1. Ratio analysis involves a comparison

1. Ratio analysis involves a comparison of the relationships between
financial statement accounts so as to analyze the financial position
and strength of a firm.
a. True
b. False
2. The current ratio and inventory turnover ratio measure the liquidity of
a firm. The current ratio measures the relationship of a firm’s
current assets to its current liabilities and the inventory turnover
ratio measures how rapidly a firm turns its inventory back into
a “quick” asset or cash.
a. True
b. False
3. If a firm has high current and quick ratios, this is always a good
indication that a firm is managing its liquidity position well.
a. True
b. False
4. The inventory turnover ratio and days sales outstanding (DSO) are two
ratios that can be used to assess how effectively the firm is managing
its assets in consideration of current and projected operating levels.
a. True
b. False
5. A decline in the inventory turnover ratio suggests that the firm’s
liquidity position is improving.
a. True
b. False
6. The degree to which the managers of a firm attempt to magnify the
returns to owners’ capital through the use of financial leverage is
captured in debt management ratios.
a. True
b. False
7. The times-interest-earned ratio is one indication of a firm’s ability
to meet both long-term and short-term obligations.
a. True
b. False
8. Profitability ratios show the combined effects of liquidity, asset
management, and debt management on operations.
a. True
b. False
9. Since 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.
a. True
b. False
10. Market value ratios provide management with a current assessment of how
investors in the market view the firm’s past performance and future
prospects.
a. True
b. False
11. Determining whether a firm’s financial position is improving or
deteriorating requires analysis of more than one set of financial
statements. Trend analysis is one method of measuring a firm’s
performance over time.
a. True
b. False
Medium:
12. If the current ratio of Firm A is greater than the current ratio of
Firm B, we cannot be sure that the quick ratio of Firm A is greater
than that of Firm B. However, if the quick ratio of Firm A exceeds
that of Firm B, we can be assured that Firm A’s current ratio also
exceeds B’s current ratio.
a. True
b. False
13. The inventory turnover and current ratios are related. The combination
of a high current ratio and a low inventory turnover ratio relative to
the industry norm might indicate that the firm is maintaining too high
an inventory level or that part of the inventory is obsolete or damaged.
a. True
b. False
14. We can use the fixed assets turnover ratio to legitimately compare
firms in different industries as long as all the firms being compared
are using the same proportion of fixed assets to total assets.
a. True
b. False
15. Suppose two firms 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, one firm has a higher debt ratio. If BEP
is greater than the interest rate on debt, the firm with the higher
debt ratio will also have a higher rate of return on common equity.
a. True
b. False
16. If the equity multiplier is 2.0, the debt ratio must be 0.5.
a. True
b. False
17. Suppose a firm wants to maintain a specific TIE ratio. If the firm
knows the level of its debt, the interest rate it will pay on that
debt, and the applicable tax rate, the firm can then calculate the
earnings level required to maintain its target TIE ratio.
a. True
b. False
18. If sales decrease and financial leverage increases, we can say with
certainty that the profit margin on sales will decrease.
a. True
b. False
Multiple Choice: Conceptual
19. Other things held constant, which of the following will not affect the
current ratio, assuming an initial current ratio greater than 1.0?
a. Fixed assets are sold for cash.
b. Long-term debt is issued to pay off current liabilities.
c. Accounts receivable are collected.
d. Cash is used to pay off accounts payable.
e. A bank loan is obtained, and the proceeds are credited to the firm’s
checking account.
20. Other things held constant, which of the following will not affect the
quick ratio? (Assume that current assets equal current liabilities.)
a. Fixed assets are sold for cash.
b. Cash is used to purchase inventories.
c. Cash is used to pay off accounts payable.
d. Accounts receivable are collected.
e. Long-term debt is issued to pay off a short-term bank loan.
Answer: a
21. Company J and Company K each recently reported the same earnings per
share (EPS). Company J’s stock, however, trades at a higher price.
Which of the following statements is most correct?
a. Company J must have a higher P/E ratio.
b. Company J must have a higher market to book ratio.
c. Company J must be riskier.
d. Company J must have fewer growth opportunities.
e. All of the statements above are correct.
22. Stennett Corp.’s CFO has proposed that the company issue new debt and
use the proceeds to buy back common stock. Which of the following are
likely to occur if this proposal is adopted? (Assume that the proposal
would have no effect on the company’s operating earnings.)
a. Return on assets (ROA) will decline.
b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. None of the statements above is correct.
e. Statements a and c are correct.
Medium:
23. Which of the following statements is most correct?
a. If a company increases its current liabilities by $1,000 and
b. If a company increases its current liabilities by $1,000 and
simultaneously increases its inventories by $1,000, its current
ratio must rise.
simultaneously increases its inventories by $1,000, its quick ratio
must fall.
c. A company’s quick ratio may never exceed its current ratio.
d. Answers b and c are correct.
e. None of the answers above is correct.
24. Which of the following actions can a firm take to increase its current
ratio?
a. Issue short-term debt and use the proceeds to buy back long-term
b. Reduce the company’s days sales outstanding to the industry average
c. Use cash to purchase additional inventory.
d. Statements a and b are correct.
e. None of the statements above is correct.
debt with a maturity of more than one year.
and use the resulting cash savings to purchase plant and equipment.
25. Which of the following actions will cause an increase in the quick
ratio in the short run?
a. $1,000 worth of inventory is sold, and an account receivable is
b. A small subsidiary which was acquired for $100,000 two years ago and
created. The receivable exceeds the inventory by the amount of
profit on the sale, which is added to retained earnings.
which was generating profits at the rate of 10 percent is sold for
$100,000 cash. (Average company profits are 15 percent of assets.)
c. Marketable securities are sold at cost.
d. All of the answers above.
e. Answers a and b above.
26. As a short-term creditor concerned with a company’s ability to meet its
financial obligation to you, which one of the following combinations of
ratios would you most likely prefer?
Current Debt
ratio TIE ratio
a. 0.5 0.5 0.33
b. 1.0 1.0 0.50
c. 1.5 1.5 0.50
d. 2.0 1.0 0.67
e. 2.5 0.5 0.71
27. Which of the following statements is most correct?
a. If two firms pay the same interest rate on their debt and have the
b. One of the problems of ratio analysis is that the relationships are
c. Generally, firms with high profit margins have high asset turnover
same rate of return on assets, and if that ROA is positive, the firm
with the higher debt ratio will also have a higher rate of return on
common equity.
subject to manipulation. For example, we know that if we use some
of our cash to pay off some of our current liabilities, the current
ratio will always increase, especially if the current ratio is weak
initially.
ratios, and firms with low profit margins have low turnover ratios;
this result is exactly as predicted by the extended Du Pont equation.
d. All of the statements above are correct.
e. None of the statements above is correct.
28. Which of the following statements is most correct?
a. An increase in a firm’s debt ratio, with no changes in its sales and
b. An increase in the DSO, other things held constant, would generally
operating costs, could be expected to lower its profit margin on
sales.
lead to an increase in the total asset turnover ratio.
c. An increase in the DSO, other things held constant, would generally
d. In a competitive economy, where all firms earn similar returns on
e. It is more important to adjust the Debt/Assets ratio than the
lead to an increase in the ROE.
equity, one would expect to find lower profit margins for airlines,
which require a lot of fixed assets relative to sales, than for
fresh fish markets.
inventory turnover ratio to account for seasonal fluctuations.
29. Company A is financed with 90 percent debt, whereas Company B, which
has the same amount of total assets, is financed entirely with equity.
Both companies have a marginal tax rate of 35 percent. Which of the
following statements is most correct?
a. If the two companies have the same basic earning power (BEP),
b. If the two companies have the same return on assets, Company B will
c. If the two companies have the same level of sales and basic earning
d. All of the answers above are correct.
e. None of the answers above is correct.
Company B will have a higher return on assets.
have a higher return on equity.
power (BEP), Company B will have a lower profit margin.
30. A firm is considering actions which will raise its debt ratio. It is
anticipated that these actions will have no effect on sales, operating
income, or on the firm’s total assets. If the firm does increase its
debt ratio, which of the following will occur?
a. Return on assets will increase.
b. Basic earning power will decrease.
c. Times interest earned will increase.
d. Profit margin will decrease.
e. Total assets turnover will increase.
31. Reeves Corporation forecasts that its operating income (EBIT) and total
assets will remain the same as last year, but that the company’s debt
ratio will increase this year. What can you conclude about the
company’s financial ratios? (Assume that there will be no change in
the company’s tax rate.)
a. The company’s basic earning power (BEP) will fall.
b. The company’s return on assets (ROA) will fall.
c. The company’s equity multiplier (EM) will increase.
d. All of the answers above are correct.
e. Answers b and c are correct.
32. Which of the following statements is most correct?
a. If two companies have the same return on equity, they should have
b. If Company A has a higher profit margin and higher total assets
the same stock price.
turnover relative to Company B, then Company A must have a higher
return on assets.
the same times interest earned (TIE) ratio.
c. If Company A and Company B have the same debt ratio, they must have
d. Answers b and c are correct.
e. None of the answers above is correct.
33. Which of the following statements is most correct?
a. If a firm’s ROE and ROA are the same, this implies that the firm is
financed entirely with common equity. (That is, common equity =
total assets).
b. If a firm has no lease payments or sinking fund payments, its times-interest-earned (TIE) ratio and fixed charge coverage ratios must be
c. If Firm A has a higher market to book ratio than Firm B, then Firm A
d. All of the statements above are correct.
e. Answers a and b are correct.
the same.
must also have a higher price earnings ratio (P/E).
34. Which of the following statements is most correct?
a. If Firms A and B have the same level of earnings per share, and the
b. Firms A and B have the same level of net income, taxes paid, and
c. Firms A and B have the same level of net income. If Firm A has a
same market to book ratio, they must have the same price earnings
ratio.
total assets. If Firm A has a higher interest expense, its basic
earnings power ratio (BEP) must be greater than that of Firm B.
higher interest expense, its return on equity (ROE) must be greater
than that of Firm B.
d. All of the answers above are correct.
e. None of the answers above is correct.
Tough:
35. Which of the following statements is most correct?
a. If Company A has a higher debt ratio than Company B, then we can be
b. Suppose two companies have identical operations in terms of sales,
c. The ROE of any company which is earning positive profits and which
sure that A will have a lower times-interest-earned ratio than B.
cost of goods sold, interest rate on debt, and assets. However,
Company A uses more debt than Company B; that is, Company A has a
higher debt ratio. Under these conditions, we would expect B’s
profit margin to be higher than A’s.
has a positive net worth (or common equity) must exceed the
company’s ROA.
d. Statements a, b, and c are true.
e. Statements a, b, and c are false.

36. You are an analyst following two companies, Company X and Company Y.
You have collected the following information:
• The two companies have the same total assets.
• Company X has a higher total assets turnover than Company Y.
• Company X has a higher profit margin than Company Y.
• Company Y has a higher inventory turnover ratio than Company X.
• Company Y has a higher current ratio than Company X.
Which of the following statements is most correct?
a. Company X must have a higher net income.
b. Company X must have a higher ROE.
c. Company Y must have a higher quick ratio.
d. Statements a and b are correct.
e. Statements a and c are correct.

37. You have collected the following information regarding Companies C and
D:
• The two companies have the same total assets.
• The two companies have the same operating income (EBIT).
• The two companies have the same tax rate.
• Company C has a higher debt ratio and a higher interest expense than
• Company C has a lower profit margin than Company D.
Based on this information, which of the following statements is most
correct?
a. Company C must have a higher level of sales.
b. Company C must have a lower ROE.
c. Company C must have a higher times-interest-earned (TIE) ratio.
Company D.
d. Company C must have a lower ROA.
e. Company C must have a higher basic earning power (BEP) ratio.
38. Blair Company has $5 million in total assets. The company’s assets are
financed with $1 million of debt, and $4 million of common equity. The
company’s income statement is summarized below:
The company wants to increase its assets by $1 million, and it plans to
finance this increase by issuing $1 million in new debt. This action
will double the company’s interest expense, but its operating income
will remain at 20 percent of its total assets, and its average tax rate
will remain at 40 percent. If the company takes this action, which of
the following will occur:
a. The company’s net income will increase.
b. The company’s return on assets will fall.
c. The company’s return on equity will remain the same.
d. Statements a and b are correct.
e. All of the answers above are correct.
Multiple Choice: Problems
39. Russell Securities has $100 million in total assets and its corporate
tax rate is 40 percent. The company recently reported that its basic
earning power (BEP) ratio was 15 percent and that its return on assets
(ROA) was 9 percent. What was the company’s interest expense?
a. $ 0
b. $ 2,000,000
c. $ 6,000,000
d. $15,000,000
e. $18,000,000
40. A firm has a profit margin of 15 percent on sales of $20,000,000. If
the firm has debt of $7,500,000, total assets of $22,500,000, and an
after-tax interest cost on total debt of 5 percent, what is the firm’s
ROA?
a. 8.4%
b. 10.9%
c. 12.0%
d. 13.3%
e. 15.1%

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