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Chapter 14

Terms in this set (105)

Classified Financial Statements
Financial statements in which similar items are arranged in groups and subtotals are shown to assist users in analyzing the statements

Example of classified financial statements is a balance sheet that separates assets and liabilities into current and noncurrent categories.
Comparative financial statements
financial statements of one company for 2 or more years presented in a side by side basis for comparison
4 widely used analytical tools are:

1. dollar and percentage change
2. trend percentages
3. component percentages
4. ratios
...
Dollar and percentage change
The amount of change is significant, and expressing that change in percentage terms adds perspective. The dollar of any change is the difference between the amount for a comparison year and the amount for a base year.

Percentage change = dividing the amount the of dollar change between years by the amount of the previous year.

If the first year is negative or absent, the percentage change can not be computed.

In measuring the dollar or percentage change in quarterly sales or earnings, it is customary to compar the result of the current quarter with those of the same quarter the previous year.
Trend percentages
Trend percentages are the changes in financial statment items from a base year to following year. Trend percentages show the extent and direction of change.

2 steps are necessary to compute trend percentages:

1. a base year is selected and each item in the financial statements for the base year is given a weight of 100 percent.

2. The second step is to express each item in ht efinancial statement for following years as a percentage of its base year amount.
component percentage
component percentages indicate the relative size of each item included in a total.
ratios
A mathmatical expression of the relationship of one item to another.
horizontal analysis
comparing financial information for a current period with similar information for prior years information .

limitation of horizontal analysis: may be overcome to some extent by finding appropriate
liquiidty
refers to the company's ability to meet its continuing obligations as they come due.
Classified Balance Sheet
Assets are presented in 3 groups:
1. Current Assets
2. Plant and equipment
3. other assets

Liabilitities are classifed into 2 categories
1. Current Liabilities
2. Long term or noncurrent liabilities
Operating Cycle
Current assets are tied to an enterpris'es operating cycle. Most companies has several operating cycles per
Current Liabilities
existing obligations that are expected to be paid by using the enterprise's current assets. (Example: notes payable due within a year. accounts payamage, unearned revenue, and accrued expense such as income tax payable, salaries payable and interest payable.)
working capital
working capital is the the excess of current asset over current liabilities
current ratio
current ratio = current assets / total current liabiliities
Quick ratio
quick ratio =

quick ratio compares only the most liquid current assets (quick assets) with current liabilities

quick assets( cash, marketable securities and receivables) / current liabiliites

quick ratio is a measure of short term liquidity
Debt Ratio
Debt Ratio = total liabilities/ total assets

Not a measure of short term liquidity, rather a measure of creditor's long term risk.
differences among industries
Retailers tend to have higher current ratios than do wholesaler .

Service industices which have no inventory generally have lower current ratios than manufacturing companies.
Window Dressing
Management may enter a year end transactions that temporarily improve key ratios. - called window dressing
Multi step income statement
draws its name from the series of steps in which costs and expenses are deducted from revenue and other non-operating items are incorporated into the income statement.

income statement divided into 4 sections:
1. Revenue
2. Cost of goods sold
3. operating expenses
4. nonoperating items
Operating Income
income from operations.
Net Income as a percentage of net sales
net income as a percentage of net sales =

net income / net sales
Earnings per share
Earnings per share =

net income / shares of capital stock outstanding.
Price - earnings ratio
Price - earnings ratio =

current market price per share of stock /
Earnings per share

p/e ratio reflects investor's expectatationa concerning the company's future performance.

a p/e ratio of 10 or less often dicates that investor expect earnings to decline
Single step income statements
The single step form of income statement takes its name from the fact that all costs and expenses are deducted from total revenue in a single step.
Investors usually consider two factors in evaluating a company's profitability:

1. The trend in earnings
2. the amount of current earnings in relation to the amount of the resources needed to produce the earnings.
...
Return of Investment (ROI)
Return of Investment (ROI) =

Return / average amount invested
Return on Assets
Return on Assets (ROA) =

Operating Income/ Average total Assets

Most successful busines have a a ROA of 10 percent or more.
Return on Equity (ROE)
Return on Equity (ROE) =

Net Income / Average Total Stockholder's Equity


measures efficency with which managment has tilized the assets under its control.

Average annual rture of 12 percent or more is good. 3
A company's current market price is $12 per share. Other items of key information from its financial statements include gross profit of $100,000; net income of $40,000; and earnings per share of $1.50. What is the company's price - earnings ratio?

A. 3.3
B. 8
C. 8.3
D. 12.5
Answer: B - 8

Price - earnings ratio

$12 / $1.50 = 8
The figure resulting from the division of net income by the number of shares of common stock outstanding is called
Earnings per share-
Financial Statements that present multi-year information side by side columns are called
Comparative financial statements
A company had sales of $10,000 in Year 1 and $13,500 in Year 2. What was the percentage increase?

A. 0
B. 17.5%
C. 35%
D. 25.9%
Answer:

C. 35%
(13,500 - $10,000) / $10,000 = 35%
Quality of earnings is a term used to describe

A. the accuracy of a company's accounting records
B. Whether a company uses the same accounting principles from one period to the next.
C. the frequency with which a company changes from one accounting method to another
D. The impact on earnings and assets of the accounting methods selected by a company
Answer:

D. The impact on earnings and assets of accounting methods selected by a company.
Primary factors in evaluating the quality of working capital include:

A. The nature of the current assets
B. earnings per share
C. the length of a company's operating cycle
D. the interest coverage ratio.
Answers: A and C

A. the nature of the current assets
C. the length of a company's operating cycle
A company had operating expenses of $400,000 in year 1 and $450,000 in year 2. Its net sales in these years were $900,000 in Year 1 and $1.1 million in Year 2. Which of the following best describes the trend in operating expense compared to sales?

A. Increased by $50,000
B. flat - there was no significant change
C. Increased from 40.9% to 44.4%
D. Decreased from 44.4% to 40.9%
Answer:

D. Decrease from 44.4% to 40.9%

Year 1: $400,000/$900,000 = 44.4%
Year 2: $450,000/$1,100,000 = 40.9%
Judging the impact on earnings of the specific accounting method a company chooses is sometimes referred to as the ________________ of earnings
Answer: Quality (of earnings)
The balance sheet ratio that measures liquidity by excluding inventory as an asset is called the ___________ ratio
Answer: quick ratio.
A company had operating income (income before taxes and interest) of $200,000 and net income of $185,000. Annual interest expense was $50,000. The interest coverage ratio was _____________ times?
Answer: 4 times

$200,000/ $50,000 = 4 times
The section of a company's statement of cash flows that is most directly related to its ability to produce a continuing, dependable cash flow for ongoing activities is the:

A. Operating activities section
B. Financing activities section
C. Investing activities section
D. Reconcilliation of the beginning and ending of cash balances
Answer:

A. Operating activities section
Which of the following are measures of different levels of profitability
A. Operating income
B. Net Income
C. Gross Profit
D. Current Ratio
Answer:

A. Operating Income
B. Net Income
C. Gross Profit
D. Current ratio
Factors helpful in judging the quality of working capital include all of the following, except:

A. Inventory turnover
B. The dividend yield
C. The length of the operating cycle
D. Accounts Receivable turnover
Answer:

B. The dividend yield

( the dividend yield while important to common stockholder is not directly related to the quality of working capital)
The income statement format that groups all revenues together, less all expenses grouped together with no intermediate subtotals in arriving at a net income amount is the ______________ step income statement
Answer:

Single step income statement
Which of the following is / are included in calculating the quick ratio?

A. Accounts payable
B. Cash
C. Inventories
D. Accounts Receivable
E. Retained Earnings
Answer: A,B, and C

Quick ratio includes the following:

A. Accounts Payable (numerator)
B. Cash (numerator)
C. Accounts receivable (denominator)
Which of the following best describes the meaning of leverage?

A. Earning more on debt than the cost of debt, enhancing the investment of preferred stockholders.

B. Earning more on debt than the cost of debt, enhancing the investment of common stockholders

C. Paying a higher return to bondholders than dividends on common stock
Answer:

B. Earning more on debt than the cost of debt, enhancing the investment of common stockholders.
Reconciling a company's net income to its net cash from operting activities includes subtractions for which of the following?

A. a decrease in prepaid expense

B. a decrease in accrued liabilities

C. Depreciation Expenses

D. An increase in accounts receivable
Answer:

B and D

B. A decrease in accrued liabilities
D. An increase in account receivable

( prepaid expenses and depreciation expense is an addition in calculating net cash from operations
A company has net income of $500,000. Included in that amount are interest expense of $35,000 and income taxes of $150,000. What is the interest coverage ratio, rounded to the nearest whole number?

A. 19 times
B. 20 times
C. 15 times
D. 14 times
Answer: B. 20 times

($500,000 +$35,000 +$150,000)/ $35,000 = 19.57 times
Changes in company's revenues, expenses, operating income and net income and net income are referred to as ________________ in earnings
Answer: Trends in earnings
Primary factors in evaluating the quality of working capital include:

A. the nature of the current assets
B. the length of a company's operating cycle
C. The interest coverage ratio
D. Earnings per share
Answer: A and B

A. The nature of the current asset
B. The length of a company's operating cycle
The return on ___________________ is a broad measure of profitability of a company based on the total investment in the company.
Answer: Assets (Return on Assets)
Gross profit minus operating expense is called

A. Operating Profit
B. Income tax expense
C. Net Income
Answer: A. Operating Profit
The subtotal that follows operating expense in multiple step income statement is called

A. Operating Income
B. Net Income
C. Gross Profit
Answer:

A. Operating Income
The length of time required to invest cash in inventory, sell the inventory, and collect the receivable is referred to as the company's ________________________.
Answer: Operating Cycle
The balance sheet ratio that measures liquidity by excluding inventory as an asset is called the ____________ ratio
Answer: Quick (ratio)
The difference between net sales and the cost of goods sold is called

A. Gross Profit
B. Operating Income
C. Earnings per share
D. Net Income
Answer:
A. Gross Profit
A company had an accounts receivable turnover rate of 5 times and an inventory turnover rate of 10 times. How many days are in the company's operating cycle, rounded to the nearest whole day?

A. 15 days
B. 37 days
C. 110 days
D. 73 days
Answer:

C. 110 days
(365/5) + (365/10) = 109.5 days
Which of the following are measures of different levels of profitability

A. Gross Profit
B. Net Income
C. Current Ratio
D. Operating Income
Answers: A, B, and D

A. Gross Profit
B. Net Income
D. Operating Income
Which of the following is NOT a section you would find in a classified income statement

A. Net Income
B. Revenue
C. Cost of Goods Sold
D. Operating Expenses
E. Current Assets
F. Non-operating items
Answer: E. Current Assets
Which of the following would you expect to find in notes to a company's financial statements?

A. Significant commitments and contingencies
B. Assets pledged to secure specific liabilities
C. detailed item-by-item amounts in a company's inventory
D. Accounting policies and methods used in the financial statements
Answer:

A, B, and D

A. Significant commitments and contingencies
B. Assets pledged to secure specific liabilities
D. Accounting policies and methods used in the financial statements
The income statement format that groups all revenues together, less all expenses grouped together, with no intermediate subtotals in arriving at a net income amount is the ________________ step income statement
Answer: Single (step income statement)
The efficient use of debt to earn a return for common stockholder's equity is called __________________ .
Answer: Leverage
Reconciling a company's net income to its net cash from operating activities include subtractions for which of the following?

A. a decrease in prepaid expenses
B. a decrease in accrued liabiliities
C. depreciation expense
D. an increase in accounts receivable
Answer: B and D

B. a decrease in accrued liabilities
D. An increase in accounts receivable
Which of the following are NOT considered in calculating the amount of a company's working capital?

A. bonds payable
B. wages payable
C. Inventories
D. capital stock
E. retained earnings
Answers: A, D, E

A. bonds payable
D. Capital Stocka
E. Retained Earnings
A company's assets include cash of $6,000; accounts receivable of $10,000; inventories of $56,000; and plant assets of $28,000, totaling $100,000. Its liabilities include accounts payable of $25,000 and bonds payable of $45,000 totaling $70,000. Its stockholder's Equity includes $10,000 of capital stock and $20,000 of retained earnings, totaling $30,000. What is the company's current ratio?

A. 1.03
B. 3.68
C. 2.88
Answer:
($6,000 +$10,000 + $56,000) / $25,000 = 2.88
If a business fails, the claims of the ________________ exceed those of the owners
Answer: Creditors
Reconciling a company's net income to its net cash from operating activities includes

a. depreciation expense
b. an increase in accounts payable
c. an increase in short term notes payable
d. an increase in accounts payable
Answers: A,B,C

A. depreciation expense
B. an increase in accounts payable
C. An increase in short term notes payable
True or false: Annual reports of companies are made available only to that company's creditors and stockholders

True or False
False
A company has sales revenue of $100,000; cost of goods sold of $40,000; operating expense of $30,000; and non-operating expense of $5,000. What is the amount of gross profit?

A. $30,000
B. $60,000
C. $25,000
D. $100,000
Answer:

B. $60,000

$100,000 - $40,000 = $60,000
An income statement that includes subtotals of profitability at intermediate steps is called a(n) _____________ income statement.
Answer: Multi-step (income statement)
A company has cash of $4,000; accounts receivable of $16,000; accounts payable of $5,000; and bonds payable of $12,000. What is the amount of the company's working capital?

A. $4,000
B. $3,000
C. $20,000
D. $15,000
answer:

D. $15,000
$4,000 + $16,000 - $5,000 = $15,000
The calcuation of the current ratio includes all of the following in the numerator except:

A. cash
B. accounts receivable
C. Retained Earnings
D. Equipment
Answer: C and D

C. Retained Earnings
D. Equipment
The return on ______________ is a broad measure of profitability of a company based on the total investment in a company
Answer: Assets (return on assets)
Which of the following is/are correct about the annual reports of companies?

A. They are limited to the company's balance sheet, income statement and statement of cash flows

B. They often include multi-year summaries of comparative information about the company.

C. They are available only to the company's stockholders as of the date the financial statement's become available.

D. They include management's own discussion and analysis of important aspects of the company.
Answer: B and D

B. They often include multi-year summaries of comparative information about the company.

D. They include management's own discussion and analysis of important aspects of the company.
0
The length of time required to invest cash in inventory, sell the inventory, and collect the receivables is referred to as the company's _______________________________ .
Answer: Operating Cycle
Which of the following subtotals would you expect to find in a classified income statement?

A. Net Income
B. Operating Income
C. Gross Profit
D. Total Current Assets
Answer: A, B, C

A. Net Income
B. Operating Income
C. Gross Profit
Gross profit minus operating expenses is called:

A. operating profit
B. Net Income
C. Income tax expense
Answer:

A. Operating Profit
A company has cash of $20,000; accounts receivable of $45,000; inventory of $60,000; plant assets (net of depreciation) of $100,000; and accounts payable of $55,000. The amount of the company's working capital is ______________ .
Answer: $70,000
A company had operating income of $250,000 and net income of $300,000 for a yer in which its total stockholder's equity was $800,000 at the beginning of the year and increased to $950,000 from the sale of additional capital stock during the year. What was the amount of the company's return on equity for the year, rounded to the nearest whole percentage?

A. 26%
B. 34%
C. 29%
D. 32%
Answer:

B. 34%
$300,000 / (($800,000 + $950,000)/2) = 34%
A company had sales of $900,000 and a cost of goods sold of $700,000 for the year. Its beginning inventory was $150,000 and its ending inventory was $130,000. What was the company's inventory turnover rate?

A. 4.7 times
B. 5.4 times
C. 5 times
D. 6.4 times
Answer:

C. 5 times

$700,000 / (( $150,000 + $130,000)/2) = 5 times
Which of the following is / are particularly relevant to a company's common stockholders if they are interested in receiving regular cash income

A. Dividend yield
B. Earnings per share
C. Return on assets
D. Price - earnings ratio
Answer:

A. Dividend yield
B. Earnings per share
D. Price - earning ratio
A statement of financial position or balance sheet, that groups similar items together is called

A. a consolidated statement
B. a classified statement
C. a comparative statement
Answer:

B. a classified statement
The financial statement ratio that measures how rapidly accounts receivable are collected is called the ______________________
Answer:

Accounts Receivable Turnover rate
Which of the following is / are correct about the debt ratio?

A. Debt ratios of companies vary by industry
B. It is a measure of short -term liquidity
C. The lower the debt ratio, the safer the position of creditors
Answer:

A. Debt ratios of companies vary by industry
C. The lower the debt ratio, the safer the position of creditors.
A widely used measure of liquidity that includes all current assets is referred to as the _______________ ratio
Current (ratio)
The ability of a company to meet its continuing obligations is referred to as _________________.
Liquidity
Reconciling a company's net income to its net cash from operating activities include additions for which of the following?

A. an increase in accounts payable
B. an increase in accounts receivable
C. an increase in short term notes payable
D. Depreciation expense
Answer: A, C, D

A. an increase in accounts payable
C. an increase in short term notes payable
D. depreciation expense.
Comparing amounts for a company over time in successive accounting periods is called

A. industry analysis
B. horizontal analysis
C. vertical analysis
Answer:

Horizontal Analysis
The relationship of one number to another related number is called a _________________ .
Ratio
A company had sales of $90,000 in Year 1 , the base year; $95,000 in Year 2; and $78,000 in Year 3. What is the trend percentage for Year 3? Round the answer to two decimal places?

A. 86.7%
B. 82%
C. 106%
Answer:

A. 86.7%

$78,000 / $90,000 = 86.7%
Consolidated financial statement present which of the following?

A. Information about parent companies only
B. Combined financial statement of parent and subsidiary companies
C. Information that places items with similar characteristics together
D. Multiple years in side-by-side columns
Answer:

B. Combined financial statements of parent and subsidiary companies
The most common approaches used for financial analysis compare information about a company in a single accounting period with

A. Information about the same company in different accounting periods
B. Information about other companies in the same industry
C. Information about other companies in the same geographic area
Answer:

A. Information about the same company in different accountiing periods.

B. Information about other companies in the same industry.0
True of false: Ratios compare only amounts within a single financial statement, such as an income statement or statement of financial position (balance sheet)

A. True
B. False
Answer:

False
A company has total assets of $1.5 million; sales of $4 million and plant and equipment , net of depreciation of $300,000. What is the component percentage for plant and equipment.

A. 20%
B. 7.5%
C. 500%
Answer:

A. 20%

$300,000 / $1,500,000 = 20%
The basis or denominator for calculating a trend percentage is:

A. a base year amount
B. the average of the previous two years' amount
C. The previous year amount
Answer:

A. a base year amount
A company had sales of $10,000 in Year 1 and $13,500 in Year 2 . What was the percentage increase?

A. 0
B. 17.5%
C. 35%
D. 25.9%
Answer:

C. 35%
($13,500 - $10,000) / $10,000 = 35%
Financial statements that present multiyear information in a side by side columns are called __________________________ financial statements.
Answer: comparative (financial statements)
The figure resulting from the division of net income by the number of shares of common stock outstanding is called ____________________.
Answer:

Earnings per share
A company's current market price is $12 per share. Other items of key information from its financial statements include gross proft of $100,000; net income of $40,000; and earnings per share of $1.50. What is the company's price - earnings ratio?

A. 3.3
B. 8
C. 8.3
D. 12.5
Answer:

B. 8
$12 / $1.50 = 8
Learning Objective 1

Explain the uses of dollar and percentage changes, trend percentages, component percentages, and ratios.
. An important aspect of financial statement analysis is determining relevant relationships among specific items of information. Companies typically present financial information for more than one time period, which permits users of the information to make comparisons that help them understand changes over time. Dollar and percentage changes and trend percentages are tools for comparing information from successive time periods. Component percentages and ratios, on the other hand, are tools for establishing relationships and making comparisons within an accounting period. Both types of comparisons are important in understanding an enterprise's financial position, results of operations, and cash flows.
Learning Objective 2

Discuss the quality of a company's earnings, assets, and working capital.
. Assessing the quality of information is an important aspect of financial statement analysis. Enterprises have some latitude in the selection of financial reporting methods within generally accepted accounting principles. Assessing the quality of a company's earnings, assets, and working capital is done by evaluating the accounting methods selected for use in preparing financial statements. Management's choice of accounting principles and methods that are in the best long-term interests of the company, even though they may currently result in lower net income, reported total assets, or working capital, leads to a conclusion of high quality in reported accounting information.
Learning Objective 3

Explain the nature and purpose of classifications in financial statements.
In classified financial statements, items with certain common characteristics are placed together in a group, or classification. The purpose of these classifications is to develop subtotals that will assist users in analyzing the financial statements.
Learning Objective 4

Prepare a classified balance sheet and compute widely used measures of liquidity and credit risk.
. In a classified balance sheet, assets are subdivided into the categories of current assets, plant and equipment, and other assets. Liabilities are classified either as current or long term.
Learning Objective 5

Prepare a multiple-step and a single-step income statement and compute widely used measures of profitability.
. In a multiple-step income statement, cost of goods sold is deducted from net sales to provide the subtotal, gross profit. Operating expenses then are deducted to arrive at income from operations. As a final step, nonoperating items are added together and subtracted from income from operations to arrive at net income. In a single-step income statement, all revenue items are listed first, and then all expenses are combined and deducted from total revenue.
Learning Objective 6

Put a company's net income into perspective by relating it to sales, assets, and stockholders' equity.
. Financial accounting information is most useful if viewed in comparison with other relevant information. Net income is an important measure of the financial success of an enterprise. To make the amount of net income even more useful than if it were viewed simply in isolation, it is often compared with the sales from which net income results, the assets used to generate the income, and the amount of stockholders' equity invested by owners to earn the net income.
Learning Objective 7

Compute the ratios widely used in financial statement analysis and explain the significance of each.
Ratios are mathematical calculations that compare one financial statement item with another financial statement item. The two items may come from the same financial statement, such as the current ratio, which compares the amount of current assets with the amount of current liabilities, both of which appear in the statement of financial position (balance sheet). On the other hand, the elements of some ratios come from different financial statements, such as the return on stockholders' equity, which compares net income from the income statement with the amount of stockholders' equity from the statement of financial position (balance sheet). Accountants and financial analysts have developed many ratios that place information from a company's financial statements in a context to permit better understanding to support decision making.
Learning Objective 8

Analyze financial statements from the viewpoints of common stockholders, creditors, and others.
Different groups of users of financial statements are interested in different aspects of a company's financial activities. Short-term creditors are interested primarily in the company's ability to make cash payments in the short term; they focus their attention on operating cash flows and current assets and liabilities. Long-term creditors, on the other hand, are more interested in the company's long-term ability to pay interest and principal and would not limit their analysis to the company's ability to make cash payments in the immediate future. The focus of common stockholders can vary from one investor to another, but generally stockholders are interested in the company's ability to pay dividends and increase the market value of the stock of the company. Each group may focus on different information in the financial statements to meet its unique objectives.
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