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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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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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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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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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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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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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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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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

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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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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.