Leverage, ROA, Total Asset TO Question

CFA Level I
#1

Could someone please explain how answer A is correct? I thought that overstating assets would increase the financial leverage ratio which would mean being more dependent on debt for finance. Thanks for your help in advance. Management will least likely understate assets to improve: A. Financial leverage ratios B. Return on assets C. Total asset turnover Answer: A In order to improve financial leverage ratios, management will need to overstate its assets. Understating assets will improve return on assets and total asset turnover ratios.

#2

This is what i think. Given the 3 choices, ROA = NI/Avg. Total Assets. So by reducing asset (denominator) you would improve the ROA. Total Asset T/O = Rev/Avg Total Asset. The same logic applies. Finally, Financial leverage = avg. Total Asset/Avg Total Equity, by reducing assets (numerator) you would be making it worse and that is why management would LEAST likely understate it to improve.

#3

Management will least likely understate assets = Management will probably overstate assets to improve: A. leverage ratio. This is true because debt is always fixed, so if you overstate assets, you overstate equity which will reduce your leverage (ratio)

#4

think about it in a real world situation…say you go to the bank and ask to borrow $100k. who are they going to give the money to: the guy with no assets or the guy with a $1 million house? the more assets you have compared to your debt, the better your leverage ratios will be. the financial leverage ratio is assets / equity. or to look at it another way (seeing as the accounting equation tells us that assets = liabilities + equity): financial leverage ratio = (liabilities + equity) / equity. if you understate your assets you reduce the equity. the liabilities, or debt, stays the same. therefore the ratio goes up, which makes your business more highly leveraged (ie the ratio gets worse). hope this makes sense, cheers

#5

I make this mistake sometimes and it drives me crazy… Focus on the words ‘least likely’ ‘should NOT’ etc

#6

yeah, circle those words draw a star on them whatever works