ch14

(1)

ch14

Student: ___________________________________________________________________________

1. A primary objective of financial statements is to provide information to current and potential investors and creditors.

True False

2. Return on equity (ROE) is a function of three ratios: net profit margin, return on assets, and financial leverage.

True False

3. Return on equity (ROE) provides insight with respect to a company's use of its assets. True False

4. Time series analysis is where we compare information for a specific company over a period of time to determine changes in operations.

True False

5. Finding comparable companies in order to compare performance is often difficult since no two companies have identical products, markets and operating strategies.

True False

6. Finding comparable companies in order to compare performance is important because ratios in isolation are difficult to evaluate.

True False

7. Component percentages are used to express items on financial statements as a percentage of a single base amount.

True False

8. Financial statement analysis is very precise and doesn't involve judgment. True False

9. Purchasing treasury stock increases the return on equity ratio. True False

10. The return on assets ratio is influenced significantly by a company's relative debt and equity financing of its assets.

(2)

11. Negative financial leverage occurs when a company has more debt than stockholders' equity. True False

12. The financial leverage percentage is positive when return on assets is greater than return on equity. True False

13. Earnings per share (EPS) is affected by treasury stock transactions. True False

14. The quality of income ratio increases when net income increases. True False

15. The profit margin ratio considers the asset base utilized to earn income. True False

16. The fixed asset turnover ratio increases when net income increases. True False

17. The cash ratio is less sensitive to small transactions involving cash than is either the current or quick ratios. True False

18. A company that has a high level of inventory and other assets above their investment in property, plant and equipment should calculate the total asset turnover ratio in addition to the fixed asset turnover ratio.

True False

19. A company with a high amount of inventory will have a much lower fixed asset turnover ratio when compared to its total asset turnover ratio.

True False

20. A higher current ratio is preferable for companies with variable cash flows. True False

21. The quick ratio decreases when the adjusting entry to record bad debt expense is recorded. True False

22. A very high current ratio and low quick ratio may indicate the company is not collecting its accounts receivables in a timely manner.

True False

23. The inventory turnover ratio is significantly affected by the choice of inventory accounting method. True False

(3)

24. The cash coverage ratio measures a firm's ability to pay its current liabilities with its cash flows from operating activities.

True False

25. The price earnings ratio is affected by the amount of risk that investors are willing to take. True False

26. The debt to equity ratio is a risk measure used by both investors and lenders. True False

27. The dividend yield ratio decreases when earnings per share increases. True False

28. Many companies use high levels of debt to finance their assets because of financial leverage benefits provided to investors when return on assets exceeds the after tax cost of interest.

True False

29. Dividend yield is calculated by dividing dividends per share by earnings per share and measures the current dividend return to investors.

True False

30. A high price earnings ratio usually indicates the market is optimistic about the company's future earnings potential.

True False

31. There are several fundamental purposes decision makers consider when they use financial data. Which of the following statements is not one of those fundamental purposes?

A. Measurement of the current condition of the business. B. Measurement of past performance of the business. C. Measurement of the book value of the assets. D. Prediction of future potential of the business.

32. When considering an investment, which of the following is not one of the three critical factors used to evaluate future earning potential of that investment?

A. Financial analysts' reports. B. Economy wide factors. C. Industry factors.

(4)

33. Which of the following statements is incorrect? A

.

A company implementing a cost advantage strategy is attempting to reduce investment in assets thereby improving the asset turnover ratio.

B. A company implementing a product differentiation strategy is attempting to improve its profit margin through charging higher prices.

C .

A company will attract a higher volume of customers and revenue by following a product differentiation strategy versus a cost advantage strategy.

D. Financial leverage is a function of both total assets and stockholders' equity. 34. Which of the following statements is correct?

A. Purchasing fixed assets through debt financing decreases financial leverage. B. Accruing an expense does not affect the net profit margin ratio.

C. Return on equity increases when the financial leverage ratio decreases. D. Purchasing treasury stock results in a decrease in asset turnover. 35. Which of the following statements is incorrect?

A. Purchasing fixed assets through equity financing decreases asset turnover. B. Accruing an expense increases the financial leverage ratio.

C. The return on equity ratio increases when treasury stock is purchased. D. The net profit margin ratio decreases when fixed assets are purchased. 36. Which of the following statements is correct?

A. Selling inventory for cost does not affect the net profit margin ratio. B. Accruing sales revenue doesn't affect the net profit margin ratio. C. The asset turnover ratio increases when fixed assets are sold for a loss. D. The net profit margin ratio decreases when common stock is issued.

37. Home Depot's operating strategy is to offer a broad assortment of high-quality merchandise and services at competitive prices using highly knowledgeable service-oriented personnel and aggressive advertising. Which of the following is not as critical to achieving its strategy?

A. Cost control

B. Product differentiation

C. High level of customer service D. High sales volume

38. Which of the following statements is false?

A. When computing the component percentages for the income statement, net income is the base figure. B. Time series analysis examines a company's performance over time.

C. It is often useful to compare a company's performance with that of a competitor.

D. The North American Industry Classification System assigns industry codes based on business operations.

(5)

39. Which of the following statements is correct? A. A ratio calculation is most relevant in isolation.

B. One of the advantages of ratio analysis is that it allows companies of different sizes to be compared. C. Finding benchmarks for comparison is a straight-forward task.

D. It is always preferable to compare a company's performance to industry-wide ratios rather than to use a competitor's ratios.

40. The base amount in preparing a common-size income statement is usually which of the following? A. Income from operations

B. Gross profit C. Net income D. Net sales

41. Which of the following statements is correct?

A. When cost of goods sold as a percentage of sales increases the gross margin percentage will increase. B. It is possible for cost of goods sold in dollars to increase while cost of goods sold as a percentage of sales

decreases.

C. If gross margin percentage is the same for the current and past year, then sales and cost of goods sold in dollars did not change.

D .

If gross margin percentage increases from one year to the next, then the net income percentage will also increase from one year to the next.

42. Which of the following statements is incorrect?

A. If selling and administrative expenses as a percentage of sales increases, then gross margin percentage will decrease.

B .

If the cost of goods sold percentage decreases and other expenses do not change, then profit margin will increase as a percentage of sales.

C .

If sales dollars decrease, a company might still report a higher gross profit percentage if cost of goods sold decreases at a faster rate than the decrease in sales.

D .

It is possible for selling and administrative expense in dollars to decrease, while selling and administrative expenses as a percentage of sales to increase.

43. During 2010, Home Style's cost of goods sold percentage was 68.2% and selling and store operating costs was 19.3% of sales. During 2009, their cost of goods sold percentage was 68.9% while selling and store operating costs was 19.2% of sales. What effect would the change in these percentages have on 2010's gross margin percentage and profit margin percentage?

A .

The decrease in the cost of goods sold percentage would increase both the gross margin and profit margin percentages, but the increase in the selling and store operating costs percentage would decrease both the gross margin and profit margin percentages.

B .

The decrease in the cost of goods sold percentage would decrease both the gross margin and profit margin percentages, but the increase in the selling and store operating costs would increase both the gross margin and profit margin percentages.

C .

The decrease in the cost of goods sold percentage would increase both the gross margin and profit margin percentages and the decrease in the selling and store operating costs percentage would decrease the profit margin percentage.

D .

The decrease in the cost of goods sold percentage would decrease both the gross margin and profit margin percentages, but selling and store operating costs would increase the profit margin percentage.

(6)

44. Which of the following ratios is not considered to be a test of profitability? A. Current ratio

B. Profit margin C. Return on assets D. Earnings per share

45. The records of Everyday Electronics Corporation for a particular period include the following:

What is the return on equity ratio? A. 13.2%.

B. 23.8%. C. 24.0%. D. 8.4%.

46. The records of Marshall Company include the following:

The return on assets is (round to the nearest tenth of a percent) A. 14.9%.

B. 18.3%. C. 15.3%. D. 14.7%.

The return on equity is (round to the nearest tenth of a percent) A. 21.1%.

B. 10.2%. C. 16.4%. D. 17.1%.

(7)

The financial leverage percentage is which of the following? A. 1.8%

B. 2.8%. C. 5.8%. D. 6.4%.

49. Which of the following transactions decreases earnings per share? A. Declaring cash dividends payable to the common stockholders. B. Purchasing treasury stock.

C. The accrual of revenue.

D. Declaring and distributing a 10% common stock dividend. 50. Which of the following transactions decreases earnings per share?

A. Collection of an account receivable.

B. Selling treasury stock for an amount less than its cost. C. A decrease in the market value per share.

D. Paying cash in advance for rent.

51. Trenton Company has provided the following information: • Net income, $240,000;

• Preferred shares issued, 6,000;

• Average common shares issued, 24,000;

• Common cash dividends declared and paid, $30,000; • Market price per share, $36

• Average treasury shares of common stock, 4,000. What were Trenton's earnings per share?

A. $8.00 B. $7.00 C. $10.50 D. $12.00

(8)

• Average treasury shares of common stock, 4,000. What was Trenton's price earnings ratio?

A. 3.0 B. 5.1 C. 3.4 D. 4.5

53. Cecilia Company reported net income of $1,200,000. Their average total liabilities were $4,300,000 and average total stockholders' equity was $5,200,000. Interest expense was $100,000 and their tax rate was 40%. What was their return on assets ratio?

A. 13.7%. B. 12.6%. C. 11.6%. D. 13.3%.

54. Which of the following transactions will increase the quality of income ratio? A. Paying cash to suppliers.

B. Accruing sales revenue.

C. Selling treasury stock for more than its cost. D. Collecting an account receivable.

55. Negative financial leverage occurs when the

A. average net (after tax) interest rate on borrowed funds is less than the company's earnings rate on its assets.

B. return on assets is more than return on equity. C. return on equity is more than return on assets. D. operating expenses exceed gross margin.

56. Which of the following transactions will increase a current ratio which is currently 2.5? A. Receiving cash from signing a 6-month note payable.

B. Accruing an expense.

C. Using cash to pay an account payable. D. Collecting an account receivable.

57. Which of the following transactions will not increase the cash ratio? A. Receiving cash from a common stock issue.

B. Refinancing a current liability with long-term debt. C. Using cash to purchase a two-month treasury bill. D. Collecting an account receivable.

(9)

58. Which of the following ratios is not an indicator of a company's short-term financial strength? A. Price/earnings ratio

B. Receivable turnover ratio C. Working capital

D. Quick ratio

59. Teague Company's working capital was $40,000 and total current liabilities were 1/4 of that amount. What was the current ratio?

A. 1 B. 3 C. 5 D. 7

60. Agnes Company reported the following data:

What was the current ratio? A. 0.5

B. 1.5 C. 2.5 D. 0.75

What was the inventory turnover ratio? A. 2.2

B. 1.8 C. 2.0 D. 3.0

(10)

What was the average days' supply in inventory? A. 165.9

B. 202.7 C. 182.5 D. 121.7

63. If the current ratio is 2, the payment of a cash dividend, which was recorded as a liability on the date of declaration, will result in which of the following?

A. An increase in the current ratio. B. A decrease in the current ratio. C. No effect on the current ratio.

D. A decrease in the cash coverage ratio

64. Which of the following transactions would increase the current ratio of a company if the ratio is currently greater than 1?

A. Paid the principal on a long-term note payable. B. Borrowed cash on a short-term note.

C. Sold inventory for more than cost. D. Purchased supplies with cash.

65. Potaw Company reported the following data at the end of 2010:

What was the accounts receivable turnover ratio? A. 30.0

B. 37.5 C. 36.5 D. 22.5

(11)

66. Potaw Company reported the following data at the end of 2010:

What was the average number of days to collect receivables during 2010? A. 16.2.

B. 14.3. C. 36.5. D. 21.9.

67. Cromwell Company began the year with a balance in inventory of $110,000 and ended the year with a balance of $102,000. The net sales for the year were $983,000 with a gross profit on sales of $295,000. What was the inventory turnover ratio?

A. 2.78 B. 9.27 C. 6.49 D. 2.89

68. Thomas Company had income before interest and taxes of $120,000. Interest expense for the period was $17,000 and income taxes amounted to $28,500. The average stockholders' equity was $680,000. What is Thomas' return on equity (ROE)?

A. 17.65%. B. 15.15%. C. 13.46%. D. 10.96%.

69. Wildlife Co. reported net income of $8.3 million, interest expense of $.5 million and they are in a 30% tax rate bracket. Their average total assets are $65.8 million and average stockholders' equity is $48.6 million. What is Wildlife's financial leverage percentage?

A. 3.7% B. 4.5% C. 4.0% D. 4.7%

70. Which of the following is false?

A. The cash ratio is the most stringent and reliable test of liquidity.

B. A company with a high level of inventory will have a quick ratio significantly lower than its current ratio.

C. A current ratio that is too high could indicate funds tied up in inventory and other working capital assets. D. Analysts consider a current ratio of 2 to be financially conservative.

(12)

71. Which of the following is false?

A. The major difference between the quick and current ratios is inventory. B. Current liabilities are the denominator in the cash, quick, and current ratios.

C. Companies that sell expensive merchandise tend to have high inventory turnover ratios. D. Some analysts do not use the cash ratio because it is very sensitive to small events. 72. Which of the following is not a measure of solvency?

A. Debt to equity ratio. B. Cash coverage ratio. C. Times interest earned ratio. D. Earnings per share.

73. Bailey Corporation reported the following information for 2010:

What is Bailey's debt-to-equity ratio? A. 2

B. 1.25 C. 1.0 D. 3.0

74. The debt-to-equity ratio measures which of the following? A. Liquidity

B. Solvency C. Profitability D. Market strength

75. Which of the accounting ratios considers the importance of cash flows relating to required interest payments?

A. Times interest earned B. Debt-to-equity C. Cash coverage D. Quick

76. Which of the following is correct?

A. The times interest earned ratio is considered a better test of the ability to cover interest charges than the cash coverage ratio.

B. The debt to equity ratio shows the relative proportion of total assets financed by debt. C

.

The higher the debt-to-equity ratio, the higher the potential return to the stockholders if return on assets (ROA) exceeds the after tax cost of interest.

D. The cash coverage ratio compares the cash generated by a company to its cash obligations for the prior period.

(13)

77. Which ratio reflects the stock market's assessment of a company's future performance? A. Price/earnings ratio

B. Dividend yield ratio C. Fixed asset turnover ratio D. Cash coverage ratio

78. The Apple Pie Company had net income of $47,500, earnings per share of $3.17 and declared dividends per share of $2.00 during 2010. On December 31, 2010, the stock had a market price of $18.50 per share. What is Apple Pie's price/earnings ratio?

A. 9.25 B. 8.11 C. 5.84 D. 0.17

79. Main Street Company paid out $2.30 in dividends per share and had earnings per share of $5.00 during 2010. The market price of the stock on December 31, 2010 was $21.00 per share. There were 15,000 shares of stock outstanding for the entire year. What was the dividend yield as of December 31, 2010?

A. 16.43%. B. 10.95%. C. 9.13%. D. 46.00%.

80. MusicPod's earnings per share ratios were $2.47 and $2.07 respectively for 2011 and 2010. MusicPod's stock was trading at $53.00 and $41.50 per share at the end of 2011 and 2010 respectively. The company paid cash dividends per share of $.85 in 2011 and $.63 in 2010. Total stockholders' equity was $13,572 million and $11,896 million in 2011 and 2010 respectively. The common shares outstanding were approximately 1,782,000 in both 2011 and 2010. What was MusicPod's price/earnings ratio for 2011? A. 21.5

B. 62.4 C. 20.0 D. 2.9

81. MusicPod's earnings per share ratios were $2.47 and $2.07 respectively for 2011 and 2010. MusicPod's stock was trading at $53.00 and $41.50 per share at the end of 2011 and 2010 respectively. The company paid cash dividends per share of $.85 in 2011 and $.63 in 2010. Total stockholders' equity was $13,572 million and $11,896 million in 2011 and 2010 respectively. The common shares outstanding were

approximately 1,782,000 during both 2011 and 2010. What was MusicPod's dividend yield ratio for 2011? A. 34.4%

B. 1.4% C. 30.4% D. 1.6%

(14)

82. Lee Company has provided the following information: • Cash flow from operating activities, $240,000;

• Net income, $204,000; • Interest expense, $20,000; • Interest cash payments, $10,000; • Income tax payments, $140,000; • Income tax expense, $136,000. What was Lee's cash coverage ratio? A. 39.0

B. 20.0 C. 19.8 D. 39.6

• Net income, $204,000; • Interest expense, $20,000; • Interest cash payments, $10,000; • Income tax payments, $140,000; • Income tax expense, $136,000.

What was Lee's times interest earned ratio? A. 39.0

B. 18.0 C. 35.4 D. 17.7

What was Lee's quality of income ratio? A. 1.18

B. 0.85 C. 1.76 D. 0.74

(15)

85. Lucas Company has provided the following information: • Cash flow from operating activities, $360,000;

• Net income, $306,000; • Interest expense, $30,000; • Interest cash payments, $20,000; • Income tax payments, $240,000; • Income tax expense, $246,000. What was Lucas' cash coverage ratio? A. 21.0

B. 31.8 C. 21.2 D. 31.0

What was Lucas' times interest earned ratio? A. 18.9

B. 19.4 C. 28.3 D. 31.0

What was Lucas' quality of income ratio? A. 0.85

B. 0.74 C. 1.18 D. 0.93

88. Which of the following transactions doesn't affect earnings per share? A. A 2-for-1 common stock split.

B. A 10% common stock dividend distribution. C. Accruing revenue at year-end.

(16)

89. Which of the following transactions increases both the quick and current ratios assuming that both ratios are greater than 1?

A. Collecting an account receivable. B. Purchasing inventory on account. C. Accruing revenue earned at year-end.

D. Selling inventory on account at the cost of the inventory.

90. Which of the following correctly describes the effect of Mogul Company declaring and distributing a 10% common stock dividend?

A. Mogul's current ratio decreased.

B. Mogul's return on equity ratio decreased.

C. Mogul's debt-to-equity ratio remained the same. D. Mogul's return on assets decreased.

91. Which of the following does not correctly describe the effect of Mogul Company declaring and distributing a 2-for-1 common stock split?

A. Mogul's current ratio remained the same.

B. Mogul's return on equity ratio remained the same. C. Mogul's debt-to-equity ratio remained the same. D. Mogul's earnings per share remained the same.

92. Which of the following ratios increases when inventory is sold on account for a price equal to its original cost?

A. Current B. Quick

C. Return on assets D. Return on equity

93. Which of the following ratios increases when cash is collected on an account receivable? A. Current

B. Quick

C. Return on assets

D. Receivable turnover ratio

94. Which of the following ratios increases when a company switches from FIFO to LIFO during a period of increasing prices?

A. Current

B. Inventory turnover C. Profit margin D. Debt-to-equity

95. Which of the following transactions decreases the quality of income ratio? A. The accrual of interest expense.

B. Collecting cash on an account receivable. C. Selling inventory on account for a profit. D. Paying cash to a supplier.

(17)

96. The year-end adjusting entry to record bad debt expense will increase which of the following ratios? A. Current

B. Quality of income C. Quick

D. Profit margin

97. The year-end adjusting entry to adjust the unearned revenue account for revenue earned, decreases which of the following ratios?

A. Current B. Debt-to-equity C. Quick

D. Profit margin

98. Which of the following ratios are not affected by issuing long-term bonds payable in exchange for cash? A. Debt-to-equity

B. Current C. Cash Ratio

D. Quality of income

99. The journal entry to record depreciation expense decreases which of the following ratios? A. Debt-to-equity

B. Earnings per share C. Fixed asset turnover D. Quality of income

100.The cash payment of a previously declared dividend increases which of the following ratios? A. Debt-to-equity

B. Earnings per share C. Price earnings ratio D. Asset turnover

(18)

101.Complete the following income statement (both dollar amounts and component percentages):

102.Packers Corporation reported the following data for the year ended December 31, 2010:

Calculate each of the following ratios: A. Profit margin

B. Return on assets C. Return on equity D. Earnings per share E. Price/earnings ratio F. Debt-to-equity ratio

G. Financial leverage percentage H. Fixed asset turnover ratio

(19)

103.At the end of 2010, Jared Corporation reported a return on assets of 16%; net income of $42,000; average total assets of $365,000, and average total liabilities of $165,000. What was Jared's financial leverage percentage?

104.At the end of 2010, Doran Corporation reported net income of $70,000, gross sales revenue of $1,525,000, and sales returns of $125,000. Calculate the profit margin ratio.

105.The records of Washington Company showed the following:

Calculate each of the following ratios: A. Return on assets

B. Return on equity

C. Financial leverage percentage

(20)

106.The 2010 financial statements of Companies Y and Z showed the following:

107.The following return on investment ratios were computed for Steven Company:

Requirements:

A. Compute financial leverage percentage for each year.

(21)

108.The following data were shown in the records of Victoria Company at the end of 2010:

Calculate each of the following ratios: A. Quick ratio

B. Current ratio

C. Receivable turnover ratio D. Inventory turnover ratio E. Average age of receivables

F. Average days' supply in inventory

109.The following data were available for Holiday Company: Sales revenue, $225,000 (including $75,000 cash sales) Cost of goods sold, $175,000

Average balance in inventory, $20,000

Average balance in accounts receivable, $20,000 Calculate each of the following ratios:

A. Inventory turnover ratio

B. Average days' supply in inventory C. Receivable turnover ratio

(22)

110.Compete Corporation reported a quick ratio of 1.75, current assets of $50,000 and a current ratio of 2. Requirements:

A. Calculate the total amount of quick assets. B. What is another name for the quick ratio?

C. Describe what type of assets are considered quick assets and give some examples. D. How does the quick ratio compare to the current ratio?

111.The following data were reported by Universe Company at year-end:

Calculate each of the following ratios: A. Debt-to-equity

B. Current ratio C. Quick ratio

D. Which, if any, of the above are liquidity ratios? E. Which, if any, of the above are profitability ratios?

(23)

112.Walkers World Company gathered the following information for 2010:

Calculate each of the following ratios: A. Receivable turnover ratio

B. Average number of days to collect C. Inventory turnover ratio

(24)

113.Indicate the effect of each item on the ratios given below in the following manner: if an item would cause an increase in the ratio, place a check in the + column; if a decrease place a check in - column; and if no change, check the 0 column. Each item is independent of the others.

114.Longhorn Company reported the following data at year-end:

Calculate each of the following ratios: A. Debt to equity

(25)

115.Carolina Company computed the following ratios for a two year period:

116.The following financial data are available for Murphy Company:

Calculate each of the following ratios: A. Return on equity

B. Price/earnings ratio C. Dividend yield

(26)

117.The following data were reported for Favre Company:

Calculate each of the following ratios: A. Dividend yield

B. Price/earnings ratio C. Quality of income

118.Polk Corporation reported the following information related to its common stock (par $10) outstanding and net income:

Calculate each of the following ratios: A. Price/earnings ratio

(27)

119.MNF Corporation gathered the following data at the end of the accounting period, December 31, 2009:

Part 1: Calculate each of the following ratios: A. Profit margin

B. Return on equity C. Earnings per share D. Dividend yield ratio E. Price/earnings ratio F. Return on assets

G. Financial leverage percentage

(28)

ch14

Key

1. A primary objective of financial statements is to provide information to current and potential investors and creditors.

TRUE

A primary objective of financial reporting is to provide useful information to external decision makers.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Blooms: Remember Difficulty: Easy Learning Objective: 14-01 Explain how a companys business strategy affects financial analysis. Libby - Chapter 14 #1 Topic Area: Understanding A Companys Strategy

2. Return on equity (ROE) is a function of three ratios: net profit margin, return on assets, and financial leverage.

FALSE

ROE includes asset turnover rather than return on assets.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Remember Difficulty: Easy Learning Objective: 14-01 Explain how a companys business strategy affects financial analysis. Libby - Chapter 14 #2 Topic Area: Understanding A Companys Strategy

3. Return on equity (ROE) provides insight with respect to a company's use of its assets. TRUE

ROE includes asset turnover, which is a measurement of the efficient use of resources.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Remember Difficulty: Easy Learning Objective: 14-01 Explain how a companys business strategy affects financial analysis. Libby - Chapter 14 #3 Topic Area: Understanding A Companys Strategy

(29)

4. Time series analysis is where we compare information for a specific company over a period of time to determine changes in operations.

TRUE

A time series analysis compares information regarding a single company over time.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Remember Difficulty: Easy Learning Objective: 14-02 Discuss how analysts use financial statements. Libby - Chapter 14 #4 Topic Area: Financial Statement Analysis

5. Finding comparable companies in order to compare performance is often difficult since no two companies have identical products, markets and operating strategies.

TRUE

Finding comparable companies is usually difficult.

6. Finding comparable companies in order to compare performance is important because ratios in isolation are difficult to evaluate.

TRUE

A ratio has more meaning when there are relevant comparisons.

7. Component percentages are used to express items on financial statements as a percentage of a single base amount.

TRUE

A component percentage expresses financial statement items relative to a single financial statement amount.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Remember Difficulty: Easy Learning Objective: 14-03 Compute and interpret component percentages. Libby - Chapter 14 #7 Topic Area: Ratio and Percentage Analysis

(30)

8. Financial statement analysis is very precise and doesn't involve judgment. FALSE

Financial statement analysis utilizes a lot of judgment.

9. Purchasing treasury stock increases the return on equity ratio. TRUE

Purchasing treasury stock reduces average stockholders' equity, the ROE denominator, therefore the ratio increases.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-04 Compute and interpret profitability ratios. Libby - Chapter 14 #9 Topic Area: Ratio and Percentage Analysis

10. The return on assets ratio is influenced significantly by a company's relative debt and equity financing of its assets.

FALSE

Return on assets is not affected by the way in which the assets were financed.

11. Negative financial leverage occurs when a company has more debt than stockholders' equity. FALSE

Negative financial leverage occurs when the return on assets is greater than return on equity.

(31)

12. The financial leverage percentage is positive when return on assets is greater than return on equity. FALSE

Positive financial leverage occurs when the return on equity is greater than return on assets.

13. Earnings per share (EPS) is affected by treasury stock transactions. TRUE

Treasury stock transactions affect the number of common shares outstanding, which is the EPS denominator.

14. The quality of income ratio increases when net income increases. FALSE

The quality of income denominator is net income; an increase in net income therefore decreases the ratio.

15. The profit margin ratio considers the asset base utilized to earn income. FALSE

The profit margin ratio is net income divided by net sales and doesn't consider the resources (assets) used to earn income.

(32)

16. The fixed asset turnover ratio increases when net income increases. FALSE

The fixed asset turnover ratio is net sales revenue divided by average net fixed assets and is therefore not affected by net income.

17. The cash ratio is less sensitive to small transactions involving cash than is either the current or quick ratios.

FALSE

The numerator in the cash ratio is cash plus cash equivalents and is therefore very sensitive to cash transactions.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-05 Compute and interpret liquidity ratios. Libby - Chapter 14 #17 Topic Area: Ratio and Percentage Analysis

18. A company that has a high level of inventory and other assets above their investment in property, plant and equipment should calculate the total asset turnover ratio in addition to the fixed asset turnover ratio. TRUE

The total asset turnover ratio includes total assets in its denominator and should be calculated for those companies with large amounts of inventory and accounts receivable in addition to fixed assets.

(33)

19. A company with a high amount of inventory will have a much lower fixed asset turnover ratio when compared to its total asset turnover ratio.

FALSE

The total asset turnover ratio includes total assets in its denominator, whereas the fixed asset turnover ratio only includes property, plant and equipment in its denominator. Therefore, the fixed asset turnover ratio will exceed the total asset turnover ratio.

20. A higher current ratio is preferable for companies with variable cash flows. TRUE

Companies with variable cash flows need a higher current ratio in order to pay their current liabilities as they become due.

21. The quick ratio decreases when the adjusting entry to record bad debt expense is recorded. TRUE

The quick ratio numerator includes net accounts receivable, which decreases when bad debt expense is recorded.

22. A very high current ratio and low quick ratio may indicate the company is not collecting its accounts receivables in a timely manner.

FALSE

Net accounts receivable is included in the denominator of both ratios.

(34)

23. The inventory turnover ratio is significantly affected by the choice of inventory accounting method. TRUE

The inventory turnover ratio numerator (cost of goods sold) and denominator (average inventory) are both influenced by the inventory accounting method used.

24. The cash coverage ratio measures a firm's ability to pay its current liabilities with its cash flows from operating activities.

FALSE

The cash coverage ratio measures the ability of a company to make its cash interest payments.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-06 Compute and interpret solvency ratios. Libby - Chapter 14 #24 Topic Area: Ratio and Percentage Analysis

25. The price earnings ratio is affected by the amount of risk that investors are willing to take. TRUE

A high price earnings ratio means that investors are paying a high multiple of earnings per share when purchasing stock, which therefore creates more risk.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-07 Compute and interpret market test ratios. Libby - Chapter 14 #25 Topic Area: Ratio and Percentage Analysis

26. The debt to equity ratio is a risk measure used by both investors and lenders. TRUE

The debt to equity measure assesses risk and is used by both lenders and investors.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Easy Learning Objective: 14-07 Compute and interpret market test ratios. Libby - Chapter 14 #26 Topic Area: Ratio and Percentage Analysis

(35)

27. The dividend yield ratio decreases when earnings per share increases. FALSE

Dividend yield is calculated by dividing dividends per share by market price per share.

28. Many companies use high levels of debt to finance their assets because of financial leverage benefits provided to investors when return on assets exceeds the after tax cost of interest.

TRUE

Debt financing can be advantageous when the return on assets exceeds the cost of the debt.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-06 Compute and interpret solvency ratios. Libby - Chapter 14 #28 Topic Area: Ratio and Percentage Analysis

29. Dividend yield is calculated by dividing dividends per share by earnings per share and measures the current dividend return to investors.

FALSE

Dividend yield is calculated by dividing dividends per share by market price per share.

30. A high price earnings ratio usually indicates the market is optimistic about the company's future earnings potential.

TRUE

A high price earnings ratio occurs when investors are willing to pay a high multiple of the current earnings per share, which is an indicator of optimism.

(36)

31. There are several fundamental purposes decision makers consider when they use financial data. Which of the following statements is not one of those fundamental purposes?

A. Measurement of the current condition of the business.

B. Measurement of past performance of the business. C. Measurement of the book value of the assets.

D. Prediction of future potential of the business.

The book value is reported and doesn't need to be measured.

32. When considering an investment, which of the following is not one of the three critical factors used to evaluate future earning potential of that investment?

A. Financial analysts' reports.

B. Economy wide factors.

C. Industry factors.

D. Individual company factors.

Financial analysts' reports aren't one of the three factors described in the textbook.

A .

A company implementing a cost advantage strategy is attempting to reduce investment in assets thereby improving the asset turnover ratio.

B. A company implementing a product differentiation strategy is attempting to improve its profit margin through charging higher prices.

C .

A company will attract a higher volume of customers and revenue by following a product differentiation strategy versus a cost advantage strategy.

D. Financial leverage is a function of both total assets and stockholders' equity.

One can't predict which decision will result in a higher volume of customers and revenue.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Reporting Blooms: Understand Difficulty: Medium Learning Objective: 14-01 Explain how a companys business strategy affects financial analysis. Libby - Chapter 14 #33 Topic Area: Understanding A Companys Strategy

(37)

A. Purchasing fixed assets through debt financing decreases financial leverage.

B. Accruing an expense does not affect the net profit margin ratio.

C. Return on equity increases when the financial leverage ratio decreases. D. Purchasing treasury stock results in a decrease in asset turnover.

Purchasing treasury stock decreases average total assets, the asset turnover ratio denominator, which therefore increases the ratio.

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Hard Learning Objective: 14-01 Explain how a companys business strategy affects financial analysis. Libby - Chapter 14 #34 Topic Area: Understanding A Companys Strategy

A. Purchasing fixed assets through equity financing decreases asset turnover.

B. Accruing an expense increases the financial leverage ratio.

C. The return on equity ratio increases when treasury stock is purchased. D. The net profit margin ratio decreases when fixed assets are purchased. The net profit margin ratio is net income divided by net sales.

A. Selling inventory for cost does not affect the net profit margin ratio.

B. Accruing sales revenue doesn't affect the net profit margin ratio. C. The asset turnover ratio increases when fixed assets are sold for a loss.

D. The net profit margin ratio decreases when common stock is issued.

Selling fixed assets at a loss reduces average total assets, the asset turnover ratio denominator, the ratio therefore increases.

(38)

37. Home Depot's operating strategy is to offer a broad assortment of high-quality merchandise and services at competitive prices using highly knowledgeable service-oriented personnel and aggressive advertising. Which of the following is not as critical to achieving its strategy?

A. Cost control

B. Product differentiation

C. High level of customer service

D. High sales volume

Product differentiation is not generally as critical as other factors for large mass market retailers.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Decision Making Blooms: Understand Difficulty: Easy Learning Objective: 14-01 Explain how a companys business strategy affects financial analysis. Libby - Chapter 14 #37 Topic Area: Understanding A Companys Strategy

38. Which of the following statements is false?

A. When computing the component percentages for the income statement, net income is the base figure.

B. Time series analysis examines a company's performance over time.

C. It is often useful to compare a company's performance with that of a competitor.

D. The North American Industry Classification System assigns industry codes based on business operations.

Net sales are the base figure.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-02 Discuss how analysts use financial statements. Libby - Chapter 14 #38 Topic Area: Financial Statement Analysis

A. A ratio calculation is most relevant in isolation.

B. One of the advantages of ratio analysis is that it allows companies of different sizes to be compared.

C. Finding benchmarks for comparison is a straight-forward task.

D. It is always preferable to compare a company's performance to industry-wide ratios rather than to use a competitor's ratios.

A significant outcome of ratio analysis is the ability to compare different size firms.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-02 Discuss how analysts use financial statements. Libby - Chapter 14 #39 Topic Area: Financial Statement Analysis

(39)

40. The base amount in preparing a common-size income statement is usually which of the following?

A. Income from operations

B. Gross profit

C. Net income D. Net sales

Net sales are the base figure.

A. When cost of goods sold as a percentage of sales increases the gross margin percentage will increase. B. It is possible for cost of goods sold in dollars to increase while cost of goods sold as a percentage of

sales decreases.

C. If gross margin percentage is the same for the current and past year, then sales and cost of goods sold in dollars did not change.

D .

If gross margin percentage increases from one year to the next, then the net income percentage will also increase from one year to the next.

If the percentage increase in sales is greater relative to the percentage increase in cost of goods sold, cost of goods sold relative to sales will decrease.

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Medium Learning Objective: 14-03 Compute and interpret component percentages. Libby - Chapter 14 #41 Topic Area: Ratio and Percentage Analysis

(40)

A. If selling and administrative expenses as a percentage of sales increases, then gross margin percentage will decrease.

B. If the cost of goods sold percentage decreases and other expenses do not change, then profit margin will increase as a percentage of sales.

C .

If sales dollars decrease, a company might still report a higher gross profit percentage if cost of goods sold decreases at a faster rate than the decrease in sales.

D .

It is possible for selling and administrative expense in dollars to decrease, while selling and administrative expenses as a percentage of sales to increase.

Selling and administrative expenses do not affect the calculation of gross margin.

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Medium Learning Objective: 14-03 Compute and interpret component percentages. Libby - Chapter 14 #42 Topic Area: Ratio and Percentage Analysis

43. During 2010, Home Style's cost of goods sold percentage was 68.2% and selling and store operating costs was 19.3% of sales. During 2009, their cost of goods sold percentage was 68.9% while selling and store operating costs was 19.2% of sales. What effect would the change in these percentages have on 2010's gross margin percentage and profit margin percentage?

A .

The decrease in the cost of goods sold percentage would increase both the gross margin and profit margin percentages, but the increase in the selling and store operating costs percentage would decrease both the gross margin and profit margin percentages.

B .

The decrease in the cost of goods sold percentage would decrease both the gross margin and profit margin percentages, but the increase in the selling and store operating costs would increase both the gross margin and profit margin percentages.

C .

The decrease in the cost of goods sold percentage would increase both the gross margin and profit margin percentages and the decrease in the selling and store operating costs percentage would decrease the profit margin percentage.

D .

The decrease in the cost of goods sold percentage would decrease both the gross margin and profit margin percentages, but selling and store operating costs would increase the profit margin percentage. A decrease in the relative percentage of cost of goods sold to sales increases both the gross margin and profit margin ratios; while the increase in the selling and store operating costs percentage results in a decrease in the profit margin percentage.

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Hard Learning Objective: 14-03 Compute and interpret component percentages. Libby - Chapter 14 #43 Topic Area: Ratio and Percentage Analysis

(41)

44. Which of the following ratios is not considered to be a test of profitability? A. Current ratio

B. Profit margin

C. Return on assets

D. Earnings per share

The current ratio measures liquidity.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Easy Learning Objective: 14-04 Compute and interpret profitability ratios. Learning Objective: 14-05 Compute and interpret liquidity ratios. Libby - Chapter 14 #44 Topic Area: Ratio and Percentage Analysis

45. The records of Everyday Electronics Corporation for a particular period include the following:

What is the return on equity ratio?

A. 13.2%. B. 23.8%.

C. 24.0%.

D. 8.4%.

The return on equity ratio (23.8%) = Net income ($200,500 - $135,000) ÷ Average stockholders' equity ($760,000 + $485,000)

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Medium Learning Objective: 14-04 Compute and interpret profitability ratios. Libby - Chapter 14 #45 Topic Area: Ratio and Percentage Analysis

(42)

The return on assets is (round to the nearest tenth of a percent)

A. 14.9%.

B. 18.3%. C. 15.3%.

D. 14.7%.

The return on assets ratio (15.3%) = Net income ($4,580,000 - $4,100,000) + Interest expense net of tax [$90,000 × (1 - .4)] ÷ Average total assets ($3,500,000)

The return on equity is (round to the nearest tenth of a percent) A. 21.1%.

B. 10.2%.

C. 16.4%.

D. 17.1%.

The return on equity ratio (21.1%) = Net income ($4,580,000 - $4,100,000) ÷ Average stockholders' equity ($3,500,000 - $1,220,000)

(43)

The financial leverage percentage is which of the following?

A. 1.8%

B. 2.8%. C. 5.8%.

D. 6.4%.

The return on equity ratio (21.1%) = Net income ($4,580,000 - $4,100,000) ÷ Average stockholders' equity ($3,500,000 - $1,220,000)

The return on assets ratio (15.3%) = Net income ($4,580,000 - $4,100,000) + Interest expense net of tax [$90,000 × (1 - .4)] ÷ Average total assets ($3,500,000)

Financial leverage percentage (5.8%) = Return on equity ratio (21.1%) - Return on assets ratio (15.3%)

49. Which of the following transactions decreases earnings per share?

A. Declaring cash dividends payable to the common stockholders.

B. Purchasing treasury stock.

C. The accrual of revenue.

D. Declaring and distributing a 10% common stock dividend.

Issuing additional shares of common stock via a stock dividend increases the number of common shares outstanding and therefore decreases earnings per share.

(44)

50. Which of the following transactions decreases earnings per share?

A. Collection of an account receivable.

B. Selling treasury stock for an amount less than its cost.

C. A decrease in the market value per share.

D. Paying cash in advance for rent.

Selling treasury increases the number of common shares outstanding and therefore decreases earnings per share.

• Average treasury shares of common stock, 4,000. What were Trenton's earnings per share?

A. $8.00

B. $7.00

C. $10.50 D. $12.00

Earnings per share ($12) = Net income ($240,000) ÷ Average number of common shares outstanding (24,000 - 4,000).

(45)

• Average treasury shares of common stock, 4,000. What was Trenton's price earnings ratio?

A. 3.0

B. 5.1

C. 3.4

D. 4.5

Earnings per share ($12) = Net income ($240,000) ÷ Average number of common shares outstanding (24,000 - 4,000).

Price earnings ratio (3) = Market price per share ($36) ÷ Earnings per share ($12)

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Hard Learning Objective: 14-07 Compute and interpret market test ratios. Libby - Chapter 14 #52 Topic Area: Ratio and Percentage Analysis

53. Cecilia Company reported net income of $1,200,000. Their average total liabilities were $4,300,000 and average total stockholders' equity was $5,200,000. Interest expense was $100,000 and their tax rate was 40%. What was their return on assets ratio?

A. 13.7%.

B. 12.6%.

C. 11.6%. D. 13.3%.

The return on assets ratio (13.3%) = Net income ($1,200,000) + Interest expense net of tax [$100,000 × (1 - .4)] ÷ Average total assets ($4,300,000 + $5,200,000)

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Hard Learning Objective: 14-04 Compute and interpret profitability ratios. Libby - Chapter 14 #53 Topic Area: Ratio and Percentage Analysis

(46)

54. Which of the following transactions will increase the quality of income ratio?

A. Paying cash to suppliers.

B. Accruing sales revenue.

C. Selling treasury stock for more than its cost. D. Collecting an account receivable.

Collecting an account receivable increases cash flows from operating activities, the quality of income numerator, the ratio therefore increases.

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Medium Learning Objective: 14-04 Compute and interpret profitability ratios. Libby - Chapter 14 #54 Topic Area: Financial Statement Analysis

55. Negative financial leverage occurs when the

A. average net (after tax) interest rate on borrowed funds is less than the company's earnings rate on its assets.

B. return on assets is more than return on equity.

C. return on equity is more than return on assets.

D. operating expenses exceed gross margin.

Financial leverage percentage equals return on equity minus return on assets.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Remember Difficulty: Medium Learning Objective: 14-04 Compute and interpret profitability ratios. Libby - Chapter 14 #55 Topic Area: Financial Statement Analysis

56. Which of the following transactions will increase a current ratio which is currently 2.5?

A. Receiving cash from signing a 6-month note payable.

B. Accruing an expense.

C. Using cash to pay an account payable.

D. Collecting an account receivable.

Using cash to pay an account payable decreases current liabilities more so percentage wise than the decrease in current assets. As a result, the current ratio increases.

AACSB: Analytic AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Apply Difficulty: Medium Learning Objective: 14-05 Compute and interpret liquidity ratios. Libby - Chapter 14 #56 Topic Area: Financial Statement Analysis

(47)

57. Which of the following transactions will not increase the cash ratio?

A. Receiving cash from a common stock issue.

B. Refinancing a current liability with long-term debt. C. Using cash to purchase a two-month treasury bill.

D. Collecting an account receivable.

Using cash to purchase a two month treasury bill decreases cash and increases cash equivalents; therefore the cash ratio doesn't change.

58. Which of the following ratios is not an indicator of a company's short-term financial strength? A. Price/earnings ratio

B. Receivable turnover ratio

C. Working capital

D. Quick ratio

The P/E ratio is a market test ratio.

AACSB: Reflective Thinking AICPA BB: Critical Thinking AICPA FN: Measurement Blooms: Understand Difficulty: Medium Learning Objective: 14-05 Compute and interpret liquidity ratios. Learning Objective: 14-07 Compute and interpret market test ratios. Libby - Chapter 14 #58 Topic Area: Financial Statement Analysis

59. Teague Company's working capital was $40,000 and total current liabilities were 1/4 of that amount. What was the current ratio?

A. 1

B. 3 C. 5

D. 7

Current liabilities ($10,000) = Working capital ($40,000) × ¼

Current assets ($50,000) - Current liabilities ($10,000) = Working capital ($40,000) Current ratio (5) = Current assets ($50,000) ÷ Current liabilities ($10,000)

(48)

What was the current ratio?

A. 0.5 B. 1.5

C. 2.5

D. 0.75

Current ratio (1.5) = Current assets ($150,000) ÷ Current liabilities ($300,000 - $200,000)

What was the inventory turnover ratio?

A. 2.2

B. 1.8 C. 2.0

D. 3.0

Inventory turnover ratio (2.0) = Cost of goods sold ($84,000) ÷ Average inventory ($38,000 + $46,000) ÷ 2