Chapter 7: Introduction to Financial Statement Analysis
Chapter 7: Introduction to Financial Statement Analysis Key
1. Financial statement ratios alone provide direct indicators of good or poor management.
FALSE
2. The return from investing in the shares of common stock has two components: cash dividends and the change
in the market price of the common stock.
TRUE
3. Theoretical and empirical research has shown that the expected return from investing in a firm relates, in part,
to the expected profitability of the firm.
TRUE
4. Common shareholders have a residual claim on all income after creditors and preferred shareholders receive
amounts contractually owed them.
TRUE
5. When a firm has securities outstanding that, if exchanged for shares of common stock, would decrease basic
earnings per share by 30% or more, generally accepted accounting principles require a dual presentation: basic
earnings per share and diluted earnings per share.
FALSE
6. Three measures of profitability for a firm engaging in operations selling merchandise in its stores, to generate
net income are: (1) Rate of return on assets, (2) Rate of return on common shareholders’ equity, and (3)
Earnings per share of common stock.
TRUE
7. ROA has particular relevance to the lenders, or creditors, of a firm.
TRUE
8. The rate of return on common shareholders’ equity (ROCE) measures a firm’s performance in using and
financing assets to generate earnings.
TRUE
9. The term financial leverage describes financing with debt and preferred stock to increase the potential return
to the residual common shareholders’ equity.
TRUE
10. To study changes in ROA, the analyst can disaggregate ROA into the product of two other ratios: the profit
margin for ROA ratio and the total assets turnover ratio.
TRUE
11. In theory, the numerator of the accounts receivable turnover ratio should include only sales made on account
if the objective is to measure how quickly a firm collects its accounts receivable.
TRUE
12. The accounts receivable turnover ratio indicates how quickly a firm collects its accounts receivable.
FALSE
13. If the firm offers terms of “net 45 days,” a days receivable outstanding of 45 days indicates that the firm
handles accounts receivable well.
TRUE
14. Inventory turnover equals cost of goods sold divided by the average inventory during the period.
TRUE
15. Some analysts calculate the inventory turnover ratio by dividing sales, rather than cost of goods sold, by the
average inventory. Using sales in the numerator will lead to correct measures of the inventory turnover ratio for
calculating the average number of days that inventory is on hand until sale.
FALSE
16. Some analysts find the reciprocal of the fixed asset turnover ratio helpful in comparing the operating
characteristics of different firms, because it measures dollars of fixed assets required to generate one dollar of
sales.
TRUE
17. Total assets turnover reflects the effects of turnover ratios for accounts receivable, inventory, and fixed
assets.
TRUE
18. Four measures for assessing short-term liquidity risk are (1) Current ratio, (2) Quick ratio, (3) Cash flow
from operations to current liabilities ratio, and (4) Working capital turnover ratios.
TRUE
19. A quick ratio approximately one-half of the current ratio is typical, although this varies by industry.
TRUE
20. Most firms want to extend their payables as long as they can, but they also want to maintain their relations
with suppliers. Businesses, therefore, negotiate hard for favorable payment terms and then delay paying until just
before the last agreed moment.
TRUE
21. Analysts use measures of long-term liquidity risk to evaluate a firm’s ability to meet interest and principal
payments on long-term debt and similar obligations as they come due. If a firm cannot make the payments on
time, it becomes insolvent and may have to reorganize or liquidate.
TRUE
22. An analyst examines changes in a firm’s ratios over the three-year period—a so-called cross-section
analysis.
FALSE
23. Many analysts use a common-size balance sheet, which expresses each balance sheet item as a percentage of
total assets.
TRUE
24. As a practical matter, most firms report segment information by _____ indicating that most firms appear to
be organized on these same lines.
A. geographical markets
B. products and services
C. major customers
D. resource inputs
E. production methods
25. The typical first step in financial statement analysis and valuation (after selecting assumptions) is:
A. Understand the Purpose and Content of the Principal Financial Statements and Related Notes.
B. Identify the Industry Economic Characteristics and Firm’s Strategy.
C. Calculate and Interpret Profitability and Risk Ratios.
D. Prepare Pro Forma, or Projected, Financial Statements.
E. Value the Firm.
26. The typical last step in financial statement analysis and valuation (after selecting assumptions) is:
A. Understand the Purpose and Content of the Principal Financial Statements and Related Notes.
B. Identify the Industry Economic Characteristics and Firm’s Strategy.
C. Calculate and Interpret Profitability and Risk Ratios.
D. Prepare Pro Forma, or Projected, Financial Statements.
E. Value the Firm.
27. The typical steps in financial statement analysis and valuation include all of the following, except
A. obtain all published reports from other financial analysts.
B. identify the industry economic characteristics and firm’s strategy.
C. calculate and interpret profitability and risk ratios.
D. prepare pro forma, or projected financial statements.
E. value the firm.
28. The typical steps in financial statement analysis and valuation include(s):
A. value the firm.
B. identify the industry economic characteristics and firm’s strategy.
C. calculate and interpret profitability and risk ratios.
D. prepare pro forma, or projected financial statements.
E. all of the above.
29. The return from investing in the shares of common stock include(s):
A. change in the market price of the common stock.
B. cash dividends.
C. interest income.
D. choices a and b.
E. all of the above.
30. The value of common stock investments will likely change between the time the shares are purchased and
the time in the future when they are sold. The difference between the eventual selling price and the purchase
price, is often called
A. speculative returns.
B. enrichment.
C. inflation.
D. price appreciation (or price depreciation, if negative).
E. deflation.
31. What affect(s) the market price of common stock shares?
A. changes in international tensions
B. economy-wide factors
C. specific industry factors
D. changes in exchange rates
E. all of the above
32. Most individuals prefer _____ to _____ and they will want a _____ expected return if they purchase
common stock shares than if they invest in a certificate of deposit.
A. more risk; less risk; higher
B. less risk; more risk; higher
C. more risk; less risk; lower
D. less risk; more risk; lower
E. none of the above
33. Most financial statement analysis explores some aspect of a firm’s
A. profitability, only.
B. risk, only.
C. value, only.
D. profitability, or its risk, or both.
E. employee turnover.
34. Which of the following is/are limitations of ratio analysis?
A. use of acquisition cost for assets rather than current replacement cost or net realizable value
B. latitude firms have in selecting from among various generally accepted accounting principles
C. changes in many ratios correlate with each other
D. must recognize conditions that have changed between the periods being compared when comparing the size
of a ratio between periods for the same firm
E. all of the above
35. Ratios provide little information unless the analyst places them in a context. After calculating the ratios, the
analyst must compare them with some standard. Which of the following is/are possible standard(s)?
A. The planned ratio for the period.
B. The corresponding ratio during the preceding period for the same firm.
C. The corresponding ratio for a similar firm in the same industry.
D. The average ratio for other firms in the same industry.
E. All of the above are possible standards.
36. Ratios provide little information unless the analyst places them in a context. After calculating the ratios, the
analyst must compare them with some standard. Which of the following is not a possible standard?
A. The planned ratio for the period.
B. The corresponding ratio during the preceding period for the same firm.
C. The corresponding ratio for a similar firm in the same industry.
D. The average ratio for other firms in the same industry.
E. The corresponding ratio during the succeeding period for the same firm.
37. Measures of profitability for a firm engaging in operations selling merchandise in its stores to generate net
income do not include:
A. rate of return on assets.
B. rate of return on common shareholders’ equity.
C. earnings per share of common stock.
D. inventory turnover ratio.
E. none of the above.
38. The following ratio relates the results of operating performance to the investments (assets) of a firm without
regard to how the firm financed those investments.
Net Income + Interest Expense Net of Income Tax Savings
----------------------------------------------------------------------Average Total Assets
The ratio is called a rate of return on:
A. assets.
B. long-term investments.
C. shareholders’ equity.
D. net income.
E. net income and interest expense net of income tax savings.
39. The rate of return on assets relates the results of operating performance to the investments of a firm without
regard to how the firm financed those investments. The ratio is calculated as follows:
A. Net Income + Interest Expense Net of Income Tax Savings
----------------------------------------------------------------------Average Total Assets
B. Net Income
----------------------------------------------------------------------Average Total Assets
C. Net Income + Interest Expense
----------------------------------------------------------------------Average Total Assets
D. Net Income + Interest Expense Net of Income Tax Savings
----------------------------------------------------------------------Ending Total Assets
E. Net Income
----------------------------------------------------------------------Ending Total Assets
40. Analysis of the Return on Assets has particular relevance to the
A. lenders.
B. employees.
C. lower-level managers.
D. government regulators.
E. unions.
41. A firm computes ROA, profit margin for ROA, and total assets turnover for each segment using the segment
disclosures. The amounts for these ratios computed at a segment level differ from those at a corporate level for
which of the following reason(s)?
A. The numerator of ROA at a firm-wide level includes all revenues and expenses except interest expense net of
taxes, whereas the numerator of ROA using the segment data includes operating revenues and expenses only.
B. The denominator of ROA at a firm-wide level is the average of assets at the beginning and end of the year,
whereas total assets at the end of the year are used in computing segment ROAs.
C. The denominator of ROA at a firm-wide level is the total assets at the end of the year, whereas the average of
assets at the beginning and end of the year, are used in computing segment ROAs.
D. choices a and b
E. choices a and c
42. The calculation of Rate of Return on Common Shareholders’ Equity (ROCE) is as follows:
Rate of Return on Common = Shareholders’ Equity
A.
Net Income - Dividends on Preferred Stock
--------------------------------------------------Ending Common Shareholders’ Equity
B.
Net Income
--------------------------------------------------Average Common Shareholders’ Equity
C.
Net Income + Dividends on Preferred Stock
--------------------------------------------------Average Common Shareholders’ Equity
D.
Net Income - Dividends on Preferred Stock
--------------------------------------------------Average Common Shareholders’ Equity
E.
Net Income + Dividends on Preferred Stock
--------------------------------------------------Ending Common Shareholders’ Equity
43. The capital provided by common shareholders during the period include(s):
A. the average par value of common stock.
B. capital contributed in excess of par value on common stock.
C. retained earnings.
D. other common shareholders’ equity accounts.
E. all of the above.
44. The capital provided by common shareholders during the period used for calculating the return on common
equity equals
A. the average par value of common stock, capital contributed in excess of par value on common stock, retained
earnings, and any other common shareholders’ equity accounts for the period.
B. average preferred shareholders’ equity less average total shareholders’ equity.
C. the ending par value of common stock, capital contributed in excess of par value on common stock, retained
earnings, and any other common shareholders’ equity accounts for the period.
D. ending preferred shareholders’ equity less ending total shareholders’ equity.
E. choices a and b
45. ROCE will exceed ROA whenever ROA exceeds the after-tax cost of borrowing plus any dividends required
for preferred shareholders. Which of the following is/are true?
A. The bond holders earn a higher return, but they undertook more risk in their investment.
B. The preferred shareholders earn a lower return, but they undertook more risk than the common shareholders
in their investment.
C. The common shareholders earn a higher return, but they undertook more risk in their investment.
D. Using lower-cost borrowed funds and then earning a rate of return on those funds higher than their cost
increases the return to the common shareholders.
E. Choices c and d.
46. ROCE disaggregates into the following components:
A. Profit Margin for ROCE Ratio x Inventory Turnover Ratio x Debt Ratio
B. Profit Margin for ROCE Ratio x Total Assets Turnover Ratio x Debt Ratio
C. Profit Margin for ROCE Ratio x Inventory Turnover Ratio x Capital Structure Leverage Ratio
D. Profit Margin for ROCE Ratio x Total Assets Turnover Ratio x Capital Structure Leverage Ratio
E. Profit Margin x Total Assets Turnover Ratio x Debt Ratio
47. The term _____ describes financing with debt and preferred stock to increase the potential return to the
residual common shareholders’ equity.
A. trading on the debt
B. trading on the equity
C. financial leverage
D. equity financing
E. none of the above
48. The capital structure leverage ratio indicates
A. the sales generated from each dollar of assets.
B. the portion of the sales dollar left over for the common shareholders after covering all operating costs and
subtracting claims of creditors and preferred shareholders.
C. the portion of the sales dollar left over for the preferred shareholders after covering all operating costs and
subtracting claims of creditors and common shareholders.
D. the proportion of total assets, or total financing, provided by common shareholders contrasted with the
financing provided by creditors and preferred shareholders.
E. the proportion of total assets, or total financing, provided by preferred shareholders contrasted with the
financing provided by creditors and common shareholders.
49. The higher the capital structure leverage ratio, the _____ is the proportion of financing that common
shareholders provide and the _____ is the proportion that creditors and preferred shareholders provide. Thus, the
_____ the capital structure leverage ratio, the _____ is financial leverage.
A. higher; lower; higher; higher
B. lower; higher; higher; higher
C. higher; lower; higher; lower
D. lower; higher; higher; lower
E. lower; higher; lower; lower
50. If the rate of return on assets for the year is 15%, a general interpretation of the ratio would be
A. the assets generated $0.15 cash per dollar of cash invested.
B. 15% of the assets produced income while the remainder were at break-even for the year.
C. before payment for use of capital, $0.15 was earned for each dollar of assets used by the company.
D. dividends of $0.15 per share were paid.
E. before payment for use of capital, $0.15 was earned for each dollar of cash used by the company.
51. Rate of return on common shareholders' equity (ROCE)
A. measures a firm's performance in using and financing assets to generate earnings and explicitly considers
financing costs.
B. a measure of profitability that incorporates the results of operating, investing, and financing activities.
C. equals net income (less dividends on preferred stock, if any) divided by average common shareholders' equity.
D. all of the above
E. none of the above
52. A small leverage ratio may indicate that a company is
A. well managed.
B. financed with a relatively large amount of common shareholders' equity.
C. financed with a relatively large number of shares of common and preferred stock.
D. financed with a relatively large amount of debt.
E. financed with a relatively large amount of debt and preferred stock.
53. Which of the following ratios is not a measure of profitability?
A. rate of return on assets
B. rate of return on common stockholders' equity
C. earnings per share of common stock
D. rate of return on preferred stockholders' equity
E. all of the above
54. Which ratio measures a firm's performance in using assets to generate earnings independent of how the firm
financed acquisition of those assets?
A. rate of return on assets
B. rate of return on common stockholders' equity
C. earnings per share of common stock
D. rate of return on preferred stockholders' equity
E. none of the above
55. The numerator of the rate of return on common shareholders' equity
A. is the amount of earnings assignable to common shareholders' equity after subtracting all amounts required to
compensate other providers of financing for the use of their funds.
B. subtracts from net income any earnings allocable to preferred stock equity, usually the dividends on preferred
stock declared during the period.
C. does not subtract the dividends on common stock because such dividends represent distributions to common
shareholders of a portion of the returns generated for them during the period.
D. all of the above
E. none of the above
56. The rate of return on common shareholders' equity
A. will exceed the rate of return on assets whenever the rate of return on assets exceeds the after-tax cost of
borrowing and any dividends required for preferred shareholders.
B. will not exceed the rate of return on assets whenever the rate of return on assets exceeds the after-tax cost of
borrowing and any dividends required for preferred shareholders.
C. will always exceed the rate of return on assets.
D. will never exceed the rate of return on assets.
E. none of the above
57. Using lower cost borrowed funds and earning a higher rate of return on those funds than their cost
A. increases the return to the common shareholders.
B. is a phenomenon called financial leverage.
C. requires the common shareholders to take on more risk in their investment.
D. all of the above
E. none of the above
58. Financial leverage
A. may increase the return to the common shareholders.
B. uses lower cost borrowed funds and earns a higher rate of return on those funds than their cost.
C. requires the common shareholders to take on more risk in their investment.
D. all of the above
E. none of the above
59. Financial leverage
A. increases the return to the common shareholders during good earnings years.
B. uses lower cost borrowed funds to earn a higher rate of return on those funds than their cost.
C. decreases the return to the common shareholders during bad earnings years.
D. all of the above
E. none of the above
60. The rate at which accounts receivable turnover
A. indicates how quickly a firm collects cash.
B. equals sales revenue divided by average accounts receivable.
C. is often expressed in terms of the average number of days that elapse between the time the firm makes the
sale and the time it later collects the cash.
D. all of the above
E. none of the above
61. Igor Corporation's accounts receivable, net of allowance for uncollectibles, were $250,000 at December 31,
Year 3, and $350,000 at December 31, Year 4. Net cash sales for Year 4 were $300,000. The accounts receivable
turnover was 6.0. Igor's net sales for Year 4 were
A. $1,500,000
B. $1,800,000
C. $2,000,000
D. $2,100,000
E. $2,200,000
62. The capital structure leverage ratio
A. indicates the portion of total assets, or total financing, provided by common shareholders contrasted with the
financing provided by creditors and preferred shareholders.
B. is larger when there is more financial leverage.
C. is smaller when there is less financial leverage.
D. all of the above
E. none of the above
63. To study changes in ROA, the analyst can disaggregate ROA into the product of two other ratios:
A. the gross profit for ROA ratio and the total assets turnover ratio.
B. the profit margin for ROA ratio and the inventory turnover ratio
C. the gross margin for ROA ratio and the inventory turnover ratio.
D. the profit margin for ROA ratio and the total assets turnover ratio
E. the gross margin for ROA ratio and the total assets turnover ratio.
64. What is calculated as follows?
?
=
Profit Margin for ROA
(before interest expense
and related income
tax savings) Ratio
x
Total Assets
Turnover
Ratio
A. return on net assets
B. return on sales margin
C. return on gross margin
D. return on assets
E. return on net income
65. To calculate the amount of net income assignable to common shareholders’ equity, the analyst does not
A. subtract all amounts required to compensate other providers of financing for the use of their funds.
B. make any further adjustment for interest.
C. subtract from net income any earnings allocable to preferred stock equity usually the dividends on preferred
stock declared during the period.
D. subtract dividends on common stock.
E. none of the above
66. The profit margin ratio for ROCE indicates
A. the sales generated from each dollar of assets.
B. the portion of the sales dollar left over for the common shareholders after covering all operating costs and
subtracting claims of creditors and preferred shareholders.
C. the portion of the sales dollar left over for the preferred shareholders after covering all operating costs and
subtracting claims of creditors and common shareholders.
D. the proportion of total assets, or total financing, provided by common shareholders contrasted with the
financing provided by creditors and preferred shareholders.
E. the proportion of total assets, or total financing, provided by preferred shareholders contrasted with the
financing provided by creditors and common shareholders.
67. The total assets turnover ratio indicates
A. the sales generated from each dollar of assets.
B. the portion of the sales dollar left over for the common shareholders after covering all operating costs and
subtracting claims of creditors and preferred shareholders.
C. the portion of the sales dollar left over for the preferred shareholders after covering all operating costs and
subtracting claims of creditors and common shareholders.
D. the proportion of total assets, or total financing, provided by common shareholders contrasted with the
financing provided by creditors and preferred shareholders.
E. the proportion of total assets, or total financing, provided by preferred shareholders contrasted with the
financing provided by creditors and common shareholders.
68. The rate which indicates how quickly a firm collects cash is the _____ turnover ratio.
A. cash
B. accounts receivable
C. sales receipts
D. inventory
E. asset
69. The _____ turnover ratio equals sales revenue divided by average accounts receivable during the period.
A. cash
B. accounts receivable
C. sales receipts
D. sales revenue
E. asset
70. The rate at which _____ turn(s) over measures how quickly a firm collects cash.
A. accounts receivable
B. assets turnover
C. inventory
D. accounts payable
E. notes receivable
71. The accounts receivable turnover ratio equals
A. profit margin divided by average accounts receivable at the end of the period.
B. gross margin divided by average accounts receivable at the end of the period.
C. sales revenue divided by ending accounts receivable at the end of the period.
D. sales revenue divided by average accounts receivable during the period.
E. gross margin divided by average accounts receivable during the period.
72. Most firms that sell to other businesses, as opposed to consumers, sell on account and collect within 30 to 90
days. Interpreting any particular firm’s accounts receivable turnover and days receivable outstanding requires
knowing the terms of sale. If a firm’s terms of sale are “net 30 days” and the firm collects its accounts receivable
in 45 days, then the
A. collections are not in accord with the stated terms.
B. situation warrants a review of the credit and collection activity to ascertain the cause.
C. situation warrants a review of the credit and collection activity to guide corrective action.
D. situation indicates that the firm handles accounts receivable well.
E. choices a, b and c
73. The _____ ratio indicates how fast firms sell their inventory items, measured in terms of the rate of
movement of goods into and out of the firm.
A. asset turnover
B. inventory turnover
C. asset
D. inventory
E. cost of goods sold
74. Managing inventory turnover involves balancing which of the following consideration(s) in setting the
optimum level of inventory and, thus, the rate of inventory turnover?
A. For a given amount of gross margin on the goods, firms prefer to sell as many goods as possible with a
minimum of assets tied up in inventories.
B. An increase in the rate of inventory turnover between periods indicates reduced costs of financing the
investment in inventory.
C. Management does not want to have so little inventory on hand that shortages result in lost sales.
D. Increases in the rate of inventory turnover caused by inventory shortages could signal a loss of customers.
E. All of the above.
75. Some analysts calculate the inventory turnover ratio by dividing sales, rather than cost of goods sold, by the
average inventory. Which of the following regarding the inventory turnover ratio is/are not true?
A. Using sales in the numerator, will lead to incorrect measures of the inventory turnover ratio for calculating the
average number of days that inventory is on hand until sale.
B. As long as the ratio of selling price to cost of goods sold remains relatively constant, either measure will
identify changes in the trend of the inventory turnover ratio.
C. Using sales in the numerator, will lead to correct measures of the inventory turnover ratio for calculating the
average number of days that inventory is on hand until sale.
D. Choices a and b.
E. None of the above.
76. _____ measures the amount of sales generated from a particular level of investments in fixed assets.
A. Fixed asset ratio
B. Fixed asset turnover ratio
C. Asset ratio
D. Fixed asset ratio
E. Inventory turnover ratio
77. Which of the following could affect(s) the fixed asset turnover ratio?
A. Firms often invest in fixed assets several periods before these assets generate sales from products
manufactured in their plants or sold in their stores.
B. A low or decreasing rate of fixed asset turnover may indicate expanding firms preparing for future growth.
C. Firms anticipating a decline in product sales could cut back expenditures on fixed assets and increase the
fixed asset turnover ratio.
D. All of the above.
E. None of the above.
78. Analysts deciding between investments must consider the comparative risks. Which of the following factors
affect the risk of business firms?
A. Economy-wide factors, such as increased inflation or interest rates, unemployment, and recessions.
B. Industry-wide factors, such as increased competition, lack of availability of raw materials, changes in
technology, and increased government regulatory actions, such as anti-trust or clean environment policies.
C. Firm-specific factors, such as labor strikes, loss of facilities due to fire or other casualty, and poor health of
key managerial personnel.
D. The amount of liquid resources available to the firm to run smoothly and effectively.
E. all of the above
79. Analysts deciding between investments must consider the comparative risks. Which of the following is/are
economy-wide factors that affect the risk of business firms?
A. increased inflation
B. increased interest rates
C. unemployment
D. recessions
E. all of the above
80. Analysts deciding between investments must consider the comparative risks. Which of the following is/are
not economy-wide factors that affect the risk of business firms?
A. increased inflation
B. increased interest rates
C. unemployment
D. recessions
E. increased competition
81. Analysts deciding between investments must consider the comparative risks. Which of the following
is/areindustry-wide factors that affect the risk of business firms?
A. increased competition
B. increased government regulatory actions, such as anti-trust or clean environment policies
C. changes in technology
D. lack of availability of raw materials
E. all of the above
82. Analysts deciding between investments must consider the comparative risks. Which of the following is/are
not industry-wide factors that affect the risk of business firms?
A. increased competition
B. increased government regulatory actions, such as anti-trust or clean environment policies
C. changes in technology
D. lack of availability of raw materials
E. increased inflation
83. Analysts deciding between investments must consider the comparative risks. Which of the following
is/arefirm-specific factors that affect the risk of business firms?
A. labor strikes
B. loss of facilities due to fire
C. poor health of key managerial personnel
D. loss of facilities due to earthquake
E. all of the above
84. Analysts deciding between investments must consider the comparative risks. Which of the following is/are
not firm-specific factors that affect the risk of business firms?
A. labor strikes
B. loss of facilities due to fire
C. poor health of key managerial personnel
D. loss of facilities due to earthquake
E. unemployment
85. Measures for assessing short-term liquidity risk include all of the following except:
A. current ratio.
B. quick ratio.
C. cash flow from operations to current liabilities ratio.
D. working capital turnover ratios.
E. price earnings ratio.
86. The current ratio equals
A. current assets plus current liabilities.
B. current assets minus current liabilities.
C. current assets multiplied by current liabilities.
D. current assets divided by current liabilities.
E. current liabilities minus current assets.
87. The current ratio indicates a firm’s ability to meet its short-term obligations. Analysts prefer a current ratio
that at least exceeds
A. .5
B. 1.0
C. 2.0
D. 3.0
E. 4.0
88. Management can take deliberate steps to produce a financial statement that presents a better current ratio at
the balance sheet date than the average, or normal, current ratio during the rest of the year. Analysts refer to
such actions as window dressing:
A. near the end of its accounting period a firm might delay normal purchases on account.
B. hasten the collections of a loan receivable, classified as noncurrent assets, and use the proceeds to reduce
current liabilities.
C. near the end of its accounting period a firm might accelerate normal purchases on account.
D. hasten the collections of a loan receivable, classified as current assets, and use the proceeds to reduce longterm liabilities.
E. choices a and b.
89. What ratio(s) customarily include(s) in the numerator cash, marketable securities, and accounts receivable,
with the denominator including all current liabilities?
A. current ratio
B. noncurrent ratio
C. acid test ratio
D. quick ratio
E. choices c and d
90. Healthy mature firms typically have a cash flow from operations to current liabilities ratio of:
A. 10% or more.
B. 20% or more.
C. 30% or more.
D. 40% or more.
E. 50% or more.
91. The accounts payable turnover ratio uses purchases on account in its computation. Although firms do not
disclose their purchases, the analyst can calculate the purchase amount as follows:
A. Purchases = Cost of Goods Sold + Ending Inventory + Beginning Inventory
B. Purchases = Cost of Goods Sold + Ending Inventory - Beginning Inventory
C. Purchases = Cost of Goods Sold - Ending Inventory + Beginning Inventory
D. Purchases = Cost of Goods Sold - Ending Inventory - Beginning Inventory
E. Purchases = Cost of Goods Sold x Ending Inventory - Beginning Inventory
92. Analysts use measures of long-term _____ to evaluate a firm’s ability to meet interest and principal
payments on long-term debt and similar obligations as they come due. If a firm cannot make the payments on
time, it becomes insolvent and may have to reorganize or liquidate.
A. insolvency factors
B. reorganization factors
C. liquidity risk
D. insolvency risk
E. cash flow risk
93. In assessing the debt ratios, analysts customarily vary the standard in relation to the stability of the firm’s
earnings and cash flows from operations. Public utilities have liabilities to assets ratios frequently on the order of
A. 0% to 10%.
B. 10% to 20%.
C. 30% to 40%.
D. 60% to 70%.
E. 90% to 100%.
94. In assessing the debt ratios, analysts customarily vary the standard in relation to the stability of the firm’s
earnings and cash flows from operations. Banks have liabilities to assets ratios, typically
A. over 10%.
B. over 30%.
C. over 50%.
D. over 70%.
E. over 90%.
95. A mature, financially healthy company typically has a cash flow from operations to total liabilities ratio of
A. 5% or more.
B. 20% or more.
C. 45% or more.
D. 70% or more.
E. 90% or more.
96. The fixed asset turnover ratio
A. measures the relation between sales and the investment in fixed assets such as property, plant, and equipment.
B. measures the amount of sales generated from a particular level of investments in fixed assets.
C. is calculated by dividing sales by the average fixed assets for the period.
D. all of the above.
E. none of the above.
97. The accounts payable turnover ratio can reveal
A. the result of sales divided by average working capital.
B. the number of days in the operating cycle.
C. the length of the operating cycle in order to compare it with industry averages.
D. the number of days that a firm's accounts payable remain outstanding.
E. none of the above.
98. During Year 2, Lamar Corporation purchased $600,000 of merchandise inventory. The cost of sales for year
2 was $660,000 and the ending merchandise inventory at December 31, Year 2 was $60,000. What was the
inventory turnover for Year 2?
A. 8.0
B. 7.3
C. 6.6
D. 6.0
E. 6.7
99. Selected data from Carson Corporation's financial statements for the year ended December 31, Year 2 are as
follows.
Current ratio
Quick ratio
Current liabilities
Accounts receivable turnover
Merchandise inventory turnover
Rate of return on assets
1.4
0.86
$450,000
6.0
4.0
6.5%
Selected Account Balances at December 31, Year 1:
Accounts receivable
Merchandise inventory
$355,000
190,000
Year 2 Operations
Sales
Cost of goods sold
$1,241,000
800,000
Assuming that prepaid expenses are immaterial, ending merchandise inventory at December 31, Year 2 is
A. $180,000
B. $210,000
C. $220,000
D. $240,000
E. $260,000
100. Why might a firm use the quick ratio instead of the current ratio in its liquidity analysis?
A. It wants to target long-term debt instead of short term debt.
B. Its accounts receivable are greater than its cash.
C. Its inventory is not very liquid.
D. It considers the cash flow amount in the quick ratio more important than the other liquidity ratios.
E. Its notes receivable are greater than its cash.
101. Ramer Company and Matson Company
Assume the following information for Ramer Company, Matson Company, and for their common industry for a
recent year.
Current ratio
Accounts receivable turnover
Inventory turnover
Interest coverage ratio
Debt-equity ratio
Return on investment
Dividend payout ratio
Earnings per share
Ramer
3.50
5.00
6.20
9.00
0.70
0.15
0.80
$3.00
Matson
2.80
8.10
8.00
12.30
0.40
0.12
0.60
$ 2.00
Industry Average
3.00
6.00
6.10
10.40
0.55
0.15
0.55
-
(CMA adapted, Jun 90 #19) Regarding the data for Ramer Company and Matson Company, which one of the following is correct if both companies
have the same total assets and the same sales?
A. Ramer has more cash than Matson.
B. Ramer has fewer current liabilities than Matson.
C. Matson has less shareholders' equity than Ramer.
D. Matson has a shorter operating cycle than Ramer.
E. None of the above is correct.
102. Ramer Company and Matson Company
Assume the following information for Ramer Company, Matson Company, and for their common industry for a
recent year.
Current ratio
Accounts receivable turnover
Inventory turnover
Interest coverage ratio
Debt-equity ratio
Return on investment
Dividend payout ratio
Earnings per share
Ramer
3.50
5.00
6.20
9.00
0.70
0.15
0.80
$3.00
Matson
2.80
8.10
8.00
12.30
0.40
0.12
0.60
$ 2.00
Industry Average
3.00
6.00
6.10
10.40
0.55
0.15
0.55
-
(CMA adapted, Jun 90 #18) Regarding the data for Ramer and Matson Company, if a company is profitable and is effectively using leverage, which
one of the following ratios is likely to be the largest?
A. return on total assets
B. return on operating assets
C. return on common equity
D. return on investment
E. none of the above
103. (CMA adapted, Jun 90 #21) Regarding the information for Ramer Company and Matson Company, assume
that some of the ratios and data for Ramer and Matson are affected by income taxes. Assuming no interperiod
income tax allocation, which of the following items would be directly affected by income taxes for the period?
A. debt-equity ratio and dividend payout ratio
B. current ratio and debt-equity ratio
C. return on investment and earnings per share
D. interest coverage ratio and current ratio
E. none of the above
104. (CMA adapted, Jun 90 #20) Regarding the data for Ramer Company and Matson Company, the attitudes of
both Ramer and Matson concerning risk are best explained by the
A. current ratio, accounts receivable turnover, and inventory turnover.
B. return on investment and dividend payout ratio.
C. current ratio and earnings per share.
D. debt-equity ratio and interest coverage ratio.
E. none of the above.
105. (CMA adapted, Dec 93 #17) Norton Inc. has a 2 to 1 current ratio. This ratio would increase to more than
2 to 1 if
A. a previously declared stock dividend were distributed.
B. the company wrote off an uncollectible receivable.
C. the company sold merchandise on open account that earned a normal gross margin.
D. the company purchased inventory on open account.
E. none of the above.
106. Mother's Company has current assets of $900,000 and current liabilities of $1,000,000. Mother's
Company's current ratio would be increased by
A. borrowing $100,000 on a line-of-credit (short-term loan).
B. purchase of merchandise inventory costing $100,000 cash.
C. purchase of marketable equity securities for $100,000 cash.
D. paying $100,000 of wages payable.
E. none of the above.
107. A measure of short-term debt paying ability is a company's
A. return on shareholders' equity.
B. return on assets.
C. quick ratio.
D. profit margin ratio.
E. none of the above.
108. (CMA adapted, Dec 87 #1) When a balance sheet amount is related to an income statement amount in
computing a ratio,
A. the balance sheet amount should be converted to an average for the year.
B. the income statement amount should be converted to an average for the year.
C. both amounts should be converted to market value.
D. the ratio loses its historical perspective because a beginning-of-the-year amount is combined with an end-ofthe-year amount.
E. none of the above.
109. King Products Corporation
King Products Corporation
Statement of Financial Position
(in thousands)
June 30
Cash
Marketable securities (at market)
Accounts receivable (net)
Inventories (at lower of cost or market)
Prepaid items
Total current assets
Long-term investments (at cost)
Land (at cost)
Building (net)
Equipment (net)
Patents (net)
Goodwill (net)
Total long-term assets
Total assets
Notes payable
Accounts payable
Accrued interest
Total current liabilities
Notes payable, 10% due 12/31/Year 12
Bonds payable, 12% due 6/30/Year 15
Total long-term debt
Total liabilities
Preferred stock-5% cumulative, $100 par, non-participating, authorized, issued and
outstanding, 2,000 shares
Common stock-$10 par, 40,000 shares authorized, 30,000 shares issued and outstanding
Additional paid-in capital--common
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 6
$ 60
40
90
120
30
$ 340
50
150
160
190
70
40
$ 660
$1,000
$ 46
94
30
$ 170
20
30
$ 50
$ 220
200
Year 5
$ 50
30
60
100
40
$280
40
150
180
200
34
26
$630
$910
$ 24
56
30
$110
20
30
$ 50
$160
200
300
150
130
$ 780
$1,000
300
150
100
$750
$910
King Products Corporation
Income Statement
For the year ended June 30
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 6
$600
440
60
10
$ 90
45
$ 45
(CMA adapted, Dec 96 #15) Refer to the King Products Corporation example. King Products Corporation's inventory turnover for the fiscal year
ended at June 30, Year 6, was
A. 3.7
B. 4.0
C. 4.4
D. 5.0
E. none of the above
110. King Products Corporation
King Products Corporation
Statement of Financial Position
(in thousands)
June 30
Cash
Marketable securities (at market)
Accounts receivable (net)
Inventories (at lower of cost or market)
Prepaid items
Total current assets
Long-term investments (at cost)
Land (at cost)
Building (net)
Equipment (net)
Patents (net)
Goodwill (net)
Total long-term assets
Total assets
Notes payable
Accounts payable
Accrued interest
Total current liabilities
Notes payable, 10% due 12/31/Year 12
Bonds payable, 12% due 6/30/Year 15
Total long-term debt
Total liabilities
Preferred stock-5% cumulative, $100 par, non-participating, authorized, issued and
outstanding, 2,000 shares
Common stock-$10 par, 40,000 shares authorized, 30,000 shares issued and outstanding
Additional paid-in capital--common
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 6
$ 60
40
90
120
30
$ 340
50
150
160
190
70
40
$ 660
$1,000
$ 46
94
30
$ 170
20
30
$ 50
$ 220
200
Year 5
$ 50
30
60
100
40
$280
40
150
180
200
34
26
$630
$910
$ 24
56
30
$110
20
30
$ 50
$160
200
300
150
130
$ 780
$1,000
300
150
100
$750
$910
King Products Corporation
Income Statement
For the year ended June 30
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 6
$600
440
60
10
$ 90
45
$ 45
(CMA adapted, Dec 96 #16) Refer to the King Products Corporation example. King Products Corporation's accounts receivable turnover for the fiscal
year ended at June 30, Year 6, was
A. 4.9
B. 5.9
C. 6.7
D. 8.0
E. none of the above
111. King Products Corporation
King Products Corporation
Statement of Financial Position
(in thousands)
June 30
Cash
Marketable securities (at market)
Accounts receivable (net)
Inventories (at lower of cost or market)
Prepaid items
Total current assets
Long-term investments (at cost)
Land (at cost)
Building (net)
Equipment (net)
Patents (net)
Goodwill (net)
Total long-term assets
Total assets
Notes payable
Accounts payable
Accrued interest
Total current liabilities
Notes payable, 10% due 12/31/Year 12
Bonds payable, 12% due 6/30/Year 15
Total long-term debt
Total liabilities
Preferred stock-5% cumulative, $100 par, non-participating, authorized, issued and
outstanding, 2,000 shares
Common stock-$10 par, 40,000 shares authorized, 30,000 shares issued and outstanding
Additional paid-in capital--common
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 6
$ 60
40
90
120
30
$ 340
50
150
160
190
70
40
$ 660
$1,000
$ 46
94
30
$ 170
20
30
$ 50
$ 220
200
Year 5
$ 50
30
60
100
40
$280
40
150
180
200
34
26
$630
$910
$ 24
56
30
$110
20
30
$ 50
$160
200
300
150
130
$ 780
$1,000
300
150
100
$750
$910
King Products Corporation
Income Statement
For the year ended June 30
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 6
$600
440
60
10
$ 90
45
$ 45
(CMA adapted, Dec 96 #17) Refer to the King Products Corporation example. King Products Corporation's average collection period for the fiscal
year ended at June 30, Year 6, using a 360-day year, was.
A. 36 days
B. 45 days
C. 54 days
D. 61 days
E. none of the above
112. King Products Corporation
King Products Corporation
Statement of Financial Position
(in thousands)
June 30
Cash
Marketable securities (at market)
Accounts receivable (net)
Inventories (at lower of cost or market)
Prepaid items
Total current assets
Long-term investments (at cost)
Land (at cost)
Building (net)
Equipment (net)
Patents (net)
Goodwill (net)
Total long-term assets
Total assets
Notes payable
Accounts payable
Accrued interest
Total current liabilities
Notes payable, 10% due 12/31/Year 12
Bonds payable, 12% due 6/30/Year 15
Total long-term debt
Total liabilities
Preferred stock-5% cumulative, $100 par, non-participating, authorized, issued and
outstanding, 2,000 shares
Common stock-$10 par, 40,000 shares authorized, 30,000 shares issued and outstanding
Additional paid-in capital--common
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 6
$ 60
40
90
120
30
$ 340
50
150
160
190
70
40
$ 660
$1,000
$ 46
94
30
$ 170
20
30
$ 50
$ 220
200
Year 5
$ 50
30
60
100
40
$280
40
150
180
200
34
26
$630
$910
$ 24
56
30
$110
20
30
$ 50
$160
200
300
150
130
$ 780
$1,000
300
150
100
$750
$910
King Products Corporation
Income Statement
For the year ended June 30
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 6
$600
440
60
10
$ 90
45
$ 45
(CMA adapted, Dec 96 #18) Refer to the King Products Corporation example. King Products Corporation's quick (acid test) ratio at June 30, Year 6,
was
A. 0.6
B. 1.1
C. 1.8
D. 2.0
E. none of the above
113. Devlin Company
Devlin Company
Statement of Financial Position
as of May 31
(in thousands)
Assets
Current assets
Cash
Trading securities
Accounts receivable (net)
Inventories
Prepaid expenses
Total current assets
Investments, at equity
Property, plant, and equipment (net)
Intangible assets (net)
Total assets
Liabilities and shareholders' equity
Current liabilities
Notes payable
Accounts payable
Accrued expenses
Income taxes payable
Total current liabilities
Long-term debt
Deferred taxes
Total liabilities
Shareholders' equity
Preferred stock, 6%, $100 par value, cumulative
Common stock, $10 par value
Additional paid-in capital-common stock
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 7
Year 6
$ 45
30
68
90
22
$255
38
375
80
$748
$ 38
20
48
80
30
$216
30
400
45
$691
$ 35
70
5
15
125
35
3
$163
$ 18
42
4
16
80
35
2
$117
150
225
114
96
$585
$748
150
195
100
129
$574
$691
Devlin Company
Income Statement
For the year ended May 31
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 7
$480
Year 6
$460
330
52
315
51
8
$ 90
36
$ 54
9
$ 85
34
$ 51
(CMA adapted, Jun 97 #13) Refer to the Devlin Company example. Devlin Company's acid-test ratio at May 31, Year 7, was
A. 0.60 to 1
B. 0.90 to 1
C. 1.14 to 1
D. 1.86 to 1
E. 2.14 to 1
114. Devlin Company
Devlin Company
Statement of Financial Position
as of May 31
(in thousands)
Assets
Current assets
Cash
Trading securities
Accounts receivable (net)
Inventories
Prepaid expenses
Total current assets
Investments, at equity
Property, plant, and equipment (net)
Intangible assets (net)
Total assets
Liabilities and shareholders' equity
Current liabilities
Notes payable
Accounts payable
Accrued expenses
Income taxes payable
Total current liabilities
Long-term debt
Deferred taxes
Total liabilities
Shareholders' equity
Preferred stock, 6%, $100 par value, cumulative
Common stock, $10 par value
Additional paid-in capital-common stock
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 7
Year 6
$ 45
30
68
90
22
$255
38
375
80
$748
$ 38
20
48
80
30
$216
30
400
45
$691
$ 35
70
5
15
125
35
3
$163
$ 18
42
4
16
80
35
2
$117
150
225
114
96
$585
$748
150
195
100
129
$574
$691
Devlin Company
Income Statement
For the year ended May 31
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 7
$480
Year 6
$460
330
52
315
51
8
$ 90
36
$ 54
9
$ 85
34
$ 51
(CMA adapted, Jun 97 #14) Refer to the Devlin Company example. Assuming there are no preferred stock dividends in arrears, Devlin Company's
return on common shareholders' equity for the year ended May 31, Year 7, was
A. 6.3 percent
B. 7.5 percent
C. 7.8 percent
D. 10.5 percent
E. 15.5 percent
115. Devlin Company
Devlin Company
Statement of Financial Position
as of May 31
(in thousands)
Assets
Current assets
Cash
Trading securities
Accounts receivable (net)
Inventories
Prepaid expenses
Total current assets
Investments, at equity
Property, plant, and equipment (net)
Intangible assets (net)
Total assets
Liabilities and shareholders' equity
Current liabilities
Notes payable
Accounts payable
Accrued expenses
Income taxes payable
Total current liabilities
Long-term debt
Deferred taxes
Total liabilities
Shareholders' equity
Preferred stock, 6%, $100 par value, cumulative
Common stock, $10 par value
Additional paid-in capital-common stock
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 7
Year 6
$ 45
30
68
90
22
$255
38
375
80
$748
$ 38
20
48
80
30
$216
30
400
45
$691
$ 35
70
5
15
125
35
3
$163
$ 18
42
4
16
80
35
2
$117
150
225
114
96
$585
$748
150
195
100
129
$574
$691
Devlin Company
Income Statement
For the year ended May 31
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 7
$480
Year 6
$460
330
52
315
51
8
$ 90
36
$ 54
9
$ 85
34
$ 51
(CMA adapted, Jun 97 #18) Refer to the Devlin Company example. Devlin Company's times interest earned for the year ended May 31, Year 7, was
A. 6.75 times
B. 11.25 times
C. 12.25 times
D. 18.75 times
E. 20.75 times
116. Devlin Company
Devlin Company
Statement of Financial Position
as of May 31
(in thousands)
Assets
Current assets
Cash
Trading securities
Accounts receivable (net)
Inventories
Prepaid expenses
Total current assets
Investments, at equity
Property, plant, and equipment (net)
Intangible assets (net)
Total assets
Liabilities and shareholders' equity
Current liabilities
Notes payable
Accounts payable
Accrued expenses
Income taxes payable
Total current liabilities
Long-term debt
Deferred taxes
Total liabilities
Shareholders' equity
Preferred stock, 6%, $100 par value, cumulative
Common stock, $10 par value
Additional paid-in capital-common stock
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 7
Year 6
$ 45
30
68
90
22
$255
38
375
80
$748
$ 38
20
48
80
30
$216
30
400
45
$691
$ 35
70
5
15
125
35
3
$163
$ 18
42
4
16
80
35
2
$117
150
225
114
96
$585
$748
150
195
100
129
$574
$691
Devlin Company
Income Statement
For the year ended May 31
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 7
$480
Year 6
$460
330
52
315
51
8
$ 90
36
$ 54
9
$ 85
34
$ 51
(CMA adapted, Jun 97 #15) Refer to the Devlin Company example. Devlin Company's inventory turnover for the year ended May 31, Year 7, was
A. 3.67 times
B. 3.88 times
C. 5.33 times
D. 5.65 times
E. 5.95 times
117. Devlin Company
Devlin Company
Statement of Financial Position
as of May 31
(in thousands)
Assets
Current assets
Cash
Trading securities
Accounts receivable (net)
Inventories
Prepaid expenses
Total current assets
Investments, at equity
Property, plant, and equipment (net)
Intangible assets (net)
Total assets
Liabilities and shareholders' equity
Current liabilities
Notes payable
Accounts payable
Accrued expenses
Income taxes payable
Total current liabilities
Long-term debt
Deferred taxes
Total liabilities
Shareholders' equity
Preferred stock, 6%, $100 par value, cumulative
Common stock, $10 par value
Additional paid-in capital-common stock
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 7
Year 6
$ 45
30
68
90
22
$255
38
375
80
$748
$ 38
20
48
80
30
$216
30
400
45
$691
$ 35
70
5
15
125
35
3
$163
$ 18
42
4
16
80
35
2
$117
150
225
114
96
$585
$748
150
195
100
129
$574
$691
Devlin Company
Income Statement
For the year ended May 31
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 7
$480
Year 6
$460
330
52
315
51
8
$ 90
36
$ 54
9
$ 85
34
$ 51
(CMA adapted, Jun 97 #16) Refer to the Devlin Company example. Devlin Company's asset turnover for the year ended May 31, Year 7, was
A. 0.08 times
B. 0.46 times
C. 0.67 times
D. 0.73 times
E. 0.93 times
118. Devlin Company
Devlin Company
Statement of Financial Position
as of May 31
(in thousands)
Assets
Current assets
Cash
Trading securities
Accounts receivable (net)
Inventories
Prepaid expenses
Total current assets
Investments, at equity
Property, plant, and equipment (net)
Intangible assets (net)
Total assets
Liabilities and shareholders' equity
Current liabilities
Notes payable
Accounts payable
Accrued expenses
Income taxes payable
Total current liabilities
Long-term debt
Deferred taxes
Total liabilities
Shareholders' equity
Preferred stock, 6%, $100 par value, cumulative
Common stock, $10 par value
Additional paid-in capital-common stock
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
Year 7
Year 6
$ 45
30
68
90
22
$255
38
375
80
$748
$ 38
20
48
80
30
$216
30
400
45
$691
$ 35
70
5
15
125
35
3
$163
$ 18
42
4
16
80
35
2
$117
150
225
114
96
$585
$748
150
195
100
129
$574
$691
Devlin Company
Income Statement
For the year ended May 31
(in thousands)
Net sales
Costs and expenses
Cost of goods sold
Selling, general, and administrative
Interest expense
Income before taxes
Income taxes
Net income
Year 7
$480
Year 6
$460
330
52
315
51
8
$ 90
36
$ 54
9
$ 85
34
$ 51
(CMA adapted, Jun 97 #17) Refer to the Devlin Company example. Devlin Company's rate of return on assets for the year ended May 31, Year 7,
was
A. 7.2 percent
B. 7.5 percent
C. 8.2 percent
D. 11.2 percent
E. 11.9 percent
119. A firm desires to increase its ratio of cash flow from operations divided by average current liabilities from
its anticipated level of 30 percent for the coming year to a more desirable level of 40 percent. Which of the
following actions is consistent with this increase?
A. increase short-term bank borrowing
B. decrease the number of days that accounts receivable are outstanding
C. decrease the number of days accounts payable are outstanding
D. increase the number of days inventories are held
E. none of the above
120. A steel manufacturer experienced a decrease in its fixed asset turnover from .9 in Year 5 to .7 in Year 6.
This change is consistent with which of the following explanations?
A. The firm sold a fully-depreciated factory on January 1, Year 6 that had been closed in Year 4 and held for sale
since then.
B. The steel industry operated at capacity during Year 6, permitting all firms to raise selling prices.
C. The firm recognized an impairment loss on a factory that became obsolete during Year 6 because of new
environmental regulations.
D. The firm decreased the number of units produced and sold because of an inability to obtain needed raw
materials.
E. none of the above
121. Inventory turnover ratio
A. indicates how fast firms sell their inventory items.
B. measured in terms of the rate of movement of goods into and out of the firm.
C. equals cost of goods sold divided by the average inventory during the period.
D. all of the above
E. none of the above
122. Various techniques are used in the analysis of financial data to emphasize the comparative and relative
importance of data presented and to evaluate the position of the firm. These techniques include(s)
A. ratio analysis.
B. common-size analysis.
C. examination of relative size among firms.
D. all of the above.
E. none of the above.
123. A common-sized income statement permit(s)
A. analysis of changes or differences in relations between revenues, expenses, and net income.
B. identification of relations that the analyst should explore further.
C. analysis of changes or differences in relations between assets, liabilities, and shareholders' equity.
D. both choices a and b.
E. both choices a and c.
124. Comparing firms using a common-size balance sheet rests on the assumption that
A. the size or scale of a business does not affect the relation between a given balance sheet item and total assets.
B. the size or scale of a business does affect the relation between a given balance sheet item and total assets.
C. the large purchaser can negotiate better terms, including lower per-unit prices.
D. more negotiating power would appear on the large purchaser’s balance sheet as proportionately smaller
amounts reported for inventory relative to the amounts reported by a smaller purchaser with less negotiating
power.
E. more negotiating power would appear on the large purchaser’s balance sheet as proportionately larger
amounts reported for accounts payable relative to the amounts reported by a smaller purchaser with less
negotiating power.
125. A common-size income statementpermits an analysis of changes or differences in the relations between
revenues, expenses, and net income and identifies relations that the analyst should explore further, such as
A. time series analysis.
B. economic analysis.
C. cross-section analysis.
D. both choices a and c.
E. both choices b and c.
126. Concerning the analysis of financial data to emphasize the comparative and relative importance of data
presented and to evaluate the position of the firm, it is important to take into consideration
A. the nature of the general business environment.
B. direct competition in a company's geographical area.
C. special situations not encountered throughout the industry.
D. all of the above.
E. none of the above.
127. Many firms sell to customers on account as a strategy to stimulate sales. Comparing accounts receivable
turnovers over time or between firms requires an analysis of
A. the growth rate in sales.
B. the amount of interest revenue generated.
C. the cost of administering the credit-granting activity.
D. the losses from uncollectible accounts.
E. all of the above.
128. An analyst examines changes in a firm’s various ratios over a three-year period—a so-called _____ analysis
and performs a _____ analysis comparing a given firm’s ratios with those of other firms for a specific period.
A. cross-section; time-series
B. time-series; cross-section
C. profitability; time-series
D. time-series; profitability
E. none of the above
129. The preparation of pro forma financial statements typically begins with the _____, followed by the _____
and then the _____.
A. balance sheet; income statement; statement of cash flows
B. statement of cash flows; income statement; balance sheet
C. income statement; balance sheet; statement of cash flows
D. income statement; statement of cash flows; balance sheet
E. balance sheet; statement of cash flows; income statement
130. What is the first step in preparing pro forma financial statements?
A. Project operating revenues.
B. Project operating expenses other than the cost of financing and income taxes.
C. Project the assets required to support the level of projected operating activity.
D. Project the financing (liabilities and contributed capital) required to fund the level of assets.
E. Project the cost of financing the debt, income tax expense, net income, dividends, and the change in retained
earnings.
131. What is the last step in preparing pro forma financial statements?
A. Project the statement of cash flows from amounts on the projected balance sheet and income statement.
B. Project operating revenues and operating expenses other than the cost of financing and income taxes.
C. Project the assets required to support the level of projected operating activity.
D. Project the financing (liabilities and contributed capital) required to fund the level of assets.
E. Project the cost of financing the debt, income tax expense, net income, dividends, and the change in retained
earnings.
132. Why would a firm prepare pro forma financial statements?
A. to ascertain whether operations will generate sufficient cash flows to finance expenditures on long-term assets
or whether the firm will need to borrow more
B. to analyze the effect of a change its product lines or pricing policies and the impact on rates of return.
C. to project future financial statement amounts for an acquisition target to ascertain the price it should pay
D. all of the above
E. none of the above
133. The traditional use of the term _____ financial statements refers to projected financial statements based on
some set of assumptions about the future. One set of assumptions might be that historical patterns (for example,
growth rates or rates of return) will continue.
A. what-if
B. estimated
C. planned
D. pro forma
E. future
134. The analysis of business transactions is facilitated by
A. reconciliation of bank balances at the end of the reporting period.
B. good internal controls and performing daily cash reconciliation.
C. developing an electronic spreadsheet showing the transactional effects.
D. maintaining a written copy of all invoices and receipts of the company for a period of at least 7 years.
E. None of these answer choices is correct.
135. In a modern corporate environment, the trial balance is prepared from the
A. financial statements.
B. computerized accounting systems.
C. journals.
D. subsidiary ledgers.
E. chart of accounts.
136. Ratio analysis is one tool management may use to examine a firm's profitability and risk. Another tool often
used by management are pro forma financial statements.
Required:
a.
b.
Describe the purpose of pro forma financial statements.
Describe how pro forma financial statements may be constructed.
a.
b.
The purpose of pro forma financial statements is to examine the impact potential management plans and assumptions may have on the
accounts within the statements. They are often future oriented, though based on past financial information and assumed relationships that
remain stable.
Constructing pro forma financial statements begins with an articulated plan or set of assumptions that management would like to explore.
Such plans may include raising the sales price of the firm's product or increasing advertising. The most recent period's financial statements,
often beginning with the income statement (operating revenues and expenses), are then altered to reflect the potential plans or altered
assumptions. The balance sheet is then changed to reflect the new information, as well as the remaining items on the income statement that
reflect financing changes. A pro forma statement of cash flows may then be created to reflect the cash flow implications of the plans or
assumptions. Management can then compare the pro forma statements (and ratios built from these statements) with its plans or assumptions
to test their viability.
137. For each of the following independent situations, suggest what ratio would provide appropriate information
to answer the question.
a.
b.
c.
d.
e.
f.
g.
h.
You need to determine the number of days outstanding for accounts receivable.
You are considering investing in bonds of a publicly held company. You wish to analyze the possibility of the company failing to meet
required interest payments.
You wish to measure and compare a firm's performance in using assets independent of the financing of the assets to the industry average.
You wish to assess a company's ability to meet immediate liabilities in an emergency.
You would like to determine how much capital is provided by common shareholders.
You wish to understand how long inventory remains on hand during the period.
You are considering how much additional long-term debt a company may be able to take on.
You are interested in how productive a company's fixed assets have been.
a.
b.
c.
d.
e.
f.
g.
h.
Accounts receivable turnover ratio or number of days’ sales in receivables
Interest coverage ratio
Rate of return on assets
Quick ratio
Leverage ratio
Days inventory held or inventory turnover ratio
Long-term debt ratio
Fixed asset turnover ratio
138. Indicate the effects (increase, decrease, no effect) of the following independent transactions on (1) the profit
margin ratio, (2) the plant asset turnover, and (3) the inventory turnover.
a.
b.
c.
d.
Payment of various repair expenses
Purchase of inventory on account
Purchase of equipment
Payment of bonds payable
Profit Margin
Ratio
__________
__________
__________
__________
Plant Asset
Turnover
__________
__________
__________
__________
Inventory
Turnover
__________
__________
__________
__________
a.
b.
c.
d.
Profit Margin
Ratio
Decrease
No effect
No effect
No effect
Payment of various repair expenses
Purchase of inventory on account
Purchase of equipment
Payment of bonds payable
Plant Asset
Turnover
No effect
No effect
Decrease
No effect
Inventory
Turnover
No effect
Decrease
No effect
No effect
139. For each of the following independent situations, solve for the unknown amount.
Current ratio
Quick ratio
Current liabilities
Current assets
Highly liquid assets
A. 0.375
B. 0.43
C. 200
D. 216
CASE A
A
0.2
400
150
80
CASE B
1.14
B
175
200
75
CASE C
2.0
1.0
100
C
100
CASE D
0.67
0.60
360
240
D
140. Use the following comparative balance sheet to compute ratios as requested.
Buff Company
COMPARATIVE BALANCE SHEET
As of December 31, Year 1 and Year 2
Assets
Current assets
Cash
Accounts receivable
Merchandise inventory
Total Current assets
Property, plant, and equipment
Building
Total Assets
Liabilities and Shareholders' Equity
Current liabilities
Advance from customer
Accounts payable
Rent payable
Utilities payable
Salaries payable
Total Current liabilities
Shareholders' Equity
Common stock, 2,000 shares
Additional paid-in capital
Retained earnings
Total Shareholders' equity
Total Liabilities and shareholders' equity
Year 2
Year 1
$10,000
6,000
20,000
$36,000
$ 5,000
4,000
15,000
$24,000
30,000
$66,000
30,000
$54,000
$ 400
1,000
2,000
200
1,000
$ 4,600
$ 500
1,000
1,500
200
800
$ 4,000
5,000
40,000
16,400
61,400
$66,000
5,000
40,000
5,000
50,000
$54,000
Compute the following ratios at year end for Year 2 for Buff Company:
a.
b.
c.
d.
Long-term debt ratio
Debt-equity ratio
Current ratio
Leverage ratio
Assume that a bank loans $10,000 cash (due in 5 years) to the company on December 31, Year 2. Make the appropriate adjustments to the financial
statements and compute the following ratios:
e.
f.
g.
h.
a.
b.
c.
d.
e.
f.
g.
h.
Long-term debt ratio
Debt-equity ratio
Current ratio
Leverage ratio
0
7.49%
7.8
1.077
14%
19.2%
10
1.16
= 0 / (61,400 + 0)
= 4,600 / 61,400
= 36,000 / 4,600
= ((54,000 + 66,000)/2) / ((50,000 + 61,400)/2)
= 10,000 / (61,400 + 10,000)
= 14,600 / 76,000
= 46,000 / 4,600
= ((54,000 + 76,000)/2) / ((50,000 + 61,400)/2)
141. Given the following information for the Siri Company, calculate the ratios as requested.
December 31,
Year 1
$100,000
400,000
50,000
300,000
100,000
50,000
Current assets
Noncurrent assets
Current liabilities
Long-term debt
Common stock, 10,000 shares
Retained earnings
Year 2
$ 100,000
40,000
30,000
1,000,000
Net income
Interest expense
Income taxes
Total revenues
a.
b.
c.
a.
b.
c.
December 31,
Year 2
$150,000
500,000
100,000
300,000
100,000
150,000
Interest coverage ratio
Long-term debt ratio at December 31, Year 2
Total assets turnover
4.25
54.5%
1.74
= (100,000 + 40,000 + 30,000) / 40,000
= 300,000 / 550,000
= 1,000,000 / ((500,000 + 650,000)/2)
142. The financial statements of the Poston Company appear below. Calculate the following ratios:
a.
b.
c.
d.
e.
f.
g.
h.
Rate of return on assets
Rate of return on common shareholders' equity
Earnings per share of common stock
Current ratio (both dates)
Cash flow from operations to current liabilities
Long-term debt ratio (both dates)
Cash flow from operations to total liabilities
Interest coverage
Current assets
Noncurrent assets
Current liabilities
Long-term liabilities
Common stock, 10,000 shares
Retained earnings
January 1
$180,000
255,000
85,000
30,000
300,000
20,000
December 31
$210,000
275,000
78,000
75,000
300,000
32,000
Operations
Net income
Interest expense
Income taxes (30 percent rate)
Cash provided by operations
Dividends declared
a.
b.
c.
d.
e.
f.
g.
h.
$84,000
3,000
36,000
30,970
72,000
$84,000 + (1-0.30)$3,000 / 0.5($435,000 + $485,000) = 18.7 percent
$84,000 / 0.5($320,000 + $332,000) = 25.8 percent
$84,000 / 10,000 shares = $8.40 per share
January 1 $180,000 / $85,000 = 2.12:1
December 31 $210,000 / $78,000 = 2.69:1
$30,970 / 0.5($85,000 + $78,000) = 38.0 percent
January 1 $30,000 / $435,000 = 6.9 percent
December 31 $75,000 / $485,000 = 15.5 percent
$30,970 / 0.5($115,000 + $153,000) = 23.1 percent
($84,000 + $36,000 + $3,000) / $3,000 = 41.0 times per year
143. (CMA Jun 96 #6) All-Things Inc. manufactures a variety of consumer products. The company's founders
have managed the company for thirty years and are now interested in retiring. Consequently, they are seeking to
sell the company. Trial Associates is looking into the acquisition of All-Things and has requested the latest
financial statements and selected financial ratios in order to evaluate All-Things' financial stability and operating
efficiency. The summary information provided by All-Things is presented below.
All-Things Inc.
Income Statement
For the Year Ended May 31,Year 6
(in thousands)
Sales (net)
Interest income
Total revenue
Costs and expenses:
Cost of goods sold
Selling and administrative expense
Depreciation and amortization expense
Interest expense
Total costs and expenses
Income before taxes
Income taxes
Net income
$30,500
500
$31,000
17,600
3,550
1,890
900
$23,940
7,060
2,900
$ 4,160
Selected Financial Ratios
5-Year
All-Things
Industry
Year 4
1.62
.63
1.83
3.21
8.50
1.02
12.1%
Year 5
1.61
.64
1.84
3.17
8.55
.86
13.2%
Average
1.63
.68
1.84
3.18
8.45
1.03
13.0%
Cash
Marketable securities (at cost)
Accounts receivable (net)
Inventory
Total current assets
Property, plant, and equipment (net)
Total assets
Year 6
$ 400
500
3,200
5,800
$ 9,900
7,100
$17,000
Year 7
$ 500
200
2,900
5,400
$ 9,000
7,000
$16,000
Accounts payable
Income taxes payable
Accrued expenses
Total current liabilities
Long-term debt
Total liabilities
$ 3,700
900
1,700
$ 6,300
2,000
$ 8,300
$ 3,400
800
1,400
$ 5,600
1,800
$ 7,400
Common stock ($1 par value)
Paid-in-capital in excess of par
Retained earnings
Total shareholders' equity
Total liabilities and shareholders' equity
2,700
1,000
5,000
$ 8,700
$17,000
2,700
1,000
4,900
$ 8,600
$16,000
Current ratio
Acid-test ratio
Total asset turnover
Inventory turnover
Times interest earned
Total debt to net worth (Total debt / Total shareholders' equity)
Net profit margin
All-Things Inc.
Comparative Statement of Financial Position
As of May 31
(In thousands)
Required:
a.
b.
c.
Calculate a new set of ratios for the fiscal Year 6 for All-Things Inc. based on the financial statements presented.
Briefly explain the analytical use of each of the seven ratios presented, describing what the investors can learn about All-Things Inc.'s
financial stability and operating efficiency.
Identify two limitations of ratio analysis.
a.
The calculation of selected financial ratios for All-Things Inc. for the fiscal Year 6 is as follows.
Current ratio = Current assets / Current liabilities =~ $9,900 / $6,300 = 1.57
Acid-test ratio = (Cash + Marketable securities + Net receivables) / Current liabilities = ($400 + $500 + $3,200) / $6,300 = 0.65
Total asset turnover = Net sales / Average total assets = $30,500 / ($17,000+$16,000)/2 = 1.85 times
Inventory turnover = Cost of goods sold / Average inventory = $17,600 / ($5,800 + $5,400)/2 = 3.14 times
Times interest earned = Income before interest & taxes / Interest expense = ($7,060 + $900) / $900 = 8.84
Total debt to net worth = Total debt / Total shareholders' equity = $8,300 / $8,700 = 0.95
Net profit margin = Net income / Net sales = $4,160 / $30,500 = 13.64%
b.
·
·
·
·
·
·
·
·
·
·
·
·
·
·
c.
·
·
The analytical use of each of the seven ratios and what investors can learn about All-Things Inc.'s financial stability and operating efficiency
is presented below.
Current ratio
Measures the ability to meet short-term obligations using short-term assets.
All-Things' ratio has declined over the last three years from 1.62 to 1.57. This declining trend, coupled with the fact that it is below the
industry average, is not yet a major concern; however, the company should be watched in the future.
Acid-test ratio
Measures the ability to meet short-term debt using the most liquid (quick) assets; i.e., excluding the amount invested in inventory.
All-Things has improved its acid-test ratio over the last three years, but it is still below the industry average. Furthermore, an acid-test ratio
below 1.0 indicates that All-Things may have difficulty meeting its short-term obligations if inventory does not turn over fast enough.
Total asset turnover
Measures the efficiency of resource use, i.e., the ability to generate sales through the use of assets. This ratio can be significantly affected by
the depreciation method used by the company, as well as the age of assets
All-Things has been steadily improving and is slightly above the industry average.
Inventory turnover
Measures how quickly inventory is sold as well as how effectively investment in inventory is used and managed. This ratio can be
significantly affected by the inventory costing method used.
All-Things' ratio has been steadily declining and is below the industry average. This slower than average situation may indicate a decline in
operating efficiency, hidden obsolete inventory, or overpriced stock items.
Times interest earned
Measures the ability to meet interest commitments from current earnings. The higher the ratio, the more safety there is for long-term
creditors.
All-Things' ratio has been improving over the last three years and is above the industry average. This indicates that All-Things has been
paying down or refinancing debt, or increasing sales and profits, which is a sign of long-term stability.
Total debt to net worth
Measures the level of protection creditors have in the case of possible insolvency. Measures the degree of financial leverage and whether or
not the firm will be able to obtain additional financing through borrowing.
All Things' ratio has deteriorated slightly in Year 6, but has been below the industry average over the last three years. This indicates that
All-Things should be able to raise additional financing through debt and still remain below the industry average, indicating long-term
stability.
Net profit margin
Measures the net income generated by each dollar of sales. The net profit margin ratio provides some indication of the ability of the firm to
absorb cost increases or sales declines.
All-Things' net profit margin has been improving and is currently above the industry average. Furthermore, this improving net profit margin
indicates the ability of the firm to weather soft economic periods, pay down debt, or take on additional debt for expansion.
At least two limitations of ratio analysis include the following.
It is often difficult to make comparisons among firms within an industry due to accounting differences. Different numbers can be shown in
the financial statements for the same economic event because of different accounting methods, such as straight-line depreciation versus
accelerated methods, LIFO versus FIFO inventory valuations. etc.
Ratios represent conditions that existed in the past, and may not be an indication of the future trend.
144. Financial statement analysis often assess the profitability and risk of an organization. Specific ratios target
each of these areas to answer questions such as "How profitable is this company?" or "How risky (liquid) is an
investment in this company?"
Required:
a.
b.
Discuss three ratios that address how profitable a company might be.
Discuss three ratios that address how risky (liquid) a company might be.
a.
Three ratios that address how profitable a company might be include the total assets turnover, net profit margin, and inventory turnover. The
total assets turnover ratio measures the efficiency of resource use, i.e., the ability to generate sales through the use of assets. The net profit
margin ratio measures the net income generated by each dollar of sales. The net profit margin ratio provides some indication of the ability
of the firm to absorb cost increases or sales declines. The inventory turnover ratio measures how quickly inventory is sold as well as how
effectively investment in inventory is used and managed. All three ratios delve into how the company is doing operationally, which is a
significant factor in its profitability.
Three ratios that address how risky (liquid) a company might be include the current ratio, times interest earned, and total debt to net worth.
The current ratio measures the ability to meet short-term obligations using short-term assets. The times interest earned ratio measures the
ability to meet interest commitments from current earnings. The higher the ratio, the more safety there is for long-term creditors. The total
debt to net worth ratio measures the level of protection creditors have in the case of possible insolvency. This ratio also measures the degree
of financial leverage and whether or not the firm will be able to obtain additional financing through borrowing.
b.
145. (CMA adapted, Jun 90 #3) Flores Company is a manufacturer of highly specialized products for
networking video-conferencing equipment. Production of specialized units are, to a large extent, under contract,
with standard units manufactured to marketing projections. Maintenance of customer equipment is an important
area of customer satisfaction. With the recent downturn in the computer industry, the video-conferencing
equipment segment has suffered, causing a slide in Flores’ performance. Flores’ Income Statement for the fiscal
year ended October 31, Year 3, is presented below.
Flores Company
Income Statement
For the Year Ended October 31, Year 3
($000 omitted)
Net sales
Equipment
Maintenance contracts
Total net sales
Expenses
Cost of goods sold
Customer maintenance
Selling expense
Administrative expense
Interest expense
Total expenses
Income before income taxes
Income taxes
Net income
$6,000
1,800
$7,800
4,600
1,000
600
900
150
$7,250
$ 550
220
$ 330
Flores’ return on sales before interest and taxes was 9 percent in fiscal Year 3 while the industry average was 12 percent. Flores’ total asset turnover
was three times, and its return on average assets before interest and taxes was 27 percent, both well below the industry average. In order to improve
performance and raise these ratios nearer to, or above, industry averages, Bill Hunt, Flores’ president, established the following goals for fiscal Year 4.
·
·
·
Return on sales before interest and taxes 11 percent
Total asset turnover 4 times
Return on average assets before interest and taxes 35 percent
To achieve Hunt's goals, Flores’ management team took into consideration the growing international video-conferencing market and proposed the
following actions for fiscal Year 4.
·
Increase equipment sales prices by 10 percent.
·
Increase the cost of each unit sold by 3 percent for needed technology and quality improvements, and increased variable costs.
·
Increase maintenance inventory by $250,000 at the beginning of the year and add two maintenance technicians at a total cost of $130,000 to
cover wages and related travel expenses. These revisions are intended to improve customer service and response time. The increased
inventory will be financed at an annual interest rate of 12 percent; no other borrowings or loan reductions are contemplated during fiscal
Year 4. All other assets will be held to fiscal Year 3 levels.
·
Increase selling expenses by $250,000 but hold administrative expenses at Year 3 levels.
·
The effective rate for Year 4 federal and state taxes is expected to be 40 percent, the same as Year 3.
It is expected that these actions will increase equipment unit sales by 6 percent, with a corresponding 6 percent growth in maintenance contracts.
Required:
a.
Prepare
a Pro
Forma
Income
Statem
ent for
Flores
Compa
ny for
the
fiscal
year
ending
Octobe
r 31,
Year 4,
on the
assump
tion
that the
propos
ed
actions
are
implem
ented
as
planne
d and
that the
increas
ed sales
objectiv
es will
be met.
(All
number
s
should
be
rounde
d to the
nearest
thousan
d, i.e.,
$000
omitted
.)
b.
Calcula
te the
followi
ng
ratios
for
Flores
Compa
ny for
fiscal
Year 4
and
determi
ne
whethe
r Bill
Hunt's
goals
will be
achieve
d.
1.
Return on sales before interest and taxes.
2.
Total asset turnover.
3.
Return on average assets before interest and taxes.
Discuss
the
limitati
ons and
difficult
ies that
can be
encoun
tered in
using
ratio
analysi
s,
particul
arly
when
making
compar
isons to
industr
y
average
s.
c.
a.
The Pro Forma Income Statement for Flores Company for the fiscal year ended October 31, Year 4, assuming
all of management's proposed actions are implemented and the increased sales objectives are met, is presented
below.
Fl
ore
s
Co
mp
an
y
Pr
o
Fo
rm
a
Inc
om
e
Sta
te
me
nt
For
the
Ye
ar
En
din
g
Oc
tob
er
31,
Ye
ar
4
($0
00
om
itte
d)
Ne
t
sal
es
E $6,996
qui
pm
ent
($6
,00
0´
1.0
6´
1.1
0)
1,908
Ma
int
ena
nce
($1
,80
0´
1.0
6)
T $8,904
ota
l
net
sal
es
Ex
pe
nse
$5,022
Co
st
of
go
ods
sol
d
($4
,60
0´
1.0
3´
1.0
6)
1,130
Cu
sto
me
r
ma
int
ena
nce
($1
,00
0+
$1
30)
S 850
elli
ng
ex
pe
nse
($6
00
+
$2
50)
900
Ad
mi
nis
trat
ive
ex
pe
nse
I
nte
res
t
[$1
50
+
($2
50
´.
12)
]
180
$8,082
Tot
al
ex
pe
nse
s
Inc 822
om
e
bef
ore
inc
om
e
tax
es
I
329
nc
om
e
tax
es
Ne $ 493
t
inc
om
e
b.
1.
Return on sales before interest and taxes = (Income before interest taxes) / Sales
= ($493 +329 +180) / $8,904 = 11.25%
The goal of 11 percent return on sales before interest and taxes would be exceeded by .25%.
2.
Total asset turnover = Sales / Average assets
= [$8,904 / ($2,600* + 250)] = 3.12
*
Year 3 average assets = Year 3 sales / Year 3 turnover of average assets
= $7,800 / 3 = $2,600
The goal of total asset turnover of four times would not be achieved (3.12 is less than 4).
3.
Return on average assets before interest and taxes = (Income before interest and taxes) / Average assets
= ($493 + 329 + 180) / ($2,600 + 250) = 35.15%
The goal of thirty-five percent return on average assets before interest and taxes would be exceeded by .15%.
c.
The limitations and difficulties that can be encountered in using ratio analyses include the following:
·
·
·
Various techniques are used in the analysis of financial data to emphasize the comparative and relative importance of data presented and to
evaluate the position of the firm. These techniques include ratio analysis, common size analysis, examination of relative size among firms,
etc. The information derived from these types of analyses should be blended. No one type of analysis is best or sufficient to support overall
findings or to serve all types of users.
The nature of the general business environment and direct competition in a company's geographical area can result in special situations not
encountered throughout the industry which creates deviations from the industry norm.
Identical companies may use different valuation or expense methods (e.g., LIFO, FIFO, average cost, standard costs, different depreciation
methods, etc.). Consequently, footnotes to the financial statements must be carefully analyzed to determine comparability.
146. What factors affect the risk of business firms?
ANALYSIS OF RISK
Analysts deciding between investments must consider the comparative risks. Various factors affect the risk of
business firms:
1. Economy-wide factors, such as increased inflation or interest rates, unemployment, and recessions.
2. Industry-wide factors, such as increased competition, lack of availability of raw materials, changes in
technology, and increased government regulatory actions, such as anti-trust or clean environment policies.
3. Firm-specific factors, such as labor strikes, loss of facilities due to fire or other casualty, and poor health of
key managerial personnel.
Analysts assessing risk generally focus on the relative liquidity of a firm. Cash and near-cash assets provide a
firm with the resources needed to adapt to the various types of risk; that is, liquid resources provide a firm with
financial flexibility. Cash links the operating, investing, and financing activities of a firm, permitting it to run
smoothly and effectively.
Assessing liquidity requires a time horizon. Consider the three questions that follow:
1. Does a firm have sufficient cash to repay a loan due tomorrow?
2. Will the firm have sufficient cash to repay the same loan due in six months?
3. Will the firm have sufficient cash to repay the same loan due in five years?
In answering the first question, the analyst probably focuses on the amount of cash on hand and in the bank
relative to the obligation coming due tomorrow. In answering the second question, the analyst compares the
amount of cash expected from operations during the next six months, as well as from any new borrowings, with
the obligations maturing during that period. In answering the third question, the analyst shifts the focus to the
longer-run cash-generating ability of a firm relative to the amount of long-term debt that will mature. Ultimately,
analysts assess whether a firm will likely become bankrupt; creditors and investors may lose the funds they
provided to a bankrupt firm.
147. Discuss how investors base their investment decisions on the return anticipated from each investment and
the risk associated with that return.
Investors base their investment decisions on the return anticipated from each investment and the risk associated
with that return.
The return from investing in the shares of common stock has two components: cash dividends and the change in
the market price of the common stock.The market price of the common stock will likely change between the
time that the shares are purchased and the time in the future when they are sold. The difference between the
eventual selling price and the purchase price, often called price appreciation (or price depreciation, if negative),
provides the second component of the return from buying the stock.
The common stock investment involves more risk than does the certificate of deposit investment. Economy-wide
factors, such as inflation, unemployment, and changes in international tensions will also affect the market price
of common shares. Also, specific industry factors, such as changes in exchange rates that affect the cost of
merchandise or changes in government regulatory actions, may influence the market price of the shares.
148. Describe the relation between financial statement analysis and investment decisions.
Relation Between Financial Statement Analysis and Investment Decisions
Theoretical and empirical research has shown that the expected return from investing in a firm relates, in part, to
the expected profitability of the firm. The analyst studies a firm’s past earnings to understand its operating
performance and to help forecast its future profitability. Investment decisions also require that the analyst assess
the risk associated with the expected return. A firm may find itself short of cash and unable to repay a shortterm loan coming due. Or, it may have so much long-term debt in its financing structure that it has difficulty
meeting the required interest and principal payments. The financial statements provide information for assessing
how these and other risk elements affect expected return. Most financial statement analysis, therefore, explores
some aspect of a firm’s profitability, or its risk, or both.
149. Why are ratios useful?
USEFULNESS OF RATIOS
Readers cannot easily answer questions about a firm’s profitability and risk from the raw information in financial
statements. For example, one cannot assess the profitability of a firm by noting the amount of net income—large
net income could result from a large firm earning small profits on its transactions or from a small firm earning
large profits. Comparing net income with the assets used to generate those earnings will provide more useful
information. The analyst expresses these (and other useful) relations between items in the financial statements in
the form of ratios. Some ratios compare items within the income statement; some use only balance sheet data;
others relate items from more than one of the three principal financial statements. Ratios aid financial statement
analysis because they conveniently summarize data in a form easy to understand, interpret, and compare.
Ratios provide little information unless the analyst places them in a context. For example, does a rate of return
on common shareholders’ equity of 8.6% indicate satisfactory performance? After calculating the ratios, the
analyst must compare them with some standard. The following list provides several possible standards:
1. The planned ratio for the period.
2. The corresponding ratio during the preceding period for the same firm.
3. The corresponding ratio for a similar firm in the same industry.
4. The average ratio for other firms in the same industry.
150. What are the limitations of ratio analysis?
LIMITATIONS OF RATIO ANALYSIS
The analyst should be aware of limitations of ratio analysis.
Because ratios use financial statement data as inputs, the same factors that cause short-comings in financial
statements will affect the ratios computed from them. Such short-comings, at least for some purposes, include
the use of acquisition cost for assets rather than current replacement cost or net realizable value and the latitude
firms have in selecting from among various generally accepted accounting principles.
2. Changes in many ratios correlate with each other. For example, the current ratio and the quick ratio often
change proportionally and in the same direction. The analyst need not compute all the ratios to assess a
particular dimension of profitability or risk.
3. When comparing the size of a ratio between periods for the same firm, the analyst must recognize conditions
that have changed between the periods being compared (for example, different product lines or geographic
markets served, changes in economic conditions, changes in prices, changes in accounting principles, and
corporate acquisitions).
4. When comparing ratios of a particular firm with those of similar firms, one must recognize differences among
the firms (for example, different methods of accounting, different operating methods, and different types of
financing).
Financial statement ratios alone do not provide direct indicators of good or poor management. Such ratios
indicate areas that the analyst should investigate further. For example, a decrease in the turnover of merchandise
inventory, ordinarily considered an undesirable trend, may reflect the accumulation of merchandise to keep retail
stores open during anticipated shortages. Such shortages may force competitors to restrict operations or to close
down. The analyst must combine ratios derived from financial statements with an investigation of other facts
before drawing conclusions.
151. A measure of profitability for a firm engaging in operations selling merchandise in its stores to generate net
income includes the rate of return on assets. Discuss the rate of return on assets.
RATE OF RETURN ON ASSETS
The rate of return on assets (ROA) measures a firm’s performance in using assets to generate net income
independent of how the firm financed the acquisition of those assets. The rate of return on assets relates the
results of operating performance to the investments (assets) of a firm without regard to how the firm financed
those investments.
The calculation of ROA is as follows:
Net Income + Interest Expense Net of Income Tax Savings
ROA = ----------------------------------------------------------------------Average Total Assets
ROA answers the question: how well has the firm done in conducting its operations independent of financing
costs? The amount in the numerator of ROA excludes any interest expense on debt and distributions to
shareholders. The calculation of the numerator amount begins with net income. If the measure of performance
in the numerator is to exclude the costs of financing, then the analysis must add back the amount of interest
expense because, in computing net income, the firm subtracts interest expense. Because firms can deduct interest
expense in calculating taxable income, interest expense does not reduce after-tax net income by one dollar for
each dollar of interest expense. Rather, each dollar of interest expense reduces after-tax net income by less than a
dollar. Thus, to calculate the numerator of ROA (which measures performance independent of financing costs),
the analyst adds back interest expense reduced by the income taxes that interest deductions save. The measure
of investment for the denominator should reflect the average amount of assets in use during the yea, because
ROA is computed for a year, . A crude but usually satisfactory figure for average total assets is one-half the sum
of total assets at the beginning and at the end of the year.
ROA has particular relevance to the lenders, or creditors, of a firm. These creditors have a senior claim on net
income and assets relative to common shareholders. Creditors receive their return via contractual interest
payments. The firm typically pays these amounts before it makes payments, usually as dividends, to other
suppliers of financing. When extending credit or providing debt financing to a firm, creditors want to be sure that
the firm can generate a ROA from using the financing that exceeds its cost. Common shareholders find ROA
useful in assessing financial leverage..
152. Discuss how the rate of return on common shareholders’ equity is calculated.
RATE OF RETURN ON COMMON SHAREHOLDERS’ EQUITY
The rate of return on common shareholders’ equity (ROCE) measures a firm’s performance in using and
financing assets to generate earnings. Unlike ROA, the rate of return on shareholders’ equity considers financing
costs. Thus, this measure of profitability incorporates the results of operating, investing, and financing decisions.
The calculation of ROCE is as follows:
Rate of Return
on Common
Shareholders’ Equity
Net Income -Dividends on Preferred Stock
= --------------------------------------------------Average Common Shareholders’ Equity
The Numerator
To calculate the amount of net income assignable to common shareholders’ equity, the analyst subtracts all
amounts required to compensate other providers of financing for the use of their funds. Expenses subtracted in
computing net income already include amounts for interest expense, so the calculation of the numerator requires
no further adjustment for interest. Because expenses exclude all dividends, the analyst must subtract from net
income any earnings allocable to preferred stock equity, usually the dividends on preferred stock declared during
the period, to measure the returns solely to the common shareholders. The analyst should not subtract dividends
on common stock, because such dividends represent distributions to common shareholders of a portion of the
returns generated for them during the period.
The Denominator
The capital provided by common shareholders during the period equals the average par value of common stock,
capital contributed in excess of par value on common stock, retained earnings, and any other common
shareholders’ equity accounts for the period. (Alternatively, subtract average preferred shareholders’ equity from
average total shareholders’ equity.)
153. Describe the relationship between return on assets and return on common shareholders’ equity.
RELATION BETWEEN RETURN ON ASSETS AND RETURN ON COMMON SHAREHOLDERS’
EQUITY
For profitable firms, it is common for ROCE to exceed ROA. ROA measures the profitability of a firm before
any payments to the suppliers of financing. Each of the various providers of financing has a claim on some
portion of the income in the numerator of ROA. Creditors receive the contractual interest to which they have a
claim; the tax savings the firm realizes from deducting interest for tax purposes reduces the interest cost to the
firm. Preferred shareholders, if any, receive the stated dividend amounts on the preferred stock. Any remaining
income belongs to the common shareholders; that is, common shareholders have a residual claim on all income
after creditors and preferred shareholders receive amounts contractually owed them. Thus,
The pool of operating income in the numerator of ROA goes first to lenders in the form of after-tax interest
expense, then any remaining amount to preferred shareholders in the form of preferred dividends, and then the
residual to the common shareholders.
ROCE will exceed ROA whenever ROA exceeds the after-tax cost of borrowing plus any dividends required for
preferred shareholders. Using lower-cost borrowed funds and then earning a rate of return on those funds higher
than their cost increases the return to the common shareholders and is a phenomenon called financial leverage.
The common
shareholders earn a higher return, but they undertook more risk in their investment. The risk results from the
firm incurring debt obligations with fixed payment amounts and dates.
154. What is financial leverage?
FINANCIAL LEVERAGE
The term financial leverage describes financing with debt and preferred stock to increase the potential return to
the residual common shareholders’ equity. Financial leverage works as follows:
1. A firm obtains funds from creditors, preferred shareholders, and common shareholders.
2. The firm invests the funds in various assets. Each period the firm generates a return on the assets. ROA
measures this return before allocating any amounts to the suppliers of financing.
3. Creditors receive a share of ROA equal to the interest rate on the amount borrowed. The tax deduction for
the cost of the interest expense reduces the cost of this debt to the firm.
4. Preferred shareholders receive a share of ROA equal to the preferred dividend rate on the preferred stock
outstanding.
5. The common shareholders have a residual claim on all income in excess of the cost of debt and preferred
shareholder financing. As long as a firm earns an ROA that exceeds the cost of debt and preferred shareholder
financing, the common shareholders benefit. They benefit because the amount earned on assets financed with
debt and the preferred shareholders’ funds exceeds the amounts the firm must pay for those funds; the excess
belongs to the common shareholders. Common shareholders must assess whether the excess return compensates
them adequately for the risk they undertake as the residual claimant on the firm’s assets.
155. Discuss any ethical issues raised by the following actions.
General Hospital is subject to a constraint in its short-term borrowing agreement with its bank. General Hospital
must have a year-end current ratio that is greater than 1.5. On December 30 of the current year, it projects that its
current ratio will be only 1.4 as of the close of business on December 31. General Hospital has a long-term loan
outstanding to its chief executive officer (CEO) that is not due for ten more years. The CEO writes a check on
December 30 payable to the General Hospital in an amount such that the current ratio on December 31 will be
1.65. General Hospital renews the loan to the CEO on January 5 of the next year.
Ethical issues confront General Hospital’smanagement when they make financial reporting decisions. Among
the questions that one might raise are: (1) does the action violate a known law or regulation and (2) has the firm
provided sufficient disclosure about the action for the users of financial statements to make their own judgments
about the ethics of such actions? Some people would argue that an ethical issue does not arise. The reporting
conforms with GAAP assuming that the firm provided sufficient disclosures for a user. Other people would
argue that an ethical issue arises because management took an action for the primary purpose of satisfying a
constraint in its short-term lending agreement. Management purposefully managed, some would say distorted
the current ratio to meet the contractual constraint.
156. Discuss any ethical issues raised by the following actions.
Lamb Inc. has a debt-equity ratio of 30 percent, which is considerably lower than most of its competitors. Lamb
Inc. has become the target of a takeover by a group of outside investors. This takeover group feels that Lamb Inc.
could service debt up to 60 percent of its financing. They plan to borrow the necessary cash to finance the
takeover and then have Lamb Inc. assume the debt. This action will result in a debt-equity ratio for Lamb Inc. of
60 percent after the takeover. The current management desires to defend Lamb Inc. against this takeover attempt.
It sells off a profitable division of the business and uses the cash proceeds to buy back outstanding common
stock. This action has the effect of increasing the debt-equity ratio to 60 percent, making Lamb Inc. less
attractive because of the sale of the profitable division, and increasing the stock price that the takeover group
must pay.
Ethical issues confront the Lamb Inc. management when they made the decision to sell off a profitable division
of the business and use the cash proceeds to buy back outstanding common stock. Lamb Inc. management
should examine (1) whether the action violates a known law or regulation and (2) whether Lamb provided
sufficient disclosure about the action for the users of financial statements to make their own judgments about the
ethics of such actions. The measurement and reporting of the effect of increasing the debt-equity ratio to 60
percent, making the firm less attractive because of the sale of the profitable division, and increasing the stock
price that the takeover group must pay conforms with GAAP. Some may argue that an ethical issue does not
arise as long as Lamb Inc. provided sufficient disclosures for a user to make informed decisions. Other people
would argue that an ethical issue arises because management took an action for the primary purpose of making
Lamb Inc.less attractive, and increasing the stock price that the takeover group must pay. Management
purposefully managed, some would say distorted, increasing the debt-equity ratio to 60 percent and may have
decreased, rather than increased, shareholder value resulting in a net economic loss to the shareholders.
157. Discuss how the analyst can disaggregate ROA into the product of two other ratios to study changes in
ROA.
DISAGGREGATING THE RATE OF RETURN ON ASSETS
To study changes in ROA, the analyst can disaggregate ROA into the product of two other ratios: the profit
margin for ROA ratio and the total assets turnover ratio.
The disaggregation follows:
Rate of
Return
on Assets
=
Profit Margin for ROA
(before interest expense
and related income
tax savings) Ratio
Net Income +
Interest Expense
Net of Income
Tax Savings
=
--------------------------Average Total Assets
x
Total Assets
Turnover
Ratio
Net Income +
Interest Expense
Net of Income
Tax Savings
X
Sales
------------------------------------------------Sales
Average Total Assets
The profit margin for ROA ratio measures a firm’s ability to control the level of expenses relative to sales, to
increase selling prices relative to the level of expenses incurred, or a combination of the two. By holding down
expenses or increasing selling prices, a firm can increase the profits from a given amount of sales activity and
thereby improve its profit margin for ROA ratio.
The total assets turnover ratio measures a firm’s ability to generate sales from a particular level of investment in
assets, or alternatively, to control the amount of assets it uses to generate a particular level of sales. The smaller
the amount of assets the firm needs to generate a given level of sales, the better (larger) its assets turnover and
the more profitable the firm.
Firms improve their ROA by increasing the profit margin for ROA ratio, the rate of assets turnover, or both.
Some firms, however, have limited flexibility to alter one or the other of these components. For example, a firm
that sells commodity products in a competitive market likely has little opportunity to increase its profit margin
for ROA by increasing prices. Such a firm would need to improve its total assets turnover (for example,
shortening the holding period for inventories with tighter controls) to increase its ROA. A firm whose activities
require substantial investments in property, plant, and equipment and that operates efficiently near its capacity
has limited ability to increase its ROA by increasing its total assets turnover. Such a firm might have more
flexibility to take actions that increase the profit margin for ROA (for example, creating brand loyalty for its
products).
158. Discuss any ethical issues raised by the following actions.
Big Store’s rate of return on assets (ROA) has fallen below analysts’ expectations in recent years because the
firm, a retailer, has added a significant number of new stores (increasing assets in the denominator of ROA) prior
to these stores generating earnings (ultimately increasing the numerator of ROA). Big Store decides to curtail the
opening of new stores for two years in an effort to allow the earnings of new stores to catch up with the
investments it made previously in store assets, thereby increasing its ROA. Management plans to restart the
growth in stores after the two years.
Ethical issues confront Big Store’s management when they make financial reporting decisions. Among the
questions that Big Store’s management might raise are: (1) Does the action violate a known law or regulation?
and (2) Has the firm provided sufficient disclosure about the action for the users of financial statements to make
their own judgments about the ethics of such actions? Big Store’s actions are in accordance with within GAAP,
and it should adequately discloses information about the choice There would be a long-term effect of the action
because the rate of future growth could be adversely affected and analysts must take the change into account in
projecting future earnings. One might argue that an ethical issue arises because management took an action for
the primary purpose of increasing return on assets (ROA). Management purposefully managed, some would say
distorted, return on assets (ROA) to make it and Big Store look better.
159. Describe the disaggregation of the rate of return on common shareholders’ equity.
DISAGGREGATING THE RATE OF RETURN ON COMMON SHAREHOLDERS’ EQUITY
ROCE disaggregates into several components (in a manner similar to the disaggregation of ROA):
Thus,
Rate of Return
on Common
Turnover
Net Income Dividends on
Preferred Stock
------------------Average
Common
Shareholders’
Equity
=
Profit
Total
Margin for
x
Assets
Leverage
Equity
Net Income Dividends on
=
Preferred Stock X
------------------Sales
Average
Total
Assets
Capital
x
Structure
Ratio
Shareholders’
ROCE
Ratio
Ratio
Average Total
Sales
X
Assets
---------------------------Average
Common
Shareholders’
Equity
The profit margin ratio for ROCE ratio indicates the portion of the sales dollar left over for the common
shareholders after covering all operating costs and subtracting claims of creditors and preferred shareholders. It
differs from the profit margin for ROA because of the subtraction for the cost of funds provided by creditors and
preferred shareholders. The total assets turnover ratio indicates the sales generated from each dollar of assets and
equals the total assets turnover in the disaggregation of ROA. The capital structure leverage ratio indicates the
proportion of total assets, or total financing, provided by common shareholders contrasted with the financing
provided by creditors and preferred shareholders. The higher the capital structure leverage ratio, the lower is the
proportion of financing that common shareholders provide and the higher is the proportion that creditors and
preferred shareholders provide. Thus, the higher the capital structure leverage ratio, the higher is financial
leverage.
160. Discuss the accounts receivable turnover ratio.
Accounts Receivable Turnover
The rate at which accounts receivable turn over indicates how quickly a firm collects cash. The accounts
receivable turnover ratio equals sales revenue divided by average accounts receivable during the period. In
theory, the numerator should include only sales made on account if the objective is to measure how quickly a
firm collects its accounts receivable. Most firms, except some retailers that deal directly with consumers (such as
fast food outlets), sell their goods and services on account. Other firms, sell both for cash and on account. Such
firms seldom disclose the proportions of cash and credit sales in their financial statements or notes. Thus, the
analyst uses sales revenue in the numerator of the accounts receivable turnover ratio, recognizing that the
inclusion of sales made for cash will increase the numerator and thereby overstate the receivables turnover ratio.
The accounts receivable turnover ratio therefore indicates how quickly a firm turns its sales into cash but not
how quickly it collects its accounts receivable.
The analyst often expresses the accounts receivable turnover in terms of the average number of days that elapse
between the time the firm makes the sale and the time it later collects the cash, sometimes called days accounts
receivable are outstanding or days outstanding for receivables. To calculate this ratio, divide 365 days by the
accounts receivable turnover ratio.
Most firms that sell to other businesses, as opposed to consumers, sell on account and collect within 30 to 90
days. Interpreting any particular firm’s accounts receivable turnover and days receivable outstanding requires
knowing the terms of sale. If a firm’s terms of sale are “net 30 days” and the firm collects its accounts receivable
in 45 days, then collections do not accord with the stated terms. Such a result warrants a review of the credit and
collection activity to ascertain the cause and to guide corrective action. If the firm offers terms of “net 45 days,”
a days receivable outstanding of 45 days indicates that the firm handles accounts receivable well.
Many firms sell to customers on account as a strategy to stimulate sales. Customers may purchase more willingly
and purchase more if they know they need only sign their name. Such firms may also encourage customers to
delay paying for their purchases as a means for the selling firm to generate interest revenue through finance
charges on the unpaid amounts. Thus, comparing accounts receivable turnovers over time or between firms
requires an analysis of the growth rate in sales, the amount of interest revenue generated, the cost of
administering the credit-granting activity, and the losses from uncollectible accounts.
161. Describe the inventory turnover ratio.
Inventory Turnover
The inventory turnover ratio indicates how fast firms sell their inventory items, measured in terms of the rate of
movement of goods into and out of the firm. Inventory turnover equals cost of goods sold divided by the average
inventory during the period.
Managing inventory turnover involves two opposing considerations. On the one hand, for a given amount of
gross margin on the goods, firms prefer to sell as many goods as possible with a minimum of assets tied up in
inventories. An increase in the rate of inventory turn-over between periods indicates reduced costs of financing
the investment in inventory. On the other hand, management does not want to have so little inventory on hand
that shortages result in lost sales. Increases in the rate of inventory turnover caused by inventory shortages could
signal a loss of customers, thereby offsetting any advantage gained by decreased investment in inventory. Firms
must balance these opposing considerations in setting the optimum level of inventory and, thus, the rate of
inventory turnover.
Some analysts calculate the inventory turnover ratio by dividing sales, rather than cost of goods sold, by the
average inventory. As long as the ratio of selling price to cost of goods sold remains relatively constant, either
measure will identify changes in the trend of the inventory turnover ratio. Using sales in the numerator, however,
will lead to incorrect measures of the inventory turnover ratio for calculating the average number of days that
inventory is on hand until sale.
162. Describe the fixed asset turnover ratio.
Fixed Asset Turnover
The fixed asset turnover ratio measures the relation between sales and the investment in fixed assets—property,
plant, and equipment. You will likely have more difficulty understanding the notion that fixed assets “turn over”
than you do in understanding turnover for inventory. A more appropriate title for the fixed asset turnover ratio
might be the fixed asset productivity ratio, because it measures the amount of sales generated from a particular
level of investments in fixed assets. Firms invest in fixed assets prior to experiencing increased sales from those
investments.
Some analysts find the reciprocal of the fixed asset turnover ratio helpful in comparing the operating
characteristics of different firms. The reciprocal ratio measures dollars of fixed assets required to generate one
dollar of sales.
The analyst should interpret changes in the fixed asset turnover ratio cautiously. Firms often invest in fixed assets
(for example, new production facilities) several periods before these assets generate sales from products
manufactured in their plants or sold in their stores. Thus, a low or decreasing rate of fixed asset turnover may
indicate an expanding firm preparing for future growth. On the other hand, a firm anticipating a decline in
product sales could cut back its expenditures on fixed assets. Such an action could increase the fixed asset
turnover ratio.
163. Discusses the four measures for assessing short-term liquidity risk.
MEASURES OF SHORT-TERM LIQUIDITY RISK
Four measures for assessing short-term liquidity risk are (1) Current ratio, (2) Quick ratio, (3) Cash flow from
operations to current liabilities ratio, and (4) Working capital turnover ratios.
Current Ratio
The current ratio equals current assets divided by current liabilities. Current assets comprise cash and assets that
a firm expects to turn into cash or sell or consume within approximately one year of the balance sheet date.
Current liabilities include obligations that will require cash (or the rendering of services) within approximately
one year. Thus, the current ratio indicates a firm’s ability to meet its short-term obligations. Analysts prefer a
current ratio that at least exceeds 1.0.
Changes in the trend of the current ratio can mislead. For example, when the current ratio exceeds 1.0, an
increase of equal amount in both current assets and current liabilities (by acquiring inventory on account) results
in a decline in the ratio, whereas equal decreases (by paying an accounts payable) result in an increased current
ratio.
In a recessionary period, a business may contract and use cash, a current asset, to pay its current liabilities.
When the current ratio exceeds 1, such action will increase it. In a boom period, firms sometimes conserve cash
by delaying payment of current liabilities, causing the reverse effect. Thus, a high current ratio may accompany
deteriorating business conditions, whereas a falling ratio may accompany profitable operations.
Furthermore, management can take deliberate steps to produce a financial statement that presents a better
current ratio at the balance sheet date than the average, or normal, current ratio during the rest of the year. For
example, near the end of its accounting period a firm might delay normal purchases on account. Or, it might
hasten the collections of a loan receivable, classified as noncurrent assets, and use the proceeds to reduce current
liabilities. Such actions will increase the current ratio. Analysts refer to such actions as window dressing.
Quick Ratio
A variation of the current ratio is the quick ratio (sometimes called the acid test ratio). The quick ratio includes
in the numerator of the fraction only those current assets that a firm could convert quickly into cash. The
numerator customarily includes cash, marketable securities, and accounts receivable. Some businesses can
convert their inventory of merchandise into cash more quickly than other businesses can convert their
receivables. The facts in each case will indicate whether the analyst should include receivables or exclude
inventories. The denominator includes all current liabilities. A quick ratio approximately one-half of the current
ratio is typical, although this varies by industry.
The general rule is that adding equal amounts to both the numerator and the denominator of a fraction moves
that fraction closer to the number 1, whereas subtracting equal amounts from both the numerator and the
denominator of a fraction makes that fraction diverge from the number 1. To be even more general, adding a to
(subtracting a from) the numerator while adding b to (subtracting b from) the denominator of the fraction makes
the fraction converge to (diverge from) the fraction a/b.
Cash Flow from Operations to Current Liabilities Ratio
Some analysts criticize the current ratio and the quick ratio to measure short-term liquidity risk because these
ratios use balance sheet amounts at a specific time. If financial statement amounts at that time are unusually
large or small, the resulting ratios will not reflect normal conditions. If management knows that analysts will
evaluate the firm using one of these ratios at a particular time, it can take steps to window dress that ratio by, for
example, using cash to pay off a current liability (reducing both numerator and denominator) or acquiring
inventory on account (increasing both numerator and denominator).
The cash flow from operations to current liabilities ratio overcomes these deficiencies. The numerator of this
ratio is cash flow from operations for the year. The denominator is average current liabilities for the year.
Healthy mature firms typically have a ratio of 40% or more.
Working Capital Turnover Ratios
During the operating cycle, a retailing firm (1) purchases inventory on account from suppliers, (2) sells inventory
for cash or on account to customers, (3) collects amounts due from customers, and (4) pays amounts due to
suppliers. This cycle recurs for most businesses. The number of days that a firm holds inventories (that is, 365
days/inventory turnover ratio) indicates the length of the period between the purchase and the sale of inventory
during each operating cycle. The number of days that a firm’s receivables remain outstanding (that is, 365
days/accounts receivable turnover ratio) indicates the length of the period between the sale of inventory and the
collection of cash from customers during each operating cycle. Firms must finance their investments in
inventories and accounts receivable. Suppliers typically provide a portion of the needed financing. The number
of days that a firm’s accounts payable remain outstanding (that is, 365 days/accounts payable turnover ratio)
indicates the length of the period between the purchase of inventory on account and the payment of cash to
suppliers during each operating cycle. The accounts payable turnover ratio equals purchases on account divided
by average accounts payable. Although firms do not disclose their purchases, the analyst can derive the amount
as follows:
Beginning Inventory + Purchases = Cost of Goods Sold + Ending Inventory
Rearranging terms yields the following:
Purchases = Cost of Goods Sold + Ending Inventory - Beginning Inventory
Interpreting the accounts payable turnover ratio involves opposing considerations. An increase in the accounts
payable turnover ratio indicates that a firm pays its obligations to suppliers more quickly, requiring cash and even
wasting the benefits of cash if the firm makes payments earlier than necessary. On the other hand, a faster
accounts payable turnover means a smaller relative amount of accounts payable that the firm must pay in the
near future. Most firms want to extend their payables as long as they can, but they also want to maintain their
relations with suppliers. Businesses, therefore, negotiate hard for favorable payment terms and then delay paying
until just before the last agreed moment.
164. Discuss measures of long-term liquidity risk.
MEASURES OF LONG-TERM LIQUIDITY RISK
Analysts use measures of long-term liquidity risk to evaluate a firm’s ability to meet interest and principal
payments on long-term debt and similar obligations as they come due. If a firm cannot make the payments on
time, it becomes insolvent and may have to reorganize or liquidate.
A firm’s ability to generate net income over several years provides the best protection against long-term liquidity
risk. If a firm is profitable, it will either generate sufficient cash from operations or obtain needed financing from
creditors and owners. The measures of profitability discussed previously therefore apply for this purpose as well.
Analysts measure long-term liquidity risk with debt ratios, the cash flow from operations to total liabilities ratio,
and the interest coverage ratio.
Debt Ratios
Several variations in debt ratios commonly appear in financial periodicals and corporate reports. We use three
debt ratios in assessing long-term liquidity risk:
1. Liabilities to Assets Ratio = Total Liabilities/Total Assets
2. Long-Term Debt Ratio = Long-Term Debt/Total Assets
3. Debt-Equity Ratio = Long-Term Debt/Shareholders’ Equity
The liabilities to assets ratio measures the proportion of assets financed with liabilities. The long-term debt ratio
measures the proportion of assets financed with long-term debt. The debt-equity ratio measures the extent of
long-term financing obtained from long-term debt relative to shareholders’ equity.
Because various versions of debt ratios correlate highly, analysts can generally rely on just a couple of these
ratios when assessing long-term liquidity risk.
In general, the higher the debt ratios, the higher the likelihood that the firm will be unable to meet fixed interest
and principal payments in the future. Most firms must decide how much financial leverage, with its attendant
risk, they can afford. Funds obtained from issuing bonds
or borrowing from a bank have a relatively low interest cost but require fixed, periodic payments that increase
the likelihood of insolvency or even bankruptcy.
In assessing the debt ratios, analysts customarily vary the standard in relation to the stability of the firm’s
earnings and cash flows from operations. The more stable the earnings and cash flows, the higher is the debt
ratio they deem acceptable or safe. Public utilities have high liabilities to assets ratios, frequently on the order of
60% to 70%. Banks have even higher liabilities to assets ratios, typically over 90%. The stability of earnings and
cash flows of firms in these industries makes these ratios acceptable to many investors. These investors might
find such high leverage unacceptable for firms with less stable earnings and cash flows, such as a computer
software developer or a biotech firm.
Because several variations of the debt ratio appear in corporate annual reports, the analyst should take care when
comparing debt ratios among firms.
Cash Flow from Operations to Total Liabilities Ratio
The debt ratios do not consider the availability of liquid assets to service various levels of debt (that is, to
provide for interest and principal payments when due). The cash flow from operations to total liabilities ratio
overcomes this deficiency. This cash flow ratio resembles the one for assessing short-term liquidity risk, but here
the denominator includes all liabilities (both current and noncurrent). A mature, financially healthy company
typically has a cash flow from operations to total liabilities ratio of 20% or more.
165. Explain how common-size balance sheets are used by analysts.
COMMON-SIZE BALANCE SHEET
Many analysts use a common-size balance sheet, which expresses each balance sheet item as a percentage of
total assets. Comparing firms using a common-size balance sheet rests on the assumption that the size or scale of
a business does not affect the relation between a given balance sheet item and total assets. This assumption need
not hold. Large firms often achieve economies of scale that affect the proportionality of the components of their
business, thus reducing the comparability of their common-size ratios with those of smaller-scale competitors.
For example, a large purchaser of goods and services has negotiating power over its suppliers, relative to the
negotiating power of a smaller purchaser, such as a single local clothing store. The large purchaser can negotiate
better terms, including lower per-unit prices (which, holding quantity constant, implies a lower per-unit recorded
amount for inventory), more frequent but proportionately smaller quantities purchased (which reduces the
quantity of inventory held by the purchaser), and better payment terms (which increases the time the purchaser
retains cash as opposed to paying it to the supplier). More negotiating power would appear on the large
purchaser’s balance sheet as proportionately smaller amounts reported for inventory and proportionately larger
amounts reported for accounts payable, relative to the amounts reported by a smaller purchaser with less
negotiating power. Typically, users would not compare the common-size balance sheets of two firms that differed
significantly in size.
166. What are pro forma financial statements?
Accountants use the term pro forma financial statements to refer to financial statements prepared under a
particular set of assumptions. One set of assumptions might be that some transactions, actually reported in the
firm’s income statement for the year under generally accepted accounting principles, had not occurred. Such
assumed-away transactions might include unusual or nonrecurring revenues, expenses, gains, and losses. In these
cases, firms report pro forma earnings to suggest to financial statement users what the firm views as normal,
recurring earnings.
The traditional use of the term pro forma financial statements refers to projected financial statements based on
some set of assumptions about the future. One set of assumptions might be that historical patterns (for example,
growth rates or rates of return) will continue. Alternatively, the pro forma financial statements might reflect new
assumptions about growth rates, debt levels, profitability, and so on. For example, a firm might project future
sales, net income, assets, and cash flows to ascertain whether operations will generate sufficient cash flows to
finance expenditures on long-term assets or whether the firm will need to borrow more. A firm might change its
product lines or pricing policies and might want to estimate the impact on rates of return. A firm might project
future financial statement amounts for an acquisition target to ascertain the price it should pay. This appendix
describes and illustrates procedures for preparing pro forma (projected) financial statements, then shows you
how to use them to value firms. In your exposure to managerial and cost accounting concepts, you will encounter
the notion of a budget. A budget for an entire firm means the same thing as pro forma (projected) financial
statements except that the statements projected typically have different uses and formats. Managers and analysts
use pro forma financials and budgets for differing reasons, but use similar procedures to prepare them.
167. What are the steps in preparing pro forma financial statements?
PREPARING PRO FORMA FINANCIAL STATEMENTS
The preparation of pro forma financial statements requires the analyst to make assumptions about the future. The
usefulness of the pro forma financial statements depends on the reasonableness of those assumptions. Various
computer spreadsheet programs ease the calculations required in preparing these statements, but the warning
“garbage-in, garbage-out” certainly applies—the results will have quality and validity no better than the input
assumptions. Careful analysts bring together, preferably in a single section of their spreadsheet, a list of all
assumptions made. Well-prepared pro forma statements allow the analyst to vary critical assumptions to see how
the results vary.
The preparation of pro forma financial statements typically begins with the income statement, followed by the
balance sheet and then the statement of cash flows. The level of operating activity usually dictates the required
amount of assets, which in turn affects the required level of financing. Amounts for the statement of cash flows
come directly from the pro forma income statement and comparative balance sheets.
The following are the steps in preparing pro forma financial statements:
1. Project operating revenues.
2. Project operating expenses other than the cost of financing and income taxes.
3. Project the assets required to support the level of projected operating activity.
4. Project the financing (liabilities and contributed capital) required to fund the level of assets in step 3.
5. Project the cost of financing the debt projected in step 4, income tax expense, net income, dividends, and the
change in retained earnings.
6. Project the statement of cash flows from amounts on the projected balance sheet and income statement.