SELF-TEST QUESTIONS

Definitional

1. The current ratio is an example of a(n) ___________ ratio. It measures a firm’s ability to
meet its _________ obligations.

2. The days sales outstanding (DSO) ratio is found by dividing average sales per day into
accounts ____________. The DSO is the length of time that a firm must wait after
making a sale before it receives ______.

3. Debt management ratios are used to evaluate a firm’s use of financial __________.

4. The debt ratio, which is the ratio of _______ ______ to _______ ________, measures the
percentage of funds supplied by creditors.

5. The _______-__________-________ ratio is calculated by dividing earnings before

interest and taxes by the amount of interest charges.

6. The combined effects of liquidity, asset management, and debt on operating results are
measured by _______________ ratios.

7. Dividing net income by sales gives the ________ ________ on sales.

8. The _______/__________ ratio measures how much investors are willing to pay for each
dollar of a firm’s reported profits.

9. Firms with higher rates of return on stockholders’ equity tend to sell at relatively high
ratios of ________ price to ______ value.

10. Individual ratios are of little value in analyzing a company’s financial condition. More
important are the _______ of a ratio over time and the comparison of the company’s
ratios to __________ average ratios.

11. The __________ ____ ______ __________ shows how return on equity is affected by
total assets turnover, profit margin, and leverage.

12. Return on assets is a function of two variables, the profit ________ and _______
________ turnover.

13. Analyzing a particular ratio over time for an individual firm is known as _______
analysis.
14. The process of comparing a particular company with a smaller set of companies in the
same industry is called ______________.

15. Financial ratios are used by three main groups: (1) __________, who employ ratios to
 help analyze, control, and thus improve their firm’s operations; (2) ________
__________, who analyze ratios to help ascertain a company’s ability to pay its debts;
and (3) _______ __________, who are interested in a company’s efficiency, risk, and
growth prospects.

16. The _______ ________ __________ ratio measures how effectively the firm uses its
plant and equipment.

17. The _______ ________ __________ ratio measures the utilization of all the firm’s assets.

18. Analysts use two procedures to examine the firm’s debt: (1) They check the _________
_______ to determine the extent to which borrowed funds have been used to finance
assets, and, (2) they review the ________ ___________ to see the extent to which fixed
charges are covered by operating profits.

19. To account for the deficiencies of the TIE ratio, bankers have developed the ________
__________ ratio, which is most useful for relatively short-term lenders.

20. The _______ _________ _______ ratio is useful for comparing firms with different tax
situations and different degrees of financial leverage.

21. If a company is financing only with common equity, the firm’s return on assets and return
on equity will be _______.

22. The _______/______ ______ ratio shows the dollar amount investors will pay for $1 of
cash flow.

Conceptual

23. The equity multiplier can be expressed as 1 – (Debt/Assets).

a. True b. False

24. A high current ratio is always a good indication of a well-managed liquidity position.

a. True b. False

25. International Appliances Inc. has a current ratio of 0.5. Which of the following actions
would improve (increase) this ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Sell some of the existing inventory at cost.
26. Refer to Self-Test Question 25. Assume that International Appliances has a current ratio
of 1.2. Now, which of the following actions would improve (increase) this ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Use cash to pay for some fixed assets.

27. Examining the ratios of a particular firm against the same measures for a small group of
firms from the same industry, at a point in time, is an example of

a. Trend analysis.
b. Benchmarking.
c. Du Pont analysis.
d. Simple ratio analysis.
e. Industry analysis.

28. Which of the following statements is most correct?

a. Having a high current ratio is always a good indication that a firm is managing its
liquidity position well.
b. A decline in the inventory turnover ratio suggests that the firm’s liquidity position is
improving.
c. If a firm’s times-interest-earned ratio is relatively high, then this is one indication that
the firm should be able to meet its debt obligations.
d. Since ROA measures the firm’s effective utilization of assets (without considering
how these assets are financed), two firms with the same EBIT must have the same
ROA.
e. If, through specific managerial actions, a firm has been able to increase its ROA,
then, because of the fixed mathematical relationship between ROA and ROE, it must
also have increased its ROE.

29. Which of the following statements is most correct?

a. 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.
b. One of the problems of ratio analysis is that the relationships are subject to
manipulation. For example, we know that if we use some cash to pay off some of our
current liabilities, the current ratio will always increase, especially if the current ratio
is weak initially, for example, below 1.0.
c. Generally, firms with high profit margins have high asset turnover ratios and firms
with low profit margins have low turnover ratios; this result is exactly as predicted by
the extended Du Pont equation.
 d. Firms A and B have identical earnings and identical dividend payout ratios. If Firm
A’s growth rate is higher than Firm B’s, then Firm A’s P/E ratio must be greater than
Firm B’s P/E ratio.
e. Each of the above statements is false.

ANSWERS

1. liquidity; current
2. receivable; cash
3. leverage
4. total debt; total assets
5. times-interest-earned
6. profitability
7. profit margin
8. price/earnings
9. market; book
10. trend; industry
11. Extended Du Pont Equation
12. margin; total assets
13. trend
14. benchmarking
15. managers; credit analysts; stock analysts
16. fixed assets turnover
17. total assets turnover
18. balance sheet; income statement
19. EBITDA coverage
20. basic earning power
21. equal
22. price/cash flow

23. b. 1 – (Debt/Assets) = Equity/Assets. The equity multiplier is equal to Assets/Equity.

24. b. Excess cash resulting from poor management could produce a high current ratio.
Similarly, if accounts receivable are not collected promptly, this could also lead to a high current
ratio. In addition, excess inventory which might include obsolete inventory could also lead to a
high current ratio.

25. d. This question is best analyzed using numbers. For example, assume current assets
equal $50 and current liabilities equal $100; thus, the current ratio equals 0.5. For answer a,
assume $5 in cash is used to pay off $5 in current liabilities. The new current ratio would be
$45/$95 = 0.47. For answer d, assume a $10 purchase of inventory is made on credit (accounts
payable). The new cur¬rent ratio would be $60/$110 = 0.55, which is an increase over the old
current ratio of 0.5
26. a. Again, this question is best analyzed using numbers. For example, assume current
assets equal $120 and current liabilities equal $100; thus, the current ratio equals 1.2. For answer
a, assume $5 in cash is used to pay off $5 in current liabilities. The new current ratio would be
$115/$95 = 1.21, which is an increase over the old current ratio of 1.2. For answer d, assume a
$10 purchase of inventory is made on credit (accounts payable). The new current ratio would be
$130/$110 = 1.18, which is a decrease over the old current ratio of 1.2.

27. b. The correct answer is benchmarking. A trend analysis compares the firm’s ratios over
time, while a Du Pont analysis shows how return on equity is affected by assets turnover, profit
margin, and leverage.

28. c. Excess cash resulting from poor management could produce a high current ratio; thus
statement a is false. A decline in the inventory turnover ratio suggests that either sales have
decreased or inventory has increased, which suggests that the firm’s liquidity position is not
improving; thus statement b is false. ROA = Net income/Total assets, and EBIT does not equal
net income. Two firms with the same EBIT could have different financing and different tax rates
resulting in different net incomes. Also, two firms with the same EBIT do not necessarily have
the same total assets; thus, statement d is false. ROE = ROA × Assets/Equity. If ROA increases
because total assets decrease, then the equity multiplier decreases, and depending on which
effect is greater, ROE may or may not increase; thus, statement e is false. Statement c is correct;
the TIE ratio is used to measure whether the firm can meet its debt obligation, and a high TIE
ratio would indicate this is so.

29. a. Ratio analysis is subject to manipulation; however, if the current ratio is less than 1.0
and we use cash to pay off some current liabilities, the current ratio will decrease, not increase;
thus statement b is false. Statement c is just the reverse of what actually occurs. Firms with high
profit margins have low turnover ratios and vice versa. Statement d is false; it does not
necessarily follow that if a firm’s growth rate is higher that its stock price will be higher.
Statement a is correct. From the information given in statement a, one can determine that the
two firms’ net incomes are equal; thus, the firm with the higher debt ratio (lower equity ratio)
will indeed have a higher ROE.