Fundamentals of Investing, 13e (Smart)

Chapter 7 Analyzing Common Stocks

7.1 Learning Goal 1

1) The top down approach to security analysis starts with top management and then
examines production and marketing strategies.
Answer: FALSE
Traditional security analysis often
takes a top-down approach. It begins with economic analysis, moves to industry
analysis, and then arrives at a fundamental analysis of a specific company.
2)
Company analysis is only concerned with how a company has performed in the past.
Answer: FALSE
. Such analysis is not meant simply to provide interesting tidbits
of information about how the company has performed in the past. Rather,
company
analysis helps investors formulate expectations about the company’s future
performance.

3) Advocates of the efficient market hypothesis would argue that it is virtually impossible
for any investor to consistently outperform the market.
Answer: TRUE
they believe that the
market is so efficient in processing new information that securities trade very close to
their correct values at all times and that even when securities are mispriced, it is nearly
impossible for investors to determine which stocks are overvalued and which are
undervalued. Thus, they argue, it is virtually impossible to consistently outperform the
market

4) Economic analysis is concerned with how the general state of the economy will impact
the performance of a particular company within a particular industry.
Answer: TRUE
the economy is so important to the market is simple. The overall
performance of the economy has a significant bearing on the performance and profitability
of most companies. the economy is so important to the market is simple. The overall
performance of the economy has a significant bearing on the performance and profitability
of most companies

5) Investors who believe that most securities are efficiently priced should not be concerned
with fundamental analysis.
Answer: FALSE  Even if investors believe that securities are efficiently priced, they still
need fundamental analysis to:

 Understand the company’s operations and future growth potential.

 Manage risk and build a portfolio aligned with their investment goals.

 Additionally, fundamental analysis helps identify stocks with long-term potential.

 ⇒ Fundamental analysis remains important, so the statement is false.

6) Fundamental analysis can only be profitable if some securities are at least
temporarily mispriced.
Answer: TRUE

 Fundamental analysis seeks to determine the true (intrinsic) value of a security.

 If all securities were always correctly priced, then analysis would not generate any profits.

 Only when there is temporary mispricing between the market price and intrinsic value can
investors profit by buying low and selling high.

7) Markets can only be efficient if many competent analysts are performing

fundamental analysis.
Answer: TRUE
fundamental analysis is of value in the selection of alternative investments for important
reasons: financial markets are as efficient as they are because a large number of people
and financial institutions invest a great deal of time and money analyzing the fundamentals
of most widely held investments. In other words, markets tend to be efficient
and securities tend to trade at or near their intrinsic values simply because a great many
people have done the research to determine what their intrinsic values should be

8) One of the basic premises of security analysis, and in particular fundamental analysis, is that
A) a stock's price is based on its past cash flows rather than on anticipated future cash flows.
B) market sectors do not move in concert with business cycles.
C) all securities have an intrinsic value that their market value will approach over time.
D) a security's risk has relatively little effect on the security's
return. Answer: C

Explanation:

 Security analysis, especially fundamental analysis, is based on the belief that:

o Every security has a true intrinsic value, determined by factors like earnings,
growth, risk, etc.
o Although market prices may temporarily differ, over time the market price will
move toward the intrinsic value.
 Other choices:
o A) Incorrect: Fundamental analysis focuses on future cash flows, not just past
performance.
o B) Incorrect: Market sectors often move in sync with business cycles.

⇒ Therefore, the correct answer is C.

o D) Incorrect: A security’s risk significantly affects its returns.


7.2 Learning Goal 2

1) Most firms tend to be more profitable and have higher stock values when the economy
is strong.
Answer: TRUE

 In a strong economy:
o Consumers spend more.
 o Businesses sell more products and services.

⇒ Therefore, this statement is true.

o Profits increase → Stock prices rise.


Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

2) The purpose of economic analysis is to gain an insight into the underlying health or
vitality of the economy and to formulate expectations about future security prices.
Answer: TRUE
Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

3) The business cycle reflects economic changes only in the industrial sectors of the
economy. Answer: FALSE
reflects economic changes in the overall economy.
Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

4) The best time to buy stock is at the peak of an economic

cycle. Answer: FALSE
to buy stock is at the trough of an economic cycle
Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

5) Developing a general economic outlook assists in the identification of industries and

firms that might be good investment opportunities.
Answer: TRUE

Building a general economic outlook allows investors to:

 Identify industries and companies that will benefit from economic trends.
 Example: If interest rates are expected to fall → real estate and financial sectors might
be good investment opportunities.

6) Federal budget deficits tend to further depress an already depressed

economy. Answer: FALSE

Thâm hụt ngân sách -> chi nhiều cho đầu tư công -> kinh tế phát triển

7) Changes in stock prices tend to lag changes in level of economic activity by several months.
Answer: FALSE
 Stock prices are considered a leading indicator of economic activity.

 They typically move ahead of the economy — rising before the economy improves and
falling before the economy worsens.

 Investors act based on expectations about the future, not just current conditions.

8) Interest rates and stock prices tend to rise and fall

together. Answer: FALSE

Interest rates and stock prices usually move in opposite directions:

 When interest rates rise, borrowing becomes more expensive → corporate profits may
fall → stock prices tend to drop.
 When interest rates fall, borrowing costs decrease → economic growth is supported →
stock prices tend to rise.

9) Which measure of the business cycle represents the market value of all goods and
services produced in a country over a twelve-month period?
A) industrial production index
B) money supply
C) gross domestic product
D) productivity average
Answer: C

10) Which one of the following is likely to have a negative effect on stock prices?
A) falling interest rates
B) a decrease in the money supply (M2)
C) low inflation
D) a decrease in the unemployment
rate Answer: B

11) The Federal Reserve through monetary policy can help expand the economy by
A) lowering income taxes on individuals.
B) reducing tariffs such that foreign exports can increase.
C) supporting a moderate growth of the money supply.
D) increasing government spending on the national
infrastructure. Answer: C có mỗi C) của Fed, Fed chỉ sử dụng C
12) Rising interest rates tend to

A) contract the level of economic activity.

B) increase the level of business investment.
C) indicate governmental expansion of the economy.
D) signal the trough of a recessionary
market. Answer: A
Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

13) The government has an expansionary economic policy when it

A) increases taxes.
B) increases government spending.
C) promotes rising interest rates.
D) limits exports of goods and
services. Answer: B
Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

14) Rising corporate profits are likely to have the greatest effect on which of the
following industrial sectors?
A) business equipment
B) defense
C) food and agriculture
D) consumer
durables Answer: A

 Business equipment (e.g., machinery, computers, tools) is sensitive to corporate profits.

 When profits rise:

 Companies invest in upgrading or expanding their operations by purchasing more

equipment.

Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: Previous Edition
Learning Goal: Learning Goal 2

15) Which of the following businesses will be positively impacted by a weak dollar?
A) retailing
B) imports
C) exports
D) personal
services Answer: C
 A weak dollar makes U.S. goods cheaper for foreign buyers.

 This boosts exports because foreign countries find American products more affordable.

16) Which of the following businesses will be negatively impacted by a strong dollar?
A) retailing
B) imports
C) exports
D) automotive
Answer: C

17) Name at least three economic variables that the affect the stock market and describe
their effects.
Answer: Inflation: high inflation increases the rate at which cash flows from investments are
discounted and therefore tends to lower their value. Inflation is also a major component of
interest rates. Interest rates: in general rising interest have a negative effect on security prices
and falling interest rates a positive effect.
Money supply: moderate growth in the money supply has a positive effect, but rapid growth
can lead to inflation and higher interest rates, which would be negative. A contracting money
supply is typical of recessions and depresses stock prices.
Exchange rates: a relatively weak dollar favors industries that are major exporters such as
agriculture and construction equipment. A strong dollar favors importers and also reduces the
possibility of inflation because imported goods are cheaper in dollar terms.
Learning Goal 3

1) To predict the demand for an industrial sector, it is essential to understand the

economic forces that affect the industry.
Answer: TRUE

 Demand for an industry’s products depends heavily on economic conditions like GDP
growth, interest rates, consumer spending, etc.

 Understanding these forces helps predict how the industry will perform.

2) Economic factors such as a weak dollar will have a negative impact on all industrial
sectors. Answer: FALSE
a weak dollar will have a positive impact on all industrial sectors.

3) Industries in the rapid expansion stage will be especially sensitive to a slowing

economy. Answer: FALSE
during which product acceptance is spreading and investors can see the industry’s future
more clearly. At this stage, economic and financial variables have little to do with the
industry’s overall performance. Investors will be interested in investing almost regardless
of the economic climate

4) The economy will expand more slowly if consumers decided to save more and reduce
their debt levels.
Answer: TRUE

 If consumers save more and spend less, consumer demand drops.

 Lower spending slows down business revenues and, therefore, slows economic growth.

5) Industry analysis focuses on the amount spent on research and development by

individual companies within the industry.
Answer: FALSE

 Industry analysis focuses on the overall characteristics and trends of an industry:

 Growth potential, competition, market size, etc.

 While R&D spending matters at the company level, it’s not the main focus of industry-
level analysis.

6) Which stage of an industry's growth cycle is most influenced by economic events?

A) initial development
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B) stability or decline
C) mature growth
D) rapid expansion
Answer: C
mature growth, which is the one most influenced by economic developments. In this stage,
expansion comes from growth of the economy. It is a slower source of overall growth than
that experienced in stage two. In stage three, the long-term nature of the industry
becomes apparent. Industries in this category include defensive ones, like food and
apparel, and cyclical ones, like autos and heavy equipment.

7) Which stage of an industry's growth cycle is interesting only for potentially high
dividend payouts?
A) initial development
B) stability or decline
C) mature growth
D) rapid expansion
Answer: B
During stability or decline:

 Companies don't have major growth opportunities.

 They often return profits to shareholders through high dividend payouts instead of
reinvesting in expansion.

8) The rapid expansion phase of an industry is characterized by

A) extreme sensitivity to interest rates and other economic factors.
B) high returns and relatively low risks.
C) willingness of investors to buy almost any stock associated with the industry.
D) many decades of sustained above average growth.
Answer: C
rapid expansion, during which product acceptance is spreading and investors can see the
industry’s future more clearly. At this stage, economic and financial variables have little to
do with the industry’s overall performance. Investors will be interested in investing almost
regardless of the economic climate. This is the phase that is of substantial interest to
investors, and a good deal of work is done to find such opportunities

9) Well managed companies rarely reach the decline stage because

A) the world's population is growing.
B) they continuously develop new products to meet the needs of changing markets.
C) consumers remain loyal to established brands.
D) all of the above.
Answer: B

 Innovation and adaptability are key.

 Companies that keep updating their products and strategies can:

 Stay competitive.
 Avoid slipping into decline even as markets evolve.
10) Which stage of an industry's growth cycle offers the greatest opportunity for an
investor who is seeking capital gains?
A) initial development
B) mature growth
C) stability or decline
D) rapid expansion
In the rapid expansion stage:
+ The industry is growing fast.
+ Revenues and profits are rising quickly.
+ Stock prices often surge, offering great potential for capital gains.

11) List and explain the various stages of the growth cycle of an industry. Also discuss
the merit of investing in the industry during each of the various stages.
Answer: The 4 stages of the growth cycle are
1. initial development stage—the industry is new and untried; investment opportunities are
not available to most investors; risks are high;
2. rapid expansion stage—product acceptance is spreading and investors can foresee the
industry's future; economic variables don't have a large effect on the industry's
performance; good time to invest in company;
3. mature growth—heavily influenced by economic development; expansion comes from
the economy's growth; may provide defensive, cyclical or current income types of investment
opportunities;
4. stability or decline—in the decline phase, demand for the industry's products is
diminishing; investment opportunities are few.

12) Briefly describe and discuss industry analysis and the motivation behind
it. Answer: Industry analysis
1. focuses on the activities of one of more industries.
2. looks at the competitive position of an industry in relation to other industries.
3. seeks answers to questions such as: How is the industry regulated? What role does
labor play in the industry? What economic forces are especially important to the industry?
4. facilitates research by using published reports such as the S&P Industry
Surveys.
5. The Industry Growth Cycle
+ Initial Development: industry is new and risks are very high.
+ Rapid Expansion: product acceptance is growing and investors become very interested.
+ Mature Growth: expansion comes from growth in the economy and the long-term nature
of the industry becomes more apparent.
+ Stability or Decline: demand for the industry’s products is diminishing and companies
are leaving the industry.
7.3 Learning Goal 4

1) Fundamental analysis is based on the presumption that the value of a stock is influenced
by the financial performance of the issuing company.
Answer: TRUE
Fundamental analysis rests on the belief that the value of a stock is influenced by the
performance of the company that issued the stock. If a company’s prospects look strong,
the market price of its stock is likely to reflect that and be bid up. However, the value of a
security depends not only on the return it promises but also on its risk exposure.
Fundamental analysis captures these dimensions (risk and return) and incorporates them
into the valuation process.

2) Fundamental analysis encompasses return (chỉ xét lợi nhuận), but not risk, in
the valuation process. Answer: FALSE
the value of a security depends not only on the return it promises but also on its risk
exposure. Fundamental analysis captures these dimensions (risk and return) and
incorporates them into the valuation process.

3) The statement of cash flows is less influenced than the income statement by choices
of accounting methods.
Answer: TRUE

4) The income statement indicates how successfully a company has utilized its
assets. Answer: TRUE
The income statement provides a financial summary of the operating results of
the firm over a period of time such as a quarter or year. It shows the revenues
generated during the period, the costs and expenses incurred, and the
company’s profits (the difference between revenues and costs). This reflects how
well a company uses its assets to make money.

5) Positive cash flow from investing activities is typical of firms experiencing healthy
growth. Answer: FALSE

Growing firms typically spend cash on investing activities (e.g., buying equipment, new
facilities). So, cash flow from investing is usually negative during growth. Positive investing
cash flow often means the company is selling assets, which is not a good sign for a growing
firm.

6) A company may appear to be profitable on its income statement, but fail to generate
strong cash flows.
Answer: TRUE
This is important because a firm that shows positive profits on its income statement may in
fact be spending more cash than it is taking in, and that could lead to financial distress

7) The balance sheet summarizes the company's operations over the last fiscal year.
Answer: FALSE
The balance sheet is a statement of what a company owns and what it owes at a specific
time

8) EBITDA stands for earnings before inflation, taxes, depreciation, and

adjustments. Answer: FALSE
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
There is no "inflation" or "adjustments" in the definition, so the given statement is incorrect.

9) Calculating the times interest earned ratio using EBITDA is more conservative than
using EBIT because it takes the cost of replacing fixed assets into consideration.
Answer: FALSE

 EBIT (Earnings Before Interest and Taxes) includes depreciation, which reflects the cost of
asset replacement.

 EBITDA excludes depreciation (loại bỏ khấu hao), meaning it is less conservative

because it ignores the wear and tear of assets.
=> Therefore, EBIT gives a more conservative view than EBITDA when calculating the Times
Interest Earned ratio

10) Which one of the following statements concerning accounting reports is correct?
A) The income statement reflects the position of a firm as of a single point in time.
B) The total equity of a firm is equal to the total assets plus the total liabilities.
C) The statement of cash flows identifies both the sources and the uses of cash.
D) The income statement reflects the amount of cash available for investment and
financing activities.
Answer: C
This statement essentially brings together items from both the balance sheet and the
income statement to show how the company obtained its cash and how it used this
valuable liquid resource. Unfortunately, because of certain accounting conventions (the
accrual concept being chief among them), a company’s reported earnings may bear little
resemblance to its cash flow. That is, whereas profits are simply the difference between
revenues and the accounting costs that have been charged against them, cash flow is the
amount of money a company actually takes in as a result of doing business

11) Cash flow from operations includes all of the following adjustments to net
income EXCEPT
A) purchases of new equipment.
B) depreciation.
C) increase or decrease in current liabilities.
D) increase or decrease in current
inventory. Answer: A
Purchasing new equipment is classified under investing activities, not operating activities.
16
12) Which of the following would be typical of a Statement of Cash Flows for a healthy firm
in a sustainable business?
A) Cash flow from operations is negative, cash flows from investment activities and
financing activities are positive.
B) Cash flow from operations , investment activities and financing activities must all
be positive.
C) Cash flow from operations is positive, cash flows from investment activities and
financing activities are negative.
D) If the Statement shows a net increase in cash, the source is
unimportant. Answer: C
Positive cash flow from operations ➔ the company is profitable in its
core business.
Negative cash flow from investing ➔ the company is reinvesting in new
assets.
Negative cash flow from financing ➔ the company is paying off debt or
returning cash to shareholders.

13) Which of the following measures excludes non-cash charges against income?
A) operating expenses
B) EBIT
C) net income before taxes
D) EBITDA
Answer: D
EBITDA removes the effects of non-cash expenses such as depreciation and amortization.
The other options (operating expenses, EBIT, net income before taxes) still include non-cash
charges like depreciation

17
14) Briefly describe fundamental analysis and the basic assumption behind
it. Answer:
1. rests on the belief that the value of a stock is influenced by the performance of the
company that issued the stock.
2. studies the financial condition and operating results of a firm.
3. uses financial ratios to understand relationships.
4. compares current ratios to historical and industry standards.
7.4 Learning Goal 5

1) Ratio analysis is the study of the relationships between various financial statement
accounts. Answer: TRUE
Ratio analysis is the study of the relationships between various financial statement
accounts . Each measure relates an item on the balance sheet (or income statement)
to another or, as
is more often the case, a balance sheet account to an operating (income statement)
item.
2) Financial ratios can reveal a lot about a company's liquidity, activity, and
profitability. Answer: TRUE
Ratios like current ratio (liquidity), asset turnover (activity), and profit margin (profitability)
show important aspects of performance.
3) The quick ratio differs from the current ratio in that accounts receivable are excluded
from current assets.
Answer: FALSE
many investors like to subtract out inventory from the current assets total when assessing
whether a firm has sufficient liquidity to meet its near-term obligations. Thus, the quick
ratio is similar to the current ratio but it excludes inventory in the numerator.
4) Return on assets is a very important analytical tool because it measures how
effectively management is using a firm's assets to generate profits.
Answer: TRUE
ROA = Net Income / Total Assets
5) A firm with a very low debt-equity ratio has a low risk of defaulting on its
loans. Answer: TRUE
a low or declining debt-equity ratio indicates lower risk exposure, as that would
suggest the firm has a more reasonable debt load (Less debt = less financial risk =
lower chance of default)

6) A firm with a very low debt-equity ratio might be able to increase return on equity by
taking on additional debt.
Answer: TRUE
If returns on borrowed funds exceed interest costs, leveraging can boost ROE.

7) The Allied Computer Co. has sales of $300 million, a net profit margin of 9%, and 10
19
million shares of common stock outstanding. It has no preferred stock outstanding. If Allied
stock trades at $50 per share, it has a price/earnings ratio of 20.9.
Answer: FALSE
Net Income = 300M × 9% = 27M
EPS = 27M / 10M shares = $2.70
P/E = $50 / $2.70 ≈ 18.5, not 20.9

8) Return on equity (ROE) is computed by dividing net income by the market value of
equity. Answer: FALSE
ROE = Net Income / Book value of Equity, not Market value
9) The PEG ratio divides the stock's current price by the growth rate of earnings
over the preceding 12 months.
Answer: FALSE (công thức tr310)

10) In seeking potential stock investments, most analysts look for companies that have
PEG ratios that are equal to or less than one.
Answer: TRUE
A PEG ratio this close to 1.0 is certainly reasonable. It suggests that the company’s P/E is
not out of line with the earnings growth of the firm. In fact, the idea is to look for stocks
that have PEG ratios that are equal to or less than 1.

11) Banks can use the times interest earned ratio as a measure of a borrower's ability to
repay their loan.
Answer: TRUE
Times interest earned is called a coverage ratio. It measures the ability of the firm to meet
(“cover”) its fixed interest payments. It is calculated as follow (công thức tr306)

12) If a firm has an equity multiplier of 3, this means that the firm has $3 in equity for
every $1 in long-term debt.
Answer: FALSE
Equity multiplier = Total Assets / Equity → Higher EM means more debt, not less.
It implies more debt relative to equity

13) Return on equity can be expressed mathematically as "(net profit margin)(total asset

turnover)(equity multiplier)."
Answer: TRUE

14) A high P/E ratio may be an indication that a stock is

overpriced. Answer: TRUE
High P/E can mean the stock is overvalued or investors expect high future growth

15) A high PEG ratio implies a high growth rate in earnings relative to the stock's
price. Answer: FALSE
A high PEG usually means price is high relative to growth, which is less favorable.

16) To determine whether a company is using leverage effectively, an analyst should consider
A) the current ratio and net working capital.
B) inventory, accounts receivable and total asset turnover ratios.
C) the debt to equity and times interest earned ratios.
D) ROA and the net profit
margin. Answer: C
These ratios assess how much debt is used and how easily the company can pay interest.

17) A company has sales of $640,000, net profit after taxes of $23,000, and a total
asset turnover of 2.5. What is the return on assets?
A) 3.6%
B) 4.5%
C) 8.1%
D)9.0%
Answer: D
ROA = Net Income ÷ Total Assets
Total Assets = Sales ÷ Asset Turnover = $640,000 ÷ 2.5 = $256,000
ROA = $23,000 ÷ $256,000 ≈ 9%

18) A company has sales of $640,000, net profit after taxes of $23,000, a total asset turnover of
4.17 and an equity multiplier of 1.67. What is the return on equity?
A) 24%
B) 9.0%
C) 8.1%
D) 4.5%
Answer: A

19) Substituting EBITDA for EBIT when computing the times interest earned ratio will
make the company appear
A) more leveraged.
B) less leveraged.
C) more profitable.
D) less efficient.
Answer: B
EBITDA is higher than EBIT (because it ignores depreciation/amortization), making interest
coverage look stronger and leverage seem lower

23
 20) The measure that indicates how efficiently assets are being used to support sales is
called the
A) total asset turnover.
B) current ratio.
C) book value.
D) net profit margin.
Answer: A
Total asset turnover is calculated as Revenue / Total Assets. This ratio measures the
efficiency of using assets to generate revenue
21) A lending institution would prefer that a firm have a debt-equity ratio and a
times interest earned ratio.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower
chọn C
Debt-equity ratio: Lenders prefer a lower debt-to-equity ratio (less debt → less risk).
Times interest earned: Lenders prefer a higher TIE (it shows the company
earns enough to cover interest easily).

22) Investors are most interested in which one of the following ratios?
A) return on assets
B) current ratio
C) net profit margin
D) return on equity
Answer: D
ROE (Return on Equity) tells investors how much profit a company is generating with shareholders'
money — it directly impacts shareholder returns

23) Which one of the following is a leverage measure?

A) times interest earned
B) net working capital
C) return on equity
D) net profit
margin Answer: A
24) If a company's ROA is high, then an investor can assume that the company
A) is in danger of defaulting on its loans.
B) pays a high dividend.
C) is profitable.
D) has more equity than debt in its capital
structure. Answer: C
High ROA means the company is efficiently using its assets to make profits. It doesn't guarantee
dividends or low debt but does mean it's profitable.

25) If a firm has an ROA of 10% and an ROE of 10%, then the
A) operating results of the firm are improving.
B) firm has no financial leverage.
C) firm must have enough cash on hand to pay some extra dividends.
D) firm is losing
money. Answer: B
ROE = ROA × Equity Multiplier
If ROA = ROE, then Equity Multiplier = 1, meaning no leverage (no debt).

26) The PEG ratio

A) preferred by investors is equal to 2.0 or higher.
B) compares the price/earnings ratio to the rate of growth of the company's earnings.
C) is a measure of a firm's liquidity.
D) measures the ability of a firm's assets to generate growth for the
firm. Answer: B
 27) ROE = (net profit margin)(total asset turnover)(equity multiplier). What is the
advantage of using this expanded version of the ROE formula versus using the simplified
version which is net income divided by total equity?
Answer: The expanded version provides more insight into a firm's operations. The net profit
margin reflects the efficiency of operations. The total asset turnover measures the ability of
assets to generate sales. The equity multiplier reflects the use of leverage.

1) A company's ratios are more meaningful when compared to other companies in the
same industry.
Answer: TRUE
Different industries have different financial structures, so comparisons within the same industry
are more accurate

2) The debt to equity ratio should be approximately the same across all industrial
sectors. Answer: FALSE
Different industries use different amounts of debt.
+ Utilities and banks often have high debt because their cash flow is stable.
+ Tech companies and startups usually have low debt because they are riskier and
grow fast.

3) Financial ratios give little indication whether a company is well managed or

not. Answer: FALSE
Ratios reveal management efficiency, profitability, liquidity, etc.
4) Investors who want to analyze a company's ratios usually need to compute them from
the financial statements.
Answer: FALSE
Many ratios are pre-computed and available from financial databases.

5) Historical comparisons will reveal whether a company's performance is improving

or deteriorating.
Answer: TRUE
Comparing past data shows if the company is improving or getting worse

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6) Generally, the market price of a stock is
A) below its book value.
B) above its book value.
C) equal to its par value.
D) equal to its book
value. Answer: B
Stocks usually trade above book value due to growth potential and future earnings expectations

7) A comparison of a firm's current financial ratios to those of prior years allows one to
A) accurately predict the future performance of a firm.
B) see how a firm's performance compares to that of a competitor.
C) see trends that are developing.
D) determine if the firm is performing better than the overall
industry. Answer: C
Time-based comparison shows trends, but not future prediction or industry comparison directly

8) Amgen's debt to equity ratio is .54 while Walmart's is .68. By comparing these ratios
we can conclude
A) that Walmart is in danger of bankruptcy.
B) that Amgen uses too little debt financing.
C) that Walmart uses too little equity financing.
D) very little because the firm's are in different
industries. Answer: D
9) Based on the information above, we can conclude that
A) company Y is more financially conservative than company X.
B) company Y is more liquid than company X.
C) company Y is reinvesting a higher percentage of its earnings in the business than
company X.
D) company Y is using assets less efficiently than company
X. Answer: C
Learning Outcome: F-09 Discuss the fundamentals of stocks and how to value them
AACSB: 3 Analytical thinking
Question Status: New Question
Learning Goal: Learning Goal 6

10) Company X and Company Y are in the same industry and have the following ratios.

Discuss the relative natures of the two companies in terms of risk and return. Identify the
more growth-oriented firm and justify your selection. Support your discussion and
conclusions by referring to the ratios.
Answer: Company Y has more financial risk because its debt/equity ratio is higher than both X
and the industry average. Y's current ratio is lower than both A's and the industry average,
indicating less liquidity and possibly a willingness to sacrifice some safety in pursuit of
efficiency. Company Y has a lower net profit margin which may be caused by higher interest
expenses due to the higher debt load. Company Y offers a higher return to shareholders based
on the return on equity ratio. Y's higher rate of return on equity is entirely due to its use of debt
financing because return on assets is the same for both companies (1.9 × 4.2 = 2.1 × 3.8).
Company X's net profit margin is slightly above the industry average, while both companies'
return on equity ratios are below the industry averages. Company Y is probably growing faster
than Company X because the dividend payout ratio is lower and the total asset turnover rate is
higher.