Question 1

The income number used in the rate of return on assets is income after interest expense is added back.

Accepted Answer

The rate of return on assets formula is (Net Income + Interest Expense) / Average Total Assets. Therefore, the income used is after interest expense is added back.

Question 2

The concept of leverage refers to the practice of using borrowed funds and amounts received from preferred stockholders in an attempt to earn an overall return that is higher than the cost of these funds.

Accepted Answer

The statement accurately depicts the concept of leverage.

Question 3

One measure of a company's overall long-term financial health is the debt-to-equity ratio.

Accepted Answer

The debt-to-equity ratio is a measure of how much debt a company has relative to its equity, which is a reflection of its overall long-term financial health. A high ratio indicates that the company is heavily reliant on borrowing to fund its operations, while a low ratio indicates a lower reliance on debt and a stronger financial position.

Question 4

Because net income is on an after-tax basis, interest in the return on assets ratio must be placed on a before-tax basis.

Accepted Answer

The return on assets (ROA) ratio is calculated using net income, which is already on an after-tax basis, and does not require adjusting interest for taxes since it focuses on the overall profitability relative to the company's total assets.

Question 5

A company with a capital structure that shifts more toward debt financing will appear to be in a stronger position to pay interest and any principal amount that may be maturing by using its cash flows generated by operating activities.

Accepted Answer

Shifting more toward debt financing increases a company's financial leverage, which can increase the risk of default on interest and principal payments if cash flows from operating activities are not sufficient to cover these obligations.

Question 6

The selection of a particular inventory valuation method has a significant effect on certain key ratios.

Accepted Answer

The inventory valuation method affects the cost of goods sold and the value of ending inventory, which in turn affect ratios such as gross profit margin, inventory turnover, and return on assets.

Question 7

The number of days' sales in inventory is the same as a company's accounting cycle.

Accepted Answer

The number of days' sales in inventory measures how many days it takes for a company to sell its inventory. It is calculated as 365 (or the number of days in the accounting cycle) divided by the inventory turnover ratio. However, the accounting cycle is the period of time in which a company completes its financial reporting, usually a year or a quarter. They are not the same thing.

Question 8

Solvency is concerned with the ability of a company to pay next year's debts as they come due.

Accepted Answer

Solvency is concerned with a company's ability to meet its long-term obligations and debts, not just those due within the next year. Liquidity, on the other hand, refers to the ability to pay short-term obligations.

Question 9

The return on sales ratio is a variation of the profit margin ratio.

Accepted Answer

The return on sales ratio (also known as net profit margin or net income ratio) is a type of profitability ratio that measures the percentage of each sales dollar that results in net income after all expenses have been paid. It is calculated by dividing net income by sales revenue. This makes it a variation or alternative way of calculating the profit margin ratio.

Question 10

A high P/E ratio always indicates that a stock is overpriced by the market.

Accepted Answer

A high P/E ratio does not always indicate that a stock is overpriced. It could also suggest that investors have high expectations for future growth and earnings potential. Furthermore, comparing a stock's P/E ratio to its industry or sector average can provide better insight into whether it is over or undervalued.

Question 11

Discontinued operations and extraordinary items are two components of the income statement that are reported after income from operations or are reported separately because of their unique nature.

Accepted Answer

Discontinued operations and extraordinary items are reported separately on the income statement due to their unique nature and are not included in income from operations.

Question 12

If a company must pay more for the amounts provided by creditors and preferred stockholders than it can earn overall, as indicated by the return on assets, there will be favorable leverage.

Accepted Answer

This scenario would result in unfavorable leverage, as the company is paying out more than it is earning. Favorable leverage occurs when a company can earn a higher return on assets compared to the cost of borrowed funds.

Question 13

Kingston Company's accounts receivable turned over nine times during the year.This translates into strict adherence of the company's net/30 credit terms by Kingston's customers.

Accepted Answer

A high accounts receivable turnover ratio indicates that the company collects its receivables frequently throughout the year, but it does not necessarily mean all customers are adhering strictly to the net 30 credit terms. Some payments could be earlier or later, affecting the average collection period.

Question 14

Various organizations publish summaries of selected ratios organized by industry for a sample of U.S.companies.

Accepted Answer

This is true. Many organizations, such as financial information providers, consulting firms, and industry associations, offer industry-specific ratio benchmarks to help companies compare their own performance with industry norms.

Question 15

The denominator of a return ratio will be some measure of the company's income for the period.

Accepted Answer

The denominator of a return ratio is typically a measure of the company's investment or equity, not its income. For example, in the return on equity (ROE) ratio, the denominator is the company's equity.

Question 16

Because discontinued segments of a business will not be part of the company's future operations, discontinued operations are disclosed separately on the income statement.

Accepted Answer

Discontinued operations are disclosed separately on the income statement to provide users of financial statements with information about the impact of these segments on the company's financial performance, as they are not expected to be part of the company's future operations.

Question 17

Analysts trying to make investment decisions may very well ignore discontinued operations, and extraordinary items.

Accepted Answer

Discontinued operations and extraordinary items are non-recurring and do not reflect the ongoing performance of a company, so analysts often exclude them to focus on the core business activities.

Question 18

Solvency is the company's ability to pay its current debts when they become due.

Accepted Answer

Solvency refers to a company's ability to meet its long-term financial obligations, whereas liquidity refers to the ability to pay short-term debts when they become due.

Question 19

The definition of a conglomerate is a company that operates in one industry and uses different inventory valuation techniques.

Accepted Answer

The definition of a conglomerate is a company that operates in multiple, unrelated industries. The use of different inventory valuation techniques is not a defining characteristic of a conglomerate.

Question 20

Since inflation is an important consideration in analyzing financial statements, the FASB requires the submission of all financial statements in an inflation-adjusted format to the SEC.

Accepted Answer

The FASB does not require the submission of financial statements in an inflation-adjusted format to the SEC. However, companies may choose to provide supplemental inflation-adjusted information in the footnotes to their financial statements.

Quiz 13: Financial Statement Analysis

The income number used in the rate of return on assets is income after interest expense is added back.