PRACTICE EXERCISES

T/f
1) An income statement reports a firm's cumulative revenues and expenses from the inception of the firm
through the income statement date.
False
2) Owners equity increases each period by the amount of the corporation's positive net cash flow.
False (only profit increases owner's equity not cash flow)

3) If two companies have the same revenues and operating expenses, their net incomes will still be
different if one company finances its assets with more debt and the other company with more equity.
True

4) Common-sized income statements are used to compare companies that have the same amount of
revenues.
False

5) Common-sized income statements restate the numbers in the income statement as a percentage of sales
to assist in the comparison of a firm's financial performance across time and with competitors.
True

6) Net profit margin is equal to the gross profit margin times the operating profit margin.
False

7) Earnings before taxes, or taxable income, is equal to operating income minus financing costs.
True

8) The more debt a company uses to finance its assets, the lower will be its operating income due to
higher interest expense.
False

9) Changes in depreciation expense do not affect operating income because depreciation is a non-cash
expense.
False

10) Earnings available to common shareholders represents income that may be reinvested in the firm or
distributed to its owners.
True

11) Financing activities have no impact on the income statement, but rather are reflected in changes in
long-term debt and short-term debt on the balance sheet.
False

12) Common stockholders' equity equals common stock issued minus treasury stock.
False

13) An income statement reports the firm's revenues and expenses for a specific period of time such as
one year.
True
14) When the present financial ratios of a firm are compared with similar ratios for another firm in the
same industry it is called trend analysis.
False

15) Theoretically, market values of assets are better for evaluating the creation of shareholder wealth than
accounting numbers, but accounting numbers are used because they are more readily available.
True

16) Financial ratios are often reported by industry or line of business because differences in the type of
business can make ratio comparisons uninformative or even misleading.
True

17) Financial ratios cannot be used to evaluate the creation of shareholder wealth because they are based
on accounting numbers that reflect historical cost and not current market values.
False

18) Common stockholders may use financial ratios to monitor manager actions to help lessen agency
problems.
True

19) Accounting information is used in financial ratio analysis because it is theoretically the best data to
guide financial decision-making.
False (bestcdata is market data)

20) Ratios of almost all companies are easily comparable because all public companies prepare their
financial reports based upon generally accepted accounting principles.
False

21) The basic format of an income statement is

A) Sales - Expenses = Profits.
B) Income - Expenses = EBIT.
C) Sales - Liabilities = Profits.
D) Assets - Liabilities = Profits.

22) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue's gross profit is equal to
A) $770,000.
B) $1,070,000.
C) $1,100,000.
D) $1,500,000.
(Gross profit = sales – cost of goods sold)

23) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue's operating income is equal to
A) $770,000.
B) $1,070,000.
C) $1,100,000.
D) $1,500,000.
[Operating income = (sales – cost of goods sold) – operating expenses]
(Operating expense is depreciation expense + administrative expense + marketing expense)

24) Financial analysis

A) uses historical financial statements and is thus useful only to assess past performance.
B) relies on generally accepted accounting principles to make comparisons between companies valid.
C) uses historical financial statements to measure a company's performance and in making financial
projections of future performance.
D) is accounting record-keeping using generally accepted accounting principles.

25) Common-sized balance sheets

A) show data for companies in the same industry.
B) show data for companies with approximately the same amount of assets.
C) show each balance sheet account as a percentage of total sales.
D) show each balance sheet account as a percentage of total assets.

26) Common-sized income statements

A) assist in the comparison of companies of different sizes.
B) show each income statement account as a percentage of total assets.
C) compare companies with the same level of total sales.
D) compare companies with the same level of net income.

27) In an ideal world, which of the following would be used to evaluate firm performance?
A) book value of assets
B) corporate retained earnings from the day of incorporation
C) accounting assets and profits
D) market value of assets

28) An analyst is evaluating two companies, A and B. Company A has a debt ratio of 50% and Company
B has a debt ratio of 25%. In his report, the analyst is concerned about Company B's debt level, but not
about Company A's debt level. Which of the following would best explain this position?
A) Company B has much higher operating income than Company A.
B) Company A has a lower times interest earned ratio and thus the analyst is not worried about the
amount of debt.
C) Company B has a higher operating return on assets than Company A, but Company A has a higher
return on equity than Company B.
D) Company B has more total assets than Company A.

28) Jones, Inc. has a current ratio equal to 1.40. Which of the following transactions will increase the
company's current ratio?
A) The company collects $500,000 of its accounts receivable.
B) The company sells $1 million of inventory on credit.
C) The company pays back $50,000 of its long-term debt.
D) The company writes a $30,000 check to pay off some existing accounts payable.
(Current ratio = current asset/current liabilities)
29) HighLev Incorporated borrows heavily and uses the leverage to boost its return on equity to 30% this
year, nearly 10% higher than the industry average. However, HighLev's stock price decreases relative to
its industry counterparts. How is this possible?
A) Markets are inefficient and fail to recognize the benefits of leverage.
B) The increased debt resulted in interest payments that made HighLev's operating income drop even
though return on equity increased.
C) Shareholders are not interested in return on equity.
D) The high levels of debt increased the riskiness of HighLev relative to its competitors.
30. Please refer to Table 4-1 for the following questions.

Table 4-1
Stewart Company
Balance Sheet
Assets:
Cash and marketable securities $600,000
Accounts receivable 900,000
Inventories 1,500,000
Prepaid expenses 75,000
Total current assets $3,075,000
Fixed assets 8,000,000
Less: accum. depr. (2,075,000)
Net fixed assets $5,925,000
Total assets $9,000,000

Liabilities:
Accounts payable $800,000
Notes payable 700,000
Accrued taxes 50,000
Total current liabilities $1,550,000
Long-term debt 2,500,000
Owner's equity (1 million shares
of common stock outstanding) 4,950,000
Total liabilities and owner's equity $9,000,000

Net sales (all credit) $10,000,000

Less: Cost of goods sold (3,000,000)
Selling and administrative
expense (2,000,000)
Depreciation expense (250,000)
Interest expense (200,000)
Earnings before taxes 4,550,000
Income taxes (1,820,000)
Net income $2,730,000

1) Based on the information in Table 4-1, the current ratio is (current ratio = current asset/current
 liabilities) 3075000/1550000=1.98:1

2) Based on the information in Table 4-1, the acid-test ratio is [Acid test ratio = (cash + account
receivable)/current liabilities] (600000 + 900000)/1550000 = 0.97

3) Based on the information in Table 4-1, the average collection period is [average collection period = no.
Of dayys in a year/account receivable turnover ratio] 365/11.1= 33 days

4) Based on the information in Table 4-1, the accounts receivable turnover is [account receivable turnover
ratio = net credit sales/account receivable] 10000000/900000 = 11.1 times

5) Based on the information in Table 4-1, the debt ratio is [debt ratio = total debt / total asset]
total debt = current liabilities + long term liabilities
(1550000+2500000)/9000000 = 0.45
6) Based on the information in Table 4-1, the OROA is [OROA = operating return on asset] [oroa =
operating profit/total asset]

[Operating profit = gross profit – operating expenses]

4750000/9000000=0.53 = 53%

7) Based on the information in Table 4-1, the times interest earned ratio is [time interest earned ratio =
operating profit/interest expense]
4750000/200000= 23.75times

8) Based on the information in Table 4-1, assuming that no preferred dividends were paid, the return on
common equity is
[Return on equity = net income/total equity]
2730000/4950000=0.55 = 55%

9) Based on the information in Table 4-1, the fixed asset turnover ratio is
[Fixed asset turnover = net sales / fixed asset]
10000000/5925000= 1.67

10) Based on the information in Table 4-1, the total asset turnover ratio is

[total asset turnover = net sales/total assets]

10000000/9000000=1.10

11) Based on the information in Table 4-1, the operating profit margin is
[Operating profit ratio= operating profit/sales]
4750000/10000000=0.48

12) Based on the information in Table 4-1, the inventory turnover ratio is
[Inventory turnover ratio= cost of goods sold/ inventory]
3000000/15000000=2.0
Theoretical Questions:

31) How does a firm use financial ratios? Who else might use financial ratios and why?

32) Why do differences in the accounting practices of firms limit the usefulness of financial ratios?

33) When comparing a firm to its peers, why is it difficult to determine the industry to which the firm
belongs? Why should you be careful when comparing a firm with industry norms?