
following statements is most correct?
a. Company A has a higher ROE than Company B.
b. Company A has a higher total assets turnover than Company B.
c. Company A has a higher operating income (EBIT) than Company B.
d. Statements a and c are correct.

D-Company recently issued new common stock and used the proceeds to reduce its short-term
notes payable and accounts payable. This action had no effect on the company’s total assets or
operating income. Which of the following effects did occur as a result of this action?
a. The company’s current ratio decreased.
b. The company’s time interest earned ratio decreased.
c. The company’s debt ratio increased.
d. The company’s equity multiplier decreased.

Which of the following actions can a firm take to increase its current ratio?
a. Issue short-term debt and use the proceeds to buy back long-term debt with a maturity of
more than one year.
b. Reduce the company’s days sales outstanding to the industry average and use the resulting
cash savings to purchase plant and equipment.
c. Use cash to purchase additional inventory.
d. None of the statements above is correct.
You are an analyst following two companies, Company X and Company Y. You have collected the
following information:
• The two companies have the same total assets.
• Company X has a higher total assets turnover than Company Y.
• Company X has a higher profit margin than Company Y.
• Company Y has a higher inventory turnover ratio than Company X.
• Company Y has a higher current ratio than Company X.
Which of the following statements is most correct?
a. Company X must have a higher net income.
b. Company X must have a higher ROE.
c. Company Y must have a higher ROA.
d. Statements a and c are correct.

An analyst has obtained the following information regarding two companies, Company X and
Company Y:
• Company X and Company Y have the same total assets.
• Company X has a higher interest expense than Company Y.
• Company X has a lower operating income (EBIT) than Company Y.
• Company X and Company Y have the same return on equity (ROE).
• Company X and Company Y have the same total assets turnover (TATO).
• Company X and Company Y have the same tax rate.
On the basis of this information, which of the following statements is most correct?
a. Company X has a higher times interest earned (TIE) ratio.
b. Company X and Company Y have the same debt ratio.
c. Company X has a higher return on assets (ROA).
d. Company X has a lower profit margin.

Company A and Company B have the same total assets, tax rate, and net income. Company A,
however, has a lower profit margin than Company B. Company A also has a higher debt ratio and,
therefore, higher interest expense than Company B. Which of the following statements is most
correct?
a. Company A has a higher total assets turnover.
b. Company A has a higher return on equity.
c. Company A has a higher basic earning power ratio.
d. All of the statements above are correct.

Company X has a higher ROE than Company Y, but Company Y has a higher ROA than Company X.
Company X also has a higher total assets turnover ratio than Company Y; however, the two
companies have the same total assets. Which of the following statements is most correct?
a. Company X has a lower debt ratio than Company Y.
b. Company X has a lower profit margin than Company Y.
c. Company X has a lower net income than Company Y.
d. Statements b and c are correct.
Blair Company has $5 million in total assets. The company’s assets are financed with $1 million of
debt and $4 million of common equity. The company’s income statement is summarized below:

Operating income (EBIT) $1,000,000

Interest 100,000
Earnings before taxes (EBT) $ 900,000
Taxes (40%) 360,000
Net income $ 540,000

The company wants to increase its assets by $1 million, and it plans to finance this increase by
issuing $1 million in new debt. This action will double the company’s interest expense but its
operating income will remain at 20 percent of its total assets, and its average tax rate will remain at
40 percent. If the company takes this action, which of the following will occur:
a. The company’s net income will increase.
b. The company’s return on assets will fall.
c. The company’s return on equity will remain the same.
d. Statements a and b are correct.

Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is $750,000,
and its P/E is 8. What is the company’s stock price?
a. $20.00
b. $30.00
c. $40.00
d. $60.00

Ruth Company currently has $1,000,000 in accounts receivable. Its days sales outstanding (DSO) is
50 days. 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. 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, what will
be the level of accounts receivable following the change? Assume a 365-day year.
a. $576,000
b. $633,333
c. $750,000
d. $900,000