# Chapter 8 Financial Statement Analysis

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1 Chapter 8 Financial Statement Analysis rue/false Questions F 1. Balance sheet items are carried at original cost or market value at the discretion of the individual firm. F 2. A primary use of the sources and uses of funds is to determine how current assets and longer-term assets are financed. Answer: rue F 3. Cash flows from investing activities would involve the purchase or sale of plant and equipment. Answer: rue F 4. Cash flows from operating activities would included the payment of cash dividends. F 5. Cash flows from financing activities would include the repurchase of debt and equity. Answer: rue F 6. he Beaver and Altman bankruptcy studies found that firms can survive at least two years once they declare bankruptcy. F 7. he Beaver and Altman bankruptcy studies indicated that ratios of failing firms signal failure as much as five years ahead of bankruptcy. Answer: rue F 8. According to Z score analysis, the higher the Z score the greater the firm's bankruptcy potential. 107

2 F 9. Financial ratios are meaningless unless they are compared to a company standard, or historical or industry data. Answer: rue F 10. he liquidity ratios measure how quickly a firm can dispose of inventory. F 11. Debt utilization ratios do not consider current liabilities. F 12. Firms with P/E ratios higher than the overall market ratio are expected to provide greater than normal returns with equal or less risk. Answer: rue F 13. Ratio analysis for large firms may be facilitated by dividing the company along industry, market, or geographic lines. Answer: rue F 14. Industry trend analysis provides a method of comparing industry performance throughout the economy and of identifying the potential winning and losing companies within an industry. Answer: rue F 15. Listing all balance sheet items at historical cost helps to reduce the distortion in profits caused by inflation. F 16. Extraordinary gains and losses are usually included in ratio analysis since they reflect on the annual operating performance of a firm. F 17. An increase in assets is considered a source of funds. F 18. Ratio analysis is equally effective in identifying either winners or losers. 108

3 F 19. he aftertax profit margin represents operating income divided by sales. F 20. Return on assets can be stated to equal net income/sales times sales/total assets. Answer: rue F 21. A firm with an average return on assets, but a high return on equity was probably able to achieve this by keeping debt down to a very low level. F 22. DuPont analysis deals primarily with the current and quick ratio. F 23. Rapid asset utilization tends to provide greater liquidity. Answer: rue F 24. A conservative investor or analyst might prefer examining the fixed charge coverage ratio rather than just the times interest earned ratio. Answer: rue F 25. For a firm with old, heavy fixed assets, replacement cost accounting will normally increase the debt to total assets ratio. F 26. For a firm with old, heavy fixed assets, replacement cost accounting will normally decrease the return on equity ratio. F 27. LIFO accounting tends to increase inventory profits. F 28. Regardless of the method of presentation in the financial statements, the analyst should eliminate the effect of extraordinary gains and losses in projecting data into the future. Answer: rue 109

4 F 29. he tax ratio for forest product companies may be low because of the tax treatment given timber cuttings. Answer: rue F 30. Corporate diversification eases the task of the financial analyst. F 31. he current cost method of inflation accounting adjusts statements by using the consumer price index. F 32. Inflation adjusted financial statements may be shown as supplements to the historical cost financial statements. Answer: rue F 33. FASB 85 requires that the statement of cash flows be divided into three sections: cash flows from operations, investments, and financing. F 34. FASB 95 requires that the statement of cash flows be divided into three sections: cash flows from operations, investments, and financing. Answer: rue F 35. Industry comparisons allow an analyst to separate quality companies from losers. Answer: rue F 36. he primary emphasis of the profitability ratios is a determination of the firm's ability to pay off short-term obligations as they come due. F 37. Debt-utilization ratios provide an indication of the way the firm is financed between debt (lenders) and equity (owners) and therefore helps the analyst determine the amount of financial risk present in the firm. Answer: rue 110

5 F 38. o examine the long-term performance over a number of years, one would use fundamental analysis. F 39. he DuPont method demonstrates the relationship between assets, sales, income, and debt for creating returns on assets and equity. Answer: rue F 40. Financial statements present a numerical picture of a company's financial and operating health. Answer: rue F 41. Since all companies must operate under generally accepted accounting principles, equal earnings per share for company A and B mean exactly the same thing to an investor. F 42. reasury stock represents shares of common stock that have been authorized but not issued. F 43. DuPont analysis illustrates that the return on equity can be increased by decreasing the amount of debt used in the capital structure. F 44. DuPont analysis illustrates the interaction of financial leverage, profit margin, and asset turnover on generating return on equity. Answer: rue 111

6 Multiple Choice Questions 45. he major device for measuring the profitability of a firm over a defined period of time is the A) income statement. B) balance sheet. C) statement of cash flow. D) none of the above. 46. he does not represent continuing operations in any way, but is simply a snapshot of the total worth of a firm at a given point in time. A) income statement B) balance sheet C) sources and uses of funds statement D) none of the above 47. he statement of cash inflows and outflows shows all of the following except. A) How the firm's balance sheet changed from one period to another. B) How funds from operations were used to finance the company's assets. C) How the firm has matched short-term and long-term sources of funds with short-term and long-term uses of funds. D) he firms cost of new borrowing. 48. Cash inflows arise from assets, liabilities, and stockholders' equity. A) increasing; increasing; decreasing B) increasing; decreasing; decreasing C) decreasing; increasing; increasing D) decreasing; increasing; decreasing Answer: C 112

7 49. Which of the following is NO a key ratio in the prediction of bankruptcy as developed by Edward Altman? A) debt to equity B) current ratio C) retained earnings as a percent of total assets D) total assets 50. ratios measure the ability of a firm to earn an adequate return on sales, total assets and invested capital. A) Asset utilization B) Liquidity C) Profitability D) Debt utilization Answer: C 51. he method of calculating return on assets which highlights the importance of sales, profit margin and asset turnover is known as A) the sales method B) DuPont analysis C) the Altman model D) the Gordon model 52. Asset utilization ratios measure all of the following except A) productivity of fixed assets in terms of sales B) the relationship of the income statement to cash of the asset groups on the balance sheet. C) how many times per year the inventory is sold and accounts receivable collected. D) the firm's ability to pay off short-term obligations as they come due. 113

8 53. he primary purpose of the liquidity ratios is to determine A) how much working capital is tied up in inventory. B) the relative level of short-term debt. C) how well a firm is able to pay off short-term obligations. D) more than one of the above. Answer: C 54. Which of the following statements about liquidity ratios is true? A) he higher the current ratio, the more likely a firm is able to pay its short-term obligations. B) he lower the quick ratios relative to the current ratio, the safer a firm is in terms of liquidity. C) he ratio of net working capital to total assets always lies between 0 and 1. D) Relatively high current ratios are usually a sign of efficient working capital management. 55. he ratios help determine the degree of financial risk and earnings volatility present in a firm. A) profitability B) asset utilization C) liquidity D) none of the above. 56. Which of the following statements are true? A) Debt to equity and debt to asset ratios measure capital structure and vary widely among industries. B) Debt utilization ratios alone do not measure a firm's ability to meet its cash obligations. C) DuPont analysis considers the impact of debt on the profitability of the firm. D) two of the above are true. 114

9 57. ratios measure the impact of external market forces on the internal performance of a firm. A) Price B) Profitability C) Liquidity D) Asset utilization 58. A high payout ratio indicates A) a firm is investing heavily in plant and equipment. B) a firm has high current obligations C) the firm is probably in the mature phase of its life cycle and does not have many growth opportunities available. D) the firm is probably in Stage II of its life cycle. Answer: C 59. Ratio analysis which compares a company to an industry is complicated because A) reliable industry data is not readily accessible. B) the accounting conventions between companies may be dissimilar. C) large companies are diversified across several industries. D) more than one of the above. 60. analysis is the process of studying a series of ratios for a company and/or industry over time. A) DuPont B) rend C) Common size D) all of the above. 115

10 61. In an inflationary economy, many firms use the method of inventory valuation to reduce distortion of profits. A) current cost B) LIFO C) FIFO D) LILO 62. Replacement cost accounting income, but assets and the debt-to-assets ratio. A) reduces; increases; lowers B) lowers; increases; increases C) increases; decreases; lowers D) none of the above 63. Corporate pension funds pose a threat to future earnings of the company because A) the company is liable for all payments. B) unfunded pensions will be paid from future earnings C) the firm may be unable to reinvest in new assets. D) all of the above 64. he statement of cash flows tells us A) accounting profit or loss B) how cash was created C) actual profit or loss D) two of the above 65. An analyst can judge a company's level of debt by comparing these ratios: A) return-on-equity to total debt-to-assets B) return-on-equity to total asset turnover C) return-on-equity to debt turnover D) return-on-equity to return-on-assets 116

11 66. A stock is a good buy when the value of these ratios except one is low compared to a market index or company history. Which one doesn't belong? A) price to book value B) price to earnings C) dividend yield D) all of the above belong 67. Which of the following is not an asset utilization ratio: A) receivable turnover B) fixed-asset turnover C) quick ratio D) all of the above are asset utilization ratios Answer: C 68. he major device that indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest: A) the balance sheet. B) the statement of cash flows. C) the income statement. D) the general ledger. 69. he primary sections of a statement of cash flows are: A) cash flows from investing, operating, and financing activities. B) cash flows from investing and operating activities plus investments. C) cash flows from investing, financing, and accounting activities. D) cash flows from investing, operating, financing, and accounting activities. 70. Financial ratios are used to weigh and evaluate: A) the operating performance and capital structure of the firm. B) which stocks are the "gold mine" stocks when investing in the market. C) which stocks are about to file for bankruptcy. D) the net present value of the company. 117

12 71. he type of ratio that allows the analyst to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital is: A) liquidity ratios. B) profitability ratios. C) asset-utilization ratios. D) debt-utilization ratios. 72. Which of the following is a good example of changes in accounting principles. A) a change in earnings per share due to an increase in the number of shares of common stock B) a change in income due to a change for post retirement benefits C) a change in earnings before taxes because of a change in internal rates on debt D) none of the above 73. When a company repurchases shares of their own common stock A) the earnings per share will rise B) the dividends paid out in total will decline C) the earnings per share growth rate will rise D) all of the above will happen 74. You would find the payment of dividends in the statement of cash flow under A) cash flows from operating activities B) cash flows from investing activities C) cash flows from financing activities D) cash flows from purchasing activities Answer: C 75. You would expect to find depreciation and amortized expenses in the statement of cash flows under A) cash flows from operating activities B) cash flows from investing activities C) cash flows from financing activities D) cash flows from purchasing activities 118

13 76. he Huck Printing Co. had sales of \$10 million, Operating Income of \$3 million; Aftertax income of \$1 million; assets of \$8 million; Stockholders' equity of \$5 million; and a total debt of \$4 million. What is Huck's return on assets? A) 37.5% B) 12.5% C) 30.0% D) 25.0% 77. he Huck Printing Co. had sales of \$10 million, Operating Income of \$3 million; Aftertax income of \$1 million; assets of \$8 million; Stockholders' equity of \$5 million; and a total debt of \$3 million. What is Huck's return on equity? A) 37.5% B) 10.0% C) 20.0% D) 60.0% Answer: C 78. he Huck Printing Co. had sales of \$10 million, Operating Income of \$3 million; Aftertax income of \$1 million; assets of \$8 million; Stockholders' equity of \$5 million; and a total debt of \$3 million. What is Huck's profit margin? A) 10.0% B) 20.0% C) 30.0% D) 33.0% 79. he Huck Printing Co. had sales of \$10 million, Operating Income of \$3 million; Aftertax income of \$1 million; assets of \$8 million; Stockholders' equity of \$5 million; and a total debt of \$3 million. What is Huck's asset turnover? A).50x B) 1.25x C) 2.50x D) 3.33x 119

14 80. he Huck Printing Co. had sales of \$10 million, Operating Income of \$3 million; Aftertax income of \$1 million; assets of \$8 million; Stockholders' equity of \$5 million; and a total debt of \$3 million. If we measure Huck's financial leverage we would most likely use which of the following ratios from chapter 8? A) Debt to equity ( 60%) and Debt to Sales (30%) B) Debt to equity (60%) and equity to assets (62.5%) C) Debt to equity (60%) and debt to assets (37.5%) D) Equity to assets (62.5%) and aftertax income to debt (33.3%) Answer: C Essay Questions 81. Given the following financial data: net income/sales = 7%; sales/total assets = 2.5X; debt/total assets = 25%. Compute the return on assets and return on equity. Answer: Return on assets = net income sales x sales total assets = 7% x 2.5% =17.5% Return on equity = Return on Assets (1- debt / total assets) = 17.5% (1-.25) = 23.3% 120

15 82. Using the following financial data given below, fill in the appropriate ratios in the table provided. ASSES: LIABILIIES & SOCKHOLDERS EQUIY: Cash \$ 2,250 Current liabilities \$ 4,500 Accounts Rec. 4,125 Long-term debt 2,250 Inventory 1,875 Common stock at par 1,500 Fixed Assets 9,000 Paid in capital in excess of par 3,000 otal Assets \$17,250 Retained earnings 6,000 otal Liabilities & \$17,250 Stockholder Equity Income before fixed charges and taxes \$9,000 Interest payments 1,125 Lease payments 1,350 axes (45% tax rate) 2,936 Net income after taxes \$3,589 Answer: Quick Ratio \$6,375/\$4, times Return on Equity \$3,589/\$10,500 34% Fixed Charge Coverage \$9,000/(\$1,125 + \$1,350) 3.64 times imes Interest Earned \$9,000/\$1, times 83. If a firm has a return on assets of 9% and a 45% debt to total assets ratio what will the return on equity be? Answer: ROA = ROE (1-D/A) 9% = ROE (1-.45) 9 = 16.4%

16 84. If a firm has an aftertax profit margin of 6%, an asset turnover of 3.5 times and no debt, what will be its return on assets and return on equity? Answer: ROA = PM x A ROA = 6% 3.5 times ROA = 21.0% Since there is no debt the ROA = ROE =21.0% ROE = ROA (1-D/A) = 21.0% (1-0) = 21.0% 85. Harding Corp. has to cover a \$15,000 sinking fund payment. he firm is in the 45% tax bracket and the treasurer wants to know how much before tax income is required for the firm to cover its sinking fund. Answer: aftertax payment = amount of before tax (1-tax rate) income needed \$15,000 = (1-.45) \$22,273 = amount of before tax income needed to make sinking fund payment 122

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