Ch14 Financial Statement Analysis PDF

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Chapter 14 Financial Statement Analysis OBJECTIVES

Obj 1 Obj 2 Obj 3 Obj 4

List basic financial statement analytical procedures. Apply financial statement analysis to assess the solvency of a business. Apply financial statement analysis to assess the profitability of a business. Describe the contents of corporate annual reports.

QUESTION GRID

True/False No Objec. tive 1 14-01 2 14-01 3 14-01 4 14-01 5 14-01 6 14-01 7 14-01 8 14-01 9 14-01 10 14-01 11 14-01 12 14-01 13 14-01 14 14-01 15 14-01 16 14-01 15 14-01 18 14-01 19 14-01 20 14-01 21 14-01 22 14-02 23 14-02

Difficulty Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Difficult Easy Easy

No . 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46

Objective 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02

Difficulty Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy

No . 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68

Objective 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-04 14-04 14-04 14-04

Difficulty Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy

529

530  Chapter 14/Financial Statement Analysis

Multiple Choice No Objec. tive 1 14-01 2 14-01 3 14-01 4 14-01 5 14-01 6 14-01 7 14-01 8 14-01 9 14-01 10 14-01 11 14-01 12 14-01 13 14-01 14 14-01 15 14-01 16 14-01 15 14-01 18 14-01 19 14-01 20 14-01 21 14-01 22 14-01 23 14-02 24 14-02 25 14-02 26 14-02 27 14-02 Exercise/Other No Objective . 1 14-01 2 14-01 3 14-01 4 14-01 5 14-01 6 14-02 7 14-02

Difficulty Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Easy Moderate Moderate Moderate

Difficulty Easy Easy Easy Moderate Easy Easy Easy

No . 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54

No . 8 9 10 11 12 13 14

Objective 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-02 14-03 14-03 14-03 14-03 14-03 14-03 14-03

Difficulty Easy Easy Easy Easy Moderate Easy Moderate Moderate Easy Moderate Easy Easy Moderate Easy Moderate Easy Easy Moderate Moderate Moderate Easy Moderate Easy Moderate Moderate Easy Easy

Objective 14-02 14-02 14-02 14-02 14-02 14-03 14-03

No . 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79

Difficulty Easy Easy Easy Easy Easy Easy Moderate

Objective 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-03 14-04 14-04 14-04

No . 15 16 15 18 19

Difficulty Easy Moderate Moderate Easy Easy Easy Easy Easy Moderate Easy Easy Easy Easy Easy Easy Easy Easy Easy Moderate Moderate Easy Moderate Easy Easy Moderate

Objective 14-03 14-03 14-03 14-03 14-03

Difficulty Easy Easy Easy Easy Moderate

Chapter 14/Financial Statement Analysis  531

Problem No Objective . 1 14-01 2 14-01 3 14-01 4 14-02

Difficulty Moderate Moderate Moderate Moderate

No . 5 6 7 8

Objective 14-02 14-02 14-02 14-02

Difficulty Moderate Easy Easy Easy

No . 9 10 11 12

Objective 14-03 14-03 14-03 14-03

Difficulty Moderate Moderate Moderate Moderate

Chapter 14—Financial Statement Analysis TRUE/FALSE 1.

If comparative balance sheets indicate no liability for bonds payable on the preceding year and a liability of $500,000 on the current year, the increase of $500,000 can be stated as a 100% increase. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 2.

Financial statements showing the current year's financial data in one column and preceding years' financial data in other columns are called horizontal statements. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 3.

Comparable financial statements are designed to compare the financial statements of two or more corporations. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 4.

The comparison of the financial data of a single company for two or more years is called horizontal analysis. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 5.

Examining relationships among data in the company's financial statements can provide knowledge that can not be gained from just looking at individual items in the statements. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Reflective Thinking | AICPA BB-Critical Thinking 6. In horizontal analysis, the current year is the base year. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 7.

On a common-size income statement, all items are stated as a percent of total assets or equities at year-end. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement

532  Chapter 14/Financial Statement Analysis

8.

The percentage analysis of increases and decreases in corresponding items in comparative financial statements is referred to as horizontal analysis. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 9.

Horizontal analysis may compare three or more statements and the earliest year could be used as the base year. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 10. A 15% change in sales will result in a 15% change in net income. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 11. A financial statement showing each item on the statement as a percentage of one key item on the statement is called common-sized financial statements. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 12. The relationship of each asset item as a percent of total assets is an example of vertical analysis. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 13. Statements in which all items are expressed in relative terms are called common-size statements. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 14. The relationship of 115 to 100 can be expressed as 1.15, 1.15:1, or 115%. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 15. Vertical analysis refers to comparing the financial statements of a single company for several years. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 16. In a common size income statement, net sales are represented by 100%. ANS: T DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 17. In a common size income statement, each item is expressed as a percentage of net income. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 18. In the vertical analysis of a balance sheet, the base for current liabilities is total liabilities. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement

Chapter 14/Financial Statement Analysis  533

19. Using vertical analysis of the income statement, a company's net income as a percentage of net sales is 10%; therefore, the cost of goods sold as a percentage of sales must be 90%. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 20. In the vertical analysis of an income statement, each item is generally stated as a percentage of total assets. ANS: F DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 21. Financial analysis is normally done only from period to period, on such values as sales from the first quarter to those of the second quarter rather than the change in cash or accounts receivable from the end of the first quarter to the end of the second quarter. ANS: F DIF: Difficult OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 22. Factors which reflect the ability of a business to pay its debts and earn a reasonable amount of income are referred to as solvency and profitability. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 23. The excess of current assets over current liabilities is referred to as working capital. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 24. Dollar amounts of working capital are difficult to assess when comparing companies of different sizes or in comparing such amounts with industry figures. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 25. Using measures to assess a business's ability to pay its current liabilities is called current position analysis. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 26. The current ratio is sometimes called the bankers' ratio. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 27. Current position analysis indicates a company's ability to liquidate current liabilities. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 28. An advantage of the current ratio is that it considers the makeup of the current assets. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 29. If two companies have the same current ratio, their ability to pay short-term debt is the same. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA BB-Critical Thinking

534  Chapter 14/Financial Statement Analysis

30. The ratio of the sum of cash, receivables, and marketable securities to current liabilities is referred to as the current ratio. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 31. A balance sheet shows cash, $75,000; marketable securities, $110,000; receivables, $90,000 and $225,000 of inventories. Current liabilities are $200,000. The current ratio is 2.5 to 1. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 32. If a firm has a current ratio of 2, the subsequent receipt of a 60-day note receivable on account will cause the ratio to decrease. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 33. If a firm has an quick ratio of 1, the subsequent payment of an account payable will cause the ratio to increase. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 34. Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 35. If the accounts receivable turnover for the current year has decreased when compared with the ratio for the preceding year, there has been an acceleration in the collection of receivables. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 36. An increase in the accounts receivable turnover may be due to an improvement in the collection of receivable or to a change in the granting of credit and/or in collection practices. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 37. If the current credit terms are 2/10, n/30 for Jones Inc., an accounts receivable turnover of 3 for the current year would be considered normal. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 38. The number of days' sales in receivables is one means of expressing the relationship between credit sales and accounts receivable. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 39. Inventory turnover shows how many times the average inventory was sold during the year. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement

Chapter 14/Financial Statement Analysis  535

40. A firm selling food should have higher inventory turnover rate than a firm selling office furniture. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA BB-Critical Thinking 41. The number of days' sales in inventory is one means of expressing the relationship between the cost of goods sold and inventory. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 42. The number of days' sales in inventory is a rough measure of the length of time it takes to sell the inventory. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 43. Assuming that the quantities of inventory on hand during the current year were sufficient to meet all demands for sales, a decrease in the inventory turnover for the current year when compared with the turnover for the preceding year indicates an improvement in the management of inventory. ANS: F DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 44. The ratio of fixed assets to long-term liabilities can indicate the ability of the business to borrow additional funds on a long-term basis. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 45. An increase in the ratio of stockholders' equity to liabilities indicates an improvement in the margin of safety for creditors. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 46. The higher the ratio of number of times interest charges earned, the lower the risk that interest payments will not be made if earnings decrease. ANS: T DIF: Easy OBJ: 14-02 NAT: AACSB Analytic | AICPA FN-Measurement 47. In computing the ratio of net sales to assets, any long-term investments are excluded from total assets. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 48. The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 49. In computing the rate earned on total assets, interest expense is added to net income before dividing by total assets. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement

536  Chapter 14/Financial Statement Analysis

50. The denominator of the rate of return on total assets ratio is the average total assets. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 51. When the rate of return on total assets ratio is greater than the rate of return on common stockholders' equity ratio, the management of the company has effectively used leverage. ANS: F DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 52. The tendency of the rate earned on stockholders' equity to vary disproportionately from the rate earned on total assets is referred to as solvency. ANS: F DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 53. The rate earned on total common stockholders' equity for most thriving businesses will be higher than the rate earned on total assets. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA BB-Critical Thinking 54. A company is using the concept of leverage or trading on equity, when it borrows money from creditors in order to earn additional income in excess of the interest cost and thereby increases the rate of return to the common stockholders. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 55. If a company's rate of return on common stockholders' equity is greater than its rate of return on total assets, the company is effectively using leverage. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA BB-Critical Thinking 56. If a company has issued only one class of stock, the earnings per share are determined by dividing net income plus interest expense by the number of shares outstanding. ANS: F DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 57. The rate earned on current assets is one of the measures of solvency. ANS: F DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 58. The ratio of the market price per share of common stock on a specific date to the annual earnings per share is referred to as the price-earnings ratio. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 59. The dividend yield rate is equal to the dividends per share divided by the par value per share of common stock. ANS: F DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement

Chapter 14/Financial Statement Analysis  537

60. Comparing dividends per share to earnings per share indicates the extent to which the corporation is retaining its earnings for use in operations. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 61. When you are interpreting financial ratios, it is useful to compare a company's ratios to some form of standard. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA FN-Measurement 62. Ratios and various other analytical measures are not a substitute for sound judgment, nor do they provide definitive guides for action. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA BB-Critical Thinking 63. Interpreting financial analysis should be considered in light of conditions peculiar to the industry and the general economic conditions. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Reflective Thinking | AICPA BB-Critical Thinking 64. A company can use comparisons of its financial data to the data of other companies and industry values to evaluate its position. ANS: T DIF: Easy OBJ: 14-03 NAT: AACSB Analytic | AICPA BB-Critical Thinking 65. The effects of differences in accounting methods are of little importance when analyzing comparable data from competing businesses. ANS: F DIF: Easy OBJ: 14-04 NAT: AACSB Analytic | AICPA BB-Critical Thinking 66. Notes to the financial statements are generally not useful. ANS: F DIF: Easy OBJ: 14-04 NAT: AACSB Analytic | AICPA FN-Reporting 67. The auditor's report is where the auditor certifies that the financial statements are correct and accurate. ANS: F DIF: Easy OBJ: 14-04 NAT: AACSB Analytic | AICPA FN-Reporting 68. In a company's annual report, the section called management discussion and analysis provides critical information in interpreting the financial statements and assessing the future of the company. ANS: T DIF: Easy OBJ: 14-04 NAT: AACSB Analytic | AICPA FN-Reporting

538  Chapter 14/Financial Statement Analysis

MULTIPLE CHOICE 1.

The relationship of $225,000 to $125,000, expressed as a ratio, is a. 2.0 to 1 b. 1.8 to 1 c. 1.5 to 1 d. 0.56 to 1 ANS: B DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 2.

If comparative balance sheets indicate no notes receivable on the preceding year and a $40,000 note receivable on the current year, the increase of $40,000 a. can be stated as 0% b. can be stated as 100% increase c. cannot be stated as a percentage d. can be stated as 500% increase ANS: C DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 3.

Assume that Axle Company reported a net loss of $50,000 in 2006 and net income of $250,000 in 2007. The increase in net income of $300,000 a. can be stated as 0% b. can be stated as 100% increase c. cannot be stated as a percentage d. can be stated as 200% increase ANS: C DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 4.

The percentage analysis of increases and decreases in individual items in comparative financial statements is called a. vertical analysis b. solvency analysis c. profitability analysis d. horizontal analysis ANS: D DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 5.

Which of the following below generally is the most useful in analyzing companies of different sizes a. comparative statements b. common-sized financial statements c. price-level accounting d. audit report ANS: B DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement

Chapter 14/Financial Statement Analysis  539

6.

The percent of fixed assets to total assets is an example of a. vertical analysis b. solvency analysis c. profitability analysis d. horizontal analysis ANS: A DIF: Easy OBJ: 14-01 NAT: AACSB Analytic | AICPA FN-Measurement 7.

What type of analysis is indicated by the following?
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