Chapter 3 Working with Financial Statement

I. True/False

1. On a common-base year financial statement, accounts receivables will be expressed

relative to current year total assets.
A. True
B. False
2. High current and quick ratios always indicate that a firm is managing its financial
liquidity position well
A. True
B. False
3. The firm's equity multiplier measures the portion of the firm’s assets that is financed by
equity.
A. True
B. False
4. You need to analyze a firm's performance in relation to its peers. You can do this either
by comparing the firms' balance sheets and income statements at absolute amount or by
comparing the firms' ratios. If you only had time to use one means of comparisons, you
should compare the firm’s financial statements.
A. True
B. False

II. Short answer

1. What effect would the following actions have on a firm’s current ratio? Assume that net
working capital is positive.
a. Inventory is purchased.
b. A supplier is paid.
c. A short-term bank loan is repaid.
d. A long-term debt is paid off early.
e. A customer pays off a credit account.
f. Inventory is sold at cost.
g. Inventory is sold for a profit.

2. Explain what it means for a firm to have a current ratio equal to .50. Would the firm be
better off if the current ratio were 1.50? What if it were 15.0?

3. In recent years. Company A has greatly increased its current ratio. At the same time, the
quick ratio has fallen. What has happened? Has the liquidity of the company improved?

4. Why is the Du Pont identity a valuable tool for analyzing the performance of a firm?
Discuss the types of information it reveals compared to ROE considered by itself.
5. Suppose a company lengthens the time it takes to pay suppliers. How would this affect
the statement of cash flows? How sustainable is the change in cash flows from this
practice?

III. Multiple Choice Question

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.

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 decreased.
C. Only Pepsi Corporation’s current ratio will be increased.
D. Only Coke Company’s current ratio will be increased.

3. Bedford Hotels and Breezewood Hotels both have $100 million in total assets and a 10
percent return on assets (ROA). Each company has a 40 percent tax rate. Bedford,
however, has a higher debt ratio and higher interest expense. Which of the following
statements is most correct?
A. The two companies have the same basic earning power (BEP).
B. Bedford has a higher return on equity (ROE).
C. Bedford has a lower level of operating income (EBIT).
D. Statements a and b are correct.

4. Which of the following actions can a firm take to increase its current ratio?
A. Issue short-term debt and use the proceeds to buy back long-term debt with a maturity
of more than one year.
B. Use the cash savings to purchase plant and equipment.
C. Use cash to purchase additional inventory.
D. None of the statements above is correct.

5. You are an analyst following two companies, Company X and Company Y. You have
collected the following information:
• The two companies have the same total assets.
• Company X has a higher total assets turnover than Company Y.
• Company X has a higher profit margin than Company Y.
• Company Y has a higher inventory turnover ratio than Company X.
 • Company Y has a higher current ratio than Company X.
Which of the following statements is most correct?
A. Company X must have a higher net income.
B. Company X must have a higher ROE.
C. Company Y must have a higher ROA
D. Statements a and c are correct.

6. According to the Statement of Cash Flows, an increase in interest expense will _____ the
cash flow from _____ activities.
A. decrease; operating
B. decrease; financing
C. increase; operating
D. increase; investment

7. A firm uses 2008 as the base year for its financial statements. The common-size, base-
year statement for 2009 has an inventory value of 1.08. This is interpreted to mean that
the 2009 inventory is equal to 108 percent of which one of the following?
A. 2008 inventory
B. 2009 total assets
C. 2008 inventory expressed as a percent of 2008 total assets
D. 2009 inventory expressed as a percent of 2009 total assets

8. A supplier, who requires payment within ten days, should be most concerned with which
one of the following ratios when granting credit?
A. Cash
B. Debt/Equity
C. Quick
D. Total debt

9. A firm generated net income of $878. The depreciation expense was $47 and dividends
were paid in the amount of $25. Accounts payables decreased by $13, accounts
receivables increased by $22, inventory decreased by $14, and net fixed assets decreased
by $8. There was no interest expense. What was the net cash flow from operating
activity?
A. 876
B. 902
C. 904
D. 922

10. Last year, which is used as the base year, a firm had cash of $52, accounts receivable of
$218, inventory of $509, and net fixed assets of $1,107. This year, the firm has cash of
$61, accounts receivable of $198, inventory of $527, and net fixed assets of $1,216. What
is the common-base year value of accounts receivable?
A. 1.08
B. 0.1
C. 0.88
 D. 0.91

IV. Excercise

1. SDJ, Inc., has net working capital of $1,370, current liabilities of $3,720, and inventory
of $1,950. What is the current ratio? What is the quick ratio?

2. Ortiz Lumber Yard has a current accounts receivable balance of $431,287. Credit sales
for the year just ended were $3,943,709. What is the receivables turnover? The days’
sales in receivables? How long did it take on average for credit customers to pay off
their accounts during the past year?

3. Y3K, Inc., has sales of $5,276, total assets of $3,105, and a debt–equity ratio of 1.40. If its
return on equity is 15 percent, what is its net income?

4. Firm A and firm B have debt–total asset ratios of 35% and 30% and returns on total
assets of 12% and 11%, respectively. Which firm has a greater return on equity?
The solution requires substituting two ratios into a third ratio. Rearranging D/TA:

5. Holliman Corp. has current liabilities of $365,000, a quick ratio of .85, inventory
turnover of 5.8, and a current ratio of 1.4. What is the cost of goods sold for the
company?