Chapter 3 - Working with Financial Statements

M.C. - A firm has total debt of $4,850 and a debt-equity ratio of .57. What is the value of the total assets?

$13,358.77 Total equity = $4,850 / .57 = $8,508.77 Total assets = $4,850 + 8,508.77 = $13,358.77

Inventory Turnover

Asset Management Ratios = COGS / Inventory

T/F - A banker or trade creditor is most concerned about a firm's profitability ratios.

False

Times Interest Earned

Long-term Solvency Ratio = EBIT/Interest

Profit Margin

Profitability Ratios =Net Income/Sales *how much profit a company makes on each sales dollar received

T/F - A healthy current ratio and an unhealthy quick ratio may be caused by excess inventory.

True

T/F - Liquidity ratios indicate how fast a firm can generate cash to pay bills.

True

M.C. - Which one of these identifies the relationship between the return on assets and the return on equity? a. Profit Margin b. Profitability Determinant c. Balance Sheet Multiplier d. DuPont Identity e. Debt-Equity Ratio

d. DuPont Identity

Market to Book Ratio

Market Value Measures =Market Value per share/Book Value per share *an indicator of how the company value the company

Price Equity Ratio

Market Value Measures =Price per Share/Earnings per Share *a proxy for investors' assessment of a company's ability to generate cash flows in the future

Ratio Analysis

financial ratios allow for better comparison through time or between companies

DuPoint Identity

popular expression breaking ROE into three parts: operating efficiency, asset use efficiency, and financial leverage = PM * TA Turnover * Equity Multiplier

Profitability Ratios

ratios that measure the rate of return a firm is earning on various measures of investment

M.C. - A firm has a debt-equity ratio of .57. What is the total debt ratio?

.36 The debt-equity ratio is .57. If total debt is $57 and total equity is $100, then total assets are $157. Total debt ratio = $57 / $157 = .36.

M.C. - Duke's Garage has cash of $68, accounts receivable of $142, accounts payable of $235, and inventory of $318. What is the value of the quick ratio?

.89 Quick ratio = ($68 + 142) / $235 = .89

M.C. - The DuPont identity can be used to help managers answer which of the following questions related to a firm's operations? I. How many sales dollars has the firm generated per each dollar of assets? II. How many dollars of assets has a firm acquired per each dollar in shareholders' equity? III. How much net profit is a firm generating per dollar of sales? IV. Does the firm have the ability to meet its debt obligations in a timely manner?

1, 2, 3

M.C. - TJ's has annual sales of $813,200, total debt of $176,000, total equity of $395,000, and a profit margin of 5.63 percent. What is the return on assets?

8.02% Return on assets = (.0563 × $813,200) / ($176,000 + 395,000) = .0802, or 8.02 percent

Total Asset Turnover

Asset Management Ratios =Sales/Total Assets *the effectiveness of the company's asset base in producing sales

Equity Multipler

Long-term Solvency Ratio = Total Assets/Total Equity OR Total Debt/Total Equity +1 *the reliance on debt for financing assets

Total Debt Ratio

Long-term Solvency Ratio = Total Debt/Total Assets *the proportion of debt a company is carrying relative to its assets

Equity Debt Ratio

Long-term Solvency Ratio = Total Debt/Total Equity *the relative uses of debt and equity as sources of capital to finance a company's assets

Return on Assets

Profitability Ratios =Net Income/Total Assets *how effectively a company's assets are being used to generate profits

Return on Equity

Profitability Ratios =Net Income/Total Equity *the ability of a company's management to realize an adequate return on equity capital

M.C. - The most acceptable method of evaluating the financial statements of a firm is to compare the firm's current: a. Financial ratios to the firm's historical ratios. b. Financial statements to the financial statements of similar firms operating in other countries. c. Financial ratios to the average ratios of all firms located within the same geographic area. d. Financial statements to those of larger firms in unrelated industries. e. Financial statements to the projections that were created based on Tobin's Q.

a. Financial ratios to the firm's historical ratios.

M.C. - The price-sales ratio is especially useful when analyzing firms that have which one of the following? a. Volatile market prices b. Negative earnings c. Positive PEG ratios d. A negative Tobin's Q e. Increasing sales

b. Negative earnings

M.C. - Lenders probably have the most interest in which one of the following sets of ratios? a. return on assets and profit margin b. long-term debt and times interest earned c. price-earnings and debt-equity d. market-to-book and times interest earned e. return on equity and price-earnings

b. long-term debt and times interest earned

M.C. - An increase in current liabilities will have which one of the following effects, all else held constant? Assume all ratios have positive values. a. Increase in the cash ratio b. Increase in the net working capital to total assets ratio c. Decrease in the quick ratio d. Decrease in the cash coverage ratio e. Increase in the current ratio

c. Decrease in the quick ratio

M.C. - Which one of the following accurately describes the three parts of the DuPont identity? a. operating efficiency, equity multiplier, and profitability ratio b. Financial leverage, operating efficiency, and profitability ratio. c. Equity multiplier, profit margin, and total asset turnover. d. Debt-equity ratio, capital intensity ratio, and profit margin. e. Return on assets, profit margin, and equity multiplier.

c. Equity multiplier, profit margin, and total asset turnover.

M.C. - Which one of the following statements is correct? a. Book values should always be given precedence over market values. b. Financial statements are rarely used as the basis for performance evaluations. c. Historical information is useful when projecting a firm's future performance. d. Potential lenders place little value on financial statement information. e. Reviewing financial information over time has very limited value.

c. Historical information is useful when projecting a firm's future performance.

M.C. - Ratios that measure a firm's liquidity are known as _____ ratios. a. Asset Management b. Long-term Solvency c. Short-term Solvency d. Profitability e. Book Value

c. Short-term solvency

M.C. - The U.S. government coding system that classifies a firm by the nature of its business operations is known as the: a. Centralized Business Index b. Peer Grouping Codes c. Standardized Industrial Classification Codes d. Governmental ID codes e. Government Engineered Coding System

c. Standardized Industrial Classification Codes

M.C. - The cash coverage ratio directly measures the ability of a firm to meet which one of its following obligations? a. payment to supplier b. payment to employee c. payment of interest to a lender d. payment of principle to a lender e. payment of a dividend to a shareholder

c. payment of interest to a lender

M.C. - On a common-size balance sheet all accounts for the current year are expressed as a percentage of: a. Sales for the period b. The base year sales c. Total equity for the base year d. Total assets for the current year e. Total assets for the base year

d. Total assets for the current year

M.C. - Which one of the following statements is correct? a. If the total debt ratio is greater than .50, then the debt-equity ratio must be less than 1.0. b. Long-term creditors would prefer the times interest earned ratio be 1.4 rather than 1.5. c. The debt-equity ratio can be computed as 1 plus the equity multiplier. d. An equity multiplier of 1.2 means a firm has $1.20 in sales for every $1 in equity. e. An increase in the depreciation expense will not affect the cash coverage ratio.

e. An increase in the depreciation expense will not affect the cash coverage ratio.

M.C. - If a firm produces a 13 percent return on assets and also a 13 percent return on equity, then the firm: a. May have short-term, but not long term b. is using its assets as efficiently as possible c. has no net working capital d. has a debt equity ratio of 1.0 e. has an equity multiplier of 1.0

e. has an equity multiplier of 1.0

Short-Term Solvency Ratio - definition

financial ratio for measuring a company's ability to pay immediate debts

Long-Term Solvency Ratio - definition

financial ratio for measuring the ability to pay off long term debt

Asset Management (Turnover) Ratios - definition

financial ratios that measure how effectively a firm is using its assets to generate revenues or cash

T/F - Ratios are used to compare different firms in the same industry.

True

T/F - Return on assets and return on equity are both profitability ratios.

True

T/F - Return on equity will be higher than return on assets if there is debt in the capital structure.

True

T/F - The asset turnover ratio and inventory turnover ratio are both efficiency ratios.

True

M.C. - A firm has net working capital of $2,715, net fixed assets of $22,407, sales of $31,350, and current liabilities of $3,908. How many dollars worth of sales are generated from every $1 in total assets?

$1.08 Total asset turnover = $31,350 / ($2,715 + 22,407 + 3,908) = 1.08 Every $1 in total assets generates $1.08 in sales.

Categories of Financial Ratios

1. Short-term Solvency (Liquidity) Ratios 2. Long-term Solvency (Leverage) Ratios 3. Asset Management (Turnover) Ratios 4. Profitability Ratios 5. Market Value Ratios

M.C. - Bernice's has $823,000 in sales. The profit margin is 3.9 percent and the firm has 7,500 shares of stock outstanding. The market price per share is $15. What is the price-earnings ratio?

3.51 Price-earnings ratio = $15 / [(.039 × $823,000) / 7,500] = 3.51

M.C. - Ratios that measure how efficiently a firm manages its assets and operations to generate net income are referred to as _____ ratios. a. Asset Management b. Long-term Solvency c. Short-term Solvency d. Profitability e. Book Value

d. Profitability

Market Value Measures

measures which examine how profitable the shares are using accounting and market values

Days' Sales in Inventory

Asset Management Ratios = 365 days/Inventory Turnover *how quickly a company uses inventory to generate sales

Days' Sales in Receivables

Asset Management Ratios =365 days/Receivables Turnover *how successful a company is in collecting its outstanding receivables

Receivables Turnover

Asset Management Ratios =Sales/Accounts Receivable

T/F - If two companies have the same ROE, they will also have the same ROA.

False

T/F - Investors are most concerned with the liquidity ratios of a company.

False

T/F - Satisfactory return on assets may be achieved through high profit margins or rapid turnover of assets, but not a combination of both.

False

T/F - The current ratio is a more severe test of a firm's liquidity than the quick ratio.

False

T/F - The higher the times interest earned ratio, the higher the interest expense.

False

T/F - Times interest earned is an example of a profitability ratio.

False

Cash Coverage

Long-term Solvency Ratio =(EBIT + Depreciation)/Interest *the ability of a company to meet interest payments

Quick Ratio

Short-term Solvency Ratio = Current Assets - Inventory/Current Liabilities

Current Ratio

Short-term Solvency Ratio = Current Assets/Current Liabilities

M.C. - A firm currently has $600 in debt for every $1,000 in equity. Assume the firm uses some of its cash to decrease its debt while maintaining its current equity and net income. Which one of the following will decrease as a result of this action? a. Equity multiplier b. Total asset turnover c. Profit margin d. Return on assets e. Return on equity

a. Equity multiplier

M.C. - Relationships determined from a firm's financial information and used for comparison purposes are known as: a. Financial Ratios b. Identities c. Dimensional Analysis d. Scenario Analysis e. Solvency Analysis

a. Financial Ratios

M.C. - If a firm has a debt-equity ratio of 1.0, then its total debt ratio must be which one of the following? a. 0 b. .5 c. 1.0 d. 1.5 e. 2.0

b. .5

M.C. - A supplier, who requires payment within 10 days, should be most concerned with which one of the following ratios when granting credit? a. Current b. Cash c. Debt-Equity d. Quick e. Total Debt

b. Cash

M.C. - The Corner Hardware has succeeded in increasing the amount of goods it sells while holding the amount of inventory on hand at a constant level. Assume that both the cost per unit and the selling price per unit also remained constant. This accomplishment will be reflected in the firm's financial ratios in which one of the following ways? a. decrease in the inventory turnover rate b. decrease in the NWC rate c. increase in the fixed asset turnover rate d. decrease in the days' sales in inventory e. decrease in the total asset turnover rate

d. decrease in the days' sales in inventory

M.C. - A common-size income statement is an accounting statement that expresses all of a firm's expenses as a percentage of: a. Total Assets b. Total Equity c. Net Income d. Taxable Income e. Sales

e. Sales

M.C. - Use the below information to answer the following question. Income Statement For the Year Net sales $631,000 COGS 442,220 Depreciation 28,100 EBIT $160,700 Interest 14,900 Taxable income $145,800 Taxes 49,600 Net income $96,200 Balance Sheet Beginning of Year End of Year Cash $ 38,200 $43,700 Accounts receivable 91,400 86,150 Inventory 203,900 214,600 Net fixed assets 516,100 537,950 Total assets $849,600 $882,400 Accounts payable $136,100 $104,300 Long-term debt 329,500 298,200 Common stock ($1 par value) 75,000 82,000 Retained earnings 309,000 397,900 Total Liab. & Equity $849,600 $882,400 What is the equity multiplier at year-end?

1.84 Equity multiplier at year-end = $882,400 / ($82,000 + 397,900) = 1.84

M.C. - Coulter Supply has a total debt ratio of .46. What is the equity multiplier?

1.85 Debt-equity ratio = .46 / (1 − .46) = .85 Equity multiplier = 1 + .85 = 1.85

M.C. - Taylor's Men's Wear has a debt-equity ratio of 56 percent, sales of $829,000, net income of $38,300, and total debt of $206,300. What is the return on equity?

10.40% Return on equity = $38,300 / ($206,300 / .56) = .1040, or 10.40 percent

M.C. - Use the below information to answer the following question. Income Statement For the Year Net sales $631,000 COGS 442,220 Depreciation 28,100 EBIT $160,700 Interest 14,900 Taxable income $145,800 Taxes 49,600 Net income $96,200 Balance Sheet Beginning of Year End of Year Cash $ 38,200 $43,700 Accounts receivable 91,400 86,150 Inventory 203,900 214,600 Net fixed assets 516,100 537,950 Total assets $849,600 $882,400 Accounts payable $136,100 $104,300 Long-term debt 329,500 298,200 Common stock ($1 par value) 75,000 82,000 Retained earnings 309,000 397,900 Total Liab. & Equity $849,600 $882,400 What is the times interest earned ratio for the year?

10.79 Times interest earned = $160,700 / $14,900 = 10.79

M.C.- The Up-Towner has sales of $913,400, costs of goods sold of $579,300, inventory of $187,400, and accounts receivable of $78,900. How many days, on average, does it take the firm to sell its inventory assuming that all sales are on credit?

118.08 days Days in inventory = 365 / ($579,300 / $187,400) = 118.08 days

M.C. - A firm has sales of $3,340, net income of $274, net fixed assets of $2,600, and current assets of $920. The firm has $430 in inventory. What is the common-size statement value of inventory?

12.22% Common-size inventory = $430 / ($2,600 + 920) = .1222, or 12.22 percent

M.C. - A firm has sales of $96,400, costs of $53,800, interest paid of $2,800, and depreciation of $7,100. The tax rate is 34 percent. What is the value of the cash coverage ratio?

15.21 Cash coverage ratio = ($96,400 − 53,800) / $2,800 = 15.21

M.C. - Reliable Cars has sales of $807,200, total assets of $1,105,100, and a profit margin of 9.68 percent. The firm has a total debt ratio of 64 percent. What is the return on equity?

19.64% Return on equity = (.0968 × $807,200) / [$1,105,100 × (1 − .64)] = .1964, or 19.64 percent

M.C. - Which of the following can be used to compute the return on equity? I. Profit margin × Return on assets II. Return on assets × Equity multiplier III. Profit margin × Total asset turnover × Debt-equity ratio IV. Net income / Total assets

2 only

M.C. - A firm has 160,000 shares of stock outstanding, sales of $1.94 million, net income of $126,400, a price-earnings ratio of 21.3, and a book value per share of $7.92. What is the market-to-book ratio?

2.12 Earnings per share = $126,400 / 160,000 = $.79 Price per share = $.79 × 21.3 = $16.827 Market-to-book ratio = $16.827 / $7.92 = 2.12

M.C. - A firm has a debt-total asset ratio of 58 percent and a return on total assets of 13 percent. What is the return on equity?

30.95% (Total assets - Total equity) / Total assets = .58 Total equity = .42 Total assets Net income = .13 Total assets Return on equity = .13 Total assets / .42 Total assets = .3095, or 30.95percent

M.C. - Corner Supply has a current accounts receivable balance of $246,000. Credit sales for the year just ended were $2,430,000. How many days on average did it take for credit customers to pay off their accounts during this past year?

36.95 days Days' sales in receivables = 365 / ($2,430,000 / $246,000) = 36.95 days

T/F - To compute the quick ratio, accounts receivable are not included in current assets.

False