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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.

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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.

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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.

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24. An analyst has prepared the following common-size balance sheet for ABC Company: ABC Company Common-size balance sheet analysis 2012 2011 Cash 5% 6% AR, net 14 15 Inventory 20 26 Prepaid expenses 3 4   Current assets 42 51 Investments 14 9 Property (net) 38 35 Intangibles 6 5 Total assets 100% 100 AP 5% 12% Current portion of long-term debt 19 3 Notes payable 8 5   Current liabilities 32 20 Long-term debt 43 60   Total liabilities 75 80 Common equity 25 20 Total liabilities&equity 100% 100% 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= 2012 2011 Current ratio =1.3 =2.6 Debt-to-equity ratio =0.737 =0.773 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.

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25. a firm has summarized its current financial statements and ratios as follows: Balance sheet data:   Total current assets $52   Total long-term assets 176   Total current liabilities 43 Income statement data:   Sales, net $127   Net income 14   Taxes 11 Selected financial ratios   Financial leverage 2.67   Equity turnover 1.49   Debt to equity ratio 1.17 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.

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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.

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27. The following financial ratio information is available for a company: EBIT margin 0.16 Total asset turnover 1.11 Interest burden 0.90 Financial leverage 2.70 Tax retention rate (1- tax rate) 0.60 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%

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28. Selected 2012 financial data for Wiler Company flow: Net sales $18,000 COGS 13,200 S,G$A expenses 3,400 Interest income 800 Interest expense 500 Gain on sale of long-term investments 1,200 Provision for income taxes 1,015 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%

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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.

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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.