CHAPTER 4

TRADITIONAL FINANCIAL ANALYSIS: SOME SHORTCOMINGS

Difficulty: 1 Correct: A

1. Whenever the current ratio is greater than 1:1, equal increases in current assets and
current liabilities result in
a) a decrease in the current ratio.
b) an increase in net working capital.
c) an increase in the current ratio.
d) None of these answers is correct.

Difficulty: 2 Correct: B

2. If current assets exceed current liabilities, payments to trade creditors made on the last
day of the month will
a) decrease the current ratio.
b) increase the current ratio.
c) decrease net working capital.
d) increase net working capital

Difficulty: 1 Correct: B

3. The number of days sales outstanding ratio for accounts receivable

a) acts as an aging schedule.
b) divides accounts receivable by sales per day for the period.
c) is independent of the accounts receivable turnover ratio.
d) can be calculated only by using annual data.

Difficulty: 1 Correct: B

4. Coverage ratios include

a) debt-to-capital ratio, fixed-charge coverage ratio, and the current ratio.
b) degree of financial leverage, fixed-charge coverage ratio, and book value per
share.
c) times interest earned ratio, debt-to-capital ratio, and breakeven analysis.
d) cash flow per share ratio, margin of safety ratio, and breakeven analysis.
Difficulty: 2 Correct: A

5. If a company has preferred stock outstanding, return on equity is defined as

a) earnings available to common shareholders divided by common shareholders'
equity.
b) return on sales times asset turnover times leverage.
c) profit divided by equity.
d) both (a) and (b) are correct.

Difficulty: 2 Correct: A

6. If the balance sheet shows an outstanding liability for deferred income taxes,
a) this indicates that accounting income exceeds income for tax purposes.
b) this indicates that accounting income is less than income for tax purposes.
c) depreciation deductions are larger for accounting purposes than for tax purposes.
d) None of these answers are correct.

Difficulty: 1 Correct: D

7. The higher the degree of financial leverage

a) the lower is the risk of not being able to meet financial obligations.
b) the lower are the current and quick ratios.
c) the lower is the operating breakeven point.
d) None of these answers is correct.

Difficulty: 1 Correct: B

8. Quality of earnings refers to

a) the level of profits.
b) the relationship of profits to cash flows.
c) sales to large and financially stable companies.
d) whether the company is included in the Fortune 500

Difficulty: 1 Correct: A

9. The fixed-charge coverage ratio is influenced by

a) the earning power of the assets.
b) accounts receivable outstanding.
c) Both (a) and (b) are correct.
d) the current ratio.
Difficulty: 1 Correct: B

10. The numerator of the defensive interval measure consists of

a) current assets.
b) quick assets.
c) total assets.
d) None of these answers are correct.

Difficulty: 2 Correct: B

11. As debt is added to the firm's capital structure, the leverage component of the
return-on-equity ratio will
a) decrease.
b) increase from a base of one.
c) increase from a base of zero.
d) None of these answers are correct.

Difficulty: 2 Correct: D

12. Which of the following items is a possible signal that the firm's earnings may be of low
quality?
a) Inadequate disclosure notes were included with the financial statements.
b) An accounting practice was recently changed.
c) Management recently changed auditors.
d) All of these answers are correct.

Difficulty: 2 Correct: C

13. Daily cash operating expenses are used in the calculation of some ratios. Which item in
the following list would not be included in daily cash operating expenses?
a) Cost of sales
b) Administrative expenses
c) Bond discount expense
d) Selling expenses

Difficulty: 1 Correct: D

14. Which of the following assets and liabilities is not included in net working capital?
a) Raw materials
b) Accrued expenses
c) Notes payable
d) Mortgage payable
Difficulty: 1 Correct: B

15. Which of the following statements about the income statement and balance sheet is true?
a) The income statement tells us the firm's position at a single point in time; the
balance sheet represents the events occurring between two points in time.
b) The balance sheet shows the net worth of shareholders at a point in time.
c) The income statement shows the assets and liabilities of a firm.
d) Transactions that change the net worth of shareholders appear on the balance
sheet.

Difficulty: 1 Correct: C

16. Comparing a company's ratios to industry averages is a frequently used method of

analysis. Which of the following is a limitation of this technique?
a) Industry data are not readily available and must be compiled by the analyst.
b) Industry averages represent the best standard, to compare firms against.
c) Other firms in the industry may be dissimilar in many respects and hence not
good bases for comparison.
d) both (b) and (c) are correct.

Difficulty: 1 Correct: A

17. Everything else held constant, if Firm A has higher operating leverage than Firm B, then
a) Firm A has higher fixed costs than Firm B.
b) for a given change in sales, Firm B will have a greater percentage change in EBIT
than Firm A.
c) Firm A uses more debt than Firm B.
d) Firm A has a lower breakeven point than Firm B.

Difficulty: 1 Correct: B

18. A firm has recently experienced a drop in profit. mars management wants to keep its
return on equity constant must
a) increase its current ratio
b) increase its asset-turnover ratio
c) reduce its average collection period
d) None of these answers are correct.
Difficulty: 2 Correct: C

19. A company's records have recently been destroyed by fire. Given the following
information, determine net income: return on equity, 22 percent; assets-net worth ratio,
2.167; profit margin, 5.6 percent; total assets, $650 million.
a) $2.16 million
b) $31.44 million
c) $66.00 million
d) $259.28 million

Difficulty: 2 Correct: D

20. A limitation of breakeven analysis is that

a) many costs are fixed over only limited ranges of output, so the analysis is good
over only that range.
b) price and output may be related, so price will not always be constant.
c) most firms sell more than one product, resulting in problems if the firm's product
mix is not stable.
d) All of these answers are correct

Difficulty: 2 Correct: A

21. When analyzing a company's financial statements, the analyst discovered a degree of
operating leverage of 3.0 and a degree of financial leverage of 1.5, The implication of this
finding is that a
a) 1 percent increase in sales will result in a 3 percent increase in EBIT.
b) 1 percent increase in sales will result in a 4.5 percent increase in net income.
c) 1 percent increase in sales will result in a 1.5 percent increase in net income.
d) Both (a) and (c) are correct.

Difficulty: 2 Correct: B

22. If a firm has a high current ratio hut a low quick rat one can conclude that
a) the firm has a large outstanding accounts receivable balance.
b) the firm has a large investment in inventory.
c) the firm has a large amount of current liabilities.
d) operating leverage is extremely high.
Difficulty: 2 Correct: C

23. Which of the following events will result in a change in a firm's net working capital
position?
a) Receivables are sold at face value.
b) Raw materials are purchased for cash.
c) Finished goods are manufactured using raw materials and sold on credit.
d) Accrued wages are paid in cash.

Difficulty: 2 Correct: A

24. At year end, Tormey Company is preparing the entry to record its income tax expense and
income tax liability. A debit to deferred taxes means that
a) tax liability exceeds tax expense.
b) income exceeds expenses.
c) tax expense exceeds tax liability.
d) tax expense exceeds income.

Difficulty: 2 Correct: A

25. For the year, the company has a higher income tax expense than the amount of tax
actually paid. This difference should
a) be recorded as deferred taxes if the difference is a timing difference.
b) be recorded as deferred taxes if the difference is a permanent difference.
c) not be recorded, as only the income statement amount is correct.
d) not be recorded, as only the tax return amount is correct.

Difficulty: 1 Correct: B

26. Firms with relatively high fixed operating costs and low variable operating costs are said
to have
a) a low degree of operating leverage.
b) a high degree of operating leverage.
c) no degree of operating leverage
d) an average degree of operating leverage

Difficulty: 1 Correct: A

27. The accounting breakeven point is that output level at which

a) total revenues equal total costs.
b) fixed costs equal variable costs.
c) total revenues equal variable costs.
d) total revenues adequately cover all fixed costs
Difficulty: 1 Correct: A

28. Book value per share is the firm's

a) net worth divided by the number of shares outstanding.
b) total assets divided by the number of shares outstanding.
c) sales divided by the number of shares outstanding.
d) net income divided by the number of shares outstanding.

Difficulty: 1 Correct: D

29. Negative financial leverage will result when the

a) firm uses more long-term debt in its capital structure.
b) firm uses less long-term debt in its capital structure.
c) interest cost on the firm's bonds is less than the operating profit return.
d) interest cost on the firm's bonds exceeds the operating profit return.

Difficulty: 2 Correct: B

30. The major problem with using the ratio of net income to total assets as a measure of
performance is that
a) assets include current assets which are not part of the long-term investment base
on which rate of return analysis should be based.
b) net income is the return to equity and total assets represent the :investment of both
debt and equity capital.
c) the ratio represents a single time period's performance and a trend over time is
much more important.
d) None of these answers is correct.

Difficulty: 2 Correct: B

31. Using the comparative balance sheet approach to financial statement analysis,
a) we cannot determine the dollar amount invested in new plant and equipment
during the year.
b) we cannot determine the net book value of assets retired during the period.
c) we can determine depreciation expense for the period.
d) Both (b) and (c) are correct.
Difficulty: 2 Correct: B

32. Current liabilities are $557,007 and the quick ratio is 1.1575. The cash flow from
operations is -$92,554. Credit sales are $1,849,802. During the period, receivables
increased $5.6,047. Use a 360-day year to calculate the defensive interval measure. The
answer is
a) 116 days.
b) 123 days.
c) 128 days.
d) 136 days.

Difficulty: 2 Correct: B

33. Total sales are $1800. The contribution margin is 25 percent and fixed costs are $300.
How much is the margin of safety?
a) 25 percent
b) 33 percent
c) 66 percent
d) 75 percent

Difficulty: 2 Correct: B

34. Net income for the year is $600. Preferred dividends received 15 percent of this amount,
with the remainder paid to common shareholders as dividends. The balance sheet
indicates shareholders' equity of $9000. How much is return on equity?
a) 6.67 percent
b) 5.67 percent
c) Zero, since everything was paid out in dividends
d) None of these answers is correct.

Difficulty: 2 Correct: D

35. The firm's marginal tax rate is 34 percent. This past year it recorded EBIT of $1000;
interest expense of $200; and preferred dividends of $100. How much is the fixed-charge
coverage ratio?
a) 5 times
b) 3.33 times
c) 2.02 times
d) 2.84 times
Difficulty: 2 Correct: C

36. The firm's marginal tax rate is 34 percent. Last year it recorded EBIT of $1000, interest
expense of $200, and paid preferred dividends of $100. How much is the degree of
financial leverage?
a) 1.25
b) 1.43
c) 1.54
d) None of these answers is correct.

Difficulty: 3 Correct: A

37. Sales are $1500, with a contribution margin of 60 percent. The degree of operating
leverage is 1.25. How much are fixed costs?
a) $180
b) $300
c) $1200
d) None of these answers is correct.

Difficulty: 2 Correct: C

38. The degree of operating leverage is 2..0. Fixed costs are $1000 and the contribution
margin is 25 percent. Actual sales are
a) $4000.
b) $2600.
c) $8000.
d) $2000.

Difficulty: 2 Correct: D

39. After-tax net income for the year is $1200. The tax rate is 40 percent. $400 was paid as a
preferred dividend with $300 paid to common shareholders as dividends. Interest expense
was $1400. Total capital consists of $2000 debt, $5000 preferred stock, and $10,000
equity. How much was return on assets for the year?
a) 5.29 percent
b) 4.71 percent
c) 12 percent
d) 9.06 percent
Difficulty: 2 Correct: B

40. The following results pertain to the firm's most recent fiscal year: degree of financial
leverage, 1.25; degree of operating leverage, 2.5; contribution margin, 35 percent. How
much is the firm’s margin of safety?
a) 80 percent
b) 40 percent
c) 20 percent
d) not enough information is provided

Difficulty: 2 Correct: B

41. Altman's Z score model found the three most important variables to be:
a) EBIT/ assets; sales/assets; current ratio.
b) EBIT/ assets; (market value of equity) / (book value of debt); sales / assets.
c) sales /assets; (working capital) /assets; current ratio.
d) (working capital) / assets; (retained earnings) / assets; sales / assets

Difficulty: 2 Correct: D

42. A firm's annual report indicates fixed assets of $9000; accumulated depreciation of
$4000; depreciation expense of $1,000; capital. expenditures this past year of $1500; and
inflation-adjusted depreciation expense of $1600. The estimated age of the assets is
a) nine years.
b) two and a quarter years.
c) six years.
d) four years.

Difficulty: 2 Correct: C

43. A note in the annual report shows deferred income taxes were increased $15 million by
an inventory transaction. The interpretation of this note is that
a) inventory was written off for accounting purposes but not for tax purposes.
b) inventory was written off for both accounting and tax purposes.
c) inventory was written off for tax purposes but not for accounting purposes.
d) None of these answers is correct.
Difficulty: 1 Correct: A

44. Section #6103 of the tax code allows shareholders who own _____ percent or more of a
company's stock to ask for and receive a copy of IRS form 1120, Schedule M-1, which
shows a reconciliation of income per accounting books with income per tax return.
a) 1
b) 2
c) 5
d) 10

Difficulty: 1 Correct: D

45. In William Beaver's study of failing and non-failing firms, he found the
a) current ratio of all firms, on average, to equal or exceed 2.0.
b) current ratio of failing firms, on average, to be below 2.0.
c) debt-to-asset ratio to be much higher for failing firms.
d) Both (a) and (c) are correct.