Question

Which of the following statements is CORRECT?

1. Other things held constant, the less debt a firm uses, the lower its return on total assets will be.
2. The advantage of the basic earning power ratio (BEP) over the return on total assets for judging a company's operating efficiency is that the BEP does not reflect the effects of debt and taxes.
3. The return on common equity (ROE) is generally regarded as being less significant, from a stockholder's viewpoint, than the return on total assets (ROA).
4. The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of current earnings. In general, investors regard companies with higher P/E ratios as being more risky and/or less likely to enjoy higher future growth.
5. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10% versus a margin of 8% for Firm B. Firm A's total debt to total capital ratio is 70% versus 20% for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is better managed, because the difference in debt, not better management, could be the cause of Firm A's higher profit margin.

Answer 1

Answer: Option b is correct.

a) This is incorrect.
Explanation:
We know that, total assets = total liabilities + shareholders equity, keeping all other things constant, less debt means less total liabilities. To balance both sides total assets should come down (as shareholder's equity is constant).
Return on assets=(Net Profit + Interest)/Total assets
If total assets come down, return on assets will increase.

b)This statement on advantage of BEP over return on total assets is correct.

c)This is incorrect:
Explanation:
Return on common equity is more significant to from stockholder's view point compared to return on total assets. This is because, return on equity ratio is meant for the equity share holders and return on total assets is meant for all investors.

d) It is incorrect.
Explanation:
Only P/E ratio of a company tells us nothing about a company. Only when we compare the P/E of a company with its peers, we can know whether the company is under valued, over valued or fairly valued.

e) It is incorrect.
Explanation:
In fact, we can reach a conclusion as to which firm is managed better based on the two facts given. Debt ratio is total liabilities/total assets, a lower ratio is considered good compared to higher ratio. Similarly, profit margin=profit/sales, low profit margin indicates high expenses and a need for management to reduce the expense.