SET 4 - Professor Onfroy Montana PDF

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SET 4 Ratio analysis involves analyzing financial statements to help appraise a firm's financial position and strength. True

The current and quick ratios both help us measure a firm's liquidity. The current ratio measures the relationship of the firm's current assets to its current liabilities, while the quick ratio measures the firm's ability to pay off short-term obligations without relying on the sale of inventories. True

Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy-to-use estimates of a firm's liquidity position. True

High current and quick ratios always indicate that the firm is managing its liquidity position well. False

. 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. False

If a firm sold some inventory on credit, its current ratio would probably not change much, but its quick ratio would increase. True

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. F

. 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.

T

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. F

In general, it's better to have a low inventory turnover ratio than a high one, as a low ratio 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. F

The days sales outstanding 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. T

If a firm's fixed assets turnover ratio is significantly higher 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. T

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. T

The more conservative a firm's management is, the higher its total debt to total capital ratio [measured as (Short-term debt + Long-term debt)/(Debt + Preferred stock + Common equity)] is likely to be. F

Other things held constant, the higher a firm's total debt to total capital ratio [measured as (Shortterm debt + Long-term debt)/(Debt + Preferred stock + common equity)], the higher its TIE ratio will be.

F

The times-interest-earned ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs T

. Profitability ratios show the combined effects of liquidity, asset management, and debt management on a firm's operating results. T

The basic earning power ratio (BEP) reflects the earning power of a firm's assets after giving consideration to financial leverage and tax effects. F

The operating margin measures operating income per dollar of assets. F

The profit margin measures net income per dollar of sales. T

The return on invested capital measures the total return that a company has provided for its investors. T

. 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. T

Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used the same or similar accounting methods.

T

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 aboveaverage inventory level and/or that part of the inventory is obsolete or damaged. T

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. F

. Other things held constant, the more debt a firm uses, the lower its profit margin will be. T

Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a profit margin of 8% for Firm B. Firm A's total debt to total capital ratio [measured as (Short-term debt + Long-term debt)/(Debt + Preferred stock + Common equity)] is 70% versus one of 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 F

Other things held constant, a decline in sales accompanied by an increase in financial leverage must result in a lower profit margin. F

Other things held constant, the more debt a firm uses, the lower its operating margin will be. F

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.

T

. Other things held constant, the more debt a firm uses, the lower its return on total assets will be. T

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. F

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). F

The return on invested capital (ROIC) differs from the return on assets (ROA). First, ROIC is based on total invested capital rather than total assets. Second, the numerator of the ROIC is after-tax operating income rather than net income. T

Market value ratios provide management with an indication of how investors view the firm's past performance and especially its future prospects. T

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. F

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 less risky and/or more likely to enjoy higher growth in the future T

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 less risky and/or more likely to enjoy higher growth in the future T

. 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. F

. 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 be a good move, as it would increase the ROE from 7.5% to 13.5%. T

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 examining changes in a firm's performance over time. T

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. F

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 turnover ratio than B. Therefore, we can conclude that A's quick ratio must be smaller than B's. F

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. T

Suppose Firms A and B have the same amount of assets, total assets are equal to total invested capital, pay the same interest rate on their debt, have the same basic earning power (BEP), finance with only debt and common equity, and have the same tax rate. However, Firm A has a higher debt to capital 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. T

If a firm's ROE is equal to 9% and its ROA is equal to 6%, its equity multiplier must be 1.5. T

A firm's ROE is equal to 9% and its ROA is equal to 6%. The firm finances only with short-term debt, long-term debt, and common equity, so assets equal total invested capital. The firm's total debt to total capital ratio must be 50%. F

One problem with ratio analysis is that relationships can sometimes 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. F

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. F...