Chapter 1 - FS Analysis

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LEARNING OBJECTIVES:

After studying this chapter, you should be able to: 1. Identify Identify the tools for financial f inancial statement statement analysis. 2. Explain why financial analysts use ratios to evaluate companies. 3. Explain liquidity and show how ratios can measure a company’s liquidity. 4. Explain profitability and show how ratios can measure a company’s profitabilit prof itability. y. 4. Explain solvency and show how ratios can measure a company’s solvency. 5. Explain some limitations of ratio analysis. 6. Discuss the need for comparative analysis.

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Financial Statement Analysis involves the evaluation of the firm’s past performance, present condition, and business potentials. The analysis provides information about the following, among others:    

Profitability of the business firm Ability to meet company obligations Safety of investment in the business Effectiveness of management in running the firm

Some of the evaluative tools and techniques used in the financial statement analysis include the following: following: 1. Horizontal Analysis (Trend or index analysis) 2. Vertical Analysis (Common-size ( Common-size FS) 3. Financial ratios 4. Gross profit variation analysis 5. Cash flow analysis

Horizontal or index analysis involves comparison of figures shown in the financial statements of two or more consecutive periods. The difference of the amount between two periods is calculated, and the percentage change from one period to the next is computed using the earlier period as the base.

Percentage Change (∆ %) =

Most Recent Value – Value – Base  Base Period Value Base Period Value

Comparisons can be between an actual amount compared against a budgeted amount, with the ‘budget’ serving as the base or pattern of performance. NOTE: If a negative or a zero amount appears in the base year, percentage change cannot be computed. 2

Vertical Analysis is the process of comparing figures in the financial statements of a single period. It involves conversion of figures in the statements to a common base. This is accomplished by expressing all figures in the statements as percentages of an important item such as total assets (in the balance sheet) or net sales (in the income statement). These converted statements are called common-size statements or percentage composition statements. Percentage composition statements are used for comparing: 1. Multiple years of data from the same firm. 2. Companies that is different in size. 3. Company to industry averages.

Ratio analysis involves development of mathematical relationships among accounts in the financial statements. Ratios calculated from these statements provide users and analysts with relevant information about the firm’s liquidity, solvency and profitability.

BASIC RULES ON RATIO CALCULATIONS 1. When calculating a ratio using balance sheet numbers only, the numerator and denominator should be from the same balance sheet date. The same are true for ratios using only income statement numbers. NOTE: Except if growth ratio is calculated.

2. If an income statement account and a balance sheet account are both used to calculate a ratio, the balance sheet account should be expressed as an average for the time period represented by the income statement account. 3. If the beginning balance of a balance sheet account is not available, the ending balance is normally used to represent the average balance of the account.

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4. If sales and/ or purchases are given without making distinction as to whether made in cash or on credit, assumptions are made depending on the ratio being calculated: 

Turnover ratios: Sales and purchases are made on credit.  Cash flow ratios: Sales and purchases are made on cash. 5. Generally, the number of days in a month or year is not critical to the analysis: a year may have 360 days, 52 weeks, and 12 months; alternatively, a year may be comprised of 365 calendar days, 300 working days or any appropriate number of days.

LIQUIDITY refers to the company’s ability to pay its current cur rent liabilities as they fall due. 1. Current Ratio/ Banker’s Ratio/ Working Capital Ratio It is a measure of adequacy of working capital. It is the primary test of solvency to meet current obligations from current assets. Computed as follows:

Current Ratio = Current Assets ÷ Current Liabilities.

2. Quick Ratio/ Acid Test Ratio It measures the number of times that the current liabilities could be paid with the available cash and near-cash assets (ex. Cash, marketable securities and current receivables). Computed as follows:

Quick Ratio = Quick Assets ÷ Current Liabilities

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1. Receivables Turnover It is the time required to complete one collection cycle from the time receivables are recorded, and then collected, to the time new receivables are recorded again. Computed as follows:

Receivable Turnover = Net Credit Sales ÷ Average Receivables

2. Average Age of Receivables/ Average Collection Period/ Days’ Sales in Receivables It indicates the average number of days during which the company must wait before receivables are collected. Computed as follows:

Average Collection Period = # of Working Days ÷ Receivables Turnover

3. Inventory Turnover It measures the number of times that the inventory is replaced during the period. Computed as follows:

Inventory Turnover = Cost of Goods Sold ÷ Average Merchandise Inventory

4. Average Age of Inventory/ Inventory Conversion Period/ Days’ Sales in Inventory It indicates the average number of days during which the company must wait before the inventories are sold.

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Computed as follows:

Average Age of Inventory = # of Working Days ÷ Inventory Turnover

5. Raw Materials Turnover The number of times raw materials are replaced or revolved during an accounting period. Computed as follows:

R Turnover = Cost of Materials Used ÷ Ave. Raw Materials Inventory

6. Work in Process Turnover The number of times work in process inventory revolved during the accounting period. Computed as follows:

WIP Turnover = Cost of goods manufactured ÷ Ave. WIP inventory

7. Finished goods turnover The number of times finished goods inventory revolved or are replaced during the accounting period. Computed as follows:

FG Turnover = Cost of goods sold ÷ Ave. FG inventory

8. Normal Operating Cycle The period of time required to convert cash into raw materials, raw materials into inventory finished goods, finished good inventory into sales and accounts receivable, and accounts receivable into cash. 6

Computed as follows:

Normal Operating Cycle = Ave. Age of Invty. + Ave. Age of Rec.

9. Trade Payables Turnover It is the time required to complete one payment cycle from the time trade payables are recorded, and then paid, to the time new trade payables are recorded again. Computed as follows:

TP Turnover = Net Credit Purchases ÷ Ave. Trade Payables

10. Average Age of Trade Payables/ Payable Deferral Period/ Days’ Purchases in Payables It indicates the length of o f time during which payables remain unpaid. Computed as follows:

AD Period = # of working days ÷ Payables Turnover

11. Current Assets Turnover It measures the movement and utilization of current assets to meet operating requirements Computed as follows:

CA Turnover = Cost of Sales + Operating Expenses** ÷ Ave. Current Assets

**NOTE: These exclude depreciation, amortization and other expenses related to long-term l ong-term assets.

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SOLVENCY refers to the ability of the company to pay its debts. These ratios involve leverage ratios. LEVERAGE refers to how much of company’s resources are financed by debt and/or preferred equity, both of which require fixed payment of interests and dividends. 1. Times Interest Earned It determines the extent to which operations cover interest expense. Computed as follows:

Times Interest Earned = EBIT ÷ Int. Expense

2. Debt to Equity Ratio This refers to the proportion of assets provided by creditors compared to that provided by owners. Computed as follows:

Debt to Equity Ratio = Total Liabilities ÷ Total SHE

3. Debt Ratio Refers to the proportion of total assets provided by the creditors. Computed as follows:

Debt Ratio = Total T otal Liabilities ÷ Total Assets

4. Equity Ratio Refers to the proportion of total assets provided by owners.

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Computed as follows:

Equity Ratio = Total SHE ÷ Total Assets

1. Return on Sales This determines the portion of sales that went into the company’s earnings. Computed as follows:

ROS = Income ÷ Net Sales

2. Return on Assets This refers to the efficiency with which assets are used to operate the business. Computed as follows:

ROA = Income ÷ Ave. Assets

What INCOME figure should be used? If the intention is to measure OPERATIONAL PERFORMANCE, income is expressed as before interest and tax; alternatively, income before ‘after 

tax’ interest may be used to exclude the effect of capital structure. 

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If the intention is to evaluate TOTAL MANAGERIAL EFFORTS, income is expressed after interest and tax. If used in DuPont Technique, income must be after interests, taxes and  preferred stock dividends. dividends.

3. Return on Equity Measures the amount earned on the owners’ or stockholders’ investment. 9

Computed as follows:

ROE = Income ÷ Ave. Equity

4. Earnings per Share Measures the amount of net income earned by each common share. Computed as follows:

EPS = Net Income – Income – P/S  P/S Div. ÷ WACSO

1. Price-Earnings Ratio It indicates the number of pesos required to buy P1 of earnings. Computed as follows:

P/E Ratio = Price Per Share ÷ EPS

2. Dividend Yield Ratio Measures the rate of return in the investor’s common stock investments. Computed as follows:

Div. Yield Ratio = Div. Per Share ÷ Price per Share

3. Dividend Payout Ratio It indicates the proportion of earnings distributed as dividends

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Computed as follows:

Div. Payout Ratio = Div. per Share ÷ EPS

1. Fixed Asset to Total Equity Measures the proportion of owners’ equity e quity to fixed assets. This indicates whether investments by owners are over or under and also shows weakness in leverage. Computed as follows:

Fixed Assets to Total Equity = Fixed Assets ÷ Total Equity

2. Fixed Assets to Total Assets Indicates possible over-expansion of plant and equipment. equipment. Computed as follows:

Fixed Asset to Total Assets = Fixed Assets ÷ Total Assets

3. Sales to Fixed Assets (Plant Turnover) Test roughly the efficiency of management in keeping plant properties employed. Computed as follows:

Sales to Fixed Assets = Net Sales ÷ Fixed Assets

4. Book Value Per Share Measures recoverable amount by common stockholders in the event of liquidation if assets are realized at their book values.

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Computed as follows:

BVPS = Common SHE ÷ CS outstanding

5. Times Preferred Dividends Earned It indicates ability to provide dividends to preferred stockholders. Computed as follows:

Times PS Div. Earned = Net Income after Tax ÷ PS Div.

6. Capital Intensity Ratio Measures efficiency of the firm to generate sales through employment of its resources. Computed as follows:

Capital Intensity Ratio = Total Assets ÷ Net Sales

7. Times Fixed Charges Earned Measures ability to meet fixed charges. Computed as follows:

TFCE = Net Income before taxes & charges ÷ Fixed charges + sinking fund payment** ** Fixed charges shall include rent, interests interests and other relevant fixed expenses; sinking fund payment must be expressed before tax.

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1. Working Capital Turnover Indicates adequacy of working capital to support operations (sale). Computed as follows:

WC Turnover = Net Sales ÷ Ave. Working Capital

2. Defensive Interval Ratio Measures coverage of current liabilities Computed as follows:

DIR = Current Liabilities ÷ Cash & Cash Equivalents

3. Payable Turnover Measures efficiency of the company in meeting the accounts payable. Computed as follows:

Payable Turnover = Net Purchases ÷ Ave. Accounts Payable

4. Fixed Asset to Long-term Liabilities Reflects extent of the utilization of resources from long-term debt. Indicative of sources of additional funds. Computed as follows:

FA to LTL = Fixed Assets ÷ Long-term Liabilities

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1. Rate of return on Average Current Asset Measures profitability of current assets invested. Computed as follows:

RoR on ACA = Income ÷ Ave. Current Assets

2. Operating profit margin Measures profit generated after consideration of operating costs. Computed as follows:

OPM = Operating Profit ÷ Net Sales

3. Cash Flow Margin Measures the ability of the firm to translate sales to cash Computed as follows:

CFM = Operating Cash Flow ÷ Net Sales

Analysis of variation in gross profit is an indispensable tool in controlling operations; the adequacy or inadequacy of gross profit determines the final results of operations (net income). Gross profit must be adequate to cover operating expenses, financing, income taxes and a desired amount of profit. profit . At times, the gross profit figure is also being used as a basis for performance evaluation.

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Gross profit is the difference between sales and cost of goods sold. It is a very important figure in the income statement because it is one of the factors that determine the final result of operations. Changes in the financial statement may be attributed to the change in any, or a combination of the following following factors: 1. Selling price 2. Volume or quantity of products sold. 3. Cost of product sold GP variance may be analyzed through the following: GP (Actual) vs. GP (Budget) GP (Current) vs. GP (Prior Period)  

NOTE: FAVORABLE if actual (current) GP is greater than budgeted (prior-period) GP. UNFAVORABLE if actual (current) GP is less than budgeted (prior-period) GP. There are different ways of analyzing gross profit variances. Presented here are 4 way, 6-way and 3-way analyses.

Sales Variance: Price factor = (Change in SP x Actual Volume or quantity) Volume/quantity Volume/quantity factor = (Change in units x Standard/Budgeted SP) Cost Variance: Price factor = (Change in CP x Actual Volume or quantity) Volume/quantity Volume/quantity factor = (Change in units x Standard/Budgeted CP) Note: The above procedures are the same as the one used in 2-way analysis for materials and labor variances.

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Sales Variance: Price factor = (Change in SP x Standard/Budgeted Volume/quantity) Volume/quantity) Volume/quantity Volume/quantity factor = (Change in units/volume x Standard/Budgeted SP) Price-volume factor = (Change in SP x Change in Units) Cost Variance: Price factor = (Change in CP x Standard/Budgeted Volume/quantity) Volume/quantity) Volume/quantity Volume/quantity factor = (Change in units/volume x Standard/Budgeted CP) Price-volume factor = (Change in CP x Change in Units) Note: The price factor refers to the change in Selling or cost prices assuming that there has been no change in units sold. The quantity or volume factor refers to the change in the number of units sold assuming that there has been no change in the selling or cost prices. The price-volume factor refers to the sales or cost of sales variances due to the combined effect of the differences in price and units sold.

Quantity/volume factor = (Change in units x Standard/Budgeted GP/unit) GP/unit) Price factor = (Change in SP x Actual Volume/quantity) Volume/quantity) Cost factor = (Change in CP x Actual Volume/quantity) Volume/quantity) Note: The quantity factor refers to the change in gross profit due to the difference in units sold. The price factor refers to the change in gross profit due to the difference in selling price.

The sales price, sales volume, cost price and cost volume variances are first computed using the approach similar to the one used for 4-way analysis. Then, 16

the sales volume and cost volume variances are analyzed further, which results in the computation of a sales mix variance and final sales volume variance. The formulas for these last two variances v ariances are as follows:

Sales mix variance: Actual units @ Standard/Budgeted Standard/Budgeted SP Less: Actual units @ Standard CP Difference Less: Actual units @ Standard Average GP SALES MIX VARIANCE

xx (xx) xx (xx) xx

Final Sales Volume Variance: Actual units @ Standard/Budgeted Standard/Budgeted Ave. GP Less: Standard/Budgeted GP FINAL SALES VOLUME VARIANCE

xx (xx) xx

ILLUSTRATIVE EXERCISES The comparative balance sheets of Philip Morris Companies, Inc. are presented below. PHILIP MORRIS COMPANIES, INC. Comparative Balance Sheets December 31 (In million Dollars) 2014

2013

ASSETS Current Assets Property, plant and equipment (net) Other Assets Total Assets

21,382 16,067 58,726 96,175

17,441 14,846 55,253 87,540

LIABILITIES and SHE Current Liabilities

21,393

19,082 17

Long-term Liabilities Stockholders’ Equity Total Liabilities and SHE

49,705 25,077 96,175

48,980 19,478 87,540

Required: (Round all computations to 2 decimal places). 1. Prepare a horizontal analysis of the balance sheet data for Philip Morris using 2013 as a base. 2. Prepare a vertical analysis of the balance sheet data for Philip Morris for 2013 and 2014.

Here are the comparative income statements of Viking Corporation VIKING CORPORATION Comparative Income Statements For the years ended December 31 (In million Dollars) 2014 Net Sales 550,000 Cost of goods sold 440,000 Gross Profit 110,000 Operating Expenses 58,000 Net Income 52,000

2013 550,000 450,000 100,000 55,000 45,000

Required: (Round all computations to 2 decimal places) 1. Prepare a horizontal analysis of the income statement data for Viking Corporation using 2013 as a base. 2. Prepare a vertical analysis of the income statement data for Viking Corporation for both years.

Indicate the effects of each of the following transactions on the company’s (A) current ratio and (B) acid-test ratio. There are the possible answers: (+) increase, (-) decrease, and (0) no effect. Before each transaction takes place, both ratios are greater than 1 to 1. 18

Transactions Example: Sell merchandise for cash. 1. Buy inventory on account. 2. Pay an account payable. 3. Borrow cash on a short-term loan. 4. Issue long-term bonds payable. 5. Collect an accounts receivable. 6. Record accrued expenses payable. 7. Sell a plant asset for cash at a profit. 8. Sell a plant asset for cash at a loss. 9. Buy marketable securities, for cash. 10. Sell merchandise on credit.

Effects on Current ratio +

Acid-test ratio +

Leen has 1,000,000 common shares outstanding. The price of the stock is P8. Leen declared dividends per share of P0.10. The balance sheet at the end of 2013 showed approximately the same amounts as that at the end of 2014. The financial statements for Leen Merchandising are as follows: Leen Company, Income Statement for 2014 (in thousands) Sales Cost of goods sold Gross profit Operating expenses: Depreciation 320 Other 1,230 Income before interest and taxes Interest expense Income before taxes Income taxes Net income

4,700 2,300 2,400

1,550 850 150 700 280 420

Leen Company, Balance Sheet at December 31, 2014 (in thousands) 19

Assets Cash Accounts receivable Inventory Total current assets Plant and equipment Accumulated depreciation Total assets

Liabilities and SHE 220 Accounts payable 440 Accrued expenses 410 Total current liabilities 1,070 Long-term debt 5,600 Common stock (2,100) Retained earnings Total liabilities and SHE 4,570

Required: (Round all computations to 2 decimal places.) 1. Current ratio 2. Acid-test ratio 3. Accounts receivable turnover 4. Inventory turnover 5. Gross profit margin 6. Operating profit margin 7. Return on sales 8. ROA – operational performance

9. ROA – total management effort 10. Return on equity

190 180 370 1,960 1,810 430 4,570

11. EPS 12. P/E ratio 13. Dividend yield 14. Payout ratio 15. Debt ratio 16. Debt-equity ratio 17. Times interest earned 18. Defensive interval ratio 19. Cash flow to total debt 20. Cash flow margin

(Interpreting Financial Statements) The Coca-Cola Company and PepsiCo, Inc. provide refreshments to every corner of the world. Selected data from the 2003 consolidated financial statements for The Coca-Cola Company and for PepsiCo, Inc. are presented here (in millions of Dollars).

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Total current assets Total current liabilities Net sales Cost of goods sold Net income Average receivables for the year Average inventories for the year Average total assets Average common shareholders’ equity Average current liabilities Average total liabilities liabilities Total assets Total liabilities Income taxes Interest expense Cash provided by operating activities

Coca-Cola 8,396 7,886 21,044 7,762 4,347 2,094 1,273 25,874 12,945 7,614 12,929 27,342 13,252 1,148 178 5,456

PepsiCo 6,930 6,415 26,971 12,379 3,568 2,681 1,377 24,401 10,713 6,234 13,702 25,327 13,453 1,424 163 4,328

Required: (Round all computations to 2 decimal places). 1. Compute the following liquidity ratios for 2003 for Coca-Cola and for PepsiCo and comment on the relative liquidity of the two competitors. a. Current ratio b. Receivables turnover c. Average collection period d. Inventory turnover e. Days in inventory f. Current cash debt coverage

2. Compute the following solvency ratios for the two companies and comment on the relative solvency of the two competitors. a. Debt to total assets. b. Times interest earned. c. Cash debt coverage ratio. 3. Compute the following profitability ratios for the two companies and comment on the relative profitability of the two competitors. competitors. a. Profit margin 21

b. Asset turnover c. Return on assets d. Return on common stockholders’ equity

KOYOT CORPORATION has the following data: 2014 Sales volume in units 5,000 Selling price per unit P10 Cost per unit P7

2013 8,000 P8 P6

Required: (Round all computations to 2 decimal places). Compute for the Gross Profit Variance using:

1. 4-way analysis 2. 6-way analysis 3. 3-way analysis

Panda Company prepared the following budgetary information for January of 2014 for its toy gun: Sales (12,000 units) Cost of goods sold Gross profit

432,000 288,000 144,000

In January, actual operations resulted in the production and sale of 13,000 units at an average selling price of P34 per unit. The cost of goods sold per unit increased by P3. Required: (Round all computations to 2 decimal places). 1. Overall GP variance. 2. Sales price variance. 3. Sales volume variance. 22

4. Cost price variance. 5. Cost volume variance.

Spaniard Company has requested you to determine the cause of the difference between its 2013 and 2014 gross profit based on the following data: 2013 200,000 120,000 80,000

Sales Cost of Goods Sold Gross Profit

2014 252,000 180,000 72,000

No additional data was made available except that unit sales increased by 20% in 2014. Required: (Round all computations to 2 decimal places). 1. Overall GP variance. 2. Price factor. 3. Cost factor. 4. Volume factor.

The following are the data for ARIUS LUKE ANGELO CORPORATION:

Sales volume in units Selling prices per unit Cost per unit

Product A 400

2014 Product L 350

Product R 1,000

Product A 500

2013 Product L 200

P4

P5

P3

P4.50

P4.20

P2.80

P1.60

P2

P1.20

P1.68

P1.80

P1.12

Product R 1,000

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Required: (Round all computations to 2 decimal places). Compute for the sales mix variance and final sales volume variance

The following data were given for Vamos Company:

Sales volume Unit selling price Unit cost

2013 Product Product A B 6,000 4,000 10 6 6 3

2014 Product Product A B 3,000 5,000 9 5 4 3

Required: (Round all computations to 2 decimal places). 1. Overall GP variance 4. Volume factor 2. Price factor 5. Mix factor 3. Cost factor

PRACTICE EXERCISES (Sources: CMA/CIA/RPCPA/AICPA/Various test banks) THEORIES

1. A high sales-to-working capital ratio could indicate a. Unprofitable use of working capital b. Sales are not adequate relative to available working capital. c. The firm is undercapitaliz undercapitalized. ed. d. The firm is not susceptible to liquidity problems. 2. Rice Inc. uses the allowance method to account for uncollectible accounts. An account receivable that was previously determined uncollectible and written off was collected during May. The effect of the collection on Rice’s current ratio and total working capital is Current Ratio Working Capital a. None None b. Increase Increase 24

c. d.

Decrease None

Decrease Increase

3. Accounts receivable turnover ratio will normally decrease as a result of a. The write-off of an uncollectible account (assume the use of the allowance for doubtful accounts method). b. A significant sales volume decrease near the end of the accounting period. c. An increase in cash sales in proportion to credit sales. d. A change in credit policy to lengthen the period of o f cash discounts. 4. The days’ sales-in-receivables -in-receivables ratio will be understated if the company a. Uses a natural business year for its accounting period. b. Uses a calendar year for its accounting period. c. Uses average receivables in the ratio calculation. d. Does not use average receivables in the ratio calculation Questions 5 through 11are based on the following information. Depoole Company is a manufacturer of Industrial products and uses a calendar year for financial reporting purposes. These questions present several of Depoole’s transactions during the year. Assume that the total quick assets exceeded total current liabilities both before and after each transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

5. Payment of a trade account payable of P64,500 would a. Increase the current ratio, but the quick ratio would not be affected. b. Increase the quick ratio, but the current ratio would not be affected. c. Increase both the current and quick ratios. d. Decrease both the current and quick ratios. 6. The purchase of raw materials for P85,000 on open account would a. Increase the current ratio. b. Decrease the current ratio. c. Increase net working capital. d. Decrease net working capital. c apital. 25

7. The collection of a current account receivable of P29,000 would a. Increase the current ratio b. Decrease the current ratio and the quick ratio c. Increase the quick ratio d. Not affect the current or quick ratio 8. Obsolete inventory of P125,000 was written off during the year. This transaction a. Decreased the quick ratio. b. Increased the quick ratio. c. Increased net working capital. d. Decreased the current ratio. 9. The issuance of new shares in a five-for-one split of common stock a. Decreases the book value per share of common stock. b. Increases the book value per share of common stock. c. Increases total shareholders’ equity. d. Decreases total shareholders’ equity. 10. The issuance of a serial bonds in exchange for an office building, with the first installment of the bonds due late this year, a. Decreases net working capital. b. Decreases the current ratio. c. Decreases the quick ratio. d. Affects all of the answers as indicated. 11. Refer to the information preceding question 1. The early liquidation of a long-term note with cash affects the a. Current ratio to a greater degree than the quick ratio. b. Quick ratio to a greater degree than the current ratio. c. Current and quick ratio to the same degree. d. Current ratio but not the quick ratio. 12. To determine the operating cycle for a retail department store, which one of the following pairs of items is needed? a. Days sales in accounts receivable and average merchandise inventory. b. Cash turnover and net sales. 26

c. Accounts receivable turnover and inventory turnover. d. Asset turnover and return on sales. 13. If the ratio of total liabilities to shareholders’ equity increases, a ratio that must also increase is a. Times interest earned. b. Total liabilities to total assets. c. Return on equity. d. The current ratio. 14. Return on investment may be calculated by multiplying total asset turnover by a. Average collection period. b. Profit margin. c. Debt ratio. d. Fixed-charge coverage. 15. If a company is profitable and is effectively using leverage, which one of the following ratios is likely to be the largest? a. Return on total assets. b. Return on operating assets. c. Return on common equity. d. Return on total equity. 16. A drop in the market price of a firm’s common stock will   immediately increase its a. Return on equity. b. Dividend payout ratio. c. Market-to-book ratio. d. Dividend yield. 17. A debt-to-equity ratio is a. About the same as the debt-to-assets ratio. b. Higher than the debt-to-assets ratio. c. Lower than the debt-to-assets ratio. d. Not correlated with the debt-to-assets ratio. 27

18. Which of the following is not a limitation of ratio analysis affecting comparability among firms? a. Different accounting policies. b. Different fiscal years. c. Different sources of information. information. d. All of the above are limitations of ratio analysis. 19. Which of the following is the worst limitation of ratio analysis affecting comparability from one interim period to the next within the firm? a. Management has an incentive to window dress financial statements to improve results. b. In a seasonal business, inventory and receivables may vary widely with year-end balances not reflecting the averages for the period. c. Comparability is impaired if different firms use different accounting policies. d. Generalizations about which ratios are strong indicators of a firm’s financial position may change from industry to industry and firm to firm. 20. In assessing the financial prospects for a firm, financial analysts use various techniques. Which of the following is an example of vertical common-size analysis? a. An assessment of the relative stability of a firm’s level of vertical integration. b. A comparison in financial ratio form between two or more firms in the same industry. c. A statement that current advertising expense is 2% greater than in the prior year. d. A statement that current advertising expense is 2% of sales. 21. Under the direct method of determining net cash provided by operating activities on the statement of cash flows, a gain on sale of plant assets would be: a. Added to the amount of operating expenses reported under the accrual basis. 28

b. Deducted from the amount of the operating expenses reported under the accrual basis. c. Deducted from the amount of sales reported under the accrual basis. d. Totally ignored since the gain is not a part of sales, cost of goods sold, or operating expenses. 22. Which of the following account changes would be classified as a use of funds? a. An increase in accounts payable c. A decrease in bonds payable b. An increase in retained earnings d. A decrease in accounts receivable 23. Shakey’s Corporation has an acid test ratio of 1.5 to 1.0. Which of the following will cause this ratio to deteriorate? a. Payment of cash dividends previously declared. b. Borrowing short-term loan from a bank. c. Sale of inventory on account. d. Sale of equipment at a loss 24. A Company has a current ratio greater than 1:1 and a quick ratio less than 1:1. Soon thereafter, all cash was used to reduce accounts payable. How did these cash payments affect (1) current ratio (2) quick ratio? a. (1) Decreased (2) Decreased c. (1) Increased (2) Decreased b. (1) Decreased (2) Increased d. (1) Increased (2) Increased 25. If Jonas Co. decides to change from FIFO to LIFO inventory method during the period of rising prices, its a. Current ratio would be reduced c. Inventory turnover will be reduced b. Debt-to-equity ratio would be reducedd. Cash flow would be reduced 26. How is the average inventory balance used in the calculation of each of the following? Acid-test ratio Inventory turnover a. Numerator Numerator b. Numerator Denominator c. Not used Denominator d. Not used Numerator 29

27. A company’s return on investment is affected by a change in Capital turnover Profit margin on sales a. Yes Yes b. Yes No c. No No d. No Yes 28. Return on investment (ROI) is a term often used to express income earned on capital invested in a business unit. A company’s ROI is increased if a. Sales increase by the same peso amount as expenses and total assets. b. Sales remain the same and expenses are reduced by the same peso amount that total assets increase. c. Sales decrease by the same dollar amount that expenses increase. d. Net profit margin on sales increases by the same percentage as total assets. 29. ROA and ROE are measures of a. Solvency b. Liquidity

c. Profitabilit P rofitability y d. Current asset activity

30. A fire has destroyed many of the financial records of National & Co. You are assigned to put together a financial report. You have found out that the return on equity to be 12% and the debt ratio was 0.40. What was the return on assets? a. 5.35% c. 6.60% b. 8.4% d. 7.20%

PROBLEMS

1. Windham Company has current assets of P400,000 and current liabilities of P500,000. Windham Company’s current ratio would be increased by a. The purchase of P100,000 of inventory on account. b. The payment of P100,000 of accounts payable. 30

c. The collection of P100,000 of accounts receivable. d. Refinancing a P100,000 long-term loan with short-term debt. Questions 2 through 5 are based on the following information. Tosh Enterprises reported the following account information.

Accounts receivable 400,000 Accounts payable 160,000 Bonds payable, due in 10 years 600,000 Cash 200,000 Interest payable, due in 3 months 20,000 Inventory 800,000 Notes payable, due in 6 months 100,000 Prepaid expenses 80,000 The company has a normal operating cycle of 6 months. 2. The current ratio for Tosh Enterprise is a. 1.68 b. 2.14 c. 5.00 d. 5.29 3. What is the company’s quick ratio? a. 0.68 b. 1.68 c. 2.14 d. 2.31 4. What will happen to the ratios below if Tosh Enterprises uses cash to pay 25% of the accounts payable? Current Ratio Quick Ratio a. Increase Increase b. Decrease Decrease c. Increase Decrease d. Decrease Increase

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5. The amount of working capital is a. 600,000 b. 1,120,000 c. 1,200,000 d. 1,220,000 Questions 6 through 8 are based on the following information. i nformation. The selected data pertain to a company at December 31.

Quick asset ratio Acid test ratio Current ratio Net sales for the year Cost of sales for the year Average total assets for the year

P203,000 2.6 to 1 3.5 to 1 P1,800,000 P990,000 P1,200,000

6. The company’s current liabilities at December 31 equal a. 59,429 b. 80,000 c. 134,857 d. 187,200 7. The company’s inventory balance at December 31 is a. 72,000 b. 187,200 c. 231,111 d. 282,857 8. The company’s asset turnover ratio for the year is a. .675 b. .825 c. 1.21 d. 1.50

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9. Watson Corporation computed the following items from its financial records for the year: Price earnings ratio 12 Payout ratio .6 Asset turnover ratio .9 The dividend yield on Watson’s common stock is a. 5.0% b. 7.2% c. 7.5% d. 10.8% 10. The following information is provided about the common stock of Evergreen Inc., at the end of the fiscal year: Number of shares outstanding 1,800,000 Par value per share 10.00 Dividends paid per share(last 12 months) 12.00 Market price per share 108.00 Basic earnings per share 36.00 Diluted earnings per share 24.00 The price-earnings ratio for Evergreen’s common stock is a. 3.0 times b. 4.5 times c. 9.0 times d. 10.8 times 11. Baylor Company paid out one-half of last year’s earnings in dividends. Baylor’s earnings increased by 20%, and the amount of its dividends increased by 15% in the current year. Baylor’s dividend payout ratio for the current year was a. 50% b. 57.5% c. 47.9% d. 78%

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12. Selected data from Starbucks are presented below. The difference between average and ending inventories is immaterial. immaterial. Current assets are comprised mainly of cash, receivables and inventories. Current ratio Quick ratio Current liabilities Inventory turnover (based on cost of sales) Gross profit margin Starbuck’s net sales for the year were w ere a. 2.4 million b. 4.0 million

2.0 1.5 600,000 8 times 40%

c. 1.2 million d. 6.0 million

13. Based on the data presented below, what is Goldilocks Corporation’s cost of sales for the year? Current ratio Acid test ratio Year end current liabilities liabilities Beginning inventory Inventory turnover a. 1,600,000 b. 2,400,000 Items 14 - 16 are based on the following information information 2012 Accounts receivable, net 40,000 Inventory 40,000 Current assets 120,000 Total assets, net 700,000 Current liabilities 70,000 Cash sales 400,000 Credit sales 120,000 Cost of sales 310,000

3.5 3.0 600,000 500,000 8.0 c. 3,200,000 d. 6,400,000

2013 42,500 50,000 140,000 750,000 80,000 420,000 125,000 324,000

2014 45,000 45,000 130,000 725,000 50,000 450,000 131,250 345,000

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14. What would be the age of receivables in 2014? a. 110 days c. 130 days b. 120 days d. None of these 15. Determine the number of days in inventory for 2013? a. 50 days c. 70 days b. 60 days d. None of these 16. Turnover of (net) working capital for 2014 is a. 9.9 b. 8.3

c. 7.15 d. None of these

17. Selected information for 2014 for Tokyo Company is as follows: Cost of goods sold Average inventory Net sales Average receivables Net income

5,400,000 1,800,000 7,200,000 960,000 720,000

Assuming 360 days in a year, what was the average number of days in operating cycle for 2014? a. 72 days c. 144 days b. 84 days d. 168 days Questions 18 through 23 are based on the following information. The statement of financial position for King Products Corporation for the fiscal years ended June 30, 2014 and June 30, 2013 is presented below. Net sales and cost of goods sold for the year ended June 30, 2014 were P600,000 and P440,000 respectively.

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King Products Corporation Statement of Financial Position (In Thousands) June 30, 2014 Cash 60 Trading securities (at Fair Value) 40 Accounts receivable (net) 90 Inventories (at lower of cost or market) 120 Prepaid items 30 Total current assets 340 Land (at cost) Building (net) Equipment Patents (net) Goodwill (net) Total long-term assets TOTAL ASSETS Notes payable Accounts payable Accrued interest Total current liabilities Notes payable, 10% due 12/31/19 Bonds payable, 12% due 6/30/21 Total long-term debt Total Liabilities Preferred stock-5% cumulative, P100 par, nonparticipating, authorized, issued and outstanding 2,000 shares Common stock-P10 par, 40,000 shares authorized, 30,000 shares issued and outstanding Additional paid in capital Retained earnings

June 30, 2013 50 30 60 100 40 280

200 160 190 70 40 600 1,000

190 180 200 34 26 630 910

46 94 30 170 20 30 50 220

24 56 30 110 20 30 50 160

200

200

300

300

150 130

150 100 36

Total Equity TOTAL LIABILITIES AND EQUITY

780 1,000

750 910

18. King Products Corporation’s inventory turnover ratio for the fiscal year at June 2014 was a. 3.7 b. 4.0 c. 4.4 d. 6.0 19. King Products Corporation’s receivables turnover ratio for this period was a. 4.9 b. 5.9 c. 6.7 d. 8.0 20. King Products Corporation’s average collection period for the fiscal year ended June 30, 2014 using a 360-day year was a. 36 days b. 45 days c. 54 days d. 61 days 21. King Products Corporation’s quick ratio at June 30, 2014  was a. 0.6 b. 1.1 c. 1.8 d. 2.0 22. Assuming that King Products Corporation’s net income for the year ended June 30, 2014 was P70,000 and there are no preferred stock dividends in arrears, King Products’ return on common equity was a. 7.8% b. 10.6% c. 10.9% d. 12.4% 37

23. Assuming that there are no preferred stock dividends in arrears, King Products Corporation’s book value per share of common stock at June 30, 2014 was a. 10.00 b. 14.50 c. 18.33 d. 19.33 24. Given an acid test ratio of 2.0, current assets of P5,000 and inventory of P2,000, the value of current liabilities is a. 1,500 b. 2,500 c. 3,500 d. 6,000 Questions 25 through 30 are based on the following information about Devlin Company. Statement of Financial Position as of May 31 (In Thousands) 2014 2013 Assets Current assets Cash 45 39 Trading securities 30 20 Accounts receivable (net) 68 48 Inventory 90 80 Prepaid expenses 22 30 Total current assets 255 216 Investments, at equity 38 30 Property, plant, and equipment (net) 375 400 Intangible assets (net) 80 45 TOTAL ASSETS 748 691

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Liabilities and equity Current liabilities Notes payable Accounts payable Accrued expenses Income taxes payable Total current liabilities Long-term debt Deferred taxes Total liabilities Equity Preferred stock, 6%, P100 par value cumulative Common stock, P10 par value Additional paid-in capital common stock Retained earnings Total equity TOTAL LIABILITIES AND EQUITY

36 70 5 15 125 35 3 163

18 42 4 16 80 35 2 117

150

150

225 114 96 585 748

195 100 129 574 691

Income Statement for the year ended May 31 (in thousands) 2014 Net sales 480 Costs and expenses Cost of goods sold 330 Selling, general and administrative administrative 52 Interest expense 8 Income before taxes 90 Income taxes 36 Net income 54

2013 460 315 51 9 85 34 51

25. Devin Company’s acid-test ratio at May 31, 2014 was a. 0.60 to 1 b. 0.90 to 1 c. 1.14 to 1 d. 1.86 to 1 39

26. Assuming there are no preferred stock dividends in arrears, Devlin Company’s return on common equity for the year ended May 31, 2014 was a. 6.3% b. 7.5% c. 7.8% d. 10.5% 27. Devlin Company’s inventory turnover  for the year ended May 31, 2014 was a. 3.67 times b. 3.88 times c. 5.33 times d. 5.65 times 28. Devlin Company’s asset turnover for the year ended May 31, 2014 a. 0.08 times b. 0.46 times c. 0.67 times d. 0.83 times 29. Devlin Company’s rate of return on as sets for the year ended May 31, 2014 a. 7.2% b. 7.5% c. 7.8% d. 11.2% 30. Devlin Company’s time-interest-earned ratio for the year ended May 31, 2014 was a. 6.75 times b. 11.25 times c. 12.25 times d. 18.75 times Don't follow your dreams; chase them! 40