1.
A change in credit policy has caused an increase in sales, an increase in discounts
taken, a decrease in the amount of bad debts, and a decrease in the investment in
accounts receivable. Based upon this information, the company's:
CalculatorTime Value Tables
A Average collection period has
. decreased.
B
Working capital has increased.
.
C Accounts receivable turnover has
. decreased.
D Percentage discount offered has
. decreased.
Choice "A" is correct. An organization's collection period is 365 days divided by its accounts
receivable turnover. The accounts receivable turnover is credit sales divided by the average net
accounts receivable balance. Since the average receivable balance has decreased and sales
have increased, the accounts receivable turnover has increased. The increased turnover
decreases the collection period.
2. Financial leverage results from the use of a source of funds for which the firm:
CalculatorTime Value Tables
A Pays a variable return on each dollar
. amount raised.
B Earns a higher rate of return from its use
. than its cost.
C
Pays a fixed percentage of revenue.
.
D
Pays a fixed percentage of income.
.
Choice "B" is correct. Financial leverage results from financing asset acquisitions by borrowing
at a rate that is less than the rate that the firm can earn on its investments. It is sometimes
referred to as "trading on the equity."
3. Consider the statements below comparing financial ratios based on historical cost to
those based on fair value. Which statements are correct?
I. Fair value disclosures can supplement historical cost ratio analysis.
II. If market prices decline, then ratios using fair value prices will show better results
than those using historical cost.
III. If market prices decline, then ratios using fair value prices will show worse results
than those using historical cost.
IV. If market prices increase, ratios using fair value prices will show higher ratios than
those using historical cost.
CalculatorTime Value Tables
A I, III, and IV,
. only
B
I and III, only
.
C II, III, and IV,
. only
D I, II, and IV,
. only
Choice "A" is correct. Fair value disclosures can supplement historical cost ratio analysis. If
market prices decline, then ratios using fair value prices will show worse results than those
using historical cost. If market prices increase, ratios using fair value prices will show higher
ratios than those using historical cost.
4. Donovan Corporation recently declared and issued a 50 percent stock dividend. This
transaction will reduce the company’s:
CalculatorTime Value Tables
A
Current ratio.
.
B Book value per common
. share.
C
Debt-to-equity ratio.
.
D Return on operating
. assets.
Choice "B" is correct. Stock dividend is the payment of a dividend to shareholders in the
form of stock instead of cash.
Because a stock dividend increases the number of common shares outstanding,
Donovan’s book value per common share will decrease.
5. The financial analysis of a company’s financial data was performed for three
consecutive years for Alma Co. The following schedule shows some of the results of
this analysis:
Year 1 Year 2 Year 3
Return on equity 18.00 22.00 23.50
(ROE) % % %
Return on assets
(ROA) 8.00% 7.80% 7.40%
Total assets
turnover 3.00 3.10 3.20
When presenting the above table to management in a board meeting, which of the
following statement is correct to be included in the report?
CalculatorTime Value Tables
A The net profit margin and the financial leverage have
. decreased.
B The net profit margin and the financial leverage have
. increased.
C The net profit margin has decreased but the financial
. leverage has increased.
D The net profit margin has increased but the financial
. leverage has decreased.
hoice "C" is correct. Comparing the financial ratios for a company over several years will
help management measure the performance of an entity. ROA is equal to the net profit
margin times total asset turnover. ROE is equal to the ROA times financial leverage.
Financial leverage is equal to average total assets divided by average equity.
Based on the table, ROA has decreased despite the total asset turnover increasing
each year. Asset turnover is calculated as sales divided by average total assets and its
year-over-year increase would suggest greater utilization of assets in the creation[KH1]
of revenue. Therefore, this would indicate that net profit margin has declined, because
the second component to ROA is net profit margin (or net income divided by sales). The
decline in ROA would indicate that despite improved asset utilization, lower net profit
margins are being achieved.
Net profit Total asset
ROA = margin × turnover
Net income Sales
= × Average total
Sales assets
Or:
Net income
ROA = Average total
assets
ROE has increased despite the decrease in ROA over the three-year period. This is an
indicator of an increase in financial leverage.
ROE = ROA × Financial leverage
Average total
Net income assets
ROE = ×
Average total
assets Average equity
Based on an analysis of the ratios provided from Year 1 to Year 3, it can be concluded
that the net profit margin has decreased, and financial leverage has increased.
6. A company has average accounts payable of $5 million, days in inventory of 73 days,
and days sales in accounts receivable of 28 days. Which of the following statements is
most accurate?
CalculatorTime Value Tables
A
The cash conversion cycle is less than 101 days.
.
B The cash conversion cycle is greater than 101
. days.
C The company is turning over inventory every 5
. days.
D The company is turning over its receivables 28
. times per year.
Choice "A" is correct. The cash conversion cycle is calculated as days in inventory plus days
sales in accounts receivable less days of payables outstanding. Days in inventory is 73 days
and days sales in accounts receivable is 28 days, which totals to 101 days. But as long as
average payables are greater than $0, there will be a days of payables outstanding to subtract
from 101 days, which means the cash conversion cycle must be less than 101 days.
7. A firm with a higher degree of operating leverage when compared to the industry
average implies that the:
CalculatorTime Value Tables
A
Firm has higher variable costs.
.
B Firm's profits are more sensitive to changes in
. sales volume.
C
Firm is more profitable.
.
D Firm uses a significant amount of debt
. financing.
Rule: Operating leverage is the presence of fixed costs in operations, which allows a
small change in sales to produce a larger relative change in profits.
Choice "B" is correct. A firm with a higher degree of operating leverage when compared
to the industry average implies that the firm's profits are more sensitive to changes in
sales volume.
8. A company's management is reviewing the most recent fiscal year's results of
operations and noted an increase in the return on assets ratio when compared with the
prior year. Which one of the following could have caused the increase?
CalculatorTime Value Tables
A Sales decreased by the same dollar amount that
. expenses increased.
B Sales increased by the same dollar amount as expenses
. and total assets.
C Sales remained the same, and expenses and total
. assets decreased.
D Sales remained the same, and ending inventory
. increased.
Choice "C" is correct. Return on assets (ROA) is an indicator of how well a company
utilizes its assets and determines how profitable a company is relative to its total assets.
ROA is best used when comparing similar companies or comparing a company to its
previous year's performance.
Return on assets (ROA) = Net income / Average total assets.
If the sales dollars remain constant, if total expenses decrease, and if total assets
decrease, then the return on total assets increases because the numerator of the ROA
fraction increases and the denominator of the ROA fraction is reduced.
9. Which one of the following changes will most likely increase the quick ratio?
CalculatorTime Value Tables
A
Increase in inventory
.
B Decrease in accounts receivable
.
C Increase in short-term
. government bonds
D
Decrease in cash
.
hoice “C” is correct. The quick ratio is a more conservative measure of liquidity. The
quick ratio, also known as the acid-test ratio, is similar to the current ratio, but it
excludes inventory and only includes more liquid current assets such as cash, short-
term marketable securities, and receivables. A higher quick ratio implies that more-liquid
current assets are available to pay current liabilities. A shift to less-liquid assets or an
increase in current liabilities will decrease this ratio. The denominator is total current
liabilities.
Cash and cash Short-term
Quick ratio equivalents + marketable securities +
= Receivables (net)
Current liabilities
An increase in short-term governmental bonds would increase the total short-term
marketable securities. An increase in the numerator of the calculation will increase the
quick ratio.
10. Given no other changes, which of the following actions would effectively increase a
firm's financial leverage index?
CalculatorTime Value Tables
A The firm issues new common stock and retires some of its long‐term
. debt.
B The firm purchases new long‐term assets and pays for the purchase
. with long‐term debt.
C
The firm reduces operating expenses by cutting employee benefits.
.
D The firm refinances its existing long‐term debt at a lower interest
. rate.
Choice "B" is correct. A measure of financial leverage is the ratio of total assets to common
shareholders' equity. Common shareholders' equity is calculated by taking total assets less total
liabilities.
The purchase of assets by debt financing will increase total assets and total liabilities without
affecting common shareholders' equity. Therefore, the financial leverage ratio of total assets to
common shareholders' equity will increase.
11. According to its financial statements, a company's gross profit margin
decreased by 3 percentage points while the company's operating profit margin
increased by 5 percentage points. Which one of the following factors could
cause both changes?
CalculatorTime Value Tables
A
An increase in the cost per unit of the goods purchased from a supplier.
.
B
An increase in selling, general, and administrative expenses.
.
C
A lowered selling price and an increase in quantities sold.
.
D Sale of fully depreciated production machinery at a gain and replacement
. of the machines with newer models.
Choice "C" is correct. The gross profit margin measures the percentage of sales
remaining after the cost of sales (cost of goods sold) have been deducted. Gross profit
margin equals gross profit divided by net sales.
The operating profit margin percentage measures the percentage of sales remaining
after the costs of sales and operating expenses have been deducted. The operating
profit represents the amount of revenues that are still available to cover nonoperating
costs. Operating profit margin percentages equals operating income divided by net
sales.
A lower sale price per unit without a reduction in cost of goods sold will reduce gross
profit margins from a percentage standpoint, but if the number of units sold increases by
more than the decrease in per-unit prices, total revenue can still increase and this can
lead to higher operating profit margins (especially if operating expenses do not change
significantly).
12. Which of the following items, if dilutive and if other conditions are met, would enter
into the determination of the weighted average shares outstanding to be used in the
basic earnings per share (basic EPS) calculation?
I. Stock options.
II. Contingent
shares.
CalculatorTime Value Tables
A
I only.
.
B
II only.
.
C
Both I and II.
.
D Neither I nor
. II.
Choice "B" is correct. Contingent shares (that are dilutive) are included in the calculation of
basic earnings per share (EPS) if (and as of the date) all conditions for issuance are met. Stock
options do not enter into the calculation of basic EPS.
13. Which of the following is not associated with a high inventory turnover ratio?
CalculatorTime Value Tables
A
A reduction in storage and obsolescence costs.
.
B Relatively short time periods between inventory
. purchases and sales.
C
A drop in the demand for the company's products.
.
D A reduction in borrowing to finance inventory
. purchases.
Choice "C" is correct. The inventory turnover ratio measures how many times a
company buys and sells inventory during a period. To calculate the ratio, divide cost of
goods sold by average inventory, with average inventory being the average of the
period's beginning and ending inventory balance. A higher ratio indicates that inventory
is selling quickly, which reduces storage and obsolescence costs. Because less money
is tied up in inventory, that means more money is available to reinvest in the business,
pay off debts, and invest in other opportunities, among other things.
A low turnover ratio could be a sign of a drop in demand for a company's product. This
decrease in demand will cause there to be fewer sales, which lowers cost of goods sold,
thereby hurting the inventory turnover ratio as opposed to increasing it.
14. If Hutton Inc. sold $100 of inventory for $100 of cash on December 31, Year 2, which
of the following ratios would decrease?
CalculatorTime Value Tables
A Working capital
. turnover
B
Return on assets
.
C
Return on equity
.
D
Net profit margin
.
Choice "D" is correct. Net profit margin is calculated as net income divided by net sales. If
inventory is sold at cost, net income does not change but net sales increases. Therefore, the
numerator does not change but the denominator increases, causing net profit margin to
decrease.
15. The current ratio divides current assets by current liabilities as a measure of a
company’s liquidity. Which of the following describes how the quick ratio differs from the
current ratio?
CalculatorTime Value Tables
A The quick ratio includes non-current assets with current assets to provide a
. more realistic test of liquidity.
B The quick ratio includes non-current assets instead of current assets to
. provide a less rigorous test of solvency.
C The quick ratio excludes cash from current assets to provide a more
. realistic test of liquidity.
D The quick ratio excludes inventory and prepaids to provide a more rigorous
. test of liquidity.
Choice "D" is correct. Excluding inventory and prepaids from current assets makes the quick
ratio more conservative. The quick ratio is a more rigorous test of liquidity by excluding
inventory and prepaids because inventory is the least liquid of current assets. The ability to
meet current obligations without liquidating inventory is important.
16. The acid-test ratio shows the ability of a company to pay its current liabilities without
having to:
CalculatorTime Value Tables
A Reduce its cash
. balance.
B Borrow additional
. funds.
C Collect its
. receivables.
D Liquidate its
. inventory.
Choice "D" is correct. The acid-test ratio, also known as the quick ratio, takes a
more conservative approach to measuring the liquidity of a company by
excluding less-liquid assets, such as inventory and prepaids, from the current
asset calculation. The theory is that in order to meet current liability
obligations, a company will need relatively liquid current assets.
The ratio can be calculated as follows:
Acid-test ratio = (Total current assets – Inventory – Prepaids) ÷ Current liabilities
Because inventory is excluded from the calculation, this ratio can be utilized to
demonstrate the ability of a company to pay its current liabilities without taking into
consideration the liquidation of inventory.
17. When reviewing a credit application, the credit manager should
be most concerned with the applicant's:
CalculatorTime Value Tables
A Profit margin and return on
. assets.
B Price/earnings ratio and
. current ratio.
C Working capital and return on
. equity.
D Working capital and current
. ratio.
Choice "D" is correct. In evaluating whether to extend credit to a potential
applicant, a review of the ability of the applicant to repay the obligation is
required. In assessing this ability, the applicant's liquidity and solvency must be
reviewed.
Working capital and the current ratio are both indicators of the liquidity position of an
applicant. Working capital equals current assets less current liabilities. The current ratio
divides current assets by current liabilities. Both ratios indicated are tools that can be
utilized in the assessment of the creditworthiness of a potential individual or entity.
18. If inventory at the end of Year 1 was overstated, and the error was not corrected
when discovered in Year 3, what is the effect of the error on the gross profit margins for
Years 1 and 2?
CalculatorTime Value Tables
Year 1 Gross Profit Year 2 Gross Profit
Margin Margin
A
Overstated Understated
.
B Overstated Overstated
Year 1 Gross Profit Year 2 Gross Profit
Margin Margin
.
C
Understated Understated
.
D
Understated Overstated
.
Choice "A" is correct. Gross profit is the excess of sales over cost of goods sold. Cost of
goods sold is equal to beginning finished goods inventory plus purchases minus ending
finished goods inventory. When ending inventory is overstated, cost of goods sold is
understated and therefore, gross profit is overstated for the period. The error reverses in
the following period because when beginning inventory is overstated, the current year
cost of goods sold will be overstated, which will understate gross profit in the following
period.
In the fact pattern, ending inventory was overstated at the end of Year 1, which will
cause cost of goods sold to be understated and result in an overstatement of gross
profit and gross profit margin in Year 1. Because ending inventory was overstated at the
end of Year 1, the Year 2 beginning inventory will be overstated. The overstatement in
beginning inventory will result in an overstatement of cost of goods sold during the
period and, therefore, an understatement of gross profit and the gross profit margin in
Year 2.
19. Using long-term debt instead of short-term debt to finance inventory purchases will
have which of the following effects?
CalculatorTime Value Tables
Current Ratio Total Debt Ratio
A Increase Increase
.
B Increase Decrease
.
C Decrease Increase
.
D Decrease Decrease
.
Choice "A" is correct. The current ratio is equal to current assets divided by current liabilities. If
current assets go up (due to the inventory purchases) while current liabilities are unchanged,
the current ratio increases. (The numerator increases, the denominator remains the same, so
the ratio increases.) Assuming a company has positive equity, debt must be lower than assets.
So if long-term debt increases and assets increase by the same amount, the percentage impact
on debt will be larger and the total debt ratio will therefore increase. (The numerator is smaller
than the denominator, so that an equal increase in both numerator and denominator causes the
ratio to increase.)
20. Which of the following is not considered a weakness of ratio analysis?
CalculatorTime Value Tables
A A firm in multiple industries has difficulty comparing its ratios to any one
. industry.
B Firms may use different valuation methods on inventory (FIFO, LIFO,
. weighted average, etc.).
C Firms may use different depreciation methods (straight‐line, double‐
. declining balance, etc.).
D Markets change from year to year, and comparing ratios over time is
. problematic.
Choice "D" is correct. Although markets change from year to year, ratio analysis can still be
valuable in analyzing how the firm has changed with the markets. It is clear that conglomerates
have difficulty comparing ratios to a single industry and that accounting assumptions affect
financial statements and ratio analysis results.
21. Which of the following is not a common problem associated with a relatively low
inventory turnover ratio?
CalculatorTime Value Tables
A High cost of funds may reduce
. profits.
B Inventory may spoil or become
. obsolete.
C Sales may be lost due to inventory
. outages.
D Storage costs are high and reduce
. profits.
Choice "C" is correct. Inventory turnover is calculated by taking cost of goods sold (COGS) and
dividing it by the average inventory.
Inventory turnover = COGS ÷ Average inventory
A low turnover means that inventory is not selling quickly, and it also implies that there is a large
inventory. If the large inventory consists of the right items, buffer (safety) stocks will be high,
which would minimize inventory stockouts or outages.
22. In order to lower its cash conversion cycle, a company should:
CalculatorTime Value Tables
A
Increase inventory turnover.
.
B Increase accounts payable
. turnover.
C Decrease days of payables
. outstanding.
D Increase days sales in accounts
. receivable.
Choice "A" is correct. The inventory turnover ratio reflects how many times a year a company is
turning over its inventory. The more times per year a company turns over its inventory, the lower
the days in inventory (how many days it takes for the company to turn over its inventory).
Because the cash conversion cycle is equal to the days in inventory plus the days sales in
accounts receivable less the days of payables outstanding, a higher inventory turnover (and
therefore lower days in inventory) will lower the cash conversion cycle.
23. If accounts payable is understated at the end of the year, which of the following
statements is correct?
CalculatorTime Value Tables
A
The current ratio is understated.
.
B The times interest earned ratio is
. understated.
C The days' purchases in accounts payable is
. understated.
D The long‐term debt‐to‐equity ratio is
. understated.
Choice "C" is correct. If accounts payable is understated at the end of the year, then current
liabilities are understated. This would cause the current ratio to be overstated. The long‐term
debt‐to‐equity ratio and the times interest earned ratio would not be affected by the problem.
However, since the days' purchases in accounts payable has average accounts payable in the
numerator, this ratio would be understated.
24. Which one of the following decisions would be consistent with a company
that wants to show a low level of debt on its financial statements?
CalculatorTime Value Tables
A
Using trade credit to purchase inventory.
.
B Retiring existing preferred stock with funds from a new common
. stock issuance.
C
Using operating leases instead of finance leases.
.
D
Using finance leases instead of operating leases.
.
Choice "B" is correct. A firmʹs capital structure relates to how a company finances its
operations and will consist of debt and equity on the balance sheet. Debt consists of all
liabilities (both interest-bearing and non-interest bearing), while equity consists of
common stock, preferred stock, additional paid-in capital (APIC), retained earnings,
accumulated other comprehensive income (AOCI), and treasury stock.
Retiring existing preferred stock with funds from a new common stock issue removes
one equity line item from the balance sheet and replaces it with another. No debt results
from the transaction, which is in line with the goal of showing a low level of debt on the
financial statements.
25. The dividend yield ratio is calculated by which one of the following methods?
CalculatorTime Value Tables
A Market price per share divided by
. dividends per share.
B Earnings per share divided by dividends
. per share.
C Dividends per share divided by market
. price per share.
D Dividends per share divided by earnings
. per share.
Choice "C" is correct. Dividend yield indicates the relationship between the dividends per
common share and the market price per common share and is calculated by dividing the
dividends by the market price.
