Question 1

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 and tourism industries, often experience fluctuations in revenue and expenses throughout the year. As a result, the financial statements of such companies can vary greatly depending on the time of year they are constructed. For example, a retail company may appear to be profitable during the holiday season when sales are high but may appear to be struggling during the slower summer months when sales are low. Therefore, it's important to consider the seasonality of a business when interpreting its financial statements.

Question 2

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 efficiently a company is managing its inventory by comparing the cost of goods sold to the average inventory balance. The days sales outstanding (DSO) ratio measures how quickly a company collects payments from its customers by comparing accounts receivable to sales. Both ratios are used to assess how effectively a firm is managing its assets.

Question 3

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 comparing financial data from multiple periods to identify patterns and changes in a firm's performance, rather than just looking at ratios for a single year.

Question 4

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 ratio, interest coverage ratio, and debt-to-assets ratio provide information about the firm's use of debt financing to generate returns for shareholders. High debt levels can magnify returns but also increase financial risk.

Question 5

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 liquidity analysis, the current and quick ratios are commonly used as quick and easy-to-calculate measures of a firm's liquidity position.

Question 6

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 levels of assets, resulting in different ROAs. Even if two firms have the same level of assets, they could have different financing structures (i.e. different levels of debt to equity ratios), which would affect their ROAs.

Question 7

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

The quick ratio measures a company's ability to meet its short-term liabilities with its most liquid assets. It excludes inventory from current assets because inventory may be difficult to sell quickly. Since Firm A has a higher inventory turnover ratio, it means it is selling inventory quickly and generating cash, which can be used to pay off its current liabilities. Therefore, Firm A's quick ratio is likely to be higher than Firm B's, as it has more liquid assets available to pay off its short-term debts.

Question 8

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-earnings ratio, indicate investors' confidence in a company's future growth potential and are closely watched by management to evaluate their performance and make strategic decisions accordingly.

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 interpret and analyze financial statements to evaluate a company's financial health, profitability, and efficiency. It involves calculating and comparing different financial ratios, such as liquidity ratios, profitability ratios, and solvency ratios. The analysis of these ratios can provide insights into a company's financial position and strength, which can be useful for making investment and other financial decisions.

Question 10

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 11

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 12

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 is a useful measure for analyzing a company's ability to cover its interest payments, but there are other factors to consider, such as cash flow, asset quality, and management's ability to generate earnings.

Question 13

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

Accepted Answer

Profitability ratios are financial metrics that reflect a company's ability to generate profits from its operations. They take into account various aspects of a company's financial performance, including liquidity (ability to meet short-term obligations), asset management (efficient use of assets to generate revenue), and debt management (effective management of debt obligations). Therefore, profitability ratios reflect the combined effects of these factors on a company's operating results.

Question 14

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 measures a firm's ability to generate sales from its fixed assets. However, it can be misleading to compare this ratio across firms if they have different proportions of fixed assets to total assets. For example, a construction company may have a much higher fixed asset turnover ratio than a software company, simply because construction companies require more fixed assets such as equipment and buildings. Therefore, it is not appropriate to use this ratio to appraise firms' effectiveness in managing their fixed assets if they have different proportions of fixed assets to total assets.

Question 15

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

Different accounting methods can affect the way financial statements are presented, making it harder to compare ratios between firms. For example, one company may use the FIFO method for inventory accounting while another uses LIFO, which can significantly impact their respective financial ratios.

Question 16

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 enough current assets to cover its current liabilities, while a low inventory turnover ratio suggests that the inventory is not being sold quickly enough. This combination may indicate that the company has too much inventory that is not selling well, leading to a higher-than-normal inventory level or obsolescence/damage of inventory.

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. Both the current ratio and inventory turnover ratio are used to measure a firm's liquidity. The current ratio measures the firm's ability to pay off its short-term liabilities using its current assets, while the inventory turnover ratio shows how efficiently the firm is able to sell its inventory and generate cash.

Question 18

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 19

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

Accepted Answer

High current and quick ratios may indicate that a firm has more liquid assets to cover short-term obligations, but they do not necessarily reflect effective management of liquidity. It's possible for a firm to have high ratios but still face liquidity problems, such as if its assets are not easily convertible to cash or if it has high levels of debt. Other factors, such as cash flow management and effective credit policies, also play a role in managing liquidity.

Question 20

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 have excess inventory, which could potentially harm its liquidity position.

Quiz 3: Analysis of Financial Statements