Handout - Financial Statement Analysis

FINANCIAL STATEMENTS AND RATIO ANALYSIS

OVERVIEW
Financial analysis is the process of examining a company’s performance in the context of its
industry and economic environment in order to arrive at a decision or recommendation.

Often, the decisions and recommendations addressed by financial analysts pertain to providing
capital to companies—specifically, whether to invest in the company’s debt or equity securities and
at what price.

Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return on its
capital that is at least equal to the cost of that capital, to profitably grow its operations, and to
generate enough cash to meet obligations and pursue opportunities.

Common-Size Analysis
Common-size analysis involves expressing financial data, including entire financial statements, in
relation to a single financial statement item, or base. Items used most frequently as the bases are
total assets or revenue. In essence, common-size analysis creates a ratio between every financial
statement item and the base item.

Types of Common-Size Analysis

• Vertical Analysis
– A vertical common-size balance sheet, prepared by dividing each item on the balance
sheet by the same period’s total assets and expressing the results as percentages,
highlights the composition of the balance sheet.
– A vertical common-size income statement divides each income statement item by
revenue, or sometimes by total assets (especially in the case of financial institutions). If
there are multiple revenue sources, a decomposition of revenue in percentage terms is
useful.
• Horizontal Analysis
– A horizontal common-size balance sheet, prepared by computing the increase or decrease
in percentage terms of each balance sheet item from the prior year or prepared by dividing
the quantity of each item by a base year quantity of the item, highlights changes in items.
– Now it’s time to look at a different way to evaluate the income statement. With
horizontal analysis, we look across the income statement at the year-over-year (YoY)
change in each line item.

Types of Ratio Comparisons

• Cross-Sectional Analysis
– Comparison of different firms’ financial ratios at the same point in time; involves
comparing the firm’s ratios with those of other firms in its industry or with industry
averages
• Benchmarking
– A type of cross-sectional analysis in which the firm’s ratio values are compared with
those of a key competitor or with a group of competitors that it wishes to emulate
• Time-Series Analysis
– Evaluation of the firm’s financial performance over time using financial ratio analysis
• Combined Analysis
– Combines cross-sectional and time-series analyses

Categories of Financial Ratios

• Activity ratios measure how efficiently a company performs day-to-day tasks, such as the
collection of receivables and management of inventory.
• Liquidity ratios measure the company’s ability to meet its short-term obligations.
• Solvency ratios measure a company’s ability to meet long-term obligations. Subsets of
these ratios are also known as “leverage” and “long-term debt” ratios.
• Profitability ratios measure the company’s ability to generate profits from its resources
(assets).
• Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with
ownership of a specified claim (e.g., a share or ownership of the enterprise).

LIQUIDITY RATIOS

Liquidity – A firm’s ability to satisfy its short-term obligations as they come due.

Most Commonly used Liquidity Ratios

1. Current Ratio

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 Current Ratio = Current Assets ÷ Current Liabilities
This ratio expresses current assets in relation to current liabilities. A higher ratio
indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations).

2. Quick Ratio
Quick (Acid-Test) Ratio = (Current Assets – Inventory – Prepaid Expenses) ÷
Current Liabilities
The quick ratio is more conservative than the current ratio because it includes only
the more liquid current assets (sometimes referred to as “quick assets”) in relation to
current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity.

3. Cash ratio
Cash ratio = Cash + Short-term marketable investments ÷ Current
Liabilities
The cash ratio normally represents a reliable measure of an entity’s liquidity in a
crisis situation.

4. Defensive interval ratio

Defensive interval ratio = Cash + Short-term marketable investments +
Receivables ÷
Daily cash expenditures
This ratio measures how long the company can continue to pay its expenses from its
existing liquid assets without receiving any additional cash inflow. A defensive interval ratio
of 50 would indicate that the company can continue to pay its operating expenses for 50
days before running out of quick assets, assuming no additional cash inflows. A higher
defensive interval ratio indicates greater liquidity.

5. Cash conversion cycle (net operating cycle)

Cash conversion cycle = Days of inventory on hand (DOH) + Days of sales
outstanding
– Number of days of payables
This metric indicates the amount of time that elapses from the point when a
company invests in working capital until the point at which the company collects cash.

SOLVENCY RATIOS

Solvency – refers to a company’s ability to fulfill its long-term debt obligations. Assessment of a
company’s ability to pay its long-term obligations (i.e., to make interest and principal payments)
generally includes an in-depth analysis of the components of its financial structure.

Most Commonly used Solvency Ratios

1. Debt-to-assets ratio
Debt-to-assets ratio = Total debt ÷ Total Assets
This ratio measures the percentage of total assets financed with debt. Generally,
higher debt means higher financial risk and thus weaker solvency.

2. Debt-to-capital ratio
Debt-to-capital ratio = Total debt ÷ (Total debt + Total shareholders’ equity)
The debt-to-capital ratio measures the percentage of a company’s capital (debt plus
equity) represented by debt. As with the previous ratio, a higher ratio generally means
higher financial risk and thus indicates weaker solvency.

3. Debt-to-equity ratio
Debt-to-equity ratio = Total debt ÷ Total shareholders’ equity
The debt-to-equity ratio measures the amount of debt capital relative to equity
capital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates
weaker solvency).

4. Financial leverage ratio

Financial leverage ratio = Average total assets ÷ Average Total
shareholders’ equity
This ratio (often called simply the “leverage ratio”) measures the amount of total
assets supported for each one money unit of equity. The higher the financial leverage ratio,
the more leveraged the company is in the sense of using debt and other liabilities to finance
assets.

5. Interest coverage
Interest coverage = EBIT ÷ Interest Payments
This ratio measures the number of times a company’s EBIT could cover its interest
payments. Thus, it is sometimes referred to as “times interest earned.” A higher interest

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 coverage ratio indicates stronger solvency, offering greater assurance that the company can
service its debt (i.e., bank debt, bonds, notes) from operating earnings.

6. Fixed charge coverage

Fixed charge coverage = (EBIT + Lease Payments) ÷ (Interest Payments +
Lease payments)
This ratio relates fixed charges, or obligations, to the cash flow generated by the
company. It measures the number of times a company’s earnings (before interest, taxes,
and lease payments) can cover the company’s interest and lease payments. Similar to the
interest coverage ratio, a higher fixed charge coverage ratio implies stronger solvency,
offering greater assurance that the company can service its debt (i.e., bank debt, bonds,
notes, and leases) from normal earnings. The ratio is sometimes used as an indication of the
quality of the preferred dividend, with a higher ratio indicating a more secure preferred
dividend.

ACTIVITY RATIOS

Activity ratios are also known as asset utilization ratios or operating efficiency ratios.

This category is intended to measure how well a company manages various activities, particularly
how efficiently it manages its various assets. Activity ratios are analyzed as indicators of ongoing
operational performance—how effectively assets are used by a company.

Most Commonly used Activity Ratios

1. Inventory turnover
Inventory turnover = Cost of sales or cost of goods sold ÷ Average
inventory
Inventory turnover lies at the heart of operations for many entities. It indicates the
resources tied up in inventory (i.e., the carrying costs) and can, therefore, be used to
indicate inventory management effectiveness. A high inventory turnover ratio relative to
industry norms might indicate highly effective inventory management while A low inventory
turnover ratio (and commensurately high DOH) relative to the rest of the industry could be
an indicator of slow-moving inventory, perhaps due to technological obsolescence or a
change in fashion.

2. Days of inventory on hand (DOH)

Days of inventory on hand (DOH) = Number of days in period ÷ Inventory
turnover

3. Receivables turnover
Receivables turnover = Revenue ÷ Average Receivables
This provides us the number of times Accounts Receivables (Credit Sales) is
converted into Cash Sales. Although limiting the numerator to sales made on credit in the
receivables turnover would be more appropriate, credit sales information is not always
available to analysts; therefore, revenue as reported in the income statement is generally
used as an approximation. A relatively high receivables turnover ratio (and commensurately
low DSO) might indicate highly efficient credit and collection. A relatively low receivables
turnover ratio would typically raise questions about the efficiency of the company’s credit
and collections procedures

4. Days of sales outstanding

Days of sales outstanding = Number of days in period ÷ Receivables
turnover

5. Payables turnover
Payables turnover = Purchases ÷ Average trade payables
The payables turnover ratio measures how many times per year the company theoretically
pays off all its creditors. For purposes of calculating these ratios, an implicit assumption is
that the company makes all its purchases using credit. If the amount of purchases is not
directly available, it can be computed as cost of goods sold plus ending inventory less
beginning inventory. A payables turnover ratio that is high (low days payable) relative to the
industry could indicate that the company is not making full use of available credit facilities.
An excessively low turnover ratio (high days payable) could indicate trouble making
payments on time, or alternatively, exploitation of lenient supplier terms.

6. Number of days of payables

Number of days of payables = Number of days in period ÷ Payables
turnover
The number of days of payables reflects the average number of days the company
takes to pay its suppliers
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 7. Working capital turnover
Working capital turnover = Revenue ÷ Average working capital
Working capital = Current Assets – Current Liabilities
Working capital turnover indicates how efficiently the company generates revenue
with its working capital. A high working capital turnover ratio indicates greater efficiency
(i.e., the company is generating a high level of revenues relative to working capital). For
some companies, working capital can be near zero or negative, rendering this ratio
incapable of being interpreted.

8. Fixed asset turnover

Fixed asset turnover = Revenue ÷ Average net fixed assets
This ratio measures how efficiently the company generates revenues from its
investments in fixed assets. Generally, a higher fixed asset turnover ratio indicates more
efficient use of fixed assets in generating revenue. A low ratio can indicate inefficiency, a
capital-intensive business environment, or a new business not yet operating at full capacity
—in which case the analyst will not be able to link the ratio directly to efficiency.

9. Total asset turnover

Total asset turnover = Revenue ÷ Average total assets
The total asset turnover ratio measures the company’s overall ability to generate
revenues with a given level of assets. A higher ratio indicates greater efficiency. Because this
ratio includes both fixed and current assets, inefficient working capital management can
distort overall interpretations. It is therefore helpful to analyze working capital and fixed
asset turnover ratios separately. A low asset turnover ratio can be an indicator of inefficiency
or of relative capital intensity of the business. The ratio also reflects strategic decisions by
management—for example, the decision whether to use a more labor-intensive (and less
capital-intensive) approach to its business or a more capital-intensive (and less labor-
intensive) approach

PROFITABILITY RATIOS

Profitability - reflects a company’s competitive position in the market, and by extension, the
quality of its management.

Most Commonly used Profitability Ratios

1. Gross profit margin
Gross profit margin = Gross profit ÷ Revenue
Gross profit margin indicates the percentage of revenue available to cover operating
and other expenses and to generate profit. Higher gross profit margin indicates some
combination of higher product pricing and lower product costs.

2. Operating profit margin

Operating profit margin = Operating income ÷ Revenue
Operating profit margin increasing faster than the gross profit margin can indicate
improvements in controlling operating costs, such as administrative overheads. In contrast,
a declining operating profit margin could be an indicator of deteriorating control over
operating costs.

3. Pre-tax Margin
Pre-tax Margin = EBT (earnings before tax but after interest) ÷ Revenue
The pretax margin reflects the effects on profitability of leverage and other (non-
operating) income and expenses. If a company’s pretax margin is increasing primarily as a
result of increasing amounts of non-operating income, the analyst should evaluate whether
this increase reflects a deliberate change in a company’s business focus and, therefore, the
likelihood that the increase will continue.

4. Net profit margin

Net profit margin = Net income ÷ Revenue
Generally, the net income used in calculating the net profit margin is adjusted for
non-recurring items to offer a better view of a company’s potential future profitability

5. Operating Return of Assets (OROA)

Operating Return of Assets (OROA) = Operating income (EBIT) ÷ Average
total assets
In this ROA calculation, returns are measured prior to deducting interest on debt
capital (i.e., as operating income or EBIT). This measure reflects the return on all assets
invested in the company, whether financed with liabilities, debt, or equity.

6. Return of Assets (ROA)

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 Return of Assets (ROA) = Net income ÷ Average total assets
ROA measures the return earned by a company on its assets. The higher the ratio,
the more income is generated by a given level of assets.

7. Return on total capital

Return on total capital = EBIT ÷ Short- and long-term debt and equity
Return on total capital measures the profits a company earns on all of the capital that
it employs (short-term debt, long-term debt, and equity).

8. Return on Equity (ROE)

Return on Equity (ROE) = Net income ÷ Average total equity
ROE measures the return earned by a company on its equity capital, including
minority equity, preferred equity, and common equity

9. Return on common equity

Return on common equity = (Net income – Preferred dividends) ÷ Average
common equity
Return on common equity measures the return earned by a company only on its
common equity.

VALUATION RATIOS

Valuation ratios - measure the quantity of an asset or flow (e.g., earnings) associated with
ownership of a specified claim (e.g., a share or ownership of the enterprise). Analysts are interested
in valuing a security to assess its merits for inclusion or retention in a portfolio.

Most Commonly used Valuation Ratios

1. Price-Earnings Ratio (P/E)
P/E = Price per share ÷ Earnings per share
The P/E ratio expresses the relationship between the price per share and the amount
of earnings attributable to a single share. In other words, the P/E ratio tells us how much an
investor in common stock pays per dollar of earnings.

2. Price-Cash Flow Ratio (P/CF)

P/CF = Price per share ÷ Cash flow per share
Price to cash flow is used as an alternative measure—particularly in situations where
earnings quality may be an issue.

3. Price-Sales Ratio (P/S)

P/S = Price per share ÷ Sales per share
Price to sales is calculated in a similar manner and is sometimes used as a
comparative price metric when a company does not have positive net income.

4. Price-Book Value Ratio (P/BV)

P/BV = Price per share ÷ Book value per share
This ratio is often interpreted as an indicator of market judgment about the
relationship between a company’s required rate of return and its actual rate of return. A ratio
greater than one would indicate that the future profitability of the company is expected to
exceed the required rate of return, and values of this ratio less than one indicate that the
company is not expected to earn excess returns.

5. Basic Earnings per Share (EPS)

Basic EPS = Net income minus preferred dividends ÷ Weighted average
number of ordinary shares
outstanding
Basic EPS provides information regarding the earnings attributable to each share of
common stock.

6. Diluted Earnings per Share (EPS)

Diluted EPS = Adjusted income available for ordinary shares, reflecting
conversion of
dilutive securities ends ÷ Weighted average number of
ordinary and
potential ordinary shares
outstanding
Accounting standards generally require the disclosure of basic as well as diluted EPS
(diluted EPS includes the effect of all the company’s securities whose conversion or exercise
would result in a reduction of basic EPS; dilutive securities include convertible debt,
convertible preferred, warrants, and options).

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 7. Cash flow per share
Cash Flow per Share = Cash flow from operations ÷ Weighted average
number of Shares Outstanding

8. EBITDA per share

EBITDA per share = EBITDA ÷ Weighted average number of shares
outstanding
EBITDA per share, because it is calculated using income before interest, taxes, and
depreciation, can be used to eliminate the effect of different levels of fixed asset investment
across companies. It facilitates comparison between companies in the same sector but at
different stages of infrastructure maturity.

9. Dividends per share

Dividends per share = Common dividends declared ÷ Weighted average
number of ordinary shares

outstanding

10. Dividend payout ratio

Dividend Payout Ratio = Common share dividends ÷ Net income
attributable to common shares
The dividend payout ratio measures the percentage of earnings that the company
pays out as dividends to shareholders.

DUPONT ANALYSIS (DECOMPOSITION OF ROE)

ROE measures the return a company generates on its equity capital. Thus, to understand what
drives a company’s ROE, a useful technique is to decompose ROE into its component parts.
(Decomposition of ROE is sometimes referred to as DuPont analysis because it was developed
originally at that company.) Decomposing ROE involves expressing the basic ratio (i.e., net income
divided by average shareholders’ equity) as the product of component ratios.

Decomposing ROE is useful in determining the reasons for changes in ROE over time for a given
company and for differences in ROE for different companies in a given time period. The information
gained can also be used by management to determine which areas they should focus on to improve
ROE.

The decomposition of ROE makes use of simple algebra and illustrates the relationship between
ROE and ROA. Expressing ROE as a product of only two of its components, we can write:

Further decomposing ROA, we can express ROE as a product of three component ratios:

To separate the effects of taxes and interest, we can further decompose the net profit margin and
write:

• DuPont System of Analysis

– System used to dissect the firm’s financial statements and to assess its financial condition
– Dupont Formula
– Multiplies the firm’s net profit margin by its total asset turnover to calculate the firm’s
return on total assets (ROA)
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 Earnings Available for Common Stockholders Sales
ROA = ×
Sales Total Assets
Earnings Available for Common Stockholders
=
Total Assets

DUPONT SYSTEM OF ANALYSIS

MULTIPLE CHOICE QUESTIONS:

1. Ratios provide a measure of a company's performance and condition.

a. definitive
b. gross
c. relative
d. absolute

2. Present and prospective shareholders are mainly concerned with a firm's .

a. risk and return
b. profitability
c. leverage
d. liquidity

3. analysis involves the comparison of different firms' financial ratios at the same point
in time.
a. Time-series
b. Cross-sectional
c. Marginal
d. Technical

4. Which of the following is used to analyze a firm's financial performance over different years?
a. time-series analysis
b. break-even analysis
c. gap analysis
d. marginal analysis

5. Which of the following is true of benchmarking?

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 a. It is an analysis in which a firm's ratio values are analyzed to project the fundamental
values of the assets for upcoming years or business cycle.
b. It is an analysis in which a firm's ratio values are compared with those of a key
competitor or with a group of competitors that it wishes to emulate.
c. It is an analysis in which a firm's financial performance over time is evaluated using
financial ratio analysis.
d. It is a financial statement analysis technique which is primarily used for forecasting
future performance.

6. Which of the following is a limitation of ratio analysis?

a. Financial ratios cannot be used to assess a firm's profitability.
b. Ratios that reveal large deviations from the norm merely indicate the
possibility of a problem.
c. It is difficult to access audited financial statements for ratio analysis.
d. Ratio analysis assumes that inflation has no effect on a firm's business.

7. An analyst should be careful when conducting ratio analysis to ensure that .

a. the overall performance of a firm is not judged on a single ratio
b. the role of inflation is ignored
c. ratios being compared should be calculated using financial statements dated at different
points in time during the year
d. different accounting procedures are used

8. Which of the following groups of ratios primarily measure risk?

a. liquidity, activity, and profitability
b. liquidity, profitability, and market
c. liquidity, activity, and debt
d. activity, debt, and profitability

9. A firm has a current ratio of 1. To increase that ratio the firm might .
a. develop a better inventory management system so the firm doesn't have to hold as
many items in inventory at one time
b. hold lower cash balances at the bank and increase holdings of interest-earning
marketable securities
c. take out a long-term bank loan and simultaneously offer customers better
credit terms, allowing them to pay their bills more slowly
d. issue bonds and use the proceeds to purchase new equipment

10. Which of the following is true of the current ratio?

a. The more predictable a firm's cash flows, the higher the acceptable current ratio.
b. A higher current ratio indicates a higher return on equity.
c. The more predictable a firm's current ratio, the higher the current liabilities.
d. A higher current ratio indicates a greater degree of liquidity.

11. The measures the activity, or liquidity, of a firm's stock of goods.

a. average collection period
b. inventory turnover ratio
c. average payment period
d. total asset turnover ratio

12. A firm with a total asset turnover lower than industry standard may have .
a. excessive debt
b. excessive interest costs
c. insufficient sales
d. insufficient fixed assets

13. A firm's total asset turnover increased from 0.75 to 0.90. Which of the following is true about
the given data?
a. The firm is generating more dollars of sales per dollar of assets now than it
was before.
b. The firm is generating fewer dollars of sales per dollar of assets now than it was before.
c. By cutting back on assets, the firm runs the risk of creating problems like inventory
stockouts and production delays.
d. The firm's stock price will go up because it is using asset more efficiently.

14. The higher, the value of the ratio, the better able a firm is to fulfill its interest
obligations.
a. dividend payout
b. average collection period
c. times interest earned
d. average payment period

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 15. Two frequently cited ratios of profitability that can be read directly from the common-size
income statement are .
a. the earnings per share and the return on total assets
b. the gross profit margin and the earnings per share
c. the gross profit margin and the return on total assets
d. the gross profit margin and the net profit margin

FOR 16-30
Dana Dairy Products Key Ratios

Income Statement
Dana Dairy Products
For the Year Ended December 31, 2019

Balance Sheet
Dana Dairy Products
December 31, 2019

16. The current ratio for Dana Dairy Products in 2019 was . (See Table 3.2)
a. 1.58
b. 0.63
c. 1.10
d. 0.91

17. Since 2018, the liquidity of Dana Dairy Products . (See Table 3.2)

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 a. has deteriorated
b. has remained the same
c. has improved
d. is not determinable

18. The net working capital for Dana Dairy Products in 2019 was . (See Table 3.2)
a. $10,325
b. -$10,325
c. -$1,425
d. $14,250

19. The inventory turnover for Dana Dairy Products in 2019 was . (See Table 3.2)
a. 43
b. 5
c. 20
d. 25

20. The inventory management at Dana Dairy Products since 2018. (See Table 3.2)
a. has deteriorated
b. has remained the same
c. has improved slightly
d. cannot be determined

21. The average collection period for Dana Dairy Products in 2019 was . (See Table 3.2)
a. 32.5 days
b. 11.8 days
c. 25.3 days
d. 35.9 days

22. If Dana Dairy Products has credit terms which specify that accounts receivable should be
paid in 25 days, the average collection period since 2018. (See Table 3.2)
a. has deteriorated
b. has remained the same
c. has improved
d. cannot be determined

23. Dana Dairy Products had a degree of financial leverage than the industry standard,
resulting in . (See Table 3.2)
a. lower; lower return on total assets
b. lower; lower return on equity
c. higher; higher return on equity
d. higher; higher return on total assets

24. The debt ratio for Dana Dairy Products in 2019 was . (See Table 3.2)
a. 50 percent
b. 11 percent
c. 55 percent
d. 44 percent

25. Dana Dairy Products' gross profit margin was inferior to the industry standard. This may
have resulted from . (See Table 3.2)
a. a high sales price
b. the high cost of goods sold
c. excessive selling and administrative expenses
d. excessive interest expense

26. The gross profit margin and net profit margin for Dana Dairy Products in 2019 were .
(See Table 3.2)
a. 13 percent and 0.9 percent, respectively
b. 13 percent and 1.5 percent, respectively
c. 2 percent and 0.9 percent, respectively
d. 2 percent and 1.5 percent, respectively

27. The return on total assets for Dana Dairy Products for 2019 was . (See Table 3.2)
a. 0.9 percent
b. 5.5 percent
c. 25 percent
d. 2.5 percent

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 28. The return on equity for Dana Dairy Products for 2019 was . (See Table 3.2)
a. 0.6 percent
b. 5.6 percent
c. 0.9 percent
d. 50 percent

29. Using the modified DuPont formula allows the analyst to break Dana Dairy Products return
on equity into 3 components: the net profit margin, the total asset turnover, and a measure
of leverage (the financial leverage multiplier). Which of the following mathematical
expressions represents the modified DuPont formula relative to Dana Dairy Products' 2019
performance? (See Table 3.2)
a. 5.6(ROE) = 2.5(ROA) × 2.22(Financial leverage multiplier)
b. 5.6(ROE) = 3.3(ROA) × 1.70(Financial leverage multiplier)
c. 4.0(ROE) = 2.5(ROA) × 2.00(Financial leverage multiplier)
d. 2.5(ROE) = 5.6(ROA) × 2.22(Financial leverage multiplier)

30. As the financial leverage multiplier increases, this may result in .

a. an increase in the net profit margin and return on investment, due to the decrease in
interest expense as debt decreases
b. an increase in the net profit margin and return on investment, due to the increase in
interest expense as debt increases
c. a decrease in the net profit margin and return on investment, due to the
increase in interest expense as debt increases
d. a decrease in the net profit margin and return on investment, due to the decrease in
interest expense as debt decreases

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