Quiz-1-

Name: Total Marks:10

Student ID: Weightage: 10%

Total Time: 60 mins

Rules for the quiz:
1. Switch off your cell phones and keep it on the corner of your desk.
2. Read All the Questions carefully before attempting the answers.
3. Solve the answers on the sheets provided.
4. Use your own calculator, sharing of calculators will not be allowed.
5. Use your own formula sheet.
6. No questions will be entertained during the quiz.
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1) The goal of the firm should be:

A) maximization of profits.
B) maximization of shareholder wealth.
C) maximization of consumer satisfaction.
D) maximization of sales.
Answer: B
Diff: 1
Topic: 1.1 Finance: An Overview
Keywords: shareholder
Principles: Principle 3: Cash Flows Are the Source of Value

4) The true owners of the corporation are the:

A) holders of debt issues of the firm.
B) preferred stockholders.
C) board of directors of the firm.
D) common stockholders.
Answer: D
Diff: 1
Topic: 1.2 Three Types of Business Organizations
Keywords: corporation
Principles: Principle 1: Money Has a Time Value

1) What is sales revenue, minus cost of goods sold and operating expenses, known as for
income statement purposes?
A) Net profit
B) Retained earnings
C) Net income available to preferred shareholders
D) EBIT
Answer: D
Diff: 2
Topic: 3.2 The Income Statement

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Keywords: income statement

Principles: Principle 3: Cash Flows Are the Source of Value

6) Which of the following would NOT be included as an asset on a corporate balance

sheet?
A) Accounts receivable
B) Common stock
C) Inventory
D) Buildings
Answer: B
Diff: 1
Topic: 3.4 The Balance Sheet
Keywords: balance sheet
Principles: Principle 3: Cash Flows Are the Source of Value

10) Why do investors prefer receiving cash sooner rather than later, according to finance
theory?
A) Incremental profits are greater than accounting profits.
B) Money received earlier can be reinvested and returns can be increased.
C) Tax considerations are important when investing.
D) Diversification leads to increased value.
Answer: B
Diff: 2
Topic: 1.4 The Four Basic Principles of Finance
Keywords: time value of money
Principles: Principle 1: Money Has a Time Value

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As in Problem 4-25, we are asked to calculate various ratios for a firm; these ratios use A balance
sheet and income statement data. We are also asked to compare our firm, Carson
Electronics, with an industry leader, BGT Electronics. Using ratios will facilitate these
comparisons, since ratios allow us to express various quantities relative to other firm data,
abstracting from the actual dollar scale of the businesses.
We look first at the balance sheet ratios, the debt ratio, and the current ratio:

Balance Sheet CARSON BGT ELECTRONICS

cash $2,000,000 $1,500,000
accounts receivable $4,500,000 $6,000,000
inventories $1,500,000 $2,500,000
current assets $8,000,000 $10,000,000
net fixed assets $16,000,000 $25,000,000
Total Assets $24,000,000 $35,000,000

accounts payable $2,500,000 $5,000,000

accrued expenses $1,000,000 $1,500,000
short-term notes payable $3,500,000 $1,500,000
Total Current Liabilities $7,000,000 $8,000,000
long-term debt $8,000,000 $4,000,000
Total Liabilities $15,000,000 $12,000,000
Total Owner's Equity $9,000,000 $23,000,000
Total Liabilities & Owner's Equity $24,000,000 $35,000,000

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BALANCE SHEET
CARSON BGT calculation equation
current ratio = 1.143 1.25 (current assets)/(current liabilities) 4-1
debt ratio = 0.625 0.343 (total debt)/(total assets) 4-6

For each ratio, the value that’s considered more desirable is boldfaced—here, both belong
to BGT. BGT has slightly better coverage of its short-term liabilities—having 25% more
current assets than it has current liabilities. The difference is not huge, however. The two
firm’s quick ratios are almost identical: 0.93 and 0.94, respectively (this ratio simply
subtracts inventories from the numerator of the current ratio). The firms therefore differ
slightly in their investments in cash and A/R. Carson has much more cash on hand than
does BGT (8.3% of total assets, vs. 4.3% for BGT), but also has a slightly larger
investment in accounts receivable (18.75% vs. 17.14%). We will need to further evaluate
the latter number when we look at average collection period. However, given these current
asset values, we can’t say that Carson is really less liquid than BGT. Good news!
However, the news is not so good on the total debt front. Carson has a much higher debt
ratio than BGT. Carson finances 62.5% of its assets with debt, while BGT uses only 34.3%
debt. (We will see more implications of this when we consider times interest earned.)
Carson’s higher leverage means that its breakeven point is relatively higher, and that it is
operating with more risk than is BGT. There should be a magnifying effect on return on
equity as a result; we’ll consider this below.
Now, let’s look at the income statement ratios:

Income Statement CARSON BGT ELECTRONICS

net sales (all credit) $48,000,000 $70,000,000
cost of goods sold ($36,000,000) ($42,000,000)
gross profit $12,000,000 $28,000,000
operating expenses ($8,000,000) ($12,000,000)
Net Operating Income (EBIT) $4,000,000 $16,000,000
Interest expense ($1,150,000) ($550,000)
Earnings before taxes $2,850,000 $15,450,000
Taxes (@40%) ($1,140,000) ($6,180,000)
Net income $1,710,000 $9,270,000

INCOME STATEMENT
CARSON BGT calculation equation
times interest earned = 3.48 29.09 (EBIT)/(interest) 4-7
operating profit margin = 8.33% 22.86% (EBIT)/(sales) 4-11
As hinted at above, Carson’s times interest earned is much lower than BGT’s. Carson’s
relatively heavy use of debt means relatively high interest charges, so that the firm is able
to cover those charges fewer times with its EBIT. However, 3.48 times is not obviously a
bad coverage ratio, and perhaps BGT’s, at over 29 times, is exceptionally high. It would be
interesting to look at the TIE for a few other firms in their industry to better gauge the
adequacy of Carson’s coverage.

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However, there’s no denying that BGT’s operating profit margin is vastly better than
Carson’s. Why? Looking at relative operating expenses, Carson’s are 16.67% of sales,
while BGT’s are 17.14%; this, then, cannot explain BGT’s superior performance. It must
be the cost of goods sold. Indeed, Carson’s COGS represent 75% of sales, while BGT’s
are only 60%. BGT’s superior gross margin explains its superior operating profit margin.
Now, let’s look at the ratios that use data from both the balance sheet and the income
statement:

BOTH
CARSON BGT calculation equation
inventory turnover = 24.00 16.80 (COGS)/(inventory) 4-5
total asset turnover = 2.00 2.00 (sales)/(total assets) 4-8
operating return on assets = 16.67% 45.71% (EBIT)/(total assets) 4-13
average collection period = 34.22 31.29 (A/R)/(annual credit sales/365) 4-3
fixed asset turnover = 3.00 2.80 (sales)/(net plant & equipment) 4-9
return on equity = 19.00% 40.30% (net income)/(common equity) 4-14

The most salient of these are the operating return on assets and the return on equity: BGT
is vastly better than Carson’s. Both firms have the same ratio of total assets to sales, but
BGT is able to generate 45.71% EBIT/TA, while Carson can only muster 16.67%. (We
have already explained this difference: BGT generates higher relative EBIT because its
cost of goods sold is so much lower than Carson’s.) BGT’s return on equity is higher than
Carson’s, since BGT has higher EBIT and lower interest charges; it therefore has higher
relative net income (a net profit margin of 13.24%, vs. Carson’s 3.56%). This is despite
BGT’s higher proportion of equity to total assets (66% vs. 38%).
On other measures, Carson is doing better. It turns its inventory and fixed assets somewhat
more than BGT, but collects its A/R just a few days later than BGT.
Thus, we can identify Carson’s biggest problem: its cost of goods sold. BGT’s ability to
keep its COGS at 60% of sales translates into much higher profit margins than Carson can
generate. I would suggest that Carson’s management focus its attention on lowering the
costs of its manufacturing inputs or raising its prices to generate more revenue per unit.

BALANCE SHEET
CARSON BGT calculation equation
current ratio = 1.143 1.25 (current assets)/(current liabilities) 4-1
debt ratio = 0.625 0.343 (total debt)/(total assets) 4-6

quick ratio = 0.93 0.94

cash/TA = 8.33% 4.29%
A/R/TA = 18.75% 17.14%
FA/TA = 66.67% 71.43%
E/TA = 37.50% 65.71%
%

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INCOME STATEMENT
CARSON BGT calculation equation
times interest earned = 3.48 29.09 (EBIT)/(interest) 4-7
operating profit margin = 8.33% 22.86% (EBIT)/(sales) 4-11

COGS/sales = 0.75 0.60

gross profit margin = 25.00% 40.00%
op exp/sales = 16.67% 17.14%
NI/sales = 3.56% 13.24%

BOTH
CARSON BGT calculation equation
inventory turnover = 24.00 16.80 (COGS)/(inventory) 4-5
total asset turnover = 2.00 2.00 (sales)/(total assets) 4-8
operating return on assets = 16.67% 45.71% (EBIT)/(total assets) 4-13
average collection period = 34.22 31.29 (A/R)/(annual credit sales/365) 4-3
fixed asset turnover = 3.00 2.80 (sales)/(net plant & equipment) 4-9
return on equity = 19.00% 40.30% (net income)/(common equity) 4-14

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