Question 1

Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, a zero debt ratio and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow money, use it to buy back stock, and raise the debt ratio to 50% and the equity multiplier to 2.0. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably be a good move, as it would increase the ROE from 7.5% to 13.5%.

Accepted Answer

Increasing the debt ratio and equity multiplier would increase the financial leverage, leading to a higher ROE. The decrease in profit margin due to interest on new debt would be offset by the increase in ROE.

Question 2

The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operating efficiency is that the BEP does not reflect the effects of debt and taxes.

Accepted Answer

The basic earning power ratio (BEP) measures a company's ability to generate operating profit without taking into account the effects of debt and taxes. This makes it a useful measure of a company's operating efficiency, as it allows for an apples-to-apples comparison of different companies' performance without being influenced by factors such as interest expenses or tax rates. In contrast, the return on total assets (ROTA) takes into account both operating income and the effects of debt and taxes, which can make it more difficult to compare the operating efficiency of different companies.

Question 3

Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry. Under these conditions, firms with 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

The answer of Suppose all firms follow similar financing policies,...

Question 4

The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as being less risky and/or more likely to enjoy higher growth in the future.

Accepted Answer

This is because companies with higher P/E ratios are often seen as having more potential for future growth and profitability, which can attract investors and drive up the price of their stock. Conversely, companies with lower P/E ratios may be seen as riskier or less likely to grow, and may therefore be priced lower by the market.

Question 5

Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's debt ratio is 70% versus one of 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A's higher profit margin.

Accepted Answer

The answer of Suppose you are analyzing two firms in...

Question 6

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

Accepted Answer

Significant variations in accounting methods can result in differences in the values of balance sheet and income statement items, which may affect the calculation and interpretation of financial ratios. Therefore, it makes meaningful ratio comparisons between firms more difficult because the ratios may not be directly comparable due to the differences in accounting methods used.

Question 7

Other things held constant, the more debt a firm uses, the lower its return on total assets will be.

Accepted Answer

This is because interest expense on debt reduces the firm's net income, which in turn reduces return on total assets.

Question 8

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 examining changes in a firm's performance over time.

Accepted Answer

Trend analysis involves comparing financial data from multiple periods to identify patterns and trends in a firm's performance. This allows for a more comprehensive assessment of whether the firm's financial position is improving or deteriorating.

Question 9

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 asset financing (i.e. different amounts of debt or equity).

Question 10

Other things held constant, the more debt a firm uses, the lower its profit margin will be.

Accepted Answer

The more debt a firm uses, the higher its interest expenses will be, which will reduce its net income and profit margin.

Question 11

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

Accepted Answer

Since the sales of a seasonal company vary throughout the year, its financial position can also change dramatically depending on when the financial statements are constructed. Therefore, the financial position may appear strong during high sales periods and weak during low sales periods, even though the true financial position may be different.

Question 12

Other things held constant, the more debt a firm uses, the lower its operating margin will be.

Accepted Answer

The answer of Other things held constant, the more debt...

Question 13

The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value. In general, investors regard companies with higher M/B ratios as being less risky and/or more likely to enjoy higher growth in the future.

Accepted Answer

This statement is true as investors generally assume that companies with higher M/B ratios have higher growth prospects, which makes them less risky to invest in.

Question 14

Other things held constant, a decline in sales accompanied by an increase in financial leverage must result in a lower profit margin.

Accepted Answer

The answer of Other things held constant, a decline in...

Question 15

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 indicates that the firm has a relatively high level of current assets, which includes inventory. A low inventory turnover ratio suggests that the firm is holding onto inventory for a longer period of time, which could indicate issues with obsolescence or damage. Therefore, the combination of these two ratios may suggest that the firm has an above-average inventory level and/or some inventory is obsolete or damaged.

Question 16

In general, if investors regard a company as being relatively risky and/or having relatively poor growth prospects, then it will have relatively high P/E and M/B ratios.

Accepted Answer

If investors regard a company as being relatively risky and/or having relatively poor growth prospects, then it will have relatively low P/E and M/B ratios.

Question 17

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, price-to-sales ratio, and market-to-book ratio are used by investors to evaluate a company's potential future earnings and growth prospects. As a result, these ratios can provide management with insights into how investors perceive the firm's performance and outlook.

Question 18

Considered alone, which of the following would increase a company's current ratio?
A) An increase in net fixed assets.
B) An increase in accrued liabilities.
C) An increase in notes payable.
D) An increase in accounts receivable.
E) An increase in accounts payable.

Accepted Answer

The answer of Considered alone, which of the following would...

Question 19

The return on common equity (ROE) is generally regarded as being less significant, from a stockholder's viewpoint, than the return on total assets (ROA).

Accepted Answer

The return on common equity (ROE) is actually considered more significant from a stockholder's viewpoint than the return on total assets (ROA). ROE measures how much profit a company generates based on the amount of shareholder equity invested in the business, whereas ROA measures how much profit a company generates based on its total assets. Therefore, ROE is more relevant for evaluating a company's efficiency in using shareholder capital to generate returns.

Question 20

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' effectiveness in managing their fixed assets, even if they have different proportions of fixed assets to total assets. However, it should be noted that the ratio may not provide a completely accurate picture of how efficiently each firm is using their fixed assets.

Quiz 4: Analysis of Financial Statements