Ch 7- Analysis of Financial Statements

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.

False

The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm.

False

The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

False

The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio.

False

Companies A and C each reported the same earnings per share (EPS), but Company A's stock trades at a higher price. Which of the following statements is CORRECT? A. Company A trades at a higher P/E ratio. B. Company A probably has fewer growth opportunities. C. Company A is probably judged by investors to be riskier. D. Company A must have a higher market-to-book ratio. E. Company A must pay a lower dividend.

A

Companies Heidee and Leaudy have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? A. Heidee has a lower times interest earned (TIE) ratio than Leaudy. B. Heidee has a lower equity multiplier than Leaudy. C. Heidee has more net income than Leaudy. D. Heidee pays more in taxes than Leaudy. E. Heidee has a lower ROE than Leaudy.

A

Which of the following would indicate an improvement in a company's financial position, holding other things constant? A. The current and quick ratios both increase. B. The inventory and total assets turnover ratios both decline. C. The debt ratio increases. D. The profit margin declines. E. The EBITDA coverage ratio declines.

A

Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT? A. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE B. Given this information, Leaudy must have the higher ROE. C. Company Leaudy has a higher basic earning power ratio (BEP). D. Company Heidee has a higher basic earning power ratio (BEP). E. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE.

A. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE

Considered alone, what would increase a company's current ratio?

An increase in accounts receivable

Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? A. Heidee has more net income than Leaudy. B. Heidee pays less in taxes than Leaudy. C. Heidee has a lower equity multiplier than Leaudy. D. Heidee has a higher ROA than Leaudy. E. Heidee has a higher times interest earned (TIE) ratio than Leaudy.

B

If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely to cause the manager to receive a better grade? A. The division's DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30. B. The division's basic earning power ratio is above the average of other firms in its industry. C. The division's total assets turnover ratio is below the average for other firms in its industry. D. The division's debt ratio is above the average for other firms in the industry. E. The division's inventory turnover is 6, whereas the average for its competitors is 8.

B

Window Dressing

Borrowing on a long-term basis and using the proceeds to retire short-term debt and improve the current ratio

Cordelion Communications is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Cordelion pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue? A. The times interest earned ratio will decrease. B. The ROA will decline. C. Taxable income will decrease. D. The tax bill will increase. E. Net income will decrease.

D *The TIE will increase, not decrease. * is false because reducing debt will lower interest, raise income, and thus raise ROA. * is false for the above reason. *is true for the above reason. * is false.

Companies Heidee and Leaudy are virtually identical in that they are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company Heidee has the higher debt ratio. Which of the following statements is CORRECT? A. Heidee has lower operating income (EBIT) than Leaudy. B. Heidee has a lower total assets turnover ratio than Leaudy. C. Heidee has a lower equity multiplier than Leaudy. D. Heidee has a higher fixed assets turnover ratio than Leaudy. E. Heidee has a higher ROE than Leaudy.

E

Heidee Corp. and Leaudy Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, Heidee uses more debt than Leaudy. Which of the following statements is CORRECT? A. Heidee would have higher net income as shown on the income statement than Leaudy. B. Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income. C. Heidee would have a lower equity multiplier for use in the DuPont equation than Leaudy. D. Heidee would have to pay more in income taxes than Leaudy. E. Heidee would have lower net income as shown on the income statement than Leaudy.

E

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.

False

A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

False

A reduction in inventories held would have no effect on the current ratio.

False

A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

False

An increase in inventories would have no effect on the current ratio.

False

An increase in the DSO, other things held constant, could be expected to increase the ROE.

False

An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio.

False

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

False

If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease.

False

If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase.

False

If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength.

False

If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.

False

Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm.

False

Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.

False

Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects.

True

There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things.

False

The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects.

False * BEP = EBIT/Assets. This is before the effects of leverage (interest) and taxes, so the statement is false.

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.

False *EBIT = Sales revenues − Operating costs Net income = EBIT − Interest − Taxes = (EBIT − Interest) × (1 − T) ROA = Net income after taxes/Assets Two firms could have identical EBITs but very different amounts of interest, different tax rates, and different assets, and thus very different ROAs.

One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger.

False *The key here is to recognize that if the CR is less than 1.0, then a given reduction in both current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were greater than 1.0. In the question, the initial CR is less than 1.0, so using cash to reduce current liabilities would lower the CR. If the CR were greater than 1.0, the statement would have been true.

One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase.

False *if the CR is greater than 1.0, then a given increase in both current assets and current liabilities would lead to a decrease in the CR. The reverse would hold if the initial CR were less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a short-term basis to build the cash account would lower the CR.

A firm's new president wants to strengthen the company's financial position. What would make it financially stronger?

Increase EBIT while holding sales constant.

A firm wants to strengthen its financial position. What would increase its current ratio?

Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. What is the reason?

Its total assets turnover must be above the industry average.

A firm wants to strengthen its financial position. What would increase its quick ratio?

Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable.

Other things held constant, what would increase a company's cash flow for the current year?

Reduce the days' sales outstanding (DSO) without affecting sales or operating costs. * Lengthening depreciable lives would lower depreciation, increase taxable income and taxes, and thus lower cash flow * Paying down accounts payable would use cash and thus reduce cash flow. * Reducing the DSO would require collecting receivables faster, which would indeed increase cash flow. * Decreasing accruals would lower cash flow. * Reducing inventory turnover would mean increasing inventories, which would use cash.

Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant?

The EBITDA coverage ratio increases

The Cavendish Company recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. Which of the following effects would occur as a result of this action?

The company's current ratio increased.

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.

True

An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

True

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.

True

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.

True

If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same.

True

If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.

True

If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

True

Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.

True

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

True

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength.

True

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

True

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.

True

The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).

True

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.

True

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.

True

Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio.

True * TIE = EBIT/Interest = (Sales − Op cost)/(Debt × Interest rate). If we know the op. costs, the amount of debt, and the interest rate, then we can solve for the sales level required to achieve the target TIE.

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.

True *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.

Suppose Firms A and B have the same amount of assets, pay the same interest rate on their debt, have the same basic earning power (BEP), and have the same tax rate. However, Firm A has a higher debt ratio. If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio.

True *The easiest way to think about this is to realize that you can borrow at a cost of 10% and invest the proceeds to earn 11%, you'll earn a surplus. If you were previously earning an ROE of 10%, then after raising and investing additional funds, your income will be higher, your equity will be the same, and thus your ROE will increase. Similarly, if a firm earns more on assets than the interest rate, there will be a surplus after paying interest on the debt that will go to the equity, thus increasing the ROE. So, if BEP > rd, then the firm can increase its expected ROE by using more debt leverage. The answer can also be seen by working out an example. The one below shows that leverage increases ROE if BEP > rd, but it could be varied to show no difference in ROE if interest rates and BEP are the same, and a reduction in ROE if the interest rate exceeds the BEP.

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.

True *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.