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FINANCIAL STATEMENT ANALYSIS: THE BIG PICTURE

TRUE-FALSE STATEMENTS
1. Comparisons within a company are often useful to detect changes in financial
relationships and significant trends.

2. Comparisons with other companies provide insight into a companys competitive


position.

3. Comparisons with industry averages provide information about a companys relative


position within the industry.

4. Horizontal analysis is also known as ratio analysis.

5. In horizontal analysis, the base year is always the later year.

6. Horizontal analysis is also known as common-size analysis.

7. In vertical analysis, the base for the asset items is total liabilities.

8. In vertical analysis, the base for income statement items is gross profit.

9. In vertical analysis, the base for liabilities is total stockholders equity.

10. Horizontal analysis is a technique for evaluating financial statement data that
expresses each item in a financial statement as a percent of a base amount.

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

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

13. In horizontal analysis, the base year is the most current year being examined.

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

15. Another name for horizontal analysis is trend analysis.

16. If a company has sales of $110 in 2005 and $154 in 2004, the percentage increase in
sales from 2004 to 2005 is 140%.

17. 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.

18. A primary purpose of vertical analysis is to observe trends over a three-year period.

19. 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.

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

21. In a common size income statement, net sales are represented by 100%.
22. In a common size income statement, each item is expressed as a percentage of net
income.

23. In a common size balance sheet, total assets are represented by 100%.

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

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

26. Using vertical analysis of the income statement, a company's net income as a
percentage of net sales is 10%; therefore, the cost of goods sold as a percentage of
sales must be 90%.

27. In the vertical analysis of an income statement, each item is generally stated as a
percentage of net income.

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

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

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

31. Receivable turnover is useful in assessing the profitability of receivables.

32. The inventory turnover ratio measures the number of times on average the inventory
was sold during the period.

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

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

35. Both profit margin and asset turnover affect a companys return on assets.

36. Leverage and return on equity are closely related.

37. 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.

38. The current ratio is one of the most utilized measures of profitability.

39. 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.
40. A current ratio of 1.2 to 1 indicates that a company's current assets exceed its current
liabilities.

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

42. Declining profitability and liquidity ratios are indications that a company may not
survive.
43. Diversification in American industry limits the usefulness of financial analysis.

44. Improper recognition of income is not one of the factors affecting quality of earnings.

45. Because pro forma earnings are based on specific rules, these amounts are highly
reliable.

COMPLETION STATEMENTS
1. The _________________ ratio divides net credit sales by average accounts receivable.

2. _____________________ ratios measure the ability of an enterprise to survive over a


long period of time.

3. The ________________ ratio measures the percentage of total assets provided by


creditors.

4. ______________ analysis, also called trend analysis, is a technique for evaluating a


series of financial statement data over a period of time.

5. Expressing each item in a financial statement as a percent of a base amount is called


______________ analysis.

6. For analysis of the financial statements, ratios can be classified into three types:
(1)_____________ ratios, (2)_____________ ratios, and (3)______________ ratios.

7. The times interest earned ratio is calculated by dividing ___________________ before


__________________ and __________________ by interest expense.

8. 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.

9. The receivables turnover ratio is calculated by dividing ________________ by average


___________________.

10. 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.

11. 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.

12. The ______________ ratio measures the percentage of earnings distributed in the
form of cash dividends.

13. The lower the _______________ to _______________ ratio, the more equity "buffer" is
available to the creditors if the company becomes insolvent.
MATCHING
SET A
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 = Liquidity ratio
P = Profitability ratio
S = Solvency ratio

____ 1. Price-earnings 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. Current ratio

____ 8. Debt to total assets ratio

____ 9. Free cash flow

____ 10. Inventory turnover ratio

SET B

. Match the ratios with their formulas by entering the appropriate letter in the space
provided.

A. Current ratio F. Times interest earned


B. Current cash debt coverage ratio G. Inventory turnover
C. Profit margin ratio H. Average collection period
D. Asset turnover I. Average days in inventory
E. Price-earnings ratio J. 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 provided by operations


____ 10.
Average current liabilities

EXERCISES

Exercise 1
Match the term below to the correct definition.

a. working capital
b. acid test ratio
c. times interest earned ratio
d. current ratio
e. vertical analysis
f. horizontal analysis

_____ Analysis of a financial statement that reveals the relationship of each statement item to
the total, which is 100%
_____ Current assets less current liabilities
_____ Study of percentage changes in comparative financial statements
_____ Ratio of most highly liquid current assets to current liabilities
_____ Ratio of interest to creditors
_____ Current assets divided by current liabilities

Exercise 2
The following table shows selected data for Browning Corporation for the past four years
ended December 31, 20X8:

20X8 20X7 20X6 20X5


Net credit sales $20,300 $18,400 $17,200 $15,500
Cost of goods sold 9,500 10,300 9,500 8,900
Inventory 13,000 12,200 8,700 9,500
Net accounts receivable 7,500 6,800 7,200 7,000

a. What was the accounts receivable turnover for 20X8?


b. What was the inventory turnover for 20X7?
Exercise 3
From the given data, calculate the following ratios for the Heedy Corporation for 20X6.
a. current ratio
b. quick ratio
c. debt to total assets ratio
d. profit margin ratio

Accounts payable $74,000


Accounts receivable 75,000
Cash 125,000
Inventory 90,000
Short-term investments 60,000
Short-term notes payable 40,000
Notes payable (due in 20X9) 50,000
Total assets 469,000
Total liabilities 185,000
Net sales 240,000
Net income 31,500

Exercise 4

Selected information from the comparative financial statements of Soyman Company for the
year ended December 31 appears below:
2005 2004
Accounts receivable (net) $ 175,000 $200,000
Inventory 130,000 150,000
Total assets 1,100,000 800,000
Current liabilities 140,000 110,000
Long-term debt 410,000 300,000
Net credit sales 800,000 700,000
Cost of goods sold 600,000 530,000
Interest expense 40,000 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, 2005. Show
computations.
1. The inventory turnover ratio for 2005 is __________.
2. The number of times interest earned ratio in 2005 is __________.
3. The receivables turnover ratio for 2005 is __________.
4. The return on assets ratio for 2005 is __________.
5. The current cash debt coverage ratio for 2005 is __________.

Exercise 5
Selected data for Boris Store appear below.
2005 2004
Net sales $630,000 $520,000
Cost of goods sold 520,000 420,000
Inventory at end of year 64,000 85,000
Accounts receivable at end of year 70,000 50,000

Instructions
Compute the following for 2005:
(a) Gross profit percentage
(b) Inventory turnover
(c) Receivables turnover

Exercise 6
Brady Corporation had the following comparative current assets and current liabilities:
Dec. 31, 2005 Dec. 31, 2004
Current assets
Cash $ 25,000 $ 30,000
Marketable securities 40,000 10,000
Accounts receivable 60,000 95,000
Inventory 110,000 90,000
Prepaid expenses 35,000 20,000
Total current assets $270,000 $245,000
Current liabilities
Accounts payable $120,000 $110,000
Salaries payable 40,000 30,000
Income tax payable 10,000 15,000
Total current liabilities $170,000 $155,000
During 2005, net credit sales and cost of goods sold were $475,000 and $250,000,
respectively. Net cash provided by operating activities for 2005 was $120,000.
Instructions
Compute the following liquidity measures for 2005:
1. Current ratio
2. Current cash debt coverage ratio
3. Receivables turnover
4. Inventory turnover

Exercise 7
Selected data from the Tatum Company are presented below:
Total assets $1,500,000
Average assets 1,700,000
Net income 275,000
Net sales 1,400,000
Average common stockholders' equity 1,000,000
Net cash provided by operating activities 275,000

Instructions
Calculate the profitability ratios that can be computed from the above information.
Exercise 8

State the effect of the following transactions on the current ratio. Use increase, decrease, or no
effect for your answer. Assume the current ratio is currently greater than 1.
(a) Collection of an accounts receivable
(b) Declaration of cash dividends
(c) Additional stock is sold for cash.
(d) Accounts payable are paid.
(e) Equipment is purchased for cash.
(f) Inventory purchases are made for cash.
(g) Temporary investments are purchased for cash.

Exercise 9
The balance sheet for Putnam Corporation at the end of the current year include the following:

Bonds payable, 6% ............................................................. $5,000,000


6% Preferred stock, $100 par ............................................. 1,000,000
Common stock, $10 par ...................................................... 2,000,000

Income before income taxes was $950,000 and income tax expense for the current year
amounted to $285,000. Cash dividends paid on common stock were $200,000, and the
common stock was selling for $40 per share at the end of the year. There were no ownership
changes during the year.

Instructions
Determine each of the following:
(a) number of times that bond interest was earned.
(b) earnings per share for common stock.
(c) price-earnings ratio.

Exercise 10

The income statement for the Updown Company for the year ended December 31, 2005,
appears below.

Sales $670,000
Cost of goods sold 390,000
Gross profit 280,000
Expenses 180,000*
Net income $ 100,000

*Includes $25,000 of interest expense and $20,000 of income tax expense.

Additional information:
1. Common stock outstanding on January 1, 2005, was 50,000 shares. On July 1, 2005,
10,000 more shares were issued.
2. The market price of Updown's stock was $18 at the end of 2005.
3. Cash dividends of $35,000 were paid, $5,000 of which were paid to preferred stockholders.

Instructions
Compute the following ratios for 2005:
(a) earnings per share.
(b) price-earnings.
(c) times interest earned.

Exercise 11
The comparative balance sheet of Granger Company appears below:
GRANGER COMPANY
Comparative Balance Sheet
December 31, 2005
____________________________________________________________________________
Assets 2005 2004
Current assets ...................................................................................... $ 340 $280
Plant assets .......................................................................................... 675 520
Total assets .................................................................................... $1,015 $800

Liabilities and stockholders' equity


Current liabilities ................................................................................... $ 180 $120
Long-term debt ..................................................................................... 250 160
Common stock ..................................................................................... 325 320
Retained earnings ................................................................................ 260 200
Total liabilities and stockholders' equity .......................................... $1,015 $800

Instructions
(a) Using horizontal analysis, show the percentage change for each balance sheet item
using 2004 as a base year.
(b) Using vertical analysis, prepare a common size comparative balance sheet.

Exercise 12
The following information was taken from the financial statements of Larkin Company:

2005 2004
Gross profit on sales ................................................................. $700,000 $765,000
Income before income taxes ..................................................... 230,000 221,000
Net income ............................................................................... 160,000 153,000
Net income as a percentage of net sales .................................. 12% 11%

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).
Exercise 13
The financial statements of Mugs Company appear below:
MUGS COMPANY
Comparative Balance Sheet
December 31, 2005
____________________________________________________________________________
Assets 2005 2004
Cash ............................................................................................... $ 25,000 $ 40,000
Marketable securities ...................................................................... 20,000 60,000
Accounts receivable (net) ............................................................... 40,000 30,000
Inventory ........................................................................................ 150,000 170,000
Property, plant and equipment (net) ............................................... 170,000 200,000
Total assets .............................................................................. $405,000 $500,000
Liabilities and stockholders' equity
Accounts payable ........................................................................... $ 25,000 $ 30,000
Short-term notes payable ............................................................... 40,000 90,000
Bonds payable ................................................................................ 75,000 160,000
Common stock ............................................................................... 175,000 145,000
Retained earnings .......................................................................... 90,000 75,000
Total liabilities and stockholders' equity..................................... $405,000 $500,000

MUGS COMPANY
Income Statement
For the Year Ended December 31, 2005

Net sales ........................................................................................ $360,000


Cost of goods sold .......................................................................... 184,000
Gross profit ..................................................................................... 176,000
Expenses
Interest expense ....................................................................... $21,000
Selling expenses ...................................................................... 30,000
Administrative expenses ........................................................... 20,000
Total expenses .................................................................... 71,000
Income before income taxes .......................................................... 105,000
Income tax expense ....................................................................... 30,000
Net income ..................................................................................... $ 75,000

Additional information:
a. Cash dividends of $50,000 were declared and paid in 2005.
b. Weighted-average number of shares of common stock outstanding during 2005 was
62,000 shares.
c. Market value of common stock on December 31, 2005, was $15 per share.
d. Net cash provided by operating activities for 2005 was $65,000.

Instructions
Using the financial statements and additional information, compute the following ratios for the
Mugs Company for 2005. Show all computations.
Computations
1. Current ratio _________.
2. Return on common stockholders' equity _________.
3. Price-earnings ratio _________.
4. Inventory turnover 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 debt coverage ratio _________.

Exercise 14
The following ratios have been computed for the Bonne Company for 2005.
Profit margin ratio 20%
Times interest earned 12 times
Receivable turnover ratio 5 times
Acid-test ratio 1.4:1
Current ratio 2.5:1
Debt to total assets ratio 24%

The 2005 financial statements for Bonne Company with missing information follows:

BONNE COMPANY
Comparative Balance Sheet
December 31, 2005
____________________________________________________________________________
Assets
2005 2004
Cash ......................................................................................... $ 25,000 $ 35,000
Marketable securities ................................................................ 15,000 15,000
Accounts receivable (net) ......................................................... ? (6) 50,000
Inventory ................................................................................... ? (8) 50,000
Property, plant, and equipment (net) ......................................... 200,000 160,000
Total assets ....................................................................... $ ? (9) $310,000

Liabilities and stockholders' equity


Accounts payable ..................................................................... $ ? (7) $ 25,000
Short-term notes payable ......................................................... 35,000 30,000
Bonds payable .......................................................................... ? (10) 20,000
Common stock .......................................................................... 200,000 200,000
Retained earnings .................................................................... 47,000 35,000
Total liabilities and stockholders' equity.............................. $ ? (11) $310,000

BONNE COMPANY
Income Statement
For the Year Ended December 31, 2005
____________________________________________________________________________
Net sales .................................................................................. $200,000
Cost of goods sold .................................................................... 100,000
Gross profit................................................................................ 100,000
Expenses:
Depreciation expense ......................................................... $ ? (5)
Interest expense ................................................................. 5,000
Selling expenses ................................................................. 10,000
Administrative expenses ..................................................... 15,000
Total expenses .............................................................. ? (4)
Income before income taxes ..................................................... ? (2)
Income tax expense ............................................................ ? (3)
Net income ............................................................................... $ ? (1)

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

Exercise 15
Baltins Corporation has issued common stock only. The company has been successful and
has a gross profit rate of 20%. The information shown below was taken from the company's
financial statements.

Beginning inventory $ 482,000


Purchases 4,146,000
Ending inventory ?
Average accounts receivable 700,000
Average common stockholders' equity 3,500,000
Sales (all on credit) 5,200,000
Net income 420,000
Instructions
Compute the following:
(a) Receivables turnover and the average number of days required to collect the accounts
receivable.
(b) The inventory turnover and the average days in inventory.
(c) Return on common stockholders' equity.

Exercise 16
The following information were provided to you by the controller of the GSM Corporation in
order to reconstruct the financial statement of the corporation when the records of the
company was totally destroyed during the onslaught of typhoon yollie:
1. Operating expenses were 15% of net sales
2. Acid-test ratio was 1.3:1
3. Times interest earned was 6 times
4. Gross margin was 35% of net sales
5. The age of receivables was 36 days
6. The beginning accounts receivable was P160,000. Use 360-day year
7. Inventory turnover was 4 times. The beginning inventory amounted to
P250,000.
8. Total debt to stockholders equity was 8:1

GSM CORPORATION
Balance Sheet
As of December 31, 2014

ASSETS
Current Assets:
Cash P?
Marketable securities 50,000
Accounts receivable, net ?
Inventories ? P?

Non-Current Assets:
Plant and Equipment, net ?
Total Assets P ?
======

TOTAL LIABILITIES AND STOCKHOLDERS EQUITY

Current Liabilities P?
Non-Current Liabilities:
Bonds Payable, 12.5% ?
Total Liabilities P?

Stockholders Equity:
Common Stock P500,000
Retained Earnings 300,000 800,000
Total Liabilities and Stockholders Equity P ?
=======

GSM CORPORATION
Income Statement
For the Year Ended December 31, 2014

Sales P?
Cost of Goods Sold ?
Gross Margin on Sales P525,000
Operating Expenses ?
Operating Income ?
Interest Expense ?
Net Income before Taxes ?
Income Tax (32%) ?
Net Income P ?
=======

Exercise 17
The following rations and other data pertain to the financial statements of ROS Corporation
for the year ended December 31, 2014:
Current Ratio 1.80 to 1
Acid-test Ratio 1.50 to 1
Working Capital P320,000
Inventory turnover (based on cost of ending inventory) 8 times
Gross Profit percentage 40%
Average age of outstanding accounts receivable (based on 360 days) 90 days
Plant Assets to Stockholders Equity 0.8 to 1
Earnings Per Share P2.00
Common Stock, shares outstanding 40,000 shares
Net Earnings for the year as a percentage of capital stock 20%
10% Bonds Payable at the beginning and end of 2014 P200,000
The company has no prepaid expenses, deferred or intangible assets

Required: Reconstruct the following financial statements:


1. Income Statement for 2014
2. Balance Sheet as of December 31, 2014.

Exercise 18
The following information relates to Best Buy and Circuit City Stores, Inc., for
their 2003 and 2002 fiscal years.

BEST BUY CO. INC.


Selected Financial Information
(Amounts in millions, except per share amounts)
March 1, 2003 March 2, 2002
Total Current Assets $4,867 $4,600
Merchandise inventories 2,046 1,875
Property and equipment, net of 2,062 1,661
depreciation
Total Assets 7,663 7,367
Total Current liabilities 3,793 3,705
Total Long-term Liabilities 1,140 1,141
Total Liabilities 4,933 4,846
Total Shareholders Equity 2,730 2,521
Total Liabilities and Shareholders Equity 7,663 7,367
Revenue 20,946 17,711
Cost of goods sold 15,710 13,941
Gross Profit 5,236 3,770
Operating income 1,010 980
Interest Expense 30 21
Earnings from continuing operations
before income tax 1,014 926
Income Tax Expense 392 356
Earnings from continuing operations 622 570
Net Earnings 99 570
Basic Earnings per share $0.13 $1.80

CIRCUIT CITY STORES, INC.


Selected Financial Information
(Amounts in millions, except per share amounts)
February 28, February 28,
2003 2002
Total Current Assets $3,103 $3,653
Merchandise inventory 1,410 1,234
Property and equipment, net of 650 733
depreciation
Total Assets 3,799 4,542
Total Current liabilities 1,280 1,641
Total Long-term Liabilities 178 167
Total Liabilities 1,458 1,808
Total Shareholders Equity 2,342 2,734
Revenues 9,954 9,518
Cost of sales, buying and warehousing 7,603 7,180
Gross Profit 2,350 2,328
Interest Expense 1 1
Earnings from continuing operations
before income tax 67 206
Provision for income tax 25 78
Earnings from continuing operations 42 128
Net Earnings 106 219
Basic Earnings per share: Continuing $0.20 $0.62
operations

Required:
a. Compute the following ratios for the companies 2003 fiscal years:
(1) Current ratio
(2) Average number of days to sell inventory (Use average inventory)
(3) Debt to asset ratio
(4) Return on investment (use average assets and use earnings from
continuing operations rather than net earnings)
(5) Gross margin percentage
(6) Asset turnover (use average assets)
(7) Return on sales ( use earnings from continuing operations rather than
net earnings)
(8) Plant assets to long-term debt ratio.
b. Which company appears to be more profitable? Explain yours answer and
identify which of the ratio(s) from Requirement a you used to reach your
conclusions.
c. Which company appears to have the higher level of financial risk? Explain
your answer and identify which of the ratio(s) from Requirement a you used
to reach your conclusion.
d. Which company appears to be charging the higher prices for its goods?
Explain your answer and identify which of the ratio(s) from Requirement a
you used to reach your conclusion.
e. Which company appears to be the more efficient in using its assets? Explain
your answer and identify which ratio(s) from Requirement a you used to
reach your conclusion.