Chap005 Essentials of Financial Statement Analysis
True/False
[QUESTION]
1. An analyst interested in learning the degree to which a company’s earnings have fluctuated
historically in relation to changes in economic growth would employ cross-sectional analysis.
2. A benchmark comparison is an analytic tool similar in approach to time-series analysis.
3. Operating and administrative efficiencies that result in lower expenses per dollar of sales
possibly explain a trend where net income grows faster than sales.
4. Return on assets will generally equal return on common equity except when the company has
no long-term debt.
5. Financial leverage is beneficial when the company earns more than the incremental after-tax
cost of debt.
6. Both common and preferred stock dividends are subtracted in arriving at net income available
to common stockholders.
7. When return on assets is high at a highly levered firm, return on common equity will be low.
8. Activity ratios describe the profitability of a company.
9. The Z-score model combines five financial ratios in a precise way to estimate a company’s
default risk.
10. Days payable outstanding helps analysts understand the company’s pattern of cash receipts
from customers.
11. A low-credit-risk company generates operating cash flows substantially in excess of what
are required to sustain its business activities.
12. Although a company’s earnings are important, an analysis of its cash flows is central to
credit evaluations and lending decisions.
13. Credit risk analysis uses financial ratios that focus on an assessment of liquidity and
solvency.
14. In the highest-risk Standard &Poor’s rating category that is a CCC/C rating, more than half
of the firms default within a year.
15. When analyzing a company’s risk of bankruptcy using Altman’s Z-score, a high Z-score
indicates low risk of default.
16. All of the following are used as financial analysis tools except
a. managements’ discussion and analysis.
b. common-size statements.
c. trend statements.
d. financial ratios.
17. Time-series analysis helps identify financial trends
a. across companies at a single point in time.
b. across business units at a single point in time.
c. over time for a single company or business unit.
d. among the companies that comprise an industry group.
18. A type of analysis that helps identify similarities and differences across companies or
business units at a single moment in time is
a. trend analysis.
b. common-size statements analysis.
c. time-series analysis.
d. cross-sectional analysis.
19. Which of the following is not correct with respect to an analyst’s use of financial
information?
a. Analysts use financial statement information to assess the economic activities of a company
and its condition.
b. The first step to informed financial statement analysis is a careful examination of the
auditor’s opinion.
c. Analysts need to understand what accounting data do and do not reveal about a company’s
economic activities and condition.
d. Analysts must always be vigilant about the possibility that accounting distortions are present
and complicate the interpretation of financial ratios, percentage relations, and trend indices.
[QUESTION]
20. Which of the following does not reflect disclosures in financial statements?
a. Related party transactions must be disclosed.
b. GAAP disclosure by segment is required only for some companies.
c. GAAP limits how much a company can disclose in their financial statements.
d. Management may disclose more than GAAP requires.
Answer: c
Learning Objective: 05-01
Difficulty: 2 Medium
AACSB: Reflective Thinking
21. Common-size financial statements recast each statement item as
a. a percentage using industry averages for the “base number.”
b. a percentage using a base year number for each line item.
c. a percentage of some “base number” on the financial statement in question.
d. a percentage of the “bottom line.”
22. An analytical tool that measures a company’s performance against a predetermined standard
is a/an
a. benchmark comparison analysis.
b. profitability analysis.
c. time-series analysis.
d. common-size statement.
23. The financial statement reporting “filter” is
a. SEC reporting regulations that vary from GAAP for publicly traded companies.
b. SEC required reporting regulations for all entities.
c. management’s distortion of accounting data.
d. management’s discretion to choose alternative accounting procedures within GAAP
24. Which one of the following helps the analyst remove the effects of an information filter?
a. Financial statements.
b. SEC Form 10-K.
c. Note disclosures in financial statements.
d. Trend analysis.
25. Trend statements help the user
a. determine the reason(s) for changes over time in each financial statement line item.
b. spot relationships among financial statement items.
c. spot changes over time in each financial statement line item.
d. identify variations between companies in financial statement line items.
REFERENCE: Ref. 05_01
Manero Company included the following information in its annual report:
2019
2018
2017
Sales
$178,400
$162,500
$155,500
Cost of goods sold
115,000
102,500
100,000
Operating expenses
50,000
50,000
45,000
Operating income
13,400
10,000
10,500
[QUESTION]
REFER TO: Ref. 05_01
26. In a common-size income statement for 2019, the operating expenses are expressed as
a. 28.0%
b. 30.3%
c. 43.8%
d. 100.0%
27. In a common-size income statement for 2017, the cost of goods sold is expressed as
a. 40.0%
b. 64.3%
c. 100.0%
d. 230.0%
28. In a common-size income statement for 2019, the cost of goods sold is expressed as
a. 64.5%
b. 100.0%
c. 112.3%
d. 130.0%
29. In a trend income statement for 2017, where 2017 is the base year, sales are expressed as
a. 84.4%
b. 92.6%
c. 100.0%
d. 150.5%
30. In a trend income statement for 2019, where 2017 is the base year, sales are expressed as
a. 87.2%
b. 100.0%
c. 114.7%
d. 148.7%
31. In comparison to year 2018, the increase in operating income of 2019 was primarily caused
by (ignore taxes):
a. the effect of sales growth.
b. the effect of cost of goods sold growth.
c. the effect of margin growth.
d. the answer cannot be derived from the information provided.
32. In comparison to year 2018, the increase in operating income of 2019 was primarily caused
by the effect of margin increase of (ignore taxes):
a. $978.
b. $1,194.
c. $2,422.
d. $3,400.
33. In comparison to year 2017, the effect of sales growth on operating income of 2018 was
(ignore taxes):
a. $473.
b. $431.
c. $6,667.
d. $7,000.
34. In a common-size balance sheet, all items are expressed as a percentage of
a. total assets.
b. total liabilities.
c. total equity.
d. total sales.
35. In a trend balance sheet, each balance sheet item is expressed as a percentage of
a. total assets.
b. the base year item.
c. sales.
d. equity.
REFERENCE: Ref. 05_02
Hansel Corporation’s condensed balance sheets appear below:
(Base Year)
2019
2018
2017
$55,000
$56,500
$70,000
495,000
410,000
440,000
20,000
27,500
40,000
$570,000
$494,000
$550,000
$40,000
$35,000
$32,500
395,000
310,000
375,000
135,000
149,000
142,500
$570,000
$494,000
$550,000
[QUESTION]
REFER TO: Ref. 05_02
36. In a common size balance sheet for 2018, plant and equipment (net) is expressed as
a. 83.0%
b. 83.6%
c. 91.1%
d. 100.0%
37. In a common size balance sheet for 2019, total liabilities and equity are expressed as
a. 89.9%
b. 96.5%
c. 100.0%
d. 111.3%
38. In a trend balance sheet for 2019, long-term liabilities are expressed as
a. 69.3%
b. 100.0%
c. 105.3%
d. 127.4%
39. In a trend balance sheet for 2018, stockholders’ equity is expressed as
a. 10.2%
b. 100.0%
c. 104.6%
d. 110.4%
40. Trend statements are better than common size statements at indicating which of the
following?
a. stability.
b. monetary changes.
c. profitability.
d. growth and decline.
41. In a common size cash flow statement, all items are expressed as a percentage of
a. sales.
b. total assets.
c. net income.
d. total equity.
[QUESTION]
42, Which statement below is not correct with respect to a company’s
strategy?
a. There are numerous strategies for achieving superior performance in any
business.
b. Developing customer loyalty while controlling costs are conflicting
strategies.
c. Low-cost leadership along with product and service differentiation create
strategic advantage for companies.
d. Strategy is never dependent upon the company’s industry.
[QUESTION]
43. Advanced technology and performance capabilities, consistent quality,
availability in multiple colors and sizes, prompt delivery, technical support
services, customer financing, distribution channels, or some other feature of
importance to customers are examples of
a. competitive advantage.
b. differentiation.
c. product leadership.
d. low-cost leadership.
Answer: b
Learning Objective: 05-02
Difficulty: 2 Medium
AACSB: Reflective Thinking
AICPA: BB Critical Thinking
Blooms: Understand
44. Earnings Before Interest (EBI) adjusts net income for which one of the following groups of
items?
a. Nonrecurring items, interest, and distortions related to accounting quality concerns.
b. Nonoperating items, after-tax interest, and distortions related to accounting quality concerns.
c. Nonoperating items, nonrecurring items, and after-tax interest.
d. Nonrecurring items, after-tax interest, and distortions related to accounting quality concerns.
45. Return on Assets (ROA) measures a firm’s
a. cost effectiveness of its operating activities.
b. profitable use of its assets.
c. profitability of sales.
d. return on shareholders’ investment.
46. Which of the following items will not cause the company’s ROA to
increase?
a. Reducing company assets without impacting sales.
b. Reducing costs.
c. Increasing the selling price per unit.
d. Increasing company assets.
47. Return on Assets (ROA) can be broken down into these two components: profit margin and
a. asset utilization margin.
b. asset turnover.
c. common earnings leverage.
d. financial structure leverage.
48. Which one of the following successful strategies will increase the Return on Assets (ROA)?
a. Increase the investment in assets used in the business.
b. Increase the profit margin.
c. Decrease sales volume.
d. Increase the annual depreciation amounts of long-lived assets.
49. The ratio that captures information about property, plant, and equipment utilization is
a. current asset turnover.
b. long-term asset turnover.
c. asset turnover.
d. property turnover.
50. Which of the following is not a valid statement?
a. Competitive ceiling is the rate of return that would be earned in the
economist’s “perfectly competitive” industry.
b. Companies that consistently earn rates of return above the floor are said to
have a competitive advantage.
c. Competition in an industry continually works to drive down the rate of
return on assets toward the competitive floor.
d. Rates of return that are higher than the industry floor stimulate more
competition as existing companies innovate and expand their market reach or
as new companies enter the industry.
Answer: a
51. Companies that consistently earn rates of return above the competitive floor in the industry
are considered to possess a
a. dominant market share.
b. niche market.
c. competitive advantage.
d. monopolistic advantage.
52. Strategies to gain a competitive advantage include product differentiation and
a. low-cost leadership.
b. building brand loyalty.
c. developing superior products.
d. improving product quality and reliability.
REFERENCE: Ref. 0_03
Condensed financial data are presented below for the Phoenix Corporation:
2019
2018
Accounts receivable
$267,500
$230,000
Inventory
312,500
257,500
Total current assets
670,000
565,000
Intangible assets
50,000
60,000
Total assets
825,000
695,000
Current liabilities
252,500
200,000
Long-term liabilities
77,500
75,000
Sales
1,640,000
Cost of goods sold
982,500
Interest expense
10,000
Income tax expense
77,500
Net income
127,500
Cash flow from operations
71,000
Cash flow from investing activities
(6,000)
Cash flow from financing activities
(62,500)
Tax rate
30%
[QUESTION]
REFER TO: Ref. 05_03
53. The return on assets ratio for 2019 is (rounded):
a. 16.3%
b. 16.9%
c. 17.7%
d. 18.2%
54. The profit margin used to calculate return on assets for 2019 is (rounded):
a. 7.9%
b. 8.2%
c. 8.5%
d. 16.3%
[QUESTION]
REFER TO: Ref. 05_03
55. The total asset turnover ratio for 2019 is (rounded):
a. 1.7 times.
b. 2.0 times.
c. 2.2 times.
d. 2.4 times
56. If there is no preferred stock, the return on common equity for 2019 is (rounded):
a. 25.8%
b. 27.9%
c. 41.4%
d. 43.4%
57. In a common size income statement for 2019, cost of goods sold is expressed as:
a. 92.0%
b. 60.0%
c. 119%
d. 167%%