Financial Management (Chapter 4: Financial Analysis-Sizing Up Firm

Performance)
4.1 Why Do We Analyze Financial Statements?

1) Which of the following parties would perform an external financial analysis?

A) A firm's compensation committee
B) A financial analyst forecasting the next period's borrowing needs
C) A firm's creditors
D) A CFO comparing the performance of the firm's various divisions

2) Which of the following parties would perform an internal financial analysis?

A) A financial analyst forecasting the next period's borrowing needs
B) A firm's competitors
C) A firm's creditors
D) Analysts for investment companies

3) Which of the following parties would be interested in an analysis of the firm's financial
statements?
A) Investors
B) Creditors
C) The firm's managers
D) all of the above

4) The analysis of a firm's financial statements can be an important factor in the firm's ability to
borrow money.
Answer: TRUE

5) The analysis of a firm's financial statements is usually of interest only to people who do not
work for the company.
Answer: FALSE

6) Individuals who do not work for a company rarely have enough information to perform a
detailed financial analysis of the company.
Answer: FALSE

4.2 Common Size Statements: Standardizing Financial Information

1) The principal reason for preparing common size statements is

A) to make meaningful comparisons between firms that are not the same size.
B) to make meaningful comparisons between different fiscal years.
C) to eliminate the effects of inflation.
D) to make meaningful comparisons between firms in different industries.

2) Common size financial statements represent all figures on the financial statements
A) in inflation adjusted dollars from a base year.
B) as if all companies being compared had the same total revenue.
C) as if all companies being compared had the same total assets.
D) as a percentage of either sales or total assets.

3) Common size income statements represent all figures on the income statement
A) as a percentage change from the previous year.
B) percentages of the current year's sales.
C) as a percentage of some benchmark figure.
D) as a percentage of total assets.

4) Common size balance sheets represent all figures on the balance sheet
A) as a percentage change from the previous year.
B) percentages of the current year's sales.
C) as a percentage of some benchmark figure.
D) as a percentage of total assets.

5) On a common size balance sheet, total assets are equal to 100%.

Answer: TRUE

6) On a common size income statement, EBIT is equal to 100%.

Answer: FALSE

7) By using common size income statements, firms can determine how various expenses as a
percentage of total sales changed from period to period.
Answer: TRUE

8) What is the purpose of using common size balance sheets and common size income
statements?
Answer: The purpose is to allow a company to compare its performance with its own prior
performance or with the performance of other firms. It is not helpful to just compare numbers,
but with common size statements firms can compare percentages, so that they can answer
questions about how their own performance changed, and how their performance compares to
that of other firms.

4.3 Using Financial Ratios

1) If you were given the components of current assets and of current liabilities, what ratio(s)
could you compute?
A) Acid test or quick ratio
B) Average collection period
C) Current ratio
D) Both A and C
E) All of the above

2) The debt ratio is a measure of a firm's

A) leverage.
B) profitability.
C) liquidity.
D) efficiency.
3) Which of the following statements is true?
A) Current assets consist of cash, accounts receivable, inventory, and net plant, property, and
equipment.
B) The quick ratio is a more restrictive measure of a firm's liquidity than the current ratio.
C) For the average firm, inventory is considered to be more "liquid" than accounts receivable.
D) A successful firm's current liabilities should always be greater than its current assets.

4) Which of the following transactions does NOT affect the quick ratio?
A) Land held for investment is sold for cash.
B) Equipment is purchased and is financed by a long-term debt issue.
C) Inventories are sold for cash.
D) Inventories are sold on a credit basis.

5) Given an accounts receivable turnover of 8 and annual credit sales of $362,000, the average
collection period (360-day year) is
A) 90 days.
B) 45 days.
C) 75 days.
D) 60 days.

6) The question "Did the common stockholders receive an adequate return on their
investment?" is answered through the use of
A) liquidity ratios.
B) profitability ratios.
C) coverage ratios.
D) leverage ratios.

Table 1
Smith Company Balance Sheet and selected Income Statement data

Assets:
Cash and marketable securities $300,000
Accounts receivable 2,215,000
Inventories 1,837,500
Prepaid expenses 24,000
Total current assets $3,286,500
Fixed assets 2,700,000
Less: accumulated depreciation 1,087,500
Net fixed assets $1,612,500
Total assets $4,899,000
Liabilities:
Accounts payable $240,000
Notes payable 825,000
Accrued taxes 42,500
Total current liabilities $1,107,000
Long-term debt 975,000
Owner's equity 2,817,000
Total liabilities and owner's equity $4,899,000
Net sales (all credit) $6,375,000
Less: Cost of goods sold 4,312,500
Selling and administrative expense 1,387,500
Depreciation expense 135,000
Interest expense 127,000
Earnings before taxes $412,500
Income taxes 225,000
Net income $187,500
Common stock dividends $97,500
Change in retained earnings $90,000

7) Based on the information in Table 1, the current ratio is

A) 2.97.
B) 1.46.
C) 2.11.
D) 2.23.

8) Based on the information in Table 1, the average collection period is

A) 71 days.
B) 84 days.
C) 64 days.
D) 127 days.

9) Based on the information in Table 1, the debt ratio is

A) 0.70.
B) 0.20.
C) 0.74.
D) 0.42.

10) Based on the information in Table 1, the net profit margin is

A) 4.61%.
B) 2.94%.
C) 1.97%.
D) 5.33%.

11) Based on the information in Table 1, the inventory turnover ratio is

A) 0.29 times.
B) 2.35 times.
C) 0.43 times.
D) 3.47 times.

12) Marshall Networks, Inc. has a total asset turnover of 2.5 and a net profit margin of 3.5%.
The firm has a return on equity of 17.5%. Calculate Marshall's debt ratio.
A) 30%
B) 40%
C) 50%
D) 60%

13) The DuPont method decomposes return on equity into

A) return on assets and the debt ratio.
B) return on assets and the equity multiplier.
C) operating income and inventory turnover.
D) net profit margin and fixed asset turnover.
14) A firm's average collection period has decreased significantly from the previous year. Which
of the following could possibly explain the results?
A) Customers are paying off their accounts quicker.
B) Customers are taking longer to pay for purchases.
C) The firm has a stricter collection policy.
D) Both A and C.

15) An increase in ________ will increase common equity.

A) paid in capital
B) retained earnings
C) dividends paid
D) both A and

16) Another name for the acid test ratio is the

A) current ratio.
B) quick ratio.
C) inventory turnover ratio.
D) average collection period.

17) Which of the following financial ratios is the best measure of the operating effectiveness of a
firm's management?
A) Current ratio
B) Gross profit margin
C) Quick ratio
D) Return on investment

18) Which of the following is included in the denominator of the times-interest-earned ratio?
A) Lease payments
B) Principal payments
C) Interest expense
D) Gross profit

19) The quick ratio is a better measure of liquidity than the current ratio if the firm has current
assets composed primarily of
A) cash.
B) inventory.
C) marketable securities.
D) accruals.

20) If a company's average collection period is higher than the industry average, then the
company might be
A) enforcing credit conditions upon its customers which are too stringent.
B) allowing its customers too much time to pay their bills.
C) too tough in collecting its accounts.
D) too liquid.
21) Why is the quick ratio a more refined measure of liquidity than the current ratio?
A) It measures how quickly cash and other liquid assets flow through the company.
B) Inventories are omitted from the numerator of the ratio because they are generally the least
liquid of the firm's current assets.
C) It is a quicker calculation to make.
D) Cash is the most liquid current asset.

22) Smith Corporation has current assets of $11,400, inventories of $4,000, and a current ratio
of 2.6. What is Smith's quick or acid test ratio?
A) 1.69
B) 0.54
C) 0.74
D) 1.35

23) Kingsbury Associates has current assets as follows:

Cash $3,000
Accounts receivable $4,500
Inventories $8,000

If Kingsbury has a current ratio of 3.2, what is its quick ratio?

A) 2.07
B) 1.55
C) 0.48
D) 0.96

24) Water Works, Inc. has a current ratio of 1.33, current liabilities of $540,000, and inventory of
$400,000. What is Water Works, Inc.'s quick ratio?
A) 1.11
B) 0.86
C) 1.90
D) 0.59

25) Which of the following ratios indicates how rapidly the firm's credit accounts are being
collected?
A) Debt ratio
B) Gross profit margin
C) Accounts receivable turnover ratio
D) Fixed asset turnover

26) Smart and Smiley Incorporated has an average collection period of 74 days. What is the
accounts receivable turnover ratio for Smart and Smiley?
A) 4.93
B) 2.47
C) 2.66
D) 1.68
27) Billing's Pit Corporation has an accounts receivable turnover ratio of 3.4. What is Billing's Pit
Corporation's average collection period?
A) 107 days
B) 102 days
C) 73 days
D) 55 days

28) Which of the following statements is true?

A) As a general rule, management would want to reduce the firm's average collection period.
B) As a general rule, management would want to reduce the firm's accounts receivable turnover
ratio.
C) As a general rule, management would want to increase the firm's average collection period.
D) As a general rule, a firm is not financially affected by the amount of time required to collect its
accounts receivable.

29) Millers Metalworks, Inc. has a total asset turnover of 2.5 and a net profit margin of 3.5%.
The total debt ratio for the firm is 50%. Calculate Millers's return on equity.
A) 17.5%
B) 19.5%
C) 21.5%
D) 23.5%

30) Snype, Inc. has an accounts receivable turnover ratio of 7.3. Stork Company has an
accounts receivable turnover ratio of 5.0. Which of the following statements is correct?
A) Snype's average collection period is less than Stork's.
B) Stork's average collection period is less than Snype's.
C) Snype has a lower accounts receivable account on average than does Stork Company.
D) Stork Company has (on average) a lower accounts receivable account than does Snype.

31) A decrease in the return on equity ratio could be caused by an increase in

A) tax rate.
B) cost of goods sold.
C) total assets.
D) both B and C.

32) Ortny Industries has an accounts receivable turnover ratio of 4.3. If Ortny has an accounts
receivable balance of $90,000, what is Ortny's average daily credit sales?
A) $387,000
B) $1,548
C) $1,060
D) $3,521

33) Spinnit, Limited has a debt ratio of .57, current liabilities of $14,000, and total assets of
$70,000. What is the level of Spinnit, Limited's total liabilities?
A) $25,900
B) $24,600
C) $39,900
D) $53,900
34) Snort and Smiley Incorporated has a debt ratio of .42, noncurrent liabilities of $20,000, and
total assets of $70,000. What is Snort and Smiley's level of current liabilities?
A) $8,400
B) $9,400
C) $12,340
D) $10,600

35) Lorna Dome, Inc. has an annual interest expense of $30,000. Lorna Dome's times-interest-
earned ratio is 4.2. What is Lorna Dome's operating income?
A) $96,000
B) $57,000
C) $126,000
D) $57,600

36) In 1996, Snout and Smith, Inc. had a gross profit of $27,000 on sales of $110,000. S & S's
operating expenses for 1996 were $13,000, and its net profit margin was .0585. Snout and
Smith had no interest expense in 1996. Using this information, what was S & S's operating profit
margin for 1996?
A) 0.245
B) 0.118
C) 0.127
D) 0.157

37) Sharky's Loan Co. has an annual interest expense of $30,000. If Sharky's times-interest-
earned ratio is 2.9, what is Sharky's Earnings Before Taxes (EBT)?
A) $87,000
B) $57,000
C) $117,000
D) $60,000

38) Skrit Corporation has a net profit margin of 15% and a total asset turnover of 1.7. What is
Skrit's return on total assets?
A) 12.3%
B) 25.5%
C) 8.8%
D) 11.1%

39) Sputter Motors has sales of $3,450,000, total assets of $1,240,000, cost of goods sold of
$2,550,000, and an inventory turnover of 6.38. What is the amount of Sputter's inventory?
A) $421,054
B) $638,112
C) $543,000
D) $399,687

40) Which of the following is the best indicator of management's effectiveness at managing the
firm's balance sheet?
A) Debt ratio
B) Total asset turnover
C) Times-interest-earned
D) Operating profit margin
41) Which of the following is the best indicator of management's effectiveness at generating
profits relative to the firm's assets?
A) Quick ratio
B) Fixed assets turnover
C) Return on assets
D) Accounts receivable turnover

42) Storm King Associates has a total asset turnover ratio of 1.90 and a return on total assets of
7.20%. What is Storm King's net profit margin?
A) 3.79
B) 13.68
C) 9.10
D) None of the above

43) A decrease in ________ will increase gross profit margin.

A) cost of goods sold
B) depreciation expense
C) interest expense
D) both A and B

44) Other things held constant, an increase in ________ will decrease the current ratio. Assume
an initial current ratio greater than 1.0.
A) accruals
B) common stock
C) average collection period
D) cash

45) GAAP, Inc. has total assets of $2,575,000, sales of $5,950,000, total liabilities of
$1,855,062, and a net profit margin of 2.9%. What is GAAP's return on equity? Round to the
nearest 0.1%.
A) 8.6%
B) 24.0%
C) 16.4%
D) 4.4%

46) Wireless Communications has a total asset turnover of 2.66, total liabilities of $1,004,162,
and sales revenues of $7,025,000. What is Wireless's debt ratio?
A) 38.0%
B) 14.3%
C) 26.7%
D) 81.1%

47) Which of the following will help an analyst determine how well a firm is able to meet its debt
obligations?
A) Total liability turnover
B) Times-interest-earned
C) Return on debt
D) Asset ratio
48) Heavy Load, Inc. has sales of $3,450,000, total assets of $1,240,000, and total liabilities of
$275,000, which consist strictly of notes payable. The firm's operating profit margin is 16.1%,
and it pays a 10% rate of interest on its notes payable. How much is the firm's times-interest-
earned?
A) 15.6
B) 45.3
C) 20.2
D) 3.0

49) An increase in ________ will decrease the times-interest-earned ratio.

A) the tax rate
B) gross profit
C) interest expense
D) common stock

50) Dew Point Dynamite, Inc. generated a 1.23 total asset turnover in its latest fiscal year on
assets of $2,112,077. The firm has total liabilities of $950,997. The firm's net profit margin was
10.3%. What is Dew Point's return on equity? Round to the nearest 0.1%.
A) 23.1%
B) 12.6%
C) 5.5%
D) 18.2%

51) An example of a liquidity ratio is the

A) quick ratio.
B) debt ratio.
C) times-interest-earned.
D) return on assets.

52) Kannan Carpets, Inc. has asked you to calculate the company's current ratio for 2001. All
you have is a partial balance sheet and some assumptions. Using the information provided,
calculate Kannan's current ratio for 2001.

Gross profit margin = 50%

Inventory turnover (COGS/Inv) = 5
2001 sales = $3,000

Assets Liabilities & Equity

Cash ? Accounts payable $50
AR $40 Accruals ?
Inventory ? Long-term debt $400
Net fixed assets $500 Equity 250
Total assets $900 Total liab. & equity ?
A) 0.3
B) 0.8
C) 1.6
D) 2.2
53) Kannan Carpets, Inc. has asked you to calculate the company's quick ratio for 2001. All you
have is a partial balance sheet and some assumptions. Using the information provided,
calculate Kannan's quick ratio for 2001.

Gross profit margin = 50%

Inventory turnover (COGS/Inv) = 5
2001 sales = $3,000

Assets Liabilities & Equity

Cash ? Accounts payable $50
AR $40 Accruals ?
Inventory ? Long-term debt $400
Net fixed assets $500 Equity 250
Total assets $900 Total liab. & equity ?
A) 0.2
B) 0.4
C) 0.6
D) 0.8

54) A firm that wants to know if it has enough cash to meet its bills would be most likely to use
which kind of ratio?
A) Liquidity
B) Leverage
C) Efficiency
D) Profitability

55) In the times-interest-earned ratio, dividend payments are included in

A) the numerator.
B) the denominator.
C) both the numerator and the denominator.
D) neither the numerator nor the denominator.

56) Assume that a particular firm has a total asset turnover ratio lower than the industry norm. In
addition, this firm's current ratio and fixed asset turnover ratio also meet industry standards.
Based on this information, we can conclude that this firm must have excessive
A) accounts receivable.
B) fixed assets.
C) debt.
D) inventory.

57) Assume that a particular firm has a total asset turnover ratio lower than the industry norm. In
addition, this firm's current ratio and acid test ratio also meet industry standards. Based on this
information, we can conclude that this firm must have excessive
A) accounts receivable.
B) fixed assets.
C) debt.
D) inventory.
58) A firm is conducting an analysis of trends over time and discovers that its inventory turnover
has declined. This may be due to
A) an increase in sales.
B) an increase in cost of goods sold.
C) an increase in inventory purchases.
D) a decrease in inventory purchases.

59) If the total asset turnover decreases, then the return on equity will
A) decrease.
B) increase.
C) not change.
D) change, but in an indeterminate way.

Use the following information to answer the following question(s).

Key Ratios for ABC, Inc. and Its Industry

ABC, Inc. 2013 Ratios Industry Average Ratios in 2013

Current ratio 1.2 1.4
Acid test ratio 0.89 0.94
Average collection period 30 days 25 days
Inventory turnover 18.1 20.3
Fixed assets turnover 4.1 4.8
Total asset turnover 2.78 2.8
Debt ratio 50% 60%
Times-interest-earned 5.5% 4.5%
Net profit margin 1.15% 1.5%
Return on equity 5.21% 7.32%

ABC, Inc. Income Statement (in thousands)

December 31, 2014
Sales (all credit) $200,000
Cost of goods sold 140,000
Gross profit on sales 60,000
Operating expenses 56,000
Operating income 4,000
Interest expense 1,000
Earnings before tax 3,000
Income tax 1,050
Net income available to common stockholders $1,950

ABC, Inc. Balance Sheet (in thousands)

December 31, 2014
Assets
Cash $2,000
Accounts receivable 17,800
Inventories 8,700
Total current assets 28,500
Gross fixed assets 70,000
Accumulated depreciation 26,500
Net fixed assets 43,500
Total assets $72,000
Liabilities and Equity
Accounts payable $18,000
Accruals 13,350
Total current liabilities 31,350
Long-term debt 8,250
Total liabilities 39,600
Common stock (par value and paid in capital) 2,000
Retained earnings 30,400
Total stockholders' equity 32,400
Total liabilities and equity $72,000
60) In 1995, ABC's average collection period is
A) 30 days.
B) 32.5 days.
C) 25 days.
D) 35 days.

61) In 2014, ABC's inventory turnover is

A) 23.9.
B) 20.3.
C) 15.5.
D) 16.1.

62) In 2014, ABC's fixed asset turnover is

A) 2.78.
B) 5.0.
C) 4.6.
D) 4.8.

63) Since 2013, ABC's efficiency at using its assets has

A) improved.
B) deteriorated.
C) remained the same.
D) been variable across components of the efficiency measures.

64) In 2014, the improvement in ABC's return on equity occurred because

A) ABC used more debt than in 1994.
B) ABC lowered its expenses in 1995 and was, therefore, more profitable.
C) ABC utilized its total assets more efficiently in 1995.
D) None of the above explain the improvement in ABC's return on equity.

65) Since 2013, ABC's liquidity has

A) improved.
B) deteriorated.
C) remained the same.
D) been variable across components of the liquidity measures.
66) Since 2013, ABC's inventory management has
A) improved.
B) deteriorated.
C) remained the same.
D) changed but in an indeterminate manner.

67) An increase in the current ratio would indicate an increase in

A) leverage.
B) liquidity.
C) return on investment.
D) operating income.

68) Which of the following is NOT a component of return on assets (ROA)?

A) Total assets
B) Cost of goods sold
C) Sales
D) Leverage

69) ________ indicates management's effectiveness in managing the firm's income statement.
A) Gross profit margin
B) Operating profit margin
C) Net profit margin
D) Return on assets

70) Holding all other variables constant, which of the following could cause a firm's current ratio
to decrease from 3.0 to 2.5? An increase in
A) inventory.
B) long-term debt.
C) accounts receivable.
D) accounts payable.

71) A firm has a return on equity of 20% and a total asset turnover of 4. Assuming a debt ratio of
50% and sales of $1,000,000, calculate net income.
A) $25,000
B) $50,000
C) $75,000
D) $100,000

72) Which of the following will increase return on equity?

A) An increase in sales with a proportionate increase in costs and expenses
B) An increase in sales relative to the asset base
C) A decrease in leverage
D) Both A and C

73) Which of the following is NOT a driving force of the operating profit margin?
A) The average selling price for each product
B) The ability to control all of the firm's expenses
C) The ability to control general and administrative expenses
D) The number of units of product sold
74) Corbin, Inc. had net income of $150,000 on sales of $5,000,000 during 1995. In addition,
the firm's total assets were $2,500,000, and its capital structure is comprised of 40% debt and
60% equity. What was Corbin's return on equity in 1995?
A) 15%
B) 2.5%
C) 10%
D) Return on equity cannot be determined with the information provided.

75) Which of the following ratios would be the most useful in evaluating the ability of a firm to
meet its short-term obligations?
A) The quick ratio (acid test)
B) Return on equity
C) Total asset turnover
D) Operating profit margin

76) If Challenge Corporation has sales of $2 million per year (all credit) and an average
collection period of 35 days, what is its average amount of accounts receivable?
A) $191,781
B) $57,143
C) $5,556
D) $97,222

77) Which of the following financial ratios is the best measure of how effectively a firm's
management is serving its stockholders?
A) Current ratio
B) Debt ratio
C) ACP
D) Return on equity

78) Colton Corp. has current assets of $4.5 million. The current ratio is 1.25 and the quick ratio
is 0.75. What is the amount of Colton's current liabilities (in millions)?
A) $4.5
B) $1.8
C) $2.4
D) $2.9
E) $3.6

79) Consolidated Industries has total interest charges of $20,000 per year. Sales of $2 million
generated an operating income of $220,000 and an after-tax profit of 6% of sales. The firm has
a marginal tax rate of 40%. What is the firm's times-interest-earned ratio?
A) 10
B) 11
C) 12
D) 13

80) Hi Sky Enterprises has total assets of $3 million, a debt ratio of 30%, and an after-tax profit
margin of 11.04% and sales of $2.5 million. What is Hi Sky's return on equity?
A) 15%
B) 35%
C) 27%
D) 13%

81) Paper Clip Office Supply had $24,000,000 in sales last year. Its total asset turnover was 3.0.
Interest expense was $100,000 (5% on its $2,000,000 of debt). The company is financed
entirely with debt and common equity. What is Paper Clip's debt ratio?
A) 20%
B) 30%
C) 25%
D) 60%
E) 16%

82) Kiosk Corp. has current assets of $4.5 million and current liabilities of $3.6 million. The
current ratio is 1.25, and the quick ratio is 0.75. How much does Kiosk have invested in
inventory (in millions)?
A) $0.8
B) $1.8
C) $2.4
D) $2.9
E) $3.6

83) Champion Company has sales of $20 million, total debt of $1.5 million, and a debt ratio of
40%. What is Champion's total asset turnover?
A) 13.33
B) 9.11
C) 6.55
D) 5.33

84) The focus of DuPont Analysis is to provide management information as to how the firm is
using its resources to maximize returns on owners' investments.
Answer: TRUE

85) The current ratio and the acid test ratio are both measures of financial leverage.
Answer: FALSE

86) Ratios that examine profit relative to investment are useful in evaluating the overall
effectiveness of the firm's management.
Answer: TRUE

87) Financial ratios that are higher than industry averages may indicate problems which are as
detrimental to the firm as ratios that are too low.
Answer: TRUE

88) According to the DuPont Analysis, an increase in net profit margin will decrease return on
assets.
Answer: FALSE
89) Financial ratios comprise the principal tool of financial analysis since they can be used to
answer a variety of questions regarding a firm's financial condition.
Answer: TRUE
90) Financial ratios can highlight a firm's financial performance with regard to liquidity, solvency,
and profitability.
Answer: TRUE

91) Ratios are used to standardize financial information.

Answer: TRUE

92) There is no such thing as a liquidity ratio being too high.

Answer: FALSE

93) A retailer that accepts credit cards will have a higher accounts receivable turnover ratio than
a retailer with its own credit department.
Answer: TRUE

94) One weakness of the times-interest-earned ratio is that it includes only the annual interest
expense as a finance expense that must be paid.
Answer: TRUE

Table 3
Financial Data for Dooley Sportswear December 31, 2013
Inventory $206,250
Long-term debt 300,000
Interest expense 5,000
Accumulated depreciation 442,500
Cash 180,000
Net sales (all credit) 1,500,000
Common stock 800,000
Accounts receivable 225,000
Operating expenses 525,000
Notes payable-current 187,500
Cost of goods sold 937,500
Plant and equipment 1,312,500
Accounts payable 168,750
Marketable securities 95,000
Prepaid insurance 80,000
Accrued wages 65,000
Retained earnings-current-year ?
Federal income taxes 5,750

95) From the information presented in Table 3, calculate the following financial ratios for the
Dooley Sportswear Company.
current ratio operating profit margin
acid test ratio net profit margin
average collection period total tangible asset turnover
inventory turnover times interest earned
gross profit margin
Answer:
Current ratio = ($180,000 + $95,000 + $225,000 + $206,250 + $80,000)/($168,750 + $187,500
+ $65,000) = ($786,250/$421,250) = 1.87
Acid test ratio = ($180,000 + $95,000 + $225,000 + $80,000)/($168,750 + $187,500 + $65,000)
= ($580,000/$421,250) = 1.38
Average collection period = ($225,000)/($1,500,000/360 days) = 54 days
Inventory turnover = ($937,500/$206,250) = 4.55
Gross profit margin = ($562,500/$1,500,000) = 0.375
Operating profit margin = ($37,500/$1,500,000) = 0.025
Net profit margin = ($26,750/$1,500,000) = 0.0178
Total asset turnover = ($1,500,000/$1,656,250) = 0.906
Times interest earned = ($37,500/$5,000) = 7.5 times

Table 4
Hokie Corporation Comparative Balance Sheet
For the Years Ending March 31, 2013 and 2014
(Millions of Dollars)
Assets 2013 2014
Current assets:
Cash $2 $10
Accounts receivable 16 10
Inventory 22 26
Total current assets $40 $46
Gross fixed assets: $120 $124
Less accumulated depreciation 60 64
Net fixed assets 60 60
Total assets $100 $106
Liabilities and Owners' Equity
Current liabilities:
Accounts payable $16 $18
Notes payable 10 10
Total current liabilities $26 $28
Long-term debt 20 18
Owners' equity:
Common stock 40 40
Retained earnings 14 20
Total liabilities and owners' equity $100 $106

Hokie had net income of $26 million for 1996 and paid total cash dividends of $20 million to their
common stockholders.

96) Calculate the following financial ratios for the Hokie Corporation using the information given
in Table 4 and 2014 information.
current ratio
acid test ratio
debt ratio
long-term debt to total capitalization
return on total assets
return on common equity
Answer:
Current ratio = ($46/$28) = 1.64
Acid test ratio = ($20/$28) = 0.71
Debt ratio = ($46/$106) = 0.43
Long-term debt to total capitalization = ($18/$78) = 0.23
Return on total assets = ($26/$106) = 0.25
Return on common equity = ($26/$60) = 0.43

97) McKinny Enterprises must raise $580,000 to pay off a bank loan at the end of the year. The
firm expects sales of $5,200,000 for the year. Depreciation for the year is $315,000. The
company's net profit margin is 5%. Can the company pay off its loan through the retention of
earnings?
Answer: Net profit = sales × net profit margin = $5,200,000 × .05 = $260,000
Internal funds generated by the firm = net profit + depreciation = $260,000 + $315,000 =
$575,000
McKinny cannot pay off its loan by using only internally generated funds.

98) S.M., Inc. had total sales of $400,000 in 2014 (70 percent of its sales are credit). The
company's gross profit margin is 10%, its ending inventory is $80,000, and its accounts
receivable is $25,000. What amount of funds can be generated by the company if it increases
its inventory turnover ratio to 10.0 and reduces its average collection period to 20 days?
Answer: Average collection period = (accounts receivable)/(annual credit sales/360 days)
20 days = (accounts receivable)/[(400,000)(.70)/360 days]
Accounts receivable = (20 × $280,000)/(360) = $15,556
Funds generated by reducing accounts receivable = $25,000 - $15,556 = $9,444
Inventory turnover = (cost of goods sold)/(ending inventory)
10.0 = [($400,000)(1 - .10)]/(ending inventory)
Ending inventory = ($360,000)/(10.0) = $36,000
Funds generated by reducing inventory = $80,000 - $36,000 = $44,000
Total funds generated = $9,444 + $44,000 = $53,444

99) Baker & Co. has applied for a loan from the Trust Us Bank to invest in several potential
opportunities. To evaluate the firm as a potential debtor, the bank would like to compare Baker
& Co. to the industry. The following are the financial statements given to Trust Us Bank:

Balance Sheet 12/31/13 12/31/14

Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and Owners' Equity
Accounts payable $150 $200
Notes payable 125 0
Current liabilities 275 200
Bonds 500 500
Owners' equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners' equity 1,605 1,780
Total liabilities and owners' equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross profit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before taxes 256 283
Taxes 87 96
Net income $169 $187

Compute the following ratios:

2013 2014 Industry Norms
Current ratio 5.0
Acid test ratio 3.0
Inventory turnover 2.2
Average collection period 90 days
Debt ratio .33
Times interest earned 7.0
Total asset turnover .75
Fixed asset turnover 1.0
Operating profit margin 20%
Net profit margin 12%
Return on total assets 9.00%
Return on equity 10.43%
Answer: Industry
2013 2014 Norm Evaluation
Current ratio 4.3x 5.7x 5.0x Satisfactory
Acid test (quick) ratio 2.1x 2.8x 3.0x Improving
Inventory turnover 1.0x 1.31x 2.2x Poor
Average collection period 90 days 78.5 days 90 days Satisfactory
Debt ratio 33% 28% 33% Satisfactory
Times interest earned 5.0x 6.0x 7.0x Poor
Total asset turnover .46x .54x .75x Poor
Fixed asset turnover .92x .99x 1.00x Satisfactory
Operating Profit Margin 29.1% 25.6% 20% Satisfactory
Net profit margin 15.36% 14.06% 12.00% Poor
Return on total assets 7.1% 7.54% 9.00% Poor
Operating income return
on investments 13.45% 13.71% 15.00% Poor
Return on equity 10.6% 10.47% 13.43% Poor
100) Baker & Co. has applied for a loan from the Trust Us Bank to invest in several potential
opportunities. To evaluate the firm as a potential debtor, the bank would like to compare Baker
& Co. to the industry. The following are the financial statements given to Trust Us Bank:

Balance Sheet 12/31/13 12/31/14

Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and Owners' Equity
Accounts payable $150 $200
Notes payable 125 0
Current liabilities 275 200
Bonds 500 500
Owners' equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners' equity 1,605 1,780
Total liabilities and owners' equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross profit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before taxes 256 283
Taxes 87 96
Net income $169 $187

a. What are the firm's financial strengths and weaknesses?

b. Should the bank make the loan? Why or why not?

Answer:
a. The firm's liquidity has improved significantly, as indicated by the current ratio and the acid
test ratio. However, the current ratio is a bit deceiving since it relies on inventory in part for
liquidity. Since the inventory is not particularly liquid (low inventory turnover), the quick ratio is a
better measure of liquidity, which is still below the industry norm. Management has done a less-
than-average job of generating operating profits on its assets (low operating income return on
investment). The cause for the low OIROI is the inefficient use of assets (low asset turnover),
especially inventory (low inventory turnover). However, this ineffectiveness is countered by
efficiencies in keeping operating expenses low (high operating profit margin). From a balance
sheet perspective, the company has less financial risk than the average firm in the industry
(slightly lower debt ratio). However, owing to the firm's lower profitability, it is not covering its
interest charges as well as the average firm in the industry (low times interest earned). Owing to
the low return on investment, the firm's return on assets and return on equity are low relative to
its competition.

b. The answer is not an easy one. The firm has improved its liquidity, but it is still having
problems at effectively managing its inventory. It may be that the loan is not needed to the
extent thought, but rather management should work at reducing its investment in inventories.
The bank would also want to know why the operating profit margin, which is still high, is falling.
Nevertheless, the loan decision could go either way.

4.4 Selecting a Performance Benchmark

1) Which of the following industries has the highest average inventory turnover ratio?
A) Retail clothing stores
B) Jewelry stores
C) Automobile dealerships
D) Supermarkets

2) Which of the following would be most responsible for a company's average collection period
being higher than the industry average?
A) If a company's growth in sales is greater than the growth of sales in the industry.
B) Being more aggressive in collecting its accounts receivable than its competitors.
C) Having credit policy standards that are more restrictive than its competitors.
D) Being more lenient in extending credit to its customers than its competitors.

3) When the present financial ratios of a firm are compared with similar ratios for another firm in
the same industry, it is called trend analysis.
Answer: FALSE

4) Firms that engage in multiple lines of business make it difficult to assign them to an industry
category for ratio analysis.
Answer: TRUE

5) A small start-up company should choose an industry leader in the same industry as a
benchmark.
Answer: FALSE

6) Companies chosen for benchmmarks should be of similar size and in the same or a similar
industry.
Answer: TRUE

4.5 Limitations of Ratio Analysis

1) Which of the following is NOT a reason why financial analysts use ratio analysis?
A) Ratios help to pinpoint a firm's strengths.
B) Ratios restate accounting data in relative terms.
C) Ratios are ideal for smoothing out the differences that may exist when comparing firms that
use different accounting practices.
D) Some of a firm's weaknesses can be identified through the usage of ratios.

2) Which of the following is NOT a limitation related to the usage of ratios when reviewing a
firm's performance?
A) Many firms experience seasonality in their operations.
B) Ratios cannot be used to compare firms that are in the same industry if one firm's sales are
higher than another firm's.
C) Some firms operate in a variety of business lines, which makes it difficult to make
comparisons.
D) Accounting practices differ widely among firms.

3) Which of the following statements is FALSE?

A) The calculation of the accounts receivable average collection period (ACP) would generally
produce a more realistic assessment of how a firm is managing its accounts receivable if the
analyst were to calculate the ACP for each month and average the results, than if the analyst
were to solely use the fiscal year-end accounts receivable value.
B) If an analyst were to compare the inventory turnover of one firm to that of another, the
comparison can be distorted if the two firms use different methods of valuing ending inventory.
C) Assume that two firms are in the same industry and one reports a higher debt ratio than the
other. We can safely say that the firm that has the highest debt ratio is the riskier of the two
firms.
D) A firm that has a current ratio that is significantly above the industry norm will, as a direct
consequence, also have a significantly better return on assets than if its current ratio was below
the industry norm.
E) All of the above statements are true.

4) Which of the following is a limitation related to the usage of ratios when reviewing a firm's
performance?
A) Ratios reveal differences in policy and performance between years.
B) Ratios can be used to compare firms that are in the same industry if one firm's sales are
higher than another firm's.
C) Financial ratios are designed for the use of creditors, not for managers.
D) Different accounting practices between firms can distort comparisons.

5) A serious pitfall in the interpretation of financial ratios arises when a company, whose
business is seasonal, ends its accounting year on March 31, while most companies in the same
industry end their accounting period on December 31.

6) Differences in accounting practices limit the use of ratio analysis.

Answer: TRUE