FIN test 1

profitability ratios

- shows the combined effect of liquidity, asset management and debt management on firm's operating results - ratios that show the combined effect of liquidity, asset management, and debt management on the firm's overall operating results - closely monitored by investors - profit margin - basic earnings power ratio - return on assets (ROA) - return on equity (ROE)

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? In all cases, assume that other things are held constant. 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. The division's basic earning power ratio is above the average of other firms in its industry.

Which of the following statements is CORRECT? a. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. b. A firm's use of debt will have no effect on its profit margin. c. If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales and a lower return on assets. d. The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable. e. If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a higher operating margin and return on assets.

c. If two firms differ only in their use of debt--i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates--but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales and a lower return on assets.

Which of the following statements is CORRECT? a. In general, if investors regard a company as being relatively risky and/or having relatively poor growth prospects, then it will have relatively high P/E and M/B ratios. b. The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. c. The "apparent," but not necessarily the "true," financial position of a company whose sales are seasonal can change dramatically during a given year, depending on the time of year when the financial statements are constructed. d. The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of accounting book value. In general, investors regard companies with higher M/B ratios as being more risky and/or less likely to enjoy higher future growth. e. 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.

c. The "apparent," but not necessarily the "true," financial position of a company whose sales are seasonal can change dramatically during a given year, depending on the time of year when the financial statements are constructed.

Which of the following statements is CORRECT? a. If a firm has high current and quick ratios, this always indicate that the firm is managing its liquidity position well. b. If a firm sold some inventory for cash and left the funds in its bank account, its current ratio would probably not change much, but its quick ratio would decline. c. If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would decline. d. If a firm sold some inventory on credit as opposed to cash, there is no reason to think that either its current or quick ratio would change. e. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets

e. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to assess how effectively a firm is managing its current assets.

which following mechanisms would most likely help motivate managers to act in the best interest of shareholders.

increase the proportion of executive compensation that comes from stock options and reduce the proportion that is paid as cash salaries.