Question 1

Which of the following statements is false?
A) Financial ratios can indicate areas of potential strength and weakness.
B) Financial ratios can serve as screening devices.
C) Financial ratios are predictive.
D) No rules of thumb apply to the interpretation of financial ratios.

Accepted Answer

Financial ratios are not predictive. They can only provide information about a company's past performance.

Question 2

When the financial leverage index is less than one, this indicates the firm is employing debt beneficially.

Accepted Answer

When the financial leverage index is less than one, it indicates that the firm is not earning enough on its investments to cover the cost of borrowing, hence not employing debt beneficially.

Question 3

Which of the following ratios would be useful in assessing short-term liquidity?
A) Current ratio, inventory turnover, fixed asset turnover.
B) Quick ratio, average collection period, cash conversion cycle.
C) Average collection period, debt ratio, return on assets.
D) Current ratio, cash interest coverage, cash-flow liquidity ratio.

Accepted Answer

The quick ratio, average collection period, and cash conversion cycle are all ratios that specifically measure short-term liquidity. The quick ratio (also known as the acid test ratio) measures a company's ability to meet short-term obligations with its most liquid assets. The average collection period measures how long it takes a company to collect its accounts receivables, which is a key component of short-term cash flow. The cash conversion cycle is the number of days it takes for a company to convert its inventory into cash. These ratios provide insight into how efficiently a company is managing its short-term assets and obligations.

Question 4

What type of ratios measure the firm's ability to meet cash needs as they arise?
A) Activity ratios.
B) Liquidity ratios.
C) Leverage ratios.
D) Profitability ratios.

Accepted Answer

Liquidity ratios measure the ability of a firm to meet its short-term cash requirements. These ratios include the current ratio, quick ratio, and cash ratio. Activity ratios measure the efficiency of a company's operations, leverage ratios measure the extent to which a company is using debt to finance its operations, and profitability ratios measure a company's ability to generate profits from its operations.

Question 5

What type of ratios measure the liquidity of specific assets and the efficiency of managing those assets?
A) Activity ratios.
B) Liquidity ratios.
C) Leverage ratios.
D) Profitability ratios.

Accepted Answer

Activity ratios, also known as asset management ratios, measure the company's ability to manage its assets efficiently. This includes measuring the liquidity of specific assets such as inventory and accounts receivable, as well as measuring the efficiency of managing those assets by tracking turnover ratios. Liquidity ratios, on the other hand, measure a company's ability to meet short-term obligations using assets that can quickly be converted to cash. Leverage ratios measure a company's debt levels and its ability to meet its debt obligations. Profitability ratios measure the company's ability to generate profits from its operations. Therefore, activity ratios are the best choice to measure the liquidity of specific assets and the efficiency of managing those assets.

Question 6

Which of the following items is an outside source of information from the corporate annual report?
A) Auditor's report.
B) Supplementary schedule of segment information.
C) Comparative statistical ratios from Annual Statement Studies.
D) Management's discussion and analysis.

Accepted Answer

The comparative statistical ratios from Annual Statement Studies are an outside source of information not included in the corporate annual report. The auditor's report, supplementary schedule of segment information, and management's discussion and analysis are all included in the corporate annual report.

Question 7

The Du Pont System helps the analyst see how a firm's decisions and activities over an accounting period interact to produce an overall return to the firm's shareholders, the return on equity.

Accepted Answer

The Du Pont System is a tool used to analyze a firm's return on equity by breaking it down into its components: net profit margin, asset turnover, and financial leverage. It helps analysts see how a firm's decisions and activities affect each component and ultimately the overall return to shareholders.

Question 8

What relationship exists between the average collection period and accounts receivable turnover?
A) There is a direct and proportional relationship.
B) Both ratios are expressed in number of times receivables are collected per year.
C) Both ratios are expressed in number of days.
D) As average collection period increases (decreases) the accounts receivable turnover decreases (increases).

Accepted Answer

The average collection period and accounts receivable turnover are inversely related. As the average collection period increases, it means that it takes longer for the company to collect its receivables, which results in a lower turnover ratio. On the other hand, a lower average collection period means that the company is collecting its receivables more quickly, resulting in a higher turnover ratio. Therefore, as the average collection period increases, the accounts receivable turnover decreases, and vice versa.

Question 9

What is the cash conversion or net trade cycle?
A) The amount of time needed to complete the normal operating cycle of a firm.
B) The amount of time it takes to manufacture or buy inventory.
C) The amount of time it takes to sell inventory.
D) The amount of time it takes to be profitable.

Accepted Answer

The cash conversion cycle or net trade cycle is the amount of time it takes for a company to convert its investments in inventory and accounts receivable into cash. It includes the time it takes to complete the normal operating cycle (buying inventory, selling it, and collecting payment from customers) and the time it takes to pay suppliers. A shorter cash conversion cycle or net trade cycle is generally better for a company, as it means the company is able to generate cash quickly and efficiently.

Question 10

The accounting and finance scandals, including Lehman Brothers, Enron, and WorldCom, illustrated the importance to investors of earnings numbers and market ratios based on those earnings numbers.

Accepted Answer

The answer of The accounting and finance scandals, including Lehman...

Question 11

What type of ratios measure the extent of a firm's financing with debt relative to equity and its ability to cover interest and fixed charges?
A) Activity ratios.
B) Liquidity ratios.
C) Market ratios.
D) Leverage ratios.

Accepted Answer

Leverage ratios measure the extent to which a firm is financed with debt relative to equity, as well as its ability to cover interest and fixed charges. Examples of leverage ratios include debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio.

Question 12

Short-term liquidity focuses on assessment of the key components of the income statement.

Accepted Answer

Short-term liquidity focuses on the assessment of the key components of the balance sheet, rather than the income statement.

Question 13

Which of the following tools and techniques are the least useful to the financial statement analyst?
A) Financial ratios.
B) Public relations material and pro forma statements prepared by the firm.
C) Trend and structural analysis.
D) Common size financial statements.

Accepted Answer

Public relations material and pro forma statements prepared by the firm can be biased and may not accurately reflect the true financial position and performance of the company. Therefore, they are considered the least useful tools and techniques for financial statement analysis.

Question 14

An upward trend in asset turnover ratios indicates improved operating efficiency.

Accepted Answer

Asset turnover ratio measures how efficiently a company uses its assets to generate revenue. Therefore, an upward trend in this ratio indicates that the company is generating more revenue with the same amount of assets, which implies improved operating efficiency.

Question 15

If a firm is using financial leverage successfully what would be the impact of doubling operating earnings?
A) The return on equity will double.
B) The return on equity will increase, but not double.
C) The return on equity will more than double.
D) The return on equity will decline by half.

Accepted Answer

When a firm uses financial leverage successfully, it means that they have a high proportion of debt in their capital structure. This allows them to generate a higher return on equity (ROE) if they are able to earn a higher return on their assets than the cost of debt. Doubling operating earnings would mean that the firm is earning a higher return on their assets, which would translate into a higher net income. As a result, the ROE would increase, but not in a linear way. Instead, it would more than double due to the effect of financial leverage. Therefore, the best answer is C.

Quiz 5: The Analysis of Financial Statements

Which of the following statements is false?

When the financial leverage index is less than one, this indicates the firm is employing debt beneficially.

Which of the following ratios would be useful in assessing short-term liquidity?

What type of ratios measure the firm's ability to meet cash needs as they arise?

What type of ratios measure the liquidity of specific assets and the efficiency of managing those assets?

Which of the following items is an outside source of information from the corporate annual report?

The Du Pont System helps the analyst see how a firm's decisions and activities over an accounting period interact to produce an overall return to the firm's shareholders, the return on equity.

What relationship exists between the average collection period and accounts receivable turnover?

What is the cash conversion or net trade cycle?

The accounting and finance scandals, including Lehman Brothers, Enron, and WorldCom, illustrated the importance to investors of earnings numbers and market ratios based on those earnings numbers.

What type of ratios measure the extent of a firm's financing with debt relative to equity and its ability to cover interest and fixed charges?

Short-term liquidity focuses on assessment of the key components of the income statement.

Which of the following tools and techniques are the least useful to the financial statement analyst?

An upward trend in asset turnover ratios indicates improved operating efficiency.

If a firm is using financial leverage successfully what would be the impact of doubling operating earnings?