FS Analysis

FINANCIAL STATEMENT ANALYSIS TRUE-FALSE STATEMENTS 1.

Earning power refers to a company’s ability to sustain its profits from operations.

2.

When the disposal of a significant segment occurs, the income statement should report both income from continuing operations and income (loss) from discontinued operations.

3.

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

4.

If a firm has only one change in accounting principle over several years, it would be classified on the income statement as an extraordinary item.

5.

A change in accounting principle occurs when the principle used in the current year is different from the one used by competitors in the current year.

6.

Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

7.

Intracompany comparisons of the same financial statement items are often useful to detect changes in financial relationships and significant trends.

8.

Comparisons of company data with industry averages provide information about a company's relative position within the industry.

9.

Horizontal, vertical, and circular analyses are the basic tools of financial statement analysis.

10.

Horizontal analysis is a technique for evaluating a financial statement item in the current year with other items in the current year.

11.

Another name for horizontal analysis is trend analysis.

12.

If a company has sales of $110 in 2001 and $154 in 2002, the percentage increase in sales from 2001 to 2002 is 140%.

13.

In horizontal analysis, if an item has a negative amount in the base year, and a positive amount in the following year, no percentage change for that item can be computed.

14.

Vertical analysis is a technique for evaluating a series of financial statement data over a period of time to determine the increase (decrease) that has taken place.

15.

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

16.

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

17.

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

18.

Using vertical analysis of the income statement, a company's net income as a percentage

132

Test Bank for Managerial Accounting, Second Edition

19.

of net sales is 15%; therefore, the cost of goods sold as a percentage of sales must be 85%. In the vertical analysis of an income statement, each item is generally stated as a percentage of net income.

20.

Liquidity ratios measure the ability of the enterprise to survive over a long period of time.

21.

A solvency ratio measures the income or operating success of an enterprise for a given period of time.

22.

The current ratio is a measure of all the ratios calculated for the current year.

23.

Inventory turnover measures the number of times on the average the inventory was sold during the period.

24.

Profitability ratios are frequently used as a basis for evaluating management's operating effectiveness.

25.

The return on assets ratio will be greater than the rate of return on common stockholders' equity if the company has been successful in trading on the equity at a gain.

26.

An advantage of the current and acid-test ratios is they use year-end balances of current asset and current liability accounts.

27.

From a creditor's point of view, the higher the total debt to total assets ratio, the lower the risk that the company may be unable to pay its obligations.

28.

A current ratio of 1.2 to 1 indicates that a company's assets exceed its current liabilities.

29.

Using borrowed money to increase the rate of return on common stockholders' equity is called "trading on the equity."

30.

Diversification in American industry limits the usefulness of financial analysis.

Answers to True-False Statements Item

1. 2. 3. 4. 5.

Ans.

T T F F F

Item

6. 7. 8. 9. 10.

Ans.

T T T F F

Item

11. 12. 13. 14. 15.

Ans.

T F T F T

Item

16. 17. 18. 19. 20.

Ans.

F T F F F

Item

21. 22. 23. 24. 25.

Ans.

F F T T F

Item

26. 27. 28. 29. 30.

Ans.

F F T T T

Financial Statement Analysis

13-3

MULTIPLE CHOICE QUESTIONS 31.

The discontinued operations section of the income statement refers to a. discontinuance of a product line. b. the income or loss on products that have been completed and sold. c. obsolete equipment and discontinued inventory items. d. the disposal of a significant segment of a business.

32.

Which one of the following would be classified as an extraordinary item? a. Expropriation of property by a foreign government b. Losses attributed to a labor strike c. Write-down of inventories d. Gains or losses from sales of equipment

33.

When a change in accounting principle occurs, a. all prior years' financial statements should be changed to reflect the newly adopted principle. b. the new principle should be used in reporting the results of operations of the current year. c. the cumulative effect of the change in principle should be reflected on the income statement as of the beginning of the next year. d. the cumulative effect of the change in accounting principle should be classified as an extraordinary item on the income statement.

34.

If an item meets one (but not both) of the criteria for an extraordinary item, it a. only needs to be disclosed in the footnotes of the financial statements. b. may be treated as sales revenue (if it is a gain) and as an operating expense (if it is a loss). c. is reported as an "other revenue or gain" or "other expense and loss," net of tax. d. is reported at its gross amount as an "other revenue or gain" or "other expense or loss."

35.

The order of presentation of nontypical items that may appear on the income statement is a. Extraordinary items, Discontinued operations, Change in accounting principle. b. Discontinued operations, Extraordinary items, Change in accounting principle. c. Change in accounting principle, Discontinued operations, Extraordinary items. d. Change in accounting principle, Extraordinary items, Discontinued operations.

36.

In analyzing the financial statements of a company, a single item on the financial statements a. should be reported in boldface type. b. must be compared with other financial data to provide more information. c. is significant only if it is large. d. should be accompanied by a footnote.

37.

Comparisons of financial data made within a company are called a. intracompany comparisons. b. interior comparisons. c. intercompany comparisons. d. intramural comparisons.

134 38.

Test Bank for Managerial Accounting, Second Edition Which one of the following is not a tool in financial statement analysis? a. Horizontal analysis b. Circular analysis c. Vertical analysis d. Ratio analysis

39

In analyzing financial statements, horizontal analysis is a a. requirement. b. tool. c. principle. d. theory.

40.

Horizontal analysis is also known as a. linear analysis. b. vertical analysis. c. trend analysis. d. common size analysis.

41.

Under which of the following cases may a percentage change be computed? a. The trend of the amounts is decreasing but all amounts are positive. b. There is no amount in the base year. c. There is a negative amount in the base year and a negative amount in the subsequent year. d. There is a negative amount in the base year and a positive amount in the subsequent year.

42.

Horizontal analysis is a technique for evaluating a series of financial statement data over a period of time a. that has been arranged from the highest number to the lowest number. b. that has been arranged from the lowest number to the highest number. c. to determine which items are in error. d. to determine the amount and/or percentage increase or decrease that has taken place.

43.

Horizontal analysis is a technique for evaluating financial statement data a. within a period of time. b. over a period of time. c. on a certain date. d. as it may appear in the future.

44.

Assume the following sales data for a company: 2003 2002 2001

$1,800,000 1,500,000 1,000,000

If 2001 is the base year, what is the percentage increase in sales from 2001 to 2003? a. 100% b. 180% c. 80% d. 55.5%

Financial Statement Analysis

13-5

45.

Comparative balance sheets are usually prepared for a. one year. b. two years. c. three years. d. four years.

46.

Vertical analysis is also known as a. perpendicular analysis. b. common size analysis. c. trend analysis. d. straight-line analysis.

47.

Vertical analysis is a technique that expresses each item in a financial statement a. in dollars and cents. b. as a percent of the item in the previous year. c. as a percent of a base amount. d. starting with the highest value down to the lowest value.

48.

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

49.

In performing a vertical analysis, the base for prepaid expenses is a. total current assets. b. total assets. c. total liabilities. d. prepaid expenses in a previous year.

50.

In performing a vertical analysis, the base for sales revenues on the income statement is a. net sales. b. sales. c. net income. d. cost of goods available for sale.

51.

In performing a vertical analysis, the base for sales returns and allowances is a. sales. b. sales discounts. c. net sales. d. total revenues.

52.

In performing a vertical analysis, the base for cost of goods sold is a. total selling expenses. b. net sales. c. total revenues. d. total expenses.

53.

Which one of the following is not a characteristic generally evaluated in ratio analysis? a. Liquidity b. Profitability c. Marketability d. Solvency

136 54.

Test Bank for Managerial Accounting, Second Edition Short-term creditors are usually most interested in assessing a. solvency. b. liquidity. c. marketability. d. profitability.

55.

Long-term creditors are usually most interested in evaluating a. liquidity. b. marketability. c. profitability. d. solvency.

56.

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

57.

In ratio analysis, the ratios are never expressed as a a. rate. b. logarithm. c. percentage. d. simple proportion.

58.

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

59.

The acid-test or quick ratio a. is used to quickly determine a company's solvency and long-term debt paying ability. b. relates cash, short-term investments, and net receivables to current liabilities. c. is calculated by taking one item from the income statement and one item from the balance sheet. d. is the same as the current ratio except it is rounded to the nearest whole percent.

60.

Winter Clothing Store had a balance in the Accounts Receivable account of $390,000 at the beginning of the year and a balance of $410,000 at the end of the year. Net credit sales during the year amounted to $4,000,000. The average collection period of the receivables in terms of days was a. 30 days. b. 365 days. c. 73 days. d. 37 days.

61.

Pine Hardware Store had net credit sales of $6,500,000 and cost of goods sold of $5,000,000 for the year. The Accounts Receivable balances at the beginning and end of the year were $600,000 and $700,000, respectively. The receivables turnover was a. 7.7 times. b. 10.8 times. c. 9.3 times. d. 10 times.

Financial Statement Analysis

13-7

Use the following information for questions 62-63. Winslow Department Store had net credit sales of $16,000,000 and cost of goods sold of $12,000,000 for the year. The average inventory for the year amounted to $2,000,000. 62.

Inventory turnover for the year is a. 8 times. b. 14 times. c. 6 times. d. 4 times.

63.

The average days in inventory during the year was a. 91 days. b. 61 days. c. 46 days. d. 26 days.

64.

Which one of the following would not be considered a liquidity ratio? a. Current ratio b. Inventory turnover c. Quick ratio d. Return on assets

65.

Asset turnover measures a. how often a company replaces its assets. b. how efficiently a company uses its assets to generate sales. c. the portion of the assets that have been financed by creditors. d. the overall rate of return on assets.

66.

The profit margin ratio is calculated by dividing a. sales by cost of goods sold. b. gross profit by net sales. c. net income by stockholders' equity. d. net income by net sales.

Use the following information for questions 67-68. Terry Corporation had net income of $200,000 and paid dividends to common stockholders of $40,000 in 2002. The weighted average number of shares outstanding in 2002 was 50,000 shares. Terry Corporation's common stock is selling for $60 per share on the New York Stock Exchange. 67.

Terry Corporation's price-earnings ratio is a. 3.8 times. b. 15 times. c. 18.8 times. d. 6 times.

68.

Terry Corporation's payout ratio for 2002 is a. $4 per share. b. 25%. c. 20%. d. 12.5%.

138 69.

Test Bank for Managerial Accounting, Second Edition Grand Company reported the following on its income statement: Income before income taxes Income tax expense Net income

$400,000 100,000 $300,000

An analysis of the income statement revealed that interest expense was $100,000. Grand Company's times interest earned was a. 5 times. b. 4 times. c. 3.5 times. d. 3 times. 70.

The debt to total assets ratio measures a. the company's profitability. b. whether interest can be paid on debt in the current year. c. the proportion of interest paid relative to dividends paid. d. the percentage of the total assets provided by creditors.

71.

Trading on the equity (leverage) refers to the a. amount of working capital. b. amount of capital provided by owners. c. use of borrowed money to increase the return to owners. d. number of times interest is earned.

72.

The current assets of Key Company are $150,000. The current liabilities are $100,000. The current ratio expressed as a proportion is a. 150%. b. 1.5:1 c. .67:1 d. $150,000 ÷ $100,000.

73.

The acid-test ratio is also referred to as the a. short run ratio. b. quick ratio. c. working capital ratio. d. contemporary ratio.

74.

A weakness of the current ratio is a. the difficulty of the calculation. b. that it doesn't take into account the composition of the current assets. c. that it is rarely used by sophisticated analysts. d. that it can be expressed as a percentage, as a rate, or as a proportion.

75.

A supplier to a company would be most interested in the a. asset turnover ratio. b. profit margin ratio. c. current ratio. d. earnings per share.

Financial Statement Analysis

13-9

76.

Which one of the following ratios would not likely be used by a short-term creditor in evaluating whether to sell on credit to a company? a. Current ratio b. Acid-test ratio c. Asset turnover d. Receivables turnover

77.

Ratios are used as tools in financial analysis a. instead of horizontal and vertical analyses. b. because they can provide information that may not be apparent from inspection of the individual components of a particular ratio. c. because even single ratios by themselves are quite meaningful. d. because they are prescribed by GAAP.

78.

The ratios that are used to determine a company's short-term debt paying ability are a. asset turnover, times interest earned, current ratio, and receivables turnover. b. times interest earned, inventory turnover, current ratio, and receivables turnover. c. times interest earned, acid-test ratio, current ratio, and inventory turnover. d. current ratio, acid-test ratio, receivables turnover, and inventory turnover.

79.

Tyner Company had $250,000 of current assets and $90,000 of current liabilities before borrowing $60,000 from the bank with a 3-month note payable. What effect did the borrowing transaction have on Tyner Company's current ratio? a. The ratio remained unchanged. b. The change in the current ratio cannot be determined. c. The ratio decreased. d. The ratio increased.

80.

A liquidity ratio measures the a. income or operating success of an enterprise over a period of time. b. ability of the enterprise to survive over a long period of time. c. short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. d. number of times interest is earned.

81.

If equal amounts are added to the numerator and the denominator of the current ratio, the ratio will always a. increase. b. decrease. c. stay the same. d. equal zero.

82.

The acid-test ratio a. is a quick calculation of an approximation of the current ratio. b. does not include all current liabilities in the calculation. c. does not include inventory as part of the numerator. d. does include prepaid expenses as part of the numerator.

1310 83.

Test Bank for Managerial Accounting, Second Edition If a company has an acid-test ratio of 1.2:1, what respective effects will the borrowing of cash by short-term debt and collection of accounts receivable have on the ratio? a. b. c. d.

Short-term Borrowing Increase Increase Decrease Decrease

Collection of Receivable No effect Increase No effect Decrease

84.

A company has a receivables turnover of 10 times. The average net receivables during the period are $300,000. What is the amount of net credit sales for the period? a. $30,000. b. $3,000,000. c. $360,000. d. Cannot be determined from the information given.

85.

If the average collection period is 30 days, what is the receivables turnover? a. 11.1 times b. 12.2 times c. 6.1 times d. None of these

86.

A general rule to use in assessing the average collection period is a. that it should not exceed 30 days. b. it can be any length as long as the customer continues to buy merchandise. c. that it should not greatly exceed the discount period. d. that it should not greatly exceed the credit term period.

87.

Inventory turnover is calculated by dividing a. cost of goods sold by the ending inventory. b. cost of goods sold by the beginning inventory. c. cost of goods sold by the average inventory. d. average inventory by cost of goods sold.

88.

A company has an average inventory on hand of $40,000 and its average days in inventory is 73 days. What is the cost of goods sold? a. $200,000. b. $2,920,000. c. $400,000. d. $1,460,000.

89.

A successful grocery store would probably have a. a low inventory turnover. b. a high inventory turnover. c. zero profit margin. d. low volume.

90.

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

Financial Statement Analysis

13-11

91.

Net sales are $6,000,000, beginning total assets are $2,800,000, and the asset turnover is 3.0. What is the ending total asset balance? a. $2,000,000. b. $1,200,000. c. $2,800,000. d. $1,600,000.

92.

The numerator of the times interest earned ratio is a. income before income taxes. b. net income. c. net income + interest expense. d. net income + interest expense + income taxes.

93.

The return on common stockholders’ equity ratio is computed by dividing net income a. by average common stockholders’ equity. b. by ending common stockholders’ equity. c. minus preferred stock dividends by average common stockholders’ equity. d. minus preferred stock dividends by ending common stockholders’ equity.

94.

The return on assets ratio is affected by the a. asset turnover ratio. b. debt to total assets ratio. c. profit margin ratio. d. asset turnover and profit margin ratios.

95.

Measures of the short-term ability of the enterprise to pay its maturing obligations are a. liquidity ratios. b. marketability ratios. c. profitability ratios. d. solvency ratios.

96.

A measure of a company’s immediate short-term liquidity is the a. current ratio. b. current cash debt coverage ratio. c. cash debt coverage ratio. d. acid-test ratio.

97.

The ratio that indicates a company’s degree of financial leverage is the a. cash debt coverage ratio. b. debt to total assets ratio. c. free cash flow ratio. d. times interest earned ratio.

98.

Earnings per share is computed by dividing net income a. by average common shares outstanding. b. by ending common shares outstanding. c. less preferred stock dividends by average common shares outstanding. d. less preferred stock dividends by ending common shares outstanding.

1312 99.

Test Bank for Managerial Accounting, Second Edition A measure of how efficiently a company uses its assets to generate sales is the a. return on assets ratio. b. profit margin ratio. c. cash return on sales ratio. d. asset turnover ratio.

100.

A limitation in calculating ratios in financial statement analysis is that a. it requires a calculator. b. no one other than management would be interested in them. c. some account balances may reflect atypical data at year end. d. they seldom identify problem areas in a company.

101.

Which of the following is not a limitation of financial statement analysis? a. The cost basis b. The use of estimates c. The diversification of firms d. The availability of information

102.

The use of alternative accounting methods a. is not a problem in ratio analysis because the footnotes disclose the method used. b. may be a problem in ratio analysis even if disclosed. c. is not a problem in ratio analysis since eventually all methods will lead to the same end. d. is only a problem in ratio analysis with respect to inventory.

103.

Traditional financial statements are based on a. unadjusted cost. b. price-level adjusted cost. c. the lower of cost or price-level adjusted historical cost. d. fair market value.

104.

Estimates are used in financial statements in determining all of the following except a. contingent losses. b. cost of goods sold. c. periodic depreciation. d. warranty costs.

105.

In addition to differences in inventory costing methods, differences also exist in reporting all of the following except a. amortization. b. depletion. c. depreciation. d. warranty costs.

Financial Statement Analysis

13-13

Answers to Multiple Choice Questions Item

31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41.

Ans.

d a b d b b a b b c a

Item

42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52.

Ans.

d b c b b c a b a c b

Item

53. 54. 55. 56. 57. 58. 59. 60. 61. 62. 63.

Ans.

c b d c b b b d d c b

Item

64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74.

Ans.

d b d b c a d c b b b

Item

75. 76. 77. 78. 79. 80. 81. 82. 83. 84. 85.

Ans.

c c b d c c b c c b b

Item

86. 87. 88. 89. 90. 91. 92. 93. 94. 95. 96.

Ans.

d c a b d b d c d a d

Item

97. 98. 99. 100. 101. 102. 103. 104. 105.

Ans.

b c d c d b a b d

EXERCISES Ex. 106 Indicate whether the following items would be reported as an ordinary or an extraordinary item in Hartley Corporation's income statement. (a) Loss attributable to labor strike. (b) Gain on sale of fixed assets. (c) Loss from fire. Hartley is a chemical company. (d) Loss from sale of marketable securities. (e) Expropriation of property by a foreign government. (f) Loss from tornado damage. Hartley Corporation is located in the Midwest's tornado alley. (g) Loss from government condemnation of property through a newly enacted law.

Solution 106 (a) (b) (c) (d)

ordinary ordinary ordinary ordinary

(6-9 min.) (e) (f) (g)

extraordinary ordinary extraordinary

Ex. 107 Stiner Company has income from continuing operations of $480,000 for the year ended December 31, 2002. It also has the following items (before considering income taxes): (1) An extraordinary fire loss of $180,000. (2) A gain of $120,000 on the discontinuance of a major segment. (3) A cumulative effect of a change in accounting principle that resulted in an increase in prior years' depreciation of $70,000. Assume all items are subject to income taxes at a 30% tax rate. Instructions Prepare an income statement, beginning with income from continuing operations.

13Test Bank for Managerial Accounting, Second Edition 14 Solution 107 (10-15 min.) STINER COMPANY Partial Income Statement For the Year Ended December 31, 2002 Income from continuing operations ............................................................ Discontinued operations Gain on discontinued segment, net of $36,000 income taxes ........... Income before extraordinary item and cumulative effect of change in accounting principle ................................................................................ Extraordinary item Fire loss, net of $54,000 tax saving ................................................... Cumulative effect of change in accounting principle Effect on prior years of change in depreciation method, net of $21,000 income tax saving ............................................................ Net income .................................................................................................

$480,000 84,000 564,000 (126,000) (49,000) $389,000

Ex. 108 Comparative information taken from the Walters Company financial statements is shown below: (a) (b) (c) (d) (e) (f)

Notes receivable Accounts receivable Retained earnings Income taxes payable Sales Operating expenses

2002 $ 20,000 182,000 30,000 45,000 900,000 170,000

2001 $ -0140,000 (40,000) 20,000 750,000 200,000

Instructions Using horizontal analysis, show the percentage change from 2001 to 2002 with 2001 as the base year. Solution 108 (a) (b) (c) (d) (e) (f)

(8-12 min.)

Base year is zero. Not possible to compute. $42,000 ÷ $140,000 = 30% increase Base year is negative. Not possible to compute. $25,000 ÷ $20,000 = 125% increase $150,000 ÷ $750,000 = 20% increase $30,000 ÷ $200,000 = 15% decrease

Ex. 109 Cline Corporation had net income of $2,000,000 in 2001. Using 2001 as the base year, net income decreased by 70% in 2002 and increased by 175% in 2003. Instructions Compute the net income reported by Cline Corporation for 2002 and 2003.

Financial Statement Analysis Solution 109

13-15

(6-9 min.)

2002: X ÷ $2,000,000 = 70% X = $2,000,000 × .70 = $1,400,000 The decrease is $1,400,000; therefore net income for 2002 is $600,000. 2003: X ÷ $2,000,000 = 175% X = $2,000,000 × 1.75 X = $3,500,000 The net income for 2003 is $5,500,000 ($2,000,000 + $3,500,000).

Ex. 110 The following items were taken from the financial statements of Smalley, Inc., over a four-year period: Item Net Sales Cost of Goods Sold Gross Profit

2003 $800,000 580,000 $220,000

2002 $650,000 460,000 $190,000

2001 $600,000 420,000 $180,000

2000 $500,000 400,000 $100,000

Instructions Using horizontal analysis and 2000 as the base year, compute the trend percentages for net sales, cost of goods sold, and gross profit. Explain whether the trends are favorable or unfavorable for each item.

Solution 110

(10-15 min.)

Item Net Sales Cost of Goods Sold Gross Profit

2003 160% 145% 220%

2002 130% 115% 190%

2001 120% 105% 180%

2000 100% 100% 100%

The trend in net sales is increasing and favorable. The cost of goods sold trend is increasing which could be unfavorable, but the sales are increasing each year at a faster pace than cost of goods sold. This is apparent by examining the gross profit percentages, which show a favorable, increasing trend.

13Test Bank for Managerial Accounting, Second Edition 16 Ex. 111 The comparative balance sheet of Grider Company appears below: GRIDER COMPANY Comparative Balance Sheet December 31, ____________________________________________________________________________ Assets 2003 2002 Current assets ...................................................................................... $ 360 $300 Plant assets .......................................................................................... 640 500 Total assets .................................................................................... $1,000 $800 Liabilities and stockholders' equity Current liabilities ................................................................................... Long-term debt ..................................................................................... Common stock ..................................................................................... Retained earnings ................................................................................ Total liabilities and stockholders' equity ..........................................

$ 150 240 350 260 $1,000

$120 160 280 240 $800

Instructions (a) Using horizontal analysis, show the percentage change for each balance sheet item using 2002 as a base year. (b) Using vertical analysis, prepare a common size comparative balance sheet.

Solution 111

(14-19 min.) GRIDER COMPANY Comparative Balance Sheet December 31,

Assets Current assets Plant assets Total assets

2003 $ 360 640 $1,000

(b) Percent 36% 64 100%

2002 $300 500 $800

(b) Percent 38% 62 100%

(a) Percent 20% 28% 25%

Liabilities and stockholders' equity Current liabilities Long-term debt Common stock Retained earnings Total liabilities and stockholders' equity

$ 150 240 350 260 $1,000

15% 24 35 26 100%

$120 160 280 240 $800

15% 20 35 30 100%

25% 50% 25% 30% 25%

Financial Statement Analysis

13-17

Ex. 112 Using the following selected items from the comparative balance sheet of Abbott Company, illustrate horizontal and vertical analysis. Accounts Receivable Inventory Total Assets

Solution 112

December 31, 2003 $ 840,000 975,000 4,000,000

December 31, 2002 $ 600,000 780,000 2,500,000

(10-15 min.) HORIZONTAL ANALYSIS

Accounts Receivable Inventory Total Assets

December 31, 2003 140% 125% 160%

December 31, 2002 100% 100% 100%

VERTICAL ANALYSIS Accounts Receivable Inventory Total Assets

December 31, 2003 21.0% 24.4% 100%

December 31, 2002 24.0% 31.2% 100%

Ex. 113 The following information was taken from the financial statements of Larkin Company: Gross profit on sales ................................................................. Income before income taxes ..................................................... Net income ............................................................................... Net income as a percentage of net sales ..................................

2003 $900,000 280,000 240,000 8%

2002 $840,000 230,000 216,000 9%

Instructions (a) Compute the net sales for each year. (b) Compute the cost of goods sold in dollars and as a percentage of net sales for each year. (c) Compute operating expenses in dollars and as a percentage of net sales for each year. (Income taxes are not operating expenses).

13Test Bank for Managerial Accounting, Second Edition 18 Solution 113 (12-15 min.) (a)

To calculate net sales divide the net income by the percentage of net income to net sales. Net Sales

(b)

2003 $240,000 ÷ 8% = $3,000,000

2002 $216,000 ÷ 9% = $2,400,000

Using the net sales information from (a) and the gross profits given, it is possible to calculate the cost of goods sold. Net Sales Less: Gross profit Cost of goods sold % of net sales

(c) Gross profit Less: Income before income taxes Operating Expenses % of net sales

2003 $3,000,000 900,000 $2,100,000

2002 $2,400,000 840,000 $1,560,000

70%

65%

2003 $900,000 280,000 $620,000

2002 $840,000 230,000 $610,000

20.7%

25.4%

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

Financial Statement Analysis Solution 114

13-19

(12-19 min.) $900,000 ———————————— = 6 times. ($140,000 + $160,000) ÷ 2

1. The inventory turnover ratio for 2002 is 6 times.

2. The times interest earned ratio in 2002 is 5.2 times. $150,000 + $60,000 + $50,000 —————————————— = 5.2 times. $50,000 3. The debt to total assets ratio for 2002 is 45%.

$140,000 + $400,000 —————————— = 45%. $1,200,000

4. The receivables turnover ratio for 2002 is 7 times.

5. The return on assets ratio for 2002 is 15%.

6.

$1,330,000 ———————————— = 7 times. ($180,000 + $200,000) ÷ 2

$150,000 ($1,200,000 + $800,000) ÷ 2 = 15%

The cash return on sales ratio for 2002 is 16.5%.

$220,000 $1,330,000 = 16.5%

7. The current cash debt coverage ratio for 2002 is 1.76 times. $220,000 ($110,000 + $140,000) ÷ 2 = 1.76 times.

Ex. 115 The comparative balance sheet for Johnson Stoll Company is given below: JOHNSON STOLL COMPANY Comparative Balance Sheet December 31, ——————————————————————————————————————————— Assets 2003 2002 Cash ............................................................................................... $ 30,000 $ 45,000 Accounts receivable (net) ............................................................... 97,500 90,000 Inventory ........................................................................................ 90,000 75,000 Plant assets (net) ........................................................................... 300,000 270,000 Total assets .............................................................................. $517,500 $480,000 Liabilities and Stockholders' Equity Accounts payable ........................................................................... $ 75,000 Mortgage payable (8%) .................................................................. 150,000 Common stock, $10 par ................................................................. 210,000 Retained earnings .......................................................................... 82,500 Total liabilities and stockholders' equity..................................... $517,500

$ 90,000 150,000 180,000 60,000 $480,000

13Test Bank for Managerial Accounting, Second Edition 20 Ex. 115 (cont.) Additional information for 2003: 1. Income before interest expense and income taxes was $168,000. 2. Sales on account were $990,000. Sales returns and allowances amounted to $5,625. 3. Cost of goods sold was $676,500. 4. Net cash provided by operating activities was $185,625. 5. Interest expense totaled $12,000. Instructions Compute the following ratios at December 31, 2003: a. Current ratio b. Acid-test ratio c. Current cash debt coverage ratio d. Receivables turnover ratio e. Average collection period f. Inventory turnover g. Average days in inventory h. Debt to total assets ratio i. Times interest earned j. Cash debt coverage ratio

Solution 115

(15-20 min.)

a. Current ratio = $217,500 ÷ $75,000 = 2.9 b. Acid-test ratio = $127,000 ÷ $75,000 = 1.7 $185,625 c. Current cash debt coverage ratio = ——————————— = 2.25 ($75,000 + $90,000) ÷ 2 $984,375 d. Receivables turnover ratio = ——————————— = 10.5 ($97,500 + $90,000) ÷ 2 e. Average collection period = 365 ÷ 10.5 = 35 days f.

$676,500 Inventory turnover = ——————————— = 8.2 ($90,000 + $75,000) ÷ 2

g. Average days in inventory = 365 ÷ 8.2 = 44.5 days h. Debt to total assets ratio = $225,000 ÷ $517,500 = .43 i.

Times interest earned = $168,000 ÷ $12,000 = 14

j.

$185,625 Cash debt coverage ratio = ———————————— = .80 ($225,000 + $240,000) ÷ 2

Financial Statement Analysis

13-21

Ex. 116 The financial statements of Albert Company appear below: ALBERT COMPANY Comparative Balance Sheet December 31, ——————————————————————————————————————————— Assets 2002 2001 Cash ............................................................................................... $ 25,000 $ 40,000 Short-term investments .................................................................. 15,000 60,000 Accounts receivable (net) ............................................................... 50,000 30,000 Inventory ........................................................................................ 50,000 70,000 Property, plant and equipment (net) ............................................... 260,000 300,000 Total assets .............................................................................. $400,000 $500,000 Liabilities and stockholders' equity Accounts payable ........................................................................... $ 20,000 Short-term notes payable ............................................................... 30,000 Bonds payable ................................................................................ 90,000 Common stock ............................................................................... 150,000 Retained earnings .......................................................................... 110,000 Total liabilities and stockholders' equity..................................... $400,000

$ 30,000 90,000 160,000 150,000 70,000 $500,000

ALBERT COMPANY Income Statement For the Year Ended December 31, 2002 Net sales ........................................................................................ Cost of goods sold .......................................................................... Gross profit ..................................................................................... Expenses Interest expense ....................................................................... Selling expenses ...................................................................... Administrative expenses ........................................................... Total expenses ................................................................... Income before income taxes .......................................................... Income tax expense ....................................................................... Net income .....................................................................................

$400,000 240,000 160,000 $18,000 28,000 24,000 70,000 90,000 27,000 $ 63,000

Additional information: a. Cash dividends of $23,000 were declared and paid in 2002. b. Weighted-average number of shares of common stock outstanding during 2002 was 30,000 shares. c. Market value of common stock on December 31, 2002, was $21 per share. d. Net cash provided by operating activities for 2002 was $60,000.

13Test Bank for Managerial Accounting, Second Edition 22 Ex. 116 (cont.) Instructions Using the financial statements and additional information, compute the following ratios for Albert Company for 2002. Show all computations. Computations 1.

Current ratio _________.

2.

Return on common stockholders' equity _________.

3.

Price-earnings ratio _________.

4.

Acid-test ratio _________.

5.

Receivables turnover _________.

6.

Times interest earned _________.

7.

Profit margin ratio _________.

8.

Average days in inventory _________.

9.

Payout ratio _________.

10.

Return on assets _________.

11.

Cash return on sales ratio _________.

12.

Cash debt coverage ratio _________.

Solution 116

(15-20 min.)

1.

Current ratio 2.8:1.

$140,000 ————— = 2.8 $50,000

2.

Return on common stockholders' equity 26.8%.

$63,000 ———————————— = .268 ($250,000 + $220,000) ÷ 2

3.

Price-earnings ratio 10 times.

$63,000 EPS = ———— = $2.10; 30,000 $21 ——— = 10 times $2.10

4.

Acid-test ratio 1.8:1.

$90,000 ———— = 1.8:1 $50,000

5.

Receivables turnover 10 times.

$400,000 ——————————— = 10 ($50,000 + $30,000) ÷ 2

Financial Statement Analysis Solution 116

13-23

(cont.)

6.

Times interest earned 6 times.

$63,000 + $27,000 + $18,000 ————————————— = 6 $18,000

7.

Profit margin ratio 15.8%.

$63,000 ———— = .158 $400,000

8.

Average days in inventory 91.3 days.

Inventory turnover = $240,000 ——————————— = 4 ($50,000 + $70,000) ÷ 2 365 days ———— = 91.3 4

9.

10.

11.

12.

Payout ratio 36.5%.

$23,000 ———— = .365 $63,000

Return on assets 14%.

$63,000 ———————————— = .14 ($400,000 + $500,000) ÷ 2

Cash return on sales ratio 15%.

$60,000 $400,000 = .15

Cash debt coverage ratio .29 times.

$60,000 ($280,000 + $140,000) ÷ 2 = .29 times

Ex. 117 The following ratios have been computed for Ryder Company for 2002. Profit margin ratio Times interest earned ratio Receivable turnover ratio Acid test ratio Current ratio Debt to total assets ratio

20% 9 times 3 times 2:1 3:1 20%

The 2002 financial statements for Ryder Company with missing information follows:

13Test Bank for Managerial Accounting, Second Edition 24 Ex. 117 (cont.) RYDER COMPANY Comparative Balance Sheet December 31, —————————————————————————————————————————— Assets 2002 2001 Cash ......................................................................................... $ 30,000 $ 45,000 Short-term investments.............................................................. 10,000 25,000 Accounts receivable (net) ......................................................... ? (6) 40,000 Inventory ................................................................................... ? (8) 50,000 Property, plant, and equipment (net) ........................................ 200,000 160,000 Total assets ....................................................................... $ ? (9) $320,000 Liabilities and stockholders' equity Accounts payable ..................................................................... $ ? (7) Short-term notes payable ......................................................... 40,000 Bonds payable .......................................................................... ? (10) Common stock .......................................................................... 220,000 Retained earnings .................................................................... 60,000 Total liabilities and stockholders' equity.............................. $ ? (11)

$ 30,000 35,000 20,000 200,000 35,000 $320,000

RYDER COMPANY Income Statement For the Year Ended December 31, 2002 —————————————————————————————————————————— Net sales .................................................................................. $150,000 Cost of goods sold .................................................................... 75,000 Gross profit................................................................................ 75,000 Expenses: Depreciation expense ......................................................... $ ? (5) Interest expense ................................................................. 5,000 Selling expenses ................................................................. 8,000 Administrative expenses ..................................................... 12,000 Total expenses .............................................................. ? (4) Income before income taxes ..................................................... ? (2) Income tax expense ............................................................ ? (3) Net income ............................................................................... $ ? (1) Instructions Use the above ratios and information from Ryder Company financial statements to fill in the missing information on the financial statements. Follow the sequence indicated. Show computations that support your answers.

Financial Statement Analysis Solution 117

13-25

(35-40 min.)

RYDER COMPANY Comparative Balance Sheet December 31, ——————————————————————————————————————————— Assets 2002 2001 Cash ................................................................................... $ 30,000 $ 45,000 Short-term investments........................................................ 10,000 25,000 Accounts receivable (net) ................................................... 60,000 (6) 40,000 Inventory ............................................................................. 50,000 (8) 50,000 Property, plant, and equipment (net) ................................... 200,000 160,000 Total assets ................................................................. $350,000 (9) $320,000 Liabilities and stockholders' equity Accounts payable ............................................................... Short-term notes payable .................................................... Bonds payable .................................................................... Common stock .................................................................... Retained earnings ............................................................... Total liabilities and stockholders' equity........................

$ 10,000 (7) 40,000 20,000 (10) 220,000 60,000 $350,000 (11)

$ 30,000 35,000 20,000 200,000 35,000 $320,000

RYDER COMPANY Income Statement For the Year Ended December 31, 2002 ——————————————————————————————————————————— Net sales ............................................................................. $150,000 Cost of goods sold .............................................................. 75,000 Gross profit.......................................................................... 75,000 Expenses Depreciation expense ................................................... $10,000 (5) Interest expense ........................................................... 5,000 Selling expenses ........................................................... 8,000 Administrative expenses ............................................... 12,000 Total expenses ........................................................ 35,000 (4) Income before income taxes ............................................... 40,000 (2) Income tax expense ............................................................ 10,000 (3) Net income ......................................................................... $ 30,000 (1) (1)

Net income = $30,000 ($150,000 × 20%).

(2)

Income before income taxes = $40,000. Let X = Income before income taxes and interest expense. X ——— = 9 times; X = $45,000; $45,000 – $5,000 = $40,000. 5,000

(3)

Income tax expense = $10,000 ($40,000 – $30,000).

(4)

Total operating expenses = $35,000 ($75,000 – $40,000).

(5)

Depreciation expense = $10,000

[$35,000 – ($5,000 + $8,000 + $12,000)].

13Test Bank for Managerial Accounting, Second Edition 26 Solution 117 (cont.) (6)

Accounts receivable (net) = $60,000. Let X = Average receivables. $150,000 ———— = 3 times; 3X = $150,000; X = $50,000. X Let Y = Accounts receivable at 12/31/02. $40,000 + Y —————— = $50,000; $40,000 + Y = $100,000; Y = $60,000. 2

(7) Accounts payable = $10,000. Let X = Current liabilities. $30,000 + $10,000 + $60,000 ————————————— = 2; 2X= $100,000; X = $50,000; X $50,000 – $40,000 = $10,000. (8) Inventory = $50,000 Let X = Total current assets X ———— = 3; X = $150,000; $150,000 – ($30,000 + $10,000 + $60,000) = $50,000. $50,000 (9) Total assets = $350,000

($30,000 + $10,000 + $60,000 + $50,000 + $200,000)

(10) Bonds payable = $20,000 Let X = Total debt X ———— = 20%; X = $70,000; $70,000 – ($10,000 + $40,000) = $20,000. $350,000 (11) Total liabilities and stockholders' equity = $350,000; same as total assets—see (9) above.

Financial Statement Analysis

13-27

Ex. 118 The financial statements for Jacqueline’s Rodeo Wear are given below: JACQUELINE’S RODEO WEAR Comparative Balance Sheet December 31, —————————————————————————————————————————— Assets 2003 2002 Current assets Cash and short-term investments.................................. $ 5,040 $ 4,920 Accounts receivable (net) .............................................. 30,240 28,960 Inventory ....................................................................... 60,480 54,800 Total current assets....................................................... 95,760 88,680 Plant assets (net) ................................................................ 156,240 148,200 Total assets .................................................................. $252,000 $236,880 Liabilities and stockholders' equity Current liabilities ................................................................. Long-term liabilities ............................................................. Common stock .................................................................... Retained earnings ............................................................... Total liabilities and stockholders' equity........................

$ 42,000 67,200 25,000 117,800 $252,000

$ 38,600 72,000 25,000 101,280 $236,880

JACQUELINE’S RODEO WEAR Income Statement For the Year Ended December 31, 2003 Net sales ....................................................................................................... Cost of goods sold ........................................................................................ Gross profit ................................................................................................... Operating expenses (including $7,200 interest and $9,000 income taxes).... Net income .................................................................................................... Net cash provided by operating activities totaled $46,800. Instructions Compute the following ratios at December 31, 2003: a. Return on assets b. Profit margin c. Asset turnover d. Gross profit rate e. Operating expenses to sales f. Cash return on sales

$360,000 252,000 108,000 68,400 $ 39,600

13Test Bank for Managerial Accounting, Second Edition 28 Solution 118 (32-16 min.) $39,600 a. Return on assets ratio = ———————————— = 16.2% ($252,000 + $236,880) ÷ 2 b. Profit margin ratio = $39,600 ÷ $360,000 = 11% $360,000 c. Asset turnover ratio = ———————————— = 1.47 $252,000 + $236,880) ÷ 2 d. Gross profit rate = $108,00 ÷ $360,000 = 30% e. Operating expenses to sales ratio = $68,400 ÷ $360,000 = 19% f.

Cash return on sales ratio = $46,800 ÷ $360,000 = 13%

Ex. 119 Selected data for Mary's Store appear below. Net sales Cost of goods sold Inventory at end of year Accounts receivable at end of year

2002 $800,000 600,000 65,000 90,000

2001 $520,000 345,000 85,000 70,000

Instructions Compute the following for 2002: (a) Gross profit percentage. (b) Inventory turnover. (c) Receivables turnover. Solution 119 (a)

(6-10 min.)

Gross profit = Net Sales – Cost of goods sold = $800,000 – $600,000 = $200,000 Gross profit percentage = Gross profit ÷ Net sales = $200,000 ÷ $800,000 = 25%

(b)

Inventory turnover = Cost of goods sold ÷ Average inventory = $600,000 ÷ [($65,000 + $85,000) ÷ 2] = 8 times

(c)

Receivables turnover = Net credit sales ÷ Average accounts receivables = $800,000 ÷ [($90,000 + $70,000) ÷ 2] = $800,000 ÷ $80,000 = 10 times

Financial Statement Analysis

13-29

Ex. 120 Walbeck Corporation has issued common stock only. The company has been successful and has a gross profit rate of 20%. The information shown below was taken from the company's financial statements. Beginning inventory Purchases Ending inventory Average accounts receivable Average common stockholders' equity Sales (all on credit) Net income

$ 482,000 4,836,000 ? 800,000 3,500,000 6,000,000 420,000

Instructions Compute the following: (a) Receivables turnover and the average collection period. (b) The inventory turnover and the average days in inventory. (c) Return on common stockholders' equity.

Solution 120 (a)

(13-18 min.)

Receivables turnover = =

Credit sales ————————————— Average accounts receivable $6,000,000 ÷ $800,000 =7.5 times

Average collection period = =

365 days —————————— Receivables turnover 365 ÷ 7.5 times = 48.7 days

(b) Inventory turnover = Cost of goods sold ÷ Average inventory First calculate ending inventory. Beginning Inventory $ 482,000 + Purchases 4,836,000 – Cost of Goods Sold (4,800,000)* Ending Inventory $ 518,000 *Since the gross profit ratio is 20%, the cost of goods sold ratio is 80%. 80% × $6,000,000 (net sales) = $4,800,000. Ending Inventory = $518,000 (per above) Average Inventory = ($482,000 + $518,000) ÷ 2 = $500,000 Inventory Turnover = $4,800,000 ÷ $500,000 = 9.6 times Days in Inventory = 365 days ÷ 9.6 times = 38 days (c)

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

13Test Bank for Managerial Accounting, Second Edition 30 Ex. 121 Bradley Corporation had the following comparative current assets and current liabilities: Dec. 31, 2002 Dec. 31, 2001 Current assets Cash $ 60,000 $ 30,000 Short-term investments 40,000 10,000 Accounts receivable 55,000 95,000 Inventory 110,000 90,000 Prepaid expenses 35,000 20,000 Total current assets $300,000 $245,000 Current liabilities Accounts payable $140,000 $110,000 Salaries payable 40,000 30,000 Income tax payable 20,000 15,000 Total current liabilities $200,000 $155,000 During 2002, credit sales and cost of goods sold were $750,000 and $400,000, respectively. Net cash provided by operating activities for 2002 was $213,000. Instructions Compute the following liquidity measures for 2002: 1. Current ratio. 2. Quick ratio. 3. Current cash debt coverage ratio. 4. Receivables turnover. 5. Inventory turnover. Solution 121

(10-15 min.)

1. Current ratio = Current assets ÷ Current liabilities = $300,000 ÷ $200,000 =1.5:1 Cash + Short-term investments + Accounts receivable 2. Quick ratio = ———————————————————————— Current liabilities $60,000 + $40,000 + $55,000 = ————————————— = .78:1 $200,000 Cash provided by operating activities Average current liabilities 3. Current cash debt coverage ratio = $213,000 = $177,500 = 1.2 times 4. Receivables turnover

Net credit sales = ————————————— Average accounts receivables $750,000 = ———— = 10 times $75,000

Financial Statement Analysis Solution 121 (cont.) 5. Inventory turnover

Cost of goods sold = ————————— Average inventory $400,000 = ———— = 4 times $100,000

Ex. 122 Selected data from O'Brien Company are presented below: Total assets Average assets Net income Net sales Average common stockholders' equity Net cash provided by operating activities

$1,600,000 1,750,000 245,000 1,225,000 1,000,000 294,000

Instructions Calculate the profitability ratios that can be computed from the above information.

Solution 122

(10-15 min.)

With the information provided, the profitability ratios that can be calculated are as follows: 1. Profit margin = Net income ÷ Net sales = $245,000 ÷ $1,225,000 = 20% 2. Asset turnover = Net sales ÷ Average assets = $1,225,000 ÷ $1,750,000 = 70% 3. Return on assets = Net income ÷ Average assets = $245,000 ÷ $1,750,000 = 14% Net income 4. Return on common stockholders' equity = ————————————————— Average common stockholders' equity = $245,000 ÷ $1,000,000 = 24.5% Net cash from operations Net sales 5. Cash return on sales = = $294,000 ÷ $1,225,000 = 24%

13-31

13Test Bank for Managerial Accounting, Second Edition 32 Ex. 123 The following data are taken from the financial statements of Duncan Company: Monthly average accounts receivable Net sales on account Terms for all sales are 2/10, n/30

2003 $ 520,000 5,200,000

2002 $ 500,000 4,500,000

Instructions (a) Compute the accounts receivable turnover and the average collection period for both years. (b) What conclusion can an analyst draw about the management of the accounts receivable?

Solution 123 (a)

(8-12 min.)

Accounts receivable turnover ratio. Accounts receivable turnover

Average collection period

(b)

2003

2002

$5,200,000 ————— 520,000

$4,500,000 ————— 500,000

10 times

9 times

365 days ———— 10 times

365 days ———— 9 times

36.5 days

40.6 days

The receivables are turning faster in 2003 than they did in 2002. There is still a problem since the normal credit period is 30 days, and the average collection period for both years exceed this target. Therefore, improvement in the management of the receivables would appear to be desirable.

Ex. 124 State the effect of the following transactions on the current ratio. Use increase, decrease, or no effect for your answer. (a) Collection of an accounts receivable. (b) Declaration of cash dividends. (c) Additional stock is sold for cash. (d) Stock investments are purchased for cash. (e) Equipment is purchased for cash. (f) Inventory purchases are made for cash. (g) Accounts payable are paid. Solution 124 (a) (b) (c) (d)

no effect decrease increase no effect

(7-11 min.) (e) (f) (g)

decrease no effect increase

Financial Statement Analysis

13-33

Ex. 125 The balance sheet for Finley Corporation at the end of the current year indicates the following: Bonds payable, 8% ............................................................. 6% Preferred stock, $100 par ............................................. Common stock, $10 par ......................................................

$4,000,000 1,000,000 2,000,000

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

Solution 125 (a)

(9-14 min.)

Times interest earned =

= (b)

Income before income taxes and interest expense —————————————————————— Interest expense $480,000 + $320,000 —————————— = 2.5 times $320,000

Net income – Preferred dividends Earnings per share = ————————————————————— Weighted average common shares outstanding $336,000 – $60,000 = ————————— = $1.38 per share 200,000 shares

(c)

Market price per share $22.00 Price-earnings ratio = —————————— = ——— = 15.9 Earnings per share $1.38

Ex. 126 The income statement for Pine Company for the year ended December 31, 2002 appears below. Sales Cost of goods sold Gross profit Expenses Net income

$620,000 380,000 240,000 190,000* $ 50,000

*Includes $20,000 of interest expense and $22,000 of income tax expense.

13Test Bank for Managerial Accounting, Second Edition 34 Ex. 126 (cont.) Additional information: 1. Common stock outstanding on January 1, 2002 was 50,000 shares. On July 1, 2002, 10,000 more shares were issued. 2. The market price of Pine's stock was $16 at the end of 2002. 3. Cash dividends of $30,000 were paid, $6,000 of which were paid to preferred stockholders. Instructions Compute the following ratios for 2002: (a) earnings per share. (b) price-earnings. (c) times interest earned.

Solution 126

(8-13 min.)

(a)

$50,000 – $6,000 $44,000 Earnings per share = —————————— = ———— = $0.80 [50,000 + (10,000 ÷ 2)] 55,000

(b)

$16.00 Price-earnings = ——— = 20 times 0.80

(c)

$50,000 + $20,000 + $22,000 Times interest earned = ————————————— = 4.6 times $20,000

Financial Statement Analysis

13-35

COMPLETION STATEMENTS 127. Discontinued operations refers to the disposal of a __________________ of a business. 128. The two criteria necessary for an item to be classified as an extraordinary item are that the transaction or event must be (1) _______________ and (2) ________________. 129. A change in depreciation methods during the year would be classified as a change in ____________________. 130. ______________ analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. 131. Expressing each item in a financial statement as a percent of a base amount is called ______________ analysis. 132. For analysis of the financial statements, ratios can be classified into three types: (1)_____________ ratios, (2)_____________ ratios, and (3)______________ ratios. 133. The times interest earned ratio is calculated by dividing ___________________ before __________________ and __________________ by interest expense. 134. The ratios used in evaluating a company's liquidity and short-term debt paying ability that complement each other are the ______________ ratio and the ______________ ratio. 135. The receivables turnover ratio is calculated by dividing ________________ by average ___________________. 136. If the inventory turnover ratio is 5 times, and the average inventory was $600,000, the cost of goods sold during the year was $______________ and the average days to sell the inventory was ______________ days. 137. Hansen Corporation had net income for the year of $300,000 and a profit margin ratio of 25%. If total average assets were $200,000, the asset turnover ratio was ____________ times. 138. The ______________ ratio measures the percentage of earnings distributed in the form of cash dividends. 139. The lower the _______________ to _______________ ratio, the more equity "buffer" is available to the creditors if the company becomes insolvent.

13Test Bank for Managerial Accounting, Second Edition 36 Answers to Completion Statements 127. 128. 129. 130. 131. 132. 133.

significant segment unusual in nature, infrequent in occurrence accounting principle Horizontal vertical (common size) liquidity, solvency, profitability (any order) income, income taxes, interest expense

134. 135. 136. 137. 138. 139.

current, acid-test (quick) net credit sales, net receivables 3,000,000, 73 6 payout debt, total assets

MATCHING Set 1 140.

For each of the ratios listed below, indicate by the appropriate code letter, whether it is a liquidity ratio, a profitability ratio, or a solvency ratio. Code: L = P = S =

Liquidity ratio Profitability ratio Solvency ratio

____ 1. Cash return on sales ratio ____ 2. Return on assets ratio ____ 3. Receivables turnover ratio ____ 4. Earnings per share ratio ____ 5. Payout ratio ____ 6. Current cash debt coverage ratio ____ 7. Acid-test ratio ____ 8. Debt to total assets ratio ____ 9. Free cash flow ____ 10. Inventory turnover ratio

Answers to Matching Set 1 P

1. Cash return on sales ratio

L

6. Current cash debt coverage ratio

P

2. Return on assets ratio

L

7. Acid-test ratio

L

3. Receivables turnover ratio

S

8. Debt to total assets ratio

P

4. Earnings per share ratio

S

9. Free cash flow

P

5. Payout ratio

L 10.

Inventory turnover ratio

Financial Statement Analysis

13-37

Set 2 141.

Match the ratios with the appropriate ratio computation by entering the appropriate letter in the space provided. A. B. C. D. E.

Current ratio Acid-test ratio Profit margin ratio Asset turnover ratio Price-earnings ratio

F. G. H. I. J.

Times interest earned ratio Inventory turnover ratio Average collection period Average days in inventory Payout ratio

Cost of goods sold ____ 1. ————————— Average inventory Net income ____ 2. ————— Net sales Cash dividends ____ 3. ——————— Net income Net sales ____ 4. ——————— Average assets Current assets ____ 5. ———————— Current liabilities 365 days ____ 6. —————————— Receivables turnover Market price per share of stock ____ 7. —————————————— Earnings per share 365 days ____ 8. ———————— Inventory turnover Income before income taxes and interest expense ____ 9. —————————————————————— Interest expense Cash + Short-term investments + Receivables (net) ____ 10. ——————————————————————— Current liabilities

Answers to Matching Set 2 1. 2. 3. 4. 5.

G C J D A

6. 7. 8. 9. 10.

H E I F B

1338

Test Bank for Managerial Accounting, Second Edition

SHORT-ANSWER ESSAY QUESTIONS S-A E 142 Horizontal and vertical analyses are analytical tools frequently used to analyze financial statements. What type of information or insights can be obtained by using these two techniques? Explain how the output of horizontal analysis and vertical analysis can be compared to industry averages and/or competitive companies.

Solution 142 Horizontal analysis allows an analyst to develop a picture of current trends in a company's operations. The analyst can see whether the accounts are increasing or decreasing and how large these changes actually are. Vertical analysis allows an analyst to evaluate financial statement items within a single financial statement. This technique helps the analyst to evaluate the relative size of the financial statement items and how the items relate to the financial statement as a whole. An example would be if current liabilities were a very large percentage of total liabilities and stockholders' equity. Both techniques allow the company to evaluate their performance and position relative to their competitors and their industry as a whole. For example, the company could evaluate their current trend in sales and see how favorably their sales performance compared to the sales performance of other companies in the industry. Another example would be comparing the relative size of long-term liabilities or retained earnings. This would show which companies have taken on a large amount of debt and which companies have reinvested earnings.

S-A E 143 The use of estimates, cost, alternative accounting methods, the presence of atypical data, and diversification of firms have been cited as factors that limit the usefulness of financial statement analysis. Identify a ratio and explain how one or more of the limiting factors can affect the usefulness of that ratio. Solution 143 Any of the profitability ratios that involve net income will be affected by the method of depreciation chosen. The use of an accelerated method, such as double-declining balance, will result in higher depreciation costs in the early years and lower depreciation costs in the later years. These costs will differ from the depreciation costs that would have been incurred if the straight-line method had been used. Therefore, because of the different costs, net income will also be different. Thus, the choice of depreciation method affects net income, which in turn affects the ratio. Both the acid-test ratio and the receivables turnover ratio are affected by the estimate of uncollectible accounts. The estimate will determine the amount of net receivables used to calculate the ratio. A high estimate will lower the net receivables and a low estimate will increase the net receivables. Thus, the accuracy of the estimate will have a direct effect on the accuracy of the ratio.

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

S-A E 145 (Communication) Fast Express specializes in the transportation of medical equipment and laboratory specimens overnight. The company has selected the following information from its most recent annual report to be the subject of an immediate press release. • • • • • •

The financial statements are being released. Net income this year was $2.1 million. Last year's net income had been $1.8 million. The current ratio has changed to 2:1 from last year's 1.5:1 The debt/total assets ratio has changed to 4:5 from last year's 3:5 The company expanded its truck fleet substantially by purchasing ten new delivery vans. The company already had twelve delivery vans. The company is now the largest medical courier in the mid-Atlantic region.

Required: Prepare a brief press release incorporating the information above. Include all information. Think carefully which information (if any) is good news for the company, and which (if any) is bad news.

13Test Bank for Managerial Accounting, Second Edition 40 Solution 145 Fast Express released its financial statements today, disclosing a 17% increase in earnings, to $2.1 million from $1.8 million last year. The company also improved its short-term liquidity. Its current ratio improved to 2:1 from last year's 1.5:1. Part of the improved performance is no doubt due to the addition of ten new delivery vans to its fleet, allowing it to become the largest medical courier in the mid-Atlantic region. The purchase of the vans, however, caused the debt/total asset ratio to decline. There are now $4 of debt for every $5 in assets, while last year, there were only $3 of debt to $5 in assets.