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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.

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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.

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13. An analyst gathered the following data for two companies in the same industry: Company A Company B Days in sales outstanding 28 32 Days of inventory on hand 32 35 Days of payables 42 40 Current assets $203,000 $189,000 Total assets 581,000 469,000 Current liabilities 73,000 71,000 Total liabilities 429,000 350,000 Shareholders' equity 152,000 119,000 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. Measure Definition Company A Company B Current ratio CA/CL 2.78 2.66 Cash conversion cycle DOS + DOH – Days payable 28 + 32 – 42 = 18 32 + 35 – 40 = 27 Financial Leverage Total assets/Sh equity 3.82 3.94

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14. The table below contains selected data from the common-size balance sheets for three different industries: utilities, financials and consumer discretionary products. % of Total Assets Industry 1 Industry 2 Industry 3 Inventories 6.9 2.6 19.4 PPE 1.9 57.5 25.4 LT Debt 18.2 31.9 19.1 Total Equity 19.5 23.2 42.3 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.

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15. An analyst calculates the following ratios for a firm: Sales/Total Assets Net Profit Margin (%) Return on Total Assets (%) Equity/ Total Assets 2.8 4 11.2 0.625 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%

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16. The following information (U.S. $ millions) for two companies operating in the same industry during the same time period is available: Company A Company B Net sales 120 300 Total assets 70 140 Total liabilities 25 40 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. Component Company A Company B Total asset turnover (sales/total assets) 120/170 1.71 300/140 2.14 Company A has a lower total asset turnover, not higher Equity (total assets – total liabilities) 70-25 $45 140-40 $100 Financial leverage multiplier (assets/equity) 70/45 1.56 140/100 1.40 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

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17. The following selected information is from a company’s most recent financial statements: (￡ millions) 2009 2008 Sales 2,801 2,885 Cost of Goods Sold 1,969 2,071 Interest Expense 123 110 Cash & Marketable Securities 108 105 Accounts Receivable 318 286 Inventories 248 285 Accounts Payable 361 346 Notes Payable 50 99 The 2009 cash conversion cycle, in days, is closest to: A. 23. B. 26. C. 28.

Ans: A. Activity Ratios Calculation Inventory Turnover 7.39 COGS/Average Inventory 1969/(248+285)/2 DOH (days on hand) 49.4 365/Inventory Turnover 365/7.39 Receivable Turnover 9.27 Sales/Average Receivables 2801/(318+286)/2 DSO (days sales o/s) 39.4 365/Receivables Turnover 365/9.27 Payables Turnover 5.57 COGS/Average Payables 1969/(361+346)/2 Days in Payables 65.5 365/Payables Turnover 365/5.57 Cash Conversion Cycle 23.3 DOH + DSO – Days In Pay 49.4 + 39.4 – 65.5

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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.

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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: Company 1 Company 2 Current ratio 2.0 2.0 Cash ratio 0.3 0.3 Quick ratio 0.5 0.8 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.

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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