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Chapter 3

Evaluating Financial Performance

True/False

1. When the present financial ratios of a firm are compared with similar ratios for another firm in the same industry it is called trend analysis.

Difficulty: Easy

Keywords: trend analysis

1. Firms that engage in multiple lines of business make it difficult to assign them to an industry category for ratio analysis.

Difficulty: Easy

Keywords: limitations of ratio analysis

1. The focus of DuPont analysis is to provide management information as to how the firm is using its resources to maximize returns on owners’ investments.

Difficulty: Easy

Keywords: DuPont analysis

1. The current ratio and the acid test ratio are both measures of financial leverage.

Difficulty: Easy

Keywords: current ratio, acid test ratio, leverage ratios

1. Ratios that examine profit relative to investment are useful in evaluating the overall effectiveness of the firm's management.

Difficulty: Moderate

Keywords: ratio analysis

1. Financial ratios that are higher than industry averages may indicate problems which are as detrimental to the firm as ratios that are too low.

Difficulty: Moderate

Keywords: industry averages

1. According to the DuPont Analysis, an increase in net profit margin will decrease return on assets.

Difficulty: Moderate

Keywords: DuPont Analysis

1. A serious pitfall in the interpretation of financial ratios arises when a company, whose business is seasonal, ends its accounting year on March 31, while most companies in the same industry end their accounting period on December 31.

Difficulty: Moderate

Keywords: limitations of ratio analysis

1. Financial ratios comprise the principal tool of financial analysis since they can be used to answer a variety of questions regarding a firm's financial condition.

Difficulty: Easy

Keywords: ratio analysis

1. Financial ratios can highlight a firm’s financial performance with regard to liquidity, solvency, and profitability.

Difficulty: Easy

Keywords: ratio analysis

1. Ratios are used to standardize financial information.

Difficulty: Easy

Keywords: ratio analysis and standardization

1. There is no such thing as a liquidity ratio being too high.

Difficulty: Moderate

Keywords: liquidity ratio

1. The lower the average collection period ratio, the more efficient is the firm in managing its investment in accounts receivable.

Difficulty: Moderate

Keywords: average collection period

1. One weakness of the times-interest-earned ratio is that it includes only the annual interest expense as a finance expense that must be paid.

Difficulty: Moderate

Keywords: times-interest-earned ratio

1. Differences in accounting practices limit the use of ratio analysis.

Difficulty: Easy

Keywords: limitations of ratio analysis, accounting practices

Multiple Choice

1. Which of the following is not a reason why financial analysts use ratio analysis?

a. Ratios help to pinpoint a firm's strengths.

b. Ratios restate accounting data in relative terms.

c. Ratios are ideal for smoothing out the differences that may exist when comparing firms that use different accounting practices.

d. Some of a firm’s weaknesses can be identified through the usage of ratios.

Difficulty: Moderate

Keywords: disadvantages of ratio analysis

1. The debt ratio is a measure of a firm’s:
2. leverage.
3. profitability.
4. liquidity.
5. efficiency.

Difficulty: Easy

Keywords: debt ratio, leverage

1. If you were given the components of current assets and of current liabilities, what ratio(s) could you compute?
2. Quick ratio
3. Average collection period
4. Current ratio
5. Both a and c
6. All of the above

Difficulty: Moderate

Keywords: current ratio, quick ratio

1. Which of the following statements is true?
2. Current assets consist of cash, accounts receivable, inventory, and net plant, property, and equipment.
3. The quick ratio is a more restrictive measure of a firm’s liquidity than the current ratio.
4. For the average firm, inventory is considered to be more "liquid" than accounts receivable.
5. A successful firm’s current liabilities should always be greater than its current assets.

Difficulty: Moderate

Keywords: quick ratio

1. Which of the following transactions does not affect the quick ratio?
2. Land held for investment is sold for cash.
3. Equipment is purchased and is financed by a long-term debt issue.
4. Inventories are sold for cash.
5. Inventories are sold on a credit basis.

Difficulty: Moderate

Keywords: quick ratio

1. Given an accounts receivable turnover of 8 and annual credit sales of $362,000, the average collection period (360-day year) is:

a. 90 days.

b. 45 days.

c. 75 days.

d. 60 days.

Difficulty: Moderate

Keywords: average collection period

1. The question "Did the common stockholders receive an adequate return on their investment?" is answered through the use of:

a. liquidity ratios.

b. profitability ratios.

c. coverage ratios.

d. leverage ratios.

Difficulty: Easy

Keywords: profitability ratios

Table 1

Smith Company Balance Sheet

Assets:

Cash and marketable securities $300,000

Accounts receivable 2,215,000

Inventories 1,837,500

Prepaid expenses 24,000

Total current assets $3,286,500

Fixed assets 2,700,000

Less: accumulated depreciation 1,087,500

Net fixed assets $1,612,500

Total assets $4,899,000

Liabilities:

Accounts payable $240,000

Notes payable 825,000

Accrued taxes 42,500

Total current liabilities $1,107,000

Long-term debt 975,000

Owner’s equity 2,817,000

Total liabilities and owner’s equity $4,899,000

Net sales (all credit) $6,375,000

Less: Cost of goods sold 4,312,500

Selling and administrative expense 1,387,500

Depreciation expense 135,000

Interest expense 127,000

Earnings before taxes $412,500

Income taxes 225,000

Net income $187,500

Common stock dividends $97,500

Change in retained earnings $90,000

1. Based on the information in Table 1, the current ratio is:

a. 2.97.

b. 1.46.

c. 2.11.

d. 2.23.

Difficulty: Moderate

Keywords: current ratio

1. Based on the information in Table 1, and using a 360-day year, the average collection period is:

a. 71 days.

b. 84 days.

c. 64 days.

d. 125 days.

Difficulty: Moderate

Keywords: average collection period

1. Based on the information in Table 1, the debt ratio is:

a. 0.70.

b. 0.20.

c. 0.74.

d. 0.42.

Difficulty: Moderate

Keywords: debt ratio

1. Based on the information in Table 1, the net profit margin is:

a. 4.61%.

b. 2.94%.

c. 1.97%.

d. 5.33%.

Difficulty: Moderate

Keywords: net profit margin

1. Based on the information in Table 1, the inventory turnover ratio is:

a. 0.29 times.

b. 2.35 times.

c. 0.43 times.

d. 3.47 times.

Difficulty: Moderate

Keywords: inventory turnover ratio

1. Marshall Networks, Inc. has a total asset turnover of 2.5 and a net profit margin of 3.5%. The firm has a return on equity of 17.5%. Calculate Marshall’s debt ratio.

a. 30%

b. 40%

c. 50%

d. 60%

Difficulty: Moderate

Keywords: DuPont Analysis, debt ratio

1. The accounting rate of return on stockholders’ investments is measured by:
2. return on assets.
3. return on equity.
4. operating income return on investment.
5. realized rate of inflation.

Difficulty: Easy

Keywords: DuPont Analysis, return on equity

1. A firm’s average collection period has decreased significantly from the previous year. Which of the following could possibly explain the results?
2. Customers are paying off their accounts quicker.
3. Customers are taking longer to pay for purchases.
4. The firm has a strict collection policy.
5. Both a and c.

Difficulty: Moderate

Keywords: average collection period

1. An increase in _________ will increase common equity.
2. paid in capital
3. retained earnings
4. dividends paid
5. both a and c
6. all of the above

Difficulty: Moderate

Keywords: common equity

1. Another name for the acid test ratio is the:
2. current ratio.
3. quick ratio.
4. inventory turnover ratio.
5. average collection period.

Difficulty: Easy

Keywords: quick ratio, acid test ratio

1. Which of the following financial ratios is the best measure of the operating effectiveness of a firm’s management?

a. Current ratio

b. Gross profit margin

c. Quick ratio

d. Return on investment

Difficulty: Moderate

Keywords: return on investment

1. Which of the following is included in the denominator of the times-interest-earned ratio?

a. Lease payments

b. Principal payments

c. Interest expense

d. Gross profit

Difficulty: Easy

Keywords: times-interest-earned ratio

1. Which of the following industries has the highest average inventory turnover ratio?

a. Retail clothing stores

b. Jewelry stores

c. Automobile dealerships

d. Supermarkets

Difficulty: Moderate

Keywords: industry trends

1. The quick ratio is a better measure of liquidity than the current ratio if the firm has current assets composed primarily of:

a. cash.

b. work in process inventory.

c. marketable securities.

d. accruals.

Difficulty: Easy

Keywords: quick ratio versus current ratio

1. If a company’s average collection period is higher than the industry average, then the company might be:

a. enforcing credit conditions upon its customers which are too stringent.

b. allowing its customers too much time to pay their bills.

c. too tough in collecting its accounts.

d. too liquid.

Difficulty: Moderate

Keywords: average collection period

1. Why is the quick ratio a more refined measure of liquidity than the current ratio?

a. It measures how quickly cash and other liquid assets flow through the company.

b. Inventories are omitted from the numerator of the ratio because they are generally the least liquid of the firm’s current assets.

c. It is a quicker calculation to make.

d. Cash is the most liquid current asset.

Difficulty: Moderate

Keywords: quick ratio versus current ratio

1. Smith Corporation has current assets of $11,400, inventories of $4,000, and a current ratio of 2.6. What is Smith’s acid test ratio?

a. 1.69

b. 0.54

c. 0.74

d. 1.35

Difficulty: Moderate

Keywords: acid test ratio, quick ratio

1. Kingsbury Associates has current assets as follows:

Cash $3,000

Accounts receivable $4,500

Inventories $8,000

If Kingsbury has a current ratio of 3.2, what is its quick ratio?

a. 2.07

b. 1.55

c. 0.48

d. 0.96

Difficulty: Moderate

Keywords: quick ratio

1. Water Works, Inc. has a current ratio of 1.33, current liabilities of $540,000, and inventory of $400,000. What is Water Works, Inc.’s quick ratio?

a. 1.11

b. 0.86

c. 1.90

d. 0.59

Difficulty: Moderate

Keywords: quick ratio

1. Which of the following ratios indicates how rapidly the firm’s credit accounts are being collected?

a. Debt ratio

b. Gross profit margin

c. Accounts receivable turnover ratio

d. Fixed asset turnover

Difficulty: Easy

Keywords: accounts receivable turnover ratio

1. Smart and Smiley Incorporated has an average collection period of 74 days. What is the accounts receivable turnover ratio for Smart and Smiley? You may use a 360-day year.

a. 4.86

b. 2.47

c. 2.66

d. 1.68

Difficulty: Moderate

Keywords: accounts receivable turnover ratio

1. Billing’s Pit Corporation has an accounts receivable turnover ratio of 3.4. What is Billing’s Pit Corporation’s average collection period?

a. 106 days

b. 102 days

c. 73 days

d. 55 days

Difficulty: Moderate

Keywords: average collection period

1. Which of the following statements is true?

a. As a general rule, management would want to reduce the firm’s average collection period.

b. As a general rule, management would want to reduce the firm’s accounts receivable turnover ratio.

c. As a general rule, management would want to increase the firm’s average collection period.

d. As a general rule, a firm is not financially affected by the amount of time required to collect its accounts receivable.

Difficulty: Moderate

Keywords: average collection period

1. Millers Metalworks, Inc. has a total asset turnover of 2.5 and a net profit margin of 3.5%. The total debt ratio for the firm is 50%. Calculate Millers’s return on equity.

a. 17.5%

b. 19.5%

c. 21.5%

d. 23.5%

Difficulty: Moderate

Keywords: DuPont Analysis, return on equity

1. Snype, Inc. has an accounts receivable turnover ratio of 7.3. Stork Company has an accounts receivable turnover ratio of 5.0. Which of the following statements is correct?

a. Snype’s average collection period is less than Stork’s.

b. Stork’s average collection period is less than Snype’s.

c. Snype has a lower accounts receivable account on average than does Stork Company.

d. Stork Company has (on average) a lower accounts receivable account than does Snype.

Difficulty: Moderate

Keywords: average collection period

1. A decrease in the operating income return on investments could be caused by an increase in:
2. tax rate.
3. cost of goods sold.
4. total assets.
5. both b and c.
6. all of the above.

Difficulty: Moderate

Keywords: operating income return on investment

1. Ortny Industries has an accounts receivable turnover ratio of 4.3. If Ortny has an accounts receivable balance of $90,000, what is Ortny’s average daily credit sales?

a. $387,000

b. $1,548

c. $1,075

d. $3,521

Difficulty: Moderate

Keywords: accounts receivable ratio

1. Snort and Smiley Incorporated has a debt ratio of .42, noncurrent liabilities of $20,000, and total assets of $70,000. What is Snort and Smiley’s level of current liabilities?

a. $8,400

b. $9,400

c. $12,340

d. $10,600

Difficulty: Moderate

Keywords: current liabilities

1. Spinnit, Limited has a debt ratio of .57, current liabilities of $14,000, and total assets of $70,000. What is the level of Spinnit, Limited’s total liabilities?

a. $25,900

b. $24,600

c. $39,900

d. $53,900

Difficulty: Moderate

Keywords: debt ratio, total liabilities

1. Lorna Dome, Inc. has an annual interest expense of $30,000. Lorna Dome’s times-interest-earned ratio is 4.2. What is Lorna Dome’s operating income?

a. $96,000

b. $57,000

c. $126,000

d. $57,600

Difficulty: Easy

Keywords: times-interest-earned, operating income

1. Sharky’s Loan Co. has an annual interest expense of $30,000. If Sharky’s times-interest-earned ratio is 2.9, what is Sharky’s Earnings Before Taxes (EBT)?

a. $87,000

b. $57,000

c. $117,000

d. $60,000

Difficulty: Moderate

Keywords: times-interest-earned ratio

Table 3

In 1996, Snout and Smith, Inc. had a gross profit of $27,000 on sales of $110,000. S & S’s operating expenses for 1996 were $13,000, and its net profit margin was .0585. Snout and Smith had no interest expense in 1996.

1. Using the information in Table 3, what was S & S’s operating profit margin for 1996?

a. 0.245

b. 0.118

c. 0.127

d. 0.157

Difficulty: Moderate

Keywords: operating profit margin

1. Using the information in Table 3, what was S & S’s tax rate in 1996?

a. 0.54

b. 0.46

c. 0.50

d. None of the above

Difficulty: Moderate

Keywords: tax rate

1. Skrit Corporation has a net profit margin of 15% and a total asset turnover of 1.7. What is Skrit’s return on total assets?

a. 12.3%

b. 25.5%

c. 8.8%

d. 11.1%

Difficulty: Easy

Keywords: return on assets

1. Sputter Motors has sales of $3,450,000, total assets of $1,240,000, cost of goods sold of $2,550,000, and an inventory turnover of 6.38. What is the amount of Sputter’s inventory?

a. $421,054

b. $638,112

c. $543,000

d. $399,687

Difficulty: Hard

Keywords: inventory turnover

1. Which of the following is the best indicator of management's effectiveness at managing the firm’s balance sheet?

a. Debt ratio

b. Total asset turnover

c. Times-interest-earned

d. Operating profit margin

Difficulty: Moderate

Keywords: total asset turnover

1. Which of the following is the best indicator of management’s effectiveness at generating profits relative to the firm’s assets?

a. Quick ratio

b. Fixed assets turnover

c. Operating income return on investment

d. Accounts receivable turnover

Difficulty: Easy

Keywords: return on investment, operating income

1. Storm King Associates has a total asset turnover ratio of 1.90 and a return on total assets of 7.20%. What is Storm King’s net profit margin?

a. 3.79

b. 13.68

c. 9.10

d. None of the above

Difficulty: Easy

Keywords: net profit margin

1. A decrease in ___________ will increase gross profit margin.
2. cost of goods sold
3. depreciation expense
4. interest expense
5. both a and b

Difficulty: Easy

Keywords: gross profit margin

1. Other things held constant, an increase in ______ will decrease the current ratio. Assume an initial current ratio greater than 1.0.

a. accruals

b. common stock

c. average collection period

d. cash

Difficulty: Moderate

Keywords: current ratio

1. GAAP, Inc. has total assets of $2,575,000, sales of $5,950,000, total liabilities of $1,855,062, and a net profit margin of 2.9%. What is GAAP’s return on equity? Round to the nearest 0.1%.

a. 8.6%

b. 24.0%

c. 16.4%

d. 4.4%

Difficulty: Moderate

Keywords: return on equity

1. Wireless Communications has a total asset turnover of 2.66, total liabilities of $1,004,162, and sales revenues of $7,025,000. What is Wireless’s debt ratio?

a. 38.0%

b. 14.3%

c. 26.7%

d. 81.1%

Difficulty: Hard

Keywords: debt ratio

1. Which of the following will help an analyst determine how well a firm is able to meet its debt obligations?

a. Total liability turnover

b. Times-interest-earned

c. Return on debt

d. Asset ratio

Difficulty: Easy

Keywords: times-interest-earned ratio

1. Heavy Load, Inc. has sales of $3,450,000, total assets of $1,240,000, and total liabilities of $275,000, which consist strictly of notes payable. The firm’s operating profit margin is 16.1%, and it pays a 10% rate of interest on its notes payable. How much is the firm’s times-interest-earned?

a. 15.6

b. 45.3

c. 20.2

d. 3.0

Difficulty: Hard

Keywords: times-interest-earned

1. An increase in _________will decrease the times-interest-earned ratio.
2. the tax rate
3. gross profit
4. interest expense
5. common stock

Difficulty: Moderate

Keywords: times-interest-earned

1. Dew Point Dynamite, Inc. generated a 1.23 total asset turnover in its latest fiscal year on assets of $2,112,077. The firm has total liabilities of $950,997. The firm’s net profit margin was 10.3%. What is Dew Point’s return on equity? Round to the nearest 0.1%.

a. 23.1%

b. 12.6%

c. 5.5%

d. 18.2%

Difficulty: Moderate

Keywords: return on equity

1. Which of the following is not a limitation related to the usage of ratios when reviewing a firm’s performance?

a. Many firms experience seasonality in their operations.

b. Ratios cannot be used to compare firms that are in the same industry if one firm’s sales are higher than another firm’s.

c. Some firms operate in a variety of business lines, which makes it difficult to make comparisons.

d. Accounting practices differ widely among firms.

Difficulty: Moderate

Keywords: limitations of ratio analysis

1. An example of liquidity ratio is the:

a. quick ratio.

b. debt ratio.

c. times-interest-earned.

d. return on assets.

Difficulty: Easy

Keywords: liquidity ratios

1. Kannan Carpets, Inc. has asked you to calculate the company’s current ratio for 2001. All you have is a partial balance sheet and some assumptions. Using the information provided, calculate Kannan’s current ratio for 2001.

Gross profit margin = 50%

Inventory turnover (COGS/Inv) = 5

2001 sales = $3,000

Assets Liabilities & Equity

Cash ? Accounts payable $50

AR $40 Accruals ?

Inventory ? Long-term debt $400

Net fixed assets $500 Equity $250

Total assets $900 Total liab. & equity ?

1. 0.3
2. 0.8
3. 1.6
4. 2.2

Difficulty: Moderate

Keywords: current ratio

1. Kannan Carpets, Inc. has asked you to calculate the company’s current ratio for 2001. All you have is a partial balance sheet and some assumptions. Using the information provided, calculate Kannan’s quick ratio for 2001.

Gross profit margin = 50%

Inventory turnover (COGS/Inv) = 5

2001 sales = $3,000

Assets Liabilities & Equity

Cash ? Accounts payable $50

AR $40 Accruals ?

Inventory ? Long-term debt $400

Net fixed assets $500 Equity $250

Total assets $900 Total liab. & equity ?

a. 0.2

b. 0.4

c. 0.6

d. 0.8

Difficulty: Hard

Keywords: quick ratio

1. A firm that wants to know if it has enough cash to meet its bills would be most likely to use which kind of ratio?

a. Liquidity

b. Leverage

c. Efficiency

d. Profitability

Difficulty: Easy

Keywords: liquidity ratios

1. In the times-interest-earned ratio, lease expense is included in:

a. the numerator.

b. the denominator.

c. both the numerator and the denominator.

d. neither the numerator nor the denominator.

Difficulty: Moderate

Keywords: times–interest-earned ratio

1. Assume that a particular firm has a total asset turnover ratio lower than the industry norm. In addition, this firm’s current ratio and fixed asset turnover ratio also meet industry standards. Based on this information, we can conclude that this firm must have excessive:

a. accounts receivable.

b. fixed assets.

c. debt.

d. inventory.

Difficulty: Moderate

Keywords: inventory, total asset turnover

1. Assume that a particular firm has a total asset turnover ratio lower than the industry norm. In addition, this firm’s current ratio and acid test ratio also meet industry standards. Based on this information, we can conclude that this firm must have excessive:

a. accounts receivable.

b. fixed assets.

c. debt.

d. inventory.

Difficulty: Moderate

Keywords: fixed assets, total asset turnover

1. A firm is conducting an analysis of trends over time and discovers that its inventory turnover has declined. This may be due to:

a. an increase in sales.

b. an increase in cost of goods sold.

c. an increase in inventory purchases.

d. a decrease in inventory purchases.

Difficulty: Moderate

Keywords: inventory turnover

1. If the total asset turnover decreases, then the return on equity will:

a. decrease.

b. increase.

c. not change.

d. change, but in an indeterminate way.

Difficulty: Moderate

Keywords: return on equity, total asset turnover

Use the following information to answer questions.

Key Ratios for ABC, Inc. and Its Industry

ABC, Inc. 1994 Ratios Industry Average Ratios in 1994

Current ratio 1.2 1.4

Acid test ratio 0.89 0.94

Average collection period 30 days 25 days

Inventory turnover 18.1 20.3

Fixed assets turnover 4.1 4.8

Total asset turnover 2.78 2.8

Debt ratio 50% 60%

Times-interest-earned 5.5% 4.5%

Net profit margin 1.15% 1.5%

Return on equity 5.21% 7.32%

ABC, Inc. Income Statement (in thousands)

December 31, 1995

Sales (all credit) $200,000

Cost of goods sold 140,000

Gross profit on sales 60,000

Operating expenses 56,000

Operating income 4,000

Interest expense 1,000

Earnings before tax 3,000

Income tax 1,050

Net income available to common stockholders $1,950

ABC, Inc. Balance Sheet (in thousands)

December 31, 1995

Assets

Cash $2,000

Accounts receivable 17,800

Inventories 8,700

Total current assets 28,500

Gross fixed assets 70,000

Accumulated depreciation 26,500

Net fixed assets 43,500

Total assets $72,000

Liabilities and Equity

Accounts payable $18,000

Accruals 13,350

Total current liabilities 31,350

Long-term debt 8,250

Total liabilities 39,600

Common stock (par value and paid in capital) 2,000

Retained earnings 30,400

Total stockholders’ equity 32,400

Total liabilities and equity $72,000

1. In 1995, ABC's average collection period is:

a. 30 days.

b. 32.5 days.

c. 25 days.

d. 35 days.

Difficulty: Easy

Keywords: average collection period

1. In 1995, ABC’s inventory turnover is:

a. 23.9.

b. 20.3.

c. 15.5.

d. 16.1.

Difficulty: Easy

Keywords: inventory turnover

1. In 1995, ABC’s fixed asset turnover is:

a. 2.78.

b. 5.0.

c. 4.6.

d. 4.8.

Difficulty: Easy

Keywords: fixed asset turnover

1. Since 1994, ABC’s efficiency at using its assets has:

a. improved.

b. deteriorated.

c. remained the same.

d. been variable across components of the efficiency measures.

Difficulty: Moderate

Keywords: asset efficiency

1. In 1995, the improvement in ABC’s return on equity occurred because:

a. ABC used more debt than in 1994.

b. ABC lowered its expenses in 1995 and was, therefore, more profitable.

c. ABC utilized its total assets more efficiently in 1995.

d. none of the above explain the improvement in ABC’s return on equity.

Difficulty: Moderate

Keywords: DuPont Analysis, return on equity

1. Since 1994, ABC’s liquidity has:

a. improved.

b. deteriorated.

c. remained the same.

d. been variable across components of the liquidity measures.

Difficulty: Moderate

Keywords: liquidity

1. Since 1994, ABC’s inventory management has:

a. improved.

b. deteriorated.

c. remained the same.

d. changed but in an indeterminate manner.

Difficulty: Moderate

Keywords: inventory management

1. An increase in the current ratio would indicate an increase in:

a. leverage.

b. liquidity.

c. return on investment.

d. operating income.

Difficulty: Easy

Keywords: current ratio, liquidity

1. Which of the following is NOT a component of operating income return on investment?

a. Total assets

b. Cost of goods sold

c. Sales

d. Taxes

Difficulty: Easy

Keywords: operating income return on investment

1. _________ indicates management’s effectiveness in managing the firm’s income statement.

a. Gross profit margin

b. Operating profit margin

c. Net profit margin

d. Return on assets

Difficulty: Easy

Keywords: operating profit margin

1. Holding all other variables constant, which of the following could cause a firm’s current ratio to decrease from 3.0 to 2.5? An increase in:
   1. inventory
   2. long-term debt
   3. accounts receivable
   4. accounts payable

Difficulty: Moderate

Keywords: current ratio

1. The inventory turnover ratio:

a. improved.

b. deteriorated.

c. remained the same.

d. changed, but in an indeterminate manner.

Difficulty: Moderate

Keywords: inventory turnover

1. A firm has a return on equity of 20% and a total asset turnover of 4. Assuming a debt ratio of 50% and sales of $1,000,000, calculate net income.

a. $25,000

b. $50,000

c. $75,000

d. $100,000

Difficulty: Hard

Keywords: DuPont Analysis

1. Which of the following will increase return on equity?

a. An increase in sales with a proportionate increase in costs and expenses

b. An increase in sales relative to the asset base

c. A decrease in leverage

d. Both a and c

Difficulty: Moderate

Keywords: DuPont Analysis, return on equity

1. Which of the following is not a driving force of the operating profit margin?

a. The average selling price for each product

b. The ability to control all of the firm’s expenses

c. The ability to control general and administrative expenses

d. The number of units of product sold

Difficulty: Moderate

Keywords: operating profit margin

1. Corbin, Inc. had net income of $150,000 on sales of $5,000,000 during 1995. In addition, the firm’s total assets were $2,500,000, and its capital structure is comprised of 40% debt and 60% equity. What was Corbin’s return on equity in 1995?

a. 15%

b. 2.5%

c. 10%

d. Return on equity cannot be determined with the information provided.

Difficulty: Moderate

Keywords: DuPont Analysis, return on equity

1. Which of the following ratios would be the most useful in evaluating the ability of a firm to meet its short-term obligations?

a. The quick ratio (acid test)

b. Return on equity

c. Total asset turnover

d. Operating profit margin

Difficulty: Easy

Keywords: quick ratio, liquidity ratios

1. Which of the following financial ratios is the best measure of how effectively a firm’s management is serving its stockholders?

a. Current ratio

b. Debt ratio

c. ACP

d. Return on equity

Difficulty: Easy

Keywords: return on equity

1. Which of the following would be most responsible for a company’s average collection period being higher than the industry average?

a. If a company’s growth in sales is greater than the growth of sales in the industry.

b. Being more aggressive in collecting its accounts receivable than its competitors.

c. Having credit policy standards that are more restrictive than its competitors.

d. Being more lenient in extending credit to its customers than its competitors.

e. None of the above.

Difficulty: Moderate

Keywords: average collection period

1. If Challenge Corporation has sales of $2 million per year (all credit) and an average collection period of 35 days, what is its average amount of accounts receivable (assume a 360-day year)?

a. $194,444

b. $ 57,143

c. $ 5,556

d. $ 97,222

Difficulty: Moderate

Keywords: average collection period, accounts receivable

1. Colton Corp. has current assets of $4.5 million. The current ratio is 1.25 and the quick ratio is 0.75. What is the amount of Colton’s current liabilities (in millions)?

a. $3.6

b. $1.8

c. $2.4

d. $2.9

e. $3.6

Difficulty: Moderate

Keywords: current ratio, quick ratio

1. Consolidated Industries has total interest charges of $20,000 per year. Sales of $2 million generated an operating income of $220,000 and an after-tax profit of 6% of sales. The firm has a marginal tax rate of 40%. What is the firm’s times-interest-earned ratio?

a. 10

b. 11

c. 12

d. 13

Difficulty: Moderate

Keywords: times-interest-earned ratio

1. Hi Sky Enterprises has total assets of $3 million, a debt ratio of 30%, and an after-tax profit margin of 11.04% and sales of $2.5 million. What is Hi Sky’s return on equity?

a. 15%

b. 35%

c. 27%

d. 13%

Difficulty: Moderate

Keywords: return on equity

1. Paper Clip Office Supply had $24,000,000 in sales last year. Its total asset turnover was 6.0. Interest expense was $100,000 (10% on its $1,000,000 of debt). The company is financed entirely with debt and common equity. What is Paper Clip’s debt ratio?

a. 20%

b. 30%

c. 25%

d. 60%

e. 16%

Difficulty: Moderate

Keywords: debt ratio

1. Kiosk Corp. has current assets of $4.5 million and current liabilities of $3.6 million. The current ratio is 1.25, and the quick ratio is 0.75. How much does Kiosk have invested in inventory (in millions)?

a. $0.8

b. $1.8

c. $2.4

d. $2.9

e. $3.6

Difficulty: Moderate

Keywords: current ratio, quick ratio, inventory

1. Champion Company has sales of $20 million, total debt of $1.5 million, and a debt ratio of 40%. What is Champion’s total asset turnover?

a. 13.33

b. 9.11

c. 6.55

d. 5.33

Difficulty: Moderate

Keywords: total asset turnover

1. Which of the following statements is false?

a. The calculation of the accounts receivable average collection period (ACP) would generally produce a more realistic assessment of how a firm is managing its accounts receivable if the analyst were to calculate the ACP for each month and average the results, than if the analyst were to solely use the fiscal year-end accounts receivable value.

b. If an analyst were to compare the inventory turnover of one firm to that of another, the comparison can be distorted if the two firms use different methods of valuing ending inventory.

c. Assume that two firms are in the same industry and one reports a higher debt ratio than the other. We can safely say that the firm that has the highest debt ratio is the riskier of the two firms.

d. A firm that has a current ratio that is significantly above the industry norm will, as a direct consequence, also have a significantly better return on assets than if its current ratio was below the industry norm.

e. All of the above statements are true.

Difficulty: Moderate

Keywords: interpreting ratio results

Short Answer

1. Discuss the limitations of ratio analysis.

Difficulty: Moderate

Keywords: limitations of ratio analysis

Table 5

Financial Data for Dooley Sportswear December 31, 1996

Inventory $206,250

Long-term debt 300,000

Interest expense 5,000

Accumulated depreciation 442,500

Cash 180,000

Net sales (all credit) 1,500,000

Common stock 800,000

Accounts receivable 225,000

Operating expenses 525,000

Notes payable-current 187,500

Cost of goods sold 937,500

Plant and equipment 1,312,500

Accounts payable 168,750

Marketable securities 95,000

Prepaid insurance 80,000

Accrued wages 65,000

Retained earnings-current-year ?

Federal income taxes 5,750

1. From the information presented in Table 5, calculate the following financial ratios for the Dooley Sportswear Company.

current ratio operating profit margin

acid test ratio net profit margin

average collection period total tangible asset turnover

inventory turnover times interest earned

gross profit margin

Acid test ratio = ($180,000 + $95,000 + $225,000 + $80,000)/($168,750 + $187,500 + $65,000) = ($580,000/$421,250) = 1.38

Average collection period = ($225,000)/($1,500,000/360 days) = 54 days

Inventory turnover = ($937,500/$206,250) = 4.55

Gross profit margin = ($562,500/$1,500,000) = 0.375

Operating profit margin = ($37,500/$1,500,000) = 0.025

Net profit margin = ($26,750/$1,500,000) = 0.0178

Total asset turnover = ($1,500,000/$1,656,250) = 0.906

Times interest earned = ($37,500/$5,000) = 7.5 times

Difficulty: Hard

Keywords: financial ratio analysis

Table 6

Hokie Corporation Comparative Balance Sheet

For the Years Ending March 31, 1995 and 1996

(Millions of Dollars)

Assets 1995 1996

Current assets:

Cash $ 2 $ 10

Accounts receivable 16 10

Inventory 22 26

Total current assets $ 40 $ 46

Gross fixed assets: $120 $124

Less accumulated depreciation 60 64

Net fixed assets 60 60

Total assets $100 $106

Liabilities and Owners’ Equity

Current liabilities:

Accounts payable $ 16 $ 18

Notes payable 10 10

Total current liabilities $ 26 $ 28

Long-term debt 20 18

Owners’ equity:

Common stock 40 40

Retained earnings 14 20

Total liabilities and owners’ equity $100 $106

Hokie had net income of $26 million for 1996 and paid total cash dividends of $20 million to their common stockholders.

1. Calculate the following financial ratios for the Hokie Corporation using the information given in Table 6 and 1996 information.

current ratio

acid test ratio

debt ratio

long-term debt to total capitalization

return on total assets

return on common equity

Current ratio = ($46/$28) = 1.64

Acid test ratio = ($20/$28) = 0.71

Debt ratio = ($46/$106) = 0.43

Long-term debt to total capitalization = ($18/$78) = 0.23

Return on total assets = ($26/$106) = 0.25

Return on common equity = ($26/$60) = 0.43

Difficulty: Moderate

Keywords: financial ratio analysis

1. McKinny Enterprises must raise $580,000 to pay off a bank loan at the end of the year. The firm expects sales of $5,200,000 for the year. Depreciation for the year is $315,000. The company’s net profit margin is 5%. Can the company pay off its loan through the retention of earnings?

Internal funds generated by the firm = net profit + depreciation = $260,000 + $315,000 = $575,000

McKinny cannot pay off its loan by using only internally generated funds.

Difficulty: Moderate

Keywords: retained earnings

1. S.M., Inc. had total sales of $400,000 in 1996 (70 percent of its sales are credit). The company’s gross profit margin is 10%, its ending inventory is $80,000, and its accounts receivable is $25,000. What amount of funds can be generated by the company if it increases its inventory turnover ratio to 10.0 and reduces its average collection period to 20 days?

Average collection period = (accounts receivable)/(annual credit sales/360 days)

20 days = (accounts receivable)/[(400,000)(.70)/360 days]

Accounts receivable = (20 × $280,000)/(360) = $15,556

Funds generated by reducing accounts receivable = $25,000 - $15,556 = $9,444

Inventory turnover = (cost of goods sold)/(ending inventory)

10.0 = [($400,000)(1 - .10)]/(ending inventory)

Ending inventory = ($360,000)/(10.0) = $36,000

Funds generated by reducing inventory = $80,000 - $46,000 = $44,000

Total funds generated = $9,444 + $44,000 = $53,444

Difficulty: Hard

Keywords: inventory turnover, average collection period

1. Discuss why debt is considered a two-edged sword.

However, during bad times, interest expense must be paid which could significantly reduce already low profits. Therefore, firms with lower debt financing would enjoy higher profits and higher returns to the investor.

Difficulty: Moderate

Keywords: leverage

1. List the four ways that improvement can be made in return on equity.
   1. Increase in sales without a disproportionate increase in costs and expenses.
   2. Reduce the firm’s cost of goods sold or operating expenses.
   3. Increase the sales relative to the asset base, either by increasing sales or by reducing the amounts invested in company assets.
   4. Increase the use of debt relative to equity, but only to the extent that it does not unduly jeopardize the firm’s financial position.

Difficulty: Moderate

Keywords: return on equity

1. Baker & Co. has applied for a loan from the Trust Us Bank in order to invest in several potential opportunities. In order to evaluate the firm as a potential debtor, the bank would like to compare Baker & Co. to the industry. The following are the financial statements given to Trust Us Bank:

Balance Sheet 12/31/95 12/31/96

Cash $305 270

Accounts receivable 275 290

Inventory 600 580

Current assets 1,180 1,140

Plant and equipment 1,700 1,940

Less: acc depr (500) (600)

Net plant and equipment 1,200 1,340

Total assets $2,380 $2,480

Liabilities and Owners’ Equity

Accounts payable $150 $200

Notes payable 125 0

Current liabilities 275 200

Bonds 500 500

Owners’ equity

Common stock 165 305

Paid-in-capital 775 775

Retained earnings 665 700

Total owners’ equity 1,605 1,780

Total liabilities and owners’ equity $2,380 $2,480

Income Statement

Sales (100% credit) $1,100 $1,330

Cost of goods sold 600 760

Gross profit 500 570

Operating expenses 20 30

Depreciation 160 200

Net operating income 320 340

Interest expense 64 57

Net income before taxes 256 283

Taxes 87 96

Net income $ 169 $ 187

Compute the following ratios:

1995 1996 Industry Norms

Current ratio 5.0

Acid test ratio 3.0

Inventory turnover 2.2

Average collection period 90 days

Debt ratio .33

Times interest earned 7.0

Total asset turnover .75

Fixed asset turnover 1.0

Operating profit margin 20%

Net profit margin 12%

Return on total assets 9.00%

Operating income return on investments 15.00%

Return on equity 10.43%

Industry

1995 1996 Norm Evaluation

Current ratio 4.3x 5.7x 5.0x Satisfactory

Acid test (quick) ratio 2.1x 2.8x 3.0x Improving

Inventory turnover 1.0x 1.31x 2.2x Poor

Average collection period 90 days 76.3 days 90 days Satisfactory

Debt ratio 33% 28% 33% Satisfactory

Times interest earned 5.0x 6.0x 7.0x Poor

Total asset turnover .46x .54x .75x Poor

Fixed asset turnover .92x .99x 1.00x Satisfactory

Operating Profit Margin 29.1% 25.6% 20,000% Satisfactory

Net profit margin 15.36% 14.06% 12.00% Poor

Return on total assets 7.1% 7.54% 9.00% Poor

Operating income return on investments 13.45% 13.71% 15.00% Poor

Return on equity 10.6% 10.47% 13.43% Poor

Difficulty: Hard

Keywords: financial ratio analysis, trend analysis

1. In reference to the above problem:

a. What are the firm’s financial strengths and weaknesses?

b. Should the bank make the loan? Why or why not?

b. The answer is not an easy one. The firm has improved its liquidity, but it is still having problems at effectively managing its inventory. It may be that the loan is not needed to the extent thought, but rather management should work at reducing its investment in inventories. The bank would also want to know why the operating profit margin, which is still high, is falling. Nevertheless, the loan decision could go either way.

Difficulty: Hard

Keywords: financial strengths and weaknesses