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• CHAPTER 19 STUDY QUESTIONS TRUE-FALSE STATEMENTS 1. Intracompany comparisons of the same financial statement items can often detect changes in financial relationships and significant trends. 2. Calculating financial ratios is a financial reporting requirement under generally accepted accounting principles. 3. Measures of a company's liquidity are concerned with the frequency and amounts of dividend payments. 4. Analysis of financial statements is enhanced with the use of comparative data. 5. Comparisons of company data with industry averages can provide some insight into the company's relative position in the industry. 6. Vertical and horizontal analyses are concerned with the format used to prepare financial statements. 7. Horizontal, vertical, and circular analyses are the most common tools of financial statement analysis. 8. Horizontal analysis is a technique for evaluating a financial statement item in the current year with other items in the current year. 9. Another name for trend analysis is horizontal analysis. 10. If a company has sales of \$110 in 2000 and \$154 in 2001, the percentage increase in sales from 2000 to 2001 is 140%. 11. 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 calculated. 12. Common size analysis expresses each item within a financial statement in terms of a percent of a base amount. 13. Vertical analysis is a more sophisticated analytical tool than horizontal analysis. 14. Vertical analysis is useful in making comparisons of companies of different sizes. 15. Meaningful analysis of financial statements will include either horizontal or vertical analysis, but not both. 16. 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%. 17. In the vertical analysis of the income statement, each item is generally stated as
• a percentage of net income. 18. A ratio can be expressed as a percentage, a rate, or a proportion. 19. A solvency ratio measures the income or operating success of an enterprise for a given period of time. 20. The current ratio is a measure of all the ratios calculated for the current year. 21. The inventory turnover ratio measures the number of times, on average, the inventory was sold during the period. 22. Profitability ratios are frequently used as a basis for evaluating management's operating effectiveness. 23. The return on total assets will be greater than the return on common shareholders' equity if the company has been successful in trading on the equity at a gain. 24. 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. 25. A current ratio of 1.2 to 1 indicates that a company's assets exceed its current liabilities. 26. All companies, regardless of size, should have a current ratio of at least 2:1. 27. Prepaid expenses are excluded from the calculation of the quick ratio. 28. The receivables turnover ratio provides information about the number of accounts turned over to a collection agency for collection. 29. Using borrowed money to increase the rate of return on common shareholders’ equity is called “trading on the equity.” 30. Diversification in Canadian industry limits the usefulness of financial analysis. Answers to True-False Statements Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. 1. T 6. F 11. T 16. F 21. T 26. F 2. F 7. F 12. T 17. F 22. T 27. T 3. F 8. F 13. F 18. T 23. F 28. F 4. T 9. T 14. T 19. F 24. F 29. T 5. T 10. F 15. F 20. F 25. T 30. T
• MULTIPLE CHOICE QUESTIONS 31. Which one of the following is not a characteristic generally evaluated in analysing financial statements? a. Liquidity b. Profitability c. Marketability d. Solvency 32. In analysing the financial statements of a company, a single item on the financial statements a. should be reported in bold-faced type. b. is more meaningful if compared to other financial information. c. is significant only if it is large. d. should be accompanied by a footnote. 33. Short-term creditors are usually most interested in evaluating a. solvency. b. liquidity. c. marketability. d. profitability. 34. Long-term creditors are usually most interested in evaluating a. liquidity and solvency. b. solvency and marketability. c. liquidity and profitability. d. profitability and solvency. 35. Shareholders are most interested in evaluating a. liquidity and solvency. b. profitability and solvency. c. liquidity and profitability. d. marketability and solvency. 36. A shareholder is interested in the ability of a firm to a. pay consistent dividends. b. appreciate in share price. c. survive over a long period. d. all of these. 37. Comparisons of financial data made within a company are called a. intracompany comparisons. b. interior comparisons. c. intercompany comparisons. d. intramural comparisons. 38. 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 analysing 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. Vertical analysis is also known as a. perpendicular analysis. b. common size analysis. c. trend analysis. d. straight-line analysis. 42. In ratio analysis, the ratios are never expressed as a a. rate. b. negative figure. c. percentage. d. simple proportion. 43. 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. 44. 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. 45. Assume the following sales data for a company: 2001 \$1,000,000 2000 900,000 1999 750,000 1998 500,000 If 1998 is the base year, what is the percentage increase in sales from 1998 to 2000? a. 100% b. 180% c. 80% d. 55.5%
• 46. Comparative financial statements are usually prepared for a. one year. b. two years. c. three years. d. four years. 47. Horizontal analysis is appropriately performed a. only on the income statement. b. only on the balance sheet. c. only on the statement of retained earnings. d. on all three of these statements. 48. A horizontal analysis performed on a statement of retained earnings would not show a percentage change in a. dividends paid. b. net income. c. expenses. d. beginning retained earnings. 49. Under which of the following cases may a percentage change be calculated? a. The trend of the balances is decreasing but all balances are positive. b. There is no balance in the base year. c. There is a negative balance in the base year and a negative balance in the subsequent year. d. There is a negative balance in the base year and a positive balance in the subsequent year. 50. Vertical analysis is a technique which expresses each item within a financial statement a. in dollars and cents. b. in terms of a percentage of the item in the previous year. c. in terms of a percent of a base amount. d. starting with the highest value down to the lowest value. 51. In common size analysis, a. a base amount is required. b. a base amount is optional. c. the same base is used across all financial statements analysed. d. the results of the horizontal analysis are necessary inputs for performing the analysis. 52. In performing a vertical analysis, the base for prepaid expenses is a. total current assets. b. total assets. c. total liabilities and shareholders’ equity. d. prepaid expenses. 53. 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. 54. In performing a vertical analysis, the base for sales returns and allowances is a. sales. b. cost of goods sold. c. net sales. d. total revenues. 55. 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. 56. A ratio calculated in the analysis of financial statements a. expresses a mathematical relationship between two numbers. b. shows the percentage increase from one year to another. c. restates all items on a financial statement in terms of dollars of the same purchasing power. d. is meaningful only if the numerator is greater than the denominator. 57. 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. 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, temporary 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 \$780,000 at the beginning of the year and a balance of \$820,000 at the end of the year. Net credit sales during the year amounted to \$5,840,000. The collection period of the receivables was a. 30 days. b. 365 days. c. 100 days.
• d. 50 days. 61. Pine Hardware Store had net credit sales of \$3,900,000 and cost of goods sold of \$3,000,000 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 ratio was a. 5.6 times. b. 6.5 times. c. 4.6 times. d. 6 times. Use the following information for questions 62-63. The Winslow Department Store had net credit sales of \$8,000,000 and cost of goods sold of \$6,000,000 for the year. The average inventory for the year amounted to \$2,000,000. 62. The inventory turnover ratio for the year is a. 4 times. b. 7 times. c. 3 times. d. 2 times. 63. The days sales in inventory during the year was a. 183 days. b. 122 days. c. 91 days. d. 52 days. 64. Which one of the following would not be considered a liquidity ratio? a. Current ratio b. Inventory turnover ratio c. Quick ratio d. Return on assets ratio 65. The assets turnover ratio 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 is calculated by dividing a. sales by cost of goods sold. b. gross profit by net sales. c. net income by shareholders' equity. d. net income by net sales. Use the following information for questions 67-68. Shannon Corporation had net income of \$250,000 and paid dividends to common
• shareholders of \$50,000 in 2001. The number of shares issued in 2001 was 50,000 shares. Shannon Corpora-tion's common shares are selling for \$40 per share on the Toronto Stock Exchange. 67. Shannon Corporation's price-earnings ratio is a. 2 times. b. 8 times. c. 10 times. d. 5 times. 68. Shannon Corporation's payout ratio for 2001 is a. \$5 per share. b. 25%. c. 20%. d. 12.5%. 69. Gifford Company reported the following on its income statement: Income before income taxes \$420,000 Income tax expense 120,000 Net income \$300,000 An analysis of the income statement revealed that interest expense was \$60,000. Gifford Company's interest coverage ratio was a. 8 times. b. 7 times. c. 6 times. d. 5 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 \$180,000. The current liabilities are \$120,000. The current ratio is a. 150%. b. 1.5:1 c. .67:1 d. \$180,000 ÷ \$120,000. 73. The current ratio may also be referred to as the a. short run ratio. b. acid test 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. b. profit margin. c. current ratio. d. earnings per share. 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 may provide information that is not apparent from inspection of the individual components of the 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, interest coverage, current ratio, and receivables turnover. b. interest coverage, inventory turnover, current ratio, and receivables turnover. c. interest coverage, acid test ratio, current ratio, and inventory turnover. d. current ratio, acid test ratio, receivables turnover, and inventory turnover. Use the following information for questions 79-80. Sweney 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. 79. What effect did the borrowing transaction have on the amount of Sweney Company's working capital? a. No effect b. \$60,000 increase c. \$90,000 increase d. \$60,000 decrease 80. What effect did the borrowing transaction have on Sweney 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. 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. includes prepaid expenses as part of the numerator. 83. 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? Short-term Borrowing Collection of Receivables a. Increase No effect b. Increase Increase c. Decrease No effect d. Decrease Decrease 84. A company has a receivables turnover ratio of 10. The average net receivables during the period are \$400,000. What is the amount of net credit sales for the period? a. \$40,000. b. \$4,000,000. c. \$480,000. d. Cannot be determined from the information given. 85. If the collection period is 50 days, what is the receivables turnover? a. 6.64 times b. 7.30 times c. 3.65 times d. None of these 86. A general rule to use in assessing the collection period is that a. it should not exceed 30 days. b. it can be any length as long as the customer continues to buy merchandise. c. it should not greatly exceed the discount period. d. it should not greatly exceed the credit term period. 87. The 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 \$60,000 and the average days to sell inventory is 29.2 days. What is the cost of goods sold? a. \$750,000. b. \$1,752,000. c. \$739,726. d. \$876,000. 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. high inventory turnover. b. low profit margin. c. high volume. d. low inventory turnover. 91. Net sales are \$1,500,000, beginning total assets are \$700,000, and the asset turnover is 3.0. What is the ending total asset balance? a. \$500,000. b. \$300,000. c. \$700,000. d. \$400,000. 92. Earnings per share is calculated a. only for common shares. b. only for preferred shares. c. for common and preferred shares. d. only for bonds. 93. Which of the following is not a profitability ratio? a. Payout ratio b. Profit margin c. Interest coverage d. Return on common shareholders' equity 94. The interest coverage ratio is also called a. the money multiplier. b. the times interest earned ratio. c. coupon coverage. d. the premium ratio. 95. The ratio that uses the number of common shares in the denominator is the a. price earnings ratio. b. return on common shareholders' equity. c. earnings per share. d. payout ratio.
• 96. Net income does not appear in the numerator of the a. profit margin. b. return on assets. c. return on common shareholders' equity. d. payout ratio. 97. Total shareholders’ equity for Quality Department Store, Inc. is \$500,000 in 2001. The number of common shares is 100,000. There are no preferred shares. In 2000, book value per share was \$4. This shows that Quality may have a. increased future earnings projections. b. increased retention of earnings. c. decreased retention of earnings. d. issued more common shares. 98. Earnings per share is calculated by dividing a. the number of common shares by net income. b. net income by the number of common shares. c. the number of preferred shares by net income. d. the number of common shares by the number of preferred shares. 99. The following ratio is required to be presented directly on the income statement. a. Current ratio b. Earnings per share c. Price-earnings ratio d. Return on common shareholders’ equity. 100. The price-earnings ratio measures a. the ratio of the market price of each share to the earnings per share. b. the ratio of the market price of each share to the total net income for the year. c. the ratio of the sales price to the net income. d. cash flow per share. 101. Juan’s Department Store’s net cash flows provided by operating activities were \$100,000 in 2002 and \$50,000 in 2001. Total cash flow was \$300,000 in 2001 and \$600,000 in 2002. Current liabilities at Dec. 31, 2001 were \$200,000 and at Dec. 31, 2002 were \$500,000. The cash current debt coverage ratio in 2002 is a. 0.20 : 1. b. 0.21 : 1. c. 0.29 : 1. d. 1.29 : 1. 102. A company’s net cash provided by operating activities divided by net sales is normally compared to a. earnings per share. b. the profit margin ratio. c. the cash current debt coverage ratio. d. the price-earnings ratio. 103. The cash total debt coverage ratio demonstrates a. the company’s ability to repay its liabilities from cash generated from all sources without having to liquidate assets.
• b. the company’s ability to repay its liabilities from cash generated from operating activities without having to liquidate assets. c. how fast the company collects cash. d. the company’s ability to meet interest payments. 104. 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. 105. Which of the following is not a limitation of financial statement analysis? a. The cost basis b. The use of estimates in accounting c. The diversification of firms d. The availability of information 106. 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. 107. 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. Answers to Multiple Choice Questions Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. 31. c 42. b 53. a 64. d 75. c 86. d 97. b 32. b 43. d 54. c 65. b 76. c 87. c 98. b 33. b 44. b 55. b 66. d 77. b 88. a 99. b 34. d 45. c 56. a 67. b 78. d 89. b 100. a 35. b 46. b 57. c 68. c 79. a 90. d 101. c 36. d 47. d 58. b 69. a 80. c 91. b 102. b 37. a 48. c 59. b 70. d 81. b 92. a 103. b 38. b 49. a 60. d 71. c 82. c 93. c 104. c 39. b 50. c 61. d 72. b 83. c 94. b 105. d 40. c 51. a 62. c 73. c 84. b 95. c 106. b 41. b 52. b 63. b 74. b 85. b 96. d 107. a