Chapter 2: Financial Statements and Analysis

48 Gitman • Principles of Finance, Eleventh Edition
Chapter 2
Financial Statements and Analysis
 Learning Goals
1. Review the contents of the stockholders’ report and the procedures for consolidating international
financial statements.
2. Understand who uses financial ratios, and how.
3. Use ratios to analyze a firm’s liquidity and activity.
4. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s
debt.
5. Use ratios to analyze a firm’s profitability and market value.
6. Use a summary of financial ratios and the DuPont System of analysis to perform a complete ratio
analysis.
 True/False
1. The Financial Accounting Standards Board (FASB) is the federal regulatory body that governs the
sale and listing of securities.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 1
Topic: Accounting Standards and Regulation
2. GAAP is the accounting profession’s rulesetting body.
Answer: FALSE
Learning Goal: 1
3. Generallyaccepted accounting principles are authorized by the Financial Accounting Standards
Board (FASB).
Answer: TRUE
Learning Goal: 1
4. Publiclyowned corporations are those which are financed by the proceeds from the treasury
securities.
Answer: FALSE
Learning Goal: 1
5. Publiclyowned corporations are required by the Securities and Exchange Commission (SEC) and
individual state securities commissions to provide their stockholders with an annual stockholders’
report.
Answer: TRUE
Learning Goal: 1
6. The president’s letter, as the first component of the stockholders’ report, is the primary
communication from management to the firm’s employees.
Answer: FALSE
Learning Goal: 1
Topic: Stockholders’ Report
7. Common stock dividends paid to stockholders are equal to the earnings available for common
stockholders divided by the number of shares of common stock outstanding.
Answer: FALSE
Learning Goal: 1
Topic: Dividends
8. The income statement is a financial summary of the firm’s operating results during a specified
period while the balance sheet is a summary statement of the firm’s financial position at a given
point in time.
Answer: TRUE
Learning Goal: 1
Topic: Income Statement
9. The par value of common stock is an arbitrarily assigned per share value used primarily for
accounting purposes.
Answer: TRUE
Learning Goal: 1
Topic: Balance Sheet
Chapter 2 Financial Statements and Analysis 50
10. Paidin capital in excess of par represents the firm’s book value received from the original sale of
common stock.
Answer: FALSE
Learning Goal: 1
11. Earnings per share represents amount earned during the period on each outstanding share of
common stock.
Answer: TRUE
Learning Goal: 1
Topic: Earnings
12. Net fixed assets represent the difference between gross fixed assets and the total expense recorded
for the depreciation of fixed assets.
Answer: TRUE
Learning Goal: 1
13. Earnings per share results from dividing earnings available for common stockholders by the number
of shares of common stock authorized.
Answer: FALSE
Learning Goal: 1
Topic: Earnings
14. Retained earnings represent the cumulative total of all earnings retained and reinvested in the firm
since its inception.
Answer: TRUE
Learning Goal: 1
15. The balance sheet is a statement which balances the firm’s assets (what it owns) against its debt
(what it owes).
Answer: FALSE
Learning Goal: 1
16. The amount paid in by the original purchasers of common stock is shown by two entries in the
firm’s balance sheet—common stock and paidin capital in excess of par on common stock.
Answer: TRUE
Learning Goal: 1
17. The original price per share received by the firm on a single issue of common stock is equal to the
sum of the common stock and paidin capital in excess of par accounts divided by the number of
shares outstanding.
Answer: TRUE
Learning Goal: 1
18. The statement of cash flows reconciles the net income earned during a given year, and any cash
dividends paid, with the change in retained earnings between the start and end of that year.
Answer: FALSE
Learning Goal: 1
Topic: Statement of Cash Flows
19. The cumulative translation adjustment is an equity reserve account on the parent company’s books
in which translation gains and losses are accumulated.
Answer: TRUE
Learning Goal: 1
Topic: International Accounting
20. The statement of cash flows provides insight into the firm’s assets and liabilities and reconciles them
with changes in its cash and marketable securities during the period of concern.
Answer: FALSE
Learning Goal: 1
21. A U.S. parent company’s foreign equity accounts are translated into dollars using the exchange rate
that prevailed when the parent’s equity investment was made (the historical rate).
Answer: TRUE
Learning Goal: 1
22. A U.S. parent company’s foreign retained earnings are adjusted to reflect gains and losses resulting
from currency movements as well as each year’s operating profits or losses.
Answer: FALSE
Learning Goal: 1
23. The Financial Accounting Standards Board (FASB) Standard No. 52 mandates that U.S.based
companies translate their foreigncurrencydenominated assets and liabilities into dollars using the
current rate (translation) method.
Answer: TRUE
Learning Goal: 1
24. Timeseries analysis is the evaluation of the firm’s financial performance in comparison to other
firm(s) at the same point in time.
Answer: FALSE
Learning Goal: 2
Topic: Ratio Analysis Basics
25. As a rule, the necessary inputs to an effective financial analysis include, at minimum, the income
statement and the statement of cash flow.
Answer: FALSE
Learning Goal: 2
26. Crosssectional ratio analysis involves comparing the firm’s ratios to those of firms in other
industries at the same point in time.
Answer: FALSE
Learning Goal: 2
27. Benchmarking is a type of crosssectional analysis in which the firm’s ratio values are compared to
those of firms in other industries, primarily to identify areas for improvement.
Answer: FALSE
Learning Goal: 2
28. Timeseries analysis evaluates performance of firms at the same point in time using financial ratios.
Answer: FALSE
Learning Goal: 2
29. The firm’s creditors are primarily interested in the shortterm liquidity of the company and its ability
to make interest and principal payments.
Answer: TRUE
Learning Goal: 2
Topic: Liquidity Analysis
30. Benchmarking is a type of timeseries analysis in which the firm’s ratio values are compared to
those of a key competitor or group of competitors, primarily to isolate areas of opportunity for
improvement.
Answer: FALSE
Learning Goal: 2
31. Ratio analysis merely directs the analyst to potential areas of concern; it does not provide conclusive
evidence as to the existence of a problem.
Answer: TRUE
Learning Goal: 2
32. In a crosssectional comparison of firms operating in several lines of business, the industry average
ratios of any of the firm’s product lines may be used to analyze the multiproduct firm’s financial
performance.
Answer: FALSE
Learning Goal: 2
33. Due to inflationary effects, inventory costs and depreciation writeoffs can differ from their true
values, thereby distorting profits.
Answer: TRUE
Learning Goal: 2
34. If an analysis is concerned only with certain specific aspects of a firm’s financial position, one or
two ratios may provide sufficient information from which to make a reasonable judgment.
Answer: TRUE
Learning Goal: 2
35. In ratio analysis, the financial statements being used for comparison should be dated at the same
point in time during the year. If not, the effect of seasonality may produce erroneous conclusions
and decisions.
Answer: TRUE
Learning Goal: 2
36. The use of the audited financial statements for ratio analysis may not be preferable because there
may be no reason to believe that the data contained in them reflect the firm’s true financial
condition.
Answer: FALSE
Learning Goal: 2
37. Both present and prospective shareholders are interested in the firm’s current and future level of risk
and return. These two dimensions directly affect share price.
Answer: TRUE
Learning Goal: 2
38. The comparison of a particular ratio to the standard (industry average) is made in order to isolate
any deviations from the norm. In the case of ratios for which higher values are preferred, as long as
the firm that is being analyzed has a value in excess of the industry average it can be viewed
favorably.
Answer: FALSE
Learning Goal: 2
39. The use of differing accounting treatments—especially relative to inventory and depreciation—can
distort the results of ratio analysis, regardless of whether crosssectional or timeseries analysis is
used.
Answer: TRUE
Learning Goal: 2
40. Inflationary effects typically have a greater impact the larger the differences in the age of the assets
of the firms being compared. Without adjustment, inflation tends to cause older firms (with older
fixed assets) to appear more efficient and profitable than newer firms (with newer fixed assets).
Answer: TRUE
Learning Goal: 2
41. Present and prospective shareholders and lenders pay close attention to the firm’s degree of
indebtedness and ability to repay debt. Shareholders are concerned since the claims of creditors must
be satisfied prior to the distribution of earnings to them. Lenders are concerned since the more
indebted the firm, the higher the probability that the firm will be unable to satisfy the claims of all
its creditors.
Answer: TRUE
Learning Goal: 2
Topic: Leverage Analysis
42. The liquidity of a business firm refers to the solvency of the firm’s overall financial position.
Answer: TRUE
Learning Goal: 3
43. The liquidity of a business firm is measured by its ability to satisfy its longterm obligations as they
come due.
Answer: FALSE
Learning Goal: 3
44. The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot
easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure of overall
liquidity.
Answer: FALSE
Learning Goal: 3
45. Since the differences in the composition of a firm’s current assets and liabilities can significantly
affect the firm’s “true” liquidity, it is important to look beyond measures of overall liquidity to
assess the activity (liquidity) of specific current accounts.
Answer: TRUE
Learning Goal: 3
46. The average age of inventory is viewed as the average length of time inventory is held by the firm or
as the average number of days’ sales in inventory.
Answer: TRUE
Learning Goal: 3
Topic: Activity Analysis
47. Total asset turnover commonly measures the liquidity of a firm’s total assets.
Answer: FALSE
Learning Goal: 3
48. The magnification of risk and return introduced through the use of fixedcost financing such as debt
and preferred stock is called financial leverage.
Answer: TRUE
Learning Goal: 4
49. The less fixedcost debt (financial leverage) a firm uses, the greater will be its risk and return.
Answer: FALSE
Learning Goal: 4
50. The higher the value of the times interest earned ratio, the higher the proportion of the firm’s interest
earnings compared to its contractual interest payments.
Answer: FALSE
Learning Goal: 4
51. In general, the more debt (other people’s money) a firm uses in relation to its assets, the smaller its
financial leverage.
Answer: FALSE
Learning Goal: 4
52. The lower the fixedpayment coverage ratio, the lower is the firm’s financial leverage.
Answer: FALSE
Learning Goal: 4
53. The higher the debt ratio, the more financial leverage a firm has and, thus, the greater will be its risk
and return.
Answer: TRUE
Learning Goal: 4
54. Typically, higher coverage ratios are preferred, but too high a ratio may indicate underutilization of
fixedpayment obligations, which may result in unnecessarily low risk and return.
Answer: TRUE
Learning Goal: 4
55. Earnings per share represent the dollar amount earned and distributed to shareholders.
Answer: FALSE
Learning Goal: 5
Topic: Profitability Analysis
56. Gross profit margin measures the percentage of each sales dollar left after the firm has paid for its
goods and operating expenses.
Answer: FALSE
Learning Goal: 5
57. Net profit margin measures the percentage of each sales dollar remaining after all costs and
expenses, including interest and taxes, have been deducted.
Answer: FALSE
Learning Goal: 5
58. Return on total assets (ROA) measures the overall effectiveness of management in generating profits
with the owners’ investment in the firm.
Answer: FALSE
Learning Goal: 5
59. The price/earnings (P/E) ratio represents the degree of confidence that investors have in the firm’s
future performance.
Answer: TRUE
Learning Goal: 5
Topic: Market Value Analysis
60. The financial leverage multiplier is the ratio of the firm’s total assets to stockholders’ equity.
Answer: TRUE
Learning Goal: 6
61. The DuPont formula allows the firm to break down its return into the net profit margin, which
measures the firm’s profitability on sales, and its total asset turnover, which indicates how
efficiently the firm has used its assets to generate sales.
Answer: TRUE
Learning Goal: 6
Topic: Dupont System Analysis
62. The DuPont system allows the firm to break its return on equity into a profitonsales component, an
efficiencyofassetuse component, and a useofleverage component.
Answer: TRUE
Learning Goal: 6
63. The McCainFeingold Act of 2002 was passed to eliminate many of the disclosure and conflict of
interest problems of corporations.
Answer: FALSE
Learning Goal: 1
64. The SarbanesOxley Act of 2002 was passed to eliminate many of the disclosure and conflict of
interest problems of corporations.
Answer: TRUE
Learning Goal: 1
65. The SarbanesOxley Act of 2002 established the Public Company Accounting Oversight Board
(PCAOB) which is a notforprofit corporation that oversees auditors of public corporations.
Answer: TRUE
Learning Goal: 1
66. The SarbanesOxley Act of 2002 established the Private Company Accounting Oversight Board
(PCAOB) which is a forprofit corporation that oversees CEOs of public corporations.
Answer: FALSE
Learning Goal: 1
67. The average age of inventory can be calculated as inventory divided by 365.
Answer: FALSE
Learning Goal: 3
68. The average age of inventory can be calculated as inventory turnover divided by 365.
Answer: FALSE
Learning Goal: 3
69. The average age of inventory can be calculated as 365 divided by inventory turnover.
Answer: TRUE
Learning Goal: 3
70. The average payment period can be calculated as accounts payable divided by average sales per day.
Answer: FALSE
Learning Goal: 3
71. The average payment period can be calculated as accounts payable divided by average purchases per
day.
Answer: TRUE
Learning Goal: 3
 Multiple Choice Questions

1. One of the most influential documents issued by a publiclyheld corporation is the
(a) letter to stockholders.
(b) annual report.
(c) cash flow statement.
(d) income statement.
Answer: B
Learning Goal: 1
2. The rulesetting body, which authorizes generally accepted accounting principles is
(a) GAAP.
(b) FASB.
(c) SEC.
(d) Federal Reserve System.
Answer: B
Learning Goal: 1
3. Accounting practices and procedures used to prepare financial statements are called
(a) SEC.
(b) FASB.
(c) GAAP.
(d) IRB.
Answer: C
Learning Goal: 1
4. The federal regulatory body governing the sale and listing of securities is called the
(a) IRS.
(b) FASB.
(c) GAAP.
(d) SEC.
Answer: D
Learning Goal: 1
5. The stockholder’s annual report must include
(a) A statement of cash flows.
(b) An income statement.
(c) A balance sheet.
(d) A statement of retained earnings.
(e) All of the above.
Answer: E
Learning Goal: 1
6. The stockholder’s report may include all of the following EXCEPT
(a) a cash budget.
(b) an income statement.
(c) a statement of cash flows.
(d) a statement of retained earnings.
Answer: A
Learning Goal: 1
7. Total assets less net fixed assets equals
(a) gross assets.
(b) current assets.
(c) depreciation.
(d) liabilities and equity.
Answer: B
Learning Goal: 1
8. The _________ provides a financial summary of the firm’s operating results during a specified
period.
(a) income statement
(b) balance sheet
(c) statement of cash flows
(d) statement of retained earnings
Answer: A
Learning Goal: 1
9. Gross profits are defined as
(a) operating profits minus depreciation.
(b) operating profits minus cost of goods sold.
(c) sales revenue minus operating expenses.
(d) sales revenue minus cost of goods sold.
Answer: D
Learning Goal: 1
10. Operating profits are defined as
(a) gross profits minus operating expenses.
(b) sales revenue minus cost of goods sold.
(c) earnings before depreciation and taxes.
(d) sales revenue minus depreciation expense.
Answer: A
Learning Goal: 1
11. Net profits after taxes are defined as
(a) gross profits minus operating expenses.
(b) sales revenue minus cost of goods sold.
(c) EBIT minus interest.
(d) EBIT minus interest and taxes.
Answer: D
Learning Goal: 1
12. Operating profits are defined as
(a) sales revenue minus cost of goods sold.
(b) earnings before interest and taxes.
(c) earnings before depreciation and taxes.
(d) earnings after tax.
Answer: B
Learning Goal: 1
13. Earnings available to common shareholders are defined as net profits
(a) after taxes.
(b) after taxes minus preferred dividends.
(c) after taxes minus common dividends.
(d) before taxes.
Answer: B
Learning Goal: 1
14. All of the following are examples of current assets EXCEPT
(a) accounts receivable.
(b) cash.
(c) accruals.
(d) inventory.
Answer: C
Learning Goal: 1
15. All of the following are examples of fixed assets EXCEPT
(a) automobiles.
(b) buildings.
(c) marketable securities.
(d) equipment.
Answer: C
Learning Goal: 1
16. All of the following are examples of current liabilities EXCEPT
(a) accounts receivable.
(b) accounts payable.
(c) accruals.
(d) notes payable.
Answer: A
Learning Goal: 1
17. The net value of fixed assets is also called its
(a) market value.
(b) par value.
(c) book value.
(d) price.
Answer: C
Learning Goal: 1
18. The _________ represents a summary statement of the firm’s financial position at a given point in
time.
(b) balance sheet
Answer: B
Learning Goal: 1
19. The _________ summarizes the firm’s funds flow over a given period of time.
(b) balance sheet
Answer: C
Learning Goal: 1
20. The statement of cash flows may also be called the
(a) sources and uses statement.
(b) statement of retained earnings.
(c) bank statement.
(d) funds statement.
Answer: A
Learning Goal: 1
21. FASB Standard No. 52 mandates that U.S. based companies must translate their foreigncurrency
denominated assets and liabilities into dollars using the
(a) Historical rate.
(b) Current rate.
(c) Average rate.
(d) None of the above.
Answer: B
Learning Goal: 1
22. Retained earnings on the balance sheet represents
(a) net profits after taxes.
(b) cash.
(c) net profits after taxes minus preferred dividends.
(d) the cumulative total of earnings reinvested in the firm.
Answer: D
Learning Goal: 1
23. The statement of retained earnings reports all of the following EXCEPT
(a) net profits after taxes.
(b) interest.
(c) common stock dividends.
(d) preferred stock dividends.
Answer: B
Learning Goal: 1
Topic: Statement of Retained Earnings
24. When preparing a statement of cash flows, retained earnings adjustments are required so that which
of the following are separated on the statement?
(a) Revenue and cost.
(b) Assets and liabilities.
(c) Depreciation and purchases.
(d) Net profits and dividends.
Answer: D
Learning Goal: 1
25. A firm had the following accounts and financial data for 2005.
Sales Revenue $3,060 Cost of goods sold $1,800

Accounts Receivable 500 Preferred stock dividends 18
Interest expense 126 Tax rate 40%
Total oper. expenses 600 Number of shares of common 1,000
Accounts payable 240 stocks outstanding
The firm’s earnings available to common shareholders for 2005 were _________.
(a) –$224
(b) $195
(c) $302
(d) $516
Answer: C
Learning Goal: 1
26. A firm had the following accounts and financial data for 2005:
Sales revenue $3,060 Cost of goods sold $1,800

Accounts receivable 500 Preferred stock dividends 18
Total operating expenses 600 Number of common shares 1,000
Accounts payable 240 outstanding
The firm’s earnings per share, rounded to the nearest cent, for 2005 was ______.
(a) $0.53
(b) $0.51
(c) $0.32
(d) $0.30
Answer: D
Learning Goal: 1
27. A firm had the following accounts and financial data for 2005.
Sales revenue $3,060 Cost of goods sold $1,800

Accounts receivable 500 Preferred stock dividends 18
Total operating expenses 600 Number of common shares 1,000
Accounts payable 240 outstanding
The firm’s net profit after taxes for 2005 was ______.
(a) –$206
(b) $213
(c) $320
(d) $206
Answer: C
Learning Goal: 1
28. On the balance sheet net fixed assets represent
(a) gross fixed assets at cost minus depreciation expense.
(b) gross fixed assets at market value minus depreciation expense.
(c) gross fixed assets at cost minus accumulated depreciation.
(d) gross fixed assets at market value minus accumulated deprecation.
Answer: C
Learning Goal: 1
29. Paidincapital in excess of par represents the amount of proceeds
(a) from the original sale of stock.
(b) in excess of the par value from the original sale of common stock.
(c) at the current market value of common stock.
(d) at the current book value of common stock.
Answer: B
Learning Goal: 1
30. Firm ABC had operating profits of $100,000, taxes of $17,000, interest expense of $34,000 and
preferred dividends of $5,000. What was the firm’s net profit after taxes?
(a) $66,000
(b) $49,000
(c) $44,000
(d) $83,000
Answer: B
Learning Goal: 1
31. Candy Corporation had pretax profits of $1.2 million, an average tax rate of 34 percent, and it paid
preferred stock dividends of $50,000. There were 100,000 shares outstanding and no interest
expense. What were Candy Corporation’s earnings per share?
(a) $3.91
(b) $4.52
(c) $7.42
(d) $7.59
Answer: C
Learning Goal: 1
32. A firm had year end 2004 and 2005 retained earnings balances of $670,000 and $560,000,
respectively. The firm paid $10,000 in dividends in 2005. The firm’s net profit after taxes in 2002
was _________.
(a) –$100,000
(b) –$110,000
(c) $100,000
(d) $110,000
Answer: A
Learning Goal: 1
33. A corporation had year end 2004 and 2005 retained earnings balances of $320,000 and $400,000,
respectively. The firm reported net profits after taxes of $100,000 in 2005. The firm paid dividends
in 2005 of _________.
(a) $0
(b) $20,000
(c) $80,000
(d) $100,000
Answer: B
Learning Goal: 1
34. A corporation had a year end 2004 retained earnings balance of $220,000. The firm reported net
profits after taxes of $50,000 in 2005 and paid dividends in 2005 of $30,000. The firm’s retained
earnings balance at year end 2005 was _________.
(a) $240,000
(b) $250,000
(c) $270,000
(d) $300,000
Answer: A
Learning Goal: 1
35. A firm had year end 2004 and 2005 retained earnings balance of $670,000 and $560,000,
respectively. The firm reported net profits after taxes of $100,000 in 2005. The firm paid dividends
in 2005 of _________.
(a) $10,000
(b) $100,000
(c) $110,000
(d) $210,000
Answer: D
Learning Goal: 1
36. Ratios provide a _________ measure of a company’s performance and condition.
(a) definitive
(b) gross
(c) relative
(d) qualitative
Answer: C
Learning Goal: 2
37. _________ analysis involves the comparison of different firms’ financial ratios at the same point in
time.
(a) Timeseries
(b) Crosssectional
(c) Marginal
(d) Quantitative
Answer: B
Learning Goal: 2
38. _________ analysis involves comparison of current to past performance and the evaluation of
developing trends.
(a) Timeseries
(b) Crosssectional
(c) Marginal
(d) Quantitative
Answer: A
Learning Goal: 2
39. The primary concern of creditors when assessing the strength of a firm is the firm’s
(a) profitability.
(b) leverage.
(c) shortterm liquidity.
(d) share price.
Answer: C
Learning Goal: 2
40. Present and prospective shareholders are mainly concerned with a firm’s
(a) risk and return.
(b) profitability.
(c) leverage.
(d) liquidity.
Answer: A
Learning Goal: 2
41. To analyze the firm’s financial performance, the following types of ratio analyses EXCEPT
_________ may be used.
(a) timeseries analysis
(b) crosssection analysis
(c) combined analysis
(d) marginal analysis
Answer: D
Learning Goal: 2
42. Timeseries analysis is often used to
(a) assess developing trends.
(b) correct errors of judgment.
(c) reflect performance relative to some norm.
(d) standardize results.
Answer: A
Learning Goal: 2
43. In ratio analysis, a comparison to a standard industry ratio is made to isolate _________ deviations
from the norm.
(a) positive
(b) negative
(c) any
(d) standard
Answer: C
Learning Goal: 2
44. _________ evidence of the existence of a problem or outstanding management performance is
provided by ratio analysis.
(a) Conclusive
(b) Inconclusive
(c) Complete
(d) Definitive
Answer: B
Learning Goal: 2
45. The analyst should be careful when conducting ratio analysis to ensure that
(a) the overall performance of the firm is not judged on a single ratio.
(b) the dates of the financial statements being compared are the same.
(c) audited statements are used.
(d) the same accounting procedures were used.
(e) all of the above.
Answer: E
Learning Goal: 2
46. The analyst should be careful when evaluating a ratio analysis that
(a) The overall performance of the firm may be judged on a single ratio.
(b) The dates of the financial statements being compared are the same time.
(c) Preaudited statements are used.
(d) All of the above.
Answer: B
Learning Goal: 2
47. _________ is where the firm’s ratio values are compared to those of a key competitor or group of
competitors, primarily to identify areas for improvement.
(a) Timeseries analysis
(b) Benchmarking
(c) Combined analysis
(d) None of the above.
Answer: B
Learning Goal: 2
48. Crosssectional ratio analysis is used to
(a) correct expected problems in operations.
(b) isolate the causes of problems.
(c) provide conclusive evidence of the existence of a problem.
(d) reflect the symptoms of a possible problem.
Answer: D
Learning Goal: 2
49. In the near term, the important ratios that provide the information critical to the shortrun operation
of the firm are
(a) liquidity, activity, and profitability.
(b) liquidity, activity, and common stock.
(c) liquidity, activity, and debt.
(d) activity, debt, and profitability.
Answer: A
Learning Goal: 2
50. One way to negate the effect of inflation on ratio analysis is to value the fixed assets at
(a) book value.
(b) liquidation value.
(c) replacement value.
(d) depreciation.
Answer: C
Learning Goal: 2
51. Inflation can distort
(a) inventory costs.
(b) accumulated depreciation.
(c) interest writeoffs.
(d) salaries and wages.
Answer: A
Learning Goal: 2
52. Without adjustment, inflation may tend to cause _________ firms to appear more efficient and
profitable than _________ firms, all else being the same.
(a) large; smaller
(b) older; newer
(c) smaller; larger
(d) newer; older
Answer: B
Learning Goal: 2
53. The following groups of ratios primarily measure risk.
(a) liquidity, activity, and profitability
(b) liquidity, activity, and common stock
(c) liquidity, activity, and debt
(d) activity, debt, and profitability
Answer: C
Learning Goal: 2
54. The _________ ratios are primarily measures of return.
(a) liquidity
(b) activity
(c) debt
(d) profitability
Answer: D
Learning Goal: 2
55. The _________ of a business firm is measured by its ability to satisfy its shortterm obligations as
they come due.
(a) activity
(b) liquidity
(c) debt
(d) profitability
Answer: B
Learning Goal: 3
56. _________ ratios are a measure of the speed with which various accounts are converted into sales or
cash.
(a) Activity
(b) Liquidity
(c) Debt
(d) Profitability
Answer: A
Learning Goal: 3
57. The _________ is useful in evaluating credit and collection policies.
(a) average payment period
(b) current ratio
(c) average collection period
(d) current asset turnover
Answer: C
Learning Goal: 3
58. The _________ measures the activity, or liquidity, of a firm’s inventory.
(a) average collection period
(b) inventory turnover
(c) quick ratio
(d) current ratio
Answer: B
Learning Goal: 3
59. The two basic measures of liquidity are
(a) inventory turnover and current ratio.
(b) current ratio and quick ratio.
(c) gross profit margin and ROE.
(d) current ratio and total asset turnover.
Answer: B
Learning Goal: 3
60. The _________ is a measure of liquidity which excludes _________, generally the least liquid asset.
(a) current ratio; accounts receivable
(b) quick ratio; accounts receivable
(c) current ratio; inventory
(d) quick ratio; inventory
Answer: D
Learning Goal: 3
61. The _________ ratio may indicate the firm is experiencing stockouts and lost sales.
(d) quick
Answer: B
Learning Goal: 3
62. The _________ ratio may indicate poor collections procedures or a lax credit policy.
(d) quick
Answer: C
Learning Goal: 3
63. ABC Corp. extends credit terms of 45 days to its customers. Its credit collection would be
considered poor if its average collection period was
(a) 30 days.
(b) 36 days.
(c) 47 days.
(d) 57 days.
Answer: D
Learning Goal: 3
64. Which of the following ratios is difficult for creditors of a firm to analyze because the data are
usually not available in published financial statements?
(a) operating leverage
(b) average payment period
(c) quick ratio
(d) average age of inventory
Answer: A
Learning Goal: 3
65. _________ are especially interested in the average payment period, since it provides them with a
sense of the billpaying patterns of the firm.
(a) Customers
(b) Stockholders
(c) Lenders and suppliers
(d) Borrowers and buyers
Answer: C
Learning Goal: 3
66. A firm has a current ratio of 1; in order to improve its liquidity ratios, this firm might
(a) improve its collection practices, thereby increasing cash and increasing its current and quick
ratios.
(b) improve its collection practices and pay accounts payable, thereby decreasing current liabilities
and increasing the current and quick ratios.
(c) decrease current liabilities by utilizing more longterm debt, thereby increasing the current and
quick ratios.
(d) increase inventory, thereby increasing current assets and the current and quick ratios.
Answer: C
Learning Goal: 3
67. As a firm’s cash flows become more predictable,
(a) the current ratio will expand.
(b) the return on equity will increase.
(c) current liabilities will decrease.
(d) current assets will decrease.
Answer: D
Learning Goal: 3
68. If the inventory turnover is divided into 360, it becomes a measure of
(a) sales efficiency.
(b) the average age of the inventory.
(c) sales turnover.
(d) the average collection period.
Answer: B
Learning Goal: 3
69. The _________ is useful in evaluating credit and collection policies.
(b) current ratio
(d) current asset turnover
Answer: C
Learning Goal: 3
70. The two categories of ratios that should be utilized to assess a firm’s true liquidity are the
(a) current and quick ratios.
(b) liquidity and profitability ratios.
(c) liquidity and debt ratios.
(d) liquidity and activity ratios.
Answer: D
Learning Goal: 3
71. A firm with a total asset turnover that is lower than industry standard but with a current ratio which
meets industry standard must have excessive
(a) fixed assets.
(b) inventory.
(c) accounts receivable.
(d) debt.
Answer: A
Learning Goal: 3
72. The following groups of ratios provide the information critical to the shortrun operation of the firm.
(a) liquidity, activity, and profitability
(b) liquidity, activity, and common stock
(c) liquidity, activity, and debt
(d) activity, debt, and profitability
Answer: A
Learning Goal: 3
73. The _________ ratios provide the information critical to the longrun operation of the firm.
(a) liquidity
(b) activity
(c) debt
(d) profitability
Answer: C
Learning Goal: 3
74. A firm with a total asset turnover lower than industry standard may have
(a) excessive debt.
(b) excessive cost of goods sold.
(c) insufficient sales.
(d) insufficient fixed assets.
Answer: C
Learning Goal: 3
75. The _________ ratio measures the proportion of total assets financed by the firm’s creditors.
(a) total asset turnover
(b) fixed asset turnover
(c) current
(d) debt
Answer: D
Learning Goal: 4
76. The _________ ratio measures the firm’s ability to pay contractual interest payments.
(a) times interest earned
(b) fixedpayment coverage
(c) debt
(d) average payment period
Answer: A
Learning Goal: 4
77. The _________ ratio may indicate that the firm will not be able to meet interest obligations due on
outstanding debt.
(a) debt
(b) net profit margin
(c) return on total assets
(d) times interest earned
Answer: D
Learning Goal: 4
78. The higher the value of _________ ratio, the better able the firm is to fulfill its interest obligations.
(a) debt
(b) average collection period
(c) times interest earned
(d) average payment period
Answer: C
Learning Goal: 4
Table 2.1
Balance Sheet
Cole Eagan Enterprises
December 31, 2005
Cash $4,500 Accounts Payable $10,000
Accounts Receivable Notes Payable
Inventory Accruals 1,000
Total Current Assets Total Current Liabilities
Net Fixed Assets LongTerm Debt
Total Assets Stockholders’ Equity
Total Liabilities & S.E.
Information (2005 values)
1. Sales totaled $110,000
2. The gross profit margin was 25 percent.
3. Inventory turnover was 3.0.
4. There are 360 days in the year.
5. The average collection period was 65 days.
6. The current ratio was 2.40.
7. The total asset turnover was 1.13.
8. The debt ratio was 53.8 percent.
79. Inventory for CEE in 2005 was _________. (See Table 2.1)
(a) $36,667
(b) $32,448
(c) $27,500
(d) $ 9,167
Answer: C
Learning Goal: 4
Topic: Balance Sheet and Activity Analysis
80. Notes payable for CEE in 2005 was _________. (See Table 2.1)
(a) $113,466
(b) $ 52,372
(c) $ 41,372
(d) $ 10,608
Answer: D
Learning Goal: 4
81. Accounts receivable for CEE in 2005 was _________. (See Table 2.1)
(a) $14,056
(b) $19,861
(c) $14,895
(d) $18,333
Answer: B
Learning Goal: 4
82. Net fixed assets for CEE in 2005 were _________. (See Table 2.1)
(a) $45,484
(b) $48,975
(c) $54,511
(d) $69,341
Answer: A
Learning Goal: 4
83. Total assets for CEE in 2005 were _________. (See Table 2.1)
(a) $ 45,895
(b) $124,300
(c) $ 58,603
(d) $ 97,345
Answer: D
Learning Goal: 4
84. Longterm debt for CEE in 2005 was _________. (See Table 2.1)
(a) $30,737
(b) $52,372
(c) $10,608
(d) $41,372
Answer: A
Learning Goal: 4
85. _________ is a term used to describe the magnification of risk and return introduced through the use
of fixed cost financing such as preferred stock and longterm debt.
(a) Financial leverage
(b) Operating leverage
(c) Fixedpayment coverage
(d) The acidtest
Answer: A
Learning Goal: 4
86. When assessing the fixedpayment coverage ratio,
(a) the lower its value the more risky is the firm.
(b) the lower its value, the lower is the firm’s financial leverage.
(c) preferred stock dividend payments can be disregarded.
(d) the higher its value, the higher is the firm’s liquidity.
Answer: A
Learning Goal: 4
87. The _________ is a popular approach for evaluating profitability in relation to sales by expressing
each item on the income statement as a percent of sales.
(a) retained earnings statement
(b) source and use statement
(c) commonsize income statement
(d) profit and loss statement
Answer: C
Learning Goal: 5
Topic: Common Size Analysis
88. The _________ indicates the percentage of each sales dollar remaining after the firm has paid for its
goods.
(a) net profit margin
(b) operating profit margin
(c) gross profit margin
(d) earnings available to common shareholders
Answer: C
Learning Goal: 5
89. The _________ measures the percentage of profit earned on each sales dollar before interest and
taxes.
Answer: B
Learning Goal: 5
90. The _________ measures the percentage of each sales dollar remaining after ALL expenses,
including taxes, have been deducted.
Answer: A
Learning Goal: 5
91. The _________ measures the overall effectiveness of management in generating profits with its
available assets.
(b) price/earnings ratio
(c) return on equity
(d) return on total assets
Answer: D
Learning Goal: 5
92. The _________ measures the return on owners’ (both preferred and common stockholders)
investment in the firm.
(b) price/earnings ratio
Answer: C
Learning Goal: 5
93. The _________ ratio is commonly used to assess the owner’s appraisal of the share value.
(a) debt
(b) price/earnings
Answer: B
Learning Goal: 5
Topic: Market Value Analysis
94. Two frequently cited ratios of profitability that can be read directly from the commonsize income
statement are
(a) the earnings per share and the return on total assets.
(b) the gross profit margin and the earnings per share.
(c) the gross profit margin and the return on total assets.
(d) the gross profit margin and the net profit margin.
Answer: D
Learning Goal: 5
95. A firm with a gross profit margin which meets industry standard and a net profit margin which is
below industry standard must have excessive
(a) general and administrative expenses.
(b) cost of goods sold.
(c) dividend payments.
(d) principal payments.
Answer: A
Learning Goal: 5
96. A firm with sales of $1,000,000, net profits after taxes of $30,000, total assets of $1,500,000, and
total liabilities of $750,000 has a return on equity of
(a) 20 percent.
(b) 15 percent.
(c) 3 percent.
(d) 4 percent.
Answer: D
Learning Goal: 5
97. The DuPont system merges the income statement and balance sheet into two summary measures of
profitability:
(a) net profit margin and return on total assets.
(b) net profit margin and return on equity.
(c) return on total assets and return on equity.
(d) net profit margin and price/earning ratio.
Answer: C
Learning Goal: 6
98. _________ is used by financial managers as a structure for dissecting the firm’s financial statements
to assess its financial condition.
(a) Statement of cash flows
(b) The DuPont system of analysis
(c) A commonsize income statement
(d) Crosssectional analysis
Answer: B
Learning Goal: 6
99. In the DuPont system, the return on total assets (asset) is equal to
(a) (return on equity)  (financial leverage multiplier).
(b) (return on equity)  (total asset turnover).
(c) (net profit margin)  (fixed asset turnover).
(d) (net profit margin)  (total asset turnover).
Answer: D
Learning Goal: 6
100. The modified DuPont formula relates the firm’s return on total assets (ROA) to the
(a) return on equity (ROE).
(b) financial leverage multiplier.
(c) net profit margin.
(d) total asset turnover.
Answer: A
Learning Goal: 6
101. In the DuPont system, the return on equity is equal to
(a) (net profit margin)  (total asset turnover).
(b) (stockholders’ equity)  (financial leverage multiplier).
(c) (return on total assets)  (financial leverage multiplier).
(d) (return on total assets)  (total asset turnover).
Answer: C
Learning Goal: 6
102. A firm with a substandard net profit margin can improve its return on total assets by
(a) increasing its debt ratio.
(b) increasing its total asset turnover.
(c) decreasing its fixed asset turnover.
(d) decreasing its total asset turnover.
Answer: B
Learning Goal: 6
103. A decrease in total asset turnover will result in _________ in the return on equity.
(a) an increase
(b) a decrease
(c) no change
(d) an undetermined change
Answer: B
Learning Goal: 6
104. A firm with a substandard return on total assets can improve its return on equity, all else remaining
the same, by
(a) increasing its debt ratio.
(b) increasing its total asset turnover.
(c) decreasing its debt ratio.
(d) decreasing its total asset turnover.
Answer: A
Learning Goal: 6
105. The three summary ratios basic to the DuPont system of analysis are
(a) net profit margin, total asset turnover, and return on investment.
(b) net profit margin, total asset turnover, and return on equity.
(c) net profit margin, total asset turnover, and equity multiplier.
(d) net profit margin, financial leverage multiplier, and return on equity.
Answer: C
Learning Goal: 6
106. The financial leverage multiplier is an indicator of a corporation utilizing
(a) operating leverage.
(b) longterm debt.
(c) total debt.
(d) total assets.
Answer: C
Learning Goal: 6
107. The financial leverage multiplier is an indicator of a corporation utilizing
(a) operating leverage.
(b) financial leverage.
(c) longterm debt.
(d) current liabilities.
Answer: B
Learning Goal: 6
108. An increase in financial leverage will result in _________ in the return on equity.
(a) an increase
(b) a decrease
(c) no change
(d) an undetermined change
Answer: A
Learning Goal: 6
109. A firm with a total asset turnover lower than the industry standard and a current ratio which meets
the industry standard may have
(a) excessive fixed assets.
(b) excessive inventory.
(c) excessive accounts receivable.
(d) excessive debt.
Answer: A
Learning Goal: 6
110. A firm with a total asset turnover lower than the industry standard may have
(a) excessive debt.
(b) excessive cost of goods sold.
(c) insufficient sales.
(d) insufficient fixed assets.
Answer: C
Learning Goal: 6
Table 2.2
Dana Dairy Products Key Ratios
Industry Actual Actual
Average 2004 2005
Current Ratio 1.3 1.0
Quick Ratio 0.8 0.75
Average collection Period 23 days 30 days
Inventory Turnover 21.7 19
Debt Ratio 64.7% 50%
Times Interest Earned 4.8 5.5
Gross Profit Margin 13.6% 12.0%
Net Profit Margin 1.0% 0.5%
Return on total assets 2.9% 2.0%
Return on Equity 8.2% 4.0%
Income Statement
Dana Dairy Products
For the Year Ended December 31, 2005
Sales Revenue $100,000
Less: Cost of Goods Sold 87,000
Gross Profits $13,000
Less: Operating Expenses 11,000
Operating Profits $2,000
Less: Interest Expense 500
Net Profits Before Taxes $1,500
Less: Taxes (40%) 600
Net Profits After Taxes $900
Balance Sheet
Dana Dairy Products
December 31, 2005
Assets
Cash $ 1,000
Accounts Receivable 8,900
Inventories 4,350
Total Current Assets $14,250
Gross Fixed Assets $35,000
Less: Accumulated Depreciation 13,250
Net Fixed Assets 21,750
Total Assets $36,000
Liabilities & Stockholders’ Equity
Accounts Payable $ 9,000
Accruals 6,675
Total Current Liabilities $15,675
Longterm Debt 4,125
Total Liabilities $19,800
Common Stock 1,000
Retained Earnings 15,200
Total Stockholders’ Equity $16,200
Total Liabilities & Stockholders Equity $36,000
111. The current ratio for Dana Dairy Products in 2005 was _________. (See Table 2.2)
(a) 1.58
(b) 0.63
(c) 1.10
(d) 0.91
Answer: D
Learning Goal: 6
112. Since 2004, the liquidity of Dana Dairy Products _________. (See Table 2.2)
(a) has deteriorated
(b) remained the same
(c) has improved
(d) cannot be determined
Answer: A
Learning Goal: 6
113. The net working capital for Dana Dairy Products in 2005 was _________. (See Table 2.2)
(a) $10,325
(b) $ 1,425
(c) –$ 1,425
(d) $14,250
Answer: C
Learning Goal: 6
114. The inventory turnover for Dana Dairy Products in 2005 was _________. (See Table 2.2)
(a) 43
(b) 5
(c) 20
(d) 25
Answer: C
Learning Goal: 6
115. The inventory management at Dana Dairy Products _________ since 2004. (See Table 2.2)
(c) has improved slightly
Answer: C
Learning Goal: 6
116. The average collection period for Dana Dairy Products in 2005 was (See Table 2.2)
(a) 32.5 days.
(b) 11.8 days.
(c) 25.3 days.
(d) 35.9 days.
Answer: A
Learning Goal: 6
117. If Dana Dairy Products has credit terms which specify that accounts receivable should be paid in
25 days, the average collection period _________ since 2004. (See Table 2.2)
(c) has improved
Answer: A
Learning Goal: 6
118. Dana Dairy Products had a _________ degree of financial leverage than the industry standard,
resulting in _________. (See Table 2.2)
(a) lower; lower return on total assets
(b) lower; lower return on equity
(c) higher; higher return on equity
(d) higher; higher return on total assets
Answer: B
Learning Goal: 6
119. The debt ratio for Dana Dairy Products in 2005 was (See Table 2.2)
(a) 50 percent.
(b) 11 percent.
(c) 55 percent.
(d) 44 percent.
Answer: C
Learning Goal: 6
120. Dana Dairy Products’ gross profit margin was inferior to the industry standard. This may have
resulted from (See Table 2.2)
(a) a high sales price.
(b) the high cost of goods sold.
(c) excessive selling and administrative expenses.
(d) excessive interest expense.
Answer: B
Learning Goal: 6
121. The gross profit margin and net profit margin for Dana Dairy Products in 2005 were (See
Table 2.2)
(a) 13 percent and 0.9 percent, respectively.
(b) 13 percent and 1.5 percent, respectively.
(c) 2 percent and 0.9 percent, respectively.
(d) 2 percent and 1.5 percent, respectively.
Answer: A
Learning Goal: 6
122. The return on total assets for Dana Dairy Products for 2005 was (See Table 2.2)
(a) 0.9 percent.
(b) 5.5 percent.
(c) 25 percent.
(d) 2.5 percent.
Answer: D
Learning Goal: 6
123. The return on equity for Dana Dairy Products for 2005 was (See Table 2.2)
(a) 0.6 percent.
(b) 5.6 percent.
(c) 0.9 percent.
(d) 50 percent.
Answer: B
Learning Goal: 6
124. Using the modified DuPont formula allows the analyst to break Dana Dairy Products return on
equity into 3 components: the net profit margin, the total asset turnover, and a measure of leverage
(the financial leverage multiplier). Which of the following mathematical expressions represents the
modified DuPont formula relative to Dana Dairy Products’ 2005 performance? (See Table 2.2)
(a) 5.6(ROE)  2.5(ROA)  2.24(Financial leverage multiplier)
(b) 5.6(ROE)  3.3(ROA)  1.70(Financial leverage multiplier)
(c) 4.0(ROE)  2.0(ROA)  2.00(Financial leverage multiplier)
(d) 2.5(ROE)  5.6(ROA)  0.44(Financial leverage multiplier)
Answer: A
Learning Goal: 6
Topic: DuPont System Analysis
125. As the financial leverage multiplier increases this may result in
(a) an increase in the net profit margin and return on investment, due to the decrease in interest
expense as debt decreases.
(b) an increase in the net profit margin and return on investment, due to the increase in interest
expense as debt increases.
(c) a decrease in the net profit margin and return on investment, due to the increase in interest
expense as debt increases.
(d) a decrease in the net profit margin and return on investment, due to the decrease in interest
expense as debt decreases.
Answer: C
Learning Goal: 6
Topic: DuPont System Analysis
126. The 2002 law that established the Public Company Accounting Oversight Board (PCAOB) was
called
(a) The McCainFeingold Act.
(b) The HarkinsOxley Act.
(c) The SarbanesHarkins Act.
(d) The SarbanesOxley Act.
Answer: D
Learning Goal: 1
127. The 2002 SarbanesOxley Act was designed to
(a) limit the compensation that could be paid to corporate CEOs
(b) eliminate the many disclosure and conflict of interest problems of corporations
(c) provide uniform international accounting standards
(d) two of the above
Answer: B
Learning Goal: 1
128. The Public Company Accounting Oversight Board (PCAOB)
(a) is a notforprofit corporation that oversees auditors of public corporations.
(b) is a notforprofit corporation that oversees managers of public corporations.
(c) is a forprofit corporation that oversees auditors of public corporations.
(d) is a forprofit corporation that oversees managers of public corporations.
Answer: A
Learning Goal: 1
129. If Nico Corporation has cost of goods sold of $300,000 and inventory of $30,000, then the inventory
turnover is _________ and the average age of inventory is _________.
(a) 36.5; 10
(b) 10; 36.5
(c) 36.0; 10
(d) 10; 36.0
Answer: B
Learning Goal: 3
130. If Nico Corporation has annual purchases of $300,000 and accounts payable of $30,000, then
average purchases per day are _________ and the average payment period is _________.
(a) 36.5; 821.9
(b) 36.0; 833.3
(c) 821.9; 36.5
(d) 833.3; 36.0
Answer: C
Learning Goal: 3
 Essay Questions
1. Ag Silver Mining, Inc. has $500,000 of earnings before interest and taxes at the year end. Interest
expenses for the year were $10,000. The firm expects to distribute $100,000 in dividends. Calculate
the earnings after taxes for the firm assuming a 40 percent tax on ordinary income.
Answer:
Earnings before interest and taxes $500,000
Less: Interest 10,000
Earnings before taxes $490,000
Less: Taxes (40%) 196,000
Earnings after taxes $294,000
Learning Goal: 1
2. At the end of 2005, the Long Life Light Bulb Company announced it had produced a gross profit of
$1 million. The company has also established that over the course of this year it has incurred
$345,000 in operating expenses and $125,000 in interest expenses. The company is subject to a 30
percent tax rate and has declared $57,000 total preferred stock dividends.
(a) How much is the earnings available for common stockholders?
(b) Compute the increased retained earnings for 2005 if the company were to declare a $4.25
common stock dividend. The company has 15,000 shares of common stock outstanding.
Answers:
(a) Gross Profits $1,000,000
Less: Operating expenses (345,000)
Operating Profits $ 655,000
Less: Interest (125,000)
Net Profits before taxes $ 530,000
Less: Taxes (30%) (159,000)
Net Profits After Taxes $ 371,000
Less: Preferred Stock Dividend (57,000)
Earnings Available for Common Stock $ 314,000
(b) Earnings Available for Common Stock $ 314,000
Dividend  (4.25)(15,000 shares) (63,750)
Increased Retained Earnings $ 250,250
Learning Goal: 1
3. Reliable Auto Parts has 5,000 shares of common stock outstanding. The company also has the
following amounts in revenue and expense accounts.
Sales revenue $ 85,000
General and administrative expense 7,500
Interest expense 3,500
Depreciation expense 5,000
Preferred stock dividends 500
Selling expense 4,000
Cost of goods sold 50,000
Calculate
(a) gross profits.
(b) operating profits.
(c) net profits before taxes.
(d) net profits after taxes (assume a 40 percent tax rate).
(e) cash flow from operations.
(f) earnings available to common stockholders.
(g) earnings per share.
Answers:
(a) Sales revenue $85,000
– cost of goods sold –50,000
Gross profits $35,000
(b) Gross profits $35,000
– operating expenses
Selling expense 4,000
General & adm. expense 7,500
$16,500
Operating profits $18,500
(c) Operating profits $18,500
– interest expense –3,500
Net profits before taxes $15,000
(d) Net profits before taxes $15,000
– taxes (40%) –6,000
Net profits after taxes $9,000
(e) Net profits after taxes $9,000
 depreciation expense  5,000
Cash flow from operations $14,000
(f) Net profits after taxes $9,000
– preferred dividends –500
earnings available for C.S. $8,500
(g) Earnings available for C.S. $8,500
______________________ =  $1.70/share
# of common shares outstanding 5,000
Learning Goal: 1
4. Colonial Furniture’s net profits before taxes for 2002 totaled $354,000. The company’s total
retained earnings were $338,000 for 2004 year end and $389,000 for 2005 year end. Colonial is
subject to a 26 percent tax rate. How large was the cash dividend declared by Colonial Furniture in
2005?
Answer:
Less: Taxes (26%) 92,040
Net Profits After Taxes $261,960
Retained Earnings (2004) $338,000
Net Profits After Taxes (2005) 261,960
Dividends X

Dividends  $210,960
Learning Goal: 1
5. On December 31, 2004, the Bradshaw Corporation had $485,000 as an ending balance for its
retained earnings account. During 2005, the corporation declared a $3.50/share dividend to its
stockholders. The Bradshaw Corporation has 35,000 shares of common stock outstanding. When the
books were closed for 2005 year end, the corporation had a final retained earnings balance of
$565,000. What was the net profit earned by Bradshaw Corporation during 2005?
Answer:
Dividends  ($3.50/share)(35,000 shares)  $122,500
Net Profits After Taxes (2005) X
Dividends 122,500

Net Profits After Taxes  $202,500
Learning Goal: 1
6. The Sunshine Company had a retained earnings balance of $850,000 at the beginning of 2005. By
the end of 2005, the company’s retained earnings balance was $950,000. During 2005, the company
earned $245,000 as net profits after paying its taxes. The company was then able to pay its preferred
stockholders $45,000. Compute the common stock dividend per share in 2005 assuming 10,000
shares of common stock outstanding.
Answer:
Net Profits After Taxes (2005) 245,000
Preferred Stock Dividend (45,000)
Common Stock Dividend X

Total common stock dividend  $100,000
Common stock dividend per share 
100,000/10,000  $10
Learning Goal: 1
7. Discuss the limitations of ratio analysis and the cautions which must be taken when reviewing a
crosssectional and timeseries analysis.
Answer: In summarizing a large number of ratios, all aspects of the firm’s activities can be
assessed. However, limitations of ratio analysis must be recognized. A comparison of
current and past ratios may reveal mismanagement. But, the ratio does not give definitive
cause to the problem. Additional investigation is necessary to confirm the possible
problem. The analyst must be cautious of the following points: 1) a single ratio does not
provide sufficient information to judge the overall performance of the firm, 2) the dates of
the financial statements should be the same, 3) audited statements should be used, 4)
similar accounting treatment of comparative data is essential, and 5) inflation and differing
asset ages can distort ratio comparisons.
Learning Goal: 2
8.
Key Financial Data
Dreamscape, Inc. Industry Average
Ratio For the Year Ended For the Year Ended
(% of Sales) December 31, 2004 December 31, 2005
Cost of goods sold 74.5% 70.0%
Gross profits 25.5 30.0
Selling expense 8.0 7.0
Gen. & admin. expense 5.1 4.9
Depreciation expense 2.4 2.0
Total operating expense 15.5 13.9
Operating profits 10.0 16.1
Interest expense 1.4 1.0
Net profits before taxes 8.6 15.1
Taxes 2.4 6.0
Net profits after taxes 5.2 9.1
Income Statement, Dreamscape, Inc.
Sales revenue $1,000,000
Less: Cost of goods sold 750,000
Gross profits $ 250,000
Less: Operating expenses
Selling Expense $70,000
Gen. & admin. expense 48,000
Total operating expense $ 138,000
Operating profits $ 112,000
Less: Interest expense $ 20,000
Net profits before taxes $ 92,000
Less: Taxes $ 36,800
Net profits after taxes $ 55,200
Prepare a commonsize income statement for Dreamscape, Inc. for the year ended December 31,
2005. Evaluate the company’s performance against industry average ratios and against last year’s
results.
Answer:
CommonSize Income Statement
Dreamscape, Inc.
Sales revenue 100%
Less: Cost of goods sold 75%
Gross profits 25%
Less: Operating expenses
Selling Expense 7.0%
Gen. & admin. expense 4.8%
Depreciation expense 2.0%
Total operating expense 13.8%
Operating profits 11.2%
Less: Interest expense 2.0%
Net profits before taxes 9.2%
Less: Taxes 3.68%
Net profits after taxes 5.52%
Dreamscape, Inc. performs significantly below industry average. All profitability ratios
(gross profit margin, operating profit margin, and net profit margin) trail the industry
norms. In 2004 expenses as a percent of sales were high.
Dreamscape, Inc. improved the management of operating expenses in 2005 meeting
industry averages. However, cost of goods sold as a percent of sales increased and is a full
5 percent above the industry average, further reducing the gross profit margin. Interest
expense is two times the average indicating high cost of debt or a high debt level. The firm
must concentrate on reducing the cost of goods sold and interest expense to improve
performance.
Learning Goal: 6
Topic: Common Size Statement Analysis
9. In an effort to analyze Clockwork Company finances, Jim realized that he was missing the
company’s net profits after taxes for the current year. Find the company’s net profits after taxes
using the following information.
Return on total assets  2%
Total Asset Turnover  0.5
Cost of Goods Sold  $105,000
Gross Profit Margin  0.30
Answer: Sales  CGS/(1 – GPM)  105,000/(1 – 0.30)  $150,000
Total Assets  Sales/(Total Asset Turnover)
 150,000/0.50  $300,000
Net Profits After Taxes  (ROA)  (Total Assets)
 (0.02)  (300,000)  $6,000
Learning Goal: 6
Topic: Ratio and Financial Statement Analysis
10. Construct the DuPont system of analysis using the following financial data for Key Wahl Industries
and determine which areas of the firm need further analysis.
Key Financial Data
Key Wahl Industries:
Sales $4,500,000
Net profits after taxes 337,500
Total assets 6,750,000
Total liabilities 3,375,000
Industry Averages:
Total asset turnover 0.71
Debt ratio 33.00%
Financial leverage multiplier 1.50
Return on total assets 6.75%
Return on equity 10.00%
Net profit margin 9.50%
Answer: Ratios for Key Wahl Industries
4,500,000
Total asset turnover   0.67
6,750,000
3,375,000
Debt ratio   50%
6,750,000
1
Financial leverage multiplier  2
1  0.5
337,500
ROA   5%
6,750,000
ROE  ROA  Financial leverage multiplier  10%
337,500
Net profit margin   7.5%
4,500,000
DuPont System of Analysis: Key Wahl Industries performs equally to industry averages
according to the return on equity. However, when dissecting the financial data further into
the three key components of the DuPont system (a profitonsale, efficiencyofasset use,
and a useofleverage component), some areas of improvement may be highlighted. Key
Wahl Industries has a lower net profit margin and return on total assets than industry
averages. Nevertheless, the firm makes up for the low profit margin through excessive use
of leverage (a 50 percent debt ratio versus 33 percent for the industry). Financial risk
could be reduced resulting in the same return on equity by increasing the net profit margin
and reducing debt.
Learning Goal: 6
11. Given the following balance sheet, income statement, historical ratios and industry averages,
calculate the Pulp, Paper, and Paperboard, Inc. financial ratios for the most recent year. Analyze its
overall financial situation for the most recent year. Analyze its overall financial situation from both a
crosssectional and timeseries viewpoint. Break your analysis into an evaluation of the firm’s
liquidity, activity, debt, and profitability.
Income Statement
Pulp, Paper and Paperboard, Inc.
Sales Revenue $2,080,976
Less: Cost of Goods Sold 1,701,000
Gross Profits $379,976
Less: Operating Expenses 273,846
Operating Profits $106,130
Less: Interest Expense 19,296
Less: Taxes (40%) 34,810
Net Profits After Taxes $52,024
Balance Sheet
December 31, 2005
Assets
Cash $ 95,000
Accounts receivable 237,000
Inventories 243,000
Total current assets $ 575,000
Gross fixed assets 500,000
Less: Accumulated depreciation 75,000
Net fixed assets $ 425,000
Total assets $1,000,000
Liabilities and stockholders’ equity
Current liabilities
Accounts payable $ 89,000
Notes payable 169,000
Accruals 87,000
Total current liabilities $ 345,000
Longterm debt 188,000
Total liabilities $ 533,000
Stockholders’ equity
Common stock 255,000
Retained earnings 212,000
Total stockholders’ equity $ 467,000
Total liabilities and stockholders’ equity $1,000,000
Historical and Industry Average Ratios
Industry
Ratio 2003 2004 2005 2005
Current Ratio 1.6 1.7 — 1.6
Quick Ratio 0.9 1.0 — 0.9
Inventory Turnover 8.1 9.3 — 8.4
Average Collection Period 33 days 37 days — 39 days
Total Asset Turnover 2.3 2.2 — 2.2
Debt Ratio 60% 56% — 58%
Times Interest Earned 2.5 3.5 — 2.3
Gross Profit Margin 21% 19.7% — 20.4%
Operating Profit Margin 4.7% 4.8% — 4.7%
Net Profit Margin 1.8% 1.6% — 1.4%
Return on total assets 4.1% 3.5% — 3.08%
Return on Equity 10.3% 7.9% — 7.3%
Answer:
Historical and Industry Average Ratios
Industry
Ratio 2003 2004 2005 2005
Current Ratio 1.6 1.7 1.67 1.6
Quick Ratio 0.9 1.0 0.96 0.9
Inventory Turnover 8.1 9.3 7.0 8.4
Average Collection Period 33 days 37 days 41 days 39 days
Total Asset Turnover 2.3 2.2 2.1 2.2
Debt Ratio 60% 56% 53% 58%
Times Interest Earned 2.5 3.5 5.5% 2.3
Gross Profit Margin 21% 19.7% 18.0% 20.4%
Operating Profit Margin 4.7% 4.8% 5.1% 4.7%
Net Profit Margin 1.8% 1.6% 2.5% 1.4%
Return on total assets 4.1% 3.5% 5.2% 3.08%
Return on Equity 0.3% 7.9% 11.1% 7.3%
LIQUIDITY: The liquidity of 3P is on target with the industry standard in 2005 and shows
no trend since 2000.
ACTIVITY: Inventory and accounts receivable management has deteriorated since 2004
and is inferior when compared to the industry standard. The low inventory turnover may
be caused by overstocking and/or obsolete inventories. The high average collection period
may have resulted from poor collections procedures. Further investigation is necessary to
determine the cause of the variances.
DEBT: 3P has less debt than the industry average. The trend since 2003 has been toward
reducing the debt ratio. The firm, therefore, is subject to less financial risk than the
average firm in the industry.
PROFITABILITY: Although the gross profit margin is inferior to the industry average,
the operating and net profit margin far exceed the standards, boosting return on total assets
and return on equity. The trend in the gross profit margin is unfavorable and may either be
caused by a slide in product prices or an escalation in cost of sales. The cause of the poor
gross profit margin should be investigated.
Overall, the firm needs to focus attention on inventory and accounts receivable
management and the cause of the poor gross profit margin. In general, the firm is in good
financial condition.
Learning Goal: 6
Topic: Complete Ratio Analysis
12. Complete the balance sheet for General Aviation, Inc. based on the following financial data.
Balance Sheet
General Aviation, Inc.
December 31, 2005
Assets
Cash $ 8,005
Marketable securities —
Accounts receivable —
Inventories —
Total current assets —
Gross fixed assets —
Less: Accumulated depreciation $50,000
Net fixed assets —
Total assets —
Liabilities and Stockholders’ Equity
Accounts payable $28,800
Notes payable —
Accruals $18,800
Total current liabilities —
Longterm debts —
Total liabilities —
Preferred stock 2,451
Common stock at par 30,000
Paidin capital in excess of par 6,400
Total stockholders’ equity —
Total liabilities and stockholders’ equity —
Key Financial Data (2005)
1. Sales totaled $720,000.
2. The gross profit margin was 38.7 percent.
3. Inventory turned 6 times.
4. There are 360 days in a year.
5. The average collection period was 31 days.
6. The current ratio was 2.35.
7. The total asset turnover was 2.81.
8. The debt ratio was 49.4 percent.
9. Total current assets equal $159,565.
Answer:
Balance Sheet
General Aviation, Inc.
December 31, 2005
Assets
Cash $ 8,005
Marketable securities 16,000
Accounts receivable 62,000
Inventories 73,560
Total current assets $159,565
Gross fixed assets 146,663
Less: Accumulated depreciation $50,000
Net fixed assets $ 96,663
Total assets $256,228
Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable $28,800
Notes payable 20,300
Accruals $18,800
Total current liabilities $67,900
Longterm debts 58,677
Total liabilities $126,577
Preferred stock 2,451
Common stock at par 30,000
Paidin capital in excess of par 6,400
Total stockholders’ equity $129,651
Total liabilities and stockholders’ equity $256,228
Learning Goal: 6
Topic: Ratio and Financial Statement Analysis

Chapter 2: Financial Statements and Analysis

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48 Gitman • Principles of Finance, Eleventh Edition

 Multiple Choice Questions

Sales Revenue $3,060 Cost of goods sold $1,800

Sales revenue $3,060 Cost of goods sold $1,800

Sales revenue $3,060 Cost of goods sold $1,800

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