Question 1

Firms A and B have the same current ratio, 0.75, the same amount of sales, 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

False

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 debt-to-equity and interest coverage ratios, measure a company's use of debt and how well they are managing their debt obligations. By leveraging debt, a company can potentially increase returns on equity, but it also increases financial risk. Therefore, debt management ratios can show the extent to which a firm's managers are attempting to magnify returns on owners' capital through the use of financial leverage.

Question 3

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

This is because differences in accounting methods can impact how items are categorized and valued on financial statements, which in turn affects the ratios that are calculated. Therefore, it is important to take these variations into account when comparing financial ratios between firms.

Question 4

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

Two firms with the same EBIT can have different ROA if they have different levels of assets. ROA takes into account the level of assets in relation to the EBIT.

Question 5

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-sales ratio are used by investors to assess a company's growth potential and financial health, thus providing management with insight into investors' expectations for the future.

Question 6

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 suggests that the firm is selling its inventory less often, which may indicate poor inventory management or slow sales. It also suggests that the firm has more inventory on hand, which ties up more of its cash and makes it less liquid. Therefore, a decline in inventory turnover ratio does not indicate improved efficiency or liquidity.

Question 7

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. While a cash budget provides a more comprehensive analysis of a firm's liquidity, the current and quick ratios are commonly used as quick and easy measures of a firm's liquidity position.

Question 8

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

The inventory turnover ratio measures how quickly a company is selling its inventory and the DSO measures how quickly a company is collecting payments from its customers. Both of these ratios are used to evaluate a company's efficiency in managing its assets.

Question 9

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 fixed assets turnover ratio can still be useful in comparing firms with different proportions of fixed assets to total assets, but it should be used in conjunction with other ratios and metrics to get a complete picture of a firm's financial performance.

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

This statement is true. Seasonal businesses, such as those in the retail or tourism industries, may show high revenues and profits during peak seasons but lower or negative figures during off-seasons. Therefore, the financial statements of these companies can vary greatly depending on when they are prepared.

Question 11

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

The basic earning power (BEP) ratio measures a firm's earning power from its assets without considering the impact of financial leverage and tax effects; it focuses solely on operating income and total assets.

Question 12

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 involves analyzing a firm's performance over time to evaluate changes in its financial position, making it true that analyzing ratios for a given year is not enough to determine whether a firm's financial position is improving or deteriorating.

Question 13

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

Asset turnover ratios and profit margins are not directly correlated in this manner. A firm can have a high profit margin with a low asset turnover if it sells high-margin products less frequently, or a low profit margin with a high asset turnover if it sells low-margin products more frequently. The conditions described do not inherently lead to a correlation between profit margins and asset turnover ratios.

Question 14

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

The current ratio and quick ratio measure different aspects of a company's liquidity. It's possible for Firm A to have a higher quick ratio than Firm B while still having a lower current ratio, as these ratios consider different sets of assets in their calculations. The quick ratio excludes inventory and other less liquid current assets, focusing on those assets that can be quickly converted to cash.

Question 15

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 company's ability to meet interest payments on its debt, but other financial ratios and factors also play a role in assessing a company's overall ability to meet its debt obligations.

Question 16

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 evaluate the financial performance of a company, which involves analyzing various financial ratios derived from financial statements. It helps in assessing a company's financial strength, liquidity, profitability, operational efficiency, and overall performance.

Question 17

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

Accepted Answer

High current and quick ratios do indicate that a firm has sufficient liquidity, but it does not necessarily mean that the firm is managing its liquidity position well. A company could be holding excess inventory or extending long payment terms to its customers, which would artificially inflate these ratios but could be detrimental to the overall financial health of the firm in the long term. Additionally, other factors such as debt levels and cash flow trends must also be considered when evaluating a firm's liquidity management.

Question 18

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

Both statements are correct.

Question 19

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 typically indicates that a firm has a good level of liquidity, while a low inventory turnover ratio suggests that the firm is not selling its inventory quickly enough. When both ratios are analyzed together, a high current ratio and a low inventory turnover ratio may suggest that the firm is holding onto an excessively high level of inventory or that some of the inventory is no longer sellable.

Question 20

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

Accepted Answer

Profitability ratios measure how efficiently a company generates profits from its operations and how well it manages its resources. They take into account factors such as liquidity, asset management, and debt management to determine the overall profitability of a business. Therefore, the statement is true.

Quiz 3: Analysis of Financial Statements Part 2 Fixed Income Securities