CHAPTER 5—BASICS OF ANALYSIS, MULTIPLE CHOICE 5 Statements in which all items are expressed only in relative terms (percentages of a base) are termed: a. Vertical Statements b. Horizontal Statements ¢. Funds Statements d Common-Size Statements, ©. none of the answers are correct ANS: D In financial statement analysis. ratios are: the only type of analysis where industry data are available absolute numbers converted to a common base fractions usually expressed in percent or times the only indication of the financial position of the firm none of the answers are correct one ge ANS: ¢ Denver Dynamics has net income of $2,000,000. Oakland Enterprises has net income of $2,500,000. Which of the following best compares the profitability of Denver and Oakland? a. Oakland Enterprises is 25% more profitable than Denver Dynamics, b, Oakland Enterprises is more profitable than Denver Dynamics, but the comparison can be quantified. ¢. Oakland Enterprises is only more profitable if itis smaller than Denver Dynamics, Further information is needed for a reasonable comparison, ©. Oakland Enterprises is more profitable if tis a larger firm than Denver Dynamics. ANS: D Which of the following can offer a type of comparison in financial statement analysis? past ratios and figures, industry averages statistics of competitors all of the answers are correct none of the answers are correct one ge ANS: D Which of the following is not a source of industry statistics? Annual Statement Studies Mergent Dividend Record Valtic Line Standard and Poor's Industry Surveys The Department of Commerce Financial Report ANS: B pao ee10. Annual Statement Studies reported the following figures for manufacturers of screw machine products for the ratio of current assets to current debt. The following figures are for a particular industry's ‘current ratio: 1.6; 1.3: 1.2. Which best describes these three numbers? 8. One third of each of the companies experienced each of the ratios. b. The average ratio was 1,3. The best firm had 1.6; The worst had 1.2 c. The median was 1.3. 1.6 is the figure for the upper quartile: 1.2 is the figure for the lower quartile. 4d, The median was 1.3. 1.6 is the figure for the lower quartile: 1.2 is the figure for the upper quale e. None of the answers are correct. ANS: C A mannfacturing fim will most likely have the heaviest investment in which type of assets? cash inventory accounts receivable investments plant, property, and equipment pepse ANS: E A retailing firm has which type of inventory? raw materials work in process merchandise raw materials and merchandise raw materials, work in process, and merchandise parse ANS: © Which of the following would not be a user of financial statements? management bankers employee unions investment analysts all of the above are users peoee ANS: E Which of the following is a government document that provides industry statistics? The Wall Street Journal Business Week Dun's ‘The Department of Commerce Financial Report Standard and Poor's Industry Survey pees ANS: Du 1. Suppose you are comparing two firms in the steel industry. One firm is large and the other is sinall. Which type of numbers would be most meaningful for statement analysis? a Absolute numbers would be most meaningful for both the large and small firm. b. Absolute numbers would be most meaningful in the large firm: relative numbers would be most meaningful in the small firm, ¢. Relative mambers would be most meaningful for the large firm: absolute numbers would be most meaningful for the small firm. 4. Relative mumbers would be most meaningful for both the large and small firm, especially for interfirm comparisons. €._Itis not meaningful to compare a large firm with a small fim. ANS: D ‘Various techniques are used in the analysis of financial data to emphasize the comparative and relative ‘importance of the data presented and to evaluate the position of the firm. Which of the following is not ‘one of the techniques used in analysis? ratio analysis, common-size analysis theory consistency cxamination of rclative size among firms review of descriptive material parse ANS: © Liquidity ratios can be used: to measure the degree of protection of long-term suppliers of funds to measure borrowing capacity to measure the earning ability of a firm to measure the finm’s ability to meet its current obligations, to measure the worth of the firm peose ANS: D Which of these statements is false? a. A ratio can be computed from any pair of numbers, b, Given the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. ‘c. Comparing ratios computed from income statement and balance sheet numbers can create difficulties due to the timing of the financial statements, Financial ratios are usally expressed in percent or times. €. In vertical analysis, a figure from the year’s statement is compared with a base selected from the prior starement. ANS: E16. 17. 18. Which of these statements is false? a. Many companies will not clearly fit into any one industry. b, A financial service uses its best judement as to Which industry the firm best fits. c The analysis of an entity’s financial statements can be more meaningful if the results are compared with industry averages and with results of competitors. 4d. When using industry averages, itis often necessary to use an industry that the firm best fits. €. A company comparison should not be made with industry averages if the company does not clearly fit into any one industry. ANS: E Which of the following does not represent a problem with financial analysis? Financial statement analysis is an art: it requires judgment decisions on the part of the analyst Financial analysis can be used to detect apparent liquidity problems. ‘There are as many ratios for financial analysis as there are pairs of figures. ‘Some industry ratio formulas vary from source to source, Adequate detailed disclosure of how the industry ratios are computed is often lacking pars ANS: B ‘Which of the following isa false statement as it relates to analysis? a. Profitability may not be a major consideration as long as the resources for repayment can be projected. Equity capital provides creditors with a cushion against loss There is a difference between the objectives that are sought by short-term grantors of credit and those sought by long-term grantors of credit. 4. Imerchandise with a 20% markup is sold on credit, it would take ten successful sales of the same amount to make up for one sale not collected €. The financial structure of the entity is of interest to creditor. ANS: D ‘Management is a user of financial analysis. Which of the following comments does not representa fait statement as to the management perspective? ‘Management is interested in the view of investors. ‘Management is interested in the view of creditors. Management is interested in the financial structure of the entity Management is interested in the assct structure of the entity. Management is always interested in maximum profitability. parse ANS: E19. Which of the following statennents is incorrect? a. The North American Industry Classification System (NAICS) was created jointly by the United States, Canada, and Mexico. b. For the NAICS. economic units with similar production processes are classified in the same industry, and the lines drawn between industries demarcate differences in production processes NAICS provides enhanced industry comparability among the three NAFTA trading partners. 4. NAICS divides the economy into twenty sectors. € Inmost sectors, NAICS provides for compatibility at the industry (six-digit) level ANS: E TRUE/FALSE 1. Liquidity ratios measure the degree of protection of long-term suppliers of funds. ANS: F 2. A given ratio is always computed the same way, no matter what the source. ANS: F 3. The ideal way to compare income statement figures, such as sales, to balance sheet figures, such as receivables, is to use a measure of the average for the balance sheet figures. ANS: T 4, In vertical common-size analysis, the dollar figure for an account is expressed in terms of that same account figure for a selected base year: ANS: F 5. Absolute figures usually have more meaning than ratio comparisons. ANS: F 6. In order to determine the meaning of a ratio, some kind of comparison, stich as an industry average ot ‘tend analysis, is helpful. ANS: T 7. Different accounting methods can cause some ratios to differ substantially ANS: T 8. Dissimilar year ends will have no impact on the results of ratios. ANS: F10. uL. 12. 14, 16. 1s 19. ‘The principal asset of a merchandising firm will usually be accounts receivable. ANS: F A service firm will usually have a low amount of inventory, consisting primarily of supplies. ANS: T Typically, the largest expense to a manufacturing firm is cost of goods sold. ANS: T ‘The descriptive information in annual reports is not useful in statement analysis: only the financial statements themselves are of value. ANS: F Based on the terms of the credit and the purpose, the objectives of financial statement analysis by creditors will vary. ANS: T Financial statement analysis isa judgmental process, ANS: T ‘There is a standard list of ratios. ANS: F ‘Common-size analysis involves expressing comparisons in percentages ANS: T Absolute figures and ratios are close to being meaningless unless compared to another figure. ANS: T When performing year-to-year change analysis, a meaningful percent change cannot be computed ‘when one number is positive and the other number is negative. ANS: T For NAICS, each country can add additional detailed industties, provided the additional detail aggregates to the NAICS level ANS: TPROBLEMS ‘Comparative income statements for 2010 and 2009 follow. Sales $8,434,000 Cost of Sales, 7,075, 400 Gross Profit 52,388, 600 ‘Operating Expenses ‘Operating Income Interest Expense 157, Earnings Before Tax. 5 833,410 Income Taxes 400,000 Net Income 433, 410 Required’ a Prepare a vertical common-size analysis of this statement for each year, using sales as the base. b, Comment briefly on the changes between the two years, based on the vertical common-size statement. ANS: a Sales Cost of Sales Gross Profit ‘Operating Expenses Operating Income Interest Expense Earnings Before Tax Income Taxes Net Income 1b. Cost of sales as a percent of sales have risen substantially. This increase is nearly offset by a decline in operating expense, Interest expense and taxes have both risen slightly in relation to sales, Toledo Toy, a manufacturer of infants’ blocks, presented the following data in its last annual report. This tend analysis begins with the year of formation, 2007. 2010 2009 Sales $61,000 $41, 00% Cost of Sales $41,300 $28,175 Net Income $9,919 $6,412 Cases of Blocks Shipped 33,126 22,661 Required: a Using 2007 as the base year. perform a horizontal, common-size analysis b, Comment on the results of the horizontal analysis 7ANS: a 2010 2009 2008 Sales 469.2 315.4 192.3 Cost of Sales 191.2 Net Income 496.0 192.5 ‘Cases of Blocks Shipped 4a7.6 187.8 b. Sales have risen rapidly. The cost of sales have risen more slowly than sales. Also, there has been a nmich faster rise in net income than in sales. The cases of blocks shipped have increased more stowly than sales dollars, indicating a rise in selling price or an improved mix of sales towards more expensive blocks. The following are simplified, vertical, common-size balance sheets for three firms—a retailer, a service firm, and a manufacturer Assets Firm A Fim B Firm C Cash, els eas Receivables 23.2 44 Inventory Bit 1s Total Curent Assets 60.4 14.0 Plant. Property. and Equipment (net) 30.3 83.4 Tnvestiments 9.3 2.6 Total Assets 100.08 100.08 Liabilities and Stockholders! Equity Total Current Liabilities 28.38 11.58 Long-Term Debt 18.1 24.8 37.8 Total Stockholders’ Equity 63.7 40.6 Total Liabilities and Stockholders’ Equity 100.08 100.08 100.08 ‘Required: Match the statements to the type of firm and explain your choice. ANS: Firm A is the retailing firm, due to the heavy investment in receivables and inventory with limited fixed assets, The store facilities may be rented. Firm B is the service firm, due to the limited inventory. Firm C is the manufacturing firm, due to the combined heavy investment in inventory and fixed assets. Also, it uses substantial long-term debta. Listed below are three groupings of financial ratios Liquidity Long-term borrowing ability Profitability Required: Briefly describe what each one measures, b. Listed below are three groups of users of financial statements, Suppliers of raw materials, Potential stockholders Bondholders Required: For each group, select the type of ratios from part (a) that each group might be most interested in, Briefly explain your choice, ANS: a. Liquidity ratios measure the finn’ ability to pay its current obligations. Long-term borrowing ability measures the degree of protection of long-term suppliers of finds. Profitability ratios measure the earning ability of the firm. b. Suppliers of raw materials would be most interested in liquidity since their goods and related, obligations are primarily short-term. Potential stockholders would be most interested in the earning ability of the firm since they share in residual profits. Bondholders would be most interested in the long-term borrowing capacity since this, measures the risk of default