Preview Extract
Chapter 5
Using Financial Statement Information
Multiple Choice Questions
1. The current ratio is
a. current assets divided by current liabilities.
b. current liabilities divided by current assets.
c. current assets divided by total liabilities.
d. total assets divided by total liabilities.
Answer: A
2. The current ratio
a. provides users with an estimate of a company’s human resources.
b. is reported on a company’s balance sheet in the asset section.
c. is a measure of a company’s solvency.
d. is a measure of a company’s liquidity.
Answer: C
3. Earnings per share
a. must appear on a company’s income statement if the company is publicly traded.
b. is rarely used by analysts since it is not required by GAAP.
c. is based on the market price of the company’s stock.
d. is typically presented in its two forms: simple and advanced.
Answer: A
4. Return on equity compares
a. the market price of the company’s stock to its dividend policy.
b. a company’s earnings to the dividends paid for the year.
c. the profits of a company to the investment made by its shareholders.
d. the profits of a company to the selling price of each share of stock.
Answer: C
5. Operating performance is a company’s ability to
a. control acquisitions of other companies in the same industry.
b. generate cash from sources other than regular operations.
c. increase its net assets through regular operations
d. employ off-balance-sheet financing.
Answer: C
6. Financial statements help present and potential investors, creditors, and other users in
assessing the amount, timing, and uncertainty of
a. future income.
b. future assets.
c. future liabilities.
d. future cash flows.
Answer: D
7. The price-earnings ratio is
a. the market price of an equity share divided by earnings per share.
b. the amount of a company’s retained earnings.
c. the purchase price of a firm's assets divided by net income.
d. used to measure the speed at which the company sells its inventories.
Answer: A
8. Financial flexibility is
a. a good indicator of a company’s ability to grow through operations.
b. evident when a company’s assets are greater than its liabilities.
c. the ability to convert existing assets into money.
d. the ability to generate cash from sources other than regular operations.
Answer: D
9. A standard audit report
a. states that a company has the right to select members of its board of directors.
b. serves as the accounting profession’s seal of approval.
c. states whether a company will be profitable or not in the future.
d. serves as a guarantee that the financial statements are free of any errors.
Answer: B
10. Liquidity is the ability
a. to increase net assets through regular operations.
b. to generate cash from sources other than regular operations.
c. to convert existing assets into cash.
d. of financial statement users to predict a company’s cash flows.
Answer: C
11. Which of the following may be a limitation of financial statements?
a. Subject to biases of management
b. Provides no information on the company’s accounting methods
c. Typically reflects the view of inherently unethical managers
d. Communicates only market values and no historical information
Answer: A
12. Which one of the following is a reason a company’s reported book value and its True
value may differ?
a. Management calculates net worth different than shareholders.
b. GAAP requires too many estimates.
c. Statements are forward-looking.
d. Statements do not reflect the company’s prospects within its business environment.
Answer: D
13. The current ratio helps assess a company’s
a. profitability.
b. asset turnover.
c. capital structure leverage.
d. solvency.
Answer: D
14. Return on equity helps assess a company’s
a. marketability.
b. solvency.
c. profitability.
d. leverage.
Answer: C
15. The quick ratio helps assess a company’s
a. annual stock price.
b. solvency.
c. inventory turnover.
d. profit during the current period.
Answer: B
16. The dividend yield ratio helps assess the
a. profitability of the current year.
b. cash return on a shareholders’ investment.
c. company’s ability to pay its current liabilities as they come due.
d. solvency of a company.
Answer: B
17. Which of the following ratios would be of primary importance to a manager in evaluating
the success of a new policy of reducing the stock of goods needed to meet customer demand?
a. Total asset turnover
b. Fixed assets turnover
c. Receivables turnover
d. Inventory turnover
Answer: D
18. Which of the following ratios might a potential investor use to determine if the return to
shareholders is a large portion of the total return generated by a company?
a. Earnings per share
b. Common equity leverage
c. Current ratio
d. Total asset turnover
Answer: B
19. Assessing a company’s inventory turnover helps assess the
a. effectiveness of a company’s collection activities.
b. ability to measure the quality of the inventory on hand.
c. speed at which inventories move through operations.
d. efficiency of a company.
Answer: C
20. Which of the following ratios would be of primary importance to a supplier in deciding to
extend credit for goods delivered?
a. Earnings per share
b. Debt/equity ratio
c. Accounts receivable turnover
d. Quick ratio
Answer: D
21. Which of the following ratios would be of primary importance to a creditor in deciding to
extend long-term credit?
a. Current ratio
b. Debt/equity ratio
c. Inventory turnover
d. Earnings per share
Answer: B
22. Which of the following ratios would be of primary importance to a manager in evaluating
the success of a computerized collection process?
a. Accounts receivable turnover
b. Account payable turnover
c. Quick ratio
d. Return of equity
Answer: A
23. Book value fails to reflect True value primarily because:
a. financial statements are irrelevant.
b. financial statements are backward-looking.
c. financial statements are forward-looking.
d. financial statements are typically biased.
Answer: B
24. Which of the following is a fundamental way in which financial accounting numbers are
useful?
a. They can predict the way the stock price will behave.
b. They are used to assess the quality of a company’s products.
c. They can be used to predict a company's future earnings.
d. They identify the effect of inflation on the value of company’s assets.
Answer: C
25. The long-term debt ratio
a. measures the significance of long-term debt as a source of asset financing.
b. measures the effect of management’s use of long-term debt.
c. compares profits to the company’s total debt.
d. is a measure of profitability.
Answer: A
26. The use of financial statements for predicting future earnings and cash flows is limited
due to
a. management bias, lack of forward-looking information, and certain inherent limitations.
b. lack of judgment, management bias, and lack of inclusion of inflationary effects.
c. lack of forward and backward-looking information.
d. lack of backward-looking information, the likelihood of management bias, and the
omission of historical costs.
Answer: A
27. Which one of the following is a step used in assessing whether a particular investment
should be made or not?
a. Determine the number of employees a company has.
b. Obtain an understanding of the company and its industry.
c. Determine the number of years the company has been in business.
d. Calculate the amount of advertising costs incurred by the company during the previous
year.
Answer: B
28. A standard audit report states that the financial statements
a. were examined in great detail and contain no errors.
b. were prepared by management.
c. were certified error free by the independent auditor.
d. represent a substantial doubt of the ability of the company to continue as a going concern.
Answer: B
29. A company would likely "take a bath"
a. in periods of extraordinary high net income.
b. just prior to creating hidden reserves.
c. when it has experienced an extremely poor year.
d. when its quality of earnings is very high.
Answer: C
30. An analyst assessed a company and determined the company to have reported a "high
quality of earnings." This implies that
a. management issued a press release indicating it was not aware of any fraud during the
current year.
b. the company’s management exercised little or no discretionary influence in reporting
financial statement information to shareholders.
c. management has used its influence in determining the dollar amounts reported on financial
statements.
d. income statement items reported during the current period can be expected to reflect future
income levels.
Answer: B
31. Managers that structure financing transactions and choose accounting methods that
exclude debt on the company’s balance sheet are using
a. hidden reserves.
b. fraudulent methods by default.
c. performance overstatement.
d. off-balance-sheet financing.
Answer: D
32. Information concerning industry averages will likely be found in
a. Barron’s.
b. The Wall Street Journal.
c. Dun & Bradstreet's Key Business Ratios.
d. The New York Times.
Answer: C
33. Common-size financial statements are expressed as
a. percentages of other numbers on the same statements.
b. a percent comparison of other companies in the same industry.
c. a common way of preparing certain types of financial statements.
d. percentages of increases and decreases compared to the previous accounting period.
Answer: A
34. The primary measure of the overall success of a company is
a. total shareholders' equity.
b. total assets.
c. net income.
d. the number of shares of stock it has sold to investors.
Answer: C
35. Many ratios require an average be used for the balance sheet numbers because the
a. income statement refers to a point in time.
b. accountants may have made errors in the financial statements.
c. balance sheet numbers are a point in time and are being compared to an income statement
number that covers a period of time.
d. income statement numbers represent a point in time and are being compared to a balance
sheet number that covers a period of time.
Answer: C
36. Using borrowed funds to generate returns for the shareholders is called
a. leverage.
b. profitability.
c. taking a bath.
d. solvency.
Answer: A
37. A company that reports high levels of common equity leverage is probably
a. reporting higher earnings per share than other companies in the same industry.
b. meeting its financing needs effectively.
c. using leverage very effectively.
d. demonstrating it has a large amount of off-balance-sheet financing.
Answer: C
38. The item that causes the greatest and most immediate effect on a company’s stock price
will generally be
a. cash on hand.
b. the company's solvency.
c. profits.
d. dependent upon the industry in which the company operates.
Answer: C
39. Investors who use accounting information to guide trading in foreign securities
a. should carefully compare expenses, but not revenues to companies in the same industry in
the United States.
b. must adjust the numbers of foreign-based companies’ financial statements and thoroughly
understand the foreign environment.
c. must contact the foreign CEO before any investment in stock occurs.
d. should contact the foreign company’s auditors to find out how much dividends will be
paid.
Answer: B
40. The DuPont model is
a. a method of off-balance sheet financing.
b. a framework to analyze ROE changes and identify value drivers.
c. a method of preparing a balance sheet.
d. a solvency calculation.
Answer: B
41. Accounting numbers are useful in that they
a. are easy to manipulate by management and help predict a company’s future earnings and
cash flows.
b. allow users to see management’s predictions of future profits and help predict a company’s
future cash flows.
c. help investors and creditors influence and monitor management’s business decisions and
help predict a company’s future earnings and cash flows.
d. help investors and creditors influence, manipulate, and monitor management’s business
decisions so that future profits are high.
Answer: C
42. The two fundamental ways in which financial accounting numbers are useful are
a. prediction and influence.
b. control and monitoring.
c. prediction and monitoring.
d. control and prediction.
Answer: D
43. True value of a company is determined by
a. adding adjustments for the business environment, unrecorded events, and types of
shareholders to the book value of a company.
b. adding adjustments for the business environment, unrecorded events, and cumulative
profits to the book value of a company.
c. adding adjustments for the business environment, management bias, and cumulative profits
to the book value of a company.
d. adding adjustments for the business environment, unrecorded events, and management bias
to the book value of a company.
Answer: D
44. What type of audit report do most companies receive from their auditors?
a. standard audit reports
b. no report unless the company has problems
c. a GAAP report
d. a comprehensive report
Answer: A
Use the information that follows taken from Campbell Company’s financial statements for
the years ending December 31, 2010 and 2009 to answer problems 45 through 48.
45. Calculate Campbell’s current and quick ratios as of December 31, 2009 and December
31, 2010 and choose the correct answers below:
a. Campbell’s quick and current ratios improved from December 31, 2009 to December 31,
2010.
b. Campbell’s quick and current ratios worsened from December 31, 2009 to December 31,
2010.
c. Campbell’s quick ratio improved but the current ratio worsened December 31, 2009 to
December 31, 2010.
d. Campbell’s quick ratio worsened but the current ratio improved from December 31, 2009
to December 31, 2010.
Answer: B
Campbell has the following solvency ratios on December 31:
The current ratio declined from 1.45 to 1.42 and the quick ratio declined from 1.18 to 1.12.
46. Calculate Campbell’s inventory turnover ratio and accounts receivable turnover ratio for
the year ended 2010. Further, assume that in Campbell’s industry, the industry average
inventory turnover ratio is 12 and the industry average receivables turnover ratio is 14.
a. Campbell’s inventory turnover ratio and accounts receivable turnover ratios are better than
average for Campbell’s industry.
b. Campbell’s inventory turnover ratio and accounts receivable turnover ratios are worse than
average for Campbell’s industry.
c. Campbell’s inventory turnover ratio is better but the accounts receivable turnover ratio is
worse than average for Campbell’s industry.
d. Campbell’s inventory turnover ratio is worse and accounts receivable turnover ratio is
better than average for Campbell’s industry.
Answer: C
Campbell has the following turnover ratios on December 31, 2010:
Inventory turnover is 12.14 compared to 12 for the industry and receivables turnover is 13.07
as compared to the industry average of 14. So, inventory turnover is better and accounts
receivable turnover is worse.
47. Calculate Campbell’s return on equity and return on assets for the year ended December
31, 2010. Assume that the income tax rate is 30%. Also assume that in Campbell’s industry,
the industry average return on equity is 19% and the average return on assets is 11%.
a. Campbell’s return on equity and return on assets are better than average for Campbell’s
industry.
b. Campbell’s return on equity and return on assets are worse than average for Campbell’s
industry.
c. Campbell’s return on equity is better but return on assets is worse than average for
Campbell’s industry.
d. Campbell’s return on equity is worse but return on assets is better than average for
Campbell’s industry.
Answer: B
Because net income is negative, both of these ratios are less than zero and both ratios are
worse than the industry average.
48. Calculate Campbell’s debt to equity ratio as of December 31, 2009 and as of December
31, 2010. Also assume that in Campbell’s industry, the industry average debt to equity ratio is
2.75 as of December 31, 2009 and as of December 31, 2010.
a. Campbell’s debt to equity ratio improved from 2009 to 2010.
b. Campbell’s debt to equity ratio was better than average for the industry both years.
c. Campbell’s debt to equity is worse than average for the industry for both years.
d. Both a and b above, but not c.
Answer: C
Campbell has the following debt to equity ratios on December 31:
Unlike the other ratios we study in this course, the lower the debt to equity ratio, the better.
Hence, the ratio worsened from 2009 to 2010 and is worse than the industry average.
49. Devin Inc. has an inventory turnover ratio of 30. Devin’s average number of day’s
inventory is:
a. Less than 10.
b. Between 10 and 12.
c. More than 12.
d. Unable to be determined based on this limited information.
Answer: C
365 / 30 = 12.2 days
50. Justin Company has total assets, liabilities, and shareholders' equity of $36,000, $15,000,
and $21,000, respectively, at the beginning of 2010. At the end of 2010, total assets,
liabilities, and shareholders' equity were reported at $32,000, $13,000, and $19,000,
respectively. What is Justin’s debt to equity ratio?
a. 0.70
b. 1.17
c. 0.71
d. 1.13
Answer: A
Answer: Debt/equity ratio = Average total liabilities / Average total shareholders’ equity
= (($15,000 + $13,000)/2) / (($21,000 + $19,000)/2) = .70
51. Justin Company has total assets, liabilities, and shareholders' equity of $36,000, $15,000,
and $21,000, respectively, at the beginning of 2010. At the end of 2010, total assets,
liabilities, and shareholders' equity were reported at $32,000, $13,000, and $19,000,
respectively. How much additional debt can Justin Company incur and still have its
debt/equity ratio remain less than or equal to 1.00?
a. $6,000
b. $25,000
c. $12,000
d. $24,000
Answer:
A. Debt/equity ratio = Average total liabilities / Average total shareholders’ equity
= (($15,000 + $13,000)/2) / (($21,000 + $19,000)/2) = .70
Average total liabilities can increase up to $20,000 and still maintain a debt/equity ratio of
1.0. In order to make the numerator equal to $20,000, the ending debt could increase up to
$25,000:
Average total liabilities = ($15,000 + $25,000)/2 = $20,000
Since total debt at the end of 2010 is $13,000, the increase in debt could be up to $12,000
($25,000 less $13,000).
52. Sheena Company has current assets, current liabilities, and long-term liabilities of
$19,000, $13,000, and $17,000, respectively. Within these amounts, $3,000 is accounts
payable, and $3,500 is accounts receivable. If $2,000 of cash were used to pay off the
accounts payable, what effect would this have on the current ratio?
a. The current ratio would increase by approximately 0.09.
b. The current ratio would decrease by approximately 0.09.
c. The current ratio would decrease by approximately 0.03.
d. There would be no change in the current ratio.
Answer: Current ratio before payment of payables = $19,000/$13,000 = 1.46
Current ratio after payment of payables = ($19,000 – $2,000)/($13,000 – $2,000) = 1.55
53. Buffalo Company has current assets, current liabilities, and long-term liabilities of
$9,000, $3,000, and $4,000, respectively at the end of 2010. How much cash can Buffalo use
to acquire equipment and retain a current ratio of at least 2.0?
a. $1,000
b. $3,000
c. $4,000
d. $6,000
Answer: Current ratio before acquisition of equipment = $9,000/$3,000 = 3.0
Current ratio after acquisition of equipment = ($9,000 – $X)/$3,000 = 2.0
So X = $3,000
If $3,000 of cash is used, then current assets = $6,000 and the current ratio = 2.0.
54. Rudy Company has total assets, liabilities, and shareholders' equity of $35,000, $28,000,
and $7,000, respectively. Assume no material change occurred during the year to totals on the
balance sheet. What amount of long-term debt must Rudy exchange for new shares of
common stock issued in order to decrease its debt/equity ratio to 1.0?
a. $17,500
b. $10,500
c. $14,000
d. $21,000
Answer:
Rudy can exchange stock for debt up to $10,500 and still keep a debt/equity ratio of 100%, or
1.0.
55. Samson Company has common stock of $150,000 and retained earnings of $140,000 at
yearend. During the year, 20,000 shares of stock were outstanding. Net income was reported
as $70,000. What is the company’s earnings per share?
a. $3.50
b. $1.07
c. $0.73
d. $10.25
Answer:
56. Grey Company has a current ratio of 0.30 and return on equity of 0.05. Which of the
following statements is the best regarding Grey’s profitability and solvency?
a. Grey is very profitable, but not very solvent.
b. Grey is very profitable and very solvent.
c. Grey is not very profitable, but very solvent.
d. Grey is not very profitable and not very solvent.
Answer: D
Solvency: Not very solvent—For every dollar of current liabilities, the company has only 30
cents of liquid assets available. It will likely not be able to pay its current debts when they
become due.
Profitability: Not very profitable— Net income is only 5 percent of the amount of average
shareholders’ equity.
57. Pasky Company has the following financial data on January 1, 2010 and January 1, 2009.
In terms of the quick and current ratio, which of the following statements is True?
a. Pasky’s short-term solvency position has improved.
b. Pasky’s short-term solvency position has declined.
c. Pasky’s short-term solvency position has remained the same
d. Pasky’s quick ratio is increasing, but its current ratio is decreasing.
Answer: D
58. Walker Company has the following assets on January 1, 2010 and January 1, 2009.
If Walker’s quick ratio is 3.00 for 2010, what is the amount of its current liabilities?
a. $325,000
b. $259,000
c. $285,000
d. There is not enough information to answer this question.
Answer: B
Quick ratio = ($439 + $302 + $36) / x = 3.0
X = $259,000
59. Norton Company has the following assets on January 1, 2010 and January 1, 2009.
If Norton’s current ratio is 2.20 for 2009 and its current liabilities are $550,000, what is the
amount of its inventory?
a. $197,000
b. $381,000
c. $238,636
d. There is not enough information to answer this question.
Answer: B
$550,000 x 2.20 = $1,210,000
$1,210,000 - $366,000 – $333,000 – $130,000 = $381,000
60. Norton Company has the following assets on January 1, 2010 and January 1, 2009.
If Norton’s quick ratio is 2.60 for 2010 and its current liabilities are $512,000, what is the
amount of its accounts receivables?
a. $324,000
b. $204,800
c. $715,200
d. There is not enough information to answer this question.
Answer: C
$512,000 x 2.60 = $1,331,200
$1,331,200 - $430,000 – $186,000 = $715,200
61. The following ratios were computed from the financial statement of Darren Technologies:
Which of the following statements is True?
a. There has been a steady decline in ROE from 2009 through 2011.
b. The increase in ROA is due primarily to the changes in asset turnover.
c. The changes in ROA could be due to increasing sales.
d. The change in ROA could be due to a large increase in the asset base of the company.
Answer: D
62. Assume that the following financial ratios were computed from the 2009 financial
statements of Florida Industries:
What was the return on equity for Florida in 2009?
a. 4%
b. 33%
c. 51%
d. 11%
Answer: B
63. Assume that the following financial ratios were computed from the 2009 financial
statements of Florida Industries:
If Florida holds its other ratios constant in 2010, but increases its capital structure leverage
ratio to 3.00, what will be the 2010 return on equity?
a. 15%
b. 51%
c. 86%
d. 44%
Answer: D
64. Assume that the following financial ratios were computed from the 2009 financial
statements of Florida Industries:
If Florida holds its other ratios constant in 2010, but increases its profit margin to 36%, what
will be the 2010 return on assets?
a. 5%
b. 78%
c. 61%
d. 51%
Answer: C
Matching Questions
1. Match the correct ratio name from the list below labeled a through g with each
formula appearing in items 1 through 5.
____ 1. (Cash + accounts receivable + marketable securities) / current liabilities
____ 2. (Net income + interest expense) / average total assets
____ 3. Current assets / current liabilities
____ 4. Net income / average number of shares of common stock
____ 5. Market price per share / earnings per share
Answer:
1. b
2. e
3. d
4. c
5. a
2. Match the correct ratio name from the list below labeled a through f with the ratio formulas
appearing in items 1 through 4.
____ 1. Market price per share / earnings per share
____ 2. Dividends per share / market price per share
____ 3. Average total liabilities / average total shareholders' equity
____ 4. Net income / average shareholders’ equity
Answer:
1. d
2. f
3. a
4. e
3. Match the correct ratio category from the list below labeled a through e with each ratio that
appears in items 1 through 12.
Answer:
1. c
2. a
3. d
4. a
5. e
6. c
7. b
8. d
9. a
10. b
11.e
12. a
4. For each characteristic which appears numbered from 1 through 5 below, select the correct
factor which should be considered in each assessment as listed in items a through e.
____ 1. Ability to get cash from sale of assets and issuance of debt or stock
____ 2. Avoiding reporting financial responsibilities on the balance sheet
____ 3. Measured by profitability and activity ratios and cash provided by operations
____ 4. Delaying the sale of inventory until the following year because current profits are
satisfactory
____ 5. Ability to convert existing assets into cash
Answer:
1. b
2. e
3. d
4. a
5. c
Short Problems
1. Smith Company has total assets, liabilities, and shareholders' equity of $20,000, $7,000,
and $13,000, respectively, at the beginning of 2010. At the end of 2010, total assets,
liabilities, and shareholders' equity were reported at $16,000, $5,000, and $11,000,
respectively.
A. How much additional debt can Smith incur and still have its debt/equity ratio remain less
than or equal to 1.00?
B. What information does the debt/equity ratio provide you?
Answer: A. Debt/equity ratio = Average total liabilities / Average total shareholders’ equity
= (($7,000 + $5,000)/2) / (($13,000 + $11,000)/2) = .50
Average total liabilities can increase up to $12,000 and still maintain a debt/equity ratio of
1.0. In order to make the numerator equal to $12,000, the ending debt could increase up to
$17,000:
Average total liabilities = ($7,000 + $17,000)/2 = $12,000
Since total debt at the end of 2010 is $5,000, the increase in debt could be up to $12,000
($17,000 less $5,000).
B. The debt/equity ratio is a leverage ratio that indicates how the company financed its
operations. At the end of 2010, Smith’ debt/equity ratio means that for every dollar of
shareholders’ equity, the company has 50 cents of debt. This ratio is low compared to many
U.S. companies.
2. Monroe Company has current assets, current liabilities, and long-term liabilities of
$12,000, $3,000, and $9,000, respectively. Within these amounts, $1,000 is accounts payable,
and $1,500 is accounts receivable. What effect will the payment of the accounts payable have
on the current ratio? Should Monroe pay the accounts payable on the last day of the year?
Explain.
Answer: Current ratio before payment of payables = $12,000/$4,000 = 4.0
Current ratio after payment of payables = ($12,000 – $1,000)/($3,000 – $1,000) = 5.5
If $1,000 of cash were used, the current ratio would increase to 5.5. Therefore, Monroe
should pay off the debt at yearend given the favorable effect on current ratio.
Use the information that follows taken from Carter Company’s financial statements for the
years ending December 31, 2010 and 2009 to answer problems 3 through 9.
3. Using the two solvency ratios (current and quick), indicate whether Carter’s solvency
position improved or deteriorated during 2010.
Answer:
Carter has the following solvency ratios on December 31:
Carter’s current and quick ratios increased significantly during 2010. Its solvency position
has greatly improved.
4. If the industry in which Carter is a member has an average accounts receivable turnover of
27 times, determine if in 2010, Carter is more or less efficient at converting sales to cash than
the average firm in its industry. Assume all sales were credit sales.
Answer: Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
= $900/$40 = 22.5 times
Carter’s receivable turnover ratio is less than the industry average, indicating a larger than
average accounts receivable balance relative to credit sales. This indicates that Carter is less
efficient in collecting receivables from customers than the average firm in its industry.
5. If the industry in which Carter is a member has an average current ratio of 1.9, determine
if, on December 31, 2010, Carter is more or less solvent than the average firm in its industry
as measured by its current ratio.
Answer: Current ratio = ($60 + $40 + $40)/$85 = 1.47
Carter’s current ratio of 1.47 is less than the industry current ratio of 1.9. This indicates that
Carter is less solvent than the average firm in its industry.
6. If the industry in which Carter is a member has an average return on equity of 22%,
determine if in 2010, Carter is more or less profitable than the average firm in its industry.
Answer: Return on equity = Net income / Average shareholders’ equity
= $100/((($200 + $35) + ($200 + $135))/2) = 35%
Carter's return on equity is greater than the industry average. This implies that Carter is more
profitable than the average firm in its industry.
7. The industry in which Carter is a member has an average return on assets of 18%. Carter
reported no interest expense during 2010. Determine if Carter is more or less profitable in
2010 than the average firm in its industry.
Answer:
Carter's return on assets is greater than its industry average. This indicates that Carter is more
profitable than the average firm in its industry.
8. If the industry in which Carter is a member has an inventory turnover of 11 times,
determine if in 2010, Carter is more or less efficient at converting inventory into sold units
than the average firm in its industry. Explain what information this ratio provides you.
Answer:
Carter's inventory turnover ratio is less than industry average, revealing a larger average
inventory relative to cost of goods sold. Carter is less efficient than the average firm in its
industry in selling its inventory. During 2010, Carter sold the entire cost of its inventory only
six times compared to other companies in this industry which sold their inventory an average
of 11 times during the year.
9. The industry in which Carter is a member has an average debt/equity ratio of 0.83.
Determine if, as measured by the debt/equity ratio on December 31, 2010, Carter is taking
full advantage of investing borrowed capital in its operations relative to that of the average
firm in its industry. Explain.
Answer: Debt/equity ratio = Average total liabilities / Average shareholders’ equity
= (($95 + $245)/2)/(($335 + $235)/2) = 0.60
Carter's debt/equity ratio is much less than its industry average. Therefore, Carter has not
issued as much debt, relative to its shareholders' equity, as that of the average firm in its
industry. Thus, Carter is not taking advantage of leverage possibilities. Leverage is an
indicator of whether the company uses borrowed funds to generate returns for the
shareholders.
10. Washington Company has current assets, current liabilities, and long-term liabilities of
$8,000, $2,000, and $5,000, respectively at the end of 2010. How much cash can Washington
use to acquire equipment and retain a current ratio of at least 2.0?
Answer: Current ratio before acquisition of equipment = $8,000/$2,000 = 4.0
Current ratio after acquisition of equipment = ($8,000 – $X)/$2,000 = 2.0
So X = $4,000
If $4,000 of cash is used, then current assets = $4,000 and the current ratio = 2.0.
11. Madison Company has current assets, current liabilities, and long-term liabilities of
$8,000, $4,000, and $6,000, respectively. Within these amounts, inventory was $2,000,
receivables were $2,000, cash was $4,000, and payables were $1,000. Calculate Madison’s
quick ratio. What information does this provide?
Answer: Quick ratio = Quick assets / Current liabilities = ($2,000 + $4,000)/$4,000 = 1.5
Madison has 1.5 times as much quick assets as current liabilities. Its ability to pay its current
debts is clearly evident.
12. Briefly describe the solvency and profitability of a company with a quick ratio of 4.74
and return on equity of 0.49.
Answer: Solvency: Very solvent—The company has 4.74 times more quick assets than
needed to pay current debt when it becomes due.
Profitability: Very profitable—Its net income is 49% of average total shareholders’ equity.
Use the information that follows taken from Tyler Company’s financial statements for the
years ending December 31, 2010 and 2009 to answer problems 13 through 19.
13. If the industry in which Tyler is a member has an inventory turnover of 9 times, determine
if Tyler is more or less efficient at converting inventory into sales than the average firm in its
industry during 2010.
Answer: Inventory turnover ratio = Cost of goods sold / Average inventory
= $600/(($40 + $80)/2) = 10 times
Tyler’s inventory turnover ratio is more than the industry average, revealing a smaller
average inventory relative to cost of goods sold. Tyler is more efficient than the average firm
in its industry in selling its inventory. During 2010, Tyler sold the entire cost of its inventory
10 times compared to other companies in this industry which sold their total inventory an
average of 9 times during the year.
14. The industry in which Tyler is a member has an average accounts receivable turnover of
10 times. How does Tyler compare in 2010? Comment on what information is provided with
this calculation and how credit managers might use it to make decisions. Assume all sales
were credit sales.
Answer: Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
= $850/($60 + $80)/2 = 12.14 times
Tyler’s receivables turnover ratio is more than the industry average, indicating a smaller than
average accounts receivable balance relative to credit sales. This indicates that Tyler is more
efficient in collecting receivables from customers than the average firm in its industry. Tyler
collects the entire dollar amount of its receivables approximate 12 times per year compared to
the industry average of 10 times per year.
15. If the industry in which Tyler is a member has an average return on assets of 11%,
determine if in 2010, Tyler is more or less profitable than the average firm in its industry.
Assume Tyler has no interest expense.
Answer: Return on assets = Net income / Average total assets
= $20/(($410 + $470)/2) = 4.5%
Tyler's return on assets is substantially less than the industry average of 11%. Therefore, Tyler
is less profitable than the average firm in its industry.
16. The industry in which Tyler is a member has an average return on equity of 10%. For
2010, determine how Tyler compares.
Answer: Return on equity = Net income / Average shareholders’ equity
= $20/(($405 + $385)/2) = 5.1%
Tyler's return on equity is less than the industry average of 10%. This implies that Tyler is
less profitable than the average firm in its industry.
17. The industry in which Tyler operates has an average current ratio of 2.1 on December 31,
2010. Comment on Tyler’s solvency compared to the industry average as measured by its
current ratio.
Answer: Current ratio = Current assets / Current liabilities = ($80 + $60 + $40) / $5 =36.
Tyler's current ratio on December 31, 2010 is 36 , which is much higher than industry
average. The current ratio indicates that Tyler is much more solvent than the average firm in
its industry on December 31, 2010.
18. The industry in which Tyler is a member has an average debt/equity ratio of 0.98.
Determine if, as measured by Tyler’s debt/equity ratio on December 31, 2010, Tyler is taking
full advantage of investing borrowed capital in its operations relative to that of the average
firm in its industry.
Answer: Debt/equity = Average liabilities / Average shareholders’ equity
= (($5+ $85)/2)/((($250 + $155) + ($250 + $135))/2) = .114 = 11.4%
Since Tyler's debt/equity ratio is much less than the industry average, this implies that Tyler
has a much smaller percentage of debt compared to its shareholders’ equity, and that more of
the company is financed with equity than with debt. Thus, Tyler is not taking advantage of
leverage possibilities.
19. Using the two solvency ratios (current and quick), indicate whether Tyler's solvency
position improved or deteriorated during 2010.
Answer: Current ratio = Current assets / Current liabilities =
2010 = ($80 + $60 + $40)/$5 = 36.00
2009 = ($40 + $80 + $80)/$85 = 2.35
Quick ratio = Quick assets / Current liabilities =
2010 = ($80 + $60)/$5 = 28.00
2009 = ($40 + $80)/$85 = 1.41
Tyler's current and quick ratio improved exponentially during 2010. However, upon closer
inspection, Tyler's ratios increased because its accounts payable was nearly eliminated due to
a possible sale of property and cash flow from operations being applied to current liabilities.
20. Monroe Company has total assets, liabilities, and shareholders' equity of $30,000,
$23,000, and $7,000, respectively. Assume no material change occurred during the year to
totals on the balance sheet. What amount of long-term debt must Monroe exchange for new
shares of common stock issued in order to decrease its debt/equity ratio to 1.0?
Answer: Actual debt/equity ratio = Average liabilities / Average shareholders’ equity
= $23,000/$7,000 = 3.29
Monroe's debt/equity ratio is currently 3.29. In paying off new debt by issuing new stock, for
every dollar added to common stock, Monroe must deduct $1 from its liabilities:
= ($23,000 – X)/($7,000 + X) = 1.00 Solve for X = $8,000
Monroe can exchange stock for debt up to $8,000 and still keep a debt/equity ratio of 100%,
or 1.0.
21. Harrison Company has common stock of $50,000 and retained earnings of $40,000 at
yearend. During the year, 10,000 shares of stock were outstanding. Net income was reported
as $5,000.
A. Calculate earnings per share.
B. How does earnings per share differ from most of the other ratios with respect to financial
statements?
Answer:
A. Earnings per share = Net income / Average number of common shares outstanding
= $5,000/10,000 = $ 0.50 per common share
B. Earnings per share must be reported on the face of the income statement whereas the other
ratios are used primarily for analysis purposes and are never reported on the financial
statements.
22. Briefly describe a company with a current ratio of 0.33 and return on equity of 0.02.
Answer: Solvency: Not very solvent—For every dollar of current liabilities, the company has
only 33 cents of liquid assets available. It will likely not be able to pay its current debts when
they become due.
Profitability: Not very profitable— Net income is only 2 percent of the amount of average
shareholders’ equity.
23. Taylor Company has the following financial data on January 1, 2010 and January 1, 2009.
A. In terms of the quick and current ratio, has the short-term solvency position of Taylor
improved, remained the same, or declined?
B. If you were a potential short-term creditor to Taylor, would you be more willing to extend
credit on either January 1, 2009 or 2010? Explain.
Answer:
Taylor’s short-term solvency position has improved significantly. Its current ratio has
increased from 3.55 to 4.0, and the quick ratio has increased from 1.95 to 2.77.
B. Taylor’s short-term solvency position on 1/1/10 is acceptable and has increased since
1/01/09. A short-term creditor would definitely be more willing to extend credit to Taylor on
1/1/10 than on 1/1/09.
24. Briefly describe a company with a quick ratio of 3.78 and return on equity of 0.05.
Answer: Solvency: Currently very solvent—Quick assets are 3.78 times as much as current
liabilities.
Profitability: Weak profitability—Net income is only 5 percent of the amount of average
shareholders’ equity. Continuation of such a low profitability will likely affect the company's
future solvency.
Short Essay Questions
1. Distinguish between backward-looking and forward-looking as it pertains to financial
statements.
Answer: Backward-looking implies that financial statements reflect historical costs—
amounts that pertain to accounting periods of our past, i.e., last year, and the year before, etc.
Forward-looking information reflects the future prospects of a company. Companies do not
issue financial statements with forward-looking amounts, although users attempt to predict
what will happen in the future based on the backward-looking perspective.
2. What role do investment services, such as Moody’s and Standard & Poor's, play in the
assessment of a business environment?
Answer: Investment services provide extensive analyses of the operations and financial
position of companies. The services also rate the riskiness of the company's outstanding debt.
Analysts use these ratings to reflect a company's future prospects within its business
environment and have a direct bearing on a company’s ability to issue debt with reasonable
terms.
3. Comment on the following news headline: "Van Buren, Inc. Takes a Bath in Current Year."
Answer: When a company experiences an extremely poor year, it sometimes chooses very
conservative accounting methods, estimates, or judgments. Conservative accounting methods
typically recognize expenses and losses in the current period. A poor year coupled with
additional expenses and losses further reduces the company’s financial condition and
operating performance in the year. This strategy, called ‘taking a bath,’ enables companies to
recognize losses in years that are already very poor, in hopes that these losses may be less
obvious. On the contrary, a company which reports an extremely poor year, that defers
additional expenses and losses to the next accounting period will likely appear to users to be
establishing a trend of losses.
4. Indicate three reasons why reported book value and True value may differ.
Answer: 1. The financial statements do not reflect the company's prospects within its business
environment.
2. The financial statements themselves are inherently limited.
3. Management tends to prepare the reports in a biased manner.
5. What must an analyst learn first prior to assessing a particular business environment?
Answer: An analyst must first learn about the company, its industry, and how the company
and industry relate to the overall economy.
6. Identify two forms of analyzing financial statements at a particular point in time. Which of
these forms is subject to great variation among different analysts?
Answer: The two forms of financial statement analysis are common-size financial statements
and ratio analysis. Ratio analysis is a manner of computing ratios based on information
provided by the income statement and/or balance sheet. Analysts select various ratios on
which to place emphasis based on the analysts’ company’s policies, personal opinion, or other
judgment factors.
7. Buchanan Company has the following financial data on December 31, 2010 and 2009:
Required: Using appropriate ratios, comment on the change in Buchanan's solvency position
and assess the probable cause of the change from 2009 to 2010.
Answer: Current ratio: 2009: ($14,000 + $12,000 + $15,000)/$8,000 = 5.13
Current ratio: 2010: ($19,000 + $4,000 + $12,000)/$18,000 = 1.94
Quick ratio: 2009: ($14,000 + $12,000)/$8,000 = 3.25
Quick ratio: 2010: ($19,000 + $4,000)/$18,000 = 1.28
Buchanan's solvency position has deteriorated during 2010.This is revealed by the decreases
in its current ratio from 5.13 to 1.94 and quick ratio from 3.25 to 1.28. It may be difficult for
Buchanan to meet its current liabilities when they are due. The reason for this deterioration is
not caused by a lack of cash flows from operations. Buchanan also did not use cash to
purchase investments nor did it receive cash from issuing long-term debt or common stock.
The reason for Buchanan 's significant deterioration in its solvency position is that it paid
$22,000 of dividends. This payment used cash that was needed for operating activities and
caused the poor current and quick ratios.
8. Why are all companies not audited by certified public accountants?
Answer: Only those companies whose equity securities are traded on public stock exchanges
are legally required to retain the services of a certified public accountant for an audit. Given
that a comprehensive audit can be very time-consuming and costly, and many of these
companies do not rely on outside sources of capital, smaller companies may choose not to be
audited.
9. Briefly explain how management may influence the quality of earnings of a company.
Answer: Managers can influence reported accounting numbers by manipulating the timing of
when transactions/business events occur. The company with a very low quality of earnings
normally means that management has used much of its discretionary influence to report the
dollar amounts on the financial statements. A high quality of earnings implies that
management has exercised little or no such influence.
10. How might a company overstate performance? Why might this occur?
Answer: A company might overstate performance by accelerating the recognition of revenues
or deferring the recognition of expenses. Managers may use this strategy in an effort to attract
capital, or in situations where companies face financial difficulties.
11. How does off-balance sheet financing make a company appear less risky?
Answer: Off-balance-sheet financing avoids the recognition of debt directly on the
company’s balance sheet. Managers have been known to structure financing transactions and
choose certain accounting methods so that debt need not be reported on the balance sheet. By
keeping the debt off the company’s balance sheet, certain ratios are improved which provides
a stronger financial picture.
12. Explain the concept of leverage.
Answer: Leverage refers to using borrowed funds to generate returns for the shareholders. A
company that borrows money at 9 percent interest then invests the funds to generate a 15
percent return is using leverage effectively. Leverage creates returns for the company’s
shareholders without using stockholder’s money. In using leverage a company typically
increases its risk because it's debt is increased. This increase in debt commits the company to
future cash obligations.
13. In what ways might an investor use accounting information provided by a foreign
company differently from information provided by a domestic corporation?
Answer: Accounting practices of different countries may differ significantly from U.S.
GAAP. An investor would benefit from adjusting the foreign statements to reflect U.S.
accounting principles. Unfortunately, adjustment by itself may not be sufficient to achieve
meaningful comparisons. Differences across environments because of social, economic, legal,
and cultural environmental influences further complicate the interpretation of the adjusted
financial statements.
14. How does operating performance differ from financial flexibility?
Answer: Operating performance represents a company's ability to grow and increase its assets
through operations. Financial flexibility refers to a company's ability to produce cash through
means other than operations, i.e., issuing debt, issuing equity, and selling long-term assets.
Companies capable of generating cash through means other than operations are considered to
be financially flexible. A company with superior operating performance is likely to be
evaluated as being financially solvent.
Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt
9780470635292, 9781119537571, 9781119444367
