CHAPTER 3: FINANCIAL STATEMENT ANALYSIS

I. MCQ
1. If company M.N’s gross margin (lợi nhuận gộp) declined, which of the following is true?
A. Its cost of goods sold increased.
B. Its cost of goods sold as a percent of sales increased.
C. Its sales increased.
D. Its net profit margin was unaffected by the decline.

2. The firm's equity multiplier (EM = Asset/Equity) measures ……..

A. the portion of the firm’s assets that is financed by equity.
B. the return the firm has earned on its investments.
C how well a firm uses its equity to generate sales
D. how efficiently the firm is utilizing its assets to generate sales.

3. The three factors DuPont Identity expresses the firm's return on equity (ROE) in terms of ……
A. profitability, asset efficiency, and leverage.
B. valuation, leverage, and interest coverage.
C. profitability, margins, and valuation.
D. equity, assets, and liabilities.

4. If Firm A and Firm B are in the same industry and use the same production method, and Firm A's
asset turnover (ATO) is higher than that of Firm B. Assuming all else equal, which statement below
is correct? (ATO = Sales/Total Asset)
A. Firm A uses asset more efficiently than Firm B.
B. Firm A has a lower amount of assets than Firm B.
C. Firm A generates higher sales than Firm B.
D. Firm A has a lower return on equity (ROE) than Firm B.

5. Which of the following statements is correct?

A. The use of debt financing will tend to lower the basic earning power (BEP) ratio, other things
held constant.
B. All else equal, increasing the debt ratio will increase the return on asset (ROA).
C. A firm that employs financial leverage will have a higher equity multiplier (EM) than an identical
firm that has no debt in its capital structure.
D. If two firms have identical sales, costs, and assets, but differ in the way they are financed, the firm
with less debt will have the higher expected return on equity (ROE).

6. Which of the following statements is correct?

A. If one firm has a higher debt ratio than another, it will have a lower times interest earned (TIE)
ratio.
B. A firm’s use of debt will have no effect on its return on equity (ROE).
C. If two firms differ only in their use of debt, the firm that uses more debt will have a lower profit
margin (PM) on sales.
D. All else equal, increasing the debt ratio will increase the return on asset (ROA).
7. An Thinh Communications recently issued new common stock and used the proceeds to pay off
some of its short-term notes payable. This action had no effect on the company’s total assets or
operating income. Which of the following effects would occur as a result of this action?
A. The company’s current ratio increased.
B. The company’s times interest earned ratio decreased.
C. The company’s basic earning power ratio increased.
D. The company’s equity multiplier increased.

II. CONCEPT QUESTIONS

1. Explain what it means for a firm to have a current ratio equal to 0.5. Would the firm be better off
if the current ratio were 1.5? What if it were 15.0 ? Explain your answers.
A firm with a current ratio of 0.50 may face liquidity issues as its current assets are not sufficient
to cover current liabilities. A ratio of 1.50 indicates a healthier liquidity position, whereas a ratio
of 15.0 might indicate inefficient use of assets.
Explanation:
When a firm has a current ratio equal to 0.50, it implies that the company has only half the
current assets needed to cover its current liabilities. This suggests a potential liquidity problem,
as the company may not be able to pay off its short-term debts as they come due.
If the firm's current ratio were 1.50, it would be in a better financial position, indicating that it
has more current assets than current liabilities and, therefore, a comfortable buffer to meet
short-term obligations.
A very high current ratio, such as 15.0, could suggest that the firm is holding too much in assets
that are not being effectively used to generate revenue, which could be a sign of inefficiency in
managing its resources.
2. Why would the inventory turnover ratio be more important when analyzing a grocery store than
an insurance company?
The inventory turnover ratio is more crucial for analyzing a grocery store than an insurance
company because grocery stores deal with perishable goods that need to be sold quickly, while
insurance companies do not have physical inventories that can become obsolete.
Explanation:
The inventory turnover ratio is a measure that indicates the number of times a company's
inventory is sold and replaced over a specified period. For businesses that rely on the sale of
physical goods, especially perishable items, this ratio is vital. Grocery stores are a prime
example. They stock perishable goods like fruits, vegetables, dairy products, and meats.

A high inventory turnover indicates that products are being sold and replaced frequently, which
is essential for items that have short shelf lives. It ensures freshness for the customer and
reduces waste due to spoilage for the store.
Conversely, insurance companies operate in the financial services sector and don't deal with
physical inventories. Their primary products are insurance policies, which don't "turn over" in
the same way tangible goods do. For insurance firms, other financial metrics, such as the loss
ratio or the combined ratio, would be more relevant indicators of performance. Therefore, while
the inventory turnover ratio is a key metric for understanding the efficiency of sales and stock
replenishment in businesses like grocery stores, it is not pertinent or applicable to insurance
companies.
3. You are provided with the following data for ABC Inc (specialized in providing fresh farm
products) and their industry.
 2021-
Ratio 2019 2020 2021 Industry
Average
Inventory Turnover 32.25 42.42 62.65 53.25
Total Asset Turnover 0.70 0.65 0.54 0.40
What can you say about the firm's asset management?
Analysis of ABC Inc.'s Asset Management:
1. Inventory Turnover: Positive Performance
o ABC Inc.’s inventory turnover has increased significantly from 32.25 in 2019 to
62.65 in 2021.
o This is higher than the industry average of 53.25, indicating that ABC Inc. is
managing its inventory efficiently and selling its stock faster.
o Since ABC Inc. specializes in fresh farm products, a high inventory turnover is
beneficial, as it reduces the risk of spoilage and excess holding costs.
2. Total Asset Turnover: Declining Efficiency
o ABC Inc.’s total asset turnover has decreased from 0.70 in 2019 to 0.54 in 2021,
though it remains above the industry average of 0.40.
o A declining total asset turnover suggests that the company is generating less
revenue per dollar of assets over time.
o Possible reasons:
 Increased investment in assets that have not yet translated into higher
sales.
 Slower revenue growth compared to asset growth.
Conclusion:
 ABC Inc. excels in inventory management, which is crucial for perishable goods.
 However, the declining total asset turnover indicates that the firm might not be using
its assets as efficiently as before.
 The company should investigate whether asset investments are leading to expected
returns or if adjustments are needed to improve overall asset efficiency.
4. Let’s analyze the return on equity of Companies A and B. Both the companies are into the
electronics industry and have the same ROE of 45%. The ratios of the two companies are as
follows:
Ratio Company A Company B

Profit margin (1) 30% 15%

Asset turnover (2) 0.5 6

Equity multiplier (3) 3 0.5

ROE = (1) * (2) * (3) 45% 45%

Based on the information provided, give comments on the two companies operation.
Analysis of Companies A and B Based on ROE Components:
Both Company A and Company B have the same Return on Equity (ROE) of 45%, but they
achieve it through very different financial strategies, as revealed by the DuPont analysis.
1. Company A’s Strategy (High Profit Margin & Leverage, Low Asset Turnover):
o High profit margin (30%): Company A earns more profit per dollar of sales,
indicating strong pricing power, premium products, or cost efficiency.
o Low asset turnover (0.5): It generates relatively low sales per dollar of assets,
which suggests capital-intensive operations or a business model focused on
fewer but higher-margin sales.
 o High equity multiplier (3): The company relies more on debt financing, meaning
it has more financial leverage. This can amplify returns but also increases financial
risk.
2. Company B’s Strategy (High Asset Turnover, Low Profit Margin & Leverage):
o Lower profit margin (15%): Company B has thinner margins, indicating a high-
volume, low-margin business model (e.g., selling electronics at competitive
prices).
o Extremely high asset turnover (6): It generates a large amount of revenue relative
to its assets, meaning the company is very efficient in using assets to drive sales.
o Low equity multiplier (0.5): Company B relies less on debt financing, making it
financially stable but with lower leverage-based return amplification.
Conclusion:
 Company A follows a high-margin, low-turnover, high-leverage model. It might operate
in a niche or premium market segment with significant reliance on debt.
 Company B follows a low-margin, high-turnover, low-leverage model, likely focusing on
high sales volume with efficient asset utilization while maintaining low financial risk.
 Both strategies can be successful, but Company A has higher financial risk due to
leverage, while Company B operates with lower profit margins but efficiently utilizes its
assets.
III. QUESTIONS AND PROBLEMS:
1. Chapter review and self-test problem:
Do the exercise 3.3 and 3.4 (p78) and check the answer (p78)
of the text book: Fundamental of Corporate finance (9Th edition)
2.Exercise 1,2,4,6,7, page 80 of the text book: Fundamental of
Corporate finance (9Th edition)

1. A firm's current ratio is an important measure of its liquidity and solvency. It is calculated
by dividing the current assets by the current liabilities. Actions that a firm takes can have a
direct effect on its current ratio, either increasing or decreasing it.
 a. Purchasing inventory would decrease the current ratio since it would reduce the
current assets and increase the current liabilities.
 b. _Paying a suppli_er would decrease the current ratio since it would reduce the current
assets and reduce the current liabilities.
 c. Repaying a short-term bank loan would increase the current ratio since it would reduce
the current liabilities without changing the current assets.
 d. Paying off a long-term debt early would increase the current ratio since it would reduce
the current liabilities without changing the current assets.
 e. When a customer pays off a credit account, the current ratio would remain the same since
it would not affect the current assets or liabilities.
 f. Selling inventory at cost would not have any effect on the current ratio since it would not
affect the current assets or liabilities.
 g. Selling inventory for a profit would increase the current ratio since it would increase the
current assets without changing the current liabilities.
2. An increase in the current ratio and a decrease in the quick ratio at Dixie Co. suggests that
the company has likely added more inventory to their current assets, which does not
necessarily indicate an improvement in liquidity.
Explanation:
The disparity between an increased current ratio and a decreased quick ratio indicates that
Dixie Co. has added more inventory to their current assets. The current ratio is a measure of a
company's ability to cover its current liabilities with its current assets, including inventory. The
quick ratio (also known as the acid-test ratio) however, takes the current ratio and excludes
inventory, as it's not always easily converted to cash.
A rise in the current ratio but a drop in the quick ratio may suggest that the company has
increased its investment in inventory. This, in most cases, doesn't necessarily mean an
improvement in liquidity, as it may be more challenging to quickly convert inventory into cash
compared to other current assets.
3. Exercise 1,2,8,9,10,11,12,13 page 81+82 of the text book:
Fundamental of Corporate finance (9Th edition)
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4, Exercise 19,22 page 83 of the text book: Fundamental of Corporate
finance (9Th edition)