LECTURE 3
ANALYSIS OF FINANCIAL STATEMENTS
(Difficulty: E = Easy, M = Medium, and T = Tough)
True-False
Easy:
Ratio analysis Answer: a Diff: E
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
Liquidity ratios Answer: b Diff: E
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
Current ratio Answer: b Diff: E
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
Asset management ratios Answer: a Diff: E
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
Inventory turnover ratio Answer: b Diff: E
5
. A decline in the inventory turnover ratio suggests that the firm's
liquidity position is improving.
a. True
, b. False
Debt management ratios Answer: a Diff: E
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
TIE ratio Answer: a Diff: E
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
Profitability ratios Answer: a Diff: E
8
. Profitability ratios show the combined effects of liquidity, asset
management, and debt management on operations.
a. True
b. False
ROA Answer: b Diff: E
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
Market value ratios Answer: a Diff: E
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
Trend analysis Answer: a Diff: E
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:
Liquidity ratios Answer: b Diff: M
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
Inventory turnover ratio Answer: a Diff: M
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
Fixed assets turnover Answer: b Diff: M
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
BEP and ROE Answer: a Diff: M
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
Equity multiplier Answer: a Diff: M
16
. If the equity multiplier is 2.0, the debt ratio must be 0.5.
a. True
b. False
, TIE ratio Answer: a Diff: M
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
Profit margin and leverage Answer: b Diff: M
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
Easy:
Current ratio Answer: c Diff: E
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.
Quick ratio Answer: d Diff: E
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.
Financial statement analysis Answer: a Diff: E
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?
ANALYSIS OF FINANCIAL STATEMENTS
(Difficulty: E = Easy, M = Medium, and T = Tough)
True-False
Easy:
Ratio analysis Answer: a Diff: E
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
Liquidity ratios Answer: b Diff: E
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
Current ratio Answer: b Diff: E
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
Asset management ratios Answer: a Diff: E
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
Inventory turnover ratio Answer: b Diff: E
5
. A decline in the inventory turnover ratio suggests that the firm's
liquidity position is improving.
a. True
, b. False
Debt management ratios Answer: a Diff: E
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
TIE ratio Answer: a Diff: E
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
Profitability ratios Answer: a Diff: E
8
. Profitability ratios show the combined effects of liquidity, asset
management, and debt management on operations.
a. True
b. False
ROA Answer: b Diff: E
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
Market value ratios Answer: a Diff: E
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
Trend analysis Answer: a Diff: E
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:
Liquidity ratios Answer: b Diff: M
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
Inventory turnover ratio Answer: a Diff: M
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
Fixed assets turnover Answer: b Diff: M
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
BEP and ROE Answer: a Diff: M
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
Equity multiplier Answer: a Diff: M
16
. If the equity multiplier is 2.0, the debt ratio must be 0.5.
a. True
b. False
, TIE ratio Answer: a Diff: M
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
Profit margin and leverage Answer: b Diff: M
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
Easy:
Current ratio Answer: c Diff: E
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.
Quick ratio Answer: d Diff: E
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.
Financial statement analysis Answer: a Diff: E
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?
