D775 Introduction to Business Finance - Set 5 - Part 2

Correct Answer: Book versus market value

Option a is correct because the collectible example demonstrates how market value can differ dramatically from book value, just as stock market prices differ from accounting values. Option b is incorrect because current and quick ratios are liquidity measures rather than valuation concepts related to the difference between recorded and perceived values. Option c is incorrect because debt versus equity describes financing sources rather than the valuation concept of book versus market value illustrated by the collectible. Option d is incorrect because revenue versus profit describes income statement relationships rather than the valuation difference between recorded value and market perception.

Correct Answer: Higher future growth expected

Option d is correct because a higher price-earnings ratio indicates investors willingly pay more per dollar of current earnings, typically because they anticipate stronger future growth. Option a is incorrect because lower growth expectations would typically result in a lower price-earnings ratio as investors would not pay premium prices for limited prospects. Option b is incorrect because dividend expectations are not the primary driver of price-earnings ratio differences, which mainly reflect growth expectations and risk perceptions. Option c is incorrect because debt reduction plans would not typically drive significant differences in price-earnings ratios between companies with similar current earnings.

Correct Answer: Relatively cheaper

Option a is correct because stocks with lower price-earnings ratios are generally considered cheaper relative to earnings, meaning investors pay less per dollar of company profit. Option b is incorrect because relatively expensive stocks would have higher price-earnings ratios, indicating investors pay premium prices for each dollar of earnings generated. Option c is incorrect because higher growth potential is typically associated with higher price-earnings ratios as investors pay premiums for anticipated future earnings growth. Option d is incorrect because market dominance does not directly correlate with lower price-earnings ratios, and dominant companies often command premium valuations from investors.

Correct Answer: Help ask the right questions

Option d is correct because financial ratios provide a framework to diagnose, forecast, and improve financial health, helping managers and analysts identify issues and ask appropriate questions. Option a is incorrect because while some disclosures may be required, the primary purpose of ratio analysis is decision support rather than regulatory compliance alone. Option b is incorrect because financial ratios inform and support management judgment rather than replacing it, as interpretation requires human decision-making and expertise. Option c is incorrect because ratios are diagnostic tools that help identify problems and opportunities but cannot guarantee future success which depends on many factors.

Correct Answer: Receivables and inventory levels

Option d is correct because receivables and inventory are key current assets, and slow collection or excess inventory buildup can cause current ratio declines requiring management attention. Option a is incorrect because marketing strategy affects sales generation rather than directly addressing the current asset and liability relationship measured by the current ratio. Option b is incorrect because long-term debt maturity dates affect long-term liabilities rather than current liabilities which are the focus of the declining current ratio. Option c is incorrect because employee compensation primarily affects operating expenses rather than directly causing changes in the current ratio liquidity measure.

Correct Answer: Discount for early payment

Option c is correct because offering discounts for early payment motivates customers to pay sooner, accelerating cash collection and improving receivables turnover without losing customers. Option a is incorrect because extending payment terms would slow collections by giving customers more time to pay, worsening rather than improving the receivables situation. Option b is incorrect because increasing credit limits expands amounts customers can owe, potentially increasing receivables balances and slowing overall collection of outstanding amounts. Option d is incorrect because eliminating credit sales would drastically reduce sales volume and customer convenience, representing an extreme measure harming business growth.

Correct Answer: Use profits to repay debt

Option d is correct because using profits to pay down debt reduces total liabilities while potentially increasing retained earnings equity, directly improving the debt-to-equity ratio. Option a is incorrect because taking additional loans would increase debt and worsen the debt-to-equity ratio rather than reducing the financial risk management seeks to address. Option b is incorrect because increasing dividends reduces retained earnings and equity, which could actually worsen the debt-to-equity ratio rather than improving balance sheet strength. Option c is incorrect because acquiring competitors typically requires financing that could increase debt levels, potentially worsening rather than improving the debt-to-equity position.

Correct Answer: Improving but not yet competitive

Option b is correct because lagging competitors indicates the company is not yet competitive on profitability, but year-over-year improvement shows positive momentum toward closing the gap. Option a is incorrect because steady improvement suggests management is addressing issues effectively, making this a situation requiring continued effort rather than crisis intervention. Option c is incorrect because the company explicitly lags competitors in profitability ratios, meaning it is not the market leader in this dimension despite showing improvement. Option d is incorrect because lagging competitors indicates significant room for continued improvement, even though the positive trend shows current initiatives are working.

Correct Answer: Identical amounts

Option c is correct because the fundamental accounting equation requires that assets always equal liabilities plus shareholders' equity, making these values exactly equal on any properly prepared statement. Option a is incorrect because the accounting equation does not allow different totals between assets and liabilities plus equity, as this would indicate an incorrectly prepared statement. Option b is incorrect because the relationship between assets and liabilities plus equity is fundamental to accounting, making them directly and necessarily related values. Option d is incorrect because balance sheet values are precise recorded amounts rather than approximate estimates, and the equation requires exact equality between both sides.

Correct Answer: Net income

Option a is correct because net income is the bottom-line profit remaining after all expenses including operating costs, interest, and taxes have been deducted from total revenue. Option b is incorrect because gross margin represents revenue minus cost of goods sold only, calculated before subtracting operating expenses, interest, and taxes from profit. Option c is incorrect because operating income represents profit after operating expenses but before interest and taxes are deducted, not the final bottom-line figure. Option d is incorrect because revenue is the top-line sales figure before any expenses are deducted, representing the starting point rather than the final profit calculation.

Correct Answer: Improve operational efficiency

Option d is correct because strong liquidity with weak activity ratios indicates the company can meet obligations but is not generating sufficient sales from assets, requiring efficiency improvements. Option a is incorrect because findings do not indicate debt problems, and focusing solely on debt reduction would not address the operational efficiency issues revealed by activity ratios. Option b is incorrect because increasing short-term borrowing would affect liquidity ratios which are already strong and would not address asset utilization efficiency problems. Option c is incorrect because reducing cash reserves would weaken the strong liquidity position without necessarily improving the operational efficiency issues activity ratios revealed.

Correct Answer: Invest in marketing to boost sales

Option c is correct because low asset turnover indicates assets are not generating enough revenue, and investing in marketing can boost sales to improve revenue from existing assets. Option a is incorrect because dividend payments distribute profits to shareholders and do not address the fundamental issue of assets failing to generate adequate sales revenue. Option b is incorrect because taking on debt changes financing structure but does not directly address the operational issue of assets underperforming in generating sales revenue. Option d is incorrect because reducing accounts payable affects supplier payment timing rather than addressing the core issue of insufficient revenue generation from assets.

Correct Answer: Liquidity ratios

Option c is correct because liquidity ratios specifically measure ability to meet short-term obligations with liquid assets, directly addressing survival of immediate financial pressures. Option a is incorrect because market ratios show how investors value the company rather than measuring ability to meet immediate short-term payment obligations. Option b is incorrect because profitability ratios measure earnings generation rather than ability to pay bills and meet immediate financial commitments to creditors. Option d is incorrect because activity ratios measure operational efficiency in using assets rather than capacity to survive short-term financial pressures and obligations.

Correct Answer: Leverage ratios

Option a is correct because leverage ratios measure how much debt a company uses relative to equity and assets, directly informing creditors about capital structure and repayment risk. Option b is incorrect because market ratios focus on investor valuation and stock prices rather than debt burden and repayment capacity that creditors need to assess. Option c is incorrect because while profitability affects repayment ability, leverage ratios more directly show existing debt load and capital structure determining repayment risk. Option d is incorrect because while liquidity helps assess short-term payment ability, leverage ratios provide more comprehensive insight into overall debt levels and long-term risk.

Correct Answer: Growth benefits versus bankruptcy risk

Option b is correct because optimal debt-equity mix balances growth benefits from cheap debt financing and tax advantages against increased bankruptcy risk from higher leverage. Option a is incorrect because revenue versus expenses relates to profitability analysis rather than capital structure decisions about financing company operations and growth. Option c is incorrect because assets versus liabilities describes balance sheet categories rather than specific tradeoffs involved in determining optimal financing proportions. Option d is incorrect because sales versus inventory relates to operational efficiency rather than financing structure decisions that determine optimal capital mix.

Correct Answer: Leverage can inflate the metric

Option d is correct because high debt financing reduces the equity denominator, which can mathematically inflate return on equity without reflecting genuine improvement in operational performance. Option a is incorrect because leverage directly affects return on equity calculations by changing the equity base, making it essential to consider when interpreting this metric. Option b is incorrect because leverage can actually increase return on equity by reducing the equity denominator, though this may not reflect sustainable performance improvement. Option c is incorrect because leverage increases financial risk through mandatory debt payments rather than eliminating any form of business risk for the company.

Correct Answer: Cross-sectional analysis

Option c is correct because cross-sectional analysis compares financial ratios across different companies within the same industry at a specific point to identify relative strengths and weaknesses. Option a is incorrect because time-series analysis examines one company's ratios over multiple periods rather than comparing to competitors at a single point in time. Option b is incorrect because vertical analysis expresses financial statement items as percentages of base figures rather than comparing ratios across different companies. Option d is incorrect because horizontal analysis examines changes within a single company over time rather than comparing performance across multiple peer companies.

Correct Answer: Time-series analysis

Option c is correct because time-series analysis examines a single company's financial ratios over multiple periods to identify trends, improvements, or deterioration in performance over time. Option a is incorrect because cross-sectional analysis compares multiple companies at a single point rather than tracking one company's performance across different periods. Option b is incorrect because competitor analysis involves comparing to other firms rather than examining one company's own historical performance trends over multiple periods. Option d is incorrect because while ratio benchmarking involves comparison, tracking one firm over time is more precisely described as time-series analysis methodology.

Correct Answer: How much debt do we use

Option c is correct because leverage ratios specifically measure the extent of debt financing relative to equity and assets, directly answering questions about capital structure and debt usage. Option a is incorrect because profitability is assessed by profitability ratios like return on assets and profit margin rather than leverage ratios focusing on debt utilization. Option b is incorrect because operational efficiency is measured by activity ratios like asset turnover rather than leverage ratios which assess overall debt levels. Option d is incorrect because investor valuation perceptions are measured by market ratios like price-earnings ratio rather than leverage ratios focusing on capital structure.

Correct Answer: Profitability ratios

Option a is correct because profitability ratios specifically measure how well a company generates earnings relative to sales, assets, or equity, directly assessing profit generation effectiveness. Option b is incorrect because liquidity ratios measure ability to meet short-term obligations rather than effectiveness of generating profits from company resources. Option c is incorrect because activity ratios measure operational efficiency in using assets to generate sales, not ultimate profitability or earnings generation from activities. Option d is incorrect because leverage ratios measure debt utilization and capital structure rather than company's effectiveness at generating earnings from available resources.