Uses and Limitations of Ratio Analysis in Finance Chapter 7 Quiz
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Questions and Answers

What is the primary purpose of comparative ratio analysis?

  • To analyze the impact of inflation on a firm's balance sheet
  • To compare a firm's ratios with those of other firms in the same industry at a specific time (correct)
  • To compare a firm's current ratios with its own ratios from the past
  • To assess the industry leaders' inventory costs

    • Why are industry averages not always a suitable target for large firms?

  • Large firms do not focus on financial performance
  • Industry averages are not reliable
  • Industry averages are only applicable to small firms
  • Large firms operate divisions in different industries, making it hard to establish meaningful industry averages (correct)

    • How does inflation affect ratio analysis?

  • Inflation makes ratio analysis more accurate
  • Inflation eliminates the need for ratio analysis
  • Inflation has no impact on financial statements
  • Inflation distorts balance sheets and affects income statements (correct)

    • When comparing firms using ratio analysis, why is it important to consider firms of similar ages?

    <p>Firms of different ages may have different financial characteristics due to their life cycle stage</p> Signup and view all the answers

    What is a significant limitation of using industry averages for benchmarking?

    <p>Industry averages do not consider differences between industries or firm sizes</p> Signup and view all the answers

    Why is it important for firms aiming to perform above average to focus on the industry leaders' ratios?

    <p>Focusing on industry leaders helps set higher performance benchmarks</p> Signup and view all the answers

    Which of the following is a limitation of ratio analysis?

    <p>All of the above</p> Signup and view all the answers

    What is a recommended approach to address the issue of seasonal factors distorting ratios?

    <p>Use monthly averages as the base for inventory and receivables</p> Signup and view all the answers

    Which of the following is an example of a window dressing technique mentioned in the text?

    <p>Borrowing long-term to be repaid quickly to distort liquidity ratios</p> Signup and view all the answers

    What is a potential issue when comparing ratios between companies that use different accounting practices?

    <p>The ratios may not be directly comparable due to differences in accounting methods</p> Signup and view all the answers

    Which of the following statements about interpreting ratios is true, according to the text?

    <p>It is difficult to generalize whether a ratio is 'good' or 'bad' without further context</p> Signup and view all the answers

    What is the primary purpose of ratio analysis, according to the information provided?

    <p>To evaluate a company's financial performance and position</p> Signup and view all the answers

    Which of the following is a limitation of ratio analysis?

    <p>A firm may have some good ratios and some bad ratios, making it difficult to assess its overall financial health.</p> Signup and view all the answers

    What is the primary purpose of the statement of retained earnings?

    <p>To demonstrate the changes in the firm's common equity and the reasons behind those changes.</p> Signup and view all the answers

    Which financial statement provides a snapshot of a firm's assets and how they are financed?

    <p>Balance sheet</p> Signup and view all the answers

    Which of the following is a use of ratio analysis?

    <p>Comparing the firm's financial performance with that of its competitors.</p> Signup and view all the answers

    What is the most difficult part of effective ratio analysis?

    <p>The judgment required to reach conclusions about a firm's financial position.</p> Signup and view all the answers

    Which financial statement reports the revenues earned and expenses incurred by a firm?

    <p>Income statement</p> Signup and view all the answers

    Why is it challenging to develop meaningful industry averages for large firms with divisions in different industries?

    <p>Different industries have varying accounting practices.</p> Signup and view all the answers

    How does inflation impact the balance sheets of firms, according to the text?

    <p>Distorts the balance sheets.</p> Signup and view all the answers

    Which factor makes it challenging to compare firms of different ages using ratio analysis?

    <p>Varying depreciation methods over time.</p> Signup and view all the answers

    How do depreciation and inventory costs influence income statements, as mentioned in the text?

    <p>They distort income statements.</p> Signup and view all the answers

    Why is it essential to consider comparable firms when analyzing financial ratios?

    <p>To avoid differences in accounting practices.</p> Signup and view all the answers

    What impact does comparing a firm's ratios over time have on financial analysis?

    <p>It provides insight into changes in operational efficiency.</p> Signup and view all the answers

    What is a potential issue when comparing liquidity ratios between companies that use different inventory valuation methods?

    <p>The liquidity ratios will be distorted and not directly comparable.</p> Signup and view all the answers

    Which of the following statements about interpreting ratios is true?

    <p>It is difficult to generalize whether a ratio is 'good' or 'bad' without additional context.</p> Signup and view all the answers

    How can the issue of seasonal factors distorting ratios be addressed?

    <p>Use monthly averages as the base for inventory and receivables instead of a single month.</p> Signup and view all the answers

    What is a potential issue when comparing ratios between companies that use different depreciation methods?

    <p>The ratios will be distorted and not directly comparable.</p> Signup and view all the answers

    Which of the following is an example of a window dressing technique mentioned in the text?

    <p>Borrowing 'long-term' to be repaid quickly to distort liquidity ratios.</p> Signup and view all the answers

    What is a potential net effect of a high fixed assets turnover ratio?

    <p>It indicates efficient use of assets or undercapitalization.</p> Signup and view all the answers

    What is the formula for calculating the net profit margin on sales?

    <p>Net profit / Sales</p> Signup and view all the answers

    What does the return on total assets (ROA) ratio measure?

    <p>The return generated from each dollar of total assets employed</p> Signup and view all the answers

    Which of the following ratios focuses specifically on returns to common stockholders?

    <p>Return on common equity (ROE)</p> Signup and view all the answers

    How might different inventory valuation methods affect profitability ratios?

    <p>Using FIFO during inflation would increase profitability ratios compared to LIFO</p> Signup and view all the answers

    How might different depreciation methods affect the return on total assets ratio?

    <p>Accelerated depreciation would decrease the ratio by reducing net income faster</p> Signup and view all the answers

    How might different accounting practices between companies affect ratio analysis comparisons?

    <p>Different practices limit the comparability of ratio analysis between firms</p> Signup and view all the answers

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