Financial Accounting, 10e (Libby)
Chapter 13 Analyzing Financial Statements
1) Financial analysis is a mechanical and mathematical process of evaluating information
reported in financial statements.
2) Return on equity (ROE) by the DuPont model is a function of three ratios: net profit margin,
return on assets, and financial leverage.
3) Return on equity (ROE) by the Du Pont model provides insight with respect to a company’s
use of its assets.
4) Time-series analysis is a comparison of information for a specific company over a period of
time to determine changes in operations.
5) Finding comparable companies in order to compare performance is often difficult since no
two companies have identical products, markets, and operating strategies.
6) Finding comparable companies in order to compare performance is important because ratios
in isolation are difficult to evaluate.
7) Component percentages are used to express items on financial statements as a percentage of a
single base amount.
8) With component percentages, the numerator comes from the income statement and the
denominator comes from the balance sheet.
9) Purchasing treasury stock increases the return on equity ratio.
10) The return on assets ratio is influenced significantly by a company’s relative debt and equity
financing of its assets.
11) Both the gross profit percentage and the net profit margin use net sales revenue in the
denominator.
12) The extent to which a company uses its liabilities to leverage up its return to stockholders is
measured by the difference between ROE and ROA.
13) Earnings per share (EPS) is affected by treasury stock transactions.
14) The quality of income ratio increases when net income increases.
15) The net profit margin ratio considers the asset base utilized to earn income.
16) The fixed asset turnover ratio increases when net income increases.
17) The cash ratio measures how much cash is on hand to cover current liabilities.
18) The fixed asset turnover ratio measures a company’s ability to use its property, plant, and
equipment to generate revenues.
19) When comparing a fixed asset turnover ratio to a total asset turnover ratio, a company with a
high amount of inventory will have a much lower fixed asset turnover ratio than total asset
turnover ratio.
20) A higher current ratio is preferable for companies that do not have predictable cash flows.
21) The quick ratio decreases when the adjusting entry to record bad debt expense is recorded.
22) A very high current ratio and a low quick ratio may indicate the company is not collecting its
accounts receivable in a timely manner.
23) The inventory turnover ratio is significantly affected by the choice of inventory accounting
method.
24) The cash coverage ratio measures a firm’s ability to pay its current liabilities with its cash
flows from operating activities.
25) The price/earnings ratio is affected by the amount of risk that investors are willing to take.
26) Equity capital is considered less risky because dividend payments are always at the
company’s discretion and are not legally enforceable until declared.
27) The dividend yield ratio decreases when earnings per share increases.
28) If an investor is considering two different companies as an investment, the investor should
choose to invest with the company that has the highest net profit margin.
29) Dividend yield is calculated by dividing dividends per share by earnings per share and
measures the current dividend return to investors.
30) A high price/earnings ratio usually indicates the market is optimistic about the company’s
future earnings potential.
31) Which of the following ratios is not part of the DuPont model?
A) Total asset turnover.
B) Debt-to-equity.
C) Net profit margin.
D) Return on equity.
32) When considering an investment, which of the following is not one of the three critical
factors used to evaluate future earnings potential of that investment?
A) Global event factors.
B) Economy-wide factors.
C) Industry factors.
D) Individual company factors.
33) Which of the following statements is incorrect about fundamental business strategies?
A) A company implementing a cost differentiation strategy is attempting to increase operating
efficiency of assets and improve the inventory turnover ratio.
B) A company implementing a product differentiation strategy is attempting to improve its net
profit margin through charging higher prices.
C) A company will be more profitable because it will attract a higher volume of customers and
sales revenue when it follows a product differentiation strategy versus a cost differentiation
strategy.
D) In general, a cost differentiation strategy results in lower profit margins whereas a product
differentiation strategy results in higher profit margins.
34) Which of the following ratios will not increase when net income increases?
A) Gross profit percentage.
B) Return on assets.
C) Return on equity.
D) Net profit margin.
35) Which of the following statements is incorrect?
A) Purchasing fixed assets through equity financing decreases total asset turnover.
B) Accruing an expense decreases earnings per share.
C) The return on equity ratio increases when treasury stock is purchased.
D) The purchase of fixed assets will cause the total asset turnover to increase.
36) Which of the following statements is correct?
A) Selling inventory at its cost does not affect the net profit margin ratio.
B) Accruing sales revenue does not affect the net profit margin ratio.
C) The total asset turnover ratio increases when fixed assets are sold at a loss.
D) The net profit margin ratio decreases when common stock is issued.
37) Home Depot’s operating strategy is to offer a broad assortment of high-quality merchandise
and services at competitive prices using highly knowledgeable service-oriented personnel and
aggressive advertising. Which of the following is not as critical to achieving Home Depot’s
strategy?
A) Cost control
B) Product differentiation
C) High level of customer service
D) High sales volume
38) Which of the following statements is false?
A) When computing the component percentages for the income statement, net income is the base
figure.
B) Time-series analysis examines a company’s performance over time.
C) It is often useful to compare a company’s performance with that of a competitor.
D) The North American Industry Classification System assigns industry codes based on business
operations.
39) Which of the following statements is correct?
A) A ratio calculation is most relevant in isolation.
B) One of the advantages of ratio analysis is that it allows companies of different sizes to be
compared.
C) Finding benchmarks for comparison is a straightforward task.
D) It is always preferable to compare a company’s performance to industry-wide ratios rather
than to use a competitor’s ratios.
40) The base amount in preparing component percentages for an income statement is usually
which of the following?
A) Income from operations.
B) Gross profit.
C) Net income.
D) Net sales.
41) Which of the following statements is correct?
A) When cost of goods sold as a percentage of sales increases, the gross profit percentage will
increase.
B) It is possible that when cost of goods sold in dollars increases, cost of goods sold as a
percentage of sales decreases.
C) If gross profit percentage is the same for the current and past year, then sales and cost of
goods sold in dollars did not change.
D) If gross profit percentage increases from one year to the next, then the net income percentage
will also increase from one year to the next.
42) Which of the following statements is incorrect?
A) If selling and administrative expenses as a percentage of sales increases, then gross profit
percentage will decrease.
B) If the cost of goods sold percentage decreases and other expenses do not change, then net
profit margin will increase as a percentage of sales.
C) If sales dollars decrease, a company might still report a higher gross profit percentage if cost
of goods sold decreases at a faster rate than the decrease in sales.
D) It is possible that when selling and administrative expense in dollars decrease, selling and
administrative expenses as a percentage of sales will increase.
43) During 2019, Home Style’s cost of goods sold percentage was 68.2%, and selling and store
operating costs were 19.3% of sales. During 2018, Home Style’s cost of goods sold percentage
was 70.1% while selling and store operating costs were 19.0% of sales. What effect would the
change in these percentages have on 2019’s gross profit percentage and net profit margin
percentage?
A) The decrease in the cost of goods sold percentage would increase both the gross profit and net
profit margin percentages, but the increase in the selling and store operating costs percentage
would decrease both the gross profit and net profit margin percentages.
B) The decrease in the cost of goods sold percentage would decrease both the gross profit and
net profit margin percentages, but the increase in the selling and store operating costs percentage
would increase both the gross profit and net profit margin percentages.
C) The decrease in the cost of goods sold percentage would increase both the gross profit and net
profit margin percentages, but the increase in the selling and store operating costs percentage
would decrease only the net profit margin percentage.
D) The decrease in the cost of goods sold percentage would decrease both the gross profit and
net profit margin percentages, but the increase in the selling and store operating costs percentage
would increase only the net profit margin percentage.
44) Which of the following ratios is not considered to be a test of profitability?
A) Current ratio.
B) Net profit margin.
C) Return on assets.
D) Earnings per share.
45) The records of Everyday Electronics Corporation for a particular period include the
following:
Average total assets
$760,000
Average total liabilities
485,000
Total revenue
200,500
Total expenses (including income tax)
135,000
The return on equity ratio is closest to:
A) 13.2%
B) 23.8%
C) 24.0%
D) 8.4%
46) The records of Marshall Company include the following:
Average total assets
$3,500,000
Average total liabilities
1,220,000
Total revenue
4,580,000
Total expenses (including income tax)
4,100,000
Interest expense (included in total expenses)
90,000
Income tax rate 40
The return on assets (calculated using the modified method discussed in the text) is closest to:
A) 14.9%.
B) 18.3%.
C) 15.3%.
D) 14.7%.
47) The records of Marshall Company include the following:
Average total assets
$3,500,000
Average total liabilities
1,220,000
Total revenue
4,580,000
Total expenses (including income tax)
4,100,000
Interest expense (included in total expenses)
90,000
Income tax rate 40%
The return on equity is closest to:
A) 21.1%
B) 10.2%
C) 16.4%
D) 17.1%
48) The records of Marshall Company include the following:
Average total assets
$5,950,000
Average total liabilities
2,074,000
Total revenue
7,786,000
Total expense (including income tax)
6,970,000
Interest expense (included in total expenses)
153,000
Income tax rate 40%
The return on assets (calculated using the modified method discussed in the text) is closest to:
A) 14.9%
B) 18.3%
C) 15.3%
D) 18.7%
49) Which of the following transactions decreases earnings per share?
A) Declaring cash dividends payable to the common stockholders.
B) Purchasing treasury stock.
C) The accrual of revenue.
D) Declaring and distributing a 10% common stock dividend.