Chapter 4 - Towson University - Search Page

					                                CHAPTER 4
                    ANALYSIS OF FINANCIAL STATEMENTS

1.   A firm wants to strengthen its financial position. Which of the following actions would increase its quick
     ratio?

     a. 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.
     b. Issue new common stock and use the proceeds to increase inventories.
     c. Speed up the collection of receivables and use the cash generated to increase inventories.
     d. Use some of its cash to purchase additional inventories.
     e. Issue new common stock and use the proceeds to acquire additional fixed assets.
     Answer: a

2.   Amram Company’s current ratio is 2.0. Considered alone, which of the following actions would lower the
     current ratio?

     a. Borrow using short-term notes payable and use the proceeds to reduce accruals.
     b. Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
     c. Use cash to reduce accruals.
     d. Use cash to reduce short-term notes payable.
     e. Use cash to reduce accounts payable.
     Answer: b
     A quick scan of the alternatives would indicate that b is obviously correct —it would lower the CR.
     Since there is only one correct answer, b must be the right answer. The following equation can also be
     used. If you add equal amounts to the numerator and denominator, then if Orig CR = or > 1.0, CR
     will decline, but if Orig CR < 1.0, CR will increase. Obviously, if you add to one but not the other,
     CR will increase or decrease in a predictable manner. This is the situation with choice b.

                                      CR = (Orig CA +/- ∆)/(Orig CL +/- ∆).

     a is false; it would leave the QR unchanged.
     b would obviously reduce the CR—CA remain constant and CL would increase.
     c is false, given that the initial CR > 1.0.
     d is false, given that the initial CR > 1.0.
     e is false, given that the initial CR > 1.0.
3.   Which of the following statements is CORRECT?

     a. If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the industry
        average, and was increasing and trending still higher, this would be interpreted as a sign of strength.
     b. A high average DSO indicates that none of its customers are paying on time. In addition, it makes no
        sense to evaluate the firm's DSO with the firm's credit terms.
     c. There is no relationship between the days’ sales outstanding (DSO) and the average collection period
        (ACP). These ratios measure entirely different things.
     d. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an
        increase in the quick ratio.
     e. If a firm increases its sales while holding its accounts receivable constant, then, other things held
        constant, its days’ sales outstanding will decline.
     Answer: e

4.   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.
     Answer: c
     a is false, because the TIE also depends on the interest rate and EBIT.
     b is false, because interest affects the profit margin.
     c is correct, because the more interest the lower the profits, hence the lower the profit margin and
     ROE.
     d is simply incorrect.
     e is incorrect. Operating margin would be identical because EBIT is in the numerator and return on
     assets would be lower.

5.   Which of the following statements is CORRECT?

     a.  If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be equal.
     b.  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.
     c. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same
         price/earnings ratio.
     d. If Firm X’s P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and/or be expected to
         grow at a faster rate.
     e. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then
         their market-to-book ratios must also be the same.
     Answer: b
     No reason for a to be true.
     b must be true, as EPS and P will be equal.
     No reason for c to be true.
     Wrong, because high risk and low growth lead to low P/Es.
     No reason for e to be true.
6.   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. Which of the following statements is CORRECT?

     a. Its total assets turnover must be above the industry average.
     b. Its return on assets must equal the industry average.
     c. Its TIE ratio must be below the industry average.
     d. Its total assets turnover must be below the industry average.
     e. Its total assets turnover must equal the industry average.
     Answer: a

     Thinking through the DuPont equation, we can see that if the firm's PM and equity multiplier are
     below the industry average, the only way its ROE can exceed the industry average is if its total assets
     turnover exceeds the industry average. The following data illustrate this point:

                   ROE =      PM        ×      TATO        ×    Eq. Mult.           ROA
     Firm           30%        9%               2.0               1.67              18%
     Industry       25%       10%                1                2.50              10%

     The above demonstrates that a is correct, and that makes d and e incorrect.
     Now consider the following:
     NI/Assets = NI/Sales     × Sales/Assets
     ROA =          PM        ×      TATO

7.   Taggart Technologies 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 Taggart 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 ROA will decline.
     b. Taxable income will decline.
     c. The tax bill will increase.
     d. Net income will decrease.
     e. The times-interest-earned ratio will decrease.
     Answer: c MEDIUM
     a is false because reducing debt will lower interest, raise net income, and thus raise ROA.
     b is false for the above reason.
     c is true for the above reason.
     d is false
     The TIE will increase because interest charges will be smaller due to less debt.

8.   Which of the following statements is CORRECT?

     a.   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.
     b. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE.
     c. An increase in the DSO, other things held constant, could be expected to increase the total assets
          turnover ratio.
     d. An increase in the DSO, other things held constant, could be expected to increase the ROE.
     e. An increase in a firm’s debt ratio, with no changes in its sales or operating costs, could be expected to
          lower its profit margin.
     Answer: e MEDIUM
     a. Sales fluctuations would have more effects on the DSO and S/Inventory ratios.
     b. ROE = ROA × Equity multiplier, so the more debt, the higher ROE for a given ROA.
     c. DSO = Receivables/Sales per day. With sales constant, an increase in DSO would mean an increase
     in receivables, hence a decline, not a rise, in the TATO (S/TA).
     d. An increase in the DSO might increase or decrease ROE, depending on how it affected sales and
     costs.
      e. More debt would mean more interest, hence a lower NI, given a constant EBIT. This would lower
      the profit margin = NI/Sales.

9.    Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic
      earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and,
      therefore, a higher interest expense. Which of the following statements is CORRECT?

      a. Company HD pays less in taxes.
      b. Company HD has a lower equity multiplier.
      c. Company HD has a higher ROA.
      d. Company HD has a higher times-interest-earned (TIE) ratio.
      e. Company HD has more net income.
      a MEDIUM
      Under the stated conditions, HD would have more interest charges, thus lower taxable income and
      taxes. Thus, a is correct. All of the other statements are incorrect.


10.   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.
      Answer: e

11.   Which of the following statements is CORRECT?

      a. Other things held constant, the more debt a firm uses, the higher its operating margin will be.
      b. 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.
      c. Other things held constant, the more debt a firm uses, the higher its profit margin will be.
      d. Other things held constant, the higher a firm's debt ratio, the higher its TIE ratio will be.
      e. Debt management ratios show the extent to which a firm's managers are attempting to reduce risk
         through the use of financial leverage. The higher the debt ratio, the lower the risk.
      Answer: b

12.   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.
      Answer: c

13.   Helmuth Inc's latest net income was $1,250,000, and it had 225,000 shares outstanding. The company
      wants to pay out 45% of its income. What dividend per share should it declare?

      a. $2.14
      b. $2.26
      c. $2.38
      d. $2.50
      e. $2.63
      Answer: d
      Net income                                                             $1,250,000
      Shares outstanding                                                        225,000
      Payout ratio                                                                 45%
      EPS = NI/shares outstanding =                                               $5.56
      DPS = EPS × Payout % =                                                      $2.50

14.   Faldo Corp sells on terms that allow customers 45 days to pay for merchandise. Its sales last year were
      $325,000, and its year-end receivables were $60,000. If its DSO is less than the 45-day credit period, then
      customers are paying on time. Otherwise, they are paying late. By how much are customers paying early
      or late? Base your answer on this equation: DSO - Credit Period = Days early or late, and use a 365-day
      year when calculating the DSO. A positive answer indicates late payments, while a negative answer
      indicates early payments.

      a. 21.27
      b. 22.38
      c. 23.50
      d. 24.68
      e. 25.91
      Answer: b
      Credit period                                                                  45
      Sales                                                                    $325,000
      Sales/day = Sales/365 =                                                   $890.41
      Receivables                                                               $60,000
      Company DSO = Receivables/Sales per day =                                   67.38
      Company DSO − Credit Period = Days early (−) or late (+) =                  22.38

15.   Wie Corp's sales last year were $315,000, and its year-end total assets were $355,000. The average firm in
      the industry has a total assets turnover ratio (TATO) of 2.4. The firm's new CFO believes the firm has
      excess assets that can be sold so as to bring the TATO down to the industry average without affecting sales.
      By how much must the assets be reduced to bring the TATO to the industry average, holding sales
      constant?

      a. $201,934
      b. $212,563
      c. $223,750
      d. $234,938
      e. $246,684
      Answer: c MEDIUM
      Sales                                                                    $315,000
      Actual total assets                                                      $355,000
      Target TATO = Sales/Total assets =                                           2.40
      Target assets = Sales/Target TATO =                                      $131,250
      Asset reduction = Actual assets − Target assets =                        $223,750

16.   A new firm is developing its business plan. It will require $615,000 of assets, and it projects $450,000 of
      sales and $355,000 of operating costs for the first year. Management is reasonably sure of these numbers
      because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires
      it to have a TIE of at least 4.0, and if the TIE falls below this level the bank will call in the loan and the
      firm will go bankrupt. What is the maximum debt ratio the firm can use? (Hint: Find the maximum dollars
      of interest, then the debt that produces that interest, and then the related debt ratio.)

      a. 41.94%
      b. 44.15%
      c. 46.47%
      d. 48.92%
      e. 51.49%
      Answer: e
      Assets                                                                   $615,000
      Sales                                                                    $450,000
      Operating costs                                                          $355,000
      Operating income (EBIT)                                                   $95,000
      Target TIE                                                                   4.00
      Maximum interest expense = EBIT/Target TIE                                $23,750
      Interest rate                                                              7.50%
      Max. debt = Max interest expense/Interest rate                           $316,667
      Maximum debt ratio = Debt/Assets                                          51.49%

17.   Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the
      last year were $595,000, and its net income was $25,000. Stockholders recently voted in a new
      management team that has promised to lower costs and get the return on equity up to 15.0%. What profit
      margin would the firm need in order to achieve the 15% ROE, holding everything else constant?

      a. 9.45%
      b. 9.93%
      c. 10.42%
      d. 10.94%
      e. 11.49%
      Answer: a
      Total assets = Equity because zero debt                                  $375,000
      Sales                                                                    $595,000
      Net income                                                                $25,000
      Target ROE                                                                15.00%
      Net income req'd to achieve target ROE = Target ROE × Equity =            $56,250
      Profit margin needed to achieve target ROE = NI/Sales = 9.45%

18.   Brookman Inc's latest EPS was $2.75, its book value per share was $22.75, it had 3 15,000 shares
      outstanding, and its debt ratio was 44%. How much debt was outstanding?

      a. $4,586,179
      b. $4,827,557
      c. $5,081,639
      d. $5,349,094
      e. $5,630,625
      Answer: e
      EPS                                                                         $2.75
      BVPS                                                                       $22.75
      Shares outstanding                                                        315,000
      Debt ratio                                                                 44.0%
      Total equity = Shares outstanding × BVPS =                              $7,166,250
      Total assets = Total equity/(1 − Debt ratio) =                         $12,796,875
      Total debt = Total assets − Equity =                                    $5,630,625

19.   Last year Harrington Inc. had 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-assets ratio was 45.0%. Based on the DuPont equation, what was
      the ROE?

      a. 13.82%
      b. 14.51%
      c. 15.23%
      d. 16.00%
      e. 16.80%
      Answer: a
      Sales                                                                     $325,000
      Assets                                                                    $250,000
      Net income                                                                 $19,000
      Debt ratio                                                                  45.0%
      Debt = Debt % × Assets =                                                  $112,500
      Equity = Assets − Debt =                                                  $137,500
      Profit margin = NI/Sales =                                                  5.85%
      TATO                                                                          1.30
      Equity multiplier = Assets/Equity =                                           1.82
      ROE                                                                        13.82%

20.   Last year Rennie Industries had sales of $305,000, assets of $175,000, a profit margin of 5.3%, and an
      equity multiplier of 1.2. The CFO believes that the company could reduce its assets by $51,000 without
      affecting either sales or costs. Had it reduced its assets by this amount, and had the debt ratio, sales, and
      costs remained constant, how much would the ROE have changed?

      a. 4.10%
      b. 4.56%
      c. 5.01%
      d. 5.52%
      e. 6.07%
      Answer: b
                                                                                     Old                         New
      Sales                                                                     $305,000                     $305,000
      Original assets                                                           $175,000
      Reduction in assets                                                                                     $51,000
      New assets = Old assets − Reduction =                                                                  $124,000
      TATO = Sales/Assets =                                                          1.74                        2.46
      Profit margin                                                                5.30%                       5.30%
      Equity multiplier                                                              1.20                        1.20
      ROE = PM × TATO × Eq. multiplier =                                          11.08%                      15.64%
      Change in ROE                                                                                            4.56%

21.   Last year Jandik Corp. had $295,000 of assets, $18,750 of net income, and a debt-to-total-assets ratio of
      37%. Now suppose the new CFO convinces the president to increase the debt ratio to 48%. Sales and total
      assets will not be affected, but interest expenses would increase. However, the CFO believes that better
      cost controls would be sufficient to offset the higher interest expense and thus keep net income unchanged.
      By how much would the change in the capital structure improve the ROE?

      a.   2.13%
      b.   2.35%
         c. 2.58%
         d. 2.84%
         e. 3.12%
         Answer: a
         Assets                                                                    $295,000
         Old debt ratio                                                                37%
         Old debt = Assets × Old debt % =                                          $109,150
         Old equity                                                                $185,850
         New debt ratio                                                                48%
         New debt = Assets × New debt % =                                          $141,600
         New Equity = Assets − New debt =                                          $153,400
         Net income                                                                 $18,750
         New ROE = New income/New Equity                                            12.22%
         Old ROE = Old income/Old Equity                                            10.09%
         Increase in ROE                                                             2.13%


22.      Last year Kruse Corp had $305,000 of assets, $403,000 of sales, $28,250 of net income, and a debt-to-total-
         assets ratio of 39%. The new CFO believes the firm has excessive fixed assets and inventory that could be
         sold, enabling it to reduce its total assets to $252,500. Sales, costs, and net income would not be affected,
         and the firm would maintain the same debt ratio (but with less total debt). By how much would the
         reduction in assets improve the ROE?

         a. 2.85%
         b. 3.00%
         c. 3.16%
         d. 3.31%
         e. 3.48%
         Answer: c MEDIUM
                                                                                    Original                       New
         Assets                                                                    $305,000                    $252,500
         Sales                                                                     $403,000                    $403,000
         Net income                                                                 $28,250                     $28,250
         Debt ratio                                                                 39.00%                      39.00%
         Debt = Assets × debt % =                                                  $118,950                     $98,475
         Equity = Assets − Debt =                                                  $186,050                    $154,025
         ROE = NI/Equity =                                                         15.184%                     18.341%
         Increase in ROE                                                                                         3.16%

(The following information applies to Problems 23 through 25.)
The balance sheet and income statement shown below are for Koski Inc. Note that the firm has no amortization
charges, it does not lease any assets, none of its debt must be retired during the next 5 years, and the notes payable
will be rolled over.

Balance Sheet (Millions of $)
Assets      2007
Cash and securities                                                                  $ 2,500
Accounts receivable                                                                   11,500
Inventories                                                                           16,000
Total current assets                                                                $30,000
Net plant and equipment                                                             $20,000
Total assets                                                                        $50,000
Liabilities and Equity
Accounts payable                                                                     $ 9,500
Notes payable                                                                          7,000
Accruals 5,500
Total current liabilities                                                        $22,000
Long-term bonds                                                                  $15,000
Total debt                                                                       $37,000
Common stock                                                                      $ 2,000
Retained earnings                                                                  11,000
Total common equity                                                              $13,000
Total liabilities and equity                                                     $50,000

Income Statement (Millions of $)                                                     2007
Net sales                                                                        $87,500
Operating costs except depreciation                                                81,813
Depreciation                                                                        1,531
Earnings bef interest and taxes (EBIT)                                            $ 4,156
Less interest                                                                       1,375
Earnings before taxes (EBT)                                                       $ 2,781
Taxes                                                                                 973
Net income                                                                        $ 1,808

Other data:
Shares outstanding (millions)                                                     500.00
Common dividends                                                                 $632.73
Int rate on notes payable & L-T bonds                                             6.25%
Federal plus state income tax rate                                                  35%
Year-end stock price                                                              $43.39

23.      What is the firm's days sales outstanding? Assume a 365-day year for this calculation.

         a. 39.07
         b. 41.13
         c. 43.29
         d. 45.57
         e. 47.97
         Answer: e
         DSO = Accounts receivable/(Sales/365) = 47.97


24.      What is the firm's book value per share?

         a. $22.29
         b. $23.47
         c. $24.70
         d. $26.00
         e. $27.30
         Answer: d MEDIUM
         BVPS = Common equity/Shares outstanding = $26.00


25.      What is the firm's equity multiplier?

         a. 3.85
         b. 4.04
         c. 4.24
         d. 4.45
         e. 4.68
         Answer: a
         Equity multiplier = Total assets/Common equity = 3.85

				
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