CHAPTER 3

ANALYSIS OF FINANCIAL STATEMENTS

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:
Current ratio Answer: a Diff: E
1. All else being equal, which of the following will increase a company’s
current ratio?

a. An increase in accounts receivable.

b. An increase in accounts payable.
c. An increase in net fixed assets.
d. Statements a and b are correct.
e. All of the statements above are correct.

Current ratio Answer: d Diff: E

2. Pepsi Corporation’s current ratio is 0.5, while Coke Company’s current
ratio is 1.5. Both firms want to “window dress” their coming end-of-year
financial statements. As part of its window dressing strategy, each firm
will double its current liabilities by adding short-term debt and
placing the funds obtained in the cash account. Which of the statements
below best describes the actual results of these transactions?

a. The transactions will have no effect on the current ratios.

b. The current ratios of both firms will be increased.
c. The current ratios of both firms will be decreased.
d. Only Pepsi Corporation’s current ratio will be increased.
e. Only Coke Company’s current ratio will be increased.

Cash flows Answer: a Diff: E

3. Which of the following alternatives could potentially result in a net
increase in a company’s cash flow for the current year?

a. Reduce the days sales outstanding ratio.

b. Increase the number of years over which fixed assets are depreciated.
c. Decrease the accounts payable balance.
d. Statements a and b are correct.
e. All of the statements above are correct.

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Leverage and financial ratios Answer: d Diff: E
4. Stennett Corp.’s CFO has proposed that the company issue new debt and
use the proceeds to buy back common stock. Which of the following are
likely to occur if this proposal is adopted? (Assume that the proposal
would have no effect on the company’s operating income.)

a. Return on assets (ROA) will decline.

b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.
e. None of the statements above is correct.

Leverage and profitability ratios Answer: e Diff: E

5. Amazon Electric wants to increase its debt ratio, which will also
increase its interest expense. Assume that the higher debt ratio will
have no effect on the company’s operating income, total assets, or tax
rate. Also, assume that the basic earning power ratio exceeds the
before- tax cost of debt financing. Which of the following will occur if
the company increases its debt ratio?

a. Its ROA will fall.

b. Its ROE will increase.
c. Its basic earning power (BEP) will stay unchanged.
d. Statements a and c are correct.
e. All of the statements above are correct.

EVA Answer: b Diff: E N

6. Which of the following statements is most correct?

a. A company that has positive net income must also have positive EVA.
b. If a company’s ROE is greater than its cost of equity, its EVA is
positive.
c. If a company increases its EVA, its ROE must also increase.
d. Statements a and b are correct.
e. All of the above statements are correct.

ROE and EVA Answer: e Diff: E

7. Which of the following statements is most correct about Economic Value
Added (EVA)?

a. If a company has no debt, its EVA equals its net income.

b. If a company has positive ROE, its EVA must also be positive.
c. A company’s EVA will be positive whenever the cost of equity
exceeds the ROE.
d. All of the statements above are correct.
e. None of the statements above is correct.

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