True/False Questions

1. Common-size statements are financial statements of companies of similar size.

2. One limitation of vertical analysis is that it cannot be used to compare two companies that are
significantly different in size.

3. The gross margin percentage is computed by dividing the gross margin by total assets.

4. The sale of used equipment at book value for cash will increase earnings per share.

5. Earnings per share is computed by dividing net income (after deducting preferred dividends) by the
average number of common shares outstanding.

6. The dividend payout ratio divided by the dividend yield ratio equals the price-earnings ratio.

7. An increase in the number of shares of common stock outstanding will decrease a company's price-
earnings ratio if the market price per share remains unchanged.

8. A company's financial leverage is negative when its return on total assets is less than its return on
common stockholders' equity.

9. When computing return on common stockholders' equity, retained earnings should be included as part of
common stockholders' equity.

10. When a retailing company purchases inventory, the book value per share of the company increases.

11. If a company's acid-test ratio increases, its current ratio will also increase.

12. Assuming a current ratio greater than 1, acquiring land by issuing more of the company's common stock
will increase the current ratio.
13. If a company successfully implements lean production, its inventory turnover ratio should decrease.
14. Short-term borrowing is not a source of working capital.

15. Working capital is computed by subtracting long-term liabilities from long-term assets.

1. F
2. F
3. F
4. F
5. T
6. T
7. F
8. F
9. T
10. F
11. T
12. F
13. F
14. T
15. F
 1. In horizontal analysis, the base year can be the immediately preceding period, or it can be a period further in the past.

ANS: T
2. A primary purpose of vertical analysis is to observe trends over a three-year period.

ANS: F
Vertical analysis is concerned primarily with relationships among items within a particular time period. Horizontal
analysis allows trends over time to be assessed.

3. Common-size analysis expresses each item in a financial statement as a percent of a base amount.

ANS: T

4. In vertical analysis of the income statement, cost of goods sold is represented by 100%.

ANS: F
In vertical analysis of the income statement, net sales are represented by 100%.

5. In vertical analysis of the balance sheet, total liabilities are represented by 100%.

ANS: F
In a vertical analysis of the balance sheet, total assets are represented by 100%.

6. In the vertical analysis of a balance sheet, the base for current liabilities is total liabilities.

ANS: F
In vertical analysis of a balance sheet, the base for all items on the balance sheet is total assets.

7. The use of common-size analysis makes comparisons more meaningful because percentages eliminate the effects of size.

ANS: T

8. Two major forms of common-size analysis are horizontal analysis and vertical analysis.

ANS: T

9. Horizontal analysis involves comparing two or more years' financial data for a single company.

ANS: T

10. Common-size statements are statements of companies of similar size and operations.

ANS: F

11. An example of horizontal analysis is the increase in cost of goods sold by 25% from 2013 to 2014.

ANS: T

12. For meaningful analysis, ratios should be compared with a standard.

ANS: T
13. Companies in the same industry may use different accounting methods, diminishing the usefulness of some industrial
averages.

ANS: T
14. Small sample sizes for an industrial report rarely cause a comparability problem in using standards.

ANS: F

15. Labor markets can impact industrial statistics and standards.

ANS: T

16. Industrial statistics should be taken as absolute norms as far as standards for comparability.

ANS: F

17. Terms of sale can produce statistical variations among companies within the same industry.

ANS: T

18. A number of online sources contain competitive information on individual company's ratios.

ANS: T

19. Industrial figures, standards and statistics should be used with so much care that they are not a very good reference point
to compare companies.

ANS: F
20. Liquidity ratios measure the ability of a company to meet its current obligations.

ANS: T

21. The current ratio is a measure of the ability of a company to pay its short-term liabilities out of short-term assets.

ANS: T

22. The inventory turnover ratio measures the number of days the average balance of accounts receivable is outstanding
before being converted into cash.

ANS: F
The inventory turnover ratio measures the number of times the average inventory turns over or was sold during the period.

23. Inventory turnover is a measure of liquidity that focuses on efficient use of inventory.

ANS: T

24. The quick ratio should be larger than the current ratio.

ANS: F
The quick ratio should be smaller than the current ratio.

25. All debt is considered in the computation of the quick ratio.

ANS: F
The quick ratio is equal to (Cash + Marketable securities + Receivables) divided by current liabilities.

26. When computing the quick ratio, a short-term note receivable would be included.

ANS: T
27. Jill's Market has an inventory turnover of 120 times. Scott's Market has a turnover of 128 times. Scott's is more effective
in managing inventory.

ANS: T

28. Profitability ratios assess the ability of a company to meets its long- and short-term obligations.

ANS: F
Leverage ratios assess the ability of a company to meets its long- and short-term obligations.

29. The dividend payout ratio is equal to common dividends divided by (Net Income  Preferred Dividends).

ANS: T
30. Dividing the market price of a share of stock by the earnings per share gives the price-earnings ratio.

ANS: T

MATCHING

Match the classifications of ratios with each description.

a. Liquidity Ratio
b. Leverage Ratio
c. Profitability Ratio
d. Horizontal Analysis
e. Trend Analysis
1. Measures the earning ability of a company
2. Measures the ability of a company to meet long and short term obligations
3. Measures the degree of protection provided to company creditors
4. Measures the ability of the company to meet its current obligations
5. Allows evaluation of the extent to which funds are used efficiently

1. ANS: C
2. ANS: B
3. ANS: B
4. ANS: A
5. ANS: C

Indicate the type of each ratio listed below.

a. Liquidity Ratio
b. Leverage Ratio
c. Profitability Ratio
6. Current ratio
7. Debt-to-equity ratio
8. Earnings per share
9. Return on sales
10. Dividend payout ratio
11. Inventory turnover ratio
12. Times-interest-earned ratio
13. Return on total assets ratio
14. Debt ratio
15. Price-earnings ratio
 6. ANS: A
7. ANS: B
8. ANS: C
9. ANS: C
10. ANS: C
11. ANS: A
12. ANS: B
14. ANS: B
15. ANS: C

Select the ratio that each statement below most properly satisfies.
a. Dividend yield ratio
b. Current ratio
c. Debt ratio
d. Return on common stockholders' equity ratio
e. Times-interest-earned ratio
f. Quick ratio
g. Debt-to-equity ratio
h. Dividend payout ratio
i. Price-earnings ratio
16. A measure of the company's ability to pay its short-term liabilities out of short-term assets
17. A measure that compares only the most liquid assets to current liabilities
18. An income statement measure of the ability of a company to service its debts
19. A measure of the degree of protection afforded creditors in case of insolvency
20. A ratio that indicates what proportion of equity and debt the company is using to finance its assets.
21. A measure of the company's success in earning a return for the common stockholders
22. The relationship between dividends and the market price of a company's stock
23. A measure viewed by many investors as an important indicator of stock values. It is found by dividing the market price
per share by the earnings per share
24. A measure that tells an investor the proportion of earnings that a company pays in dividends

16. ANS: B
17. ANS: F
18. ANS: E
19. ANS: C
20. ANS: G
21. ANS: D
22. ANS: A
23. ANS: I
24. ANS: H

COMPLETION

1. _________________ expresses a line item as a percentage of some prior-period amount.

2. _____________________ expresses a line item as a percentage of some other line item for the same period.

3. ____________ are fractions or percentages computed by dividing one account or line-item amount by another.

4. _________________ measure the ability of a company to meet its current obligations.

5. The measures of the ability of a company to meets its long- and short-term obligations are known as _______________.
 6. For meaningful analysis, ratios should be compared with a ____________.

7. The ________________ is a measure of the ability of a company to pay its short-term liabilities out of short-term assets.

8. The _________________ is a measure of liquidity that compares only the most liquid assets with current liabilities.

9. How long it takes a company to turn its receivables into cash is known as the ________________.

10. The _____________________ gives the number of days inventory is held before being sold.

11. The _________________ uses the income statement to assess a company’s ability to service its debt.

12. The ________________ is computed by dividing a company’s total liabilities by its total assets.

13. ______________ and ____________ are the two major sources of capital.

14. The ________________ is calculated by dividing total liabilities by total stockholders’ equity.

15. Creditors would like the debt-to-equity ratio to be _______, indicating that stockholders have financed most of the assets
of the firm.

16. ____________________ represents the percentage of each sales dollar that is left over from net income after all expenses
have been subtracted.

17. The ratios that allow investors, creditors, and managers to evaluate the extent to which invested funds are being used
efficiently are called ____________.

18. A company measures how efficiently it is using its assets by calculating the _______________.

19. The ___________________ is calculated by dividing the market price per share by earnings per share.

20. Investors who prefer gains through appreciation will generally prefer a ___________ payout ratio.

1. Horizontal analysis
2. Vertical analysis
3. Ratios
4. Liquidity Ratios
5. Leverage Ratios
6. Standard
7. Current Ratio
8. Quick Ratio / Acid-test
9. Accounts Receivable Turnover
10. Inventory Turnover Ratio
11. Times-interest-earned-ratio
12. Debt Ratio
13. Investors & Creditors
14. Debt to equity ratio
15. Low
16. Return on Sales
17. Profitability Ratios
18. Return on Assets
19. Price Earnings Ratio
 20. Lower

PROBLEM

1. Eaton Corporation had net income of $6,000,000 in 2010. Using 2014 as the base
year, net income decreased by 70% in 2013 and increased by 140% in 2014.

Required: Compute the net income reported by Eaton Corporation for 2013 and 2014.

ANS:

2013: X ÷ $6,000,000 = 70%

X = $6,000,000  0.70 = $4,200,000
The decrease is $4,200,000; therefore net income for 2009 is
$1,800,000.

2014: X ÷ $6,000,000 = 140%

X = $6,000,000  1.4
X = $8,400,000

2. The following items were taken from the financial statements of Ritz Inc., over a 4-
year period:

Item 2014 2013 2012 2011

Net Sales $800,000 $700,000 $550,000 $500,000
Cost of Goods Sold 560,000 500,000 420,000 400,000
Gross Margin $240,000 $200,000 $130,000 $100,000

Required: Using horizontal analysis and 2011 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.

ANS:

Item 2014 2013 2012 2011

Net Sales 160% 140% 110% 100%
Cost of Goods Sold 140% 125% 105% 100%
Gross Margin 240% 200% 130% 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 margin percentages, which show a
favorable, increasing trend.

Figure 16-6
London Company provided the following income statements for its first 3 years of operation:

Year 1 Year 2 Year 3

Net sales $975,0 $1,150,0 $1,280,0
00 00 00
Less: cost of goods ($676,0 ($910,0 ($945,0
sold 00) 00) 00)
Gross margin $299,0 $240,0 $335,00
00 00 0
Less:
Operating ($185,0 ($215,0 ($235,0
expenses 00) 00) 00)
Income taxes ($45,6 ($10,0 ($40,0
00) 00) 00)
Net income $68,4 $15,0 $60,00
00 00 0

3. Refer to Figure 16-6. Prepare a horizontal analysis using Year 1 as the base year.
Explain if the results are favorable or unfavorable.

ANS:
Year 1 is the base year. Therefore every dollar amount in Year 1 is 100% of itself.

Percent per line item = (Dollar amount of line item/Dollar amount of base year line item) x 100%

Year 1 Year 2 Year 3

Dollar Percenta Dollar Percenta Dollar Percenta
ge ge ge
Net sales $975,00 100% $1,150,00 118% $1,280,0 131%
0 0 00
Less: cost of goods ($676,00 100 ($910,00 135 ($945,00 140
sold 0) 0) 0)
Gross margin $299,00 100 $240,00 80 $335,00 112
0 0 0
Less:
Operating ($185,00 100 ($215,00 116 ($235,00 127
expenses 0) 0) 0)
Income taxes ($45,60 100 ($10,00 22 ($40,00 88
0) 0) 0)
Net income $68,40 100 $15,00 22 $60,00 88
0 0 0

The increase in net sales is favorable, however the rate at which the cost of goods sold is
increase is faster than the rate that net sales is increasing which could become an issue in the
future. Also the operating expenses are increasing quickly.

4. Refer to Figure 16-6. Prepare a vertical analysis by using net sales as the base.

ANS:
Since the analysis is based on net sales, net sales in each year equals 100% of itself. Then every
line item on the income statement is expressed as a percentage of that year's net sales.

Percent per line item = Dollar amount of line item/Dollar amount of that year's net sales x 100

Year 1 Year 2 Year 3

Dollar Percenta Dollar Percenta Dollar Percenta
ge ge ge
Net sales $975,00 100% $1,150,0 100% $1,280,0 100%
0 00 00
Less: cost of goods ($676,00 69 ($910,00 79 ($945,00 74
sold 0) 0) 0)
Gross margin $299,00 31 $240,00 21 $335,00 26
0 0 0
Less:
Operating ($185,00 19 ($215,00 19 ($235,00 18
expenses 0) 0) 0)
 Income taxes ($45,60 5 ($10,00 1 ($40,00 3
0) 0) 0)
Net income $68,40 7 $15,00 1 $60,00 5
0 0 0

Figure 16-3.
The current asset section of the balance sheets of the Shamrock Company as of June 30, 2014
and 2013 is presented below.

2014 2013
Cash and cash equivalents $ $
75,000 58,800
Trade accounts receivable, net 157,500 193,200
Inventory 208,200 253,400
Other current assets 18,40 15,50
0 0
Total current assets $ $
459,100 520,900
Total assets $2,650,00 $3,430,00
0 0

5. Refer to Figure 16-3. In the spaces provided below, complete a horizontal analysis of
the current asset section of Shamrock Company's balance sheet for 2013. Your answers for "%
Change" should be rounded to one decimal place, e.g., 10.3%. Provide a short evaluation of this
analysis.

$ Change % Change

ANS:

$ Change % Change
Cash and cash equivalents $ 16,200 27.6%
Trade accounts receivable, net (35,700) (18.5%)
Inventory (45,200) (17.8%)
Other current assets 2,900 18.7%

Shamrock Company experienced a large gain in cash and cash equivalents, which indicates the
company is more liquid than the previous accounting period. Accounts receivable decreased,
perhaps as a result of decreased sales or better collections by the credit department. The
increase in other current assets is also large, although compared to the dollar amount of cash, is
not as significant. Inventory declined which could mean goods are moving faster, which in turn
generates additional sales.

6. Boyle Corporation had the following comparative current assets and current
liabilities:

Dec. 31, 2014 Dec. 31, 2013

Current assets
Cash $ 20,000 $ 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 $260,000 $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 2014, credit sales and cost of goods sold were $600,000 and $350,000, respectively.

Required: Compute the following liquidity measures for 2014:

A. Current ratio.
B. Acid-test ratio.
C. Receivables turnover.
D. Inventory turnover.

ANS:

A. Current ratio = Current assets ÷ Current liabilities

= $260,000 ÷ $200,000 = 1.3 : 1

B.

C.

D.

7. Assuming a starting point of a 1:1 relationship, 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. Short-term investments are purchased for cash.
E. Equipment is purchased for cash.
F. Inventory purchases are paid for cash.

ANS:

A. no effect
B. decrease
C. increase
D. no effect
E. decrease
F. no effect

8. Presented below are selected data from the financial statements of Harper
Company for 2014, 2013, and 2012.

2014 2013 2012

Total assets $1,205,00 $952,000 $945,000
0
Cost of goods sold 360,000 420,000 440,000
Inventory 56,000 64,000 53,000
Net income 65,000 25,000 16,000

A. Calculate Harper's inventory turnover ratio for 2014 and 2013.

B. Calculate the number of days in inventory at December 31, 2014. At
December 31, 2013. Assume 365 days in a year.
C. Explain the implications of your calculations with respect to inventory
management.

ANS:

A. Cost of goods sold/Average inventory =

2014: $360,000/[($56,000 + $64,000)/2] = 6.0 times
2013: $420,000/[($64,000 + $53,000)/2] = 7.2 times

B. Number of days in the period/Inventory turnover =

2014: 365/6.0 = 60.8 days
2013: 365/7.2 = 50.7 days

C. During 2014, this company is holding its inventory an average of

60.8 days before selling it. This is up 10 days from 2013. This could
indicate a large amount of obsolete inventory or problems in the
sales department. It may also indicate that the company is pricing its
goods too high, and the market is reacting by reducing demand for
the company's products.

9. Presented below are selected data from the financial statements of eMonstore.com
for 2014, 2013, and 2012.

2014 2013 2012

Total assets $650,000 $821,000 $800,000
Net credit sales $800,000 $650,000 $720,000
Accounts receivable $85,000 $79,000 $74,000

A. Calculate eMonstore.com's accounts receivable turnover ratio for

2014 and 2013.
B. Calculate the number of days the average balance of receivables is
outstanding before being converted into cash (turnover in days) for
2014 and 2013.
C. What problems do you see with the company's credit policy if the
terms are net 30 days? Explain.
ANS:

A. Net credit sales/Average accounts receivable

2014: $800,000/[($85,000 + $79,000)/2] = 9.8 times
2013: $650,000/[($79,000 + $74,000)/2] = 8.5 times

B. 2014: 365/9.8 = 37.2

2013: 365/8.5 = 42.9

C. The collection period is 7.2 days more than the company's credit
policy, but since 2013, the company has improved collections by 5.7
days (42.9 less 37.2). If current efforts are kept up, the collection can
probably be reduced to 30 days.

10. The following information is summarized from the balance sheets of Kress Inc. and
Ross Corp. at December 31, 2013. Neither company has inventory.

Kress Ross
Current Assets:
Cash and cash equivalents $ $100,200
340,800
Short-term investments 12,000 7,600
Accounts receivable, net 377,000 42,000
Notes receivable, net 36,300 18,000
Prepaid assets 207,40 40,000
0
Total current assets $ $207,800
973,500

Current liabilities $ $150,000

860,900
Other liabilities 5,000,400 300,500
Stockholders' equity 2,400,300 800,700

1. Using the information provided above, compute the following for each
company at December 31, 2013:
A. Current Ratio
B. Quick Ratio

2. Comment briefly on the liquidity of each of these two companies. Which

company appears to be the most liquid?

ANS:

1. A. Kress Ross

B. Kress Ross
2. Ross appears to be the more liquid. Its current and quick ratios are
greater than Kress's. Even though the dollars of working capital are
larger for Kress, the ratio calculated in part B indicates that Ross has a
better liquidity position.

Figure 16-5.
The following information that was obtained from the 2014 and 2013 financial statements of
James Company, Norris Corporation, and Zorro Company:

(In millions) James Norris Zorro

Accounts receivable 12/31/14 $ 33,000 $ 22,000 $ 41,500
12/31/13 30,000 12,800 42,600

Inventory 12/31/14 $ 2,600 $ 12,600 $ 54,200

12/31/13 23,900 32,800 44,000

Net sales (Credit) 2014 $620,000 $320,000 $510,000

2013 610,000 310,000 760,000

Cost of goods sold 2014 $211,000 $406,000 $311,000

2013 156,000 200,000 310,000

11. Refer to Figure 16-5. Compare the three companies and answer the following:

A. Compute the accounts receivable turnover ratio for each company

for 2014.
B. Which company appears to have the best liquidity position based
solely on the accounts receivable turnover? Explain.

ANS:

A. Net credit sales/Average accounts receivable =

James $620,000/[($33,000 + $30,000)/2] = 19.7

Norris $320,000/[($22,000 + $12,800)/2] = 18.4
Zorro $510,000/[($41,500 + $42,600)/2] = 12.1

B. James appears to have the best liquidity position, although Norris is

not far behind. James collects its receivables 19.7 times per year,
while Norris collects receivables 18.4 times per year, and Zorro
collects receivables only 12.1 times per year.

12. Refer to Figure 16-5. Compare the three companies and answer the following:

A. Compute the number of days inventory is held before being sold for
each company for 2014.
B. Which company appears to have the best liquidity position based
solely on the inventory analysis? Explain.
ANS:

A. Inventory turnover ratio = Cost of goods sold/Average inventory

James $211,000/[($22,600 + $23,900)/2] = 9.1 times

Norris $406,000/[($12,600 + $32,800)/2] = 17.9 times
Zorro $311,000/[($54,200 + $44,000)/2] = 6.3 times

Number of days inventory is held before being sold = 365

days/inventory turnover ratio

James 365/9.1 = 40.1 days

Norris 365/17.9 = 20.4 days
Zorro 365/6.3 = 57.9 days

B. Norris Corporation appears to be in the best liquidity position based

on the number of days inventory is held before being sold. Norris
holds inventory 20.4 days before selling, James holds inventory 40.1
days, while Zorro holds inventory 57.9 days.

Figure 16-2.
Financial statements for Grange Company appear below:

Grange Company
Comparative Balance Sheet
December 31, 2014 and 2013
2014 2013
Current assets:
Cash and marketable securities $ $
180,000 160,000
Accounts receivable, net 150,000 120,000
Inventory 100,000 100,000
Prepaid expenses 40,00 50,000
0
Total current assets 470,000 430,000
Noncurrent assets:
Plant & equipment, net 1,390,00 1,320,00
0 0
Total assets $1,860,00 $1,750,00
0 0

Current liabilities:
Accounts payable $ $
130,000 130,000
Accrued liabilities 60,000 80,000
Notes payable, short term 100,00 100,00
0 0
Total current liabilities 290,000 310,000
Noncurrent liabilities:
Bonds payable $ $
270,000 300,000
Total liabilities 560,00 610,00
0 0
Stockholders' equity:
Preferred stock, $5 par, 5% 100,000 100,000
Common stock, $5 par 220,000 220,000
 Additional paid-in capital--common stock 190,000 190,000
Retained earnings $ $
790,000 630,000
Total stockholders' equity 1,300,00 1,140,00
0 0
Total liabilities & stockholders' equity $1,860,00 $1,750,00
0 0

Grange Company
Income Statement
For the Year Ended December 31, 2014
Sales (all on account) $2,400,00
0
Cost of goods sold 1,680,00
0
Gross margin 720,000
Operating expenses 280,00
0
Net operating income 440,000

Interest expense 30,00

0
Net income before taxes 410,000
Income taxes (30%) 123,00
0
Net income $
287,000

Dividends during 2014 totaled $127,000, of which $5,000 were preferred dividends.

The market price of a share of common stock on December 31, 2014, was $100.

13. Refer to Figure 16-2.

Required: Compute the following liquidity ratios for 2014:

A. current ratio
B. quick ratio
C. accounts receivable turnover ratio
D. inventory turnover ratio
E. inventory turnover in days

ANS:

A. Current ratio = current assets/current liabilities = $470,000/$290,000

= 1.62 to 1

B. Quick ratio = (Cash + Marketable securities + Receivables)/current

liabilities
= $180,000 + $150,000/290,000 = $330,000/$290,000 = 1.14 to 1

C. Accounts Receivable Turnover Ratio = Net Sales/Average Accounts

Receivable =
$2,400,000/[($150,000 + $120,000)/2] = $2,400,000/$135,000 =
17.78 times

D. Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory =

 $1,680,000/[($100,000 + $100,000)/2] = $1,680,000/$100,000 =
16.80 times

E. Inventory Turnover in Days = 365 days/Inventory Turnover Ratio =

365 days/16.80 = 21.7 days

14. Refer to Figure 16-2.

Required: Compute the following leverage ratios for 2014:

A. times-interest-earned ratio
B. debt ratio
C. debt-to-equity ratio

ANS:

A. Times-interest-earned = Net operating income ÷ Interest expense

ratio
= $440,000 ÷ $30,000 = 14.67 times

B. Debt ratio = Total Liabilities ÷ Total Assets

= $560,000 ÷ $1,860,000 = 0.30 to 1

C. Debt-to-equity ratio = Total Liabilities ÷ Total Stockholders'

Equity
= $560,000 ÷ $1,300,000 = 0.43 to 1

15. Refer to Figure 16-2.

Required: Compute the following profitability ratios for 2014:

A. Return on Sales
B. Return on Total Assets
C. Return on Common Stockholders' Equity
D. Earnings per share

ANS:

A. Return on Sales = Net Income ÷ Sales = $287,000 ÷ $2,400,000 =

0.1196 or 11.96%

B. Return on Total Assets = [Net income + interest expense(1  tax

rate)] ÷ Average total assets = $287,000 + [$30,000  (1 – 0.30)] ÷
($1,860,00 + $1,750,000) ÷ 2 = $308,000 ÷ $1,805,000 = 17.06%

C. Return on Common Stockholders' Equity = (Net income  Preferred

Dividends) ÷ Average Common Stockholders Equity = ($287,000 
$5,000 ÷ ($1,200,000 + $1,040,000) ÷ 2 = $282,000 ÷ $1,120,000
= 25.18%

D. Earnings per share = (Net income  Preferred Dividends) ÷ Average

common shares outstanding = $282,000 ÷ ($220,000 ÷ $5) =
$282,000 ÷ $44,000 = $6.41

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-5

NAT: BUSPROG: Analytic
STA: AICPA: FN-Measurement | IMA: FSA | ACBSP: APC-23-Financial Statement Analysis
KEY: Bloom's: Application NOT: 10 min.

16. Smith Inc. is a wholesaler of snow skiing gear. During 2014, Smith expanded its
retail business by adding over 50 shops. The following information is obtained from the
comparative financial statements included in the company's 2014 annual report.

Dec. 31, Dec. 31,

2014 2013
Total liabilities $26,000,000 $18,000,000
Total stockholders' equity 34,000,000 38,000,000

FOR THE FISCAL YEARS ENDED Dec. 31

2014 2013
Depreciation expense $ 2,000,000 $ 6,000,000
Interest expense 3,400,000 3,200,000
Income tax expense 12,600,000 18,100,000
Net income 6,000,000 15,000,000
Net cash provided by operations 41,000,000 (400,000)
Total dividends paid 2,000,000 12,000,000
Cash used to purchase plant assets 32,000,000 18,000,000
Payments on long-term debt 1,600,000 1,800,000

1. Using the information provided above, compute the following for 2014
and 2013:
A. Debt-to-equity ratio (at each year-end)
B. Times-interest-earned ratio

2. Briefly explain the implications of your findings with respect to these

two leverage ratios.

ANS:

1. A. Total liabilities/Total stockholders' equity =

2014: $26,000,000/$34,000,000 = 0.76
2013: $18,000,000/$38,000,000 = 0.47

B. (Net income + interest expense + income tax expense)/Interest

expense =
2014: ($6,000,000 + $3,400,000 + $12,600,000)/$3,400,000 =
6.47
2013: ($15,000,000 + $3,200,000 + $18,100,000)/$3,200,000 =
11.34

2. Both the debt-to-equity ratio and the times-interest-earned ratio are

leverage ratios to assess a company's ability to meet its long- and
short-term obligations. The debt-to-equity ratio indicates the company's
ability to pay liabilities, which is about 76 cents of every dollar of net
worth for 2014. The times interest earned ratio is used to assess the
company's ability to service its debt. It indicates that Smith Inc. earns
about 6.5 times as much as the amount of interest expense incurred.

17. The income statement for Ray Company for the year ended December 31, 2013,
appears below.

Sales $610,000
Cost of goods sold 380,000
Gross margin 230,000
Expenses 170,000*
Net income $ 60,000

*Includes $30,000 of interest expense and $18,000 of income tax expense.

Additional information:
1. Common stock outstanding during 2013 totaled 45,000 shares.
2. The market price of Ray's stock was $15 at the end of 2013.
3. Cash dividends of $30,000 were paid, $6,000 of which were paid to
preferred stockholders.

Required: Compute the following ratios for 2013:

A. earnings per share.
B. price-earnings.
C. times-interest-earned ratio.

ANS:

A. Earnings per share

B. Price-earnings

C. Times interest earned

18. The following information is available from the balance sheets at the end of 2014
and 2013 for Shelley Company:

2014 2013
Accounts payable $ $
80,000 40,000
Accrued liabilities 65,000 25,000
Taxes payable 10,000 20,000
Short-term notes payable -0- 60,000
Bonds payable due within next year 200,00 200,00
0 0
Total current liabilities $ $
355,000 345,000
Bonds payable $ $
800,000 300,000
Common stock, $5 par $1,000,00 $1,000,00
0 0
Retained earnings 695,00 55,00
0 0
Total stockholders' equity $1,695,00 $1,055,00
0 0
Total liabilities and stockholders' equity $2,850,00 $1,700,00
0 0
Net income for 2014 and 2013 was $340,000 and $300,000, respectively. Interest expense was
$45,000 for 2014 and the tax rate is 30%. Answer the following:

A. Calculate the return on common stockholders' equity ratio for 2014.

B. Calculate the return on total assets ratio for 2014.
C. What is the difference between the return on stockholders' equity
and the return on assets?

ANS:

A. (Net income  preferred dividends)/Average common stockholders'

equity = ($340,000  $0)/[($1,695,000 + $1,055,000)/2] = 24.7%

B. [Net income + interest expense(1  tax rate)])/Average total assets

=
[$340,000 + $45,000(0.70)] / [($2,850,000 + $1,700,000)/2] =
16.3%

C. Return on assets provides the return provided by the stockholders

and creditors. Return on common stockholders' equity indicates the
return provided by common stockholders only.

PTS: 1 DIF: Difficulty: Challenging OBJ: LO: 16-5

NAT: BUSPROG: Analytic
STA: AICPA: FN-Measurement | IMA: FSA | ACBSP: APC-23-Financial Statement Analysis
KEY: Bloom's: Application NOT: 5 min.

19. The following ratios have been computed for Gilbert Company for 2014.

Return on sales 20%

Times-interest-earned ratio 15
Accounts receivables turnover ratio 5
Acid-test ratio 1.60 : 1
Current ratio 3:1
Debt ratio 26%

Gilbert Company's 2014 financial statements with missing information follow:

GILBERT COMPANY
Comparative Balance Sheet
December 31, 2014
Assets 2014 2013
Cash $ 25,000 $ 35,000
Short-term Investments 15,000 15,000
Accounts receivable (net) ? (6) 60,000
Inventory ? (8) 50,000
Property, plant, and equipment (net) 200,000 150,000
Total assets $ ? (9) $310,000

Liabilities and stockholders' equity

Accounts payable $ ? (7) $ 25,000
Short-term notes payable 35,000 30,000
Bonds payable ? (10) 20,000
Common stock 200,000 200,000
Retained earnings 59,000 35,000
Total liabilities and stockholders' equity $ ? (11) $310,000
 GILBERT COMPANY
Income Statement
For the Year Ended December 31, 2014
Net sales $250,000
Cost of goods sold 125,000
Gross profit 125,000
Expenses:
Depreciation expense $ ? (5)
Interest expense 5,000
Selling expenses 10,000
Administrative expenses 15,000
Total expenses ? (4)
Income before income taxes ? (2)
Income tax expense ? (3)
Net income $ ? (1)

Required: Use the above ratios and information from the Gilbert Company financial statements
to fill in the missing information on the financial statements. Follow the sequence indicated.
Show computations that support your answers.

ANS:

GILBERT COMPANY
Comparative Balance Sheet
December 31, 2014
Assets 2014 2013
Cash $ 25,000 $ 35,000
Marketable securities 15,000 15,000
Accounts receivable (net) 40,000 (6) 60,000
Inventory 70,000 (8) 50,000
Property, plant, and equipment (net) 200,000 150,000
Total assets $350,000 (9) $310,000

Liabilities and stockholders' equity

Accounts payable $ 15,000 (7) $ 25,000
Short-term notes payable 35,000 30,000
Bonds payable 41,000 (10) 20,000
Common stock 200,000 200,000
Retained earnings 59,000 35,000
Total liabilities and stockholders' equity $350,000 (11) $310,000

GILBERT COMPANY
Income Statement
For the Year Ended December 31, 2014
Net sales $250,000
Cost of goods sold 125,000
Gross profit 125,000
Expenses
Depreciation expense $25,000 (5)
Interest expense 5,000
Selling expenses 10,000
Administrative expenses 15,000
Total expenses 55,000 (4)
Income before income taxes 70,000 (2)
Income tax expense 20,000 (3)
Net income $ 50,000 (1)

(1) Net income = $50,000 ($250,000  20%).

(2) Income before income taxes = $70,000.

Let X = Income before income taxes and interest expense.

X = $75,000
$75,000  $5,000 = $70,000

(3) Income tax expense = $20,000 ($70,000  $50,000).

(4) Total operating expenses = $55,000 ($125,000  $70,000).

(5) Depreciation expense = [$55,000  ($5,000 + $10,000 +

$25,000 $15,000)].

(6) Accounts receivable (net) = $40,000.

Let X = Average receivables.

5X = $250,000.
X = $50,000.

Let Y = Accounts receivable at 12/31/10.

$60,000 + Y = $100,000
Y = $40,000

(7) Accounts payable = $15,000.

Let X = Current liabilities.

1.60X = $80,000
X = $50,000
$50,000  $35,000 = $15,000

(8) Inventory = $70,000

Let X = Total current assets

X = $150,000
$150,000  ($25,000 + $15,000 + $40,000) = $70,000

(9) Total assets = $350,000

($25,000 + $15,000 + $40,000 + $70,000 + $200,000)

(10) Bonds payable = $41,000

Let X = Total debt

X = $91,000
$91,000  ($15,000 + $35,000) = $41,000
(11) Total liabilities and stockholders' equity = $350,000; same as total
assets-see (9) above.

20. Winter 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 5,636,000
Ending inventory ?
Average accounts receivable 700,000
Average common stockholders' equity 3,500,000
Sales (all on credit) 7,000,000
Net income 525,000

Required: Compute the following:

A. Receivables turnover and the average collection period.
B. Inventory turnover and the days in inventory.
C. Return on common stockholders' equity.

ANS:

(A) Receivables turnover =

= $7,000,000 ÷ $700,000
= 10 times
Average collection
=
period
= 365 ÷ 10 times
= 36.5 days

(B) Inventory turnover = Cost of goods sold ÷ Average inventory

First calculate ending inventory.
Beginning Inventory $ 482,000
+ Purchases 5,636,000
 Cost of Goods Sold (5,600,000)*
Ending Inventory $ 518,000

*Since the gross profit ratio is 20%, the cost of goods sold ratio is
80%.
80%  $7,000,000 (net sales) = $5,600,000.

Ending Inventory = $518,000 (per above)

Average Inventory = ($482,000 + $518,000) ÷ 2 = $500,000
Inventory Turnover = $5,600,000 ÷ $500,000 = 11.2 times
Days in Inventory = 365 days ÷ 11.2 times = 32.6 days

(C)
$525,000 ÷ $3,500,000 = 15%

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-3 | LO: 16-5

NAT: BUSPROG: Analytic
STA: AICPA: FN-Measurement | IMA: FSA | ACBSP: APC-23-Financial Statement Analysis
KEY: Bloom's: Application NOT: 10 min.

Figure 16-4.
Condensed financial statements for Black Company appear below:

Comparative Balance Sheets

2014 2013
Cash $ $
128,000 201,000
Accounts receivable 472,000 438,000
Inventories 797,000 673,000
Prepaid expenses 81,000 92,000
Plant and equipment (net) 2,655,00 2,428,00
0 0
Total assets $4,133,00 $3,832,00
0 0

Accounts payable $ $
198,000 280,600
Long-term bonds payable 1,000,000 1,000,000
Preferred stock, 10%, $100 par 450,000 450,000
Common stock, no par 1,800,000 1,800,000
Retained earnings 685,00 301,40
0 0
Total liabilities and stockholders’ equity $4,133,00 $3,832,00
0 0

Income Statement
December 31, 2014
Sales, net $5,400,00
0
Less cost of goods sold 3,240,00
0
Gross margin 2,160,000
Less operating expenses 1,010,00
0
Net operating income 1,150,000
Interest expense 80,00
0
Net income before taxes 1,070,000
Less income taxes 321,00
0
Net income $
749,000

There were 72,000 shares of common stock outstanding throughout the 2014. Dividends on
common stock amounted to $320,400 and dividends on preferred stock amounted to $45,000.
The market value of a share of common stock was $54 at the end of 2014. The income tax rate is
30%.

21. Refer to Figure 16-4.

Required: Calculate the following liquidity ratios for 2014.

A. Current Ratio
B. Quick Ratio
C. Accounts Receivable Turnover Ratio
D. Inventory Turnover Ratio
E. Inventory Turnover in Days

ANS:

A. Current ratio = current assets/current liabilities =

$1,478,000/$198,000 = 7.46 to 1

B. Quick ratio = (Cash + Marketable securities + Receivables)/current

liabilities = $128,000 + 0 + $472,000/$198,000 =
$600,000/$198,000 = 3.03 to 1

C. Accounts Receivable Turnover Ratio = Net Sales/Average Accounts

Receivable = $5,400,000/[($472,000 + $438,000)/2] =
$5,400,000/$455,000 = 11.87 times

D. Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory =

$3,240,000/[($797,000 + $673,000)/2] = $3,240,000/$735,000 =
4.41 times

E. Inventory Turnover in Days = 365 days/Inventory Turnover Ratio =

365 days/4.41 = 82.77 days

22. Refer to Figure 16-4.

Required: Calculate the following leverage ratios for 2014:

A. times-interest-earned ratio
B. debt ratio
C. debt-to-equity ratio

ANS:

A. Times-interest-earned ratio = Net operating income/Interest expense

= $1,150,000/$80,000 = 14.38

B. Debt ratio = Total Liabilities/Total Assets = $1,198,000/$4,133,000 =

0.29

C. Debt-to-equity ratio = Total Liabilities/Total Stockholders' Equity =

$1,198,000/$2,935,000 = 0.41

PTS: 1 DIF: Difficulty: Moderate OBJ: LO: 16-4

NAT: BUSPROG: Analytic
STA: AICPA: FN-Measurement | IMA: FSA | ACBSP: APC-23-Financial Statement Analysis
KEY: Bloom's: Application NOT: 5 min.

23. Refer to Figure 16-4.

Required: Calculate the following profitability ratios for 2014.

A. Return on Sales
B. Return on Total Assets
C. Return on Common Stockholders' Equity
D. Earnings per share
ANS:

A. Return on Sales = Net Income/Sales = $749,000/$5,400,000 =

0.1387 or 13.87%

B. Return on Total Assets = [Net income + interest expense(1  tax

rate)]/Average total assets = $749,000 + [$80,000  (1 – 0.30)]/
[($4,133,000 + $3,832,000)/2] = $805,000/$3,982,500 = 20.21%

C. Return on Common Stockholders' Equity = (Net income  Preferred

Dividends)/Average Common Stockholders Equity = ($749,000 
$45,000/($2,485,000 + $2,101,400) ÷ 2 = $704,000/$2,293,200 =
30.70%

D. Earnings per share = (Net income  Preferred Dividends)/Average

common shares outstanding = $749,000  $45,000/$72,000 =
$704,000/$72,000 = $9.78

Figure 16-7

Kooper Co.
Income Statement
For the Year Ended December 31, 2013

Revenues:
Net sales $383,000
Less: Cost of goods sold $121,700
Gross margin 261,300
Less: Operating expenses
Selling expenses 41,500
Administrative expenses 56,500
Interest expense 12,000
Total expenses 100,000
Net income $ 151,300

Kooper Co.
Balance Sheet
December 31, 2013

Assets
Current assets:
Cash $53,000
Accounts receivable 64,300
Marketable securities 10,500
Inventory 93,250
Total current assets $221,050
Property, plant, and equipment:
Store equipment $325,000
Less Accumulated depreciation 162,100 $162,900
Office equipment $ 149,750
Less Accumulated depreciation 72,750 77,000
Total property, plant, and equipment 239,900
Total assets $460,950
 Liabilities
Current liabilities:
Accounts payable $97,200
Salaries payable 28,700
Total current liabilities $ 125,900
Long-term liabilities:
Note payable (due 2013) 154,000
Total liabilities $279,900

Stockholders’ Equity

Total stockholders’ equity 181,050

Total liabilities and equity $460,950

There were 30,000 shares of common stock outstanding throughout 2013. Dividends on
common stock amounted to $21,000 and dividends on preferred stock amounted to $30,000.
The market value of a share of common stock was $36 at the end of 2013. The income tax rate
is 40%. The accounts receivable and inventory accounts had beginning balances of $58,500 and
$101,400 respectively. Total assets at the beginning of the year were $430,500.

24. Refer to Figure 16-7.

Required: Calculate the following ratios:

A. Current ratio
B. Quick ratio
C. Accounts receivable turnover ratio and accounts receivable turnover in days
D. Inventory turnover ratio and inventory turnover in days

ANS:
A.
Current ratio = Current assets/Current liabilities
$221,050/$125,900 = 1.76

B.
Quick or Acid-test Ratio = (Cash + Marketable securities + Receivables)/Current liabilities
($53,000 + $10,500 + $64,300)/$125,000 = 1.02

C.
Accounts Receivable Turnover Ratio = Net sales/Average accounts receivable
$383,000/(($58,500 + $64,300)/2) = 6.24

Turnover in days = 365/Receivable turnover ratio

365/6.24 = 58.49 days

D. Inventory turnover ratio = Cost of goods sold/Average inventory

$121,700/(($101,400 + $93,250)/2) = 1.25

Turnover in days = 365/Inventory turnover ratio

365/1.25 = 292 days

25. Refer to Figure 16-7.

Required: Calculate the following ratios:

A. return on sales
B. return on total assets
C. earnings per share
D. price-earnings ratio

ANS:
A.
Return on sales= Net income/Sales
$151,300/$383,000 = 0.395 or 39.5%

B.
Return on total assets = Net income + [Interest expense x (1-Tax rate)]/Average total assets
$151,000 +[$12,000 x (1-.40)]/(($430,500 + $460,950)/2) = 0.355 or 35.5%

C.
Earnings per share = (Net income - Preferred dividends)/Average common shares
($151,300 - $30,000)/30,000 = $4.04

D.
Price-earnings ratio = Market price per share/Earnings per share
$36/$4.04 = 8.91

26. Refer to Figure 16-7.

Required: Calculate the following ratios:

A. Debt ratio
B. Debt-to-equity ratio

State what information each ratio is providing to the company.

ANS:
Debt ratio = Total liabilities/total
assets
$279,900/$460,950 = 0.61

The debt ratio is 0.61, which means that 61% of the company’s assets are financed by creditors.

Debt-to-equity ratio = Total liabilities/Total stockholders'

equity
$279,900/$181,050 = 1.55

The debt-to-equity ratio indicates what proportion of equity and debt the company is using to
finance its assets.