financial analysis techniques(Reading 28)

Exercise Problems:

1. If a firm has a net profit margin of 21% and a return on equity of 14%, its equity turnover ratio is closest to:

A. 0.67x

B. 0.78x

C. 1.5x

Ans: A

The calculation are as follows:

0.14    =          0.21              *Equity turnover

→Equity turnover= 0.14/0.21=0.67

2. The following is the information on Company A:

The firm’s return on assets (ROA) is closest to:

A. 11%

B. 12%

C. 25%

Ans: B

→Asset=3,500/Debt ratio=3,500/0.175=20,000

Equity=Asset –Liabilities=20,000-5,000=15,000

ROA =

           = 0.12

3. A company collected $57,500 in accounts receivable and repaid $37,500 in interest bearing short-term loans. The combined effect that transactions will invrease CFO for the company is:

A. $20,000

B. $57,500

C. 95,000

Ans: B

Collecting account receivable will increase CFO by $57,500. Repaying short-term loan is a financing activities, which reduces CFF (rather than CFO) by $37,500.

4. Three companies operating in the same industry produced the following results during the same year:

Which company produced the highest gross profit margin during the year?

A. Company A

B. Company B

C. Company C

Ans: A.

The days of inventory on hand (DOH) can be deconstructed into:

→ Cost of goods sold = 365 *

So the cost of goods sold for the three companies:

A =365 *(1.8/60) =10.95

B =365 *(2.0/60) =12.17

C= 365 *(2.3/65) =12.92

The formula for gross profit margin is:

Gross profit margins for the three companies are:

A= 1- (10.95/25) =0.562

B= 1- (12.17/26) =0.532

C= 1- (12.92/27) =0.522

(This could also be solved somewhat intuitively by recognizing that company A achieved roughly comparable sales results on proportionately much less inventory in both dollar amount and in days of inventory on hand. Its profit margin must have been higher!)

5. The cash conversion cycle (CCC) decreases if there is an increase in the number of:

A. Days of payables.

B. Days of sales outstanding (DSO).

C. Days of inventory on hand (DOH).

Ans: A.

The cash conversion cycle shoes how long it takes a firm to convert resource inputs into cash flows.

Increasing the number of days of payables reduces the cash conversion cycle.

B. Increasing  the DSO increases the CCC.

C. Increasing  the DOH increases the CCC.

6. A company’s days of sales outstanding (DSO) decreased, while its cost of goods sold (COGS) relative to sales and receivable remain unchanged. The company’s gross profit will:

A. Decline.

B. Increase.

C. Remain unchanged.

Ans. B.

A decrease in DSO means that receivables turnover increased. For receivables turnover to increase while receivables remained stable means that revenues must have increased. This will result in higher gross profits because the gross margin remained the same.

7. Selected information for a company and the common size data for its industry are provided below.

Which of the following is most likely a contributor to the company’s inferior ROE compared to that of the industry? The company’s:

A. Tax burden ratio.

B. Interest burden ratio.

C. Financial leverage ratio.

Ans. C.

8. The following information is available:

The company’s cash conversion cycle (in days) is closest to:

A. 38.2.

B. 45.2.

C. 76.4.

Ans: A.

9. An analyst has calculated the following ratios for a company:

The company’s return on equity (ROE) is closest to:

A. 4.8%.

B. 15.2%.

C. 22.7%.

Ans: B.

Using DuPont analysis, there are two ways to calculate ROE from the information provided:

ROE

= Net profit margin × Asset turnover × Financial leverage

= 11.7 × 0.89 × 1.46

= 15.2

ROE

= ROA × Financial leverage

=10.4×1.46

=15.2

10. Selected information from a company’s recent income statement and balance sheets is presented below.

The company operates in an industry in which suppliers offer terms of 2/10, net 30. The payables turnover for the average company in the industry is 8.5 times. Which of the following statements is most accurate? In 2011, the company on average:

A. took advantage of early payment discounts.

B. paid its accounts within the payment terms provided.

C. paid its accounts more promptly than the average firm in the industry.

Ans: C.

Purchases

= COGS + End inventory – Beginning inventory

= 1,320,000 + (63,000 – 71,500) = 1,311,500

Average payables = ? × (129,600 + 157,200) = 143,400

Payables turnover

 = Purchases ÷ Average payables

 = 1,311,500 ÷ 143,400

= 9.15 times

Days in payables = 365 ÷ Payables turnover ratio

Firm: 365 days ÷ 9.15 = 39.9 days

Industry: 365 days ÷ 8.5 times = 42.9 days

The firm’s days in payables is 39.9 days; therefore, it appears the firm does not normally take supplier-provided discounts (paying in 10 days) nor pay its accounts within the 30-day terms provided. However, on average, the firm is paying faster than the average firm in the industry (42.9 days).

11. Which of the following will most likely result in an increase in a company’s sustainable growth rate?

A. Higher tax burden ratio

B. Lower interest burden ratio

C. Higher dividend payout ratio

Ans: A.

Sustainable growth rate = Retention ratio × ROE.

The higher a company’s ROE and its ability to finance itself from internally generated funds (a higher retention ratio), the greater its sustainable growth rate.

In the five-factor ROE, any factor that increases ROE will increase sustainable growth:

ROE = Tax burden × Interest burden × EBIT margin × Asset turnover × Leverage.

A higher tax burden ratio (Net income/Earnings before tax) implies that the company can keep a higher percentage of pretax profits; this implies a lower tax rate and a higher ROE.

B is incorrect. The interest burden ratio is earnings before tax to EBIT, and a lower ratio means that the company has higher borrowing costs (it gets to keep a lower pre-tax income from a given EBIT), implying a lower ROE and sustainable growth.

C is incorrect.  Dividend payout ratio=1-retention ratio

A higher dividend payout ratio will lead to a lower retention ratio, which will in turn result in a decrease in a company’s sustainable growth rate.

12. The use of financial ratio analysis is most likely limited in which of the following situations? When:

A. providing a means of evaluating management’s ability.

B. comparing companies using different accounting methods.

C. providing insights into microeconomic relationships within a company that help analysts project earnings and free cash flow.

Ans: B.

Financial ratio analysis is limited by the use of alternative accounting methods. Accounting methods play an important role in the interpretation of financial ratios. The lack of consistency across companies makes comparability difficult to analyze and limits the usefulness of ratio analysis.

13. An analyst gathered the following data for two companies in the same industry:

Which of the following is the most appropriate conclusion the analyst can make? Compared to Company B, Company A:

A. is more liquid.

B. has more financial risk.

C. has a longer time between cash outlay and cash collection.

Ans: A.

Company A has a higher current ratio and shorter cash conversion cycle and it therefore more liquid. The lower financial leverage ratio indicates that it has less financial risk, not more, and it has less time between cash outlay and cash collection.

14. The table below contains selected data from the common-size balance sheets for three different industries: utilities, financials and consumer discretionary products.

LT = Long Term; PPE = Property, plant and equipment

Which of the following statements is most accurate?

A. Industry 1 is the utility industry and Industry 2 is the financial industry.

B. Industry 2 is the utility industry and Industry 3 is the consumer discretionary products industry.

C. Industry 1 is the consumer discretionary products industry and Industry 3 is the financial industry.

Ans: B.

The utility industry [2] has a large percentage of PPE and long term debt and low inventories; the consumer discretionary products industry [3] would have high inventories.

15. An analyst calculates the following ratios for a firm:

The return on equity (in %) for this firm is closest to:

A. 6.4.

B. 7.0.

C. 17.9.

Ans: C.

ROE = Net Profit Margin x Sales/Total Assets x Total Assets/Equity

= 4.0 x 2.8 x 1/0.625 = 17.9%.

Alternatively, ROE = Return on Total Assets x Total Assets/Equity = 11.2 x 1/0.625 = 17.9%

16. The following information (U.S. $ millions) for two companies operating in the same industry during the same time period is available:

If both companies achieve a return on equity of 15% for the period, which of the following statements is most likely correct? Compared to Company B, Company A has a:

A. higher net profit margin.

B. higher total asset turnover.

C. lower financial leverage multiplier.

Ans: A.

The DuPont system can be used to break down the ROE into three components:

ROE = Profit margin x total asset turnover x financial leverage multiplier.

Company A has a higher financial leverage multiplier, not lower

Company A’s Net Profit Margin from ROE: = 15% = (net profit margin) x 1.71 x 1.56

Company A’s net profit margin = 5.6%

Company A’s Net Profit Margin from ROE: = 15% = (net profit margin) x 2.14 x 1.40

Company A’s net profit margin = 5.0%

The net profit margin could also be computed by computing net income for each company from the basic ROE definition: ROE = Net Income/Common Equity

For Company A: ROE = 15% = net income/ (70-25); net income is 6.75, and net profit margin = net income/Sales = 6.75/ 120 = 5.6%.)

For Company B: ROE = 15% = net income/ (140-40); net income is 15, and net profit margin = net income/Sales = 15/ 300 = 5.0%.)

Company A has a higher net profit margin than Company B

17. The following selected information is from a company’s most recent financial statements:

The 2009 cash conversion cycle, in days, is closest to:

A. 23.

B. 26.

C. 28.

Ans: A.

18. In the evaluation of credit ratings, a company will most likely be assigned a higher credit rating if it has a:

A. lower EBITDA/Interest ratio.

B. lower dividends-to-total-debt ratio.

C. higher five year average of its coefficient of variation of its operating margin.

Ans: B.

A lower dividend means more retention and increased equity: higher retained cash flow will result in a higher credit rating.

A is incorrect. Just like the interest coverage ratio (=EBIT/ Interest expense), EBITDA/Interest ratio can also measure the protection available to bondholders (creditors) in the form of the adequacy of a firm’s earnings to cover interest expense. Higher ratios are better.

Ratios of operating earnings, EBITD, or some measure of free flow to interest expense or total debt make up the most important part of the credit rating formula. Firms with greater earnings in relation to their debt and in relation to their interest expense are better credit risks.

C is incorrect. Margin stability- stability of the relevance profitability margins indicates a higher probability of repayment (leads to a better debt rating and a lower interest rate). Highly variable operating results make lenders nervous.

19. An analyst prepares common-size balance sheets for two companies operating in the same industry. The analyst notes that both companies had the same proportion of current liabilities, long-term liabilities, and shareholders’ equity and the following ratios:

The most reasonable conclusion is that, compared with Company 2, Company 1 had a:

A. higher percentage of assets associated with inventory.

B.  B. higher percentage of assets associated with accounts receivable.

C. lower percentage of assets associated with marketable securities.

Ans: A.

Currentratio==

Quick ratio=

Cash ratio=

The current ratio includes inventory but the quick ratio does not. (Current ratio is higher than quick ratio and quick ratio is higher than cash ratio.) The quick ratio includes accounts receivable but the cash ratio does not. The denominator for all three ratios is current liabilities, which are the same proportion for both companies. The difference in ratios is therefore created by inventory and accounts receivable. Company 1 has the higher percentage of inventory because the difference between the current ratio and quick ratio is greater for that company. Company 2 had the higher percentage of accounts receivable because the difference between the quick ratio and the cash ratio is greater for Company 2.

20. An analyst gathers the following information about a company:

Cost of goods sold               $18.4 million

Average inventory                 $2.5 million

Receivables turnover                   24 times

Number of days of payables        25 days

Under U.S.GAAP, the company’s cash conversion cycle (in days) is closest to:

A. 40.

B. 59.

C. 65.

Ans: A.

Cash conversion cycle = DOH+ DSO – payables payment period

Inventory turnover = COGS/Ave. Inventory=$18.4/$2.5=7.36

DOH: Days of inventory on hand= 365/inventory turnover =365/7.36 = 49.6 days

DSO: Days Sales Outstanding =365/ Receivables turnover=365/24 =15.2 days

Number of days of payables =25 days

Cash conversion cycle =49.6+15.2-25=39.8 days

21. Two companies operating in the same industry both achieved the same return on equity with the same net sales, but the two companies were different with respect to return on total assets. Compared with the company that had the higher return on total assets, the company with the lower return on total assets most likely had a higher:

A. total asset turnover.

B. financial leverage multiplier.

C. proportion of common equity in its capital structure.

Ans: B.

The traditional DuPont model decomposes return on assets into net profit margin and asset turnover before including leverage:

ROE=xx

        = Net profit margin x asset turnover x leverage

        =ROA X leverage

If the two companies have the same ROE, the company with the lower ROA must have a higher financial leverage multiplier.

A is incorrect. With the information given, we cannot determine whether the company has a higher or lower total asset turnover.

C is incorrect. The company has a higher financial leverage (=Ave. total asset/ Ave. total equity), which means its proportion of common equity in the capital structure (= Ave. total equity/ Ave. total asset) is lower.

22. If an analyst is preparing common-size financial statements the most appropriate way

of expressing the interest expense is as a percentage of:

A. sales.

B. total liabilities.

C. total interest-bearing debt.

Ans: A.

Common-size financial statement allows analysts to compare different sized companies or to identify changes within a company over time by normalizing each line item against a relevant benchmark. For balance sheets, all items are expressed as a percentage of total assets. For income statements, all items are expressed as a percentage of revenue.

Interest expense is an income statement account and the common-size percentage should be computed as a percentage of sales for that company.

23. A company’s cash conversion cycle is most likely to decrease if that company experiences a(n):

A. increase in the payables turnover ratio.

B. decrease in the inventory turnover ratio.

C. increase in the receivables turnover ratio.

D. decrease in the payables payment period.

Ans: C.

Cash conversion cycle

= Days of inventory on hand (DOH) + Days Sales Outstanding (DSO) – payables payment period

=+ – payables payment period

A increase in the receivables turnover ratio will decrease the DSO, which will decrease the cash conversion cycle.

A is incorrect.

Payables turnover ratio=

Payables turnover ratio will not affect the cash conversion cycle.

B is incorrect. A decrease in the inventory turnover ratio will increase the DOH, which will increase the cash conversion cycle.

D is incorrect. A decrease in the payables payment period will increase the cash conversion cycle.

24. An analyst has prepared the following common-size balance sheet for ABC Company:

Based only on the change in the current ratio and debt-to-capital ratio, how did the company’s liquidity and solvency change during 2012?

A. An increase in liquidity and an increase in solvency.

B. A decrease in liquidity and a decrease in solvency.

C. A decrease in liquidity and an increase in solvency.

Ans: C.

Current ratio=

Debt-to-capital ratio=

Liquidity deteriorated substantially as indicated by the declining current ratio. The decline in liquidity was due in large part to the significant increase in the current portion of long-term debt (from 3% of total assets to 19%).

At the same time, solvency increased (improved) somewhat as indicated by the decline in the debt-to-total capital.

25. a firm has summarized its current financial statements and ratios as follows:

The firm’s return on equity (ROE) is closest to:

A.    11%.

B.     16%.

C.     45%.

Ans: B.

DuPont Model:

ROE=Net profit margin x Total asset turnover x financial leverage

Net profit margin===0.110

Total asset turnover ==

                                ==0.557

Financial leverage=2.67

ROE=Net profit margin x Total asset turnover x financial leverage

        =0.110x0.557x2.67 =0.164

Since equity turnover (=sales/equity) is given, an alternative solution is to calculate the net profit margin and then see that ROE =(NI/S)x(S/Equity)=0.11x1.49=16.4%. the solution above is using the traditional method, but sometimes an alternative approach can give the correct answer quicker.

26. If a firm’s current ratio increases while its quick ratio stays the same, that would most likely be explained by:

A. An increase in the days of inventory on hand.

B. A decrease in the days of inventory on hand.

C. An increase in the days of sales outstanding.

A is incorrect.

Currentratio==

Quick ratio=

The main difference between the current and the quick ratios is the current ratio includes inventory (and other current assets) in the numerator. So if the current ratio increased while the quick ratio remained constant, that would be best explained by an increase in the days of inventory on hand.

27. The following financial ratio information is available for a company:

The company’s return on equity (ROE) is closest to:

A.    15.5%.

B.     17.3%.

C.     25.9%

Ans: C.

ROE

=x xxx

=tax burden x interest burden x EBIT margin x asset turnover x leverage

=0.60 xx0.90 x 0.16 x 1.11 x 2.70

= 25.89%

28. Selected 2012 financial data for Wiler Company flow:

Wiler’s operating profit margin for 2012 is closest to:

A. 7.8%.

B. 10.5%.

C. 16.1%.

Ans: A.

Operating profit= sales –COGS-SG&A

                          = $18,000-13,200-3,400

                          =$1,400

Operating profit margin ===7.8%

29. If a firm’s financial leverage ratio declined while its debt to equity ratio remained constant, that would most likely be caused by a relative:

A. Increase in the amount of current liabilities.

B. Decrease in the amount of current liabilities.

C. Decrease in the amount of current assets.

Ans: B.

Financial leverage=

Total assets= non-interest bearing debt + interest bearing debt+common equity

Debt-to-equity=

So if the financial leverage ratio declines while the debt-to-equity ratio remains constant, the most likely explanation would be a decrease in the no-interest bearing debt which would be mostly current liabilities.

30. A company would most likely report a lower total asset turnover ratio than its competitors if it:

A. Uses an accelerated system to depreciate fixed assets while its competitors generally depreciate fixed assets using the straight line method.

B. Is in the startup stage of its life cycle while its industry is mature.

C. Writes off bad debt as they become uncollectible while its competitors record an allowance for doubtful accounts based on collections experience.

Ans: B.

Total asset turnover =

Since the company is in the startup stage of its life cycle, it would have limited sales volumes relative to the capital investment required to penetrate a mature industry. Therefore, its total asset turnover ratio would likely be more conservative (lower) than its competitors.

A is incorrect. Using accelerated depreciation results in a smaller average total asset denominator. This change would increases the total asset turnover ratio and would be less conservative.

C is incorrect. Bad debts written off and allowances for doubtful accounts would both reduce the net sales numerator and the average total assets denominator. More information is needed to determine whether this situation would conservatively impact the total asset turnover ratio.

31. The following information is available for ABC company:

The difference between the firm’s ROA and its ROE is closest to:

A.    2.0%.

B.     2.5%.

C.     3.6%.

Ans: C.

Debt-to-equity==0.5 and debt= $3,500,000

Then the equity= $7,000,000

Total assets= operating liabilities +debt + equity

                   =$1,500,000 + 3,500,000 + 7,000,000

                   =$12,000,000

ROA==0.05

So NI= $12,000,000 x 0.05 = $600,000

ROE===8.6%

ROE-ROA=8.6%-5%=3.6%

32. Sun Group, Inc. (SGI) uses LIFO inventory costing under U.S.GAAP. During fiscal 2012, the company had net sales of $15.0 million. SGI began the year with no inventory and made purchase at a rate of 100,000 units per quarter. The effective corporate tax rate was 40%. Additional information is as follows:

SGI’s net profit margin for 2012 was closest to:

A. 24%.

B. 31%.

C. 40%.

Ans: A.

Unite sales:

$15,000,000/$50= 300,000 units

COGS (LIFO):

Net profit margin ($000):

Net profit margin = $ 3,600 / $15,000 = 24%

33. An analyst has summarized the following key financial information for a firm:

The EBIT margin for year 2012 is closest to:

A.    26.0%.

B.     31.0%.

C.     42.2%.

Ans: B.

The EBIT margin (operating profit margin) is derived from the following:

Since net income (NI)= EBIT – interest expense – taxes

Then EBIT = NI + interest expense + taxes

==

The calculation becomes =31.0%

34. Selected information for a company and the common size data for its industry are provided below.

Which of the following is most likely a contributor to the company’s inferior ROE compared to that of the industry? The company’s:

A. Tax burden ratio.

B. Interest burden ratio.

C. EBIT margin.

Ans. C.

35. Given the following information about a company:

What is the most appropriate conclusion an analyst can make about the solvency of the company? Solvency has:

A. Improved because the debt-to-equity ratio decreased.

B. Deteriorated because the debt-to-equity ratio increased.

C. Improved because the fixed charge coverage ratio increased.

Ans: A.

The debt-to-equity ratio decreased thereby improving solvency; the fixed charge coverage ratio remained the same.

36. The following information is taken from a company’s annual report (all figures in millions):

During the year the Company entered into a 20-year tak-or-pay contract that requires us to purchase a minimum of $0.750 of hydro-electrical power annually, stating next year.

The company’s average cost of long-term borrowing is 7%.

If an analyst were to include the take-or-pay contract in his analysis, the company’s debt-to-equity ratio and return-on-assets, respectively, will be closest to:

A. 1.58; 10.0%.

B. 1.65; 9.4%.

C. 1.65; 10.0%.

Ans: B.

The total sum of the payments should be added to both liabilities and assets.

The revised debt-to-equity==1.65.

The revised ROA==9.4%.

37. Selected financial information for a company as of the end of the current year is presented below.

If last year the current ratio, defensive interval, and operating cycle were 1.22, 54 days and 208 days, receptively, which of the following statements is most accurate? The company’s:

A. Current ratio has decreased.

B. Defensive interval increased.

C. Operating cycle has decreased.

Ans: C.

Cash ratio=

So CL=(Cash + marketable securities) / cash ratio

          =$520/0.03

          =$17,333

Currentratio==$23,100/$17,333=1.33 

(higher: increased from 1.22)

DSO ====117

DOH===78

Operating cycle = DSO+DOH=117+78=195

(shorter: decreased from 208)

Defensive interval=

                                 ==50days

(shorter: decreased from 54 days)

38. To gain insight into what portion of the company’s assets is liquid, an analyst will most likely use:

A. the cash ratio.

B. the current ratio.

C. common-size balance sheets.

Ans: C.

A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets.

Common-size statements normalize balance sheets and allow the analyst to more easily compare performance across firms and for a single firm over time. Also, common-size analysis is appropriate for quickly viewing certain financial ratios.

A and B are incorrect. Both cash ratio and current ratio are liquidity ratios that can be employed by analysts to determine the firm’s ability to pay its short-term liabilities. But they cannot help the analysts to gain insight into what portion of the company’s assets is liquid.

39. Two manufacturing companies operating in the sale industry have different net fixed asset turnover ratios. The difference most likely occurs because the company with the higher ratio:

A. had significantly lower amortization expense for the year.

B. was operating with older equipment that had a low cost basis.

C. recently invested a substantial amount in new plant and equipment.

Ans: B.

A company operating with old, low-cost equipment that is likely to be fully depreciated would tend to have a high fixed asset turnover ratio because average total assets are low.

Fixed asset turnover=

40. A junior analyst wants to understand the underlying components of the DuPont method to better see what changes are driving the changes in ROE. Which of the following items is a direct component of the original (three-part) DuPont equation?

A. Asset turnover.

B. Gross profit margin.

C. Debt-to-equity ratio.

A.    ating theese  leverage to 1.5, but the increased borrowing costs would reduce the ef

Ans: A.

The three-part DuPont approach is as follows:

 net profit margin x asset turnover x leverage ratio

where the leverage ratio is assets-to-equity.

41. Of the following methods of examining the uncertainty of financial outcomes around point estimates, which answers hypothetical questions about the effect of changes in a single variable and which uses assumed probability distributions for key variables?

Ans: A.

Sensitivity analysis is based on hypothetical (“what if”) questions about a single variable, such as “what if sales decline by 10%?” simulation is a technique in which probability distributions for key variables are assumed and a computer is used to generate a distribution of outcomes based on repeated random selection of values for the key variables. Scenario analysis is based on one or more specific scenarios (a specific set of outcomes for key variables), which include changes in multiple variables.

42. Bao, Inc., uses short-term bank debt to buy inventory. Assuming an initial current ratio that is greater than 1, and an initial quick (or acid test) ratio that is less than 1, what is the effect of these transactions on the current ratio and the quick ratio?

A. Both ratios will decrease.

B. neither ratio will decrease.

C. Only one ratio will decrease.

Ans: A.

As an example, start with CA=2, CL=1, and Inv =1.2. we begin with a current ratio of 2 and a quick ratio of 0.8. if the firm increases short-term bank debt (a current liability) by 1 to buy inventory (a current asset) of 1, both the numerator and denominator increase by 1, resulting in 3/2=1.5 (new current ratio) and (3-2.2)/2=0.4 (new quick ratio).

43. From the extended (5-part) DuPont equation, which of the following components describes the equation EBT/EBIT?

A. Tax burden.

B. EBIT margin.

C. Interest burden.

Ans: C.

EBT/WBIT is the interest burden, the second component in the extended DuPont equation. It shows that more leverage does not always lead to higher ROE. As leverage rises, so does the interest burden. The positive effects of leverage can be offset by the higher interest payments that accompany higher levels of debt.

A is incorrect. Net income / EBT is called the tax burden and is equal to (1-rax rate). The higher the tax rate, the lower the ROE level.

B is incorrect. EBIT/ revenue is called the EBIT margin or operating margin.

44. Which of the following is most likely presented on a common-size balance sheet or common-size income statement?

A. Total asset turnover.

B. Operating profit margin.

C. Return on common equity.

Ans: B.

Operating profit margin can be read directly from a common-size income statement. Asset turnover and return on equity mix balance sheet and income statement items.

45. Two firms in the same industry show the following ratios for the most recent year after all proper adjustments have been made for dilutive securities and differences in financial reporting standards:

Based on this information, the better financial performance of these two firms:

A. is Company Y because it has the highest EPS.

B. is Company Z because it generated the most CFO per share.

C. Cannot be determined because per-share ratios are not comparable.

Ans: C.

When stated on a per-share basis, difference companies’ financial data cannot be compared meaningfully because these depend on the number of shares outstanding, which is unrelated to the companies’ operating performance or profitability. A company with a $200 share price should have much higher valuation measures than a company with a $2 share price.

46. A firm pays accrued wages with cash. Assuming a current ratio greater than one and a quick ratio that is less than one, what will be the impact on the current ratio and the quick ratio?

A. Both ratios will remain the same.

B. The current ratio will increase and the quick ratio will decrease.

C. The current ratio will decrease and the quick ratio will increase.

Ans: B.

Reducing the numerator and denominator by the same amount will increase a ratio that is greater than one and decrease a ratio that is less than one.

47.  Bao Company has a cash conversion cycle of 80 days. If the company’s average receivables turnover increases from 11 to 12, the company’s cash conversion cycle:

A. decreases by approximately 3 days.

B. increases by approximately 3 days

C. decreases by approximately 1 days

ans: A.

Cash conversion cycle

= Days of inventory on hand (DOH) + Days Sales Outstanding (DSO) – payables payment period

DSO= ==33.18

=30.42

33.18-30.42=2.76

This means the CCC decreases by 2.76 days.

48. The presentation format of balance sheet data that standardizes the first-year values to 1.0 and presents subsequent year’s amounts relative to 1.0 is a(n):

A. indexed balance sheet.

B. vertical common-size balance sheet.

C. horizontal common-size balance sheet.

Ans: C.

On horizontal common-size balance sheet, the divisor is the first year values so they are all standardized to 1.0 by construction. Trends in the values of these items as well as the relative growth in these items are readily apparent. A vertical common-size balance sheet expresses all balance sheet accounts as a percentage of total assets and does not standardize the initial year.

49. Bao Corp. has a current ratio above 1 and a quick ratio less than 1. Which of the following actions will increase the current ratio and decrease the quick ratio? Bao Corp.:

A. buys fixed assets on credit.

B. uses cash to purchase inventory.

C. pays off accounts payable from cash.

Ans: C.

Paying off accounts payable from cash lowers current assets and current liabilities by the same amount. Because the current ratio started off above 1, the current ratio will increase. Because the quick ratio started off less than 1, it will decrease further.

A is incorrect. Buying fixed assets on credit decreases both ratios because the denominator increases, with no change to the numerator.

C is incorrect. Using cash to purchase inventory would result in no change in the current ratio but would decrease the quick ratio by decreasing the numerator.

50. A company has a Cash conversion cycle of 70 days. If the company’s payables turnover decreases from 11 to 10 and days of sales outstanding increase by 5, the company’s Cash conversion cycle will:

A. decreases by approximately 8 days.

B. decreases by approximately 3 days.

C. increases by approximately 2 days.

Ans: C.

Cash conversion cycle (CCC)

= Days of inventory on hand (DOH) + Days Sales Outstanding (DSO) – payables payment period

Payables payment period

===33.18days

=36.5days

Since the payables payment period increases by 3.32 days and receivables days increases by 5, CCC increases by 1.68 days.

51. The following data pertains to a company’s common-size financial statements.

The company’s after-tax return on common equity is closest to:

A. 15%.

B. 20%.

C. 25%

Ans: B.

ROE===0.2

If the debt ratio (TD/TA) is equal to 40% and the firm has no preferred stock, the percentage of equity is 1-0.4, or 60%.

52. Which of the following statements about financial ratios is most accurate?

A. A company with a high debt-to-equity ratio will have a return on assets that is greater than its return on equity.

B. Any firm with a high net profit margin will have a high gross profit margin and vice versa.

C. A company that has an inventory turnover of 6 times, a receivables turnover of 9 times, and a payables turnover of 12 times will have a cash conversion cycle of approximately 71 days.

Ans: C.

The cash conversion cycle is:

Cash conversion cycle

= Days of inventory on hand (DOH) + Days Sales Outstanding (DSO) – payables payment period

=+ –

=+-

=60.8+40.6-30.4

=71 days.

ROA is lower than ROE when net income is positive and debt is present. Just the fact that a company has a high gross profit margin does not necessary mean it will have a high net profit margin. For example, the company could have very high operating expenses and end up with a low net profit margin.

53. Nan Chen, CFA, calculates the following ratios for Bao Company:

These ratios most likely suggest that during the period shown, Bao’s:

A. use of operating leases increased.

B. interest obligations increased faster than earnings.

C. capital structure became more reliant on equity financing.

Ans: A.

Operating lease payments distinguish the fixed charge coverage ratio from the interest coverage ratio. The fixed charge coverage ratio is decreasing at the same time the interest coverage ratio is increasing, which means the company’s operating lease payments are increasing. (Note that the years are presented right-to-left.)

B is incorrect. The increasing interest coverage ratio suggests earnings before interest and taxes are increasing more (or decreasing less) than the interest payments on the company’s debt.

C is incorrect. The debt-to-capital ratio is essentially unchanged in the period shown, which implies that the company has not changed its capital structure significantly.

54. Yang Liu, CFA, gathered the following data about a company:

The company’s return on equity:

A. decreased because the company’s profit margin decreased.

B. increased because the company’s asset turnover and leverage increased.

C. remained constant because the company’s decreased profit margin was just offset by increases in asset turnover and leverage.

Ans: A.

ROE 2011=0.7x0.85x0.15x1.5x1.5=0.2008

ROE 2012=0.7x0.85x0.10x1.8x1.6=0.1714x

Profit margin fell, and the increase in the total asset turnover ratio and the leverage multiplier were not enough to offset the decline, so ROE decreased.

55. Bao Company’s common-size financial statements show the following information:

Bao’s long-term debt-to-equity ratio and current ratio are closest to:

Ans: A.

If equity equals 45% of assets and current liabilities equal 20%, long-term debt must be 35%.

long-term debt-to-equity ratio

===0.778=77.8%

CA=0.1+0.15+0.20

Current ratio===2.25

56. Zhan Wang, CFA, compiles the following information for a company:

The cash conversion cycle (CCC) for the company is closest to:

A. 143.

B. 207.

C. 256.

Ans: C.

The cash conversion cycle (CCC) is calculated as:

cash conversion cycle (CCC) = days of inventory on hand (DOH)+days of sales outstanding (DSO) – number of days of payables

DOH =  =  = 328.5

DSO =  =  = 73

number of days of payables =  =  = 146

cash conversion cycle (CCC) = 328.5 + 73 – 146 = 255.5.

Note that purchases should be used in the calculation of number of days of payables if given or if the necessary information is available (i.e., purchases = COGS – beginning inventory + ending inventory).