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CHAPTER 13

FINANCIAL ANALYSIS: THE BIG PICTURE


SUMMARY OF QUESTIONS BY STUDY OBJECTIVE AND BLOOMS TAXONOMY
Item

SO

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Item

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2.
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Item SO
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Item
True-False Statements
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5
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AP
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C
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5
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Multiple Choice Questions
K
111.
5
K
143.
K
112.
6
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144.
K
113.
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K
145.
AP 114.
6
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146.
AP 115.
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AP 116.
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148.
AP 117.
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C
150.
AP 119.
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C
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AP 121.
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AP 123.
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C
158.
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K
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AP
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C
162.
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AP
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AP
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AP
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AP
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AP 137.
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AP
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AP 138.
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AP
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AP 139.
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K
171.

108.

AP

140.

K
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K

109.
110.

5
5

AP
K

141.
142.

6
6

K
K

75.
76.
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78.

SO

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SO

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Item

SO

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6
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K
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AP
AP
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AN
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AN
AP
AP
AP

175.
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AP
AP
AN
AP
AP
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AP
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AP
AP
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AP
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AN
AP
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AN
C

172.

AP

204.

173.
174.

6
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AP
AP

205.
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7
7

K
C

13-2

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

207.
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2
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K
K
AP
AP
AP

212
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4
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AP
AP
AP
AN
C

229.
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4
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AN
AP

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4, 5
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AP
AN

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2
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K
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239.
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249.

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251.

252.

Brief Exercises
217. 4, 5
AP
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5
AP
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5
AP
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AP

221.
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AP
AP
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225.
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AN
AP
AP
AP

Exercises
6
AP

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AN

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AP

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K

233.

Completion Statements
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6
Matching
Short Answer Essay
253. 4, 5
C
254.

13-3

Financial Analysis: The Big Picture

SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE


S.O. 1
Item
1.
46.

Type
TF
MC

S.O. 4 (cont.)
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87.
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211.
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229.
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Be
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Be
Be
Be
Be
Ex
Ex
Ex
C

S.O. 2
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S.O. 5
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74.
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Type
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MC

S.O. 2 (cont.)
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207.
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236.
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Type
MC
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Be
Be
Be
Be
C
C
C

S.O. 5 (cont.)
Item
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217.
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231.
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240.

Type
MC
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Be
Be
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Ex
Ex
C

S.O. 3
Item
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9.
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69.
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Type
TF
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MC

S.O. 6
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74.
75.
112.
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Type
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MC
MC
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MC
MC

S.O. 4
Item
12.
13.
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16.
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74.
75.
76.
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79.
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85.
86.

Type
TF
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MC
MC

S.O. 6 (cont.)
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116.
117.
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Type
MC
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MC
MC
MC
MC

13-4

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

S.O. 6 (cont.)

S.O. 6 (cont.)

S.O. 6 (cont.)

S.O. 6 (cont.)

S.O. 6 (cont.)

Item
137.
138.
139.
140.
141.
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146.
147.

Type
MC
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Item
156.
157.
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Type
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Item
175.
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Type
MC
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Item
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Type
MC
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Be
Be

Item
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235.
241.
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246.
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248.

148.
149.
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154.
155.

MC
MC
MC
MC
MC
MC
MC
MC

167.
168.
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172 .
173.
174.

MC
MC
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MC
MC
MC
MC
MC

186.
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191
192.
193.

MC
MC
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MC

222.
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233.

Be
Be
Be
Be
Be
Be
Be
Ex

Item
43.
44.
45.
203.
204.
205.
206.

Note: TF = True-False
MC = Multiple Choice

C = Completion
Ex = Exercise

Type
Ex
Ex
C
C
C
C
C
C
C
C

S.O. 7
Type
TF
TF
TF
MC
MC
MC
MC

Be = Brief Exercise

The chapter also contains two sets of ten Matching questions each and four Short-Answer Essay
questions.

Financial Analysis: The Big Picture

13-5

CHAPTER STUDY OBJECTIVES


1. Understand the concept of sustainable income. Sustainable income refers to a companys
ability to sustain its profits from operations.
2. Indicate how irregular items are presented. Irregular itemsdiscontinued operations,
extraordinary items, and changes in accounting principlesare presented on the income
statement net of tax below Income before irregular items to highlight their unusual nature.
3. Explain the concept of comprehensive income. Comprehensive income includes all
changes in stockholders equity during a period except those resulting from investments by
stockholders and distributions to stockholders. Other comprehensive income is added to net
income to arrive at comprehensive income.
4. Describe and apply horizontal analysis. Horizontal analysis is a technique for evaluating a
series of data over a period of time to determine the increase or decrease that has taken
place, expressed as either an amount or a percentage.
5. Describe and apply vertical analysis. Vertical analysis is a technique that expresses each
item within a financial statement as a percentage of a relevant total or a base amount.
6. Identify and compute ratios used in analyzing a company's liquidity, solvency, and
profitability. Financial ratios are provided in Illustration 13-16 (liquidity), Illustration 13-17
(solvency) and Illustration 13-18 (profitability).
7. Understand the concept of quality of earnings. A high quality of earnings provides full and
transparent information that will not confuse or mislead users of the financial statements.
Issues related to quality of earnings are (1) alternative accounting methods, (2) proforma
income, and (3) improper recognition.

13-6

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

TRUE-FALSE STATEMENTS
1.

Earning power refers to a companys ability to sustain its profits from operations.

2.

One objective of the income statement is to separate the results of continuing operations
from those of discontinued operations.

3.

When the disposal of a significant segment occurs, the income statement should report
both income from continuing operations and income (loss) from discontinued operations.

4.

An event or transaction should be classified as an extraordinary item if it is unusual in


nature or if it occurs infrequently.

5.

Companies report most changes in accounting principle currently.

6.

The loss on disposal of a significant component of a business is disclosed in the statement


of retained earnings.

7.

A change in accounting principle occurs when the principle used in the current year is
different from the one used by competitors in the current year.

8.

Comprehensive income includes all changes in stockholders equity during a period


except those resulting from investments by stockholders and distributions to stockholders.

9.

Comprehensive income includes all revenues, expenses, gains, losses, and dividends.

10.

Intracompany comparisons of the same financial statement items are often useful to detect
changes in financial relationships and significant trends.

11.

Comparisons of company data with industry averages provide information about a


company's relative position within the industry.

12.

Horizontal, vertical, and circular analyses are the basic tools of financial statement
analysis.

13.

In horizontal analysis, the base year is the most current year being examined.

14.

Horizontal analysis is a technique for evaluating a financial statement item in the current
year with other items in the current year.

15.

Another name for horizontal analysis is trend analysis.

16.

If a company has sales of $110 in 2007 and $154 in 2006, the percentage decrease in
sales from 2006 to 2007 is 140%.

17.

In horizontal analysis, if an item has a negative amount in the base year, and a positive
amount in the following year, no percentage change for that item can be computed.

18.

A primary purpose of vertical analysis is to observe trends over a three-year period.

Financial Analysis: The Big Picture

13-7

19.

Vertical analysis is a technique for evaluating a series of financial statement data over a
period of time to determine the increase (decrease) that has taken place.

20.

Common size analysis expresses each item in a financial statement as a percent of a base
amount.

21.

In a common size income statement, net sales are represented by 100%.

22.

In a common size income statement, each item is expressed as a percentage of net


income.

23.

In a common size balance sheet, total assets are represented by 100%.

24.

In the vertical analysis of a balance sheet, the base for current liabilities is total liabilities.

25.

Vertical analysis is useful in making comparisons of companies of different sizes.

26.

Using vertical analysis of the income statement, a company's net income as a percentage
of net sales is 15%; therefore, the cost of goods sold as a percentage of sales must be
85%.

27.

In the vertical analysis of an income statement, each item is generally stated as a


percentage of net income.

28.

Liquidity ratios measure the ability of the enterprise to survive over a long period of time.

29.

A solvency ratio measures the income or operating success of an enterprise for a given
period of time.

30.

The current ratio is a measure of all the ratios calculated for the current year.

31.

Receivable turnover is useful in assessing the profitability of receivables.

32.

The inventory turnover ratio measures the number of times on the average the inventory
was sold during the period.

33.

Inventory turnover is a measure of liquidity that focuses on efficient use of inventory.

34.

Profitability ratios are frequently used as a basis for evaluating management's operating
effectiveness.

35.

Both profit margin and asset turnover affect a companys return on assets.

36.

Leverage and return on equity are closely related.

37.

The return on assets ratio will be greater than the rate of return on common stockholders'
equity if the company has been successful in trading on the equity at a gain.

38.

The current ratio is one of the most utilized measures of profitability.

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

13-8
39.

From a creditor's point of view, the higher the total debt to total assets ratio, the lower the
risk that the company may be unable to pay its obligations.
A current ratio of 1.2 to 1 indicates that a company's current assets exceed its current
liabilities.

40.
41.

Using borrowed money to increase the rate of return on common stockholders' equity is
called "trading on the equity."

42.

Declining profitability and liquidity ratios are indications that a company may not survive.

43.

Alternative accounting methods affect the quality of earnings.

44.

Improper recognition of income is not one of the factors affecting the quality of earnings.

45.

Because pro forma earnings are based on specific rules, these amounts are highly reliable.

Answers to True-False Statements


1.
2.
3.
4.
5.
6.
7.

T
T
T
F
F
F
F

8.
9.
10.
11.
12.
13.
14.

T
F
T
T
F
F
F

15.
16.
17.
18.
19.
20.
21.

T
F
T
F
F
T
T

22.
23.
24.
25.
26.
27.
28.

F
T
F
T
F
F
F

29.
30.
31.
32.
33.
34.
35.

F
F
F
T
T
T
T

36.
37.
38.
39.
40.
41.
42.

T
F
F
F
T
T
T

43. T
44. F
45. F

MULTIPLE CHOICE QUESTIONS


46.

Which of the following income statement figures would probably be the best indicator of a
companys future performance?
a. Total revenues
b. Income from operations
c. Net income
d. Gross profit

47.

An income statement would not include


a. other revenue and gains.
b. extraordinary items.
c. discontinued operations.
d. dividends paid.

48.

The discontinued operations section of the income statement refers to


a. discontinuance of a product line.
b. the income or loss on products that have been completed and sold.
c. obsolete equipment and discontinued inventory items.
d. the disposal of a significant segment of a business.

Financial Analysis: The Big Picture

13-9

49.

Which one of the following would be classified as an extraordinary item?


a. Expropriation of property by a foreign government
b. Losses attributed to a labor strike
c. Write-down of inventories
d. Gains or losses from sales of equipment

50.

When a change in accounting principle occurs


a. prior years' financial statements should not be changed to reflect the newly adopted
principle.
b. the new principle should be used in reporting the results of operations of the current
year.
c. the cumulative effect of the change in principle should be reflected on the income
statement as of the beginning of the next year.
d. the cumulative effect of the change in accounting principle should be classified as an
extraordinary item on the income statement.

51.

If an item meets one (but not both) of the criteria for an extraordinary item, it
a. only needs to be disclosed in the footnotes of the financial statements.
b. may be treated as sales revenue (if it is a gain) and as an operating expense (if it is a
loss).
c. is reported as an "other revenue or gain" or "other expense and loss," net of tax.
d. is reported at its gross amount as an "other revenue or gain" or "other expense or
loss."

52.

The order of presentation of items that may appear on the income statement is
a. Extraordinary items, Discontinued operations, Income before income taxes.
b. Discontinued operations, Extraordinary items, Income before income taxes.
c. Income before income taxes, Discontinued operations, Extraordinary items.
d. Income before income taxes, Extraordinary items, Discontinued operations.

53.

Which of the following items appears on the income statement before income before
irregular items?
a. Other comprehensive income
b. Extraordinary items
c. Income tax expense
d. Discontinued operations

54.

Which of the following items should be classified as an extraordinary item on an income


statement?
a. Gain on the sale of property, plant or equipment
b. Loss due to expropriation of property by a foreign government
c. Loss due to discontinued operations
d. Excess of the selling price over the cost of treasury stock

55.

When a company changes from one acceptable accounting method to another, the
cumulative effect of the change is disclosed
a. in the retained earnings statement, as a correction to the opening balance.
b. as a footnote.
c. in the income statement, above income from continuing operations.
d. in the income statement, below income from continuing operations.

13-10

56.

57.

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Christines Noell Shoppe had severe damage done to its Christmas inventory due to an
escaped circus elephant rampaging through the store. The inventory loss was $80,000
before applicable taxes of $20,000. Christines Noell Shoppe should record the loss as a(n)
a. $80,000 loss in other expenses and losses.
b. $80,000 extraordinary loss.
c. $60,000 extraordinary loss.
d. $100,000 extraordinary loss.
Esters Bunny Barn has experienced a $40,000 loss due to tornado damage to their
inventory. Tornados have never before occurred in this area. Assuming that the companys
tax rate is 30%, what amount will be reported for this loss on the income statement?
a. $40,000
b. $28,000
c. $12,000
d. $36,000

58.

Wenger Company reported income before taxes of $600,000 and an extraordinary loss of
$150,000. Assume that the companys tax rate is 30%. What amounts will be reported on
the income statement for income before irregular items and extraordinary items, respectively?
a. $420,000 and $150,000
b. $420,000 and $105,000
c. $495,000 and $150,000
d. $495,000 and $105,000

59.

Wonka Candy Company sold its lollipop division resulting in a loss of $30,000. Assuming a
tax rate of 25%, the loss on this disposal will be reported on the income statement at what
amount?
a. $37,500
b. $7,500
c. $30,000
d. $22,500

60.

Which of the following is not an irregular item on the income statement?


a. Discontinued operations
b. Extraordinary items
c. Other revenues and expenses
d. Loss on disposal of a significant component of a business

61.

Which of the following would be considered a disposal of a segment?


a. Shifting production activities from one location to another
b. Elimination of a major class of customers
c. Phasing out of a model
d. Disposal of part of a line of business

62.

Extraordinary items are reported on the income statement immediately


a. below income from continuing operations.
b. after comprehensive income.
c. below income before taxes.
d. after discontinued operations.

Financial Analysis: The Big Picture

13-11

63.

Which of the following would not be considered a change in accounting principle?


a. Changing the estimated percentage used in calculating bad debt expense.
b. Changing the inventory costing method used from FIFO to LIFO.
c. Changing from straight-line depreciation to double-declining balance depreciation.
d. Changing from the cost method of accounting for investments to the equity method.

64.

In reporting discontinued operations, the income statement should show in a special


section:
1. gains on the disposal of a discontinued component.
2. losses on the disposal of a discontinued component.
a. 1 only
b. 2 only
c. neither 1 nor 2
d. both 1 and 2

65.

Kandy Kane Corporation has income before taxes of $400,000 and an extraordinary gain
of $100,000. If the income tax rate is 25% on all items, the income statement should show
income before irregular items and extraordinary items, respectively, of
a. $325,000 and $100,000.
b. $325,000 and $75,000.
c. $300,000 and $100,000.
d. $300,000 and $75,000.

66.

The disposal of a significant segment of a business is called


a. a change in accounting principle.
b. an extraordinary item.
c. an other expense.
d. discontinued operations.

67.

Tinker, Inc. disposes of an unprofitable segment of its business. The operation of the
segment suffered a $160,000 loss in the year of disposal. The loss on disposal of the
segment was $80,000. If the tax rate is 30%, and income before income taxes was
$1,000,000,
a. the income tax expense on the income before discontinued operations is $228,000.
b. the income from continuing operations is $700,000.
c. net income is $760,000.
d. the losses from discontinued operations are reported net of income taxes at $120,000.

68.

Michelangelo, Inc. decided on January 1 to discontinue its telescope manufacturing


division. On July 1, the divisions assets with a book value of $630,000 are sold for
$450,000. Operating income from January 1 to June 30 for the division amounted to
$75,000. Ignoring income taxes, what total amount should be reported on Michelangelos
income statement for the current year under the caption, Discontinued Operations?
a. $75,000.
b. $105,000 loss.
c. $180,000 loss.
d. $255,000.

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Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

69.

Comprehensive income would not include


a. dividends declared.
b. unrealized gains on available-for-sale securities.
c. discontinued operations.
d. extraordinary gains and losses.

70.

Which of the following would be considered an Other Comprehensive Income item?


a. Net income
b. Gain on disposal of discontinued operations
c. Extraordinary loss related to flood
d. Unrealized loss on available-for-sale securities
Laurel, Inc. has the following partial balance sheet:

71.

LAUREL, INC.
Balance Sheet (partial)
Stockholders Equity:
Common Stock
Retained Earnings
Total Paid-in capital and retained earnings
Add: Unrealized gain on available-for-sale securities
Total Stockholders Equity:

$6,000,000
2,000,000
8,000,000
1,000,000
$9,000,000

What effect will it have on comprehensive income?


a. No effect on comprehensive income
b. Increase of $1,000,000 in comprehensive income
c. Increase of $9,000,000 in comprehensive income
d. Decrease of $1,000,000 in comprehensive income
72.

Hardy Inc. has an investment in trading securities of $50,000. This investment experienced
an unrealized loss of $3,000 during the current year. Assuming a 35% tax rate, the effect of
this loss on comprehensive income will be
a. no effect.
b. $50,000 increase.
c. $17,500 decrease.
d. $33,500 decrease.

73.

Which of the following would be considered an Other comprehensive income item?


a. Gain on disposal of discontinued operations
b. Unrealized loss on available-for-sale securities
c. Extraordinary loss related to flood
d. Net income

74.

Comparisons of financial data made within a company are called


a. intracompany comparisons.
b. interior comparisons.
c. intercompany comparisons.
d. intramural comparisons.

Financial Analysis: The Big Picture

13-13

75.

Which one of the following is not a tool in financial statement analysis?


a. Horizontal analysis
b. Circular analysis
c. Vertical analysis
d. Ratio analysis

76.

In analyzing financial statements, horizontal analysis is a


a. requirement.
b. tool.
c. principle.
d. theory.

77.

Horizontal analysis is also known as


a. linear analysis.
b. vertical analysis.
c. trend analysis.
d. common size analysis.

78.

Under which of the following cases may a percentage change be computed?


a. The trend of the amounts is decreasing but all amounts are positive.
b. There is no amount in the base year.
c. There is a negative amount in the base year and a negative amount in the subsequent
year.
d. There is a negative amount in the base year and a positive amount in the subsequent
year.

79.

Horizontal analysis is a technique for evaluating a series of financial statement data over a
period of time
a. that has been arranged from the highest number to the lowest number.
b. that has been arranged from the lowest number to the highest number.
c. to determine which items are in error.
d. to determine the amount and/or percentage increase or decrease that has taken place.

80.

Horizontal analysis of comparative financial statements includes the


a. development of common size statements.
b. calculation of liquidity ratios.
c. calculation of dollar amount changes and percentage changes from the previous to the
current year.
d. evaluation of financial statement data that expresses each item in a financial statement
as a percentage of a base amount.

81.

Horizontal analysis is a technique for evaluating financial statement data


a. within a period of time.
b. over a period of time.
c. on a certain date.
d. as it may appear in the future.

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Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

82.

If year one equals $800, year two equals $840, and year three equals $880, the
percentage to be assigned for year three in a trend analysis, assuming that year 1 is the
base year, is
a. 110%.
b. 105%.
c. 95%.
d. 100%.

83.

If year one equals $800, year two equals $840, and year three equals $896, the
percentage to be assigned for year two in a trend analysis, assuming that year 1 is the
base year, is
a. 100%.
b. 89%.
c. 105%.
d. 112%.

84.

Assume the following sales data for a company:


2008
2007
2006

$900,000
840,000
700,000

If 2006 is the base year, what is the percentage increase in sales from 2006 to 2007?
a. 125%
b. 167%
c. 25%
d. 20%
85.

If year one equals $600, year two equals $650, and year three equals $780, the
percentage to be assigned for year one in a trend analysis, assuming that year 1 is the
base year, is
a. 100%.
b. 89%.
c. 105%.
d. 112%.

86.

In horizontal or trend analysis, each item is expressed as a(n)


a. amount.
b. percentage.
c. rate.
d. amount or a percentage.

87.

Assume the following sales data for a company:


2008
2007
2006

$945,000
780,000
650,000

If 2006 is the base year, what is the percentage increase in sales from 2006 to 2007?
a. 25%
b. 20%
c. 125%
d. 143%

Financial Analysis: The Big Picture

88.

Comparative balance sheets are usually prepared for


a. one year.
b. two years.
c. three years.
d. four years.

89.

Assume the following cost of goods sold data for a company:


2008
2007
2006

13-15

$1,500,000
1,200,000
900,000

If 2006 is the base year, what is the percentage increase in cost of goods sold from 2006
to 2008?
a. 167%
b. 67%
c. 60%
d. 40%
90.

In horizontal analysis, each item is expressed as a percentage of the


a. net income amount.
b. stockholders equity amount.
c. total assets amount.
d. base-year amount.

91.

Dawn Corporation reported net sales of $400,000, $440,000, and $480,000 in the years
2005, 2006, and 2007, respectively. If 2005 is the base year, what is the trend percentage
for 2007?
a. 83%
b. 109%
c. 120%
d. 140%

92.

Comparisons of data within a company are an example of the following comparative basis:
a. Industry averages
b. Inter-company
c. Intra-company
d. Inter-regional

93.

Vertical analysis is also known as


a. perpendicular analysis.
b. common size analysis.
c. trend analysis.
d. straight-line analysis.

94.

In a common size balance sheet, the 100 percent figure is


a. total current assets.
b. total property, plant and equipment.
c. total liabilities.
d. total assets.

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Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

95.

In a common size financial statement, which of the following is given a percentage of 100
percent?
a. Total liabilities
b. Net income
c. Total assets
d. Cost of goods sold

96.

In a common size income statement, the 100% figure is


a. net income.
b. cost of goods sold.
c. gross profit.
d. net sales.

97.

A balance sheet that displays only component percentages is called a ________ balance
sheet.
a. condensed
b. common size
c. comparative
d. trendy

98.

Vertical analysis is a technique that expresses each item in a financial statement


a. in dollars and cents.
b. as a percent of the item in the previous year.
c. as a percent of a base amount.
d. starting with the highest value down to the lowest value.

99.

In vertical analysis
a. a base amount is required.
b. a base amount is optional.
c. the same base is used across all financial statements analyzed.
d. the results of the horizontal analysis are necessary inputs for performing the analysis.

100.

The best way to study the relationship of the components within a financial statement is to
prepare
a. common size statements.
b. a trend analysis.
c. profitability analysis.
d. ratio analysis.

101.

In performing a vertical analysis, the base for prepaid expenses is


a. total current assets.
b. total assets.
c. total liabilities.
d. prepaid expenses in a previous year.

102.

In performing a vertical analysis, the base for sales revenues on the income statement is
a. net sales.
b. sales.
c. net income.
d. cost of goods available for sale.

Financial Analysis: The Big Picture

103.

In performing a vertical analysis, the base for sales returns and allowances is
a. sales.
b. sales discounts.
c. net sales.
d. total revenues.

104.

In performing a vertical analysis, the base for cost of goods sold is


a. total selling expenses.
b. net sales.
c. total revenues.
d. total expenses.

Use the following information for questions 105 -106:


Fairy Dust, Inc. has the following Income Statement (in millions):
FAIRY DUST, INC.
Income Statement
For the Year Ended December 31, 2007
Net Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Net Income

$150
50
100
40
$ 60

105.

Using vertical analysis, what percentage is assigned to Net Sales?


a. 150%
b. Cant be computed
c. 60%
d. 100%

106.

Using vertical analysis, what percentage is assigned to Gross Profit?


a. 66.7%
b. 100%
c. Cant be computed
d. 50%

Use the following information for questions 107-108:


Moon Beam, Inc. has the following income statement (in millions):
MOON BEAM, INC.
Income Statement
For the Year Ended December 31, 2007
Net Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Net Income

$180
60
120
75
$ 45

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Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

107.

Using vertical analysis, what percentage is assigned to Cost of Goods Sold?


a. 67%
b. 33%
c. 100%
d. None of the above

108.

Using vertical analysis, what percentage is assigned to Net Income?


a. 100%
b. 75%
c. 25%
d. None of the above

109.

Given the following data for a company:


Current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities & stockholders equity

$ 360
480
640
520
$2,000

How would common stock appear on a common size balance sheet?


a. 75.0%
b. 55.1%
c. 32.0%
d. Cannot be determined from the data given
110.

The following schedule is a display of what type of analysis?


Current assets
Property, plant, and equipment
Total assets
a.
b.
c.
d.

Amount
$100,000
300,000
$400,000

Percent
25%
75%
100%

Horizontal analysis
Differential analysis
Vertical analysis
Ratio analysis

111.

In vertical analysis, the base amount for salary & wages expense is generally
a. net sales.
b. salary & wages expense in a previous year.
c. gross profit.
d. net income.

112.

Which one of the following is not a characteristic generally evaluated in ratio analysis?
a. Liquidity
b. Profitability
c. Marketability
d. Solvency

Financial Analysis: The Big Picture

113.

Ratios are most useful in identifying


a. trends.
b. differences.
c. causes.
d. relationships.

114.

Short-term creditors are usually most interested in assessing


a. solvency.
b. liquidity.
c. marketability.
d. profitability.

115.

A common measure of liquidity is


a. return on assets.
b. receivables turnover.
c. profit margin.
d. debt to equity.

116.

A common measure of profitability is the


a. current ratio.
b. current cash debt coverage ratio.
c. return on common stockholders equity ratio.
d. debt to total assets.

117.

A common measure of long-term solvency is


a. the cash debt coverage ratio.
b. the current ratio.
c. the asset turnover ratio.
d. inventory turnover.

118.

Return on assets ratio is most closely related to


a. profit margin and debt to total assets ratio.
b. profit margin and asset turnover ratio.
c. times interest earned and debt to stockholders equity ratio.
d. profit margin and free cash flow.

119.

Return on common stockholders equity ratio is most closely related to


a. gross profit rate and operating expenses to sales ratio.
b. profit margin and free cash flow.
c. times interest earned and debt to stockholders equity ratio.
d. return on asset ratio and leverage (debt to total assets ratio).

120.

Long-term creditors are usually most interested in evaluating


a. liquidity.
b. marketability.
c. profitability.
d. solvency.

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Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

121.

Which one of the following would be considered a long-term solvency ratio?


a. Receivables turnover
b. Return on total assets
c. Current cash debt coverage ratio
d. Debt to total assets ratio

122.

Stockholders are most interested in evaluating


a. liquidity.
b. solvency.
c. profitability.
d. marketability.

123.

In ratio analysis, the ratios are never expressed as a


a. rate.
b. logarithm.
c. percentage.
d. simple proportion.

124.

The current ratio is


a. calculated by dividing current liabilities by current assets.
b. used to evaluate a company's liquidity and short-term debt paying ability.
c. used to evaluate a company's solvency and long-term debt paying ability.
d. calculated by subtracting current liabilities from current assets.

125.

The current ratio is a


a. liquidity ratio.
b. profitability ratio.
c. long-term solvency ratio.
d. cash flow ratio.

126.

A company with $60,000 in current assets and $40,000 in current liabilities pays a $1,000
current liability. As a result of this transaction, the current ratio and working capital will
a. both decrease.
b. both increase.
c. increase and remain the same, respectively.
d. remain the same and decrease, respectively.

127.

The receivables turnover and inventory turnover ratios are used to analyze
a. long-term solvency.
b. profitability.
c. liquidity.
d. leverage.

128.

Spring Clothing Store had a balance in the Accounts Receivable account of $760,000 at
the beginning of the year and a balance of $840,000 at the end of the year. Net credit sales
during the year amounted to $6,000,000. The average collection period of the receivables
in terms of days was
a. 30 days.
b. 365 days.
c. 51.1 days.
d. 48.7 days.

Financial Analysis: The Big Picture

13-21

129.

Spring Clothing Store had a balance in the Accounts Receivable account of $760,000 at
the beginning of the year and a balance of $840,000 at the end of the year. Net credit sales
during the year amounted to $6,000,000. The receivables turnover ratio was
a. 7.1 times.
b. 7.3 times.
c. 7.5 times.
d. 7 times.

130.

A high receivables turnover ratio indicates


a. customers are making payments quickly.
b. a large portion of the companys sales are on credit.
c. many customers are not paying their receivables.
d. the companys sales have increased.

131.

Oak Hardware Store had net credit sales of $4,225,000 and cost of goods sold of
$3,000,000 for the year. The Accounts Receivable balances at the beginning and end of
the year were $600,000 and $700,000, respectively. The receivables turnover ratio was
a. 5.6 times.
b. 6.5 times.
c. 4.6 times.
d. 6 times.

132.

Fall Clothing Store had a balance in the Accounts Receivable account of $820,000 at the
beginning of the year and a balance of $880,000 at the end of the year. Net credit sales
during the year amounted to $6,120,000. The receivables turnover ratio was
a. 7.2 times.
b. 7 times.
c. 6.9 times.
d. 6.8 times.

133.

Fall Clothing Store had a balance in the Accounts Receivable account of $810,000 at the
beginning of the year and a balance of $850,000 at the end of the year. Net credit sales
during the year amounted to $5,814,980. The average collection period of the receivables
in terms of days was
a. 50 days.
b. 52.1 days.
c. 365 days.
d. 52.9 days.

134.

Rose Hardware Store had net credit sales of $3,920,000 and cost of goods sold of
$3,000,000 for the year. The Accounts Receivable balances at the beginning and end of
the year were $650,000 and $750,000, respectively. The receivables turnover ratio was
a. 6.5 times.
b. 6.0 times.
c. 5.6 times.
d. 6.2 times.

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Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Use the following information for questions 135-136.


Flagstaff Department Store had net credit sales of $13,000,000 and cost of goods sold of
$10,000,000 for the year. The average inventory for the year amounted to $2,500,000.
135.

The inventory turnover ratio for the year is


a. 4 times.
b. 7 times.
c. 3 times.
d. 2 times.

136.

The average days in inventory during the year was approximately


a. 183 days.
b. 122 days.
c. 91 days.
d. 52 days.

Use the following information for questions 137-138.


Charles Department Store had net credit sales of $9,000,000 and cost of goods sold of
$6,000,000 for the year. The average inventory for the year amounted to $2,500,000.
137.

The inventory turnover ratio for the year is


a. 3.6 times.
b. 3.2 times.
c. 3.0 times.
d. 2.4 times.

138.

The average days in inventory during the year was approximately


a. 101 days.
b. 114 days.
c. 122 days.
d. 152 days.

139.

Which one of the following would not be considered a liquidity ratio?


a. Current ratio
b. Inventory turnover ratio
c. Current cash debt coverage ratio
d. Return on assets ratio

140.

The asset turnover ratio is


a. net sales divided by net income.
b. average total assets divided by net income.
c. net sales divided by average total assets.
d. average total assets divided by net sales.

141.

The assets turnover ratio measures


a. how often a company replaces its assets.
b. how efficiently a company uses its assets to generate sales.
c. the portion of the assets that have been financed by creditors.
d. the overall rate of return on assets.

Financial Analysis: The Big Picture

142.

13-23

The profit margin ratio is calculated by dividing


a. sales by cost of goods sold.
b. gross profit by net sales.
c. net income by stockholders' equity.
d. net income by net sales.

Use the following information for questions 143-144.


Bunting Corporation had net income of $250,000 and paid dividends to common stockholders of
$50,000 in 2007. The weighted average number of shares outstanding in 2007 was 50,000
shares. Bunting Corporation's common stock is selling for $50 per share on the New York Stock
Exchange.
143.

144.

Bunting Corporation's price-earnings ratio is


a. 2 times.
b. 8 times.
c. 10 times.
d. 5 times.
Bunting Corporation's payout ratio for 2007 is
a. $5 per share.
b. 25%.
c. 20%.
d. 12.5%.

Use the following information for questions 145-146.


Luthor Corporation had net income of $160,000 and paid dividends to common stockholders of
$40,000 in 2007. The weighted average number of shares outstanding in 2007 was 50,000
shares. Luthor Corporation's common stock is selling for $50 per share on the New York Stock
Exchange.
145.

Luthor Corporation's price-earnings ratio is


a. 3.2 times.
b. 15.6 times.
c. 10 times.
d. 5 times.

146.

Luthor Corporation's payout ratio for 2007 is


a. $5 per share.
b. 25%.
c. 20%.
d. 12.5%.

147.

The debt to total assets ratio measures


a. the company's profitability.
b. whether interest can be paid on debt in the current year.
c. the proportion of interest paid relative to dividends paid.
d. the percentage of the total assets provided by creditors.

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148.

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Frank Company reported the following on its income statement:


Income before income taxes
$420,000
Income tax expense
120,000
Net income
$300,000
An analysis of the income statement revealed that interest expense was $80,000. Frank
Company's times interest earned was
a. 8 times.
b. 5.25 times.
c. 6.25 times.
d. 5 times.

149.

Trading on the equity (leverage) refers to the


a. amount of working capital.
b. amount of capital provided by owners.
c. use of borrowed money to increase the return to owners.
d. number of times interest is earned.

150.

Raye Company reported the following on its income statement:


Income before income taxes
Income tax expense
Net income

$500,000
150,000
$350,000

An analysis of the income statement revealed that interest expense was $80,000. Raye
Company's times interest earned was
a. 8 times.
b. 7.25 times.
c. 6.25 times.
d. 4.4 times.
151.

A company that is leveraged is one that


a. has a high earnings per share.
b. contains debt financing.
c. contains equity financing.
d. has a high current ratio.

152.

The current assets of Sol Company are $180,000. The current liabilities are $120,000. The
current ratio expressed as a proportion is
a. 150%.
b. 1.5:1.
c. .67:1.
d. $180,000 $120,000.

153.

A weakness of the current ratio is


a. the difficulty of the calculation.
b. it uses year-end balances of current asset and current liability accounts.
c. it is rarely used by sophisticated analysts.
d. it can be expressed as a percentage, as a rate, or as a proportion.

Financial Analysis: The Big Picture

13-25

154.

A supplier to a company would be most interested in the


a. asset turnover ratio.
b. profit margin ratio.
c. current ratio.
d. earnings per share.

155.

Which one of the following ratios would not likely be used by a short-term creditor in
evaluating whether to sell on credit to a company?
a. Current ratio
b. Inventory turnover ratio
c. Asset turnover ratio
d. Receivables turnover ratio

156.

Ratios are used as tools in financial analysis


a. instead of horizontal and vertical analyses.
b. because they can provide information that may not be apparent from inspection of the
individual components of the financial statements.
c. because even single ratios by themselves are quite meaningful.
d. because they are prescribed by GAAP.

157.

The ratios that are used to determine a company's short-term debt paying ability are
a. asset turnover, times interest earned, current ratio, and receivables turnover.
b. times interest earned, inventory turnover, current ratio, and receivables turnover.
c. times interest earned, receivables turnover ratio, current ratio, and inventory turnover.
d. current ratio, current debt coverage ratio, receivables turnover, and inventory turnover.

158.

Arte Company had $250,000 of current assets and $90,000 of current liabilities before
borrowing $60,000 from the bank with a 3-month note payable. What effect did the
borrowing transaction have on Arte Company's current ratio?
a. The ratio remained unchanged.
b. The change in the current ratio cannot be determined.
c. The ratio decreased.
d. The ratio increased.

159.

A liquidity ratio measures the


a. income or operating success of an enterprise over a period of time.
b. ability of the enterprise to survive over a long period of time.
c. short-term ability of the enterprise to pay its maturing obligations and to meet
unexpected needs for cash.
d. number of times interest is earned.

160.

If equal amounts are added to the numerator and the denominator of the current ratio and
the ratio is over one, the ratio will always
a. increase.
b. decrease.
c. stay the same.
d. equal zero.

13-26
161.

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

If a company has a current ratio of 1.2:1, what respective effects will the borrowing of cash
by short-term debt and collection of accounts receivable have on the ratio?
a.
b.
c.
d.

Short-term Borrowing
Increase
Increase
Decrease
Decrease

Collection of Receivable
No effect
Increase
No effect
Decrease

162.

A company has a receivables turnover ratio of 10. The average net receivables during the
period are $400,000. What is the amount of net credit sales for the period?
a. $40,000
b. $4,000,000
c. $480,000
d. Cannot be determined from the information given

163.

If the average collection period is 55 days, what is the receivables turnover?


a. 6.64 times
b. 7.30 times
c. 3.65 times
d. None of the above

164.

A general rule to use in assessing the average collection period is that it


a. should not exceed 30 days.
b. can be any length as long as the customer continues to buy merchandise.
c. should not greatly exceed the return period.
d. should not greatly exceed the credit term period.

165.

The inventory turnover is calculated by dividing


a. cost of goods sold by the ending inventory.
b. cost of goods sold by the beginning inventory.
c. cost of goods sold by the average inventory.
d. average inventory by cost of goods sold.

166.

A company has an average inventory on hand of $60,000 and its average days in inventory
is 29.2 days. What is the cost of goods sold?
a. $750,000
b. $1,752,000
c. $1,680,000
d. $876,000

167.

A successful grocery store would probably have


a. a low inventory turnover.
b. a high inventory turnover.
c. zero profit margin.
d. low volume.

168.

Net sales are $1,500,000, beginning total assets are $700,000, and the asset turnover is
3.0. What is the ending total asset balance?
a. $500,000
b. $300,000
c. $700,000
d. $400,000

Financial Analysis: The Big Picture

13-27

Use the following information for questions 169-176.


The following information pertains to Soho Company. Assume that all balance sheet amounts
represent both average and ending balance figures. Assume that all sales were on credit.
Assets
Cash and short-term investments
Accounts receivable (net)
Inventory
Property, plant and equipment
Total Assets

$ 40,000
25,000
20,000
210,000
$295,000

Liabilities and Stockholders Equity


Current liabilities
Long-term liabilities
Stockholders equitycommon
Total Liabilities and Stockholders Equity

$ 60,000
85,000
150,000
$295,000

Income Statement
Sales
Cost of goods sold
Gross margin
Operating expenses
Net income

$ 85,000
45,000
40,000
20,000
$ 20,000

Number of shares of common stock


Market price of common stock
Dividends per share
Cash provided by operations

6,000
$20
.90
$30,000

169.

What is the current ratio for this company?


a. 1.42
b. .80
c. 1.16
d. .60

170.

What is the receivables turnover for this company?


a. 2.8 times
b. 2 times
c. 3.4 times
d. 3 times

171.

What is the inventory turnover for this company?


a. 2 times
b. 2.25 times
c. 1 time
d. .44 times

13-28

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

172.

What is the return on assets for this company?


a. 6.8%
b. 10.5%
c. 11.7%
d. 26.7%

173.

What is the profit margin for this company?


a. 42.86%
b. 18.75%
c. 23.5%
d. 15.0%

174.

What is the return on common stockholders equity for this company?


a. 13.3%
b. 5%
c. 23.3%
d. 53.3%

175.

What is the price earnings ratio for this company?


a. 6 times
b. 2.5 times
c. 8 times
d. 4 times

176.

What is the current cash debt coverage ratio for this company?
a. .5 times
b. 3 times
c. .33 times
d. .14 times

177.

Leno Corporation reported net income $24,000; net sales $400,000; and average assets
$600,000 for 2007. What is the 2007 profit margin?
a. 6%
b. 12%
c. 40%
d. 200%

Financial Analysis: The Big Picture

13-29

Use the following information for questions 178-185.


The following information pertains to Cashe Company. Assume that all balance sheet amounts
represent both average and ending balance figures. Assume that all sales were on credit.
Assets
Cash and short-term investments
Accounts receivable (net)
Inventory
Property, plant and equipment
Total Assets

$ 40,000
30,000
25,000
215,000
$310,000

Liabilities and Stockholders Equity


Current liabilities
Long-term liabilities
Stockholders equitycommon
Total Liabilities and Stockholders Equity

$ 60,000
95,000
155,000
$310,000

Income Statement
Sales
Cost of goods sold
Gross margin
Operating expenses
Net income

$ 90,000
45,000
45,000
20,000
$ 25,000

Number of shares of common stock


Market price of common stock
Dividends per share
Cash provided by operations

6,000
$20
1.00
$40,000

178.

What is the current ratio for this company?


a. 1.42
b. .78
c. 1.58
d. .67

179.

What is the receivables turnover for this company?


a. 2.8 times
b. 2 times
c. 3.4 times
d. 3 times

180.

What is the inventory turnover for this company?


a. 1.8 times
b. 2.25 times
c. 1 time
d. .44 time

181.

What is the return on assets for this company?


a. 6.8%
b. 10.5%
c. 8.1%
d. 16.1%

13-30

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

182.

What is the profit margin for this company?


a. 50.0%
b. 55.6%
c. 23.5%
d. 27.8%

183.

What is the return on common stockholders equity for this company?


a. 7.3%
b. 16.1%
c. 23.5%
d. 53.3%

184.

What is the price earnings ratio for this company?


a. 6 times
b. 4.2 times
c. 8 times
d. 4.8 times

185.

What is the current cash debt coverage ratio for this company?
a. .67 times
b. 3 times
c. .33 times
d. .14 times

Use the following information for questions 186-187.


The following information is available for Charles Company:
Accounts receivable
Inventory
Net credit sales
Cost of goods sold
Net income
186.

187.

2007
$ 360,000
280,000
3,000,000
1,200,000
300,000

The receivables turnover ratio for 2007 is


a. 8.3 times.
b. 3.9 times.
c. 7.9 times.
d. 10.0 times.
The inventory turnover ratio for 2007 is
a. 4.3 times.
b. 4.0 times.
c. 2.0 times.
d. 2.4 times.

2006
$ 400,000
320,000
1,400,000
1,060,000
170,000

Financial Analysis: The Big Picture

Use the following information for questions 188-189.


The following amounts were taken from the financial statements of Alien Company:
Current liabilities
Long-term liabilities
Interest Expense
Income tax expense
Net income
Net cash provided by operating activity

2007
$280,000
800,000
100,000
120,000
300,000
480,000

188.

The times interest earned ratio for 2007 is


a. 3.0 times.
b. 4.8 times.
c. 4.0 times.
d. 5.2 times.

189.

The cash debt coverage ratio for 2007 is


a. 50.5%.
b. 44.4%.
c. 31.6%.
d. 62.5%.

2006
$220,000
600,000
50,000
58,000
170,000
270,000

Use the following information for questions 190-192.


The following amounts were taken from the financial statements of Palmer Company:
2007
Total assets
$800,000
Net sales
720,000
Gross profit
352,000
Net income
144,000
Weighted average number of common shares outstanding 120,000
Market price of common stock
$36
190.

The return on assets ratio for 2007 is


a. 18%.
b. 16%.
c. 36%.
d. 32%.

191.

The profit margin ratio for 2007 is


a. 10%.
b. 15%.
c. 20%.
d. 30%.

2006
$1,000,000
650,000
320,000
117,000
120,000
$40

13-31

13-32

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

192.

The price-earnings ratio for 2007 is


a. 30 times.
b. 20 times.
c. 10 times.
d. 5 times.

193.

Solvency is of most interest to


a. short-term creditors.
b. stockholders.
c. competitors.
d. long-term creditors.

194.

The current ratio would be of most interest to


a. short-term creditors.
b. long-term creditors.
c. stockholders.
d. customers.

195.

Which measure(s) is(are) an evaluation of a companys ability to pay current liabilities?


1. Current cash debt coverage ratio.
2. Current ratio.
a. 1 only
b. 2 only
c. Both1 and 2.
d. Neither 1 nor 2.

196.

Which measure(s) is(are) useful in evaluating the efficiency in managing inventories?


1. Inventory turnover ratio
2. Days in inventory
a. 1 only
b. 2 only
c. Both 1 and 2
d. Neither 1 nor 2

197.

Which of these is not a liquidity ratio?


a. Current ratio.
b. Asset turnover ratio.
c. Inventory turnover ratio.
d. Receivables turnover ratio.

198.

Socrates Corporation reported net income $48,000; net sales $400,000; and average
assets $600,000 for 2007. What is the 2007 profit margin?
a. 6%.
b. 12%.
c. 40%.
d. 200%.

Financial Analysis: The Big Picture

13-33

Use the following information for questions 199-200.


Panza Corporation had net income of $250,000 and paid dividends to common stockholders of
$50,000 in 2007. The weighted average number of shares outstanding in 2007 was 50,000
shares. Panza Corporation's common stock is selling for $40 per share on the New York Stock
Exchange.
199. Panza Corporation's price-earnings ratio is
a. 2 times.
b. 8 times.
c. 10 times.
d. 5 times.
200.

Panza Corporation's payout ratio for 2007 is


a. $5 per share.
b. 25%.
c. 20%.
d. 12.5%.

201.

A successful discount retail store such as Kmart would probably have


a. a low inventory turnover.
b. a high inventory turnover.
c. zero profit margin.
d. low volume.

202.

Net sales are $3,000,000, beginning total assets are $1,400,000, and the asset turnover is
3.0 times. What is the ending total asset balance?
a. $1,000,000.
b. $600,000.
c. $1,400,000.
d. $800,000.

203.

The use of alternative accounting methods


a. is not a problem in ratio analysis because the footnotes disclose the method used.
b. may be a problem in ratio analysis even if disclosed.
c. is not a problem in ratio analysis since eventually all methods will lead to the same
end.
d. is only a problem in ratio analysis with respect to inventory.

204.

Which situation below might indicate a company has a low quality of earnings?
a. Revenue is recognized when earned.
b. Repair costs are capitalized and then depreciated.
c. The financial statements are prepared in accordance with generally accepted
accounting principles.
d. The same accounting principles are used each year.

205.

Which of the following ratios may be used to measure a companys quality of earnings?
a. Price-earnings ratio
b. Return on assets ratio
c. Current ratio
d. Times interest earned ratio

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

13-34
206

Which situation below might indicate a company has a low quality of earnings?
a. The same accounting principles are used each year.
b. Revenue is recognized when earned.
c. Maintenance costs are capitalized and then depreciated.
d. The financial statements are prepared in accordance with generally accepted
accounting principles.

Answers to Multiple Choice Questions


46.
47.
48.
49.
50.
51.
52.
53.
54.
55.
56.
57.
58.
59.
60.
61.
62.
63.
64.
65.
66.
67.
68.

b
d
d
a
b
d
c
c
b
a
c
b
b
d
c
b
d
a
d
d
d
b
b

69.
70.
71.
72.
73.
74.
75.
76.
77.
78.
79.
80.
81.
82.
83.
84.
85.
86.
87.
88.
89.
90.
91.

a
d
b
a
b
a
b
b
c
a
d
c
b
a
c
d
a
d
b
b
b
d
c

92.
93.
94.
95.
96.
97.
98.
99.
100.
101.
102.
103.
104.
105.
106.
107.
108.
109.
110.
111.
112.
113.
114.

c
b
d
c
d
b
c
a
a
b
a
c
b
d
a
b
c
c
c
a
c
d
b

115.
116.
117.
118.
119.
120.
121.
122.
123.
124.
125.
126.
127.
128.
129.
130.
131.
132.
133.
134.
135.
136.
137.

b
c
a
b
d
d
d
c
b
b
a
c
c
d
c
a
b
a
b
c
a
c
d

138.
139.
140.
141.
142.
143.
144.
145.
146.
147.
148.
149.
150.
151.
152.
153.
154.
155.
156.
157.
158.
159.
160.

d
d
c
b
d
c
c
b
b
d
c
c
b
b
b
b
c
c
b
d
c
c
b

161.
162.
163.
164.
165.
166.
167.
168.
169.
170.
171.
172.
173.
174.
175.
176.
177.
178.
179.
180.
181.
182.
183.

c
b
a
d
c
a
b
b
a
c
b
a
c
a
a
a
a
c
d
a
c
d
b

184.
185.
186.
187.
188.
189.
190.
191.
192.
193.
194.
195.
196.
197.
198.
199.
200.
201.
202.
203.
204.
205.
206

d
a
c
b
d
a
b
c
a
d
a
c
c
b
b
b
c
b
b
b
b
a
c

BRIEF EXERCISES
Be. 207
Listed below are some selected Items that may appear on a corporate income statement. Indicate
the order in which these items would appear on an income statement. (The first one should be
assigned the number 1, the second 2, etc.)
______
______
______
______
______
______

Extraordinary item
Income before income taxes
Discontinued operations
Net income
Income from continuing operations
Income tax expense

Financial Analysis: The Big Picture

Solution 207

13-35

(5-8 min.)

5
1
4
6
3
2
Be. 208
Indicate whether the following items would be reported as an ordinary or an extraordinary item in
Mariette Corporation's income statement.
(a)

Loss attributable to labor strike.

(b)

Gain on sale of fixed assets.

(c)

Loss from fire. Mariette is a chemical company.

(d)

Loss from sale of marketable securities.

(e)

Expropriation of property by a foreign government.

(f)

Loss from tornado damage. Mariette Corporation is located in the Midwest's tornado alley.

(g)

Loss from government condemnation of property through newly enacted law.

Solution 208
(a)
(b)
(c)
(d)
(e)
(f)
(g)

(6-9 min.)

ordinary
ordinary
ordinary
ordinary
extraordinary
ordinary
extraordinary

Be. 209
The Alley Company has income from continuing operations of $490,000 for the year ended
December 31, 2007. It also has the following items (before considering income taxes):
(1)

An extraordinary fire loss of $120,000.

(2)

A gain of $60,000 on the discontinuance of a major segment.

(3)

A cumulative effect of a change in accounting principle that resulted in an increase in prior


years' depreciation of $50,000.

Assume all items are subject to income taxes at a 30% tax rate.
Instructions
Prepare an income statement, beginning with income from continuing operations.

13-36

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Solution 209

(10-15 min.)
ALLEY COMPANY
Partial Income Statement
For the Year Ended December 31, 2007

Income from continuing operations.............................................................


Discontinued operations
Gain on discontinued segment, net of $18,000 income taxes............
Extraordinary item
Fire loss, net of $36,000 tax savings..................................................
Cumulative effect of change in accounting principle
Effect on prior years of change in depreciation method, net of
$15,000 income tax savings...........................................................
Net income..................................................................................................

$490,000
42,000
(84,000)
(35,000)
$413,000

Be. 210
An inexperienced accountant for Acorn Corporation showed the following in Acorns 2007 income
statement: Income before income taxes $300,000; Income tax expense $108,000; Extraordinary
loss from tornado (before taxes) $60,000; and Net income $132,000. The extraordinary loss and
taxable income are both subject to a 30% tax rate.
Instructions
Prepare a corrected income statement beginning with Income before income taxes.
Solution 210

(5-10 min.)
ACORN CORPORATION
Partial Income Statement

Income before income taxes.................................................................


Income tax expense ($300,000 30%).................................................
Income before extraordinary item..........................................................
Extraordinary loss from tornado, net of $18,000
($60,000 30%) tax savings...........................................................
Net income............................................................................................

$300,000
90,000
210,000
(42,000)
$168,000

Be. 211
Comparative information taken from the Fogerty Company financial statements is shown below:
(a)
(b)
(c)
(d)
(e)

Accounts receivable
Retained earnings
Sales
Operating expenses
Income taxes payable

2007
175,000
30,000
855,000
170,000
22,000

2006
140,000
(40,000)
750,000
200,000
20,000

Financial Analysis: The Big Picture

13-37

Instructions
Using horizontal analysis, show the percentage change from 2006 to 2007 with 2006 as the base
year.
Solution 211 (6-10 min.)
(a)
(b)
(c)
(d)
(e)

$35,000 $140,000 = 25% increase


Base year is negative. Not possible to compute.
$105,000 $750,000 = 14% increase
$30,000 $200,000 = 15% decrease
$2,000 $20,000 = 10% increase

Be. 212
The following items were taken from the financial statements of Flash, Inc., over a three-year
period:
Item
Net Sales
Cost of Goods Sold
Gross Profit

2007
$226,000
150,000
$ 76,000

2006
$212,000
140,000
$ 72,000

2005
$200,000
136,000
$ 64,000

Instructions
Using horizontal analysis and 2005 as the base year, compute the trend percentages for net
sales, cost of goods sold, and gross profit. Explain whether the trends are favorable or
unfavorable for each item.
Solution 212

(8-12 min.)

Item
Net Sales
Cost of Goods Sold
Gross Profit

2007
113%
110%
119%

2006
106%
103%
113%

2005
100%
100%
100%

The trend in net sales is increasing and favorable. The cost of goods sold trend is increasing,
which could be unfavorable, but the sales are increasing each year at a faster pace than cost of
goods sold. This is apparent by examining the gross profit percentages, which show a favorable,
increasing trend.

Be. 213
The following items were taken from the financial statements of Horace, Inc., over a three-year
period:
Item
Net Sales
Cost of Goods Sold
Gross Profit
Instructions

2007
$355,000
214,000
$141,000

2006
$336,000
206,000
$130,000

2005
$300,000
186,000
$114,000

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

13-38

Compute the following for each of the above time periods.


a. The amount and percentage change from 2005 to 2006.
b. The amount and percentage change from 2006 to 2007.
Solution 213

(5-9 min.)

Item

2007
$
19,000
8,000
11,000

Net Sales
Cost of Goods Sold
Gross Profit

Percent
5.6
3.9
8.5

2006
$___
Percent
36,000
12.0
20,000
10.8
16,000
14.0

Be. 214
Using these data from the comparative balance sheet of Luca Company, perform horizontal
analysis.
December 31, 2007
December 31, 2006
Accounts receivable
$ 500,000
$ 400,000
Inventory
780,000
600,000
Total assets
3,220,000
2,800,000
Solution 214

(5-10 min.)

Accounts receivable
Inventory
Total assets
*

$100,000
.25
$400,000

Dec. 31, 2007


$ 500,000
780,000
3,220,000
$180,000
.30
$600,000

Dec. 31, 2006


$ 400,000
600,000
2,800,000

Increase or (Decrease)
Amount
Percentage*
$100,000
25%
180,000
30%
420,000
15%

$420,000
.15
$2,800,000

Be. 215
If Parthenon Company had net income of $672,300 in 2007 and it experienced a 20% increase in
net income over 2006, what was its 2006 net income?
Solution 215

(5-10 min.)

Net Income
$672,300 X
X
.20X = $672,300 X
1.20X = $672,300
X = $560,250
.20

2007
$672,300

2006
X

Increase
20%

Financial Analysis: The Big Picture

13-39

Be. 216
Horizontal analysis (trend analysis) percentages for Vishnu Companys sales, cost of goods sold,
and expenses are listed here.
Horizontal Analysis
Sales
Cost of good sold
Expenses

2007
98.2%
102.5
108.6

2006
104.8%
98.0
96.4

2005
100.0%
100.0
100.0

Instructions
Explain whether Vishnus net income increased, decreased, or remained unchanged over the 3year period.
Solution 216

(5-10 min.)

Comparing the percentages presented results in the following conclusions: The net income for
Vishnu increased in 2006 because of the combination of an increase in sales and a decrease in
both cost of good sold and expenses. However, the reverse was true in 2007 as sales decreased,
while both cost of goods sold and expenses increased. This resulted in a decrease in net income.

Be. 217
Using the following selected items from the comparative balance sheet of Georgia Company,
illustrate horizontal and vertical analysis.
Accounts Receivable
Inventory
Total Assets
Solution 217

December 31, 2007


$ 670,000
450,000
3,200,000

December 31, 2006


$ 600,000
350,000
3,000,000

(8-12 min.)
HORIZONTAL ANALYSIS

Accounts Receivable
Inventory
Total Assets

December 31, 2007


112%
129%
107%

December 31, 2006


100%
100%
100%

VERTICAL ANALYSIS
Accounts Receivable
Inventory
Total Assets

December 31, 2007


21%
14%
100%

December 31, 2006


20%
12%
100%

13-40

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Be. 218
Using these data from the comparative balance sheet of Luca Company, perform vertical analysis.
December 31, 2007
$ 500,000
780,000
3,220,000

Accounts receivable
Inventory
Total assets
Solution 218

(5-10 min.)
Dec. 31, 2007
Amount
Percentage*
$ 500,000
15.5%
780,000
24.2%
3,220,000
100.0%

Accounts receivable
Inventory
Total assets
*

December 31, 2006


$ 400,000
600,000
2,800,000

$500,000
.155
$3,220,000
$780,000
.242
$3,220,000

**

Dec. 31, 2007


Amount
Percentage**
$ 400,000
14.3%
600,000
21.4%
2,800,000
100.0%

$400,000
.143
$2,800,000
$600,000
.214
$2,800,000

Be. 219
Vertical analysis (common-size) percentages for Wallace Companys sales, cost of goods sold,
and expenses are listed here.
Vertical Analysis
Sales
Cost of good sold
Expenses

2007
100.0%
59.2
26.5

2006
100.0%
62.4
27.4

2005
100.0%
64.5
28.5

Did Wallace Companys net income as a percent of sales increase, decrease, or remain
unchanged over the 3-year period? Provide numerical support for your answer.
Solution 219

(5-10 min.)

Sales
Cost of good sold
Expenses
Net income

2007
100.0
(59.2)
(26.5)
14.3

2006
100.0
(62.4)
(27.4)
10.2

2005
100.0
(64.5)
(28.5)
7.0

Net income as a percent of sales for Wallace increased over the three-year period because cost of
goods sold and expenses both decreased as a percent of sales every year.

Financial Analysis: The Big Picture

13-41

Be. 220
Selected information from the comparative financial statements of Bean Town Company for the
year ended December 31 appears below:
2007
2006
Accounts receivable (net)
$ 175,000
$200,000
Inventory
130,000
150,000
Total assets
1,100,000
800,000
Current liabilities
140,000
110,000
Long-term debt
410,000
300,000
Net credit sales
800,000
700,000
Cost of goods sold
600,000
530,000
Interest expense
40,000
25,000
Income tax expense
60,000
29,000
Net income
150,000
85,000
Net cash provided by operating activities
220,000
135,000
Instructions
Answer the following questions relating to the year ended December 31, 2007. Show computations.
1. The inventory turnover ratio for 2007 is __________.
2. The number of times interest earned ratio in 2007 is __________.
3. The receivables turnover ratio for 2007 is __________.
4. The return on assets ratio for 2007 is __________.
5. The current cash debt coverage ratio for 2007 is __________.
Solution 220

(10-15 min.)

$600,000
1. The inventory turnover ratio for 2007 is 4.3 times. = 4.3 times.
($130,000 + $150,000) 2
2. The number of times interest earned ratio in 2007 is 6.25 times.
$150,000 + $60,000 + $40,000
= 6.25 times.
$40,000
3. The receivables turnover ratio for 2007 is 4.3 times.
$ 800,000
= 4.3 times.
($175,000 + $200,000) 2
4. The return on assets ratio for 2007 is 15.8%.
$150,000
= 15.8%.
($1,100,000 + $800,000) 2
5. The current cash debt coverage ratio for 2007 is 1.76 times.
$220,000

13-42

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

= 1.76 times
($140,000 + $110,000) 2
Be. 221
Selected data for Natasha Store appear below.
Net sales
Cost of goods sold
Inventory at end of year
Accounts receivable at end of year

2007
$630,000
520,000
64,000
70,000

2006
$520,000
420,000
85,000
50,000

Instructions
Compute the following for 2007:
(a) Gross profit percentage
(b) Inventory turnover
(c) Receivables turnover
Solution 221
(a)

(6-10 min.)

Gross profit = Net Sales - Cost of goods sold


= $630,000 - $520,000
= $110,000
Gross profit percentage = Gross profit Net sales
= $110,000 $630,000
= 17.5%

(b)

Inventory turnover = Cost of goods sold Average inventory


= $520,000 [($64,000 + $85,000) 2]
= 6.98 times

(c)

Receivables turnover = Net credit sales Average accounts receivables


= $630,000 [($70,000 + $50,000) 2]
= $630,000 $60,000
= 10.5 times

Be. 222
Walton Corporation had the following comparative current assets and current liabilities:
Dec. 31, 2007
Dec. 31, 2006
Current assets
Cash
$ 25,000
$ 30,000
Marketable securities
40,000
10,000
Accounts receivable
60,000
95,000
Inventory
110,000
90,000
Prepaid expenses
35,000
20,000
Total current assets
$270,000
$245,000

Financial Analysis: The Big Picture

Current liabilities
Accounts payable
Salaries payable
Income tax payable
Total current liabilities
Be. 222 (cont.)

$120,000
40,000
10,000
$170,000

13-43

$110,000
30,000
15,000
$155,000

During 2007, net credit sales and cost of goods sold were $475,000 and $250,000, respectively.
Net cash provided by operating activities for 2007 was $120,000.
Instructions
Compute the following liquidity measures for 2007:
1. Current ratio
2. Current cash debt coverage ratio
3. Receivables turnover
4. Inventory turnover
Solution 222

(8-12 min.)

1. Current Ratio = Current Assets Current Liabilities


= $270,000 $170,000
= 1.6:1
Cash provided by operations
$120,000

Average current liabilities


($170,000 $155,000) 2
$120,000
=
= .74 times
$162,500

2. Current cash debt coverage ratio =

Net credit sales


$475,000
3. Receivables Turnover = =
Average accounts receivables ($60,000 + $95,000) 2
$475,000
= = 6.1 times
$77,500
4. Inventory Turnover

Cost of goods sold


$250,000
= =
Average inventory
($110,000 + $90,000) 2
$250,000
= = 2.5 times
$100,000

Be. 223
Selected data from the ONeal Company are presented below:
Total assets
$1,500,000
Average assets
1,700,000
Net income
275,000
Net sales
1,400,000

13-44

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Average common stockholders' equity


Net cash provided by operating activities

1,000,000
275,000

Instructions
Calculate the profitability ratios that can be computed from the above information.
Solution 223

(10-15 min.)

With the information provided, the profitability ratios that can be calculated are as follows:
1. Profit margin = Net income Net sales
= $275,000 $1,400,000
= 19.6%
2. Asset turnover = Net sales Average assets
= $1,400,000 $1,700,000
= .82 times
3. Return on assets = Net income Average assets
= $275,000 $1,700,000
= 16.2%
Net income
4. Return on common stockholders' equity =
Average common stockholders' equity
= $275,000 $1,000,000
= 27.5%

Be. 224
The following data are taken from the financial statements of Billy Company:
Average accounts receivable
Net sales on account
Terms for all sales are 2/10, n/30

2007
$ 530,000
5,600,000

2006
$ 550,000
5,200,000

Instructions
(a) Compute the accounts receivable turnover and the average collection period for both years.
(b) What conclusion can an analyst draw about the management of the accounts receivable?
Solution 224

(8-12 min.)

(a)
Accounts receivable turnover

2007

2006

$5,600,000

530,000

$5,200,000

550,000

10.6 times

9.5 times

Financial Analysis: The Big Picture

Average collection period

365 days

10.6 times

365 days

9.5 times

34.4 days

38.4 days

13-45

(b)

The receivables are turning faster in 2007 than they did in 2006. There is still a problem
since the normal credit period is 30 days, and the average collection period for both years
exceed this target. Therefore, improvement in the management of the receivables would
appear to be desirable.
Be. 225
State the effect of the following transactions on the current ratio. Use increase, decrease, or no
effect for your answer.
(a)

Collection of an accounts receivable

(b)

Declaration of cash dividends

(c)

Additional stock is sold for cash

(d)

Accounts payable are paid

(e)

Equipment is purchased for cash

(f)

Inventory purchases are made for cash

(g)

Temporary investments are purchased for cash

Solution 225
(a)
(b)
(c)
(d)
(e)
(f)
(g)

(7-11 min.)

no effect
decrease
increase
increase
decrease
no effect
no effect

Be. 226
The balance sheet for Prentice Corporation at the end of the current year includes the following:
Bonds payable, 6% .......................................................
6% Preferred stock, $100 par .......................................
Common stock, $10 par ................................................

$5,000,000
1,000,000
2,000,000

Income before income taxes was $950,000 and income tax expense for the current year
amounted to $285,000. Cash dividends paid on common stock were $200,000, and the common
stock was selling for $40 per share at the end of the year. There were no ownership changes
during the year.
Instructions
Determine each of the following:

13-46
(a)
(b)
(c)

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Number of times that bond interest was earned.


Earnings per share for common stock.
Price-earnings ratio.

Financial Analysis: The Big Picture

Solution 226
(a)

(b)

13-47

(6-12 min.)

Times interest earned =

Income before income taxes and interest expense

Interest expense

$950,000 + $300,000
=
$300,000

4.17 times

Net income - Preferred dividends


Earnings per share =
Weighted average common shares outstanding
$665,000 - $60,000
= $3.03 per share
200,000 shares

(c)

Market price per share


$40.00
Price-earnings ratio = = = 13.20 times
Earnings per share
$3.03

Be. 227
The income statement for the OverUnder Company for the year ended December 31, 2007,
appears below.
Sales
Cost of goods sold
Gross profit
Expenses
Net income

$670,000
390,000
280,000
180,000*
$100,000

*Includes $25,000 of interest expense and $20,000 of income tax expense.


Additional information:
1. Common stock outstanding on January 1, 2007, was 50,000 shares. On July 1, 2007, 10,000
more shares were issued.
2. The market price of OverUnder's stock was $18 at the end of 2007.
3. Cash dividends of $35,000 were paid, $5,000 of which were paid to preferred stockholders.
Instructions
Compute the following ratios for 2007:
(a) Earnings per share.
(b) Price-earnings.
(c) Times interest earned.

13-48

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Solution 227
(a)

(6-10 min.)

Earnings per share


$100,000 - $5,000
$95,000
= = $1.73
[50,000 + (10,000 2)]
55,000

(b)

Price-earnings
$18.00
= 10.4 times
1.73

(c)

Times interest earned


$100,000 + $25,000 + $20,000
= 5.8 times
$25,000

Be. 228
Selected data taken from the 2006 financial statements of trading card company Bottoms
Company, Inc. are as follows (in millions).
Net sales
Current liabilities, February 28, 2005
Current liabilities, February 28, 2006
Net cash provided by operating activities
Total liabilities, February 28, 2005
Total liabilities, February 28, 2006
Capital expenditures
Cash dividends

$295.9
39.5
47.5
23.0
64.2
71.2
2.6
6.5

Instructions
Compute these ratios at February 20, 2006:
(a) Current cash debt coverage ratio
(b) Cash debt coverage ratio
(c) Free cash flow
Provide a brief interpretation of your results.
Solution 228

(10-15 min.)

(a) Current cash debt coverage ratio =

Net cash provided by operating activities


Average current liabilities

$23.0
= .529 times
($39.5 $47.5) 2

Bottoms Company could cover (or pay) more than 52% of its current liabilities with cash
generated by operating activities.

Financial Analysis: The Big Picture

Solution 228
(b)

13-49

(cont.)

Cash debt coverage ratio =

Net cash provided by operating activities


Average toral liabilities

$23.0
= .34 times
($64.2 $71.2) 2

Bottoms Company could cover (or pay) about a third of its total liabilities with cash generated
by operating activities.
(c) Free cash flow = Cash provided by operating activities Capital expenditures Cash dividends
$13.9 = $23.0 $2.6 $6.5
Bottoms Company generated enough cash from operating activities to maintain its current
productive capacity and pay dividends. The free cash flow that remained could have been
used to expand operations, pay additional dividends, or reduce debt.

EXERCISES
Ex. 229
Dick Corporation had net income of $4,000,000 in 2005. Using 2005 as the base year, net income
decreased by 40% in 2006 and increased by 110% in 2007.
Instructions
Compute the net income reported by Dick Corporation for 2006 and 2007.
Solution 229

(8-12 min.)

2006: X $4,000,000 = 40%


X = $4,000,000 .40 = $1,600,000
The decrease is $1,600,000; therefore net income for 2006 is $2,400,000; ($4,000,000
$1,600,000).
2007: X $4,000,000 = 110%
X = $4,000,000 1.1 = $4,400,000
The increase is $4,400,000; therefore net income for 2007 is $8,400,000; ($4,000,000 +
$4,400,000).

13-50

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Ex. 230
The following items were taken from the financial statements of John, Inc., over a four-year period:
Item
Net Sales
Cost of Goods Sold
Gross Profit

2007
$725,000
530,000
$195,000

2006
$640,000
480,000
$160,000

2005
$575,000
435,000
$140,000

2004
$500,000
400,000
$100,000

Instructions
Using horizontal analysis and 2004 as the base year, compute the trend percentages for net
sales, cost of goods sold, and gross profit. Explain whether the trends are favorable or
unfavorable for each item.
Solution 230

(10-15 min.)

Item
Net Sales
Cost of Goods Sold
Gross Profit

2007
145%
133%
195%

2006
128%
120%
160%

2005
115%
109%
140%

2004
100%
100%
100%

The trend in net sales is increasing and favorable. The cost of goods sold trend is increasing
which could be unfavorable, but the sales are increasing each year at a faster pace than cost of
goods sold. This is apparent by examining the gross profit percentages, which show a favorable,
increasing trend.

Ex. 231
The comparative balance sheet of Stuart Company appears below:
STUART COMPANY
Comparative Balance Sheet
December 31,
____________________________________________________________________________
Assets
2007
2006
Current assets ......................................................................................
$ 340
$280
Plant assets ..........................................................................................
675
520
Total assets ....................................................................................
$1,015
$800
Liabilities and stockholders' equity
Current liabilities ...................................................................................
Long-term debt .....................................................................................
Common stock .....................................................................................
Retained earnings ................................................................................
Total liabilities and stockholders' equity ..........................................

$ 180
250
325
260
$1,015

$120
160
320
200
$800

Instructions
(a) Using horizontal analysis, show the percentage change for each balance sheet item using
2006 as a base year.

13-51

Financial Analysis: The Big Picture

(b)

Using vertical analysis, prepare a common size comparative balance sheet.

Solution 231

(14-19 min.)
STUART COMPANY
Comparative Balance Sheet
December 31,
2007
(b)

Assets
Current assets
Plant assets
Total assets
Liabilities and stockholders' equity
Current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and stockholders' equity

2006
(b)

Amount
$ 340
675
$1,015

Percent
33%
67
100%

$ 180
250
325
260
$1,015

18%
25
32
25
100%

(a)
Percentage
Amount Percent Change
$280
35%
21%
520
65
30%
$800
100%
27%
$120
160
320
200
$800

15%
20
40
25
100%

50%
56%
2%
30%
27%

Ex. 232
The following information was taken from the financial statements of Adam Company:
Gross profit on sales .................................................................
Income before income taxes .....................................................
Net income ...............................................................................
Net income as a percentage of net sales ..................................

2007
$700,000
230,000
160,000
12%

2006
$765,000
221,000
153,000
11%

Instructions
(a) Compute the net sales for each year.
(b) Compute the cost of goods sold in dollars and as a percentage of net sales for each year.
(c) Compute operating expenses in dollars and as a percentage of net sales for each year.
(Income taxes are not operating expenses).
Solution 232
(a)

(12-15 min.)

To calculate net sales, divide net income by the percentage of net income to net sales.
Net Sales

(b)

2007
$160,000 12% = $1,333,333

2006
$153,000 11% = $1,390,909

Using the net sales information from (a) and the gross profits given, it is possible to calculate
the cost of goods sold.
2007
2006
Net Sales
$1,333,333
$1,390,909

13-52

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Less: Gross profit


Cost of goods sold
% of net sales
Solution 232 (cont)
(c)
Gross profit
Less: Income before income taxes
Operating Expenses
% of net sales

700,000
$ 633,333

765,000
$ 625,909

47.5%

45%

2007
$700,000
230,000
$470,000

2006
$765,000
221,000
$544,000

35.3%

39.1%

Ex. 233
The financial statements of Kupps Company appear below:
KUPPS COMPANY
Comparative Balance Sheet
December 31,
____________________________________________________________________________
Assets
2007
2006
Cash ............................................................................................... $ 25,000
$ 40,000
Marketable securities ......................................................................
20,000
60,000
Accounts receivable (net) ...............................................................
40,000
30,000
Inventory ........................................................................................ 150,000
170,000
Property, plant and equipment (net) ............................................... 170,000
200,000
Total assets .............................................................................. $405,000
$500,000
Liabilities and stockholders' equity
Accounts payable ........................................................................... $ 25,000
Short-term notes payable ...............................................................
40,000
Bonds payable ................................................................................
75,000
Common stock ............................................................................... 175,000
Retained earnings ..........................................................................
90,000
Total liabilities and stockholders' equity..................................... $405,000

$ 30,000
90,000
160,000
145,000
75,000
$500,000

Financial Analysis: The Big Picture

13-53

KUPPS COMPANY
Income Statement
For the Year Ended December 31, 2007
Net sales ........................................................................................
Cost of goods sold ..........................................................................
Gross profit .....................................................................................
Expenses
Interest expense .......................................................................
Selling expenses ......................................................................
Administrative expenses ...........................................................
Total expenses ....................................................................
Income before income taxes ..........................................................
Income tax expense .......................................................................
Net income .....................................................................................

$360,000
184,000
176,000
$21,000
30,000
20,000
71,000
105,000
30,000
$ 75,000

Additional information:
a. Cash dividends of $50,000 were declared and paid in 2007.
b. Weighted-average number of shares of common stock outstanding during 2007 was 62,000
shares.
c. Market value of common stock on December 31, 2007, was $15 per share.
d. Net cash provided by operating activities for 2007 was $65,000.
Instructions
Using the financial statements and additional information, compute the following ratios for the
Kupps Company for 2007. Show all computations.
Computations
1.

Current ratio _________.

2.

Return on common stockholders' equity _________.

3.

Price-earnings ratio _________.

4.

Inventory turnover ratio _________.

5.

Receivables turnover _________.

6.

Times interest earned _________.

7.

Profit margin ratio _________.

8.

Average days in inventory _________.

9.

Payout ratio _________.

10.

Return on assets _________.

11.

Cash debt coverage ratio _________.

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

13-54

Solution 233

(15-20 min.)
$235,000
= 3.6
$65,000

1.

Current ratio 3:6.

2.

$75,000
Return on common stockholders' equity 30.93%. = .3093
($265,000 + $220,000) 2

3.

Price-earnings ratio 12.4 times.

$75,000
EPS = = $1.21
62,000
$15
= 12.4 times
$1.21

4. Inventory turnover ratio 1.15 times.

5.

Receivables turnover 10.3 times.

Solution 233

$184,000
= 1.15
($150,000 + $170,000) 2
$360,000
= 10.3
($40,000 + $30,000) 2

(cont.)

6.

Times interest earned 6 times.

$75,000 + $30,000 + $21,000


= 6
$21,000

7.

Profit margin ratio 20.8%.

$75,000
= .208
$360,000

8.

Average days in inventory 317.4 days.

9.

Payout ratio 67%.

$50,000
= .67
$75,000

10.

Return on assets 16.6%.

$75,000
= .166
($405,000 + $500,000) 2

11.

Cash debt coverage ratio .31 times.

365 days
= 317.4
1.15

$65,000
= .31
($140,000 + $280,000) 2

Ex. 234
The following ratios have been computed for Reit Company for 2007.
Profit margin ratio
Times interest earned
Receivable turnover ratio

20%
12 times
5 times

Acid-test ratio
Current ratio
Debt to total assets ratio

1.4:1
2.5:1
24%

Financial Analysis: The Big Picture

13-55

The 2007 financial statements for Reit Company with missing information follows:
REIT COMPANY
Comparative Balance Sheet
December 31,

Assets
2007
2006
Cash ......................................................................................... $ 25,000
$ 35,000
Marketable securities ................................................................
15,000
15,000
Accounts receivable (net) .........................................................
?
(6)
50,000
Inventory ...................................................................................
?
(8)
50,000
Property, plant, and equipment (net) ......................................... 200,000
160,000
Total assets ....................................................................... $
?
(9)
$310,000
Liabilities and stockholders' equity
Accounts payable ..................................................................... $
?
(7)
Short-term notes payable .........................................................
35,000
Bonds payable ..........................................................................
?
(10)
Common stock .......................................................................... 200,000
Retained earnings ....................................................................
47,000
Total liabilities and stockholders' equity.............................. $
?
(11)
Ex. 234 (cont.)

$ 25,000
30,000
20,000
200,000
35,000
$310,000

REIT COMPANY
Income Statement
For the Year Ended December 31, 2007

Net sales ..................................................................................


$200,000
Cost of goods sold ....................................................................
100,000
Gross profit................................................................................
100,000
Expenses:
Depreciation expense .........................................................
$ ?
(5)
Interest expense .................................................................
5,000
Selling expenses .................................................................
10,000
Administrative expenses .....................................................
15,000
Total expenses ..............................................................
?
(4)
Income before income taxes .....................................................
?
(2)
Income tax expense ............................................................
?
(3)
Net income ...............................................................................
$ ?
(1)
Instructions
Use the above ratios and information from the Reit Company financial statements to fill in the
missing information on the financial statements. Follow the sequence indicated. Show
computations that support your answers.

13-56

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Solution 234

(35-40 min.)

REIT COMPANY
Comparative Balance Sheet
December 31,

Assets
2007
2006
Cash ...................................................................................
$ 25,000
$ 35,000
Marketable securities ..........................................................
15,000
15,000
Accounts receivable (net) ...................................................
30,000 (6)
50,000
Inventory .............................................................................
55,000 (8)
50,000
Property, plant, and equipment (net) ...................................
200,000
160,000
Total assets .................................................................
$325,000 (9)
$310,000
Liabilities and stockholders' equity
Accounts payable ...............................................................
Short-term notes payable ....................................................
Bonds payable ....................................................................
Common stock ....................................................................
Retained earnings ...............................................................
Total liabilities and stockholders' equity........................

$ 15,000 (7)
35,000
28,000 (10)
200,000
47,000
$325,000 (11)

$ 25,000
30,000
20,000
200,000
35,000
$310,000

Financial Analysis: The Big Picture

Solution 234

13-57

(cont.)

REIT COMPANY
Income Statement
For the Year Ended December 31, 2007

Net sales .............................................................................


$200,000
Cost of goods sold ..............................................................
100,000
Gross profit..........................................................................
100,000
Expenses
Depreciation expense ...................................................
$15,000 (5)
Interest expense ...........................................................
5,000
Selling expenses ...........................................................
10,000
Administrative expenses ...............................................
15,000
Total expenses ........................................................
45,000 (4)
Income before income taxes ...............................................
55,000 (2)
Income tax expense ............................................................
15,000 (3)
Net income .........................................................................
$ 40,000 (1)
(1)

Net income = $40,000; ($200,000 20%).

(2)

Income before income taxes = $55,000.


Let X = Income before income taxes and interest expense.
X
= 12 times; X = $60,000; $60,000 - $5,000 = $55,000.
5,000

(3)

Income tax expense = $15,000; ($55,000 - $40,000).

(4)

Total operating expenses = $45,000; ($100,000 - $55,000).

(5)

Depreciation expense = $15,000; [$45,000 - ($5,000 + $10,000 + $15,000)].

(6)

Accounts receivable (net) = $30,000.


Let X = Average receivables.
$200,000
= 5 times; 5X = $200,000; X = $40,000.
X
Let Y = Accounts receivable at 12/31/07.
$50,000 + Y
= $40,000; $50,000 + Y = $80,000; Y = $30,000.
2

(7) Accounts payable = $15,000.


Let X = Current liabilities.
$25,000 + $15,000 + $30,000
= 1.4; 1.4X = $70,000; X = $ 50,000;
X
$50,000 - $35,000 = $15,000.
(8) Inventory = $55,000

13-58

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

Solution 234

(cont.)

Let X = Total current assets.


X
= 2.5; X = $125,000; $125,000 - ($25,000 + $15,000 + $30,000) = $55,000.
$50,000
(9) Total assets = $325,000

($25,000 + $15,000 + $30,000 + $55,000 + $200,000)

(10) Bonds payable = $28,000


Let X = Total debt
X
= 24%; X = $78,000; $78,000 - ($15,000 + $35,000) = $28,000.
$325,000
(11) Total liabilities and stockholders' equity = $325,000; same as total assetssee (9) above.

Ex. 235
Baltics Corporation has issued common stock only. The company has been successful and has a
gross profit rate of 20%. The information shown below was taken from the company's financial
statements.
Beginning inventory
Purchases
Ending inventory
Average accounts receivable
Average common stockholders' equity
Sales (all on credit)
Net income

$ 482,000
4,146,000
?
700,000
3,500,000
5,200,000
420,000

Instructions
Compute the following:
(a) Receivables turnover and the average number of days required to collect the accounts
receivable.
(b) The inventory turnover and the average days in inventory.
(c) Return on common stockholders' equity.
Solution 235
(a)

(13-18 min.)

Receivables turnover =
=
=
Average collection period

Credit sales

Average accounts receivable


$5,200,000 $700,000
7.4 times
=
=
=

365 days

Receivables turnover
365 7.4 times
49 days

Financial Analysis: The Big Picture

Solution 235
(b)

(cont.)

Inventory turnover = Cost of goods sold Average inventory


First calculate ending inventory.
Beginning Inventory
$ 482,000
+ Purchases
4,146,000
- Cost of Goods Sold
(4,160,000)*
Ending Inventory
$ 468,000
*Since the gross profit ratio is 20%, the cost of goods sold ratio is 80%.
80% $5,200,000 (net sales) = $4,160,000.
Ending Inventory = $468,000 (per above)
Average Inventory = ($482,000 + $468,000) 2 = $475,000
Inventory Turnover = $4,160,000 $475,000 = 8.8 times
Days in Inventory = 365 days 8.8 times = 41.5 days

(c)

Net income
Return on common stockholders' equity =
Average common stockholders' equity
$420,000 $3,500,000 = 12%

13-59

13-60

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

COMPLETION STATEMENTS
236. Discontinued operations refers to the disposal of a __________________ of a business.
237. The two criteria necessary for an item to be classified as an extraordinary item are that the
transaction or event must be (1) _______________ and (2) ________________.
238. A change in depreciation methods during the year would be classified as a change in
____________________.
239. ______________ analysis, also called trend analysis, is a technique for evaluating a series
of financial statement data over a period of time.
240. Expressing each item in a financial statement as a percent of a base amount is called
______________ analysis.
241. For analysis of the financial statements, ratios can be classified into three types:
(1)_____________ ratios, (2)_____________ ratios, and (3)______________ ratios.
242. The times interest earned ratio is calculated by dividing ___________________ before
__________________ and __________________ by interest expense.
243. The ratios used in evaluating a company's liquidity and short-term debt paying ability that
complement each other are the ______________ ratio and the ______________ ratio.
244. The receivables turnover ratio is calculated by dividing ________________ by average
___________________.
245. If the inventory turnover ratio is 5 times, and the average inventory was $600,000, the cost
of goods sold during the year was $______________ and the average days to sell the
inventory was ______________ days.
246. Gretle Corporation had net income for the year of $300,000 and a profit margin ratio of
25%. If total average assets were $200,000, the asset turnover ratio was ____________
times.
247. The ______________ ratio measures the percentage of earnings distributed in the form of
cash dividends.
248. The lower the _______________ to _______________ ratio, the more equity "buffer" is
available to the creditors if the company becomes insolvent.

Financial Analysis: The Big Picture

13-61

Answers to Completion Statements


236.
237.
238.
239.
240.
241.
242.

significant segment
unusual in nature, infrequent in occurrence
accounting principle
Horizontal
vertical (common size)
liquidity, solvency, profitability (any order)
income, income taxes, interest expense

243.
244.
245.
246.
247.
248.

current, acid-test (quick)


net credit sales, net receivables
3,000,000, 73
6
payout
debt, total assets

MATCHING
SET A
249.

For each of the ratios listed below, indicate by the appropriate code letter, whether it is a
liquidity ratio, a profitability ratio, or a solvency ratio.
Code:
L =
P =
S =

Liquidity ratio
Profitability ratio
Solvency ratio

____ 1. Price-earnings ratio


____ 2. Return on assets ratio
____ 3. Receivables turnover ratio
____ 4. Earnings per share ratio
____ 5. Payout ratio
____ 6. Current cash debt coverage ratio
____ 7. Current ratio
____ 8. Debt to total assets ratio
____ 9. Free cash flow
____ 10. Inventory turnover ratio

Answers to Matching
P

1. Price-earnings ratio

6. Current cash debt coverage ratio

2. Return on assets ratio

7. Current ratio

3. Receivables turnover ratio

8. Debt to total assets ratio

4. Earnings per share ratio

9. Free cash flow

5. Payout ratio

L 10.

Inventory turnover ratio

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

13-62

SET B
250.

Match the ratios with their formulas by entering the appropriate letter in the space provided.
A.
B.
C.
D.
E.

Current ratio
Current cash debt coverage ratio
Profit margin ratio
Asset turnover
Price-earnings ratio

F.
G.
H.
I.
J.

Times interest earned


Inventory turnover
Average collection period
Average days in inventory
Payout ratio

Cost of goods sold


____ 1.
Average inventory
Net income
____ 2.
Net sales
Cash dividends
____ 3.
Net income
Net sales
____ 4.
Average assets
Current assets
____ 5.
Current liabilities
365 days
____ 6.
Receivables turnover
Market price per share of stock
____ 7.
Earnings per share
365 days
____ 8.
Inventory turnover
Income before income taxes and interest expense
____ 9.
Interest expense
Cash provided by operations
____ 10.
Average current liabilities

Answers to Matching
1.
2.
3.
4.
5.

G
C
J
D
A

6.
7.
8.
9.
10.

H
E
I
F
B

Financial Analysis: The Big Picture

13-63

SHORT-ANSWER ESSAY QUESTIONS


S-A E 251
What issues must be considered when determining whether or not a loss from earthquake
destruction should be treated as an extraordinary item?
Solution 251
For the loss to be treated as extraordinary, the earthquake must be unusual and infrequently
occurring (not expected to recur in the foreseeable future, given the geographic area.)
S-A E 252
Manuel Mentirosa, the CEO of Mystical Products, is a successful entrepreneur but a poor student
of accounting. He asks you to explain to him, in a memo, the bases of comparison for ratio
analysis.
Solution 252
To:
Manuel Mentirosa
From: Student name
Re:
Bases of Comparison for Ratio Analysis
There are three bases of comparison for ratio analysis. They include:
Intra-company: This basis compares a ratio for the current year to the same ratio for one or more
prior years.
Inter-company: This basis compares a ratio for one company with the same ratio for one or more
competing companies.
Industry averages: This basis compares a ratio for a company with the industry average for the
same ratio.
S-A E 253
Horizontal and vertical analyses are analytical tools frequently used to analyze financial
statements. What type of information or insights can be obtained by using these two techniques?
Explain how the output of horizontal analysis and vertical analysis can be compared to industry
averages and/or competitive companies.
Solution 253
Horizontal analysis allows an analyst to develop a picture of current trends in a company's
operations. The analyst can see whether the account amounts are increasing or decreasing and
how large these changes actually are in comparison to a base year. Vertical analysis allows an

13-64

Test Bank for Financial Accounting: Tools for Business Decision Making, Fourth Edition

analyst to evaluate financial statement items within a single financial statement. This technique
helps the analyst to evaluate the relative size of the financial statement items and how the items
relate to the financial statement as a whole. An example would be if current liabilities were a very
large percentage of total liabilities and stockholders' equity.

Financial Analysis: The Big Picture

Solution 253

13-65

(cont.)

Both techniques allow an analyst to evaluate a companys performance and position relative to its
competitors and its industry as a whole. For example, the analyst could evaluate a companys
current trend in sales and see how favorably its sales performance compared to the sales
performance of other companies in the industry. Another example would be comparing the relative
size of long-term liabilities or retained earnings. This would show which companies have taken on
a large amount of debt and which companies have reinvested earnings.

S-A E 254

(Communication)

Overnight Delivery specializes in the overnight transportation of medical equipment and laboratory
specimens. The company has selected the following information from its most recent annual
report to be the subject of an immediate press release.

The financial statements are being released.


Net income this year was $3.1 million. Last year's net income had been $2.8 million.
The current ratio has changed to 2:1 from last year's 1.6:1.
The debt/total assets ratio has changed to 4:6 from last year's 3:6.
The company expanded its truck fleet substantially by purchasing ten new delivery vans.
The company already had twelve delivery vans. The company is now the largest medical
courier in the mid-Atlantic region.

Required:
Prepare a brief press release incorporating the above information. Include all information. Think
carefully which information (if any) is good news for the company, and which (if any) is bad news.
Solution 254
Overnight Delivery released its financial statements today, disclosing an 11% increase in earnings,
to $3.1 million from $2.8 million last year. The company also improved its short-term liquidity. Its
current ratio improved to 2:1 from last year's 1.6:1. Part of the improved performance is no doubt
due to the addition of ten new delivery vans to its fleet, allowing it to become the largest medical
courier in the mid-Atlantic region. The purchase of the vans, however, caused the debt/total assets
ratio to deteriorate. There are now $4 of debt for every $6 in assets, while last year, there were
only $3 of debt to $6 in assets.