2 Chapter and 3 Test Questions
The following balance sheet and income statement should be used for questions #1 through
#6:
Windswept, Inc.
2005 Income Statement
($ in millions)
2004
2005
Net sales
$7,180
$8,450
Less: Cost of goods sold
6,152
Less: Operating expenses
460
400
Earnings before interest and taxes
568
Less: Interest paid
50
70
Taxable Income
$518
$740
Less: Taxes
181
259
Net income
$337
$481
7,240
810
Windswept, Inc.
2004 and 2005 Balance Sheets
($ in millions)
2004
2005
Cash
$ 120 $ 140
Accounts payable
$1,120
Accounts rec.
930
780
Long-term debt
1,210
Inventory
1,480 1,520
Common stock
Total
$2,530 $2,440 Retained earnings
Net fixed assets
3,150 3,600
Total assets
$5,680 $6,040 Total liabilities & equity
2004
2005
$1,110
840
3,200
530
3,000
710
$5,680 $6,040
Question 1
A quick review glance at Windswepts income statement reveals increasing profitability from 2004 to 2005. Which of the following
statements is most likely correct with respect to the increasing net margin?
a. Net margin increased because of increasing gross margins
b. Net margin increased primarily because of declining interest rates
c. Net margin increased because of higher sales in 2005
d. Net margin increased because of better operating expense control in 2005
e. None of the above
Answer Question 1
As can be seen from the calculations below Gross Margins didnt change but Operating Margins did
increase by 2%. Thus we can see that the Net Margin likely increased because of better operating
expense controls in 2005.
Answer : D
Question 2
Industry average liquidity ratios for Windswepts industy are:
Current ratio 1.9
Quick ratio 0.7
Which of the following best describes Windswepts liquidity position:
a. Better than the industry and improving
b. Better than the industry, but declining
c. Below industry average, but improving
d. Below industry average and getting worse
e. None of the above
Answer Question 2
Current Ratio = Current Assets/Current Liabilities
Current Ratio 2004 = 2,530/1,110 = 2.28
Current Ratio 2005 = 2,440/1,120 = 2.18
Quick Ratio = (CA Inventory)/Current Liabilities
Quick Ratio 2004 = 1,050/1,110 = .95
Quick Ratio 2005 = 920/1,120 = .82
Both the current ratio and the quick ratio are better than the industry but have been declining.
Answer : B
Question 3
Ryan Jones, an analyst with Goldhiem Soxs, observes that the quality of Windswepts accounts receivable seems to be going down.
Given the available information, would you agree with him? Why or why not?
a. Agree the declining accounts receivable indicates an inability to collect the debt
b. Agree the declining accounts receivable indicates managements lack of confidence
c. Disagree the average collection period is declining as sales increase
d. Disagree the average collection period is increase in proportion to sales growth
e. None of the above
Answer Question 3
First one should calculate the average collection period (AR/Daily Credit Sales).
ACP 2004 = 930 / (7,180/360) = 46.6
ACP 2005 = 780 / (8,450/360) = 33.2
This ratio shows that Windswept is able to collect on its sales quicker than it has in the past. This would
mean that the quality of the AR has actually increased.
Answer : C
Question 4
In analyzing Windswept, you notice that their current ratio is decreasing. Which of the following best
describes why this is happening?
a. The firm is reducing its use of current liabilities
b. The firm has obtained better margins
c. Relative to sales, the firm is holding more inventory
d. Retained earnings
e. None of the above
Answer Question 4
A is incorrect as current liabilities has actually increased slightly.
B is incorrect as margins do not affect the current ratio.
C is incorrect as an increase in inventory relative to sales would actually increase the current ratio.
D is incorrect as RE do not affect the current ratio.
Answer : E
Question 5
Assuming that depreciation expense in 2005 is $50, what is Windswepts 2005 CFO?
a. $411
b. $631
c. $651
d. $8620
e. None of the above
Answer Question 5
We will use the indirect method to calculate CFO.
Answer : C
Question 6
What is Windswepts payout ratio in 2005?
a. Between 16% and 17%
b. Between 21% and 22%
c. Between 27% and 28%
d. Between 62% and 63%
e. None of the above
Answer Question 6
The payout ratio is the % of Net Income that is paid to stockholders in the form of dividends (Dividends/Net Income).
We know NI = $481 but we have to find Dividends paid. To do this we look at Retained Earnings. We know
that 2005 RE = 2004 RE + 2005 NI 2005 Div.
Substituting in the data gives us $710 = $530 + $481 Div.
Solving for Dividends gives you $301.
Now to get the payout ratio you take 301/481 = 62.6%
Answer : D
Question 7
Which of the following is (are) sources of cash?
I. an increase in accounts receivable
II. a decrease in common stock
III.
an increase in long-term debt
IV.
a decrease in accounts payable
a. I only
b. III only
c. II and IV only
d. I and III only
e. I, II, and IV only
Answer Question 7
An increase in AR means that more of your sales are for credit and NOT cash.
A decrease in common stock can only occur if you BUY commons stock with cash.
An increase in long-term debt means you RECEIVED cash from your lender.
A decrease in AP means that you paid down a debt USING cash.
Answer : B
Question 8
The higher the inventory turnover measure, the:
a. faster a firm sells its inventory.
b. faster a firm collects payment on its sales.
c. longer it takes a firm to sell its inventory.
d. greater the amount of inventory held by a firm.
e. None of the above
Answer Question 8
Inventory turnover is calculated using the formula: COGS / Inventory
Therefore the only way to increase the inventory turnover ratio would be for COGS to increase or
Inventory to decrease.
Answer : A
Question 9
The only difference between Joes and Moes is that Joes has old, fully depreciated equipment. Moes just
purchased all new equipment which will be depreciated over eight years. Assuming all else equal:
a. Joes will have a lower profit margin.
b. Joes will have lower liquidity ratios.
c. Moes will have a higher net income.
d. Moes will have a lower profit margin.
e. none of the above
Answer Question 9
Since Joes old machinery is fully depreciated they will not have any depreciation expense on the income
statement. Thus holding everything else constant Joe will have higher Operating Profits and Net
Income as they have lower operating expenses (depreciation is an operating expense).
Depreciation long or term assets like PP&E due not directly affect liquidity ratios.
Answer : D
Question 10
Samuelsons has a debt-to-equity ratio of 40 percent, sales of $8,000, net income of $600, and total debt of
$2,400. What is the return on equity?
a. 6.25 percent
b. 7.50 percent
c. 9.75 percent
d. 10.00 percent
e. None of the above
Answer Question 10
Return on Equity is equal to Net Income/Equity
Net Income is equal to $600.
Debt/Equity = .40 where Debt =$2,400. Substituting for debt and solving for equity gives you Equity =
$2,400/.4 = $6,000
ROE = $600/$6,000 = 10%
Answer : D
Question 11
In the Manning case, one of the subject firms had significantly increasing liquidity ratios. In the solution in
class, we said this could be interpreted as a bad thing because:
a. Too much liquidity hurts profitability
b. Increasing liquidity ratios are bad for bond ratings
c. The ratio increased because of the build-up of cash and decreasing A/P
d. The ratio increased because of increasing low-quality current assets
e. None of the above
Answer Question 11
See the Manning case discussion for further information.
Answer : D
The following balance sheet and income statement is for questions #12 to #17:
Notes:
do not average balance sheet data when calculating ratios
Jokers current ratio at the end of 2008 is 2.4
assume a 360 day year
All sales are on credit
Depreciation expense in 2008 is $200 (in millions, like the financial statements)
The firms constant dividend payout ratio is 25%
The ratio template is for your convenience (it will not be graded)
Jokers, Inc.
2008 Income Statement
($ in millions)
Net sales
Less: Cost of goods sold
Less: operating expense
Earnings before interest and taxes
Less: Interest paid
Taxable Income
Less: Taxes
Net income
$8,600
6,130
1,200
1,270
130
$1,300
380
$ 760
Jokers, Inc.
2007 and 2008 Balance Sheets
($ in millions)
2007
2008
2007
Cash
$ 1100 $ 1,983
Accounts payable
Accounts rec.
1,481
????
Accrued wages
700
Inventory
3,319
2,850
Total C. Liab
Total C.Assets $ 5,900 $ ????
Long-term debt
7,875
Net fixed assets 11,285
????
Common stock
3,500
Retained earnings
2,990
Total assets
$17,185 $?????
Total liab.& equity
$17,185
2008
$ 2,120
???
$ 2,820
7,800
5,250
????
$?????
$ 2,270
$ 2,870
Industry average ratios__ ____________________________________________________Jokers Ratios_______________
Gross Margin
= 28%
Operating Margin
= 19%
Net margin
= 13%
Average collection period
= 67
Inventory turnover
= 3.3
Fixed asset turnover
= .64
Total asset turnover
= .55
Debt ratio
Current ratio
Quick ratio
Times Interest earned
ROA
ROE
Cash ratio (cash/Curr Liab)
= .43
= 2.9
= 2.0
= 12.3
= 4.1%
= 8.4%
=.23
Question 12
The CEO of Jokers makes the following assertions in the firms annual report:
I.
The firm must bring down production costs to be competitive with the industry
II.
The firms operating expenses are well below industry average
III.
The firm is more conservatively finance than the typical firm in the industry
IV.
The firms ability to service the interest payments on debt is better than average
Given the data, how many of the assertions are correct?
a. 0
b. 1
c. 2
d. 3
e. 4
Answer Question 12
False. Jokers has about the average gross margin. GM=($8,600$6,130)/$8,600=28.7% versus Industry of 28% .
False. Operating margin is below average. Operating margin =$1,270/$8,600=14.8% versus Industry of 19%.
False. The debt ratio is higher than average. Debt ratio =Debt/Assets. To find Total Assets we first need to find RE. RE=$2,990+
$760-$760*.25=$3,560. Add this to Current Liab, Long-term debt, and Common stock to get $19,480 for
Liabilities+Equity = Total Assets. Thus the debt ratio is ($2,870+$7,800)/$19,480 = 54.8% versus Industry of 43%.
False. Times Interest Earned is below average. Times interest earned is $1,270/$130=9.8 versus Industry of 12.3.
Answer : A
Question 13
An analyst argues that the firms ROA is low because management holds too much cash. Is this a plausible argument?
a. No keeping extra cash makes the firm less risky
b. No the amount of cash does not impact the ROA
c. No the firm has a lean cash position
d. Yes the heavy cash position increases assets and therefore deceases ROA
e. Yes the heavy cash position always decreases the times interest earned and therefore the ROA
Answer Question 13
ROA = Net Income / Total Assets. Therefore ROA can decline if NI goes down or if Total Assets go up.
Holding too much cash could cause Total Assets to be artificially high (and ROA to be low).
The cash ratio for Jokers is high relative to the industry.
Answer : D
Question 14
In order to be in line with the industry average, what volume of inventory should Jokers be holding in 2008? (base
your calculations on the relationship between COGS and inventory; solution rounded to nearest $10)
a. The firm is currently in line with industry averages
b. $1,860
c. $2,200
d. $2,240
e. None of the above
Answer Question 14
Inventory turnover = COGS/Inventory. For the industry that ratio is 3.3. Jokers Inc.s COGS are $6,130.
Solving for Inventory gives you Inventory = $6,130/3.3 = $1860 (rounded).
Answer : B
Question 15
Considered in isolation and relative to the industry, what is the impact of the Jokers average collection period and
Jokers net margin on the firms ROA (e.g., does ACP tend to increase or decrease ROA)?
Impact of ACP on ROA
a. increase
b. decrease
c. increase
d. decrease
Impact of Net Margin on ROA
increase
increase
decrease
decrease
Answer Question 15
ACP = Accounts Receivable/Daily Credit Sales = To get AR we need to first find the firms current assets. Using the Current ratio we
can solve for current assets = $2,870 * 2.4 = $6,880 . With that we can solve for AR = $6,880-$1,983-$2,850=$2,055.
Now ACP = $2,055 / ($8,600/360) = 86 versus the Industry of 67. This would cause ROA to decrease as Jokers has
more assets than the industry.
Net Margin = Net Income / Sales = $760/$8,600 = 8.8% versus the Industry of 13%. This would cause ROA to decrease as Jokers has
lower Net Income thus a lower return.
Answer : D
Question 16
How much accounts receivable did the firm have on the balance sheet date in 2008?
a. $2655
b. $3025
c. $3335
d. $3435
e. None of the above
Answer Question 16
See question 15 Answer for the method of solving for AR in 2008. AR 2008 = $2,055
Answer : E
Question 17
What is Jokers CFO for 2008?
a. -$33
b. $905
c. $960
d. $2153
e. none of the above
Answer Question 17
Using the Indirect Method we get CFO = $950
Answer : B