Question 1

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

Accepted Answer

When a company uses too much debt, it has to pay interest on the debt, which can significantly reduce profit margins. Therefore, the more debt a firm uses, the lower its profit margin will be, all other things remaining constant.

Question 2

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 total debt to total capital ratio [measured as (Short-term debt + Long-term debt)/(Debt + Preferred stock + Common equity)] is 70% versus 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

A's higher total debt to total capital ratio would tend to lower its profit margin.Since its margin is already higher,this indicates that A is the better managed company.

Question 3

Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects.These ratios include the Price/Earnings,the Market/Book,and Enterprise Value/EBITDA ratios.

Accepted Answer

Market value ratios are used to gauge investor sentiment and can help management understand how the market views the company's potential future performance. The commonly used market value ratios are Price/Earnings, Market/Book, and Enterprise Value/EBITDA.

Question 4

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

Accepted Answer

This statement is true because when a firm uses more debt, it increases its financial leverage, which magnifies the effects of changes in earnings on the return on total assets. Therefore, if earnings increase, the return on total assets will increase, but if earnings decrease, the return on total assets will decrease even more. As a result, the more debt a firm uses, the higher the risk of its returns being adversely affected.

Question 5

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 less risky and/or more likely to enjoy higher growth in the future.

Accepted Answer

The statement is true. Higher P/E ratios are often seen as a positive indicator of a company's future prospects, as investors are willing to pay more for a share of its future earnings potential. This is because higher P/E ratios may reflect a perception of lower risk, stronger growth prospects, or both. However, it is important to note that P/E ratios alone should not be used as the sole basis for investment decisions, as they may be affected by a wide range of factors that may not necessarily reflect a company's underlying financial strength or potential.

Question 6

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

Accepted Answer

PM = NI / Sales.A decline in sales would,other things held constant,increase the PM.An increase in financial leverage would lead to higher interest charges,which would decrease net income,which would decrease the PM.So,the net effect could be an increase or a decrease in the PM,or no change.

Question 7

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) is calculated by dividing earnings before interest and taxes (EBIT) by total assets, which gives an indication of a company's operating efficiency before taking into account the effects of financing decisions (debt) and tax rates. In contrast, the return on total assets (ROA) takes into account the effects of interest expense and taxes, which can distort operating efficiency. Therefore, the BEP is a better measure for comparing the operating efficiency of companies with different levels of debt and tax rates.

Question 8

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

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 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 of 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 10

In general,if investors believe that a company is relatively risky and/or has relatively poor growth prospects,then the company will have relatively high P/E,M/B,and EV/EBITDA ratios.

Accepted Answer

If investors believe that a company is risky or has poor growth prospects, they would typically demand a higher return on their investment, resulting in a lower P/E, M/B, and EV/EBITDA ratio.

Question 11

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

Stockholders should,and generally do,consider the ROE as probably the single most important ratio based strictly on the financial statements.

Question 12

Klein Cosmetics has a profit margin of 5.0%,a total assets turnover ratio of 1.5 times,no debt and therefore an equity multiplier of 1.0,and an ROE of 7.5%.The CFO recommends that the firm borrow money,use the funds to buy back stock,and raise the equity multiplier to 2.0.The size of the firm (assets)would not change.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

DuPont equation: ROE = PM × TATO × Equity multiplier.Given the data,the statement is true. 11ea856c_8bed_544a_9aec_5713791033f6_TB1222_00

Question 13

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

Accepted Answer

Operating margin is calculated based on operating income and revenue, which are not directly affected by the amount of debt a firm uses. Debt influences financing costs and leverage, not operating performance.

Question 14

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 could have identical EBITs but different amounts of interest,tax rates,and assets,resulting in different ROAs. 11ea856c_8bec_df19_9aec_8bff1ed367a6_TB1222_00

Question 15

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 cause distortions in financial ratios and make it more challenging to compare and analyze financial statements of different companies. If all firms used the same or similar accounting methods, it would be easier to compare their financial performance and make meaningful ratio comparisons.

Question 16

The return on invested capital measures the total return that a company has provided for its investors.

Accepted Answer

The return on invested capital (ROIC) is a financial performance ratio that measures how efficiently a company is using its capital to generate profits for investors. It takes into account both debt and equity investments and is considered a comprehensive measure of a company's profitability.

Question 17

The return on invested capital (ROIC)differs from the return on assets (ROA).First,ROIC is based on total invested capital rather than total assets.Second,the numerator of the ROIC is after-tax operating income rather than net income.

Accepted Answer

This statement is true. ROIC and ROA are different measures that use different calculations.

Question 18

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 less risky and/or more likely to enjoy higher growth in the future.

Accepted Answer

This is because a higher M/B ratio indicates that investors are willing to pay more than the accounting book value for a company's assets, which can signify confidence in the company's future prospects for growth and profitability. It is also often interpreted as an indication of the market's perception of a company's risk level.

Question 19

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

Think about the DuPont equation: ROE = PM × TATO × 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 20

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.

Quiz 4: Analysis of Financial Statements