Question 1

It is appropriate to use the fixed assets turnover ratio to appraise firms' effectiveness in managing their fixed assets if and only if all the firms being compared have the same proportion of fixed assets to total assets.

Accepted Answer

The FA turnover is Sales/FA,and it gives an indication of how effectively the firm utilizes its FA.The proportion of FA to TA is not relevant to this usage.

Question 2

Debt management ratios show the extent to which a firm's managers are attempting to magnify returns on owners' capital through the use of financial leverage.

Accepted Answer

Debt management ratios, such as the debt-to-equity ratio and interest coverage ratio, indicate how much debt a company uses to finance its operations and how well it can cover its interest expenses. By using financial leverage, a company aims to increase its return on equity. Therefore, debt management ratios do show the extent to which the firm's managers are attempting to magnify returns on owners' capital through financial leverage.

Question 3

A decline in a firm's inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving,i.e.,it is becoming more liquid.

Accepted Answer

A decline in inventory turnover ratio actually suggests that the firm is managing its inventory less efficiently and may be experiencing slower sales. This could potentially have a negative impact on the firm's liquidity position.

Question 4

The inventory turnover and current ratio are related.The combination of a high current ratio and a low inventory turnover ratio,relative to industry norms,suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged.

Accepted Answer

A high current ratio is consistent with a lot of inventory.A low inventory turnover is also consistent with a lot of inventory.If the CR exceeds industry norms and the turnover is below the norms,then the firm has more inventory than most other firms,given its sales.It could just be carrying a lot of good inventory,but it might also have a normal amount of "good" inventory plus some "bad" inventory that has not been written off.So the statement is true.

Question 5

Firms A and B have the same current ratio,0.75,the same amount of sales and cost of goods sold,and the same amount of current liabilities.However,Firm A has a higher inventory turnover ratio than B.Therefore,we can conclude that A's quick ratio must be smaller than B's.

Accepted Answer

Firm A has the higher inventory turnover,so given the same cost of goods,it must have less inventory.Thus,since the two firms have the same CR,then A must have the higher QR,not the lower one.Therefore,the statement is false.

Question 6

High current and quick ratios always indicate that a firm is managing its liquidity position well.

Accepted Answer

High current ratios and quick ratios only indicate that a company has a good amount of liquidity, but it doesn't necessarily mean that they are managing it well. There are other factors to consider such as the company's debt level, cash flow, and overall financial health.

Question 7

Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects.

Accepted Answer

Market value ratios, such as price-to-earnings ratio and price-to-book ratio, reflect investors' expectations for the company's future earnings and growth potential, and therefore provide insights into how investors perceive the company's prospects.

Question 8

Even though Firm A's current ratio exceeds that of Firm B,Firm B's quick ratio might exceed that of A.However,if A's quick ratio exceeds B's,then we can be certain that A's current ratio is also larger than that of B.

Accepted Answer

This question can be answered by thinking carefully about the ratios:
Demonstration that the first sentence is true:
 $$\begin{array} { r c c c c c c } 
& \mathrm { CR } = & \frac { \mathrm { C } + \mathrm { A } / \mathrm { R } + \mathrm { Inv } } { \mathrm { CL } } & \mathrm { A } > \mathrm { B } & \mathrm { QR } = & \frac { \mathrm { C } + \mathrm { A } / \mathrm { R } } { \mathrm { CL } } & \mathrm { B } > \mathrm { A } \
& \mathrm { A } : & \frac { 1 + 1 + 3 } { 3 } & 1.67 & & \frac { 1 + 1 } { 3 } & 0.67 \
\mathrm { QR } ( \mathrm { B } ) > \mathrm { QR } ( \mathrm { A } ) & & \mathrm { B } : & \frac { 1 + 1 + 1 } { 2 } & 1.50 & & \
& & & \frac { 1 + 1 } { 2 } & 1.00
\end{array}$$
$\mathrm{CR}=\frac{\mathrm{C}+\mathrm{A} / \mathrm{R}+\operatorname{In} v}{\mathrm{CL}} \quad \mathrm{A}>\mathrm{B} \quad \mathrm{QR}=\quad \frac{\mathrm{C}+\mathrm{A} / \mathrm{R}}{\mathrm{CL}} \quad \mathrm{B}>\mathrm{A}$
A: $ \quad \frac{1+1+3}{3} $                       $ 1.67 $                       $ \frac{1+1}{3} $             0.67
$\mathrm{QR}(\mathrm{B})>\mathrm{QR}(\mathrm{A})$
B:     $ \quad \frac{1+1+1}{2} $                  $ 1.50 $                          $ \frac{1+1}{2} $           1.00 
Demonstration that second sentence is false:
 $$\begin{array} { c c c c c c c } 
& \mathrm { CR } = & \frac { \mathrm { C } + \mathrm { A } / \mathrm { R } + \operatorname { Inv } } { \mathrm { CL } } & \mathrm { A } > \mathrm { B } & \mathrm { QR } = & \frac { \mathrm { C } + \mathrm { A } / \mathrm { R } } { \mathrm { CL } } & \mathrm { B } > \mathrm { A } \
& \mathrm { A } : & \frac { 1 + 1 + 3 } { 3 } & 1.0 & & \frac { 1 + 1 } { 3 } &0 .67 \
\mathrm { QR } ( \mathrm { B } ) < \mathrm { QR } ( \mathrm { A } ) & \mathrm { B } : & \frac { 1 + 1 + 4 } { 4 } & 1.5 & & \frac { 1 + 1 } { 4 } & 0.5 \mathrm { 0 }
\end{array}$$ The key is inventory,which is in the CR but not in the QR.The firm with more inventory can have the higher CR but the lower QR.

Question 9

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

Accepted Answer

Ratio analysis is a technique used to analyze a company's financial statements to evaluate its financial position and strength. It involves calculating various ratios that measure a company's liquidity, profitability, debt, and other financial metrics. The results of ratio analysis can help investors, creditors, and other stakeholders make informed decisions about investing in or lending to a company.

Question 10

The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically,depending on the time of year when the financial statements are constructed.

Accepted Answer

Many of the ratios show sales over some past period such as the last 12 months divided by an asset such as inventories as of a specific date.Assets like inventories vary at different times of the year for a seasonal business,thus leading to big changes in the ratio.

Question 11

Profitability ratios show the combined effects of liquidity,asset management,and debt management on operating results.

Accepted Answer

Profitability ratios such as return on assets, return on equity, and gross profit margin take into account not only the company's liquidity, asset management, and debt management, but also its ability to generate profits from those resources. Therefore, they reflect the overall impact of these factors on the company's profitability.

Question 12

The basic earning power ratio (BEP)reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects.

Accepted Answer

BEP = EBIT/Assets.This is before the effects of leverage (interest)and taxes,so the statement is false.

Question 13

Although a full liquidity analysis requires the use of a cash budget,the current and quick ratios provide fast and easy-to-use measures of a firm's liquidity position.

Accepted Answer

The statement is true. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios are widely used as quick and easy-to-use measures of a firm's liquidity position.

Question 14

The inventory turnover ratio and days sales outstanding (DSO)are two ratios that are used to assess how effectively a firm is managing its assets.

Accepted Answer

Both the inventory turnover ratio and days sales outstanding (DSO) are commonly used ratios to assess a company's efficiency in managing its assets. The inventory turnover ratio measures how quickly a company is selling its inventory and replenishing it, while DSO measures the average number of days it takes for a company to collect payment from its customers after a sale. Both of these ratios provide insight into a company's operational efficiency and ability to generate cash flow.

Question 15

Suppose firms follow similar financing policies,face similar risks,have equal access to capital,and operate in competitive product and capital markets.Under these conditions,then firms that have high profit margins will tend to have high asset turnover ratios,and firms with low profit margins will tend to have low turnover ratios.

Accepted Answer

Think about the DuPont equation: ROE = PM F1F1F1S1F1F1F10 TATO F1F1F1S1F1F1F10 Equity multiplier.Similar financing policies will lead to similar Equity multipliers.Moreover,competition in the capital markets will cause ROEs to be similar,because otherwise capital would flow to industries with high ROEs and drive returns down toward the average,given similar risks.To have similar ROEs,firms with relatively high PMs must have relatively low TATOs,and vice versa.Therefore,the statement is false.

Question 16

Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods.

Accepted Answer

If firms use different accounting methods for recording income, assets, and liabilities, it can distort the financial ratios, making it hard to compare different firms. For instance, one firm may use the first-in, first-out (FIFO) method for inventory record-keeping, while another firm uses the last-in, first-out (LIFO) method. This difference could have a significant impact on their reported profitability, liquidity, and solvency ratios, making the comparison between these firms meaningless.

Question 17

The current ratio and inventory turnover ratios both help us measure the firm's liquidity.The current ratio measures the relationship of a firm's current assets to its current liabilities,while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash.

Accepted Answer

The statement is true.

Question 18

The times-interest-earned ratio is one,but not the only,indication of a firm's ability to meet its long-term and short-term debt obligations.

Accepted Answer

The times-interest-earned ratio measures a firm's ability to cover its interest payments with its earnings, but there are other factors that can affect a firm's ability to meet its debt obligations, such as cash flow, liquidity, and overall financial health.

Question 19

Since the 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.

Accepted Answer

EBIT = Sales revenues F1F1F1S1F1F1F10 Operating costs
Net income = EBIT F1F1F1S1F1F1F10 Interest F1F1F1S1F1F1F10 Taxes = (EBIT F1F1F1S1F1F1F10 Interest)F1F1F1S1F1F1F10 (1 F1F1F1S1F1F1F10 T)
ROA = Net income after taxes/Assets
Two firms could have identical EBITs but very different amounts of interest,different tax rates,and different assets,and thus very different ROAs.

Question 20

Determining whether a firm's financial position is improving or deteriorating requires analyzing more than the ratios for a given year.Trend analysis is one method of measuring changes in a firm's performance over time.

Accepted Answer

Trend analysis compares a firm's financial performance over multiple years to identify patterns and changes, providing insight into whether their financial position is improving or deteriorating. It goes beyond just looking at the ratios for a single year.

Quiz 3: Analysis of Financial Statements