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# Business Finance FIR 3410

University of Memphis

GPA 3.81

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This 8 page Class Notes was uploaded by Ashlynn Kuhn on Friday October 23, 2015. The Class Notes belongs to FIR 3410 at University of Memphis taught by Staff in Fall. Since its upload, it has received 42 views. For similar materials see /class/228431/fir-3410-university-of-memphis in Finance, Real Estate & Law at University of Memphis.

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Date Created: 10/23/15

CHAPTER 3 ANALYSIS OF FINANCIAL STATEMENTS Current ratio Answer a 1 All else being equal which of the following will increase a company s current ratio a An increase in accounts receivable b An increase in accounts payable c An increase in net fixed assets d Statements a and b are correct e All of the statements above are correct Quick ratio Answer b 2 Which of the following actions will increase a company s quick ratio a Reduce inventories and use the proceeds to reduce long term debt b Reduce inventories and use the proceeds to reduce current liabilities c Issue short term debt and use the proceeds to purchase inventory d Issue long term debt and use the proceeds to purchase fixed assets e Issue equity and use the proceeds to purchase inventory Cash flows Answer a 3 Which of the following alternatives could potentially result in a net increase in a company s cash flow for the current year a Reduce the days sales outstanding ratio Increase the number of years over which fixed assets are depreciated c Decrease the accounts payable balance o d Statements a and b are correct e All of the statements above are correct Leverage and financial ratios Answer d 4 Stennett Corp s CFO has proposed that the company issue new debt and use the proceeds to buy back common stock Which of the following are likely to occur if this proposal is adopted Assume that the proposal would have no effect on the company s operating income a Return on assets ROA will decline b The times interest earned ratio TIE will increase c Taxes paid will decline Liquidity ratios 5 Financial statement analysis 6 Miscellaneous ratios 7 d Statements a and c are correct e None of the statements above is correct Right now Callaghan Motors has a current ratio of 16 and a quick ratio of 12 The company is considering increasing its short term notes payable and to use the proceeds to increase its cash holdings Which of the following will occur if the company undertakes this change a The current ratio and the quick ratio will both decline b The current ratio will increase but the quick ratio will decline c The current ratio will decline but the quick ratio will remain unchanged d The current ratio will increase but the quick ratio will remain unchanged e The current ratio and the quick ratio will both increase Company A and Company B have the same total assets return on assets ROA and profit margin However Company A has a higher debt ratio and interest expense than Company B Which of the following statements is most correct Company A has a higher ROE return on equity than Company B Company A has a higher total assets turnover than Company B Company A has a higher operating income EBTT than Company B Statements a and b are correct Statements a and c are correct Q0 m The Andes Beverage Company plans to use cash on its balance sheet to reduce its long term debt This plan is not expected to have any effect on sales If the plan succeeds which of the following will occur Tts current ratio will decline Its quick ratio will decline Tts total assets turnover will increase Statements a and b are correct All of the statements above are correct Q0 m Answer 2 Answer 2 Answer I a e e Miscellaneous ratios Answer a 8 Companies A and B have the same profit nargin and debt ratio However Company A has a higher return on assets and a higher return on equity than Company B Which of the following can explain these observed ratios a Company A must have a higher total assets turnover than Company Company A must have a higher equity multiplier than Company B b c Company A must have a higher current ratio than Company B d Statements b and c are correct e All of the statements above are correct Liquidity ratios Answer d 9 Last year Thatcher Industries had a current ratio of 12 a quick ratio of 08 and current liabilities of 500000 Which of the following statements is most correct a If the company obtained a short term bank loan for 500000 and used the proceeds to purchase inventory its current ratio would fall b Last year Thatcher industries had 200000 in inventories c Last year Thatcher industries had 416667 in current assets d Statements a and b are correct e All of the statements above are correct Current ratio Answer e 10 Which of the following actions can a firm take to increase its current ratio a Tssue short term debt and use the proceeds to buy back long term debt with a maturity of more than one year b Reduce the company s days sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment c Use cash to purchase additional inventory d Statements a and b are correct e None of the statements above is correct Ratio analysis Answer c 11 As a short term creditor concerned with a company s ability to meet its financial obligation to you which one of the following combinations of ratios would you most likely prefer Current Debt ratio 212 ratio a 05 05 033 b 10 10 050 c 15 15 050 d 20 10 067 e 25 05 071 Leverage and financial ratios Answer d 12 Companies A and B have the same total assets tax rate and earnings before interest and taxes EBIT Company A however has a higher debt ratio Which of the following statements is most correct Company A has a lower return on assets ROA Company A has a lower basic earning power BEP Company A has a lower times interest earned TIE ratio Statements a and c are correct m a 0 o m All of the statements above are correct Ratio analysis Answer d 13 An analyst has obtained the following information regarding two companies Company X and Company Y I Company X and Company Y have the same total assets I Company X has a higher interest expense than Company Y I Company X has a lower operating income EBIT than Company Y I Company X and Company Y have the same return on equity ROE I Company X and Company Y have the same total assets turnover TATO I Company X and Company Y have the same tax rate the basis of this information which of the following statements is most correct a Company X has a higher times interest earned TIE ratio b Company X and Company Y have the same debt ratio c Company X has a higher return on assets ROA d Company X has a lower profit margin e Company X has a higher basic earning power BEP ratio Market price per share Answer b 14 You are given the following information Stockholders equity 1250 priceearnings ratio 5 shares outstanding 25 and marketbook ratio 15 Calculate the market price of a share of the company s stock a 3333 b 7500 c l000 d l6667 e l3332 Marketbook ratio Answer c 15 Meyersdale Office Supplies has common equity of 40 million The company s stock price is 80 per share and its narket to book ratio is 40 How nany shares of stock does the company have outstanding a 500000 b l25000 c 2000000 d 800000000 e It is impossible to determine Liquidity ratios Answer a 16 Oliver Incorporated has a current ratio equal to 16 and a quick ratio equal to 12 The company has 2 million in sales and its current liabilities are 1 million What is the company s inventory turnover ratio DQOO QJ m m m m m m o m N o Solution 1 Current ratio Answer a Remember the current ratio is CACL In order to increase the current ratio either current assets must increase or current liabilities must decrease Accounts receivable are a current asset and if they increase the current ratio will increase So statement a is true Accounts payable are a current liability so if they increase the current ratio declines So statement b is false Net fixed assets are long term assets not current assets so they will not affect the current ratio So statement c is false 2 Quick ratio Answer b Statement b is correct Statement a is false since these actions would have no effect on the quick ratio as the numerator and denominator of the quick ratio would remain the same Statement b is true since reducing current liabilities would decrease the denominator of the quick ratio thus increasing the ratio Statement c is false since these actions would increase the denominator of the quick ratio but have no effect on the numerator thus decreasing the quick ratio Statement d is false since these actions would have no effect on the quick ratio Statement e is false since these actions would have no effect on the quick ratio 3 Cash flows Answer a Statement a is correct The other statements are false Increasing the years over which fixed assets are depreciated results in smaller amounts being depreciated each year Given that depreciation is a non cash expense and is used to reduce taxable income the change would result in less depreciation expense and higher taxes for the year Since taxes are paid with cash the company39s cash flow would decrease In addition decreasing accounts payable results in using cash to pay off the accounts payable balance 4 Leverage and financial ratios Answer d Statements a and c are correct The increase in debt payments will reduce net income and hence reduce ROA Also higher debt payments will result in lower taxable income and less tax Therefore statement d is the best choice 5 Liquidity ratios Answer a Both the numerator and denominator of the current ratio and quick ratio are going to increase by the same amount If the ratio is greater than one before the change this will result in a decline in the ratio Therefore statement a is the only correct answer If you don t see this try the following example Current assets 160 and current liabilities 100 so the current ratio l60lOO 16 Now add an equal amount to both current assets and current liabilities say 20 so the new current ratio 160 20lOO 20 15 The same principle applies to the quick ratio Financial statement analysis Answer e Fron1 the first sentence both ferS have the same net income sales and assets Since A has more debt it must have less equity Thus its ROE calculated as Net incomeEquity is higher than B s So statement a is correct Since the two firms have the same total assets and sales their total assets turnover ratios must be the same So statement b is false If A has higher interest expense than B but the same net income this means that A must have higher operating income EBTT than B Therefore statement c is correct Since statements a and c are correct the correct choice is statement e Miscellaneous ratios Answer e The current ratio is CACL We are not making any changes to CL but we are reducing CA using cash Therefore the current ratio will fall so statement a is true The quick ratio is CA TNVCL Again CA will decrease but CL and TNV are unchanged Therefore the quick ratio will decline so statement b is true Total assets turnover ratio is SalesTA Since sales are unchanged but assets are declining total assets turnover ratio will increase Therefore statement c is true Since statements a b c and d are true statement e is the correct choice Miscellaneous ratios Answer a The Du Pont equation states ROE PM X TATO X EM The firms have the same profit margin and equity multiplier The equity multiplier is the same because both companies have the same debt ratio If Company A has a higher ROE than B then from the Du Pont equation Company A also has a higher total assets turnover ratio than B The current ratio does not explain the ratios discussed Therefore only statement a explains the observed ratios Liquidity ratios Answer d Current ratio 12 Current assetsCurrent liabilities 12 CA500000 CA 600000 New current ratio 600000 500000500000 500000 11 Quick ratio 08 Current assets InventoryCurrent liabilities 08 600000 Inv500000 O8500000 600000 Inv Inv 600000 400000 200000 Therefore statement e is the correct choice Current ratio Answer e Ratio analysis Answer c Leverage and financial ratios Answer d ROA Net incomeTotal assets Interest expense is higher for Company A hence its net income is lower than Company B s Therefore ROAA lt ROAB TIE EBITInterest Company A has higher interest expense therefore its TIE ratio is lower than Company B s Since statements a and c are correct statement d is the correct choice Ratio analysis Answer d We can conclude that X has a lower NI because it has a lower EBIT and higher interest than Y but the same tax rate as Y Sales for each company are the same because they have the same total assets and the same total assets turnover ratio TATO SalesTA Therefore since X has a lower NI and same sales as Y it must follow that it has a lower profit margin NISales Market price per share Answer b Total market value 125015 1875 Market value per share 187525 Alternative solution Book value per share 125025 50 Market value per share 5015 75

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