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Reading 46: Working Capital Management - LOS a ~ Q1-6

1.An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the results to the industry averages:

Financial Ratio

Iridescent Carpeting

Industry Average

Current Ratio

2.3x

1.8x

Net Profit Margin

22%

24%

Return on Equity

17%

20%

Total Debt / Total Capital

35%

56%

Times Interest Earned

4.7x

4.1x

Based on the above data, which of the following can the analyst conclude?

A)   Iridescent Carpeting has better short-term liquidity than its competitors.

B)   Iridescent Carpeting has stronger profitability than its competitors.

C)   Iridescent Carpeting has more financial risk than its competitors.

D)   Iridescent Carpeting is most likely a younger company than its competitors.


2.In a recent staff meeting, David Hurley, stated that analysts should understand that financial ratios mean little by themselves. He advised his colleagues to evaluate financial ratios carefully. During the discussion he made the following statements:

Statement 1: A company can be compared with others in its industry by relating its financial ratios to industry norms. However, care must be taken because many ratios are industry-specific, but not all ratios are important to all industries.

Statement 2: Comparing a company to the overall economy is useless because overall business conditions are constantly changing. Specifically, it is not the case that financial ratios tend to improve when the economy is strong and weaken during recessionary times.

Are statements 1 and 2 as made by Hurley regarding financial ratio analysis correct?

 

Statement 1

Statement 2

 

A)                                        Incorrect       Correct

B)                                        Incorrect       Incorrect

C)                                        Correct  Incorrect

D)                                        Correct  Correct


3.Which of the following is least likely an indicator of a firm’s liquidity?

A)   Cash as a percentage of sales.

B)   Amount of credit sales.

C)   Inventory turnover.

D)   Quick ratio.


4.A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most likely conclude that the firm:

A)   has better credit controls than its peer companies.

B)   makes less credit sales than the average firm in its industry.

C)   has a lower cash conversion cycle than its peer companies.

D)   may have credit policies that are too strict.


5.Alton Industries will have better liquidity than its peer group of companies if its:

A)   quick ratio is lower.

B)   average trade payables are lower.

C)   ROA is higher.

D)   receivables turnover is higher.


6.Which of the following is NOT a limitation to financial ratio analysis?

A)   Differences in international accounting practices.

B)   The use of alternative accounting methods.

C)   A firm that operates in only one industry.

D)   The need to use judgment.

答案和详解如下:

1.An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the results to the industry averages:

Financial Ratio

Iridescent Carpeting

Industry Average

Current Ratio

2.3x

1.8x

Net Profit Margin

22%

24%

Return on Equity

17%

20%

Total Debt / Total Capital

35%

56%

Times Interest Earned

4.7x

4.1x

Based on the above data, which of the following can the analyst conclude?

A)   Iridescent Carpeting has better short-term liquidity than its competitors.

B)   Iridescent Carpeting has stronger profitability than its competitors.

C)   Iridescent Carpeting has more financial risk than its competitors.

D)   Iridescent Carpeting is most likely a younger company than its competitors.

The correct answer was A)

Based on the data provided, the analyst can conclude that Iridescent Carpeting has weaker profitability than its competitors based on the net profit margin and return on equity. The analyst can also conclude that the company has less financial leverage (risk) than the industry average based on the total debt / total capital and the times interest earned ratios. The analyst can conclude that the company has better short-term liquidity than the industry average (i.e., its competitors) based on the current ratio.


2.In a recent staff meeting, David Hurley, stated that analysts should understand that financial ratios mean little by themselves. He advised his colleagues to evaluate financial ratios carefully. During the discussion he made the following statements:

Statement 1: A company can be compared with others in its industry by relating its financial ratios to industry norms. However, care must be taken because many ratios are industry-specific, but not all ratios are important to all industries.

Statement 2: Comparing a company to the overall economy is useless because overall business conditions are constantly changing. Specifically, it is not the case that financial ratios tend to improve when the economy is strong and weaken during recessionary times.

Are statements 1 and 2 as made by Hurley regarding financial ratio analysis correct?

 

Statement 1

Statement 2

 

A)                                        Incorrect       Correct

B)                                        Incorrect       Incorrect

C)                                        Correct  Incorrect

D)                                        Correct  Correct

The correct answer was C)

Financial ratios are meaningless by themselves. To have meaning an analyst must use them with other information. An analyst should evaluate financial ratios based on industry norms and economic conditions. Statement 1 is correct. However, statement 2 is not because financial ratios tend to improve when the economy is strong and weaken when the economy is in a recession. So, financial ratios should be reviewed in light of the current stage of the business cycle.


3.Which of the following is least likely an indicator of a firm’s liquidity?

A)   Cash as a percentage of sales.

B)   Amount of credit sales.

C)   Inventory turnover.

D)   Quick ratio.

The correct answer was B)

No inferences about liquidity are warranted based on this measure. A firm may have higher credit sales than another simply because it has more sales overall. Cash as a proportion of sales, inventory turnover, and a firm’s quick ratio are all indicators of liquidity.


4.A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most likely conclude that the firm:

A)   has better credit controls than its peer companies.

B)   makes less credit sales than the average firm in its industry.

C)   has a lower cash conversion cycle than its peer companies.

D)   may have credit policies that are too strict.

The correct answer was D)

The firm’s average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm’s credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are “better.” We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle.


5.Alton Industries will have better liquidity than its peer group of companies if its:

A)   quick ratio is lower.

B)   average trade payables are lower.

C)   ROA is higher.

D)   receivables turnover is higher.

The correct answer was D)

Higher receivables turnover is an indicator of better receivables liquidity since receivables are converted to cash more rapidly. A lower quick ratio is an indication of less liquidity. Lower trade payables could be related to better liquidity, but could also be consistent with very poor liquidity and a requirement from its suppliers of cash payment. ROA is not a liquidity measure.


6.Which of the following is NOT a limitation to financial ratio analysis?

A)   Differences in international accounting practices.

B)   The use of alternative accounting methods.

C)   A firm that operates in only one industry.

D)   The need to use judgment.

The correct answer was C)

If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios.

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