FS Analysis

FINANCIAL STATEMENT ANALYSIS
TRUE-FALSE STATEMENTS
1. Earning power refers to a company’s ability to sustain its profits from operations.
2. When the disposal of a significant segment occurs, the income statement should report
both income from continuing operations and income (loss) from discontinued operations.
3. An event or transaction should be classified as an extraordinary item if it is unusual in

nature or if it occurs infrequently.
4. If a firm has only one change in accounting principle over several years, it would be
classified on the income statement as an extraordinary item.
5. A change in accounting principle occurs when the principle used in the current year is
different from the one used by competitors in the current year.
6. Comprehensive income includes all changes in stockholders’ equity during a period

except those resulting from investments by stockholders and distributions to stockholders.
7. Intracompany comparisons of the same financial statement items are often useful to
detect changes in financial relationships and significant trends.
8. Comparisons of company data with industry averages provide information about a

company's relative position within the industry.
9. Horizontal, vertical, and circular analyses are the basic tools of financial statement
analysis.
10. Horizontal analysis is a technique for evaluating a financial statement item in the current
year with other items in the current year.
11. Another name for horizontal analysis is trend analysis.
12. If a company has sales of $110 in 2001 and $154 in 2002, the percentage increase in
sales from 2001 to 2002 is 140%.
13. In horizontal analysis, if an item has a negative amount in the base year, and a positive
amount in the following year, no percentage change for that item can be computed.
14. Vertical analysis is a technique for evaluating a series of financial statement data over a
period of time to determine the increase (decrease) that has taken place.
15. Common size analysis expresses each item in a financial statement as a percent of a
base amount.
16. In the vertical analysis of a balance sheet, the base for current liabilities is total liabilities.
17. Vertical analysis is useful in making comparisons of companies of different sizes.
18. Using vertical analysis of the income statement, a company's net income as a percentage
13- Test Bank for Managerial Accounting, Second Edition
2
of net sales is 15%; therefore, the cost of goods sold as a percentage of sales must be
85%.
19. In the vertical analysis of an income statement, each item is generally stated as a
percentage of net income.
20. Liquidity ratios measure the ability of the enterprise to survive over a long period of time.
21. A solvency ratio measures the income or operating success of an enterprise for a given
period of time.
22. The current ratio is a measure of all the ratios calculated for the current year.
23. Inventory turnover measures the number of times on the average the inventory was sold
during the period.
24. Profitability ratios are frequently used as a basis for evaluating management's operating
effectiveness.
25. The return on assets ratio will be greater than the rate of return on common stockholders'
equity if the company has been successful in trading on the equity at a gain.
26. An advantage of the current and acid-test ratios is they use year-end balances of current
asset and current liability accounts.
27. From a creditor's point of view, the higher the total debt to total assets ratio, the lower the
risk that the company may be unable to pay its obligations.
28. A current ratio of 1.2 to 1 indicates that a company's assets exceed its current liabilities.
29. Using borrowed money to increase the rate of return on common stockholders' equity is
called "trading on the equity."
30. Diversification in American industry limits the usefulness of financial analysis.
Answers to True-False Statements
Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
1. T 6. T 11. T 16. F 21. F 26. F
2. T 7. T 12. F 17. T 22. F 27. F
3. F 8. T 13. T 18. F 23. T 28. T
4. F 9. F 14. F 19. F 24. T 29. T
5. F 10. F 15. T 20. F 25. F 30. T
Financial Statement Analysis 13-3
MULTIPLE CHOICE QUESTIONS

31. The discontinued operations section of the income statement refers to
a. discontinuance of a product line.
b. the income or loss on products that have been completed and sold.
c. obsolete equipment and discontinued inventory items.
d. the disposal of a significant segment of a business.
32. Which one of the following would be classified as an extraordinary item?

a. Expropriation of property by a foreign government
b. Losses attributed to a labor strike
c. Write-down of inventories
d. Gains or losses from sales of equipment
33. When a change in accounting principle occurs,

a. all prior years' financial statements should be changed to reflect the newly adopted
principle.
b. the new principle should be used in reporting the results of operations of the current
year.
c. the cumulative effect of the change in principle should be reflected on the income
statement as of the beginning of the next year.
d. the cumulative effect of the change in accounting principle should be classified as an
extraordinary item on the income statement.
34. If an item meets one (but not both) of the criteria for an extraordinary item, it
a. only needs to be disclosed in the footnotes of the financial statements.
b. may be treated as sales revenue (if it is a gain) and as an operating expense (if it is a
loss).
c. is reported as an "other revenue or gain" or "other expense and loss," net of tax.
d. is reported at its gross amount as an "other revenue or gain" or "other expense or
loss."
35. The order of presentation of nontypical items that may appear on the income statement is
a. Extraordinary items, Discontinued operations, Change in accounting principle.
b. Discontinued operations, Extraordinary items, Change in accounting principle.
c. Change in accounting principle, Discontinued operations, Extraordinary items.
d. Change in accounting principle, Extraordinary items, Discontinued operations.
36. In analyzing the financial statements of a company, a single item on the financial
statements
a. should be reported in boldface type.
b. must be compared with other financial data to provide more information.
c. is significant only if it is large.
d. should be accompanied by a footnote.
37. Comparisons of financial data made within a company are called

a. intracompany comparisons.
b. interior comparisons.
c. intercompany comparisons.
d. intramural comparisons.
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38. Which one of the following is not a tool in financial statement analysis?
a. Horizontal analysis
b. Circular analysis
c. Vertical analysis
d. Ratio analysis
39 In analyzing financial statements, horizontal analysis is a

a. requirement.
b. tool.
c. principle.
d. theory.
40. Horizontal analysis is also known as

a. linear analysis.
b. vertical analysis.
c. trend analysis.
d. common size analysis.
41. Under which of the following cases may a percentage change be computed?
a. The trend of the amounts is decreasing but all amounts are positive.
b. There is no amount in the base year.
c. There is a negative amount in the base year and a negative amount in the subsequent
year.
d. There is a negative amount in the base year and a positive amount in the subsequent
year.
42. Horizontal analysis is a technique for evaluating a series of financial statement data over a
period of time
a. that has been arranged from the highest number to the lowest number.
b. that has been arranged from the lowest number to the highest number.
c. to determine which items are in error.
d. to determine the amount and/or percentage increase or decrease that has taken
place.
43. Horizontal analysis is a technique for evaluating financial statement data

a. within a period of time.
b. over a period of time.
c. on a certain date.
d. as it may appear in the future.
44. Assume the following sales data for a company:

2003 $1,800,000
2002 1,500,000
2001 1,000,000
If 2001 is the base year, what is the percentage increase in sales from 2001 to 2003?
a. 100%
b. 180%
c. 80%
d. 55.5%
45. Comparative balance sheets are usually prepared for

a. one year.
b. two years.
c. three years.
d. four years.
46. Vertical analysis is also known as

a. perpendicular analysis.
b. common size analysis.
c. trend analysis.
d. straight-line analysis.
47. Vertical analysis is a technique that expresses each item in a financial statement
a. in dollars and cents.
b. as a percent of the item in the previous year.
c. as a percent of a base amount.
d. starting with the highest value down to the lowest value.
48. In vertical analysis,

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

a. total current assets.
b. total assets.
c. total liabilities.
d. prepaid expenses in a previous year.
50. In performing a vertical analysis, the base for sales revenues on the income statement is
a. net sales.
b. sales.
c. net income.
d. cost of goods available for sale.
51. In performing a vertical analysis, the base for sales returns and allowances is
a. sales.
b. sales discounts.
c. net sales.
d. total revenues.
52. In performing a vertical analysis, the base for cost of goods sold is
a. total selling expenses.
b. net sales.
c. total revenues.
d. total expenses.
53. Which one of the following is not a characteristic generally evaluated in ratio analysis?
a. Liquidity
b. Profitability
c. Marketability
d. Solvency
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54. Short-term creditors are usually most interested in assessing
a. solvency.
b. liquidity.
c. marketability.
d. profitability.
55. Long-term creditors are usually most interested in evaluating

a. liquidity.
b. marketability.
c. profitability.
d. solvency.
56. Stockholders are most interested in evaluating

a. liquidity.
b. solvency.
c. profitability.
d. marketability.
57. In ratio analysis, the ratios are never expressed as a

a. rate.
b. logarithm.
c. percentage.
d. simple proportion.
58. The current ratio is

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

a. is used to quickly determine a company's solvency and long-term debt paying ability.
b. relates cash, short-term investments, and net receivables to current liabilities.
c. is calculated by taking one item from the income statement and one item from the
balance sheet.
d. is the same as the current ratio except it is rounded to the nearest whole percent.
60. Winter Clothing Store had a balance in the Accounts Receivable account of $390,000 at
the beginning of the year and a balance of $410,000 at the end of the year. Net credit
sales during the year amounted to $4,000,000. The average collection period of the
receivables in terms of days was
a. 30 days.
b. 365 days.
c. 73 days.
d. 37 days.
61. Pine Hardware Store had net credit sales of $6,500,000 and cost of goods sold of
$5,000,000 for the year. The Accounts Receivable balances at the beginning and end of
the year were $600,000 and $700,000, respectively. The receivables turnover was
a. 7.7 times.
b. 10.8 times.
c. 9.3 times.
d. 10 times.
Use the following information for questions 62-63.
Winslow Department Store had net credit sales of $16,000,000 and cost of goods sold of
$12,000,000 for the year. The average inventory for the year amounted to $2,000,000.
62. Inventory turnover for the year is

a. 8 times.
b. 14 times.
c. 6 times.
d. 4 times.
63. The average days in inventory during the year was

a. 91 days.
b. 61 days.
c. 46 days.
d. 26 days.
64. Which one of the following would not be considered a liquidity ratio?
a. Current ratio
b. Inventory turnover
c. Quick ratio
d. Return on assets
65. Asset turnover measures

a. how often a company replaces its assets.
b. how efficiently a company uses its assets to generate sales.
c. the portion of the assets that have been financed by creditors.
d. the overall rate of return on assets.
66. The profit margin ratio is calculated by dividing

a. sales by cost of goods sold.
b. gross profit by net sales.
c. net income by stockholders' equity.
d. net income by net sales.
Use the following information for questions 67-68.
Terry Corporation had net income of $200,000 and paid dividends to common stockholders of
$40,000 in 2002. The weighted average number of shares outstanding in 2002 was 50,000
shares. Terry Corporation's common stock is selling for $60 per share on the New York Stock
Exchange.
67. Terry Corporation's price-earnings ratio is

a. 3.8 times.
b. 15 times.
c. 18.8 times.
d. 6 times.
68. Terry Corporation's payout ratio for 2002 is

a. $4 per share.
b. 25%.
c. 20%.
d. 12.5%.
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69. Grand Company reported the following on its income statement:
Income before income taxes $400,000
Income tax expense 100,000
Net income $300,000
An analysis of the income statement revealed that interest expense was $100,000. Grand
Company's times interest earned was
a. 5 times.
b. 4 times.
c. 3.5 times.
d. 3 times.
70. The debt to total assets ratio measures

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

a. amount of working capital.
b. amount of capital provided by owners.
c. use of borrowed money to increase the return to owners.
d. number of times interest is earned.
72. The current assets of Key Company are $150,000. The current liabilities are $100,000.
The current ratio expressed as a proportion is
a. 150%.
b. 1.5:1
c. .67:1
d. $150,000 ÷ $100,000.
73. The acid-test ratio is also referred to as the

a. short run ratio.
b. quick ratio.
c. working capital ratio.
d. contemporary ratio.
74. A weakness of the current ratio is

a. the difficulty of the calculation.
b. that it doesn't take into account the composition of the current assets.
c. that it is rarely used by sophisticated analysts.
d. that it can be expressed as a percentage, as a rate, or as a proportion.
75. A supplier to a company would be most interested in the

a. asset turnover ratio.
b. profit margin ratio.
c. current ratio.
d. earnings per share.
76. Which one of the following ratios would not likely be used by a short-term creditor in
evaluating whether to sell on credit to a company?
a. Current ratio
b. Acid-test ratio
c. Asset turnover
d. Receivables turnover
77. Ratios are used as tools in financial analysis

a. instead of horizontal and vertical analyses.
b. because they can provide information that may not be apparent from inspection of the
individual components of a particular ratio.
c. because even single ratios by themselves are quite meaningful.
d. because they are prescribed by GAAP.
78. The ratios that are used to determine a company's short-term debt paying ability are
a. asset turnover, times interest earned, current ratio, and receivables turnover.
b. times interest earned, inventory turnover, current ratio, and receivables turnover.
c. times interest earned, acid-test ratio, current ratio, and inventory turnover.
d. current ratio, acid-test ratio, receivables turnover, and inventory turnover.
79. Tyner Company had $250,000 of current assets and $90,000 of current liabilities before
borrowing $60,000 from the bank with a 3-month note payable. What effect did the
borrowing transaction have on Tyner Company's current ratio?
a. The ratio remained unchanged.
b. The change in the current ratio cannot be determined.
c. The ratio decreased.
d. The ratio increased.
80. A liquidity ratio measures the

a. income or operating success of an enterprise over a period of time.
b. ability of the enterprise to survive over a long period of time.
c. short-term ability of the enterprise to pay its maturing obligations and to meet
unexpected needs for cash.
d. number of times interest is earned.
81. If equal amounts are added to the numerator and the denominator of the current ratio, the
ratio will always
a. increase.
b. decrease.
c. stay the same.
d. equal zero.
82. The acid-test ratio

a. is a quick calculation of an approximation of the current ratio.
b. does not include all current liabilities in the calculation.
c. does not include inventory as part of the numerator.
d. does include prepaid expenses as part of the numerator.
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83. If a company has an acid-test ratio of 1.2:1, what respective effects will the borrowing of
cash by short-term debt and collection of accounts receivable have on the ratio?
Short-term Borrowing Collection of Receivable
a. Increase No effect
b. Increase Increase
c. Decrease No effect
d. Decrease Decrease
84. A company has a receivables turnover of 10 times. The average net receivables during
the period are $300,000. What is the amount of net credit sales for the period?
a. $30,000.
b. $3,000,000.
c. $360,000.
d. Cannot be determined from the information given.
85. If the average collection period is 30 days, what is the receivables turnover?
a. 11.1 times
b. 12.2 times
c. 6.1 times
d. None of these
86. A general rule to use in assessing the average collection period is

a. that it should not exceed 30 days.
b. it can be any length as long as the customer continues to buy merchandise.
c. that it should not greatly exceed the discount period.
d. that it should not greatly exceed the credit term period.
87. Inventory turnover is calculated by dividing

a. cost of goods sold by the ending inventory.
b. cost of goods sold by the beginning inventory.
c. cost of goods sold by the average inventory.
d. average inventory by cost of goods sold.
88. A company has an average inventory on hand of $40,000 and its average days in
inventory is 73 days. What is the cost of goods sold?
a. $200,000.
b. $2,920,000.
c. $400,000.
d. $1,460,000.
89. A successful grocery store would probably have

a. a low inventory turnover.
b. a high inventory turnover.
c. zero profit margin.
d. low volume.
90. An aircraft company would most likely have

a. a high inventory turnover.
b. a low profit margin.
c. high volume.
d. a low inventory turnover.
91. Net sales are $6,000,000, beginning total assets are $2,800,000, and the asset turnover is
3.0. What is the ending total asset balance?
a. $2,000,000.
b. $1,200,000.
c. $2,800,000.
d. $1,600,000.
92. The numerator of the times interest earned ratio is

a. income before income taxes.
b. net income.
c. net income + interest expense.
d. net income + interest expense + income taxes.
93. The return on common stockholders’ equity ratio is computed by dividing net income
a. by average common stockholders’ equity.
b. by ending common stockholders’ equity.
c. minus preferred stock dividends by average common stockholders’ equity.
d. minus preferred stock dividends by ending common stockholders’ equity.
94. The return on assets ratio is affected by the

a. asset turnover ratio.
b. debt to total assets ratio.
c. profit margin ratio.
d. asset turnover and profit margin ratios.
95. Measures of the short-term ability of the enterprise to pay its maturing obligations are
a. liquidity ratios.
b. marketability ratios.
c. profitability ratios.
d. solvency ratios.
96. A measure of a company’s immediate short-term liquidity is the

a. current ratio.
b. current cash debt coverage ratio.
c. cash debt coverage ratio.
d. acid-test ratio.
97. The ratio that indicates a company’s degree of financial leverage is the
a. cash debt coverage ratio.
b. debt to total assets ratio.
c. free cash flow ratio.
d. times interest earned ratio.
98. Earnings per share is computed by dividing net income

a. by average common shares outstanding.
b. by ending common shares outstanding.
c. less preferred stock dividends by average common shares outstanding.
d. less preferred stock dividends by ending common shares outstanding.
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99. A measure of how efficiently a company uses its assets to generate sales is the
a. return on assets ratio.
b. profit margin ratio.
c. cash return on sales ratio.
d. asset turnover ratio.
100. A limitation in calculating ratios in financial statement analysis is that

a. it requires a calculator.
b. no one other than management would be interested in them.
c. some account balances may reflect atypical data at year end.
d. they seldom identify problem areas in a company.
101. Which of the following is not a limitation of financial statement analysis?

a. The cost basis
b. The use of estimates
c. The diversification of firms
d. The availability of information
102. The use of alternative accounting methods

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

a. unadjusted cost.
b. price-level adjusted cost.
c. the lower of cost or price-level adjusted historical cost.
d. fair market value.
104. Estimates are used in financial statements in determining all of the following except
a. contingent losses.
b. cost of goods sold.
c. periodic depreciation.
d. warranty costs.
105. In addition to differences in inventory costing methods, differences also exist in reporting
all of the following except
a. amortization.
b. depletion.
c. depreciation.
d. warranty costs.
Answers to Multiple Choice Questions
Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans.
31. d 42. d 53. c 64. d 75. c 86. d 97. b
32. a 43. b 54. b 65. b 76. c 87. c 98. c
33. b 44. c 55. d 66. d 77. b 88. a 99. d
34. d 45. b 56. c 67. b 78. d 89. b 100. c
35. b 46. b 57. b 68. c 79. c 90. d 101. d
36. b 47. c 58. b 69. a 80. c 91. b 102. b
37. a 48. a 59. b 70. d 81. b 92. d 103. a
38. b 49. b 60. d 71. c 82. c 93. c 104. b
39. b 50. a 61. d 72. b 83. c 94. d 105. d
40. c 51. c 62. c 73. b 84. b 95. a
41. a 52. b 63. b 74. b 85. b 96. d
EXERCISES
Ex. 106
Indicate whether the following items would be reported as an ordinary or an extraordinary item in
Hartley Corporation's income statement.
(a) Loss attributable to labor strike.
(b) Gain on sale of fixed assets.
(c) Loss from fire. Hartley is a chemical company.
(d) Loss from sale of marketable securities.
(e) Expropriation of property by a foreign government.
(f) Loss from tornado damage. Hartley Corporation is located in the Midwest's tornado alley.
(g) Loss from government condemnation of property through a newly enacted law.
Solution 106 (6-9 min.)

(a) ordinary (e) extraordinary
(b) ordinary (f) ordinary
(c) ordinary (g) extraordinary
(d) ordinary
Ex. 107
Stiner Company has income from continuing operations of $480,000 for the year ended
December 31, 2002. It also has the following items (before considering income taxes):
(1) An extraordinary fire loss of $180,000.
(2) A gain of $120,000 on the discontinuance of a major segment.
(3) A cumulative effect of a change in accounting principle that resulted in an increase in prior
years' depreciation of $70,000.
Assume all items are subject to income taxes at a 30% tax rate.
Instructions
Prepare an income statement, beginning with income from continuing operations.
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STINER COMPANY
Partial Income Statement
For the Year Ended December 31, 2002
Income from continuing operations ............................................................ $480,000
Discontinued operations
Gain on discontinued segment, net of $36,000 income taxes ........... 84,000
Income before extraordinary item and cumulative effect of change in
accounting principle ................................................................................ 564,000
Extraordinary item
Fire loss, net of $54,000 tax saving ................................................... (126,000)
Cumulative effect of change in accounting principle
Effect on prior years of change in depreciation method, net of
$21,000 income tax saving ............................................................ (49,000)
Net income ................................................................................................. $389,000
Ex. 108
Comparative information taken from the Walters Company financial statements is shown below:
2002 2001
(a) Notes receivable $ 20,000 $ -0-
(b) Accounts receivable 182,000 140,000
(c) Retained earnings 30,000 (40,000)
(d) Income taxes payable 45,000 20,000
(e) Sales 900,000 750,000
(f) Operating expenses 170,000 200,000
Instructions
Using horizontal analysis, show the percentage change from 2001 to 2002 with 2001 as the base
year.

(a) Base year is zero. Not possible to compute.
(b) $42,000 ÷ $140,000 = 30% increase
(c) Base year is negative. Not possible to compute.
(d) $25,000 ÷ $20,000 = 125% increase
(e) $150,000 ÷ $750,000 = 20% increase
(f) $30,000 ÷ $200,000 = 15% decrease
Ex. 109
Cline Corporation had net income of $2,000,000 in 2001. Using 2001 as the base year, net
income decreased by 70% in 2002 and increased by 175% in 2003.
Instructions
Compute the net income reported by Cline Corporation for 2002 and 2003.

2002: X ÷ $2,000,000 = 70%
X = $2,000,000 × .70 = $1,400,000
The decrease is $1,400,000; therefore net income for 2002 is $600,000.
2003: X ÷ $2,000,000 = 175%

X = $2,000,000 × 1.75
X = $3,500,000
The net income for 2003 is $5,500,000 ($2,000,000 + $3,500,000).
Ex. 110
The following items were taken from the financial statements of Smalley, Inc., over a four-year
period:
Item 2003 2002 2001 2000

Net Sales $800,000 $650,000 $600,000 $500,000
Cost of Goods Sold 580,000 460,000 420,000 400,000
Gross Profit $220,000 $190,000 $180,000 $100,000
Instructions
Using horizontal analysis and 2000 as the base year, compute the trend percentages for net
sales, cost of goods sold, and gross profit. Explain whether the trends are favorable or
unfavorable for each item.

Item 2003 2002 2001 2000
Net Sales 160% 130% 120% 100%
Cost of Goods Sold 145% 115% 105% 100%
Gross Profit 220% 190% 180% 100%
The trend in net sales is increasing and favorable. The cost of goods sold trend is increasing
which could be unfavorable, but the sales are increasing each year at a faster pace than cost of
goods sold. This is apparent by examining the gross profit percentages, which show a favorable,
increasing trend.
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Ex. 111
The comparative balance sheet of Grider Company appears below:
GRIDER COMPANY
Comparative Balance Sheet
December 31,
____________________________________________________________________________
Assets 2003 2002
Current assets ...................................................................................... $ 360 $300
Plant assets .......................................................................................... 640 500
Total assets .................................................................................... $1,000 $800
Liabilities and stockholders' equity

Current liabilities ................................................................................... $ 150 $120
Long-term debt ..................................................................................... 240 160
Common stock ..................................................................................... 350 280
Retained earnings ................................................................................ 260 240
Total liabilities and stockholders' equity .......................................... $1,000 $800
Instructions
(a) Using horizontal analysis, show the percentage change for each balance sheet item using
2002 as a base year.
(b) Using vertical analysis, prepare a common size comparative balance sheet.
GRIDER COMPANY
December 31,
(b) (b) (a)

Assets 2003 Percent 2002 Percent Percent
Current assets $ 360 36% $300 38% 20%
Plant assets 640 64 500 62 28%
Total assets $1,000 100% $800 100% 25%

Current liabilities $ 150 15% $120 15% 25%
Long-term debt 240 24 160 20 50%
Common stock 350 35 280 35 25%
Retained earnings 260 26 240 30 30%
Total liabilities and stockholders' equity $1,000 100% $800 100% 25%
Ex. 112
Using the following selected items from the comparative balance sheet of Abbott Company,
illustrate horizontal and vertical analysis.
December 31, 2003 December 31, 2002

Accounts Receivable $ 840,000 $ 600,000
Inventory 975,000 780,000
Total Assets 4,000,000 2,500,000

HORIZONTAL ANALYSIS

Accounts Receivable 140% 100%
Inventory 125% 100%
Total Assets 160% 100%
VERTICAL ANALYSIS

Accounts Receivable 21.0% 24.0%
Inventory 24.4% 31.2%
Total Assets 100% 100%
Ex. 113
The following information was taken from the financial statements of Larkin Company:
2003 2002
Gross profit on sales ................................................................. $900,000 $840,000
Income before income taxes ..................................................... 280,000 230,000
Net income ............................................................................... 240,000 216,000
Net income as a percentage of net sales .................................. 8% 9%
Instructions
(a) Compute the net sales for each year.
(b) Compute the cost of goods sold in dollars and as a percentage of net sales for each year.
(c) Compute operating expenses in dollars and as a percentage of net sales for each year.
(Income taxes are not operating expenses).
18
(a) To calculate net sales divide the net income by the percentage of net income to net sales.
2003 2002
Net Sales $240,000 ÷ 8% = $3,000,000 $216,000 ÷ 9% = $2,400,000
(b) Using the net sales information from (a) and the gross profits given, it is possible to
calculate the cost of goods sold.
2003 2002
Net Sales $3,000,000 $2,400,000
Less: Gross profit 900,000 840,000
Cost of goods sold $2,100,000 $1,560,000
% of net sales 70% 65%
(c) 2003 2002

Gross profit $900,000 $840,000
Less: Income before income taxes 280,000 230,000
Operating Expenses $620,000 $610,000
% of net sales 20.7% 25.4%
Ex. 114
Selected information from the comparative financial statements of Fryman Company for the year
ended December 31, appears below:
2002 2001
Accounts receivable (net) $ 180,000 $200,000
Inventory 140,000 160,000
Total assets 1,200,000 800,000
Current liabilities 140,000 110,000
Long-term debt 400,000 300,000
Net credit sales 1,330,000 700,000
Cost of goods sold 900,000 530,000
Interest expense 50,000 25,000
Income tax expense 60,000 29,000
Net income 150,000 85,000
Net cash provided by operating activities 220,000 135,000
Instructions
Answer the following questions relating to the year ended December 31, 2002. Show computa-
tions.
1. The inventory turnover ratio for 2002 is __________.
2. The times interest earned ratio in 2002 is __________.
3. The debt to total assets ratio for 2002 is __________.
4. The receivables turnover ratio for 2002 is __________.
5. The return on assets ratio for 2002 is __________.
6. The cash return on sales ratio for 2002 is __________.
7. The current cash debt coverage ratio for 2002 is __________.

$900,000
1. The inventory turnover ratio for 2002 is 6 times. ———————————— = 6 times.
($140,000 + $160,000) ÷ 2
2. The times interest earned ratio in 2002 is 5.2 times.

$150,000 + $60,000 + $50,000
—————————————— = 5.2 times.
$50,000
$140,000 + $400,000
3. The debt to total assets ratio for 2002 is 45%. —————————— = 45%.
$1,200,000
$1,330,000
4. The receivables turnover ratio for 2002 is 7 times. ———————————— = 7 times.
($180,000 + $200,000) ÷ 2
$150,000
5. The return on assets ratio for 2002 is 15%. ($1,200,000 + $800,000) ÷ 2 = 15%
$220,000
6. The cash return on sales ratio for 2002 is 16.5%. $1,330,000 = 16.5%
7. The current cash debt coverage ratio for 2002 is 1.76 times.
$220,000
($110,000 + $140,000) ÷ 2 = 1.76 times.
Ex. 115
The comparative balance sheet for Johnson Stoll Company is given below:
JOHNSON STOLL COMPANY
December 31,
———————————————————————————————————————————
Assets 2003 2002
Cash ............................................................................................... $ 30,000 $ 45,000
Accounts receivable (net) ............................................................... 97,500 90,000
Inventory ........................................................................................ 90,000 75,000
Plant assets (net) ........................................................................... 300,000 270,000
Total assets .............................................................................. $517,500 $480,000
Liabilities and Stockholders' Equity
Accounts payable ........................................................................... $ 75,000 $ 90,000
Mortgage payable (8%) .................................................................. 150,000 150,000
Common stock, $10 par ................................................................. 210,000 180,000
Retained earnings .......................................................................... 82,500 60,000
Total liabilities and stockholders' equity..................................... $517,500 $480,000
20
Ex. 115 (cont.)
Additional information for 2003:
1. Income before interest expense and income taxes was $168,000.
2. Sales on account were $990,000. Sales returns and allowances amounted to $5,625.
3. Cost of goods sold was $676,500.
4. Net cash provided by operating activities was $185,625.
5. Interest expense totaled $12,000.
Instructions
Compute the following ratios at December 31, 2003:
a. Current ratio
b. Acid-test ratio
c. Current cash debt coverage ratio
d. Receivables turnover ratio
e. Average collection period
f. Inventory turnover
g. Average days in inventory
h. Debt to total assets ratio
i. Times interest earned
j. Cash debt coverage ratio

a. Current ratio = $217,500 ÷ $75,000 = 2.9
b. Acid-test ratio = $127,000 ÷ $75,000 = 1.7
$185,625
c. Current cash debt coverage ratio = ——————————— = 2.25
($75,000 + $90,000) ÷ 2
$984,375
d. Receivables turnover ratio = ——————————— = 10.5
($97,500 + $90,000) ÷ 2
e. Average collection period = 365 ÷ 10.5 = 35 days
$676,500
f. Inventory turnover = ——————————— = 8.2
($90,000 + $75,000) ÷ 2
g. Average days in inventory = 365 ÷ 8.2 = 44.5 days
h. Debt to total assets ratio = $225,000 ÷ $517,500 = .43
i. Times interest earned = $168,000 ÷ $12,000 = 14
$185,625
j. Cash debt coverage ratio = ———————————— = .80
($225,000 + $240,000) ÷ 2
Ex. 116
The financial statements of Albert Company appear below:
ALBERT COMPANY
December 31,
———————————————————————————————————————————
Assets 2002 2001
Cash ............................................................................................... $ 25,000 $ 40,000
Short-term investments .................................................................. 15,000 60,000
Accounts receivable (net) ............................................................... 50,000 30,000
Inventory ........................................................................................ 50,000 70,000
Property, plant and equipment (net) ............................................... 260,000 300,000
Total assets .............................................................................. $400,000 $500,000
Accounts payable ........................................................................... $ 20,000 $ 30,000
Short-term notes payable ............................................................... 30,000 90,000
Bonds payable ................................................................................ 90,000 160,000
Common stock ............................................................................... 150,000 150,000
Retained earnings .......................................................................... 110,000 70,000
Total liabilities and stockholders' equity..................................... $400,000 $500,000
ALBERT COMPANY
Income Statement
Net sales ........................................................................................ $400,000

Cost of goods sold .......................................................................... 240,000
Gross profit ..................................................................................... 160,000
Expenses
Interest expense ....................................................................... $18,000
Selling expenses ...................................................................... 28,000
Administrative expenses ........................................................... 24,000
Total expenses ................................................................... 70,000
Income before income taxes .......................................................... 90,000
Income tax expense ....................................................................... 27,000
Net income ..................................................................................... $ 63,000
Additional information:
a. Cash dividends of $23,000 were declared and paid in 2002.
b. Weighted-average number of shares of common stock outstanding during 2002 was 30,000
shares.
c. Market value of common stock on December 31, 2002, was $21 per share.
d. Net cash provided by operating activities for 2002 was $60,000.
22
Ex. 116 (cont.)
Instructions
Using the financial statements and additional information, compute the following ratios for Albert
Company for 2002. Show all computations.
Computations
1. Current ratio _________.
2. Return on common stockholders' equity _________.
3. Price-earnings ratio _________.
4. Acid-test ratio _________.
5. Receivables turnover _________.
6. Times interest earned _________.
7. Profit margin ratio _________.
8. Average days in inventory _________.
9. Payout ratio _________.
10. Return on assets _________.
11. Cash return on sales ratio _________.
12. Cash debt coverage ratio _________.

$140,000
1. Current ratio 2.8:1. ————— = 2.8
$50,000
$63,000
2. Return on common stockholders' equity 26.8%. ———————————— = .268
($250,000 + $220,000) ÷ 2
$63,000
3. Price-earnings ratio 10 times. EPS = ———— = $2.10;
30,000
$21
——— = 10 times
$2.10
$90,000
4. Acid-test ratio 1.8:1. ———— = 1.8:1
$50,000
$400,000
5. Receivables turnover 10 times. ——————————— = 10
($50,000 + $30,000) ÷ 2
Solution 116 (cont.)

$63,000 + $27,000 + $18,000
6. Times interest earned 6 times. ————————————— = 6
$18,000
$63,000
7. Profit margin ratio 15.8%. ———— = .158
$400,000
8. Average days in inventory 91.3 days. Inventory turnover =
$240,000
——————————— = 4
($50,000 + $70,000) ÷ 2
365 days
———— = 91.3
4
$23,000
9. Payout ratio 36.5%. ———— = .365
$63,000
$63,000
10. Return on assets 14%. ———————————— = .14
($400,000 + $500,000) ÷ 2
$60,000
11. Cash return on sales ratio 15%. $400,000 = .15
$60,000
12. Cash debt coverage ratio .29 times. ($280,000 + $140,000) ÷ 2 = .29 times
Ex. 117
The following ratios have been computed for Ryder Company for 2002.
Profit margin ratio 20%
Times interest earned ratio 9 times
Receivable turnover ratio 3 times
Acid test ratio 2:1
Current ratio 3:1
Debt to total assets ratio 20%
The 2002 financial statements for Ryder Company with missing information follows:
24
Ex. 117 (cont.)
RYDER COMPANY
December 31,
——————————————————————————————————————————
Assets 2002 2001
Cash ......................................................................................... $ 30,000 $ 45,000
Short-term investments.............................................................. 10,000 25,000
Accounts receivable (net) ......................................................... ? (6) 40,000
Inventory ................................................................................... ? (8) 50,000
Property, plant, and equipment (net) ........................................ 200,000 160,000
Total assets ....................................................................... $ ? (9) $320,000
Accounts payable ..................................................................... $ ? (7) $ 30,000
Short-term notes payable ......................................................... 40,000 35,000
Bonds payable .......................................................................... ? (10) 20,000
Common stock .......................................................................... 220,000 200,000
Retained earnings .................................................................... 60,000 35,000
Total liabilities and stockholders' equity.............................. $ ? (11) $320,000
RYDER COMPANY
Income Statement
——————————————————————————————————————————
Net sales .................................................................................. $150,000
Cost of goods sold .................................................................... 75,000
Gross profit................................................................................ 75,000
Expenses:
Depreciation expense ......................................................... $ ? (5)
Interest expense ................................................................. 5,000
Selling expenses ................................................................. 8,000
Administrative expenses ..................................................... 12,000
Total expenses .............................................................. ? (4)
Income before income taxes ..................................................... ? (2)
Income tax expense ............................................................ ? (3)
Net income ............................................................................... $ ? (1)
Instructions
Use the above ratios and information from Ryder Company financial statements to fill in the
missing information on the financial statements. Follow the sequence indicated. Show
computations that support your answers.

RYDER COMPANY
December 31,
———————————————————————————————————————————
Assets 2002 2001
Cash ................................................................................... $ 30,000 $ 45,000
Short-term investments........................................................ 10,000 25,000
Accounts receivable (net) ................................................... 60,000 (6) 40,000
Inventory ............................................................................. 50,000 (8) 50,000
Property, plant, and equipment (net) ................................... 200,000 160,000
Total assets ................................................................. $350,000 (9) $320,000

Accounts payable ............................................................... $ 10,000 (7) $ 30,000
Short-term notes payable .................................................... 40,000 35,000
Bonds payable .................................................................... 20,000 (10) 20,000
Common stock .................................................................... 220,000 200,000
Retained earnings ............................................................... 60,000 35,000
Total liabilities and stockholders' equity........................ $350,000 (11) $320,000
RYDER COMPANY
Income Statement
———————————————————————————————————————————
Net sales ............................................................................. $150,000
Cost of goods sold .............................................................. 75,000
Gross profit.......................................................................... 75,000
Expenses
Depreciation expense ................................................... $10,000 (5)
Interest expense ........................................................... 5,000
Selling expenses ........................................................... 8,000
Administrative expenses ............................................... 12,000
Total expenses ........................................................ 35,000 (4)
Income before income taxes ............................................... 40,000 (2)
Income tax expense ............................................................ 10,000 (3)
Net income ......................................................................... $ 30,000 (1)
(1) Net income = $30,000 ($150,000 × 20%).
(2) Income before income taxes = $40,000.

Let X = Income before income taxes and interest expense.
X
——— = 9 times; X = $45,000; $45,000 – $5,000 = $40,000.
5,000
(3) Income tax expense = $10,000 ($40,000 – $30,000).
(4) Total operating expenses = $35,000 ($75,000 – $40,000).
(5) Depreciation expense = $10,000 [$35,000 – ($5,000 + $8,000 + $12,000)].

26
(6) Accounts receivable (net) = $60,000.
Let X = Average receivables.
$150,000
———— = 3 times; 3X = $150,000; X = $50,000.
X
Let Y = Accounts receivable at 12/31/02.

$40,000 + Y
—————— = $50,000; $40,000 + Y = $100,000; Y = $60,000.
2
(7) Accounts payable = $10,000.

Let X = Current liabilities.
$30,000 + $10,000 + $60,000
————————————— = 2; 2X= $100,000; X = $50,000;
X
$50,000 – $40,000 = $10,000.
(8) Inventory = $50,000

Let X = Total current assets
X
———— = 3; X = $150,000; $150,000 – ($30,000 + $10,000 + $60,000) = $50,000.
$50,000
(9) Total assets = $350,000 ($30,000 + $10,000 + $60,000 + $50,000 + $200,000)
(10) Bonds payable = $20,000

Let X = Total debt
X
———— = 20%; X = $70,000; $70,000 – ($10,000 + $40,000) = $20,000.
$350,000
(11) Total liabilities and stockholders' equity = $350,000; same as total assets—see (9) above.
Ex. 118
The financial statements for Jacqueline’s Rodeo Wear are given below:
JACQUELINE’S RODEO WEAR

December 31,
——————————————————————————————————————————
Assets 2003 2002
Current assets
Cash and short-term investments.................................. $ 5,040 $ 4,920
Accounts receivable (net) .............................................. 30,240 28,960
Inventory ....................................................................... 60,480 54,800
Total current assets....................................................... 95,760 88,680
Plant assets (net) ................................................................ 156,240 148,200
Total assets .................................................................. $252,000 $236,880

Current liabilities ................................................................. $ 42,000 $ 38,600
Long-term liabilities ............................................................. 67,200 72,000
Common stock .................................................................... 25,000 25,000
Retained earnings ............................................................... 117,800 101,280
Total liabilities and stockholders' equity........................ $252,000 $236,880
JACQUELINE’S RODEO WEAR

Income Statement
Net sales ....................................................................................................... $360,000

Cost of goods sold ........................................................................................ 252,000
Gross profit ................................................................................................... 108,000
Operating expenses (including $7,200 interest and $9,000 income taxes).... 68,400
Net income .................................................................................................... $ 39,600
Net cash provided by operating activities totaled $46,800.
Instructions
Compute the following ratios at December 31, 2003:
a. Return on assets
b. Profit margin
c. Asset turnover
d. Gross profit rate
e. Operating expenses to sales
f. Cash return on sales
28
$39,600
a. Return on assets ratio = ———————————— = 16.2%
($252,000 + $236,880) ÷ 2
b. Profit margin ratio = $39,600 ÷ $360,000 = 11%
$360,000
c. Asset turnover ratio = ———————————— = 1.47
$252,000 + $236,880) ÷ 2
d. Gross profit rate = $108,00 ÷ $360,000 = 30%
e. Operating expenses to sales ratio = $68,400 ÷ $360,000 = 19%
f. Cash return on sales ratio = $46,800 ÷ $360,000 = 13%
Ex. 119
Selected data for Mary's Store appear below.
2002 2001
Net sales $800,000 $520,000
Cost of goods sold 600,000 345,000
Inventory at end of year 65,000 85,000
Accounts receivable at end of year 90,000 70,000
Instructions
Compute the following for 2002:
(a) Gross profit percentage.
(b) Inventory turnover.
(c) Receivables turnover.

(a) Gross profit = Net Sales – Cost of goods sold
= $800,000 – $600,000
= $200,000
Gross profit percentage = Gross profit ÷ Net sales

= $200,000 ÷ $800,000
= 25%
(b) Inventory turnover = Cost of goods sold ÷ Average inventory

= $600,000 ÷ [($65,000 + $85,000) ÷ 2]
= 8 times
(c) Receivables turnover = Net credit sales ÷ Average accounts receivables

= $800,000 ÷ [($90,000 + $70,000) ÷ 2]
= $800,000 ÷ $80,000
= 10 times
Ex. 120
Walbeck Corporation has issued common stock only. The company has been successful and has
a gross profit rate of 20%. The information shown below was taken from the company's financial
statements.
Beginning inventory $ 482,000
Purchases 4,836,000
Ending inventory ?
Average accounts receivable 800,000
Average common stockholders' equity 3,500,000
Sales (all on credit) 6,000,000
Net income 420,000
Instructions
Compute the following:
(a) Receivables turnover and the average collection period.
(b) The inventory turnover and the average days in inventory.
(c) Return on common stockholders' equity.

(a) Credit sales
Receivables turnover = —————————————
Average accounts receivable
= $6,000,000 ÷ $800,000 =7.5 times
365 days
Average collection period = ——————————
Receivables turnover
= 365 ÷ 7.5 times = 48.7 days
(b) Inventory turnover = Cost of goods sold ÷ Average inventory

First calculate ending inventory.
Beginning Inventory $ 482,000
+ Purchases 4,836,000
– Cost of Goods Sold (4,800,000)*
Ending Inventory $ 518,000
*Since the gross profit ratio is 20%, the cost of goods sold ratio is 80%.
80% × $6,000,000 (net sales) = $4,800,000.
Ending Inventory = $518,000 (per above)

Average Inventory = ($482,000 + $518,000) ÷ 2 = $500,000
Inventory Turnover = $4,800,000 ÷ $500,000 = 9.6 times
Days in Inventory = 365 days ÷ 9.6 times = 38 days
(c) Net income

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

30
Ex. 121
Bradley Corporation had the following comparative current assets and current liabilities:
Dec. 31, 2002 Dec. 31, 2001
Current assets
Cash $ 60,000 $ 30,000
Short-term investments 40,000 10,000
Accounts receivable 55,000 95,000
Inventory 110,000 90,000
Prepaid expenses 35,000 20,000
Total current assets $300,000 $245,000
Current liabilities
Accounts payable $140,000 $110,000
Salaries payable 40,000 30,000
Income tax payable 20,000 15,000
Total current liabilities $200,000 $155,000
During 2002, credit sales and cost of goods sold were $750,000 and $400,000, respectively. Net
cash provided by operating activities for 2002 was $213,000.
Instructions
Compute the following liquidity measures for 2002:
1. Current ratio.
2. Quick ratio.
3. Current cash debt coverage ratio.
4. Receivables turnover.
5. Inventory turnover.

1. Current ratio = Current assets ÷ Current liabilities
= $300,000 ÷ $200,000 =1.5:1
Cash + Short-term investments + Accounts receivable

2. Quick ratio = ————————————————————————
Current liabilities
$60,000 + $40,000 + $55,000
= ————————————— = .78:1
$200,000
Cash provided by operating activities

3. Current cash debt coverage ratio = Average current liabilities
$213,000
= $177,500 = 1.2 times
Net credit sales

4. Receivables turnover = —————————————
Average accounts receivables
$750,000
= ———— = 10 times
$75,000

Cost of goods sold
5. Inventory turnover = —————————
Average inventory
$400,000
= ———— = 4 times
$100,000
Ex. 122
Selected data from O'Brien Company are presented below:
Total assets $1,600,000
Average assets 1,750,000
Net income 245,000
Net sales 1,225,000
Average common stockholders' equity 1,000,000
Net cash provided by operating activities 294,000
Instructions
Calculate the profitability ratios that can be computed from the above information.

With the information provided, the profitability ratios that can be calculated are as follows:
1. Profit margin = Net income ÷ Net sales

= $245,000 ÷ $1,225,000 = 20%
2. Asset turnover = Net sales ÷ Average assets

= $1,225,000 ÷ $1,750,000 = 70%
3. Return on assets = Net income ÷ Average assets

= $245,000 ÷ $1,750,000 = 14%
Net income
4. Return on common stockholders' equity = —————————————————
Average common stockholders' equity
= $245,000 ÷ $1,000,000 = 24.5%
Net cash from operations

5. Cash return on sales = Net sales
= $294,000 ÷ $1,225,000 = 24%
32
Ex. 123
The following data are taken from the financial statements of Duncan Company:
2003 2002
Monthly average accounts receivable $ 520,000 $ 500,000
Net sales on account 5,200,000 4,500,000
Terms for all sales are 2/10, n/30
Instructions
(a) Compute the accounts receivable turnover and the average collection period for both years.
(b) What conclusion can an analyst draw about the management of the accounts receivable?

(a) Accounts receivable turnover ratio. 2003 2002
$5,200,000 $4,500,000
Accounts receivable turnover ————— —————
520,000 500,000
10 times 9 times
365 days 365 days

Average collection period ———— ————
10 times 9 times
36.5 days 40.6 days
(b) The receivables are turning faster in 2003 than they did in 2002. There is still a problem
since the normal credit period is 30 days, and the average collection period for both years
exceed this target. Therefore, improvement in the management of the receivables would
appear to be desirable.
Ex. 124
State the effect of the following transactions on the current ratio. Use increase, decrease, or no
effect for your answer.
(a) Collection of an accounts receivable.
(b) Declaration of cash dividends.
(c) Additional stock is sold for cash.
(d) Stock investments are purchased for cash.
(e) Equipment is purchased for cash.
(f) Inventory purchases are made for cash.
(g) Accounts payable are paid.

(a) no effect (e) decrease
(b) decrease (f) no effect
(c) increase (g) increase
(d) no effect
Ex. 125
The balance sheet for Finley Corporation at the end of the current year indicates the following:
Bonds payable, 8% ............................................................. $4,000,000

6% Preferred stock, $100 par ............................................. 1,000,000
Common stock, $10 par ...................................................... 2,000,000
Income before income taxes was $480,000 and income tax expense for the current year
amounted to $144,000. Cash dividends paid on common stock were $300,000, and the common
stock was selling for $22 per share at the end of the year. There were no ownership changes
during the year.
Instructions
Determine each of the following:
(a) times that bond interest was earned.
(b) earnings per share for common stock.
(c) price-earnings ratio.

(a) Income before income taxes and interest expense
Times interest earned = ——————————————————————
Interest expense
$480,000 + $320,000
= —————————— = 2.5 times
$320,000
(b) Net income – Preferred dividends

Earnings per share = —————————————————————
Weighted average common shares outstanding
$336,000 – $60,000
= ————————— = $1.38 per share
200,000 shares
(c) Market price per share $22.00

Price-earnings ratio = —————————— = ——— = 15.9
Earnings per share $1.38
Ex. 126
The income statement for Pine Company for the year ended December 31, 2002 appears below.
Sales $620,000
Cost of goods sold 380,000
Gross profit 240,000
Expenses 190,000*
Net income $ 50,000
*Includes $20,000 of interest expense and $22,000 of income tax expense.

34
Ex. 126 (cont.)
Additional information:
1. Common stock outstanding on January 1, 2002 was 50,000 shares. On July 1, 2002, 10,000
more shares were issued.
2. The market price of Pine's stock was $16 at the end of 2002.
3. Cash dividends of $30,000 were paid, $6,000 of which were paid to preferred stockholders.
Instructions
Compute the following ratios for 2002:
(a) earnings per share.
(b) price-earnings.
(c) times interest earned.

$50,000 – $6,000 $44,000
(a) Earnings per share = —————————— = ———— = $0.80
[50,000 + (10,000 ÷ 2)] 55,000
$16.00
(b) Price-earnings = ——— = 20 times
0.80
$50,000 + $20,000 + $22,000

(c) Times interest earned = ————————————— = 4.6 times
$20,000
COMPLETION STATEMENTS
127. Discontinued operations refers to the disposal of a __________________ of a business.
128. The two criteria necessary for an item to be classified as an extraordinary item are that the
transaction or event must be (1) _______________ and (2) ________________.
129. A change in depreciation methods during the year would be classified as a change in
____________________.
130. ______________ analysis, also called trend analysis, is a technique for evaluating a
series of financial statement data over a period of time.
131. Expressing each item in a financial statement as a percent of a base amount is called
______________ analysis.
132. For analysis of the financial statements, ratios can be classified into three types:
(1)_____________ ratios, (2)_____________ ratios, and (3)______________ ratios.
133. The times interest earned ratio is calculated by dividing ___________________ before
__________________ and __________________ by interest expense.
134. The ratios used in evaluating a company's liquidity and short-term debt paying ability that
complement each other are the ______________ ratio and the ______________ ratio.
135. The receivables turnover ratio is calculated by dividing ________________ by average

___________________.
136. If the inventory turnover ratio is 5 times, and the average inventory was $600,000, the cost
of goods sold during the year was $______________ and the average days to sell the
inventory was ______________ days.
137. Hansen Corporation had net income for the year of $300,000 and a profit margin ratio of
25%. If total average assets were $200,000, the asset turnover ratio was ____________
times.
138. The ______________ ratio measures the percentage of earnings distributed in the form of
cash dividends.
139. The lower the _______________ to _______________ ratio, the more equity "buffer" is
available to the creditors if the company becomes insolvent.
36
Answers to Completion Statements
127. significant segment 134. current, acid-test (quick)
128. unusual in nature, infrequent in occurrence 135. net credit sales, net receivables
129. accounting principle 136. 3,000,000, 73
130. Horizontal 137. 6
131. vertical (common size) 138. payout
132. liquidity, solvency, profitability (any order) 139. debt, total assets
133. income, income taxes, interest expense
MATCHING
Set 1
140. For each of the ratios listed below, indicate by the appropriate code letter, whether it is a
liquidity ratio, a profitability ratio, or a solvency ratio.
Code:
L = Liquidity ratio
P = Profitability ratio
S = Solvency ratio
____ 1. Cash return on sales ratio
____ 2. Return on assets ratio
____ 3. Receivables turnover ratio
____ 4. Earnings per share ratio
____ 5. Payout ratio
____ 6. Current cash debt coverage ratio
____ 7. Acid-test ratio
____ 8. Debt to total assets ratio
____ 9. Free cash flow
____ 10. Inventory turnover ratio
Answers to Matching Set 1
P 1. Cash return on sales ratio L 6. Current cash debt coverage ratio

P 2. Return on assets ratio L 7. Acid-test ratio
L 3. Receivables turnover ratio S 8. Debt to total assets ratio
P 4. Earnings per share ratio S 9. Free cash flow
P 5. Payout ratio L 10. Inventory turnover ratio
Set 2
141. Match the ratios with the appropriate ratio computation by entering the appropriate letter in
the space provided.
A. Current ratio F. Times interest earned ratio

B. Acid-test ratio G. Inventory turnover ratio
C. Profit margin ratio H. Average collection period
D. Asset turnover ratio I. Average days in inventory
E. Price-earnings ratio J. Payout ratio
Cost of goods sold

____ 1. —————————
Average inventory
Net income
____ 2. —————
Net sales
Cash dividends
____ 3. ———————
Net income
Net sales
____ 4. ———————
Average assets
Current assets
____ 5. ————————
Current liabilities
365 days
____ 6. ——————————
Receivables turnover
Market price per share of stock

____ 7. ——————————————
Earnings per share
365 days
____ 8. ————————
Inventory turnover
Income before income taxes and interest expense

____ 9. ——————————————————————
Interest expense
Cash + Short-term investments + Receivables (net)

____ 10. ———————————————————————
Current liabilities
Answers to Matching Set 2

1. G 6. H
2. C 7. E
3. J 8. I
4. D 9. F
5. A 10. B
38
SHORT-ANSWER ESSAY QUESTIONS
S-A E 142
Horizontal and vertical analyses are analytical tools frequently used to analyze financial
statements. What type of information or insights can be obtained by using these two techniques?
Explain how the output of horizontal analysis and vertical analysis can be compared to industry
averages and/or competitive companies.
Solution 142
Horizontal analysis allows an analyst to develop a picture of current trends in a company's
operations. The analyst can see whether the accounts are increasing or decreasing and how
large these changes actually are. Vertical analysis allows an analyst to evaluate financial
statement items within a single financial statement. This technique helps the analyst to evaluate
the relative size of the financial statement items and how the items relate to the financial
statement as a whole. An example would be if current liabilities were a very large percentage of
total liabilities and stockholders' equity.
Both techniques allow the company to evaluate their performance and position relative to their
competitors and their industry as a whole. For example, the company could evaluate their current
trend in sales and see how favorably their sales performance compared to the sales performance
of other companies in the industry. Another example would be comparing the relative size of
long-term liabilities or retained earnings. This would show which companies have taken on a
large amount of debt and which companies have reinvested earnings.
S-A E 143
The use of estimates, cost, alternative accounting methods, the presence of atypical data, and
diversification of firms have been cited as factors that limit the usefulness of financial statement
analysis. Identify a ratio and explain how one or more of the limiting factors can affect the
usefulness of that ratio.
Solution 143
Any of the profitability ratios that involve net income will be affected by the method of depreciation
chosen. The use of an accelerated method, such as double-declining balance, will result in higher
depreciation costs in the early years and lower depreciation costs in the later years. These costs
will differ from the depreciation costs that would have been incurred if the straight-line method
had been used. Therefore, because of the different costs, net income will also be different. Thus,
the choice of depreciation method affects net income, which in turn affects the ratio.
Both the acid-test ratio and the receivables turnover ratio are affected by the estimate of
uncollectible accounts. The estimate will determine the amount of net receivables used to
calculate the ratio. A high estimate will lower the net receivables and a low estimate will increase
the net receivables. Thus, the accuracy of the estimate will have a direct effect on the accuracy
of the ratio.
S-A E 144 (Ethics)

A trusted employee of Wilderness Tours was caught in the act of embezzling funds. He
confessed to earlier embezzlements, but retracted the confession on the advice of his attorney.
Over the course of the most recent quarter, it has been determined that $20,000 was embezzled.
Wilderness Tours has suffered adverse publicity in the recent past because of serious injury to
five tourists that occurred during a two week "Winter Wilds Adventure" tour. The company has
therefore decided to avoid publicity and has agreed to drop all charges against the embezzling
employee. In return, the employee has agreed to a notation of "Terminated—Not to be Rehired"
to be appended to his personnel file.
Required:
1. Who are the stakeholders in the decision not to prosecute?
2. Was it ethical for the company to decide not to prosecute? Explain.
Solution 144
1. The stakeholders include
• The embezzling employee
• The other employees
• Company management
• Other companies who might hire the embezzling employee
2. The company was certainly within its legal rights not to prosecute the embezzling employee.
However, the decision not to prosecute may not be ethical. First, it does not serve public
justice. The embezzling employee could find a job elsewhere, and harm someone else
financially. Second, to the extent that other employees know of the act and of the decision,
morale may be harmed. The decision is also not the best one for the employee. Having never
been forced to face the consequences of his dishonest acts, he is not deterred from (and may
even feel encouraged to) commit similar acts in the future. The one argument that would
support the premise that the decision was ethical is that the public disclosure would cause
harm greater than that caused by keeping silent. Even this argument lacks force, because it
implies a lack of moral courageousness.
S-A E 145 (Communication)

Fast Express specializes in the transportation of medical equipment and laboratory specimens
overnight. The company has selected the following information from its most recent annual report
to be the subject of an immediate press release.
• The financial statements are being released.
• Net income this year was $2.1 million. Last year's net income had been $1.8 million.
• The current ratio has changed to 2:1 from last year's 1.5:1
• The debt/total assets ratio has changed to 4:5 from last year's 3:5
• The company expanded its truck fleet substantially by purchasing ten new delivery vans.
• The company already had twelve delivery vans. The company is now the largest medical
courier in the mid-Atlantic region.
Required:
Prepare a brief press release incorporating the information above. Include all information. Think
carefully which information (if any) is good news for the company, and which (if any) is bad news.
40
Solution 145
Fast Express released its financial statements today, disclosing a 17% increase in earnings, to
$2.1 million from $1.8 million last year. The company also improved its short-term liquidity. Its
current ratio improved to 2:1 from last year's 1.5:1. Part of the improved performance is no doubt
due to the addition of ten new delivery vans to its fleet, allowing it to become the largest medical
courier in the mid-Atlantic region. The purchase of the vans, however, caused the debt/total
asset ratio to decline. There are now $4 of debt for every $5 in assets, while last year, there were
only $3 of debt to $5 in assets.

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FINANCIAL STATEMENT ANALYSIS

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

6. Comprehensive income includes all changes in stockholders’ equity during a period

8. Comparisons of company data with industry averages provide information about a

11. Another name for horizontal analysis is trend analysis.

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

30. Diversification in American industry limits the usefulness of financial analysis.

Answers to True-False Statements

MULTIPLE CHOICE QUESTIONS

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

33. When a change in accounting principle occurs,

37. Comparisons of financial data made within a company are called

39 In analyzing financial statements, horizontal analysis is a

40. Horizontal analysis is also known as

43. Horizontal analysis is a technique for evaluating financial statement data

44. Assume the following sales data for a company:

45. Comparative balance sheets are usually prepared for

46. Vertical analysis is also known as

48. In vertical analysis,

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

55. Long-term creditors are usually most interested in evaluating

56. Stockholders are most interested in evaluating

57. In ratio analysis, the ratios are never expressed as a

58. The current ratio is

59. The acid-test or quick ratio

Use the following information for questions 62-63.

62. Inventory turnover for the year is

63. The average days in inventory during the year was

65. Asset turnover measures

66. The profit margin ratio is calculated by dividing

Use the following information for questions 67-68.

67. Terry Corporation's price-earnings ratio is

68. Terry Corporation's payout ratio for 2002 is

70. The debt to total assets ratio measures

71. Trading on the equity (leverage) refers to the

73. The acid-test ratio is also referred to as the

74. A weakness of the current ratio is

75. A supplier to a company would be most interested in the

77. Ratios are used as tools in financial analysis

80. A liquidity ratio measures the

82. The acid-test ratio

86. A general rule to use in assessing the average collection period is

87. Inventory turnover is calculated by dividing

89. A successful grocery store would probably have

90. An aircraft company would most likely have

92. The numerator of the times interest earned ratio is

94. The return on assets ratio is affected by the

96. A measure of a company’s immediate short-term liquidity is the

98. Earnings per share is computed by dividing net income

100. A limitation in calculating ratios in financial statement analysis is that

101. Which of the following is not a limitation of financial statement analysis?

102. The use of alternative accounting methods

103. Traditional financial statements are based on

Answers to Multiple Choice Questions

Solution 106 (6-9 min.)

Solution 108 (8-12 min.)

Solution 109 (6-9 min.)

The decrease is $1,400,000; therefore net income for 2002 is $600,000.

2003: X ÷ $2,000,000 = 175%

The net income for 2003 is $5,500,000 ($2,000,000 + $3,500,000).

Item 2003 2002 2001 2000

Solution 110 (10-15 min.)