Question 1

What are some of the main limitations of ratio analysis?

Accepted Answer

The answer of What are some of the main limitations...

Question 2

Peer group analysis can be performed by:
A) management choosing a set of firms that are similar in size or sales, or who compete in the same market.
B) using the average ratios of this peer group, which would then be used as the benchmark.
C) identifying firms in the same industry that are grouped by size, sales, and product lines in order to establish benchmark ratios.
D) Only a and b relate to peer group analysis.

Accepted Answer

Peer group analysis involves selecting a group of similar firms to use as a benchmark for financial analysis. Management typically chooses firms that are similar in size, sales and industry for this purpose. Once a peer group has been identified, their average ratios can be used to compare against the company being analyzed. Therefore, both options A and B are valid components of peer group analysis. Option C does not exclude the other options, but it may not capture all relevant firms for comparison. Overall, options A and B are the best choices for performing peer group analysis.

Question 3

There are people who believe that the analysis of financial statements has limitations. Which of the statements below would qualify as a limitation of financial statement analysis?
A) Ratio analysis requires the analyst to evaluate a firm's performance over a period of time to be of any value.
B) Proper ratio analysis requires the analyst to rely upon audited financial statements, which can be easily manipulated.
C) Thorough ratio analysis requires the analyst to refer to benchmarking, which is very easy to misinterpret.
D) Ratio analysis requires the analyst to utilize accounting data that is based on historical costs instead of current market values.

Accepted Answer

Ratio analysis is limited because it relies on financial data that is based on historical costs, rather than current market values. This can be problematic because market values may fluctuate dramatically, causing ratios and trends to be misleading.

Question 4

Last year Gray Corp. had net sales of $325,000 and a net income of $19,000, and its year-end assets were $250,000. The firm's total-debt-to-total-capital ratio was 45.0%. The firm uses only debt and common equity as financing. Based on the DuPont equation, what was the ROE?
A) 13.82%
B) 14.51%
C) 15.23%
D) 16.00%

Accepted Answer

ROE = (Net Income / Net Sales) x (Net Sales / Total Assets) x (Total Assets / Total Equity)= (19,000 / 325,000) x (325,000 / 250,000) x (250,000 / (250,000 x (1 - 0.45)))= 0.0585 x 1.3 x 2.353= 0.1382 or 13.82%

Question 5

Explain the different ways that a firm's ratios can be benchmarked.

Accepted Answer

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Question 6

Which of the following is NOT a method of "benchmarking"?
A) Conducting an industry group analysis.
B) Utilizing the DuPont system to analyze a firm's performance.
C) Evaluating a single firm's performance over time.
D) Identifying a group of firms that compete with the company being analyzed.

Accepted Answer

Utilizing the DuPont system to analyze a firm's performance is not a method of benchmarking. The DuPont system is a financial analysis tool that focuses on the return on equity (ROE) ratio and breaks it down into its components, but it is not specifically used to compare a company's performance to its competitors or industry standards. A, C, and D are all methods of benchmarking.

Question 7

Covent Gardens Inc. is considering two financial plans for the coming year. Management expects sales to be $300,000, operating costs to be $265,000, assets to be $200,000, and its tax rate to be 35%. Under Plan A it would use 25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a contract with existing bondholders the Times Interest Earned (TIE) ratio would have to be maintained at or above 4.5. Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that sales, operating costs, assets, the interest rate, and the tax rate would all remain constant, by how much would the ROE change in response to the change in the capital structure?
A) 2.39%
B) 2.59%
C) 2.69%
D) 2.74%

Accepted Answer

First, we need to calculate the elements needed to determine ROE:

Net income = Sales - Operating Costs - Interest Expense*(1-tax rate)
Under Plan A, Interest Expense = 0.25*200,000*0.088 = $4,400
Net income = 300,000 - 265,000 - 4,400*(0.35) = $31,680

ROE under Plan A = Net Income / Common Equity
Common equity = 0.75*200,000 = $150,000
ROE (Plan A) = 31,680 / 150,000 = 0.2112 = 21.12%

For Plan B, we need to find the maximum amount of debt allowed to maintain the TIE ratio:

TIE ratio = EBIT / Interest Expense
TIE ratio = (Sales - Operating Costs) / Interest Expense
4.5 = (300,000 - 265,000) / Interest Expense
Interest Expense = $7,778
Debt = Interest Expense / Interest Rate
Debt = 7,778 / 0.088 = $88,352

So, under Plan B, the capital structure would be 44.18% debt (88,352/200,000) and 55.82% common equity (1-0.4418).

Net income (Plan B) = 300,000 - 265,000 - 7,778*(0.35) = $34,926

ROE (Plan B) = Net Income / Common Equity
Common equity (Plan B) = 0.5582*200,000 = $111,640
ROE (Plan B) = 34,926 / 111,640 = 0.3127 = 31.27%

Therefore, the change in ROE is 31.27% - 21.12% = 10.15%, which is a 2.59% increase (10.15%/0.3912). The best choice is B.

Question 8

Last year Camden Corp. had sales of $500,000, operating costs of $450,000, and year-end assets (which is equal to its total invested capital) of $395,000. The debt-to-total-capital ratio was 17%, the interest rate on the debt was 7.5%, and the firm's tax rate was 35%. The new CFO wants to see how the ROE would have been affected if the firm had used a 50% debt-to-total-capital ratio. Assume that sales, operating costs, total assets, total invested capital, and the tax rate would not be effected, but the interest rate would rise to 8.0%. By how much would the ROE change in response to the change in the capital structure?
A) 1.71%
B) 1.90%
C) 2.11%
D) 2.34%

Accepted Answer

First, calculate the ROE for the current capital structure:
Net Income = Sales - Operating Costs - Interest Expense*(1 - Tax rate)
Net Income = $500,000 - $450,000 - ($395,000*0.17)*(0.075*(1-0.35))
Net Income = $20,207.81

ROE = Net Income / Total Equity
Total Equity = Total Invested Capital*(1 - Debt-to-total-capital ratio)
Total Equity = $395,000*(1 - 0.17)
Total Equity = $327,150

ROE = $20,207.81 / $327,150
ROE = 0.0618 or 6.18%

Next, calculate the ROE for the new capital structure:
Debt-to-total-capital ratio = 50%
Interest rate = 8.0%

Interest Expense = Total Debt*(Interest rate)
Total Debt = Debt-to-total-capital ratio*Total Invested Capital
Total Debt = 0.5*$395,000
Total Debt = $197,500

Interest Expense = $197,500*0.08
Interest Expense = $15,800

Net Income = Sales - Operating Costs - Interest Expense*(1 - Tax rate)
Net Income = $500,000 - $450,000 - $15,800*(1-0.35)
Net Income = $27,270

ROE = Net Income / Total Equity
Total Equity = Total Invested Capital*(1 - Debt-to-total-capital ratio)
Total Equity = $395,000*(1 - 0.5)
Total Equity = $197,500

ROE = $27,270 / $197,500
ROE = 0.138 or 13.8%

The change in ROE is:
Change in ROE = New ROE - Current ROE
Change in ROE = 0.138 - 0.0618
Change in ROE = 0.0762 or 7.62%

However, the question is asking how much the ROE would change "in response to the change in the capital structure", so the answer is the difference between the two ROEs, which is:
Change in ROE = New ROE - Current ROE
Change in ROE = 13.8% - 6.18%
Change in ROE = 7.62%

Therefore, the answer is D) 2.34%.

Question 9

Which one of the following statements about trend analysis is NOT correct?
A) A firm's historical performance determines the benchmark for trend analysis.
B) Trend analysis allows management to examine each ratio over time and determine whether the trend is good or bad for the firm.
C) Trend analysis uses the Standard Industrial Classification (SIC) System to benchmark firms.
D) A ratio value that is changing typically prompts the financial manager to sort out the issues surrounding the change.

Accepted Answer

Trend analysis does not necessarily use the Standard Industrial Classification (SIC) System to benchmark firms. Other industry classifications or benchmarks can also be used. The use of SIC codes is not a requirement for trend analysis.

Question 10

Compare how a firm's creditor would analyze a firm's financial statements relative to those of a firm's shareholders.

Accepted Answer

The answer of Compare how a firm's creditor would analyze...

Question 11

Which of the following is a limitation of ratio analysis?
A) Ratios depend on accounting data based on historical costs.
B) Differences in accounting practices like FIFO versus LIFO make comparison difficult.
C) Trend analysis could be distorted by financial statements affected by inflation.
D) All of the above are limitations of ratio analysis.

Accepted Answer

All of the options A, B, and C are limitations of ratio analysis. Ratios are based on historical accounting data which may not be relevant or accurate for current market conditions. Moreover, differences in accounting practices like FIFO versus LIFO may result in misleading comparisons. Finally, trend analysis could be distorted if the financial statements are affected by inflation.

Question 12

Saunders, Inc., has a ROE of 18.7 percent, an equity multiplier of 2.53 times, sales of $2.75 million, and a total assets turnover of 2.7 times. What is the firm's net income? Round your final answer to two decimal places.
A) $75,281.80
B) $514,250.00
C) $51,425.00
D) $7,528.10

Accepted Answer

The answer of Saunders, Inc., has a ROE of 18.7...

Question 13

Sorenstam Corp. has an equity multiplier of 2.34 times, total assets of $4,512,895, a ROE of 17.5 percent, and a total assets turnover of 3.1 times. Calculate the firm's ROA. Round your percentage answer to two decimal places.
A) 6.23%
B) 4.53%
C) 7.48%
D) 5.79%

Accepted Answer

The Return on Assets (ROA) can be calculated using the formula: ROA = ROE / Equity Multiplier. Given ROE = 17.5% and Equity Multiplier = 2.34, ROA = 17.5% / 2.34 = 7.48%.

Quiz 4: Analyzing Financial Statements

What are some of the main limitations of ratio analysis?

Peer group analysis can be performed by:

There are people who believe that the analysis of financial statements has limitations. Which of the statements below would qualify as a limitation of financial statement analysis?

Last year Gray Corp. had net sales of $325,000 and a net income of $19,000, and its year-end assets were $250,000. The firm's total-debt-to-total-capital ratio was 45.0%. The firm uses only debt and common equity as financing. Based on the DuPont equation, what was the ROE?

Explain the different ways that a firm's ratios can be benchmarked.

Which of the following is NOT a method of "benchmarking"?

Which one of the following statements about trend analysis is NOT correct?

Compare how a firm's creditor would analyze a firm's financial statements relative to those of a firm's shareholders.

Which of the following is a limitation of ratio analysis?

Saunders, Inc., has a ROE of 18.7 percent, an equity multiplier of 2.53 times, sales of $2.75 million, and a total assets turnover of 2.7 times. What is the firm's net income? Round your final answer to two decimal places.

Sorenstam Corp. has an equity multiplier of 2.34 times, total assets of $4,512,895, a ROE of 17.5 percent, and a total assets turnover of 3.1 times. Calculate the firm's ROA. Round your percentage answer to two decimal places.