University of Tunis

Tunis Business School

Principles of Finance
Tutorial n°7 : Financial Statement Analysis
Professor: Dr. Ridha Esghaier

(Spring 2023)

Q1. A high current ratio is always a good indication of a well-managed liquidity position
a. True b. False

False. Current Ratio = (Cash + Receivables + inventory) / Current Liabilities

Excess cash resulting from poor management could produce a high current ratio. Similarly, if accounts receivable are not
collected promptly, this could also lead to a high current ratio. In addition, excess inventory which might include
obsolete inventory could also lead to a high current ratio.

Q2. In order to assess a company’s ability to fulfill its long-term obligations, an analyst would most likely
examine:
a. activity ratios.
b. liquidity ratios.
c. solvency ratios.
d. profitability ratios.
e. efficiency ratios.

Q3. Which of the following is NOT CORRECT?

a. a Low inventory turnover ratio suggests that firm might have old inventory or its control might be poor
b. The equity multiplier can be expressed as 1 – (Debt/Assets)
c. a high DSO means that firm collects on sales is too slowly
d. Firms with low debt ratios are less risky, but also forgo the opportunity to leverage up their return on equity
e. Stockholders may want more leverage because it magnifies expected earnings

Q4. Which of the following statements is most correct?

a. Having a high current ratio is always a good indication that a firm is managing its liquidity position well.
b. A decline in the inventory turnover ratio suggests that the firm’s liquidity position is improving.
c. If a firm’s times-interest-earned (TIE) ratio is relatively high, then this is one indication that the firm
should be able to meet its debt obligations.
d. Since ROA measures the firm’s effective utilization of assets (without considering how these assets are
financed), two firms with the same EBIT must have the same ROA.
e. If, through specific managerial actions, a firm has been able to increase its ROA, then, because of the
fixed mathematical relationship between ROA and ROE, (ROE = ROA × Assets/Equity) it must also have
increased its ROE.

Excess cash resulting from poor management could produce a high current ratio; thus statement a is false. A
decline in the inventory turnover ratio suggests that either sales have decreased or inventory has increased, which
suggests that the firm’s liquidity position is not improving; thus statement b is false. ROA = Net income/Total
assets, and EBIT does not equal net income. Two firms with the same EBIT could have different financing and
different tax rates resulting in different net incomes. Also, two firms with the same EBIT do not necessarily
have the same total assets; thus, statement d is false. ROE = ROA × Assets/Equity. If ROA increases because
total assets decrease, then the equity multiplier decreases, and depending on which effect is greater, ROE may or
may not increase; thus, statement e is false. Statement c is correct; the TIE ratio is used to measure whether the
firm can meet its debt obligation, and a high TIE ratio would indicate this is so.
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Q5. Which of the following statements is False?
a. The use of debt lower the ROA but also could raise the ROE
b. If a company is financed only with common equity, the return on assets (ROA) and the return on
equity (ROE) are the same
c. Higher M/B ratios are generally associated with firms with relatively high rates of return on
common equity
d. Generally, firms with high profit margins have high asset turnover ratios and firms with low profit margins
have low turnover ratios; this result is exactly as predicted by the extended Du Pont equation.
e. The Basic Earning Power ratio is useful for comparing firms with different tax situations and
different degrees of financial leverage

Q6. A company has a current ratio of 0.5. Which of the following actions would improve (increase) this
ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Sell some of the existing inventory at cost.

This question is best analyzed using numbers. For example, assume current assets equal $50 and
current liabilities equal $100; thus, the current ratio equals 0.5. For answer a, assume $5 in cash is used
to pay off $5 in current liabilities. The new current ratio would be $45/$95 = 0.47. For answer d,
assume a $10 purchase of inventory is made on credit (accounts payable). The new current ratio would
be $60/$110 = 0.55, which is an increase over the old current ratio of 0.5.

Ratio analysis is subject to manipulation; if the current ratio is less than 1 and we use cash to pay
off some current liabilities, the current ratio will decrease. If we purchase additional inventory on
credit (accounts payable), the current ratio will increase.

Q7.

Based only on the information above, the most appropriate conclusion is that, over the period FY13
to FY15, the company’s:
a. net profit margin and financial leverage have decreased.
b. net profit margin and financial leverage have increased.
c. net profit margin has decreased but its financial leverage has increased.

C is correct. The company’s net profit margin has decreased and its financial leverage has increased.
ROA = Net profit margin × Total asset turnover. ROA decreased over the period despite the increase in
total asset turnover; therefore, the net profit margin must have decreased.
ROE = Return on assets × Financial leverage. ROE increased over the period despite the drop in ROA;
therefore, financial leverage must have increased.

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Q8. A firm has $4 billion in total assets. The other side of its balance sheet consists of $0.4 billion in
current liabilities, $1.2 billion in long-term debt, and $2.4 billion in common equity. The company has
500 million shares of common stock outstanding, and its stock price is $25 per share. What is the firm’s
market-to-book ratio?
a. 2.00
b. 4.27
c. 5.21
d. 3.57
e. 1.42

Q9. A company recently reported net income of $3,500,000. It has 700,000 shares of common stock,
and it currently trades at $25 a share. The company continues to expand and anticipates that one year
from now its net income will be $4,500,000. Over the next year the company also anticipates issuing an
additional 100,000 shares of stock. Assuming the company’s price/earnings ratio remains at its current
level, what will be the company’s stock price one year from now?
a. $25.25
b. $27.50
c. $28.125
d. $31.00
e. $33.00

Q10. A firm is just being formed. It will need $2 million of assets, and it expects to have an EBIT of
$400,000. The firm will own no securities, so all of its income will be operating income. If it chooses
to, it can finance up to 50% of its assets with debt that will have a 9% interest rate. The fiem has no
other liabilities. Assuming a 40% tax rate on all taxable income, what is the difference between the
expected ROE if the firm finances with 50% debt versus the expected ROE if it finances entirely with
common stock?
a. 7.2%
b. 6.6%
c. 6.0%
d. 5.8%
e. 9.0%

Total assets = $2,000,000; EBIT = $400,000; rd = 9% ; T = 40%.

D/A = 0.5 = 50%, so Equity = 0.5x($2,000,000) = $1,000,000.

D/A = 0% D/A = 50%

EBIT $400,000 $400,000
Interest 0 90,000*
Taxable income $400,000 $310,000
Taxes (40%) 160,000 124,000
Net income (NI) $240,000 $186,000

* If D/A = 50%, then half of assets are financed by debt, so Debt = 0.5x($2,000,000) = $1,000,000.
At a 9% interest rate, Interest = 0.09x($1,000,000) = $90,000.

For D/A = 0%, ROE = NI/Equity = $240,000/$2,000,000 = 12%.

For D/A = 50%, ROE = $186,000/$1,000,000 = 18.6%.
Difference = 18.6% – 12.0% = 6.6%.

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Q11. Du Pont Equation: Effect of increasing debt ratio on the ROE
A company’s ROE last year was 2.5%, but its management has developed a new operating plan
designed to improve things. The new plan calls for a total asset of $5,000 that would be financed with
50% debt, which will result in interest charges of $240 per year. Management projects an EBIT of $800
on sales of $8,000. Under these conditions, the federal-plus-state tax rate will be 40%. If the changes
are made, what return on equity will the company earn?
a. 2.50%
b. 13.44%
c. 13.00%
d. 14.02%
e. 14.57%

ROE = Net income/Sales x Sales/Assets x Assets/Common Equity

Profit Margin Total assets TurnOver equity multiplier

Net income = (EBIT – interest charges) (1- 40%)

= (800 – 240) (1- 40%) = $336
Profit Margin = Net income / Sales = 336 / 8,000 = 0.042
Total asset turnover = Sales/Tot. Assets = 8,000/5,000 = 1.6
Equity multiplier = 1/ (1- debt ratio) = 1/ (1-0.5) = 2

→ ROE = 0.042 x 1.6 x 2 = 13.44%

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