Chapter 4 - Fin Mgnt PDF

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CHAPTER 4: ANALYSIS OF FINANCIAL STATEMENT 1. HD Corp and LD Corp have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. Both firms finance using only debt and common equity and total assets equal total invested capital. However, HD uses more debt than LD. Which of the following statements is CORRECT? a. Without more information, we cannot tell if HD or LD would have a higher or lower net income. b. HD would have the lower equity multiplier for use in the DuPont equation. c. HD would have to pay more in income taxes. d. HD would have the lower net income as shown on the income statement. e. HD would have the higher operating margin.

ANSWER:

d

RATIONALE: More debt would mean more interest, hence a lower NI, given a constant EBIT, so d is correct. Also, we can rule out a and e, and HD would also have the higher multiplier, which rules out b. And with more interest, HD would have to pay less taxes, not more.

2. Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both firms finance using only debt and common equity and total assets equal total invested capital. Both companies have positive net incomes. Company HD has a higher total debt to total capital 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.

ANSWER:

a

RATIONALE: 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.

3. Companies HD and LD have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Both firms finance using only debt and common equity and total assets equal total invested capital. Company HD has a higher total debt to total invested capital ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company HD has a lower equity multiplier. b. Company HD has more net income. c. Company HD pays more in taxes. d. Company HD has a lower ROE. e. Company HD has a lower times-interest-earned (TIE) ratio.

ANSWER:

e

RATIONALE: HD has higher interest charges. Basic earning power equals EBIT/Assets, and since assets and BEP are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, HD’s higher interest charges means that its TIE must be lower. Thus, e is correct. All of the other statements are incorrect.

4.

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

5.

Which of the following statements is CORRECT?

a. A decline in a firm’s inventory turnover ratio suggests that it is improving both its inventory management and its liquidity position, i.e., that it is becoming more liquid. b. In general, it’s better to have a low inventory turnover ratio than a high one, as a low one indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose sales as a result of running out of stock. c. If a firm’s fixed assets turnover ratio is significantly lower than its industry average, this could indicate that it uses its fixed assets very efficiently or is operating at over capacity and should probably add fixed assets. d. The more conservative a firm’s management is, the higher its total debt to total capital ratio is likely to be. e. The days sales outstanding ratio tells us how long it takes, on average, to collect after a sale is made. The DSO can be compared with the firm’s credit terms to get an idea of whether customers are paying on time.

ANSWER: e

6.

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 total debt to total capital 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 total debt to total capital ratio, the lower the risk.

ANSWER: b

7.

Which of the following statements is CORRECT?

a. Other things held constant, the less debt a firm uses, the lower its return on total assets will be. b. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company’s operating efficiency is that the BEP does not reflect the effects of debt and taxes. c. The return on common equity (ROE) is generally regarded as being less significant, from a stockholder’s viewpoint, than the return on total assets (ROA). d. The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as being more risky and/or less likely to enjoy higher future growth. e. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A’s total debt to total capital ratio is 70% versus 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A’s higher profit margin.

ANSWER: b

8.

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

9. Walter Industries’ current ratio is 0.5. Considered alone, which of the following actions would increase the company’s current ratio? a. Borrow using short-term notes payable and use the cash to increase inventories. b. Use cash to reduce accruals. c. Use cash to reduce accounts payable. d. Use cash to reduce short-term notes payable. e. Use cash to reduce long-term bonds outstanding.

ANSWER:

a

RATIONALE: The following equation can 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. We see that a is correct.

Example: Original

Plus

CA/CL

$1

1

New CA/CL

0.50

Old CR

0.67

New CR

CR rises if initial CR is less than 1.0

1

10. Safeco’s current assets total to $20 million versus $10 million of current liabilities, while Risco’s current assets are $10 million versus $20 million of current liabilities. Both firms would like to “window dress” their end-of-year financial statements, and to do so they tentatively plan to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions? a. The transactions would improve Safeco’s financial strength as measured by its current ratio but lower Risco’s current ratio. b. The transactions would lower Safeco’s financial strength as measured by its current ratio but raise Risco’s current ratio. c. The transactions would have no effect on the firm’ financial strength as measured by their current ratios. d. The transactions would lower both firm’ financial strength as measured by their current ratios. e. The transactions would improve both firms’ financial strength as measured by their current ratios.

ANSWER:

b

RATIONALE: The key here is to recognize that if the CR is less than 1.0, then a given increase to both current assets and current liabilities will increase the CR, while the reverse will hold if the initial CR is greater than 1.0. Thus, the transactions would make Risco look stronger but Safeco look weaker. Here’s an illustration: Safeco: Original

2.00

Plus

New

Old

New CA/CL

$10

CA/CL CR

CR

1.50 CR falls because initial CR is greater than 1.0

Risco: Original CR

0.50

Plus CR

New

Old

New CA/CL

$10

CA/CL

0.67 CR rises because initial CR is less than 1.0

All of the statements except b are incorrect.

11. Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. Both firms finance using only debt and common equity and total assets equal total invested capital. However, company HD has a higher total debt to total capital ratio. Which of the following statements is CORRECT? a. Given this information, LD must have the higher ROE. b. Company LD has a higher basic earning power ratio (BEP). c. Company HD has a higher basic earning power ratio (BEP). d. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company HD will have the higher ROE.

e. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company HD will have the higher ROE.

ANSWER:

e

RATIONALE: The companies have the same EBIT and assets, hence the same BEP ratio. If the interest rate is less than the BEP, then using more debt will raise the ROE. Therefore, statement e is correct. The others are all incorrect.

12. Which of the following statements is CORRECT? a. 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 B’s. b. 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. c. 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. d. Suppose all firms follow similar financing policies, face similar risks, have equal access to capital, and operate in competitive product and capital markets. However, firms face different operating conditions because, for example, the grocery store industry is different from the airline industry. Under these conditions, firms with high profit margins will tend to have high asset turnover ratios, and firms with low profit margins will tend to have low turnover ratios. e. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the firm borrow funds using long-term debt, use the funds to buy back stock, and raise the equity multiplier to 2.0. The size of the firm (assets) would not change. She thinks that operations would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This would probably not be a good move, as it would decrease the ROE from 7.5% to 6.5%.

ANSWER: b

Multiple Choice: Problems

A good bit of relatively simple algebra is involved in these problems, and although the calculations are simple, it will take students some time to set up the problems and do the arithmetic. We allow for this when assigning problems for a timed test. Also, note that students must know the definitions of a number of ratios to answer the questions. We provide our students with a formula sheet on exams, using the relevant sections of Appendix C at the then of the text. Otherwise, they spend too much time trying to memorize thing rather than trying to understand the issues. The difficulty of the problems depends on (1) whether or not students are provided with a formula sheet and (2) the amount of time they have to work the problems. Out difficulty assessments assume that they have a formula sheet and a“reasonable” amount of time for the test. Note that a few of the problems are trivially easy if students have formula sheets. To work some of the problems, students must transpose equations and solve for items that are normally inputs. For example, the equation for the profit margin is given as Profit margin = Net income/Sales. We might have a problem where sales and the profit margin are given and then require students to find the firm’s net income. We explain to our students in class before the exam that they will have to transpose terms in the formulas to work some problems. Problems 84 through 114 are all stand-along problems with individualized data. Problems 115 through 133 are all based on a common set of financial statements, and they require students to calculate ratios and find items like EPS, TIE, and the like using this data set. The financial statements can be changed algorithmically, and this changes the calculated ratios and other items.

13. Ryngard Corp’s sales last year were $38,000, and its total assets were $16,000. What was its total assets turnover ratio (TATO)? a. 2.04 b. 2.14 c. 2.26 d. 2.38 e. 2.49

ANSWER:

d

RATIONALE: Sales Total assets

$38,000 $16,000

TATO = Sales/Total assets =

2.38

14. Beranek Corp has $720,000 of assets (which equal total invested capital), and it uses no debt —it is financed only with common equity. The new CFO wants to employ enough debt to raise the total debt to total capital ratio to 40%, using the proceeds from borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? a. $273,600 b. $288,000 c. $302,400 d. $317,520 e. $333,396 ANSWER:

b

RATIONALE: Total assets = Total invested capital Target debt to total capital ratio

$720,000 40%

Debt to achieve target ratio = Amount borrowed = Target % × Invested capital = $288,000

15. Ajax Corp’s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm’s times-interest-earned (TIE) ratio? a. 4.72 b. 4.97

c. 5.23 d. 5.51 e. 5.80

ANSWER:

e

RATIONALE: Sales

$435,000

Operating costs

$362,500

Operating income (EBIT)

$ 72,500

Interest charges

$ 12,500

TIE ratio = EBIT/Interest =

5.80

16. Royce Corp’s sales last year were $280,000, and its net income was $23,000. What was its profit margin? a. 7.41% b. 7.80% c. 8.21% d. 8.63% e. 9.06%

ANSWER:

c

RATIONALE: Sales Net income Profit margin = NI/Sales

$280,000 $23,000 8.21%

17. River Corp’s total assets at the end of last year were $415,000 and its net income was $32,750. What was its return on total assets? a. 7.89% b. 8.29% c. 8.70% d. 9.14% e. 9.59%

ANSWER:

a

RATIONALE: Total assets Net income

$415,000 $32,750

ROA = NI/Assets =

7.89%

18. X-1 Corp’s total assets at the end of last year were $405,000 and its EBIT was 52,500. What was its basic earning power (BEP) ratio? a. 11.70% b. 12.31% c. 12.96% d. 13.61% e. 14.29%

ANSWER:

c

RATIONALE: Total assets EBIT BEP = EBIT/Assets =

$405,000 $52,500 12.96%

19. Zero Corp’s total common equity at the end of last year was $405,000 and its net income was $70,000. What was its ROE? a. 14.82% b. 15.60% c. 16.42% d. 17.28% e. 18.15%

ANSWER:

d

RATIONALE: Common equity Net income

$405,000 $70,000

ROE = NI/Equity =

17.28%

20. Your sister is thinking about starting a new business. The company would require $375,000 of assets, and it would be financed entirely with common stock. She will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business? a. $41,234 b. $43,405 c. $45,689 d. $48,094 e. $50,625 ANSWER:

e

RATIONALE: Assets = Equity

$375,000

Target ROE

13.5%

Required net income = Target ROE × Equity =

$50,625

21. Herring Corporation has operating income of $225,000 and a 40% tax rate. The firm has short-term debt of $120,000, long-term debt of $330,000, and common equity of $450,000. What is its return on invested capital? a. 13.75% b. 14.33% c. 15.00% d. 16.25% e. 17.10%

EBIT

$225,000

Tax rate

40%

Short-term debt

$120,000

Long-term debt

$330,000

Common equity

$450,000

ROIC = [EBIT(1 – T)]/(STD + LTD + E)

15%

ANSWER: RATIONALE:

c

22. Song Corp’s stock price at the end of last year was $23.50 and its earnings per share for the year were $1.30. What was its P/E ratio? a. 17.17 b. 18.08 c. 18.98 d. 19.93 e. 20.93

ANSWER:

b

RATIONALE: Stock price EPS P/E = Stock price/EPS

$23.50 $1.30 18.08

23. Hoagland Corp’s stock price at the end of last year was $33.50, and its book value per share was $25.00. What was its market/book ratio? a. 1.34 b. 1.41 c. 1.48

d. 1.55 e. 1.63

ANSWER: