LECTURE 3
ANALYSIS OF FINANCIAL STATEMENTS
(Difficulty: E = Easy, M = Medium, and T = Tough)
True-False
Easy:
Ratio analysis Answer: a
1
. Rat
ati
io an
ana
alys
ysi
is invol
olv
ves a co
com
mpar
ari
ison of the relat
ati
ions
nsh
hips
financial statement accounts so as to analyze the financial
and strength of a firm.
a. True
b. False
Liquidity ratios Answer: b
2
. The
The cu
curr
rren
ent
t rati
ratio
o an
and
d inve
invent
ntor
ory
y tu
turn
rnov
over
er r
rat
atio
io m
mea
easu
sure
re tthe
he liq
liq
a firm.
firm. The
The curr
curren
ent
t rati
ratioo measure
measures
s the rela
relati
tions
onship
hip of
current
ratio
rat assets
io measu
mea res to
sures howits
rapcurrent
rapidly a liabilities
idly fir
firm
m tur
turns and
ns its the
its inveinventory
invento
ntory
ry back
back
"quick" asset or cash.
a. True
b. False
Current ratio Answer: b
3
. If a firm has
has hi
hig
gh curr
curre
ent and
and quic
quick
k rat
ratios, t
th
his is alw
alway
indication that a firm is managing its liquidity position well.
a. True
b. False
Asset management ratios Answer: a
4
. Th
The
e inven
invento
tory
ry turn
turnov
over
er rati
ratio
o and da
days
ys sa
sale
les
s out
outst
stan
andi
ding
ng (D
(DSO
SO)
)
ratios that can be used to assess how effectively the firm is
its assets in consideration of current and projected operating
a. True
b. False
Inventory turnover ratio Answer: b
5
. A dec
ecl
line in the
the inve
ven
ntory tur
turnov
ove
er rati
tio
o sugg
gge
ests tha
that th
liquidity position is improving.
a. True
, b. False
Debt management ratios Answer: a
6
. The degree to which the managers of a firm attempt to mag
returns
returns to owners'
owners' capita
capitall thro
through
ugh the use of financi
financial
al lev
captured in debt management ratios.
a. True
b. False
TIE ratio Answer: a
7
. Th
The
e ti
time
mes-
s-in
inte
tere
rest
st-e
-ear
arne
ned
d rati
ratio
o is on
one
e in
indi
dica
cati
tion
on of a fi
firm
rm's
's
to meet both long-term and short-term obligations.
a. True
b. False
Profitability ratios Answer: a
8
. Pro
rof
fitab
abi
ility ra
rat
tios show the comomb
bine
ned
d ef
eff
fects of liqu
qui
idit
management, and debt management on operations.
a
b.
. T
Fr
au
le
se
ROA Answer: b
9
. Sinc
Since
e RO
ROAA meas
measur
ures
es the
the fir
firm'
m's
s ef
effe
fect
ctiv
ive
e ut
util
iliz
izat
atio
ion
n of asasse
sets
ts
consider
considering
ing how these
these asse
assets
ts are financ
financed),
ed), two firm
firms
s with
with
EBIT must have the same ROA.
a. True
b. False
Market value ratios Answer: a
10
. Mar
Marke
ket
t va
value
lue ratio
ratios
s pr
provi
ovide
de m
man
anage
agemen
ment
t wi
with
th a curre
current
nt a
asse
ssess
ssme
me
investor
investors
s in the market view the firm's past perform
performance
ance an
prospects.
a. True
b. False
Trend analysis Answer: a
11
. Determining whether a firm's financial position is impr
deter
deterior
iorat
ating
ing requi
require
res
s anal
analysi
ysis
s of more
more tha
thann one set
set of
stat
statem
emen
ents
ts.
. Tren
Trend
d anal
analys
ysis
is is one
one meth
method
od of measu
measuri
ring
ng
performance over time.
a. True
b. False
,Medium:
Liquidity ratios Answer: b
12
. If t
the
he cur
curre
rent
nt rat
ratio
io oof
f Firm
Firm A is gre
great
ater
er t
tha
han
n th
the
e curr
curren
ent
t
Firm B, we cannot be sure that the quick ratio of Firm A is
than that
that of Firm
Firm B. How
However
ever,
, if the ququick
ick ra
ratio
tio of F
Firm
irm A
that of Firm B, we can be ass assured
ured that Firm A's current
current ra
exceeds B's current ratio.
a. True
b. False
Inventory turnover ratio Answer: a
13
. The inven
inventor
tory
y turno
turnove
ver
r and curr
current
ent ratio
ratios
s are
are relat
related.
ed. Th
The
e co
of a high current ratio and a low inventory turnover ratio rel
the industry norm might indicate that the firm is maintaining
an inventory level or that part of the inventory is obsolete or
a. True
b. False
Fixed assets turnover Answer: b
14
. We ca
can
n use the fix
fixed as
ass
sets tu
tur
rnove
ver
r ratio to legit
iti
imat
ate
ely
firms in different industries as long as all the firms being
are using the same proportion of fixed assets to total assets.
a. True
b. False
BEP and ROE Answer: a
15
. Supp
Suppos
ose
e two
two firm
firms
s ha
have
ve tthe
he s
sam
ame
e am
amou
ount
nt o
of
f as
asse
sets
ts,
, pa
pay
y th
the
e sa
same
me
rate on their debt, have the same basic earning power (BEP),
the same tax rate. However
However,
, one
one firm
firm has a higher
higher debt ratio.
is greater than the interest rate on debt, the firm with th
debt ratio will also have a higher rate of return on common equ
a. True
b. False
Equity multiplier Answer: a
16
. If t
the
he equ
equit
ity
y mul
multi
tipl
plie
ier
r is 2.0,
2.0, the
the d
deb
ebt
t r
rat
atio
io must
must b
be
e 0
0.5
.5.
.
a. True
b. False
, TIE ratio Answer: a
17
. Su
Supp
ppos
ose
e a fir
firm
m wan
wants
ts to ma
main
inta
tain
in a spe
speci
cifi
ficc T
TIE
IE ra
rati
tio.
o. If
knows the level of its debt, the interest rate it will pay
debt,
debt, an
and
d the app
appli
licab
cable
le tax rat
rate,
e, the firm
firm can the
thenn calcu
calcu
earnings level required to maintain its target TIE ratio.
a. True
b. False
Profit margin and leverage Answer: b
18
. If sa
sale
les
s decre
decreas
ase
e and fina
financ
ncia
ial
l le
leve
vera
rage
ge in
incr
crea
ease
ses,
s, we can
can
certainty that the profit margin on sales will decrease.
a. True
b. False
Multiple Choice: Conceptual
Easy:
Current ratio Answer: c
19
. Othe
Other
r t
thi
hing
ngs
s hel
held
d ccon
onst
stan
ant,
t, whic
which
h o
of
f t
the
he foll
follow
owin
ing
g wwil
ill
l not af
current ratio, assuming an initial current ratio greater than 1
a. Fixed
Fixed as
assets
sets a
are
re so
sold
ld fo
for
r cas
cash.
h.
b. Long-te
Long-term
rm debt is issued
issued to pay
pay off current
current liabiliti
liabilities.
es.
c. Account
Accountss recei
receivab
vable
le are coll
collect
ected.
ed.
d. Cash iis
s used to pay off accounts
accounts payable.
payable.
e. A bank loan is oobtained
btained,
, and the proceeds
proceeds are cre
credited
dited to t
checking account.
Quick ratio Answer: d
20
. Othe
Other
r t
thi
hing
ngs
s hel
held
d c
con
onst
stan
ant,
t, whic
which
h o
of
f t
the
he foll
follow
owin
ing
g wwil
ill
l not af
quick ratio? (Assume that current assets equal current liabili
a. Fixed
Fixed as
assets
sets a
are
re so
sold
ld fo
for
r cas
cash.
h.
b. Cash
Cash is used to pupurch
rchase
ase inv
invent
entorie
ories.
s.
c. Cash iis
s used to pay off accounts
accounts payable.
payable.
d. Account
Accountss recei
receivab
vable
le are coll
collect
ected.
ed.
e. Long-te
Long-term
rm debt is issued
issued to ppay
ay off a sh
short-term
ort-term bank loan
loan.
.
Financial statement analysis Answer: a
21
. Co
Comp
mpan
any
y J and Comp
Compan
any
y K each
each rece
recent
ntly
ly re
repo
port
rted
ed th
the
e sa
same
me ea
earn
rn
share
share (EPS).
(EPS). Company
Company J’
J’s
s stock,
stock, howev
however,
er, trades
trades at a highe
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
1
. Rat
ati
io an
ana
alys
ysi
is invol
olv
ves a co
com
mpar
ari
ison of the relat
ati
ions
nsh
hips
financial statement accounts so as to analyze the financial
and strength of a firm.
a. True
b. False
Liquidity ratios Answer: b
2
. The
The cu
curr
rren
ent
t rati
ratio
o an
and
d inve
invent
ntor
ory
y tu
turn
rnov
over
er r
rat
atio
io m
mea
easu
sure
re tthe
he liq
liq
a firm.
firm. The
The curr
curren
ent
t rati
ratioo measure
measures
s the rela
relati
tions
onship
hip of
current
ratio
rat assets
io measu
mea res to
sures howits
rapcurrent
rapidly a liabilities
idly fir
firm
m tur
turns and
ns its the
its inveinventory
invento
ntory
ry back
back
"quick" asset or cash.
a. True
b. False
Current ratio Answer: b
3
. If a firm has
has hi
hig
gh curr
curre
ent and
and quic
quick
k rat
ratios, t
th
his is alw
alway
indication that a firm is managing its liquidity position well.
a. True
b. False
Asset management ratios Answer: a
4
. Th
The
e inven
invento
tory
ry turn
turnov
over
er rati
ratio
o and da
days
ys sa
sale
les
s out
outst
stan
andi
ding
ng (D
(DSO
SO)
)
ratios that can be used to assess how effectively the firm is
its assets in consideration of current and projected operating
a. True
b. False
Inventory turnover ratio Answer: b
5
. A dec
ecl
line in the
the inve
ven
ntory tur
turnov
ove
er rati
tio
o sugg
gge
ests tha
that th
liquidity position is improving.
a. True
, b. False
Debt management ratios Answer: a
6
. The degree to which the managers of a firm attempt to mag
returns
returns to owners'
owners' capita
capitall thro
through
ugh the use of financi
financial
al lev
captured in debt management ratios.
a. True
b. False
TIE ratio Answer: a
7
. Th
The
e ti
time
mes-
s-in
inte
tere
rest
st-e
-ear
arne
ned
d rati
ratio
o is on
one
e in
indi
dica
cati
tion
on of a fi
firm
rm's
's
to meet both long-term and short-term obligations.
a. True
b. False
Profitability ratios Answer: a
8
. Pro
rof
fitab
abi
ility ra
rat
tios show the comomb
bine
ned
d ef
eff
fects of liqu
qui
idit
management, and debt management on operations.
a
b.
. T
Fr
au
le
se
ROA Answer: b
9
. Sinc
Since
e RO
ROAA meas
measur
ures
es the
the fir
firm'
m's
s ef
effe
fect
ctiv
ive
e ut
util
iliz
izat
atio
ion
n of asasse
sets
ts
consider
considering
ing how these
these asse
assets
ts are financ
financed),
ed), two firm
firms
s with
with
EBIT must have the same ROA.
a. True
b. False
Market value ratios Answer: a
10
. Mar
Marke
ket
t va
value
lue ratio
ratios
s pr
provi
ovide
de m
man
anage
agemen
ment
t wi
with
th a curre
current
nt a
asse
ssess
ssme
me
investor
investors
s in the market view the firm's past perform
performance
ance an
prospects.
a. True
b. False
Trend analysis Answer: a
11
. Determining whether a firm's financial position is impr
deter
deterior
iorat
ating
ing requi
require
res
s anal
analysi
ysis
s of more
more tha
thann one set
set of
stat
statem
emen
ents
ts.
. Tren
Trend
d anal
analys
ysis
is is one
one meth
method
od of measu
measuri
ring
ng
performance over time.
a. True
b. False
,Medium:
Liquidity ratios Answer: b
12
. If t
the
he cur
curre
rent
nt rat
ratio
io oof
f Firm
Firm A is gre
great
ater
er t
tha
han
n th
the
e curr
curren
ent
t
Firm B, we cannot be sure that the quick ratio of Firm A is
than that
that of Firm
Firm B. How
However
ever,
, if the ququick
ick ra
ratio
tio of F
Firm
irm A
that of Firm B, we can be ass assured
ured that Firm A's current
current ra
exceeds B's current ratio.
a. True
b. False
Inventory turnover ratio Answer: a
13
. The inven
inventor
tory
y turno
turnove
ver
r and curr
current
ent ratio
ratios
s are
are relat
related.
ed. Th
The
e co
of a high current ratio and a low inventory turnover ratio rel
the industry norm might indicate that the firm is maintaining
an inventory level or that part of the inventory is obsolete or
a. True
b. False
Fixed assets turnover Answer: b
14
. We ca
can
n use the fix
fixed as
ass
sets tu
tur
rnove
ver
r ratio to legit
iti
imat
ate
ely
firms in different industries as long as all the firms being
are using the same proportion of fixed assets to total assets.
a. True
b. False
BEP and ROE Answer: a
15
. Supp
Suppos
ose
e two
two firm
firms
s ha
have
ve tthe
he s
sam
ame
e am
amou
ount
nt o
of
f as
asse
sets
ts,
, pa
pay
y th
the
e sa
same
me
rate on their debt, have the same basic earning power (BEP),
the same tax rate. However
However,
, one
one firm
firm has a higher
higher debt ratio.
is greater than the interest rate on debt, the firm with th
debt ratio will also have a higher rate of return on common equ
a. True
b. False
Equity multiplier Answer: a
16
. If t
the
he equ
equit
ity
y mul
multi
tipl
plie
ier
r is 2.0,
2.0, the
the d
deb
ebt
t r
rat
atio
io must
must b
be
e 0
0.5
.5.
.
a. True
b. False
, TIE ratio Answer: a
17
. Su
Supp
ppos
ose
e a fir
firm
m wan
wants
ts to ma
main
inta
tain
in a spe
speci
cifi
ficc T
TIE
IE ra
rati
tio.
o. If
knows the level of its debt, the interest rate it will pay
debt,
debt, an
and
d the app
appli
licab
cable
le tax rat
rate,
e, the firm
firm can the
thenn calcu
calcu
earnings level required to maintain its target TIE ratio.
a. True
b. False
Profit margin and leverage Answer: b
18
. If sa
sale
les
s decre
decreas
ase
e and fina
financ
ncia
ial
l le
leve
vera
rage
ge in
incr
crea
ease
ses,
s, we can
can
certainty that the profit margin on sales will decrease.
a. True
b. False
Multiple Choice: Conceptual
Easy:
Current ratio Answer: c
19
. Othe
Other
r t
thi
hing
ngs
s hel
held
d ccon
onst
stan
ant,
t, whic
which
h o
of
f t
the
he foll
follow
owin
ing
g wwil
ill
l not af
current ratio, assuming an initial current ratio greater than 1
a. Fixed
Fixed as
assets
sets a
are
re so
sold
ld fo
for
r cas
cash.
h.
b. Long-te
Long-term
rm debt is issued
issued to pay
pay off current
current liabiliti
liabilities.
es.
c. Account
Accountss recei
receivab
vable
le are coll
collect
ected.
ed.
d. Cash iis
s used to pay off accounts
accounts payable.
payable.
e. A bank loan is oobtained
btained,
, and the proceeds
proceeds are cre
credited
dited to t
checking account.
Quick ratio Answer: d
20
. Othe
Other
r t
thi
hing
ngs
s hel
held
d c
con
onst
stan
ant,
t, whic
which
h o
of
f t
the
he foll
follow
owin
ing
g wwil
ill
l not af
quick ratio? (Assume that current assets equal current liabili
a. Fixed
Fixed as
assets
sets a
are
re so
sold
ld fo
for
r cas
cash.
h.
b. Cash
Cash is used to pupurch
rchase
ase inv
invent
entorie
ories.
s.
c. Cash iis
s used to pay off accounts
accounts payable.
payable.
d. Account
Accountss recei
receivab
vable
le are coll
collect
ected.
ed.
e. Long-te
Long-term
rm debt is issued
issued to ppay
ay off a sh
short-term
ort-term bank loan
loan.
.
Financial statement analysis Answer: a
21
. Co
Comp
mpan
any
y J and Comp
Compan
any
y K each
each rece
recent
ntly
ly re
repo
port
rted
ed th
the
e sa
same
me ea
earn
rn
share
share (EPS).
(EPS). Company
Company J’
J’s
s stock,
stock, howev
however,
er, trades
trades at a highe
Which of the following statements is most correct?
