Chapter 3 - Instructor Testbank PDF

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Textbook: Brigham, Ehrhardt, Gessaroli and Nason. Financial Management Theory and Practice, Third Canadian Edition, Nelson Education Ltd. 2017...

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS 1. Current ratio and quick ratio both help us measure the firm’s liquidity. The current ratio measures the relationship of a firm’s current assets to its current liabilities, while the quick ratio subtracts inventory from other current assets. a. True b. Fals e ANSWER: True 2. Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easyto-use measures of a firm’s liquidity position. a. True b. Fals e ANSWER: True 3. High current and quick ratios always indicate that a firm is managing its liquidity position well. a. True b. Fals e ANSWER: Fals e 4. The inventory turnover ratio and days sales outstanding (DSO) are two ratios used to assess how effectively a firm is managing its assets. a. True b. Fals e ANSWER: True 5. “Mark to market” is the process of adjusting the valuation of assets from their recorded accounting value to a

valuation based on market prices. a. True b. Fals e ANSWER: True 6. The average collection period tells how many days it takes a business to pay money for trade credits to its suppliers. a. True b. Fals e ANSWER: Fals e 7. A decline in a firm’s inventory turnover ratio suggests that it is managing its inventory more efficiently and also that its liquidity position is improving, i.e., it is becoming more liquid. a. True Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS b. Fals e ANSWER: Fals e 8. 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. a. True b. Fals e ANSWER: True 9. U.S. regulators are fundamentally opposed to changing from Generally Accepted Accounting Principles (GAPP) to International Financial Reporting Standards (IFRS). a. True b. Fals e ANSWER: Fals e 10. The times-interest-earned ratio is one, but not the only, indication of a firm’s ability to meet its long-term and shortterm debt obligations. a. True b. Fals e ANSWER: True 11. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results. a. True b. Fals e ANSWER: True 12. Market value ratios provide management with an indication of how investors view the firm’s past performance and especially its future prospects. a. True b. Fals e ANSWER: True 13. Determining whether a firm’s financial position is improving or deteriorating requires analyzing more than the ratios for a given year. Trend analysis is one method of measuring changes in a firm’s performance over time. a. True b. Fals e Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS ANSWER: True 14. The “apparent,” but not the “true,” financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed. a. True b. Fals e ANSWER: True 15. Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods. a. True b. Fals e ANSWER: True 16. The basic earning power ratio (BEP) shows the earning power of a firm’s assets after giving consideration to financial leverage and tax effects. a. True b. Fals e ANSWER: Fals e 17. The inventory turnover and current ratio are related. The combination of a high current ratio and a low inventory turnover ratio, relative to industry norms, suggests that the firm has an above-average inventory level and/or that part of the inventory is obsolete or damaged. a. True b. Fals e ANSWER: True 18. To take full advantage of the credit term provided, management should try to lengthen the average payables period with cautions. a. True b. Fals e ANSWER: True 19. It is appropriate to use the fixed assets turnover ratio to appraise firms’ effectiveness in managing their fixed assets if all the firms being compared have the same proportion of fixed assets to total assets. a. True b. Fals e ANSWER: Fals e Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS 20. Since the 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. Fals e ANSWER: Fals e 21. Other things held constant, a decline in sales and a simultaneous increase in financial leverage must result in a lower profit margin. a. True b. Fals e ANSWER: Fals e 22. Suppose firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. Under these conditions, then firms that have high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. a. True b. Fals e ANSWER: Fals e 23. Even though Firm A’s current ratio exceeds that of Firm B, Firm B’s quick ratio might exceed that of A. However, if A’s quick ratio exceeds B’s, then we can be certain that A’s current ratio is also larger than that of B. a. True b. Fals e ANSWER: Fals e 24. Firms A and B have the same current ratio, 0.75; the same amount of sales, and the same amount of current liabilities. However, Firm A has a higher inventory than B. Therefore, we can conclude that A’s quick ratio must be smaller than B’s. a. True b. Fals e ANSWER: Fals e 25. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the interest rate on that debt, the applicable tax rate, and its operating costs. With this information, the firm can calculate the amount of sales required to achieve its target TIE ratio. a. True Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS b. Fals e ANSWER: True 26. Suppose Firms A and B 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, Firm A has a higher debt ratio. If BEP is greater than the interest rate on debt, Firm A will have a higher ROE as a result of its higher debt ratio. a. True b. Fals e ANSWER: True 27. If a firm finances with only debt and common equity, and if its equity multiplier is 3.0, then its debt ratio must be 0.667. a. True b. Fals e ANSWER: True 28. One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase. a. True b. Fals e ANSWER: Fals e 29. One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger. a. True b. Fals e ANSWER: Fals e 30. Considered alone, which of the following would increase a company’s current ratio? a. an increase in net fixed assets b. an increase in accrued liabilities c. an increase in notes payable d. an increase in accounts receivable ANSWER: d 31. Which of the following would, generally, indicate an improvement in a company’s financial position, other things held Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS constant? a. The TIE declines. b. The DSO increases. c. The EBITDA coverage ratio increases. d. The current and quick ratios both decline. ANSWER: c 32. A firm wants to strengthen its financial position. Which action would increase its current ratio? a. Use cash to repurchase some of the company’s own stock. b.Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than 1 year. c. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash. d.Use cash to increase inventory holdings. ANSWER: c 33. Which statement about inventories is correct? a. A reduction in inventories held would have no effect on the current ratio. b.An increase in inventories would have no effect on the current ratio. c. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. d.A reduction in the inventory turnover ratio will generally lead to an increase in the ROE. ANSWER: c 34. Companies E and P each reported the same earnings per share (EPS), but Company E’s stock trades at a higher price. Which of the following statements is correct? a. Company E probably has fewer growth opportunities than company P. b. Company E is probably judged by investors to be riskier than company P. c. Company E must pay a lower dividend than company P. d. Company E trades at a higher P/E ratio than company P. ANSWER: d 35. Which of the following statements is correct? a. If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. b.If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. c. Other things held constant, the higher a firm’s expected future growth rate, the lower its P/E ratio is likely to be. d.The higher the market/book ratio, then, other things held constant, the higher one would expect to find the market value added (MVA). ANSWER: d Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS 36. Which of the following is an example of window dressing? a. borrowing on a long-term basis and using the proceeds to retire short-term debt to improve the current ratio b.offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories c. using some of the firm’s cash to reduce long-term debt d.any action that improves a firm’s fundamental, long-run position and thus increases its intrinsic value. ANSWER: a 37. Casey Communications recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company’s total assets or operating income. What would occur as a result of this action? a. The company’s current ratio would increase. b. The company’s times-interest-earned ratio would decrease. c. The company’s basic earning power ratio would increase. d. The company’s equity multiplier would increase. ANSWER: a 38. A firm’s new president wants to strengthen the company’s financial position. Which action would make it financially stronger? a. increase accounts receivable while holding sales constant b. increase EBIT while holding sales constant c. increase accounts payable while holding sales constant d. increase notes payable while holding sales constant ANSWER: b 39. 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 likely result in the manager receiving a better grade? In all cases, assume that other things are held constant. a. The division’s basic earning power ratio is above the average of other firms in its industry. b. The division’s total assets turnover ratio is below the average for other firms in its industry. c. The division’s debt ratio is above the average for other firms in the industry. d. The division’s inventory turnover is 6, whereas the average for its competitors is 8. ANSWER: a 40. Which of the following would indicate an improvement in a company’s financial position, other things held constant? a. The debt ratio increases. b. The profit margin declines. c. The EBITDA coverage ratio declines. d. The current and quick ratios both increase. Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS ANSWER: d 41. If a bank loan officer were considering a company’s request for a loan, which of the following statements is correct? a. The lower the company’s EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. b.Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. c. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. d.The lower the company’s TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm. ANSWER: c 42. Which of the following statements is correct? a. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. b.A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure. c. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. d.Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favourable basis than income from stock. ANSWER: b 43. A firm wants to strengthen its financial position. Which action 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 ANSWER: a 44. Amram Company’s current ratio is 1.9. Considered alone, which action would reduce the company’s 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 short-term notes payable d. use cash to reduce accounts payable ANSWER: b 45. Which statement about accounts receivable is correct? a. If a security analyst saw that a firm’s DSO was higher than the industry average and was increasing and trending still higher, this would be interpreted as a sign of strength. Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS b.If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its DSO will increase. c. There is no relationship between the DSO and the ACP. These ratios measure entirely different things. d.If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding will decline. ANSWER: d 46. 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.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. c. 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. d.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 profit margin on sales. ANSWER: b 47. 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 the same. 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 also to be expected to grow at a faster rate. ANSWER: b 48. Which of the following might represent a major distortion brought about by a move to implement “mark to market” accounting? a. A rise or fall in the market value of assets will not afford investors a better basis for assessing the future value of their investments. b.Uncertainty regarding whether the adjusted market prices reflect temporary or permanent changes to the asset’s value may result in ambiguous signals when financial ratios are prepared. c. Financial statements represent historical information in that they reflect collective past performance (balance sheet) and the most recent past performance (income statement). As such, it is not necessary to adjust asset valuation to reflect current market values. d.Since prices change over time, “mark to market” is inferior to current accounting methods because a move to “mark to market” asset valuation will create a disconnect Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 3 - ANALYSIS OF FINANCIAL STATEMENTS between past and future financial information. ANSWER: b 49. Many countries, including Canada, have replaced Generally Accepted Accounting Principles (GAPP) with International Financial Reporting Standards (IFRS). Why has the United States not made this change to date? a. There is a fear that such a move would distort the analysis of a firm’s performance over time. b.Moving to this new accounting standard would impose major financial costs on U.S. firms during the current period of poor performance and economic uncertainty. c. U.S. companies are, by and large, unaffected by activities in other jurisdictions, and as such, the change in accounting practices would result in only minor adjustments to financial statements. d.The change to IFRS practices would have a major affect on financial statements, but investors do not rely heavily on financial statement information in making future investment decisions. ANSWER: b 50. Which statement regarding the Du Pont analysis is correct? a. Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase. b.Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE. c. The modified Du Pont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE. d.Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease. ANSWER: a 51. You observe that a firm’s ROE is above the industry average, but its profit margin and debt ratio are both below the industry a...