CFIN 4, 4th Edition Scott Besley | Eugene F. Brigham solutions manual and test bank

CFIN 4, 4th Edition Scott Besley | Eugene F. Brigham solutions manual and test bank

 

1. The income statement measures the flow of funds into (i.e. revenue) and out of (i.e. expenses) the firm over a certain time period. It is always based on accounting data.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Income statement

2. The balance sheet is a financial statement measuring the flow of funds into and out of various accounts over time while the income statement measures the progress of the firm at a point in time.

a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Financial statements

3. An increase in an asset account is a source of cash, whereas an increase in a liability account is a use of cash. a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Sources and uses of cash

4. Depreciation, as shown on the income statement, is regarded as a use of cash because it is an expense. a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Sources and uses of cash

5. When a firm pays off a loan using cash, the source of funds is the decrease in the asset account, cash, while the use of funds involves a decrease in a liability account, debt.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Sources and uses

6. Non-cash assets are expected to produce cash over time but the amount of cash they eventually produce could be higher or lower than the values at which the assets are carried on the books.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Non-cash assets

7. Taxes, payment patterns, and reporting considerations, as well as credit sales and non-cash costs, are reasons why operating cash flows can differ from accounting profits.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Operating cash flows

8. 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

ANSWER: True

DIFFICULTY: Easy

TOPICS: Ratio analysis

9. The current ratio and inventory turnover ratio measure the liquidity of a firm. The current ratio measures the relation 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

ANSWER: False

DIFFICULTY: Easy

TOPICS: Liquidity ratios

10. If a firm has high current and quick ratios, this always is a good indication that a firm is managing its liquidity position well.

a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Current ratio

11. A decline in the inventory turnover ratio suggests that the firm's liquidity position is improving. a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Inventory turnover ratio

12. 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

ANSWER: True

DIFFICULTY: Easy

TOPICS: Debt management ratios

13. Profitability ratios show the combined effects of liquidity, asset management, and debt management on operations. a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Profitability ratios

14. 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

ANSWER: True

DIFFICULTY: Easy

TOPICS: Trend analysis

15. The information contained in the annual report is used by investors to form expectations about future earnings and dividends.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Annual report

16. The balance sheet presents a summary of the firm's revenues and expenses over an accounting period. a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Financial statements

17. On the balance sheet, total assets must equal total liabilities plus stockholders equity. a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Balance sheet

18. One of the biggest noncash items on the income statement is depreciation which needs to be subtracted from net income to determine cash flows for the firm.

a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Cash flows

19. A firm's net income reported on its income statement must equal the operating cash flows on the statement of cash flows.

a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Accounting profit and cash flows

20. A statement reporting the impact of a firm's operating, investing, and financing activities on cash flows over an accounting is the statement of cash flows.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Statement of cash flows

21. When a firm conducts a seasoned equity offering, it increases an equity account which is an example of a source of funds.

a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Sources and uses of cash

22. When a firm conducts a stock repurchase, it increases an equity account which is an example of a source of funds. a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Sources and uses of cash

23. A liquid asset is an asset that can be easily converted into cash without a significant loss of its original value. a. True

b. False

ANSWER: True

DIFFICULTY: Easy

TOPICS: Liquidity ratios

24. Genzyme Corporation has seen its days sales outstanding (DSO) decline from 38 days last year to 22 days this implying that more of the firm's suppliers are being paid on time.

a. True

b. False

ANSWER: False

DIFFICULTY: Easy

TOPICS: Days sales outstanding (DSO)

25. Funds supplied by common stockholders mainly includes capital stock, paid-in capital, and retained earnings, while total equity is comprised of common equity plus preferred stock.

a. True

b. False

ANSWER: True

DIFFICULTY: Medium

TOPICS: Total equity

26. Retained earnings is the cash that has been generated by the firm through its operations which has not been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and thus, these cash accounts, when added together, will always be equal to the total retained earnings of the firm.

a. True

b. False

ANSWER: False

DIFFICULTY: Medium

TOPICS: Retained earnings

27. The financial position of companies whose business is seasonal can be dramatically different depending upon the

time of year chosen to construct financial statements. This time sensitivity is especially true with respect to the firm's balance sheet.

a. True

b. False

ANSWER: True

DIFFICULTY: Medium

TOPICS: Balance sheet changes

28. In order to accurately estimate cash flow from operations, depreciation must be added back to net income. The reason for this is that even though depreciation is deducted from revenue it is really a non-cash charge.

a. True

b. False

ANSWER: True

DIFFICULTY: Medium

TOPICS: Cash flows

29. In accounting, emphasis is placed on determining net income. In finance, the primary emphasis also is on net income because that is what investors use to value the firm. However, a secondary consideration is cash flow because that's what is used to run the business.

a. True

b. False

ANSWER: False

DIFFICULTY: Medium

TOPICS: Cash flow and net income

30. Current cash flow from existing assets is highly relevant to the investor. However, the value of the firm depends primarily upon its growth opportunities. As a result, profit projections from those opportunities are the only relevant future flows with which investors are concerned.

a. True

b. False

ANSWER: False

DIFFICULTY: Medium

TOPICS: Future cash flows

31. 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

ANSWER: False

DIFFICULTY: Medium

TOPICS: Liquidity ratios

32. 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

ANSWER: True

DIFFICULTY: Medium

TOPICS: Inventory turnover ratio

33. We can use the fixed asset 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

ANSWER: False

DIFFICULTY: Medium

TOPICS: Fixed asset turnover

34. Suppose two firms with the same amount of assets pay the same interest rate on their debt and earn the same rate of return on their assets, and that ROA is positive. However, one firm has a higher debt ratio. Under these conditions, the firm with the higher debt ratio will also have a higher rate of return on common equity.

a. True

b. False

ANSWER: True

DIFFICULTY: Medium

TOPICS: ROA and ROE

35. 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

ANSWER: True

DIFFICULTY: Medium

TOPICS: TIE ratio

36. The fixed charge coverage ratio recognizes that firms often lease equipment under contract and thus, some firms must meet more than just their scheduled interest payments out of earnings. Therefore, the fixed charge coverage is more inclusive than the TIE ratio.

a. True

b. False

ANSWER: True

DIFFICULTY: Medium

TOPICS: Fixed charge coverage ratio

37. If sales decrease and financial leverage increases, we can say with certainty that the profit margin on sales will decrease.

a. True

b. False

ANSWER: False

DIFFICULTY: Medium

TOPICS: Profit margin and leverage

38. Selling new stock is an equity transaction; it does not affect any asset or liability account and therefore, does not appear on the statement of cash flows.

a. True

b. False

ANSWER: False

DIFFICULTY: Medium

TOPICS: Financing activities

39. 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 payoff a short-term bank loan.

ANSWER: d

RATIONALE: The quick ratio is calculated as follows:

The only action that doesn't affect the quick ratio is statement d. While this action decreases receivables (a current asset), it increases cash (also a current asset). The net effect is no change in the quick ratio.

DIFFICULTY: Easy

TYPE: Conceptual

TOPICS: Quick ratio

40. One would calculate changes in balance sheet accounts for a. A typical ratio analysis.

b. Pro forma balance sheet construction. c. Statement of cash flows construction. d. Profit and loss analysis.

e. Pro forma income statement construction.

ANSWER: c

DIFFICULTY: Easy

TOPICS: Statement of cash flows

41. All of the following represent cash outflows to the firm except a. Taxes.

b. Interest payments. c. Dividends.

d. Purchase of plant and equipment. e. Depreciation.

ANSWER: e

DIFFICULTY: Easy

TOPICS: Cash flows

42. Other things held constant, if a firm holds cash balances in excess of their optimal level in a non-interest bearing account, this will tend to lower the firm's

a. Profit margin.

b. Total asset turnover. c. Return on equity.

d. All of the above.

e. Answers b and c above.

ANSWER: e

DIFFICULTY: Easy

TOPICS: Excessive cash balances

43. 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.

ANSWER: c

DIFFICULTY: Easy

TOPICS: Current ratio

44. The annual report contains all of the following financial statements except a. income statement.

b. statement of changes in long-term financing. c. statement of cash flows.

d. balance sheet.

e. statement of retained earnings.

ANSWER: b

DIFFICULTY: Easy

TOPICS: Annual report

45. Which of the following financial statements shows a firm's financing activities (how funds were generated) and investment activities (how funds were used) over a particular period of time?

a. balance sheet

b. income statement

c. statement of retained earnings d. statement of cash flows

e. proxy statement

ANSWER: d

DIFFICULTY: Easy

TOPICS: Financial statements

46. Which of the following statements shows the portion of the firm's earnings that has been saved rather than paid out as dividends?

a. balance sheet

b. income statement

c. statement of retained earnings d. statement of cash flows

e. proxy statement

ANSWER: c

DIFFICULTY: Easy

TOPICS: Financial statements

47. Which of the following financial statements includes information about a firm's assets, equity, and liabilities?

a. Income statement

b. Cash flow statement c. Balance sheet

d. Statement of retained earnings e. All of the above

ANSWER: c

DIFFICULTY: Easy

TOPICS: Financial statements

48. When constructing a Statement of Cash Flows, which of the following actions would be considered a source of funds?

a. increase in the cash account b. decrease in accounts payable c. increase in inventory

d. increase in long-term bonds e. increase in fixed assets

ANSWER: b

DIFFICULTY: Easy

TOPICS: Financial statements

49. Which of the following groups probably would not be interested in the financial statement analysis of a firm?

a. creditors

b. management of the firm c. stockholders

d. Internal Revenue Service

e. All of the above would be interested in the financial statement analysis.

ANSWER: d

DIFFICULTY: Easy

TOPICS: Ratio analysis

50. Which of the following ratios measures how effectively a firm is managing its assets?

a. quick ratio

b. times interest earned c. profit margin

d. inventory turnover ratio e. price earnings ratio

ANSWER: d

DIFFICULTY: Easy

TOPICS: Inventory turnover ratio

51. If your goal is determine how effectively a firm is managing its assets, which of the following sets of ratios would you examine?

a. profit margin, current ratio, fixed charge coverage ratio b. quick ratio, debt ratio, time interest earned

c. inventory turnover ratio, days sales outstanding, fixed asset turnover ratio d. total assets turnover ratio, price earnings ratio, return on total assets

e. time interest earned, profit margin, fixed asset turnover ratio

ANSWER: c

DIFFICULTY: Easy

TOPICS: Asset management ratios

52. Which of the following ratios measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs?

a. fixed charge coverage ratio b. debt ratio

c. times-interest-earned ratio d. return on equity

e. profit margin

ANSWER: c

DIFFICULTY: Easy

TOPICS: TIE ratio

53. An analysis of a firm's financial ratios over time that is used to determine the improvement or deterioration in its financial situation is called

a. sensitivity analysis b. DuPont chart

c. ratio analysis d. progress chart e. trend analysis

ANSWER: e

DIFFICULTY: Easy

TOPICS: Trend analysis

54. Which of the following statements is most correct?

a. An increase in a firm's debt ratio, with no changes in its sales and operating costs, could be expected to lower its profit margin on sales.

b. An increase in DSO, other things held constant, would generally lead to an increase in the total asset turnover ratio.

c. An increase on the DSO, other things held constant, would generally lead to an increase in the ROE.

d. In a competitive economy, where all firms earn similar returns on equity, one would expect to find lower profit margins for airlines, which require a lot of fixed assets relative to sales, than for fresh fish markets.

e. It is more important to adjust the Debt/Asset ratio than the inventory turnover ratio to account for seasonal fluctuations.

ANSWER: a

RATIONALE: Statement a is true because, if a firm takes on more debt, its interest expense will rise, and this will lower its profit margin. Of course, there will be less equity than there would have been, hence the ROE might rise even though the profit margin fell.

DIFFICULTY: Medium

TOPICS: Financial statement analysis

55. Which of the following statements is correct?

a. The annual report contains four basic financial statements: the income statement; balance sheet; statement of cash flows; and statement of changes in long-term financing.

b. Although the annual report is geared toward the average stockholder, it represents financial analysts' most complete source of financial information about the firm.

c. The key importance of annual report information is that it is used by investors when they form their expectations about the firm's future earnings and dividends and the riskiness of those cash flows.

d. The annual report provides no relevant information for use by financial analysts or by the investing public. e. None of the above statements is correct.

ANSWER: c

DIFFICULTY: Medium

TOPICS: Annual report

56. A firm's current ratio has steadily increased over the past 5 years, from 1.9 five years ago to 3.8 today. What would a financial analyst be most justified in concluding?

a. The firm's fixed assets turnover probably has improved. b. The firm's liquidity position probably has improved.

c. The firm's stock price probably has increased. d. Each of the above is likely to have occurred.

e. The analyst would be unable to draw any conclusions from this information.

ANSWER: b

DIFFICULTY: Medium

TOPICS: Liquidity ratios

57. Which of the following actions will cause an increase in the quick ratio in the short run?

a. $1,000 worth of inventory is sold, and an account receivable is created. The receivable exceeds the inventory by the amount of profit of the sale, which is added to retained earnings.

b. A small subsidiary which was acquired for $100,000 two years ago and which was generating profits at the rate of 10 percent is sold for $100,000 cash. (Average company profits are 15 percent of assets.)

c. Marketable securities are sold at cost. d. All of the above.

e. Answers a and b above.

ANSWER: e

DIFFICULTY: Medium

TOPICS: Quick ratio

58. Which of the following statements is correct?

a. In the text, depreciation is regarded as a use of cash because it reduces fixed assets, which then must be replaced.

b. If a company uses some of its cash to pay off short-term debt, then its current ratio will always decline, given the way ratio is calculated, other things held constant.

c. During a recession, it is reasonable to think that most companies inventory turnover ratios will change while their fixed asset turnover ratio will remain fairly constant.

d. During a recession, we can be confident that most companies' DSOs (or ACPs) will decline because their sales will probably decline.

e. Each of the above statements is false.

ANSWER: e

DIFFICULTY: Medium

TOPICS: Miscellaneous ratio behavior

59. As a short-term creditor concerned with a company's ability to meet its financial obligation to you, which one of the following combinations of ratios would you most likely prefer?

Current				Debt
ratio		TIE		ratio

a.	0.5             0.5             0.33
b.	1.0             1.0             0.50
c.	1.5             1.5             0.50
d.	2.0             1.0             0.67
e.	2.5             0.5             0.71

ANSWER: c

DIFFICULTY: Medium

TOPICS: Ratio analysis

60. Which of the following statements about ratio analysis is incorrect?

a. Classifying a large, well-diversified firm into a single industry often is difficult because many of the firm's divisions are involved with different products from different industries.

b. As a rule of thumb, it is safe to conclude that any firm with a current ratio greater than 1.0 should be able to meet its current obligations, that is, pay bills that come due in the current period. [Current ratio = (Current assets) / (Current liabilities)]

c. Sometimes firms attempt to use "window dressing" techniques to make their financial statements look better than they actually are in the current period.

d. Computing the values of the ratios is fairly simple; the toughest and most important part of ratio analysis is interpretation of the values derived from the computations.

e. General conclusions about a firm should not be made by examining one or a few ratios, ratio analysis should be comprehensive.

ANSWER: b

DIFFICULTY: Medium

TOPICS: Ratio analysis

61. Yesterday, Bicksler Corporation purchased (and received) raw materials on credit from its supplier. All else equal, if

Bicksler's current ratio was 2.0 before the purchase, what effect did this transaction have on Bicksler's current ratio?

a. increased b. decreased

c. stayed the same

d. There is not enough information to answer this question. e. None of the above is a correct answer.

ANSWER: b

DIFFICULTY: Medium

TOPICS: Current ratio

62. Bubbles Soap Corporation has a quick ratio of 1.0 and a current ratio of 2.0 implying that a. the value of current assets is equal to the value of inventory.

b. the value of current assets is equal to the value of current liabilities. c. the value of current liabilities is equal to the value of inventory.

d. All of the above.

e. None of the above.

ANSWER: c

DIFFICULTY: Medium

TOPICS: Current ratio and quick ratio

63. Which of the following statements is most correct?

a. firms with relatively low debt ratios have higher expected returns when the business is good. b. firms with relatively low debt ratios are exposed to risk of loss when the business is poor.

c. firms with relatively high debt ratios have higher expected returns when the business is bad. d. firms with relatively high debt ratios have higher expected returns when the business is good. e. none of the above.

ANSWER: d

DIFFICULTY: Medium

TOPICS: Debt management ratios

64. All other things constant, an increase in a firm's profit margin would

a. increase the additional funds needed for financing a growth in operations. b. decrease the additional funds needed for financing a growth in operations.

c. have no effect on the additional funds needed for financing a growth in operations. d. decrease its taxes.

e. none of the above.

ANSWER: b

DIFFICULTY: Medium

TOPICS: Profit margin

65. Which of the following statements is correct?

a. If Company A has a higher debt ratio that Company B, then we can be sure that A will have a lower times- interest-earned ratio than B.

b. Suppose two companies have identical operations in terms of sales, cost of goods sold, interest rate on debt, and assets. However, Company A used more debt than Company B; that is, Company A has a higher debt ratio. Under these conditions, we would expect B's profit margin to be higher than A's.

c. The ROE of any company which is earning positive profits and which has a positive net worth (or common equity) must exceed the company's ROA.

d. Statements a, b, and c are all true. e. Statements a, b, and c are all false.

ANSWER: b

DIFFICULTY: Tough

TOPICS: ROE and debt ratios

66. 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 their 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.

ANSWER: d

RATIONALE: Pepsi Corporation:

Before: Current ratio = 50/100 = 0.50. After: Current ratio = 150/200 = 0.75.

Coke Company:

Before: Current ratio = 150/100 = 1.50. After: Current ratio = 250/200 = 1.25.

DIFFICULTY: Easy

TOPICS: Current ratio

67. The Charleston Company is a relatively small, privately owned firm. Last year the company had after-tax income of

$15,000 and 10,000 shares were outstanding. The owners were trying to determine the market value for the stock, prior to taking the company public. A similar firm which is publicly traded had a price/earnings ratio of 5.0. Using only the information given, estimate the market value of one share of Charleston's stock.

a. $10.00 b. $7.50 c. $5.00 d. $2.50 e. $1.50

ANSWER: b

RATIONALE: EPS = $15,000/10,000 = $1.50. P/E = 5.0 = P/$1.50. P = $7.50

DIFFICULTY: Easy

TOPICS: Market price per share

68. If Boyd Corporation has sales of $2 million per year (all credit) and days sales outstanding of 35 days, what is its average amount of accounts receivable outstanding (assume a 360 day year)?

a. $194,444 b. $57,143 c. $5,556

d. $97,222 e. $285,714

ANSWER: a

RATIONALE: A/R = (Sales/360)(DSO) = (($2,000,000)/(360))(35) = $194,444.

DIFFICULTY: Easy

TOPICS: Accounts receivable

69. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has debt of $7,500,000, total assets of

$22,500,000, and an after-tax interest cost on total debt of 5 percent, what is the firm's ROA?

a. 8.4% b. 10.9% c. 12.0% d. 13.3% e. 15.1%

ANSWER: d

RATIONALE: Net income = 0.15($20,000,000) = $3,000,000. ROA = $3,000,000/$22,500,000 = 13.3%.

DIFFICULTY: Easy

TOPICS: ROA

70. Collins Company had the following partial balance sheet and complete income statement information for last year:

Balance Sheet: Cash	$ 20
A/R	1,000
Inventories	2,000
Total current assets	$ 3,020
Net fixed assets	2,980
Total assets	$ 6,000
Income Statement: Sales	$10,000
Cost of goods sold	9,200
EBIT	$ 800
Interest (10%)	400
EBT	$ 400
Taxes (40%)	160
Net Income	$ 240

The industry average DSO is 30 (360-day basis). Collins plans to change its credit policy so as to cause its DSO to equal the industry average, and this change is expected to have no effect on either sales or cost of goods sold. If the cash generated from reducing receivables is used to retire debt (which was outstanding all last year and which has a

10% interest rate), what will Collins' debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet?

a. 33.33% b. 45.28% c. 52.75% d. 60.00% e. 65.71%

ANSWER: e

RATIONALE: Current DSO = 36 days. Industry average DSO = 30 days.

Reduce receivables by

Debt = $400/0.10 = $4,000.

Debt to assets =

DIFFICULTY: Medium

TOPICS: Financial statement analysis

71. A firm has total interest charges of $10,000 per year, sales of $1 million, a tax rate of 40 percent, and a net profit margin of 6 percent. What is the firm's times-interest-earned ratio?

a. 16 times b. 10 times c. 7 times d. 11 times e. 20 times

ANSWER: d

RATIONALE: NI = $1,000,000(0.06) = $60,000.

EBT = $60,000/0.6 = $100,000.

EBIT = $100,000 + $10,000= $110,000.

TIE = EBIT/I = $110,000/$10,000 = 11 times.

DIFFICULTY: Medium

TOPICS: TIE ratio

72. Alumbat Corporation has $800,000 of debt outstanding, and it pays an interest rate of 10 percent annually on its bank loan. Alumbat's annual sales are $3,200,000; its average tax rate is 40 percent; and its net profit margin on sales is 6 percent. If the company does not maintain a TIE ratio of at least 4 times, its bank will refuse to renew its loan, and bankruptcy will result. What is Alumbat's current TIE ratio?

a. 2.4 b. 3.4 c. 3.6 d. 4.0 e. 5.0

ANSWER: e

RATIONALE: TIE = EBIT/I, so find EBIT and I.

Interest = $800,000 × 0.1 = $80,000.

Net income = $3,200,000 × 0.06 = $192,000.

Taxable income = EBT = $192,000/(1 − T) = $192,000/0.6 = $320,000.

EBIT = $320,000 + $80,000 = $400,000.

TIE = $400,000/$80,000 = 5.0 times.

DIFFICULTY: Medium

TOPICS: TIE ratio

73. Determine the increase or decrease in cash for Rinky Supply Company for last year, given the following information. (Assume no other changes occurred during the past year.)

Decrease in marketable securities	=	$25
Increase in accounts receivables	=	$50
Increase in notes payable	=	$30
Decrease in accounts payable	=	$20
Increase in accrued wages and taxes	=	$15
Increase in inventories	=	$35
Retained earnings a. −$50	=	$ 5
b. +$40
c. −$30
d. +$20
e. −$10

ANSWER: c

RATIONALE: Statement of cash flows:

Cash Flows from Operations

Retained earnings $ 5

Additions (sources of cash):

Increase in accrued wages and taxes 15

Subtractions (uses of cash):

Increase in accounts receivable (50) Increase in inventories (35) Decrease in accounts payable (20)

Net Cash Flows from Operations ($85)

Cash Flows Associated with Financing Activities

	Decrease in marketable securities	$25
Increase in notes payable	30
Net Cash Flows from Financing		55
	Net reduction in Cash		($30)
DIFFICULTY: TOPICS:	Medium Change in cash flows

74. Cannon Company has enjoyed a rapid increase in sales in recent years, following a decision to sell on credit.

However, the firm has noticed a recent increase in its collection period. Last year, total sales were $1 million, and

$250,000 of these sales were on credit. During the year, the accounts receivable account averaged $41,664. It is expected that sales will increase in the forthcoming year by 50 percent, and, while credit sales should continue to be the same proportion of total sales, it is expected that the days sales outstanding will also increase by 50 percent. If the resulting increase in accounts receivable must be financed by external funds, how much external funding will Cannon need?

a. $41,664 b. $52,086 c. $47,359 d. $106,471 e. $93,750

ANSWER: b

RATIONALE: DSO = ($41,664/$250,000)/360 = 60 days.

New A/R = (($250,000)(1.5)/(360))(60)(1.5) = $93,750.

Hence, increase in receivables = $93,750 − $41,664 = $52,086.

DIFFICULTY: Medium

TOPICS: Receivables increase

75. The Meryl Corporation's common stock currently is selling at $100 per share, which represents a P/E ratio of 10. If the firm has 100 shares of common stock outstanding, a return on equity of 20 percent, and a debt ratio of 60 percent, what is its return on total assets (ROA)?

a. 8.0% b. 10.0% c. 12.0% d. 16.7% e. 20.0%

ANSWER: a

RATIONALE: P/E = 10 = $100/EPS

EPS = $100/10 = $10.

Earnings = NI = $10(100 shares) = $1,000.

ROE = NI/Equity = $1,000/Equity = 20%

Equity = $1,000/0.20 = $5,000.

Debt ratio = 60%, so Equity ratio = 40% = Equity/TA

TA = Equity/0.40 = $5,000/0.40 = $12,500.

ROA = NI/TA = $1,000/$12,500 = 0.08 = 8%.

DIFFICULTY: Medium

TOPICS: ROA

76. Selzer Inc. sells all its merchandise on credit. It has a profit margin of 4 percent, days sales outstanding equal to 60 days, receivables of $150,000, total assets of $3 million, and a debt ratio of 0.64. What is the firm's return on equity (ROE)?

a. 7.1% b. 33.3% c. 3.3% d. 71.0% e. 8.1%

ANSWER: c

RATIONALE: (Sales per day)(DSO) = A/R

(Sales/360)(60) = $150,000

Sales = $900,000.

Profit margin = Net profit after tax/Sales.

Net profit = 0.4($900,000) = $36,000.

Debt ratio = 0.64 = Total debt/$3,000,000.

Total debt = $1,920,000.

Total equity = $3,000,000 − $1,920,000 = $1,080,000.

ROE = $36,000/$1,080,000 = 3.3%.

DIFFICULTY: Medium

TOPICS: ROE

77. You are given the following information about a firm: The growth rate equals 8 percent; return on assets (ROA) is

10 percent; the debt ratio is 20 percent; and the stock is selling at $36. What is the return on equity (ROE)?

a. 14.0% b. 12.5% c. 15.0% d. 2.5% e. 13.5%

ANSWER: b

RATIONALE: Debt ratio = TL/TA = 20%, so Equity = (1 − 0.20)TA = 0.80(TA).

ROA = NI/TA = 10%. NI = 10%(TA) = 0.10(TA).

ROE = NI/Equity = [0.10(TA)]/[0.80(TA)] = 0.10/0.80 = 0.125 = 12.5%.

DIFFICULTY: Medium

TOPICS: ROE

78. Assume Meyer Corporation is 100 percent equity financed. Calculate the return on equity, given the following information:

(1) Earnings before taxes = $1,500; (2) Sales = $5,000;

(3) Dividend payout ratio = 60%; (4) Total assets turnover = 2.0; (5) Applicable tax rate = 30%.

a. 25% b. 30% c. 35% d. 42% e. 50%

ANSWER: d

RATIONALE: NI = $1,500(1 − 0.3) = $1,050.

Total assets turnover = Sales/TA = 2.0.

TA = Sales/2.0 = $5,000/2.0 = $2,500 = Equity.

ROE = NI/Equity = $1,050/$2,500 = 42%.

DIFFICULTY: Medium

TOPICS: ROE

79. The Amer Company has the following characteristics:

Sales: $1,000

Total Assets: $1,000

Total Debt/Total Assets: 35% EBIT: $ 200

Tax rate: 40% Interest rate on total debt: 4.57%

What is Amer's ROE?

a. 11.04% b. 12.31% c. 16.99% d. 28.31% e. 30.77%

ANSWER: c

RATIONALE: Calculate debt and equity:

Debt = D/A × TA = 0.35($1,000) = $350.

Equity = TA − Debt = $1,000− $350 = $650.

Calculate net income and ROE:

Net income = (EBIT − I)(1 − T) = [$200 − 0.0457($350)](0.6) = $110.4.

ROE = $110.4/$650 = 16.99%.

DIFFICULTY: Medium

TOPICS: ROE

80. Aurillo Equipment Company (AEC) projected that its ROE for next year would be just 6%. However, the financial staff has determined that the firm can increase its ROE by refinancing some high interest bonds currently outstanding. The firm's total debt will remain at $200,000 and the debt ratio will hold constant at 80%, but the interest rate on the refinanced debt will be 10%. The rate on the old debt is 14%. Refinancing will not affect sales which are projected to be $300,000. EBIT will be 11% of sales, and the firm's tax rate is 40%. If AEC refinances its high interest bonds, what will be its projected new ROE?

a. 3.0% b. 8.2% c. 10.0% d. 15.6% e. 18.7%

ANSWER: d

RATIONALE: Relevant information:

Old ROE = NI/Equity = 0.06 = 6%.

Sales = $300,000; EBIT = 0.11(Sales) = 0.11($300,000) = $33,000.

Debt = $200,000; D/A = 0.80 = 80%.

Tax rate = 40%.

Interest rate change: Old bonds 14%; new bonds 10%.

Calculate total assets and equity amounts:

Since debt = $200,000, total assets = $200,000/0.80 = $250,000.

E/TA = 1 − D/A = 1 − 0.80 = 0.20.

Equity = E/TA × TA = 0.20 × $250,000 = $50,000.

Construct comparative Income Statements from EBIT, and calculate new ROE:

		Old	New
EBIT	$33,000	$33,000
Less: Interest	28,000	20,000
EBT	5,000	13,000
Less: Taxes (40%)	2,000	5,200
Net income	$ 3,000	$ 7,800
	New ROE = NI/Equity = $7,800/$50,000 = 0.1560 = 15.6%.
DIFFICULTY: TOPICS:	Medium ROE and refinancing

81. Savelots Stores' current financial statements are shown below:

Inventories	$ 500	Accounts payable	$ 100
Other current assets	400	Short-term notes payable	370
Fixed assets	370	Common equity	800
Total assets	$1,270	Total liab. and equity	$1,270

Sales	$2,000
Operating costs	1,843
EBIT	157
Less: Interest	37
EBT	120
Less: Taxes (40%)	48
Net income	72

A recently released report indicates that Savelots' current ratio of 1.9 is in line with the industry average. However, its accounts payable, which have no interest cost and which are due entirely to purchases of inventories, amount to only 20% of inventory versus an industry average of 60%. Suppose Savelots took actions to increase its accounts payable to inventories ratio to the 60% industry average, but it (1) kept all of its assets at their present levels (that is, the asset side of the balance sheet remains constant) and (2) also held its current ratio constant at 1.9. Assume that Savelots' tax rate is 40%, that its cost of short-term debt is 10%, and that the change in payments will not affect operations. In addition, common equity would not change. With the changes, what would be Savelots' new ROE?

a. 10.5% b. 7.8% c. 9.0% d. 13.2% e. 12.0%

ANSWER: a

RATIONALE: The firm is not using its "free" trade credit (that is, accounts payable (A/P)) to the same extent as other companies. Since it is financing part of its assets with 10% notes payable, its interest expense is higher than necessary.

Calculate the increase in payables:

Current (A/P)/Inventories ratio = 100/500 = 0.20.

Target A/P = 0.60(Inventories) = 0.60(500) = 300.

Increase in A/P = 300 − 100 = 200.

Because the current ratio and total assets remain constant, total liabilities and equity must be unchanged. The increase in accounts payable must be matched by an equal decrease in interest bearing notes payable. Notes payable decline by 200. Interest expense decreases by 200 × 0.10 = 20.

Construct comparative Income Statements:

Old New

Sales $2,000 $2,000

Operating costs 1,843 1,843

EBIT 157 157

Less: Interest 37 17

EBT 120 140

Less: Taxes 48 56

Net income (NI) $ 72 $ 84

ROE = NI/Equity = $72/$800 = 9%. $84/$800 = 10.5%.

New ROE = 10.5%.

DIFFICULTY: Medium

TYPE: Problem

TOPICS: ROE and financing

82. Harvey Supplies Inc. has a current ratio of 3.0, a quick ratio of 2.4, and an inventory turnover ratio of 6. Harvey's total assets are $1 million and its debt ratio is 0.20. The firm has no long-term debt. What is Harvey's sales figure if the total cost of goods sold is 75% of sales?

a. $960,000 b. $720,000

c. $1,620,000 d. $120,000

e. $540,000

ANSWER: a

RATIONALE: Current liabilities: (0.2)($1,000,000) = $200,000.

Current assets: CA/$200,000 = 3.0; CA = $600,000.

Inventory: ($600,000 − I)/$200,000 = 2.4; I = $120,000.

Sales: (0.75)S/$120,000 = 6; S = $720,000/0.75 = $960,000.

DIFFICULTY: Medium

TOPICS: Sales volume

83. Given the following information, calculate the market price per share of WAM Inc.

Earnings after interest and taxes = $200,000

Earnings per share = $2.00

Stockholders' equity = $2,000,000

Market/Book ratio = 0.20 a. $20.00

b. $8.00 c. $4.00 d. $2.00 e. $1.00

ANSWER: c

RATIONALE: Number of shares = $200,000/$2.00 = 100,000.

Book value per share = $2,000,000/100,000

= $20. Market value = 0.2(Book value) = 0.2($20) = $4.00 per share.

DIFFICULTY: Medium

TOPICS: Market price per share

84. On its December 31st balance sheet, LCG Company reported gross fixed assets of $6,500,000 and net fixed assets of $5,000,000. Depreciation for the year was $500,000. Net fixed assets a year earlier on December 31st, had been

$4,700,000. What figure for "Cash Flows Associated with Long-Term Investments (Fixed Assets)" should LCG

report on its Statement of Cash Flows for the current year?

a. $500,000 b. $600,000 c. $700,000 d. $800,000 e. $900,000

ANSWER: d

RATIONALE: Funds = NFA1 – NFA0 + Depreciation

= $5,000,000 – $4,700,000 + $500,000 = $800,000.

Alternative long-form solution:

Current Year One Year Ago

Gross fixed assets $6,500,000 $5,700,000

Accumulated depreciation 1,500,000 1,000,000

Net fixed assets 5,000,000 4,700,000

Accumulated assetsYear ago

= $4,700,000 + ($1,500,000 − $500,000)

= $5,700,000.

Funds used to purchase = GFACurrent − GFAYear ago fixed assets

= $6,500,000 − $5,700,000 = $800,000.

DIFFICULTY: Medium

TOPICS: Depreciation cash flows

85. Lombardi Trucking Company has the following data:

Assets:	$10,000	Profit margin:	3.0%
Debt ratio:	60.0%	Interest rate:	10.0%
Tax rate:	40%	Total asset turnover:	2.0

What is Lombardi's TIE ratio?

a. 0.95 b. 1.75 c. 2.10 d. 2.67 e. 3.45

ANSWER: d

RATIONALE: TA Turnover = S/A = 2 S/$10,000 = 2 S = $20,000

Debt = $6,000 INT = $6,000 (0.1) = $600

NI = $600

EBIT $1,600

Int. 600

EBT $1,000

Taxes (40%) 400

NI $ 600

TIE = $1,600/$600 = 2.67

DIFFICULTY: Tough

TOPICS: TIE ratio

86. Retailers Inc. and Computer Corp. each have assets of $10,000 and a return on common equity equal to 15%.

Retailers has twice as much debt and twice as many sales relative to Computer Corp. Retailers' net income equals

$750, and its total asset turnover is equal to 3. What is Computer Corp.'s profit margin?

a. 2.50% b. 5.00% c. 7.50% d. 10.00%

e. 12.50%

ANSWER:	c
RATIONALE:	D = Debt for Computer Corp.;	S	=	Sales for Computer Corp.
	2D = Debt for Retailers;	2S	=	Sales for Retailers

Retailers: $1,500 − 0.3D = $750 D = $2,500 Computer

Corp.: NI = $1,125 Retailers:

S = $15,000

DIFFICULTY: Tough

TOPICS: Profit margin

 

 

 

CFIN4 - CHAPTER 2

INTEGRATIVE PROBLEM SOLUTION

a. Begin by reviewing briefly what balance sheets and income statements are. Then give an overview of the statement of cash flows. Explain that some data (net income, depreciation, and dividends) come from the income statement, while the other items reflect differences between balance sheet accounts and thus show changes in those accounts between the two dates.

The cash flow statement highlights some important aspects of Computron’s financial condition. First, note that the firm’s net operating cash flow is -$73,780, so its operations are draining cash despite the positive net income reported on the income statement. Second, because of its negative cash flow from operations, Computron had to borrow a total of $126,180 in long- and short-term debt to cover its operating cash outlays, to pay for fixed asset additions, and to pay dividends. Even after all this borrowing, Computron’s cash account still fell by $5,600 during 2010.

b. Financial ratios are used to get an idea about how well the company is being operated, and where it needs improving. The ratio categories, and their purposes, are as follows:

1. Liquidity: Can the company make required payments in the short run (defined as the next year)?

2. Asset management: Are the investments in assets about right in view of sales levels?

3. Debt management (financing mix): Does the company have about the right amount of debt, or is it over leveraged?

4. Profitability: Are costs under good control as reflected in the profit margin, ROE, and ROE?

5. Market values: Do investors like what they see as reflected in the P/E and M/B ratios?

c. Computron has $540,200 in obligations that must be satisfied within the coming year. Will it have trouble meeting its required payments? A full liquidity analysis requires a cash budget, but these two ratios provide quick, easy‑to‑use measures of liquidity:

2010 2009 Industry

Current ratio 2.4x 2.3x 2.7x

Quick ratio 0.8x 0.8x 1.0x

Computron’s current and quick ratios have both held steady from 2009 to 2010, but they are slightly below the industry average. With a 2010 current ratio of 2.4, Computron could liquidate assets at only 1/2.4 = 0.42 = 42% of book value and still pay off current creditors in full. In general, inventories are the least liquid of a firm’s current assets, and they are the assets on which losses are most likely to occur in the event of a forced sale. Computron’s quick ratio of 0.8 indicates that even if receivables can be collected in full, the firm would still need to raise some cash from the sale of inventories to meet its current claims.

d.

2010 2009 Industry

Inventory turnover 3.9x 4.0x 5.8x

As a rough approximation, each item of Computron’s inventories was sold and then restocked, or “turned over,” 3.9 times during 2010. This compares poorly with the industry average of 6.0 times, and the downward trend from 2009 is also worrisome. This analysis raises the question of whether Computron is holding excess inventories (relative to its sales level), and also whether any of its inventories is old and obsolete, hence worth less than its stated value. A problem arises in calculating and analyzing inventory turnover. Sales occur throughout the year, but the inventory figure is for one point in time. If a firm’s sales are highly seasonal, or are experiencing a strong trend, it would be preferable to use an average inventory amount. An average monthly figure would be best, but (beginning of year + end of year)/2 is better than a point value because it at least adjusts for sales trends. For Computron, 2010 average inventories = ($715,200 + $836,000)/2 = $775,600, so average inventory turnover for 2010 = $3,250,000/$775,600 = 4.2x.

2010 2009 Industry

DSO 37.6 days 36.8 days 32.0 days

The days sales outstanding (DSO) represents the average length of time that the firm must wait after making a sale before it receives cash. Computron’s DSO is above the industry average and is trending higher, so it looks bad.

The DSO can also be compared with the firm’s credit terms. To illustrate, if Computron’s sales terms called for payment within 30 days, then a 37.6‑day DSO would indicate that some customers are taking well in excess of the 30‑day limit, because some presumably are paying on time, by the 30th day. Note that, as with inventories, an average figure for receivables would be better than the end‑of‑year amount.

2010 2009 INDUSTRY

Fixed assets turnover 10.7x 10.0x 10.7x

Total assets turnover 2.3x 2.3x 2.6x

Computron’s fixed assets turnover ratio has improved from 2009 to 2010 to reach the industry average, but its total assets turnover ratio has remained relatively constant at a level just below the industry average. Thus, the company is utilizing its fixed assets at the industry average level, but its total assets turnover is below average. As indicated earlier, Computron might have excess inventories and receivables, and this would lower the total assets turnover relative to the fixed assets turnover. (Note again that average values of fixed and total assets would provide a better indication of the assets actually used to generate sales for the year.)

e.

2010 2010 Industry

Debt ratio 58.4% 54.8% 50.0%

TIE 2.0x 3.3x 2.5x

FCC 1.6x 2.4x 2.1x

All three measures reflect the extent of debt usage, but they focus on different aspects. Computron’s debt ratio is above the industry average, and the trend is up. Creditors have supplied over one‑half the firm’s total financing. Computron probably would find it difficult to borrow additional funds at a reasonable cost without first raising more equity capital. Note that another leverage ratio, the debt‑to‑equity ratio, is also used in practice. Computron’s debt‑to‑equity ratio for 2010 is 1.41, indicating that creditors have contributed $1.41 for each dollar of equity capital.

The tie ratio focuses on the firm's ability to cover its interest payments. In some situations, this is a better measure of debt usage than the debt ratio. For example, a firm might show a high debt ratio, but if its assets are old and largely depreciated, hence shown on the balance sheet at a low value even though the assets are really quite valuable and produce high income and cash flows, then the debt ratio might be overstating the impact of the debt on the firm's riskiness. In Computron’s case, however, the 2010 tie is below the industry average and falling, and this, like the debt ratio, indicates high and possibly excessive use of debt.

The fixed charge coverage (FCC) ratio is similar to the tie ratio, but it is more inclusive in that it recognizes that long‑term lease contracts also represent fixed, contractual payments. Computron’s 2010 FCC ratio is also below the industry average, and it is falling. Again, this points out that Computron uses substantially more fixed charge financing than the average firm in the industry, so it probably would have trouble obtaining additional debt or lease financing. Note also that there are many variations of the coverage ratios, depending on the purpose of the analysis.

f.

2010 2009 Industry

Profit margin 1.1% 2.6% 3.5%

Computron’s profit margin is low and falling. This indicates that its sales prices are relatively low, that its costs are relatively high, or both. Note that because we are primarily concerned with the profitability to common stockholders, net income available to common stockholders after preferred dividends have been paid is used to calculate profit margin.

2010 2009 Industry

ROA 2.7% 6.0% 9.1%

ROE 6.4 13.3 18.2

Computron’s ROA and ROE are substantially below the industry average, and falling. These are “bottom line” ratios, and because they are poor, one would anticipate that the company’s common stock has not been doing very well.

g.

2010 2009 Industry

P/E 13.6x 9.7x 14.2x

M/B 0.9x 1.3x 1.4x

The P/E ratio shows how much investors are willing to pay per dollar of reported profits. At the end of 2010, Computron’s stock sold for $6.00 per share; its reported earnings were $44,220/100,000 = $0.44 per share; and the result was a P/E ratio of $6.00/$0.44 = 13.6x. Note that the firm’s P/E ratio actually improved from 2009 to 2010, almost reaching the industry average. However, this was not caused by an increase in stock price—the price fell by almost 30 percent, from $8.50 to $6.00. Rather, the P/E ratio rose because of the 2010 earnings decline—earnings fell by almost 50 percent from the 2009 level. With earnings normalized (averaged over several years), Computron’s P/E ratio would be well below the industry average, indicating that investors view Computron as being riskier and/or as having poorer growth prospects than the average firm in the industry.

The M/B ratio gives another indication of how investors regard the company. Good companies with consistently high rates of return on equity sell at higher multiples of book value than those with low returns. In 2010, Computron had a book value (of equity) per share of $685,988/100,000 = $6.86 and a stock price of $6.00, for an M/B ratio of $6.00/$6.86 = 0.9x. This is well below the 1.4x industry average, which is not surprising given Computron’s poor ROE.

h. The DuPont equation provides an overview of (1) a firm’s profitability as measured by ROA and ROE, (2) its expense control as measured by the profit margin, and (3) its assets utilization as measured by the total assets turnover, combining these items in the equation shows how the different factors interact to determine ROA and ROE. The data for Computron and the industry are given below.

Total assets

DuPont Profit margin turnover

Equation: (profit/sales) x (Sales/TA) = ROA

2010: 1.15% x 2.33 = 2.7%

2009: 2.56 x 2.34 = 6.0

Industry: 3.50 x 2.6 = 9.1

We see that Computron’s expense control as reflected in the profit margin is both poor and trending down, and that its total assets utilization is somewhat below average but holding steady. These measures combine to produce an ROA that is very low and falling.

i. Sales per day amount to $3,850,000/360 = $10,694. Accounts receivable are now $402,000, or 37.6 days’ sales. If A/R can be reduced to 27.6 days without affecting sales, then the balance sheet item A/R would be $10,694 x 27.6 = $295,154, down $106,846 from the current level. That $106,846 could be used (1) to reduce debt, which would lower interest charges and thus increase profits, (2) to buy back stock, which would lower shares outstanding and thus raise EPS; or (3) to invest in productive assets, which presumably would raise net income. In any event, EPS, hence DPS, should increase.

The change also might improve the risk picture as reflected in the debt ratio (if the $106,846 were used to reduce debt), and it would almost certainly improve the coverage ratios. This would lower the firm’s perceived riskiness. All of this would improve the stock price. (Note, however, that reducing accounts receivable by 10 days of sales is not a cost-free action.)

j. Some of the problems and limitations of financial statement analysis are discussed below.

(1) Many large firms operate a number of different divisions in quite different industries, and in such cases it is difficult to develop a meaningful set of industry averages for comparative purposes. This tends to make ratio analysis more useful for small, narrowly‑focused firms than for large, multi‑divisional ones.

(2) Most firms want to be better than average, so merely attaining average performance is not necessarily good. To achieve high‑level performance, it is preferable to target on the industry leaders' ratios.

(3) Inflation distorts firms’ balance sheets. Further, because inflation affects both depreciation charges and inventory costs, profits also are affected. Thus, a ratio analysis for one firm over time, or a comparative analysis of firms of different ages, must be interpreted with care and judgment.

(4) Seasonal factors can also distort ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventories is the one just before versus the one just after the canning season. This problem can be minimized by using monthly averages for inventories when calculating ratios such as turnover.

(5) Firms can employ “window dressing” techniques to make their financial statements look better to credit analysts. To illustrate, a Chicago builder borrowed on a two‑year basis on December 29, 2010, held the proceeds of the loan as cash for a few days, and then paid off the loan ahead of time on January 5, 2006. This improved his current and quick ratios, and made his year‑end 2006 balance sheet look good. However, the improvement was strictly temporary; a week later the balance sheet was back at the old level.

(6) Different operating and accounting practices can distort comparisons. As noted earlier, inventory valuation and depreciation methods can affect the financial statements and thus distort comparisons among firms that use different accounting procedures. Also, if one firm leases a substantial amount of its productive equipment, then it might show relatively few assets in comparison to its sales, because leased assets often do not appear on the balance sheet. At the same time, the lease liability might not be shown as a debt. Thus, leasing can artificially improve both the debt and turnover ratios.

(7) It is difficult to generalize about whether a particular ratio is “good” or “bad.” For example, a high current ratio might indicate a strong liquidity position, which is good, or excessive cash, which is bad, because excess cash in the bank is a non-earning asset. Similarly, a high fixed assets turnover ratio can occur either because a firm uses its assets efficiently or because it is undercapitalized and simply cannot afford to buy enough assets.

(8) A firm might have some ratios that look “good” and others that look “bad,” making it difficult to tell whether the company is, on balance, in a strong or a weak position. However, statistical procedures can be used to analyze the net effects of a set of ratios. Many banks and other lending organizations use these procedures to analyze firms' financial ratios and, on the basis of their analyses, classify companies according to their probability of getting into financial distress.

Conclusion: In this chapter, we looked at financial statements from a historical perspective, to see how well the company has been run. Our real interest, though, is in the future. In the next chapter, we go on to forecast financial statements to get an idea of where the firm will be going in the future.