FA5e Text Bank CH 05. Chapter 5 Analyzing and Interpreting Financial Statements.

FA5e Text Bank CH 05. Chapter 5 Analyzing and Interpreting Financial Statements. Learning Objectives – coverage by question True/False Multiple Choice Exercises Problems Essay Questions LO1 Prepare and analyze co ...

FA5e Text Bank CH 05. Chapter 5 Analyzing and Interpreting Financial Statements. Learning Objectives – coverage by question True/False Multiple Choice Exercises Problems Essay Questions LO1 Prepare and analyze common-size financial statements. (p. 221) LO2 Compute and interpret measures of return on investment, including return on equity (ROE), return on assets (ROA), and return on financial leverage (ROFL). (p. 224) LO3 Disaggregate ROA into profitability (profit margin) and efficiency (asset turnover) components. (p. 227) LO4 Compute and interpret measures of liquidity and solvency. (p. 232) LO5 Appendix 5A: Measure and analyze the effect of operating activities on ROE. (p. 240) LO6 Appendix 5B: Prepare pro forma financial statements. (p. 242) Chapter 5: Analyzing and Interpreting Financial Statements True False Topic: Asset turnover LO: 2 1. Asset turnover measures a company’s profitability. Answer: False Rationale: Asset turnover is a productivity concept. It indicates the amount of sales revenue a company generates from using its asset investment. Topic: NOPAT LO: 5 2. NOPAT is equivalent to income from operating activities. Answer: False Rationale: NOPAT is net operating income after taxes. It excludes nonoperating amounts and focuses on operating activities. Topic: Profitability and RNOA LO: 5 3. If Company A is more profitable than Company B, then Company A will have a higher RNOA than Company B. Answer: False Rationale: RNOA depends on profitability but also depends on asset productivity. If Company B has a much higher asset productivity, its RNOA could be higher despite the lower profitability. Topic: Use of ratios LO: 1, 2, 3, 4 4. Ratios provide one way to compare companies in the same industry regardless of their size. Answer: True Rationale: Ratios mitigate problems arising from attempting to compare companies of different sizes. Topic: Financial leverage and ROE LO: 2 5. Highly leveraged firms have higher ROE than lower leveraged firms. Answer: False Rationale: Financial leverage does not affect the ROE computation because it is based on operating profit. Return on financial leverage is ROE less ROA, so the higher the ROE, the higher the financial leverage. Topic: Inventory turnover rate LO: 3 6. All things equal, the higher a company’s inventory turnover rate, the better. Answer: True Rationale: Companies want to minimize inventory levels but still be able to meet demand and avoid stock-outs. Higher inventory turnover means the company is selling its inventory more quickly which reduces the number of days that inventory is held.©Cambridge Business Publishers, 2017 Test Bank, Chapter 5 5-3 Topic: Financial leverage and debt ratings LO: 2 7. All else being equal, a higher financial leverage will increase a company’s debt rating and decrease the interest rate it must pay. Answer: False Rationale: Higher levels of financial leverage increase the probability of bankruptcy and resulting lower credit ratings and higher costs for borrowed funds. Topic: Horizontal and vertical analysis. LO: 1 8. Vertical analysis examines changes in financial data across time. Answer: False Rationale: Vertical analysis is a method that attempts to overcome the size of a company by stating financial information is a ratio form. Horizontal analysis examines changes in financial data across time. Topic: Current ratio LO: 4 9. A current ratio greater than 1.0 is generally desirable for a company. Answer: True Rationale: A company with a current ratio greater that 1.0 indicates positive net working capital. Companies prefer greater levels of current assets than current liabilities because higher liquidity indicates a more likely chance the company can pay its debts as they become due. Topic: Disaggregation of profit margin and asset turnover LO: 3 10. Return on assets can be disaggregated into profit margin and an expense-to-sales ratio. Answer: False Rationale: Return on assets can be disaggregated into profit margin and asset turnover. The expense-to-sales ratio measures the percentage of each sales dollar that goes to cover a specific expense item. Topic: Times interest earned LO: 4 11. The times interest earned ratio reflects the number of times that the company earned interest during the year. Answer: False Rationale: Times interest earned ratio reflects the operating income available to pay interest expense during the year. Topic: ROA meaning LO: 3 12. Charlie Plumbing Supplies has a return on assets (ROA) of 24%, while the industry average of similar companies is 13%. This means that Charlie Plumbing Supplies’ asset turnover is higher than the industry average. Answer: False Rationale: This is not necessarily the case, since ROA is made up of two components, profit margin times asset turnover. Without any more information, we cannot determine if it is the asset turnover or the profit margin, or both, that is driving the higher ROA .©Cambridge Business Publishers, 2017 5-4 Financial Accounting, 5thEdition Topic: Limitations of ratio analysis LO: 1 13. One benefit of using ratio analysis to compare two firms in the same industry is that ratios are immune to size and current accounting rules. Answer: False Rationale: By using percentage comparisons, ratio analysis makes firms of different sizes more comparably. However, two firms in the same industry may use very different accounting methods, which would flow through to the ratios and make them non-comparable. Topic: Solvency LO: 4 14. Solvency ratios measure a company’s ability to meet its debt obligations. Answer: True Rationale: A solvent company is one that can meet its debt obligations, including principal and interest payments as they come due. Topic: Vertical analysis LO: 1 15. A common size balance sheet expresses the balance sheet items as a percentage of total assets. Answer: True Rationale: A common size balance sheet shows the proportion of the company’s assets and liabilities in terms of their relative size. Topic: Proforma financial statements LO: 6 16. When determining forecasted revenues for proforma purposes, managers should consider economic conditions, potential company changes, and changes in the company’s competitive environment. Answer: True Rationale: A company can use publicly available information from competitors, suppliers, customers, industry organizations, and governmental agencies.©Cambridge Business Publishers, 2017 Test Bank, Chapter 5 5-5 Multiple Choice Topic: Turnover rates and company value LO: 3 1. All things equal, increasing turnover, increases: ) Sales B) Expenses C) Assets D) Shareholder value Answer: D Rationale: All things equal, increasing turnover rates increases ROE which also increases shareholder value. Topic: Liquidity LO: 4 2. Liquidity refers to: A) The life cycle of the company B) The amount of receivables the company has in its balance sheet C) The amount of financial leverage D) None of the above Answer: D Rationale: Liquidity refers to cash, the amount on hand available to pay current obligations as they become due. Topic: Ratios LO: 3, 4 3. Which one of the following ratios does not involve assets? A) Account receivable turnover B) Current ratio C) Profit margin D) Inventory turnover Answer: C Rationale: Profit margin measures net income against sales revenue, both components of which are income statement amounts and not assets.