Reading 55: LOS c ～ Q21-23

21.Furniture Factory, Inc., is a world-wide industry leader in the office furniture manufacturing industry. Use the following ratio table to answer the next three questions.

Which of the following interpretations of ratio analysis is most accurate?

A)   Furniture Factory, Inc., has a higher credit risk than the average company in the industry based on the debt to equity (D/E) ratio.

B)   The liquidity position of Furniture Factory, Inc., has been steadily improving.

C)   The leverage position of Furniture Factory, Inc., has been steadily improving.

D)   Furniture Factory, Inc., has a higher credit risk than the average company in the industry based on the times interest earned ratio.

The correct answer was  A)

Furniture Factory, Inc., has a higher credit risk than the average company in the industry based on the D/E ratio. The total amount of debt to equity has steadily increased over the past few years. Currently Furniture Factory, Inc., has almost twice the level of total D/E as the industry average.

22.Which of the following statements describes the most likely interpretation of the liquidity position of Furniture Factory, Inc? Furniture Factory, Inc., has:

A)   managed their inventory more efficiently than the industry.

B)   a serious liquidity problem compared to the industry.

C)   difficulty meeting short-term obligations.

D)   continuously improved their leverage position compared to the industry.

The correct answer was  A)

Furniture Factory, Inc., manages their inventory more efficiently than the industry. This is most obvious by comparing the inventory turnover ratio to the industry. The inventory turnover ratio is computed by dividing cost of goods sold by the average inventory. Therefore, the higher the turnover ratio the more efficient the company is in managing inventory. Comparing the current asset and quick ratio also reflects a low level of inventory for the company. The quick ratio is right in line with industry average, while the current ratio is much higher for the industry. However, this is to be expected if a company is very efficient in managing their inventory. The company does not appear to have a serious liquidity or leverage problem. While the total amount of debt to equity is increasing, the times interest earned ratio is improving and provides adequate cushion for debt obligations.

23.Based on the ratio analysis table for Furniture Factory, Inc., complete the following statement. Creditors would most likely:

A)   not consider lending more money to Furniture Factory, Inc., due to the significant problems that are apparent with both liquidity and leverage.

B)   be willing to lend more money to Furniture Factory, Inc., without any reservations.

C)   downgrade the credit quality of Furniture Factory, Inc., and increase the amount of interest charged to cover the increasing default risk.

D)   require additional information to explain the apparent contradictions in the liquidity and leverage ratios.

The correct answer was  D)

Creditors would recognize the efficient inventory management as a strength for the company and would not be overly concerned with the liquidity position of the company. They would probably be more concerned about the increasing amount of total debt to equity as compared to the industry. However, the times interest coverage ratio indicates the company has adequate cash flow coverage to meet their debt obligations. There is no indication of loan covenants being violated that would warrant an increase in the interest rate charged.