Exam Questions Davis Financial Statement Analysis Chapter 12

Chapter 12

Financial Statement Analysis

Chapter Learning Objectives

1. Prepare a horizontal analysis of a balance sheet and income statement and use it to analyze a company’s performance. (Unit 12.1)

A horizontal analysis shows the dollar changes in a company’s account balances from one year to the next. The percentage changes are calculated using the formula:

1. Prepare a common-size balance sheet and income statement and use it to analyze a company’s performance. (Unit 12.2)

Common-size financial statements show all the company’s account balances as a percentage of a particular total. On the balance sheet, all accounts are shown as a percentage of total assets. On the income statement, all accounts are shown as a percentage of net sales.

1. Calculate and interpret basic financial statement ratios. (Unit 12.3)

There are four types of financial ratios. Liquidity ratios measure a company’s ability to manage its current assets and current liabilities. These ratios include working capital, current ratio, acid-test (quick) ratio, accounts receivable turnover, average collection period, inventory turnover, and average days to sell inventory.

Leverage ratios measure a company’s ability to meet its debt obligations. These ratios include the debt ratio, debt-to-equity ratio, and times interest earned.

Profitability ratios measure how well a company can generate a profit or return on an investment. These ratios include gross margin, return on assets, and return on common stockholders’ equity.

Market measure ratios, which are valid only for publicly traded companies, measure how well a company’s stock is performing as an investment. These ratios include earnings per share, price/earnings ratio, and dividend payout ratio.

1. Explain how to use sources of industry information to draw conclusions about a company’s performance. (Unit 12.4)

To compare a company’s performance to that of competitors, you must first determine its industry category. All businesses can be categorized by industry, using either a four-digit SIC code or a six-digit NAICS code. Statistics on specific categories, including common-size statements and financial ratios, are available from various sources such as Dun & Bradstreet’s Industry Norms and Financial Ratio Benchmarks and the Risk Management Association’s Annual Statement Studies: Financial Ratio Benchmarks. Using ratio analysis and information acquired from these sources, you can develop a thorough knowledge of industry trends and future outlooks, which you can use to evaluate your company’s performance.

TRUE-FALSE STATEMENTS

1. Generally Accepted Accounting Principles require that companies present financial statements that include the current year and two previous years.
2. The type of analysis that looks at the changes in the account balances over time is referred to as horizontal analysis.
3. The first step in preparing a horizontal analysis of a firm’s financial statements is to break down the balance sheet to indicate which assets are expected to sold in within the next two years.
4. Because an absolute dollar change does not give the whole picture, a percentage change is often included in a horizontal analysis.
5. The percentage change, as shown in horizontal analysis, is calculated as:

(current year account balance – previous year account balance) ÷ current year account balance

(current year account balance – previous year account balance) ÷ previous year account balance

LO: 1, Bloom: K, Unit: 12-1, Difficulty: Easy, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. In a horizontal analysis balance sheet, the percentage change columns do not add up in the same way as the dollar amounts because each of the percentages was calculated using a different denominator.
2. Another form of horizontal analysis is called trend analysis.
3. Trend analysis is very useful for analyzing the financial statements, but not for analyzing supplemental information reported in corporate annual reports.
4. In a trend analysis of cost of goods sold over the last three months, all cost of goods sold accounts are shown as a percentage of the current quarter.
5. A helpful approach to examine changes in the relative size of account balances within a single statement is referred to as horizontal analysis.
6. Vertical analysis is also referred to as common-size analysis.
7. Common-size statements are especially helpful in comparing companies of different size.
8. In preparing a common-size balance sheet, you express all asset account balances as a percentage of cash.

LO: 2, Bloom: AP, Unit: 12-2, Difficulty: Moderate, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. In preparing a common-size balance sheet, you express all individual liability or equity account balances as a percentage of total assets.
2. Unlike the percentage columns in a horizontal analysis, the columns in a common-size percentage statement can be totaled.
3. In preparing a common-size income statement, you express all revenue and expense accounts as a percentage of net income.
4. A firm’s ability to pay its obligations as they come due and to meet any unforeseen needs for cash is referred to as liquidity.
5. Working capital is the difference between a firm’s total assets and total liabilities.
6. Land is the ultimate liquid asset.
7. A firm’s ability to convert non-cash assets into cash is referred to as liquidity.
8. The most common measure of short-term liquidity is the quick ratio.
9. The current ratio is also referred to as the quick ratio.
10. While the current and acid-test ratios provide information about liquidity, they do not indicate the underlying quality of current assets.
11. Inventory turnover measures how many times, on average, a company’s inventory is sold during the year.
12. The quality of assets is assessed through the profitability ratios.
13. The gross margin percentage shows how much of each sales dollar is available to cover operating expenses and provide a profit after the cost of goods sold has been covered.
14. Earnings per share represents how much of a company’s current net income is available to distribute to each share of stock held by an investor.
15. The formula for return on common stockholders’ equity is, net sales revenue minus preferred dividends, divided by average common stockholders’ equity.
16. The price-earnings ratio indicates what multiple of current earnings investors are willing to pay for a share of stock.
17. Dun & Bradstreet’s Industry Norms and Key Business Ratios provide financial ratios for key industries, as well as condensed common-sized balance sheets and income statements.

Answers for True-False Statements

MULTIPLE-CHOICE QUESTIONS

1. Which of the following authorities require that companies present comparative financial statements that include both the current year and the previous year?
   1. IRS
   2. GAAP
   3. IIA
   4. GAAS
2. Rather than looking only at the balances reported on the financial statements, it is helpful to look at the changes in the account balances over time. This is called
   1. common analysis.
   2. vertical analysis.
   3. horizontal analysis.
   4. benchmarking
3. Horizontal analysis is
   1. looking at the changes in the account balances reported on a financial statement over time.
   2. looking at the changes in the account balances within a financial statement for one year.
   3. preparing an analysis of the profitability ratios in columns.
   4. looking at the changes in the account balances within a financial statement for three years.
4. Which of the following is the formula for calculating the percentage change in the horizontal analysis of a financial statement?

1. Because an absolute dollar change does not give the whole picture, horizontal analysis generally includes which of the following?
   1. Rational dollars
   2. Percentage changes
   3. Explanations
   4. Budget amounts
2. Turbo Company’s accounts receivable account balance was $100,000 at the beginning of the year and $120,000 at the end of the year. Turbo’s percentage change calculation at the end of the current year is
   1. 16.7% decrease.
   2. 16.7% increase.
   3. 20% decrease.
   4. 20% increase.
3. The calculations are the easy part of a horizontal analysis, the challenge is
   1. gathering the data.
   2. interpreting the results.
   3. determining the data.
   4. finding a use for the data.
4. A form of horizontal analysis in which each year’s account balance is expressed as a percentage of the base year is called
   1. trend analysis.
   2. percentage analysis.
   3. common size analysis.
   4. quick analysis.
5. Assume that the accounts receivable balances are $110,000, $112,000 and $116,000 for 2021, 2022, and 2023, respectively. The trend percentage for 2023 is
   1. 3.6%.
   2. 5.5%.
   3. 103.6%.
   4. 105.5%.
6. Which of the following is the formula for calculating the percentage in trend analysis?

1. Which of the following is not a use of trend analysis?
   1. For revealing more information about performance than is revealed by just one year’s worth of change
   2. For comparing changes in related accounts
   3. For analyzing information other than that found on the balance sheet and income statement, such as supplemental information reported in annual reports
   4. For comparing changes in unrelated accounts
2. Which of the following is not a use of trend analysis?
   1. For revealing more information about performance than is revealed by just one year’s worth of change
   2. For comparing changes in related accounts
   3. To measure liquidity
   4. For analyzing information other that found on the balance sheet and income statement, such as supplemental information reported in annual reports
3. A helpful approach in examining changes in the relative size of account balances within a single statement is referred to as
   1. common-size analysis and trend analysis.
   2. vertical analysis and horizontal analysis.
   3. trend analysis and horizontal analysis.
   4. common-size analysis and vertical analysis.
4. Another term for vertical analysis is
   1. common-size analysis.
   2. liquidity analysis.
   3. horizontal analysis.
   4. leverage analysis.
5. Common-size statements are especially useful in comparing
   1. a company’s performance across time.
   2. companies of different sizes.
   3. supplemental information included in the corporate annual report.
   4. companies of the same size.
6. In preparing a common-size balance sheet, you express all account balances as a percentage of
   1. total stockholders’ equity.
   2. total liabilities.
   3. total assets plus total liabilities minus stockholders’ equity.
   4. total assets.
7. The formula used in preparing a common-size balance sheet is

1. The formula for determining the common-size percentage for liabilities is

1. In preparing a common-size income statement, you express all revenue and expense account as a percentage of
   1. net income.
   2. operating income.
   3. gross profit.
   4. net sales revenue.
2. The formula for preparing a common-size income statement is

1. In interpreting common-size financial statements denominated in a foreign currency, a word of caution is that there may be differences in the
   1. accounting principles the companies use for reporting.
   2. culture of the company’s stakeholders.
   3. time period covered in the statements.
   4. classification of balance sheet items.
2. On a common-size balance sheet, notes payable is shown as a percentage of
   1. total liabilities.
   2. current liabilities.
   3. total assets.
   4. total stockholders’ equity.
3. On a common-size balance sheet, notes receivable is shown as a percentage of
   1. total liabilities.
   2. current liabilities.
   3. total stockholders’ equity.
   4. total assets.
4. On a common-size balance sheet, common stock is shown as a percentage of
   1. total liabilities.
   2. total assets.
   3. current liabilities.
   4. total stockholders’ equity.
5. On a common-size income statement, selling expense is shown as a percentage of
   1. net sales revenue.
   2. operating income.
   3. net income.
   4. gross profit.
6. On a common-size income statement, income taxes are shown as a percentage of
   1. operating income.
   2. net sales revenue.
   3. net income.
   4. gross profit.
7. On a common-size income statement, interest expense is shown as a percentage of
   1. operating income.
   2. net sales revenue.
   3. net income.
   4. gross profit.
8. The following financial statement items are shown for J&T Manufacturing.

Calculate the common-size percentage for inventory.

• 1. 8%
  2. 14%
  3. 20%
  4. 500%

1. The following financial statement items are shown for J&T Manufacturing.

Calculate the common-size percentage for salaries payable.

• 1. 7%
  2. 10%
  3. 23%
  4. 433%

1. The following financial statement items are shown for J&T Manufacturing.

Calculate the common-size percentage for gross margin.

• 1. 0.8%
  2. 11.6%
  3. 42.8%
  4. 57.1%

1. The following financial statement items are shown for J&T Manufacturing.

Calculate the common-size percentage for insurance expense.

• 1. 3.3%
  2. 5.8%
  3. 23.3%
  4. 50.0%

1. A firm’s ability to pay its obligations as they come due and to meet any unforeseen needs for cash is called
   1. current ratio.
   2. liquidity.
   3. working capital.
   4. accounts receivable turnover.
2. Which of the following is not a measure of liquidity?
   1. Working capital
   2. Average collection period
   3. Acid-test
   4. Price-earnings ratio
3. Which of the following will probably not be a result if a company’s liquidity is poor?
   1. Workers will quit if they are not paid on time.
   2. Debt and/or equity will exceed the company’s maximum allowed amount.
   3. Banks may not loan the company funds.
   4. Customers will seek other sources of goods when the company’s product is not available.
4. Investigating liquidity is important because
   1. if a company cannot pay its bills on time, it will have difficulty obtaining resources needed to continue operating.
   2. a company needs the ability to buy long-term assets.
   3. a company’s price earnings ratio will decline.
   4. GAAP requires that assets must exceed liabilities.
5. The difference between a firm’s current assets and its current liabilities is
   1. cash flow.
   2. working capital.
   3. current ratio.
   4. return on Assets.
6. The most common measure of short-term liquidity is the
   1. acid-test.
   2. current ratio.
   3. quick ratio.
   4. working capital.
7. The current ratio is calculated as
   1. current assets divided by current liabilities.
   2. current assets divided by total assets.
   3. current liabilities divided by current assets.
   4. current liabilities divided by total liabilities.
8. The calculation of working capital is
   1. current assets plus current liabilities.
   2. current assets less current liabilities.
   3. current assets times current liabilities.
   4. current assets divided by current liabilities.
9. Because the assets included in the current ratio have different levels of liquidity that reflect different degrees of collectability, many companies use which of the following ratios to measure current liquidity?
   1. Current ratio
   2. Acid-test
   3. Working capital
   4. Return on equity
10. Which of the following ratios uses the smallest dollar value of assets?
    1. Current ratio
    2. Working capital
    3. Quick ratio
    4. Debt ratio
11. A more stringent measure of liquidity than the current ratio is referred to as
    1. current asset turnover.
    2. acid-test.
    3. collectability test.
    4. debt to equity ratio.
12. The acid-test is calculated as

1. A problem with the current and acid test ratios is that, although they provide information about liquidity, they do not indicate
   1. the dollar amounts of the differences.
   2. the underlying quality of the current assets.
   3. all the current assets.
   4. the nature of the liabilities.
2. The accounts receivable turnover is calculated as

1. The average collection period reveals how many days, on average,
   1. it takes between when an order is placed until the cash is collected.
   2. the company takes to collect cash from a credit sale.
   3. the company takes to collect past due accounts.
   4. it takes between when an original contact is made to collect an account until the cash is collected.
2. The average collection period is calculated as

1. The inventory turnover measures how many
   1. days, on average, it takes between when an order is placed until the inventory is shipped.
   2. times, on average, a company’s inventory is sold during the year.
   3. times, on average, the company takes to replace inventory during the year.
   4. days, on average, it takes between when inventory is received to its sale to customers.
2. The inventory turnover is calculated as

1. The average days to sell inventory is calculated as

1. The quality of assets is assessed through
   1. turnover ratios.
   2. working capital.
   3. current ratio.
   4. profitability ratios.
2. A high accounts receivable turnover rate may indicate all of the following except
   1. fast collection of accounts receivables.
   2. greater liquidity.
   3. credit terms that are too tight.
   4. inventory levels are high.
3. Generally, a high inventory turnover rate is considered
   1. good.
   2. bad.
   3. indifferent.
   4. proportionate to net income.
4. A high inventory turnover might signal
   1. a problem with old and obsolete inventory.
   2. an overstock of inventory.
   3. poor inventory management.
   4. credit terms that are too tight.
5. A low inventory turnover might signal
   1. a problem with old and obsolete inventory.
   2. fast-moving inventory.
   3. too much inventory.
   4. not enough inventory on hand.
6. Which of the following is not a leverage ratio?
   1. Debt-to-equity ratio
   2. Times interest earned ratio
   3. Price earnings ratio
   4. Debt ratio
7. Which of the following is an advantage of a company using equity rather than debt to finance a project?
   1. Dividends do not need to be paid.
   2. Interest is tax deductible, whereas dividends paid are not.
   3. Dividends require less cash than does paying interest on debt.
   4. No taxation occurs, similar to bonds.
8. Which of the following is not an advantage of a company using equity rather than debt to finance a project?
   1. Interest requires more cash than does paying dividends.
   2. Dividends do not need to be paid.
   3. Equity does not need to be repaid whereas debt does.
   4. Interest is tax deductible.
9. The debt ratio measures the ratio of liabilities to
   1. net income.
   2. assets.
   3. revenue.
   4. stockholders’ equity.
10. The formula for calculating the debt ratio is
    1. total liabilities divided by total assets.
    2. long-term liabilities divided by total assets.
    3. Total liabilities divided by total liabilities and stockholders’ equity.
    4. total debt divided by total stockholders’ equity.
11. The debt-to-equity ratio measures the amount of financing provided by creditors relative to
    1. equity earned from operations.
    2. equity provided by retained earnings.
    3. equity provided by owners.
    4. equity earned through dividends.
12. The formula for calculating the debt-to-equity ratio is
    1. total liabilities divided by total stockholders’ equity.
    2. total liabilities divided by stockholders’ equity provided by preferred stockholders.
    3. long-term liabilities divided by total stockholders’ equity.
    4. long-term liabilities divided by stockholders’ equity provided by preferred stockholders.
13. Debt is not a free resource because
    1. the use of debt funds is restricted as designated by the debt instrument.
    2. companies must pay interest on the borrowings.
    3. companies must restrict cash flow until the debt is repaid.
    4. companies do not pay interest on the borrowings.
14. The times interest earned ratio measures a company’s ability to
    1. maintain profit after paying interest.
    2. pay interest and debt on the due date.
    3. make interest payments out of current earnings.
    4. pay interest and debt from current assets already on hand.
15. A note of caution in interpreting the debt ratio is that
    1. all debt decreases liquidity ratios.
    2. financing arrangements, such as leases, may be off-balance sheet arrangement and not be classified as debt on the balance sheet.
    3. financing arrangements, such as leases, may be classified as debt when in fact they do not require interest payments.
    4. long-term debt may be inflated because of a desire to reduce the current ratio.
16. Which of the following parties are not interested in a company’s ability to remain profitable over the long-run?
    1. investors, employees, and the IRS
    2. employees, investors, and the IRS
    3. creditors, creditors, and the IRS
    4. Investors, employees, and creditors
17. The ratio that shows how much of each sales dollar that is available to cover operating expenses and provide a profit after the cost of goods sold has been covered is called
    1. the contribution margin ratio.
    2. return on equity.
    3. the internal rate of return.
    4. the gross margin ratio.
18. The gross margin percentage shows how much of each sales dollar is available after which of the following income statement components has been covered?
    1. Cost of goods sold
    2. Contribution margin
    3. Operating expenses
    4. Net income.
19. The gross margin percentage is calculated as
    1. gross margin divided by cost of goods sold.
    2. gross margin divided by net sales revenue.
    3. gross margin divided by net income.
    4. net income divided by gross margin.
20. The return on assets ratio measures how well
    1. current assets are used to provide cash for the purchase of long-term assets.
    2. a company’s assets create sales revenue.
    3. a company manages its assets.
    4. assets have been employed in conducting the business.
21. Which of the following parties would be least interested in the return on assets?
    1. Creditors
    2. Stockholders
    3. Vendors
    4. Managers
22. The formula for the return on assets is

1. Which of the following is not a component of common stockholders’ equity?
   1. Long-term debt
   2. Common stock
   3. Additional paid-in capital
   4. Retained earnings
2. The return on common stockholders’ equity measures how
   1. well operations have provided funds to common stockholders.
   2. well funds provided by common stockholders have been used to generate a return for the company.
   3. well funds provided by common stockholders have been converted to cash.
   4. liquid a company is.
3. The formula for the return on common stockholders’ equity is

1. Which of the following is the reason that preferred dividends declared during the period are deducted from net income in calculating return on common stockholders’ equity?
   1. Preferred dividends reduce the amount of income available for distribution to common stockholders.
   2. Preferred dividends are not paid from net income.
   3. Preferred dividends are not a part of stockholders’ equity.
   4. Preferred dividends are not paid until all common stockholders have received their dividends, so preferred dividends are not relevant in the formula and so must be taken out of the equation.
2. Earnings per share represents how much
   1. of a company’s current net income has been distributed for each share of stock held by an investor.
   2. of a company’s current net income can be distributed for each share of stock held by an investor.
   3. of a company’s contribution margin is available to be distributed to each stockholder.
   4. gross profit of a company can be distributed for each share of stock held by an investor.
3. Which of the following statements relating to earnings per share is not true?
   1. It is an often-reported measure of the potential return to stockholders.
   2. It is a financial measure.
   3. It is a cash measure.
   4. It is based on the accrual basis of accounting.
4. Earnings per share must be reported on the face of every income statement that is prepared in accordance with
   1. generally accepted accounting principles.
   2. the National Association of State Boards of Accountancy standards.
   3. ethical standards set by the American Institute of Certified Public Accountants.
   4. the laws of the federal government.
5. Which of the following is the reason that preferred dividends are deducted from net income in calculating earnings per share?
   1. They are not paid from net income.
   2. They are not a part of stockholders’ equity.
   3. They are paid to preferred stockholders, not common stockholders.
   4. They are not paid until all common stockholders have received their dividends, so preferred dividends are not relevant in the formula and so must be taken out of the equation.
6. The price/earnings ratio indicates
   1. the amount of earnings that a company is willing to pay to shareholders in the form of dividends.
   2. what multiple of current earnings investors are willing to pay for a share of stock.
   3. the net income available to pay out in dividends to shareholders.
   4. the amount of earnings in relation to total assets.
7. When will the price/earnings ratio change?
   1. At the end of each year
   2. Every time dividends are paid
   3. Every time a share of stock is traded
   4. Every time the stock price changes
8. The 2020 and 2021 partial balance sheets for Ottoman Industries are shown below.

Calculate Ottoman’s working capital for 2021.

• 1. $26,000
  2. $36,000
  3. 1.65
  4. 1.53

1. Which of the following measures how much of earnings per share is returned to common stockholders in the form of dividends?
   1. Earnings per share
   2. Dividend payout ratio
   3. Price/earnings ratio
   4. Return on assets
2. The 2020and 2021 partial balance sheets for Ottoman Industries is shown below.

Calculate the current ratio for 2021.

• 1. 0.47
  2. 0.62
  3. 1.37
  4. 2.20

1. The 2020 and 2021 partial balance sheets for Ottoman Industries is shown below:

Calculate the 2021 acid-test ratio.

• 1. 1.27
  2. 1.51
  3. 1.43
  4. 2.20

1. The 2020, 2021, and 2022 partial balance sheets for Ottoman Manufacturing Company appear below.

Net credit sales for Ottoman were $126,000 for 2020, $120,000 for 2021 and $114,000 for 2022, while cost of goods sold was $84,000 for 2020, $82,400 for 2021 and $72,500 for 2022.

What is the average collection period for 2022?

1. 68.6 days
2. 70.5 days
3. 74.9 days
4. 76.8 days

Average collection period = 365 ÷ 5.18 = 70.5 days

1. The 2020, 2021, and 2022 partial balance sheets for Ottoman Manufacturing Company appear below.

Net credit sales for Ottoman were $126,000 for 2020, $120,000 for 2021 and $114,000 for 2022, while cost of goods sold was $84,000 for 2020, $82,400 for 2021 and $72,500 for 2022.

What is the accounts receivable turnover for 2021?

1. 3.75 times
2. 4.61 times
3. 5.00 times
4. 6.00 times
5. The 2020, 2021, and 2022 partial balance sheets for Ottoman Manufacturing Company appear below.

Net credit sales for Ottoman were $126,000 for 2020, $120,000 for 2021 and $114,000 for 2022, while cost of goods sold was $84,000 for 2020, $82,400 for 2021 and $72,500 for 2022.

What is the inventory turnover for 2021?

• 1. 2.75 times
  2. 3.17 times
  3. 4.00 times
  4. 4.14 times

1. The 2020, 2021, and 2022 partial balance sheets for Ottoman Manufacturing Company appear below.

Net credit sales for Ottoman were $126,000 for 2020, $120,000 for 2021 and $114,000 for 2022, while cost of goods sold was $84,000 for 2020, $82,400 for 2021 and $72,500 for 2022.

What is the average number of days to sell inventory for 2022?

• 1. 133 days
  2. 137 days
  3. 141 days
  4. 146 days

Average days to sell inventory: 365 ÷ 2.5 = 146 days

1. The 2021 and 2022 balance sheets for Ottoman Manufacturing Company appear below:

What is the debt ratio for 2022?

• 1. 39.2%
  2. 61.4%
  3. 68.6%
  4. 100%

1. The 2021 and 2022 partial balance sheets for Ottoman Manufacturing Company appear below:

What is the debt-to-equity ratio for 2022?

• 1. 2.19
  2. 1.80
  3. 1.25
  4. 0.46

1. The income statement for Otto Construction Company appears below:

Average total assets total $240,000. Otto’s income tax rate is 25%. What is the times interest earned ratio?

• 1. 2.38
  2. 3.13
  3. 3.16
  4. 4.17

1. The income statement for Otto Construction Company appears below:

Average total assets total $240,000. Otto’s income tax rate is 25%. What is the gross margin percentage?

• 1. 12.5%
  2. 15.8%
  3. 35.6%
  4. 44.4%

1. The income statement for Otto Construction Company appears below:

Average total assets total $240,000. Otto’s income tax rate is 25%.

What is the return on assets?

• 1. 15.6%
  2. 15.8%
  3. 16.8%
  4. 17.6%

1. Barber Industries reported net sales of $92,000, net income of $32,000, dividends paid to preferred stockholders of $7,000, dividends paid to common stockholders of $10,000, average number of shares outstanding is 5,000 and average common stockholders’ equity of $96,000. What is the return on common stockholders’ equity?
   1. 26.0%
   2. 33.3%
   3. 88.5%
   4. 95.8%
2. Barber Industries reported net sales of $92,000, net income of $32,000, dividends paid to preferred stockholders of $7,000, and dividends paid to common stockholders of $10,000. The average number of shares outstanding is 5,000. What is the earnings per share?
   1. $18.40
   2. $16.40
   3. $6.40
   4. $5.00
3. Barber Industries reported net income of $32,000, earnings per share of $2, and paid dividends of $3 per share or a total of $3,000. The stock sells for $20 per share. What is the price/earnings ratio?
   1. 10.00
   2. 10.67
   3. 1.50
   4. 6.67
4. Barber Industries reported net income of $32,000, earnings per share of $1.20 and paid dividends of $0.30 per share. What is the dividend payout ratio?
   1. 400%
   2. 25%
   3. $4
   4. $1.50
5. Numerous resources are available to assist in developing an understanding of a company’s competitive environment. The U.S. Census Bureau collects a wide array of statistics and makes them available through which of the following sites?
   1. http://www.census.gov/
   2. http://www.stats.com/
   3. http://www.census.com/
   4. http://www.statistics.gov/

Answers to Multiple-Choice Questions

MATCHING

1. Match the following terms to the appropriate statement by placing the letter to the left of each statement.

1. d –Horizontal analysis
2. e – Liquidity
3. j – Working capital
4. g – Quick ratio
5. i –Vertical analysis
6. h – Return on assets
7. c –Financial leverage
8. b – Earnings per share
9. a – Common-size analysis
10. f – Price earnings ratio

BRIEF EXERCISES

1. Last year Boxer Corporation had net income of $24,000, income tax expense of $7,200 and interest expense of $2,000. What is Boxer’s times interest earned ratio?

($24,000 + $7,200 + $2,000) ÷ $2,000 = 16.6 times

1. Foreman Outfitters, a retail store of camping supplies, has sales of $300,000 and cost of goods sold of $210,000. Beginning inventory was $20,000 and ending inventory was $12,000. What is the company’s average days to sell inventory?

$210,000 ÷ [($20,000 + 12,000) ÷ 2] = 13.125

365 days ÷ 13.125 = 27.81 days

1. Foreman Outfitters, a retail store of camping supplies, has total assets of $170,000 and total liabilities of $70,000. What is Foreman’s debt-to-equity ratio?

$70,000 ÷ ($170,000 − $70,000) = 70%

1. Walker Company had net income of $30,000. The company has 10,000 shares of common stock and 3,000 shares of preferred stock outstanding. There was no change in the number of shares of stock from the previous year. The company declared and paid dividends of $2.00 per share on the common stock and $1.70 per share on the preferred stock. What is Walker’s earnings per common share?

[$30,000 – (3,000 × $1.70)] ÷ 10,000 = $2.49

1. Hannah Corporation purchased merchandise totaling $180,000 during the year. At the end of the year, the income statement showed $200,000 of cost of goods sold and ending inventory to $40,000. What was Hannah’s inventory turnover?

Beginning inventory = $180,000 ̶ $200,000 ̶ $40,000 = $60,000

$200,000 ÷ $50,000 = 4 times per year

1. Gant Wholesale Company has $2,000 in cash, $7,000 in accounts receivable, $12,000 in inventory, and $3,000 in prepaid expenses. Liabilities totaled $20,000, with $6,000 current and $14,000 long-term. What is Gant’s acid-test ratio?

($2,000 + $7,000) ÷ $6,000 = 1.5

1. Gant Wholesale Company has $2,000 in cash, $7,000 in accounts receivable, $12,000 in inventory, and $3,000 in prepaid expenses. Liabilities totaled $20,000, with $6,000 current and $14,000 long-term. What is Gant’s working capital?

$2,000 + $7,000 + $12,000 + 3,000 − $6,000 = $18,000

1. Gant Wholesale Company has $2,000 in cash, $20,000 in accounts receivable, $34,000 in inventory, and $1,600 in prepaid expenses. Liabilities totaled $120,000, with $36,000 current and $84,000 long-term. What is Gant’s current ratio?

($2,000 + $20,000 + $34,000 + $1,600) ÷ $36,000 = 1.60

1. XYZ Corporation reported net income of $75,700 last year. The company incurred interest expense of $5,000. Assets on January 1^st were $640,000 and on December 31^st, had increased by $40,000. The income tax rate was 30%. What is XYZ’s return on total assets?

$75,700 + [($5,000 × (1 – 30%)] ÷ [($640,000 + $680,000) ÷ 2] = 12%

1. ABC Corporation reported net income of $26,000 last year. The company reported earnings per share of $2.80. ABC paid dividends of $1.75 on each share of outstanding stock. What was ABC’s dividend payout ratio?

$1.75 ÷ $2.80 = 62.5%

EXERCISES

1. Utica Corporation reported the following financial information:

Required:

1. If you prepared a horizontal analysis for inventory, what dollar change will be shown for 2022?
2. If you prepared a horizontal analysis for sales, what percentage change will be shown for 2022?
3. $94,000 ̶ $88,000 = $6,000
4. ($460,000 ̶ $580,000) ÷ $580,000 = (20.7%)
5. Utica Corporation reported the following financial information:

Required:

1. What is the trend percentage for cash in 2022 with 2020 as the base year?
2. What is the trend percentage for inventory in 2022 with 2020 as the base year?
3. $10,000 ÷ $30,000 = 33.33%

b. $94,000 ÷ $80,000 = 117.5%

1. M&M Manufacturing has provided the following comparative income statements:

Required:

Prepare a horizontal analysis of M&M’s 2022 income statement.

1. M & M Manufacturing has provided the following comparative income statements for 2021 and 2022.

Required:

Prepare a common-size analysis of M & M’s income statement for 2022.

1. The 2020and 2021 balance sheets for Ottoman Manufacturing Company appear below:

Required:

Prepare a common-size balance sheet for 2021.

1. The following data have been taken from the financial records of Bubba’s Body Shop for the current year:

Required:

• 1. Calculate the price/earnings ratio.
  2. Calculate the current ratio.

1. $60 ÷ $8 = 7.5
2. $52,000 ÷ $20,000 = 2.60
3. The following data have been taken from the records of Bubba’s Body Shop for the current year:

Required:

• 1. Calculate the dividend payout ratio.
  2. Calculate the return on common stockholders’ equity.

1. $4 ÷ $8 = 50%
2. $20,000 ÷ $108,000 = 18.5%
3. Phelps Piping Company manufactures PVC pipe. The company has provided the following selected financial information:

Required:

• 1. What is Phelps’ accounts receivable turnover for 2021?
  2. What is Phelps’ gross margin percentage for 2021?

1. $360,000 ÷ [($50,000 + $70,000) ÷ 2] = 6.0 times
2. ($360,000 ̶ $221,400) ÷ $360,000 = 38.5%
3. Phelps Piping Company manufactures PVC pipe. The company has provided the following selected financial information:

Required:

• 1. What is Phelps’ average days to sell inventory for 2021?
  2. What is Phelps’ debt ratio for 2021?

1. $315,000 ÷ [($80,000 + $70,000) ÷ 2] = 4.2 times; 365 ÷ 4.2 = 86.9 days
2. $207,000 ÷ $460,000 = 45%
3. M & M has provided the following comparative income statements and supplemental information:

Required:

1. Calculate M & M’s gross margin percentage for 2021.
2. Calculate M & M’s price/earnings ratio for 2021.
3. Calculate M & M’s dividend payout ratio for 2021.
4. $64,000 ÷ $132,000 = 48.48%
5. $16.00 ÷ $2.70 = 5.93
6. $1.40 ÷ $2.70 = 51.85%
7. Ottoman Manufacturing Company reported net sales (all credit) of $120,000 and $140,000 for 2020 and 2021, respectively and net income of $24,000 and $32,000 for 2020 and 2021, respectively. Ottoman’s 2020 and 2021 balance sheets appear below:

Required:

• 1. Calculate the working capital for 2021.
  2. Calculate the accounts receivable turnover for 2021.
  3. Calculate the debt ratio for 2021.

1. $62,000 ̶ $30,000 = $32,000
2. $140,000 ÷ [($20,000 + $19,000) ÷ 2] = 7.18 times
3. $70,000 ÷ $102,000 = 68.63%
4. The 2020 and 2021 partial balance sheets for Myers Manufacturing Company appear below:

Required:

• 1. Calculate Myers’ current ratio for 2021.
  2. Calculate Myers’ debt ratio for 2021.
  3. Calculate Myer’s debt-to-equity ratio for 2021.

1. $52,000 ÷ $40,000 = 1.30
2. $120,000 ÷ $172,000 = 69.8%
3. $120,000 ÷ $52,000 = 2.31
4. The 2020 and 2021 balance sheets for Ottoman Manufacturing Company appear below along with selected financial information. Ottoman declared no dividends during either year, and had 1,000 shares of stock outstanding throughout each year.

Required:

• 1. Calculate the acid-test ratio for 2020.
  2. Calculate the working capital for 2021.
  3. Calculate earnings per share for 2021.

1. ($15,000 + $19,000) ÷ $30,000 = 1.13
2. $62,000 − $20,000 = $42,000
3. ($40,000 − $26,000) ÷ 1,000 = $14.00
4. The 2020 and 2021 partial balance sheets for Ottoman Manufacturing Company appear below along with selected financial information:

Required:

• 1. Calculate Ottoman’s inventory turnover and average days to sell inventory for 2021.
  2. Calculate Ottoman’s accounts receivable turnover and average collection period for 2021.

1. $80,000 ÷ [($34,000 + $30,000) ÷ 2] = 2.5 times per year turnover

365 ÷ 2.5 = 146 days average days to sell inventory

1. $120,000 ÷ $20,000 = 6 times per year turnover

365 ÷ 6 = 60.8 days collection period

PROBLEMS

1. The current asset portion of Wilderness Outfitters, Inc.’s balance sheet is as follows (in $000s).

Required:

Prepare a horizontal analysis of Wilderness’s current assets, rounding your answers to one decimal place.

1. Barnett Publishing Inc. reported the following current asset data (in $000s) in its 2021 annual report.

Required:

Prepare a trend analysis of Barnett’s current assets, rounding your answers to one decimal place. Comment on any significant trends you identify.

• Merchandise inventory increased substantially in 2021, likely due to an anticipated increase in demand, or possibly due to a major problem in declining sales and forecasting errors.
• Cash and equivalents and short-term investments declined in 2020 and 2021 reflecting a decrease in the firm’s liquidity.
• Accounts receivable also declined in 2020 and 2021 which could mean increased collections. However, in light of the decrease in cash and the explosion in inventory, this decline more likely reflects a decline in sales.
• Prepaid expenses and other also declined in 2019 which could indicate that the firm is trying to reduce commitments in these areas or is trimming expenses.

1. Penny Saver Inc. and Buy 4 Less Stores are both discount retailers. As their adapted income statements (in $ millions) for 2021 show, Penny Saver sales revenue and net income were more than three times those amounts of Buy 4 Less.

Required:

1. Prepare a common-size income statement for each company. Express all percentages using one decimal place. Your answers may not add perfectly due to rounding.
2. Which company did the better job of managing expenses? How did you reach your conclusion?

a.

b. Buy 4 Less is better at managing cost of goods sold, while Penny Saver is better at managing the cost of selling, general & administrative expenses. Penny Saver manages expenses better overall with 4.9% of every sales dollar resulting in net income, as opposed to 0.7% for Buy 4 Less.

1. Selected financial statement data for Oran Company are presented below.

During 2021, net sales were $950,000, and cost of goods sold was $775,000.

Required:

1. Compute the following ratios at December 31, 2021:
2. Current ratio
3. Acid-test ratio
4. Average collection period
5. Average days to sell inventory
6. Assume credit terms are 2/10, net 30. What conclusion could an analyst draw about the management of accounts receivable?

a. (1) Current ratio = ($40,000 + $25,000 + $100,000 + $85,000) ÷ $100,000 = 2.5 to 1

(2) Acid-test ratio = ($40,000 + $25,000 + $100,000) ÷ $100,000 = 1.65 to 1

(3) A/R turnover = $950,000 ÷ [($100,000 + $80,000) ÷ 2] = 10.56 times

Average collection period = 365 ÷ 10.56 = 34.6 days

(4) Inventory turnover = $775,000 ÷ [($85,000 + $65,000) ÷ 2] = 10.33 times

Average days to sell inventory = 365 ÷ 10.33 = 35.3 days

b. The average collection period exceeds the normal credit period of 30 days. Therefore, the management of accounts receivable needs to be improved.

1. Selected information from the comparative financial statements of Faure Company for the year ended December 31, appears below:

There is no preferred stock and the tax rate is 30%.

Required:

Calculate each of the following for 2021:

1. Debt ratio
2. Debt-to-equity ratio
3. Times interest earned ratio
4. Gross margin percentage
5. Return on assets
6. Return on common stockholders’ equity
7. Debt ratio = ($140,000 + $400,000) ÷ $1,200,000 = 45%
8. Debt-to-equity ratio = ($140,000 + $400,000) ÷ ($1,200,000 − $540,000) = 81.8%
9. Times interest earned ratio = ($150,000 + $60,000 + $50,000) ÷ $50,000 = 5.2 times
10. Gross margin percentage = ($1,330,000 − $900,000) ÷ $1,330,000 = 32.3%
11. Return on assets = [$150,000 + ($50,000 × (1 − .30))] ÷ [($1,200,000 + $800,000) ÷ 2] = 18.5%
12. Stockholder’s equity 2021 = ($1,200,000 − $140,000 − $400,000) = $660,000

Stockholder’s equity 2020 = ($800,000 − $110,000 − $300,000) = $390,000

Return on common stockholders’ equity = ($150,000 − $0) ÷ [($660,000 + $390,000) ÷ 2] = 28.6%

1. The balance sheet for Blan Corporation at the end of the current year indicates the following:

Bonds payable, 8% $4,000,000

6% Preferred stock, $100 par 1,000,000

Common stock, $10 par 2,000,000

Income before income taxes was $480,000 and income taxes expense for the current year amounted to $144,000. Cash dividends paid on common stock were $300,000, and the common stock was selling for $22 per share at the end of the year. There were no ownership changes during the year.

Required:

Calculate each of the following:

1. Earnings per share
2. Price/earnings ratio
3. Dividend payout ratio
4. Preferred dividends = 6% × $1,000,000 = $60,000

($480,000 − $144,000 − $60,000) ÷ ($2,000,000 ÷ $10) = $1.38/share

1. $22 ÷ $1.38 = 15.9 times
2. Common dividends = $300,000 ÷ 200,000 shares = $1.50/share

$1.50 ÷ $1.38 = 108.7%

1. Assume you have prepared a horizontal analysis of your company’s balance sheet and income statement and have found some account balances you believe need to be investigated. What would be a cause of each of the following changes in account balances?
   1. Decrease in accrued salaries
   2. Sales increased by a greater percentage than cost of goods sold
   3. Accounts receivable decreased
   4. Significant drop in long-term debt
   5. Decrease in retained earnings

• 1. What are common-size financial statements? How are common-size financial statements used?
  2. What is the base for a common-size income statement?
  3. What is the base for a common-size balance sheet?

1. Common size financial statements express each financial statement amount as a percentage of a key component. Common size balance sheets express all components as a percentage of total assets. Common size income statements express all components as a percentage of net sales. A common-size analysis examines changes in the relative size of account balances within a single statement. Common-size statements are especially helpful in comparing companies of different sizes.
2. In preparing a common-size income statement, you express all revenue and expense accounts as a percentage of net sales revenue.
3. In preparing a common-size balance sheet, you express all account balances, asset, liability, and equity, as a percentage of total assets.
4. Three measures of liquidity are working capital, current ratio, and acid-test ratio. What do each of these measures show, and how are they each calculated?

Working capital measures a company’s ability to pay its obligations as they come due. It is calculated as the difference between current assets and current liabilities.

Current ratio is the most common measure of short-term liquidity. It measures the number of times that current assets cover current liabilities. It is calculated as current assets divided by current liabilities.

The acid-test ratio measures current liquidity. It is a more stringent measure of liquidity than the current ratio and indicates a company’s ability to maintain liquidity in the short-run. It is calculated by dividing cash, cash equivalents and accounts receivable by current liabilities.

1. Most companies use a combination of debt and equity to obtain the assets needed to fund their operations. Two leverage ratios are the debt ratio and the debt-to-equity ratio. What do each of these measures show, and how are they each calculated?

The debt ratio shows the proportion of assets that are financed through debt. It is calculated by dividing total liabilities by total assets.

The debt-to-equity ratio measures the amount of financing provided by creditors relative to the amount provided by owners. The formula is total liabilities divided by total stockholders’ equity.

1. Two measures of liquidity are the accounts receivable turnover and the inventory turnover. What do each of these measures show and how are they each calculated?

The accounts receivable turnover and inventory turnover indicate the underlying quality of current assets. Accounts receivable turnover is a measure of the liquidity of a company’s accounts receivables. It shows how many times, on average, a company’s receivables balance is turned over or collected during the year. It is calculated as net credit sales divided by average accounts receivable balance.

The inventory turnover measures how many times, on average, a company’s inventory turns over or is sold during the year. It is calculated as the cost of goods sold divided by average inventory balance.

ESSAY

1. Managers look at the financial statement to see how well a company is doing, but the account balances alone do not tell managers enough. Horizontal and trend analyses are commonly used by managers to help assess the company’s financial strengths and weaknesses.

Required:

Explain what horizontal analysis and trend analysis are and how amounts are used in their calculations. What are the steps in preparing horizontal and trend analysis?

Rather than looking only at the balances reported on the financial statements, it is helpful to look at the changes in the account balances over time using horizontal analysis. Horizontal analysis is used to compare account balances across time by showing the dollar difference between years in each account balance.

Trend analysis is a form of horizontal analysis where each year’s account balances is expressed as a percentage of the base year’s (earliest year’s) account balance. Trend analysis is useful for analyzing other information such as supplemental information reported in corporate annual reports and to compare changes in related accounts, for example sales and operating income.

The first step in preparing horizontal analysis is to gather the financial statements for at least two years. Calculate the dollar difference between the current year’s balance and the previous year’s balance in each account. Divide the dollar difference by the previous year’s balance to find the percentage change. Show both the dollar difference and the percentage change in horizontal statements.

The steps to preparing a trend analysis start with gathering at least two years of data and typically several years. Choose the earliest year to be the base year. Divide each year’s account balance by the base year balance to find the percentage change. Show the percentage changes under the corresponding years for each financial statement line item analyzed.

• 1. What does liquidity mean?
  2. List two reasons liquidity is important to companies.
  3. What is the difference between working capital and current ratio?
  4. What could cause a company’s current ratio to be high, but its acid-test ratio to be low?

1. Liquidity is a firm’s ability to pay its obligations as they come due, to meet any unforeseen needs for cash, and to convert non-cash assets into cash.
2. A company must be able to meet its obligations as they come due. It also needs the ability to take advantage of opportunities as they arise.
3. Working capital is the difference between current assets and current liabilities expressed in dollars, while current ratio is current assets divided by current liabilities expressed as a proportion of the number of times current assets exceed current liabilities.
4. When a company’s current ratio is high, that indicates that the company has excess current assets over current liabilities. The assets included in the quick ratio do not include assets that may take longer to convert into cash, inventory and prepaids. A high current asset ratio and low acid-test ratio would indicate that the company’s current assets consist of large amounts of inventory and prepaid assets, that are not quickly converted to cash.
   1. What does the gross margin percentage measure and how is it calculated?
   2. What does the return on assets measure and how is it calculated?
   3. What does the return on common stockholders’ equity measure and how is it calculated?
5. The gross margin percentage shows how much of each sales dollar is available to cover operating expenses and provide a profit after the cost of goods sold has been covered. It is a measure of the company’s ability to generate income from the sale of goods or services. It is calculated by dividing gross margin by net sales revenue.
6. The return on assets ratio measures how well assets have been employed in conducting the business. It is calculated by dividing net income plus interest expense net of tax, by average total assets.
7. The return on common stockholders’ equity measures how well the funds provided by common stockholders have been used to generate a return for the company. It is calculated by net income less preferred dividends, by average common stockholders’ equity.
8. Dun and Bradstreet’s Industry Norms and Key Business Ratios and the Almanac of Business and Industrial Financial Ratios are two publications relevant to managers interested in understanding a company’s performance relative to its competitors.

Required:

• 1. What is the meaning of SIC and NAICS?
  2. Explain how the SIC and NAICS codes were developed.

1. SIC is the Standard Industrial Classification and NAICS is the North American industry Classification System.
2. The SIC system was developed in 1939 and 1940 and has been revised several times. It assigns a two-digit code to major industry groups and then further identifies specific industries by a four-digit code. The NAICS codes, a joint project of the United States, Canada, and Mexico, were first published in 1997. Because this system recognized changes that have occurred in the global economy since 1940, it provides greater consistency in the classification of firms within industries. As a result, the six-digit NAICS codes are replacing SIC codes in government statistical reporting.
3. Most companies use a combination of debt and equity to obtain the assets needed to fund operations.

Required:

Discuss the advantages and disadvantages of using debt versus equity financing as it relates to dividends, interest, and risk.

High levels of debt pose a risk for the company, because debt and interest must be repaid. In comparison, equity, or common and preferred stock, does not need to be repaid, nor do dividends need to be declared. High levels of debt pose a risk for creditors, too, because they run the risk of not being repaid in the event the company fails. All things held equal, current stockholders prefer debt financing over equity because it does not dilute their ownership in the company.