Chapter 28 – Financial Analysis of Performance
TRUE/FALSE
1. It is in the best interests of a company to base executive compensation on a single performance
measure.
2. Per the Sarbanes-Oxley Act of 2002, a compensation committee, comprised of a public corporation’s
top executives, must be established to determine the salaries and wages of its employees.
3. Per the Sarbanes-Oxley Act of 2002, public corporations must establish a compensation committee to
determine how its top executives will be compensated.
4. Investors, creditors, and customers are considered external users of financial statements.
5. Liquidity is the ability to earn a satisfactory net income.
6. Profitability is the ability to pay bills when due and to meet unexpected needs for cash.
7. Market strength is the ability to increase the wealth of stockholders.
8. Past performance is rarely a good indicator of future performance.
9. In general, the greater the investment risk taken, the lower the return required as compensation.
10. The analysis of risk and return is important to both investors and creditors.
11. Financial statement analysis can be both past- and future-oriented.
12. The use of rule-of-thumb measures is not an exact science and should be used with great care.
13. Rule-of-thumb measures are the best standards of comparison in financial performance evaluation.
14. A limitation of using industry norms in financial performance evaluation is that some companies in the
same industry may not be comparable.
15. Both diversified companies and conglomerates operate in a single, well-defined industry.
16. Disclosure of segment information is useless in the analysis of diversified companies.
17. Companies in the same industry are required to use the same methods to value inventory and to
depreciate similar assets.
18. Accounting methods may be a source of incomparability among companies.
19. In a diversified company, segments may be represented by different industries, geographical markets,
and major customers.
20. The comparison of financial measures or ratios of the same company over a period of times is superior
to the use of rule-of-thumb measures.
21. Most companies issue interim financial statements to the public on a monthly basis.
22. Interim financial statements report data for a period of more than one year.
23. One of the main parts of an annual report of a publicly held corporation is the five– to ten-year
projection.
24. Reports made to the SEC by public companies are often more comprehensive than those issued to the
public.
25. Form 10-Q refers to the annual report filed with the SEC.
26. The most complete financial newspaper in the United States is the Financial Times.
27. Interim financial statements are subjected to a full audit by an independent auditor.
28. The annual report of a publicly held corporation usually does not contain the auditors’ report.
29. For details about the financial histories of companies, one could consult publications of Moody’s and
Standard & Poor’s.
30. Companies file their quarterly reports with the SEC on Form 8K.
31. A change in the company’s auditors must be reported to the SEC within a few days of the change.
32. Vertical analysis will result in common-size statements.
33. Trend analysis requires the establishment of a base year for comparison purposes.
34. Vertical analysis is the same as common-size analysis.
35. Horizontal analysis will reveal the percentage of net sales consumed by salaries expense.
36. In a common-size income statement, net income is represented by 100 percent.
37. In horizontal analysis, the base year is the most current year being examined.
38. In a common-size income statement, each item is expressed as a percentage of net sales.
39. It is possible for horizontal analysis to indicate a decrease in revenues from one year to another and an
increase in net income.
40. In a common-size balance sheet, total assets are represented by 100 percent.
41. Determining the percentage change in an item from one year to the next is a type of horizontal
analysis.
42. The index number used in trend analysis is computed by dividing the base year amount by the index
year amount, and multiplying that result by 100.
43. A 20 percent change in net sales will result in a 20 percent change in net income.
44. When using an index number, one sets the first (oldest) number in a series equal to 100.
45. Common-size statements are useful in assessing the changes in the composition of statements over
time.
46. A primary purpose of vertical analysis is to observe trends over a five-year period.
47. The quick ratio and the debt to equity ratio are measures of short-term debt-paying ability.
48. Ratio analysis is useful only if the ratio states a meaningful relationship between two numbers.
49. The receivable turnover is useful in assessing the profitability of receivables.
50. Inventory turnover is a measure of liquidity that focuses on the relative size of inventory.
51. Days’ payable measures the relative size of accounts payable.
52. Asset turnover is most closely associated with a company’s liquidity position.
53. Both profit margin and asset turnover affect a company’s return on assets.
54. The cash flow yield equals net income divided by net cash flows from operating activities.
55. Declining profitability and liquidity ratios are indications that a company may not survive.
56. The interest coverage ratio and the debt to equity ratio are short-term measures of liquidity.
57. The receivables turnover measures the relative size of the accounts receivable and the effectiveness of
credit policies.
58. The price/earnings (P/E) ratio is an indication of investor confidence in a company.
59. The operating cycle is equal to days’ sales uncollected plus days’ inventory on hand.
60. The sale of plant assets and the payment of dividends will reduce free cash flow.
61. Dividends yield is a market strength ratio.
MULTIPLE CHOICE
1. Executive officers’ compensation is typically comprised of all of the following except
a.
incentive bonuses.
b.
declared dividends.
c.
stock option awards.
d.
annual base salaries.
2. Market strength refers most closely to the ability to
a.
survive for many years.
b.
pay bills when they fall due.
c.
earn a satisfactory net income.
d.
increase the wealth of stockholders.
3. The ability to pay bills when due and to meet unexpected needs for cash most closely describes
a.
cash flow adequacy.
b.
long-term solvency.
c.
liquidity.
d.
profitability.
4. Financial performance measurement is useful for all of the following except assessment of
a.
accounting methods.
b.
return by investors.
c.
risk by creditors.
d.
risk by investors.
5. A general rule in choosing among alternative investments is the greater the risk taken, the
a.
greater the return required.
b.
lower the potential expected.
c.
greater the price of the investment.
d.
lower the profits expected.
6. A company is referred to as a diversified company or a conglomerate if it operates in
a.
many related industries.
b.
many unrelated industries.
c.
many and varied locations throughout the world.
d.
one single major industry.
7. Which of the following must be reported by diversified companies for each of their operating
segments?
a.
Segment profit or loss, expenses, and earnings per share
b.
Segment profit or loss, certain revenue and expense items, and segment assets
c.
Assets, liabilities, and earnings per share
d.
Segment profit or loss, expenses, and unidentifiable assets
8. Which of the following is the least useful in evaluating a relationship as either favorable or
unfavorable?
a.
Past and current performances of the company
b.
Industry averages
c.
Past performance of the company
d.
Rule-of-thumb measures
9. The existence of diversified companies makes which of the following very difficult?
a.
Comparison with industry norms
b.
The preparation of interim financial statements
c.
Use of more than one depreciation or inventory method
d.
The compilation of segmented information
10. Which of the following situations severely limits the use of industry norms as standards of
comparison?
a.
The fact that little information exists on industry norms
b.
The existence of conglomerates
c.
The presentation of segmented information
d.
A downward turn in the economy
11. Dun & Bradstreet publishes
a.
data on average ratios and relationships.
b.
credit ratings of companies.
c.
data on industry norms.
d.
all of these.
12. Within a few days of certain major events, a report must be issued by publicly held corporations to
a.
stockholders.
b.
the SEC.
c.
Dun & Bradstreet.
d.
creditors.
13. Publicly held corporations must file annual reports with the SEC. All such reports are available
a.
only to the SEC, the company’s owners and management, and the company’s auditors.
b.
only to other SEC companies and the issuing company’s owners and management.
c.
only to the SEC, the company’s management, and the company’s auditors.
d.
to the general public.
14. An annual analysis called “Industry Norms and Key Business Ratios” is compiled and reported by
a.
Forbes magazine.
b.
Moody’s Investor Services.
c.
Dun & Bradstreet.
d.
Mergent, Inc.
15. One of the best places to look for early signals of change in a company’s profitability is the
a.
annual report sent to the SEC.
b.
year-end financial statements.
c.
interim financial statements.
d.
annual report sent to stockholders.
16. To find the most comprehensive information about a company’s performance during the year, one
would look to
a.
interim financial statements.
b.
the annual report sent to the SEC.
c.
The Wall Street Journal.
d.
the annual report sent to stockholders.
17. A balance sheet that displays only component percentages is called a
a.
condensed balance sheet.
b.
comparative balance sheet.
c.
segmented balance sheet.
d.
common-size balance sheet.
18. One reason that a common-size statement is a useful tool in financial performance evaluation is that it
enables the user to
a.
make better comparisons of two companies of different sizes in the same industry.
b.
determine which companies in a single industry are of the same size.
c.
judge the relative potential of two companies of similar size in different industries.
d.
determine which companies in a single industry are of the same value.
19. Horizontal analysis of comparative financial statements includes the
a.
development of common-size statements.
b.
calculation of dollar amount changes and percentage changes from the previous to the
current year.
c.
calculation of the percentage of net sales for each item listed.
d.
calculation of liquidity ratios.
20. In trend analysis, each item is expressed as a percentage of the
a.
net income amount.
b.
total assets amount.
c.
base year amount.
d.
retained earnings amount.
21. In a common-size income statement for a retail store, the 100 percent amount is for
a.
net revenues.
b.
cost of goods sold.
c.
gross profit.
d.
net income.
22. In a common-size balance sheet for a retail store, the 100 percent amount is for
a.
merchandise inventory.
b.
total property, plant, and equipment.
c.
total assets.
d.
total current assets.
23. In a trend analysis, an index number of 139 for 20xx sales indicates that
a.
sales for 20xx were 139 percent higher than sales for the same company in the base year.
b.
sales for 20xx for this company were 139 percent of the sales figure of another company
being used in the comparison.
c.
sales for 20xx were 139 percent of the sales for the same company in the base year.
d.
actual sales for 20xx exceeded budgeted sales for 20xx by 39 percent.
24. An example of horizontal analysis is
a.
common-size statements.
b.
trend analysis.
c.
ratio analysis.
d.
profitability analysis.
25. What is the best way to study the relationship of the components of financial statements?
a.
Perform ratio analysis.
b.
Perform trend analysis.
c.
Perform horizontal analysis.
d.
Prepare common-size statements.
26. In conducting horizontal analysis, it is important to focus attention on the changes in
a.
the composition of the statements.
b.
dollar amounts and their percentages.
c.
dollar amounts.
d.
percentages.
27. If Year 1 equals $1,400, Year 2 equals $1,554, and Year 3 equals $1,750, the index number to be
assigned for Year 3 in trend analysis, assuming that Year 1 is the base year, is
a.
100.
b.
135.
c.
125.
d.
130.
28. If sales for 2008 (the base year), 2009, and 2010 are $20,000, $15,600, and $26,000, respectively, the
index numbers assigned to 2009 and 2010, respectively, are
a.
62.4 and 135.
b.
156 and 125.
c.
128.2 and 140.
d.
78 and 130.
29. In a common-size financial statement, which of the following is given a designation of 100 percent?
a.
Cost of goods sold
b.
Total assets
c.
Total liabilities
d.
Net income
30. If dividends declared per share during 2008 (the base year), 2009, and 2010 are $2.40, $1.80, and
$3.84, respectively, the index numbers assigned to 2009 and 2010, respectively, are
a.
75 and 160.
b.
60 and 165.
c.
180 and 150.
d.
133.3 and 180.
31. In a common-size financial statement, a designation of 25 percent could not be given to
a.
total stockholders’ equity.
b.
net revenues.
c.
net earnings.
d.
total current assets.
32. Ratios are most useful in identifying
a.
causes.
b.
differences.
c.
relationships.
d.
trends.
33. A common measure of liquidity is
a.
profit margin.
b.
receivable turnover.
c.
return on assets.
d.
asset turnover.
34. A common measure of profitability is the
a.
asset turnover.
b.
debt to equity ratio.
c.
current ratio.
d.
receivable turnover.
35. A common measure of long-term solvency is the
a.
receivable turnover.
b.
asset turnover.
c.
debt to equity ratio.
d.
current ratio.
36. Return on assets is most closely related to
a.
interest coverage and the debt to equity ratios.
b.
profit margin and the debt to equity ratio.
c.
profit margin and asset turnover.
d.
inventory turnover and profit margin.
37. Which of the following ratios involves the market price of a company’s stock?
a.
Return on equity
b.
Dividends yield
c.
Profit margin
d.
Cash flow yield
38. Liquidity ratios are an indication of a company’s
a.
ability to effectively employ its resources.
b.
overall debt to equity position.
c.
overall debt position.
d.
ability to pay bills when they are due and to meet unexpected needs for cash.
39. The calculation of free cash flow contains a deduction for
a.
interest expense.
b.
depreciation.
c.
dividends.
d.
net cash flows from operating activities.
40. The current ratio is a
a.
liquidity ratio.
b.
profitability ratio.
c.
long-term solvency ratio.
d.
market strength ratio.
41. The receivable turnover and inventory turnover ratios are used to analyze
a.
leverage.
b.
long-term solvency.
c.
profitability.
d.
liquidity.
42. Days’ inventory on hand is used to analyze
a.
cash flow adequacy.
b.
liquidity.
c.
profitability.
d.
long-term solvency.
43. Which of the following describes the interest coverage ratio?
a.
Income before income taxes plus interest expense divided by interest expense
b.
Income after income taxes plus interest expense divided by interest expense
c.
Income after income taxes divided by interest expense
d.
Income before income taxes minus interest expense divided by interest expense
44. Which of the following describes the asset turnover ratio?
a.
Average total assets divided by sales
b.
Net sales divided by net income
c.
Net sales divided by average total assets
d.
Average total assets divided by net income
45. Which of the following describes the return on assets ratio?
a.
Average total assets divided by net income
b.
Net income plus income tax expense divided by average total assets
c.
Average total assets divided by net sales
d.
Net income divided by average total assets
46. Which of the following best describes the debt to equity ratio?
a.
Average total assets divided by total liabilities
b.
Average total assets divided by stockholders’ equity
c.
Stockholders’ equity divided by total liabilities
d.
Total liabilities divided by stockholders’ equity
47. A change from FIFO to LIFO in a period of rising prices will
a.
decrease both the current ratio and the inventory turnover ratio.
b.
increase both the current ratio and the inventory turnover ratio.
c.
increase the current ratio and decrease the inventory turnover ratio.
d.
decrease the current ratio and increase the inventory turnover ratio.
48. How would the collection of an account receivable affect the current ratio and the quick ratio,
respectively?
a.
No effect on current ratio; increase in quick ratio
b.
Increase in current ratio; increase in quick ratio
c.
No effect on current ratio; no effect on quick ratio
d.
Decrease in current ratio; decrease in quick ratio
49. The number of days’ sales uncollected is determined by dividing
a.
the number of days in a year by the receivable turnover.
b.
the number of days in a year by average accounts receivable.
c.
net income by average accounts receivable.
d.
sales by average accounts receivable.
50. A quick ratio that is much smaller than the current ratio indicates that
a.
inventories represent a large portion of current assets.
b.
the company has a low inventory turnover.
c.
inventories represent a small portion of current assets.
d.
the company has a high inventory turnover.
51. What is the effect of the payment of an account payable on the current ratio and the quick ratio,
respectively? (Assume the current ratio was 2.3 times and the quick ratio was 2.1 times before this
transaction.)
a.
Decrease in current ratio; no effect on quick ratio
b.
Increase in current ratio; increase in quick ratio
c.
No effect on current ratio; no effect on quick ratio
d.
Decrease in current ratio; decrease in quick ratio
52. Assuming that the current ratio was 1.6 times and the quick ratio was 1.4 times before this transaction,
the entry to record the payment of a previously declared and recorded cash dividend will
a.
increase the current ratio and the quick ratio.
b.
decrease the current ratio and the quick ratio.
c.
increase the current ratio but have no effect on the quick ratio.
d.
have no effect on the current ratio or the quick ratio.
53. A company with a current ratio of 2.4 times will see that ratio decrease when the company
a.
pays a large current liability.
b.
declares a 10 percent stock dividend on its common stock.
c.
borrows cash by issuing a short-term note payable.
d.
converts a short-term liability to a long-term liability.
54. During the year, Dempsey Corporation’s current ratio increased while its quick ratio decreased. Which
of the following could help explain this situation?
a.
A decrease in accounts receivable during the year
b.
An increase in accounts payable during the year
c.
The sale of short-term investments during the year
d.
An increase in inventory levels during the year
55. Following are the financial statements for Starman Corporation for the year ended December 31, 20xx.
Assume that all balance sheet amounts represent both average and ending figures.
Starman Corporation
Balance Sheet
December 31, 20xx
Assets
Cash
$ 20,000
Marketable securities
30,000
Accounts receivable
50,000
Inventory
100,000
Long-term receivables
35,000
Property, plant, and equipment
65,000
Total assets
$300,000
Liabilities and Stockholders’ Equity
Current liabilities
$100,000
Long-term liabilities
60,000
Stockholders’ equity
140,000
Total liabilities and stockholders’ equity
$300,000
Net sales
$400,000
Cost of goods sold
240,000
Gross margin
$160,000
Operating expenses
40,000
Income before income taxes
$120,000
Income taxes expense
30,000
Net income
$ 90,000
What is the current ratio for this corporation? Round your answer to two decimal places.
a.
1.00 times
b.
1.54 times
c.
1.70 times
d.
2.00 times
56. Following are the financial statements for Starman Corporation for the year ended December 31, 20xx.
Assume that all balance sheet amounts represent both average and ending figures.
Starman Corporation
Balance Sheet
December 31, 20xx
Assets
Cash
$ 20,000
Marketable securities
30,000
Accounts receivable
50,000
Inventory
100,000
Long-term receivables
35,000
Property, plant, and equipment
65,000
Total assets
$300,000
Liabilities and Stockholders’ Equity
Current liabilities
$100,000
Long-term liabilities
60,000
Stockholders’ equity
140,000
Total liabilities and stockholders’ equity
$300,000
Net sales
$400,000
Cost of goods sold
240,000
Gross margin
$160,000
Operating expenses
40,000
Income before income taxes
$120,000
Income taxes expense
30,000
Net income
$ 90,000
What is the receivable turnover for this corporation?
a.
8.0 times
b.
6.0 times
c.
4.8 times
d.
1.8 times
57. Following are the financial statements for Starman Corporation for the year ended December 31, 20xx.
Assume that all balance sheet amounts represent both average and ending figures.
Starman Corporation
Balance Sheet
December 31, 20xx
Assets
Cash
$ 20,000
Marketable securities
30,000
Accounts receivable
50,000
Inventory
100,000
Long-term receivables
35,000
Property, plant, and equipment
65,000
Total assets
$300,000
Liabilities and Stockholders’ Equity
Current liabilities
$100,000
Long-term liabilities
60,000
Stockholders’ equity
140,000
Total liabilities and stockholders’ equity
$300,000
Net sales
$400,000
Cost of goods sold
240,000
Gross margin
$160,000
Operating expenses
40,000
Income before income taxes
$120,000
Income taxes expense
30,000
Net income
$ 90,000
What is the inventory turnover for this corporation? Round your answer to one decimal place.
a.
1.2 times
b.
1.6 times
c.
2.4 times
d.
4.0 times
58. Following are the financial statements for Starman Corporation for the year ended December 31, 20xx.
Assume that all balance sheet amounts represent both average and ending figures.
Starman Corporation
Balance Sheet
December 31, 20xx
Assets
Cash
$ 20,000
Marketable securities
30,000
Accounts receivable
50,000
Inventory
100,000
Long-term receivables
35,000
Property, plant, and equipment
65,000
Total assets
$300,000
Liabilities and Stockholders’ Equity
Current liabilities
$100,000
Long-term liabilities
60,000
Stockholders’ equity
140,000