Chapter 03 – Analyzing Financial Statements
CHAPTER 3 – ANALYZING FINANCIAL STATEMENTS
questions
LG1-LG5 1. Classify each of the following ratios according to a ratio category (liquidity ratio, asset
management ratio, debt management ratio, profitability ratio, or market value ratio).
LG1 2. For each of the actions listed, determine what would happen to the current ratio. Assume nothing
else on the balance sheet changes and that net working capital is positive.
LG1-LG5 3. Explain the meaning and significance of the following ratios
a. Quick ratio: Inventories are generally the least liquid of a firm’s current assets. Further,
Chapter 03 – Analyzing Financial Statements
c. Return on equity: Return on equity (ROE) measures the return on the common stockholders’
LG2 4. A firm has an average collection period of 10 days. The industry average ACP is 25 days. Is this a
good or poor sign about the management of the firm’s accounts receivable?
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Chapter 03 – Analyzing Financial Statements
LG3 5. A firm has a debt ratio of 20 percent. The industry average debt ratio is 65 percent. Is this a good or
poor sign about the management of the firm’s financial leverage?
LG4 6. A firm has an ROE of 20 percent. The industry average ROE is 12 percent. Is this a good or poor
sign about the management of the firm?
LG6 7. Why is the DuPont system of analysis an important tool when evaluating firm performance?
Many of the ratios discussed in the chapter are interrelated. So a change in one ratio may well affect
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Chapter 03 – Analyzing Financial Statements
LG6 8. A firm has an ROE of 10 percent. The industry average ROE is 15 percent. How can the DuPont
system of analysis help the firm’s managers identify the reasons for this difference?
The basic DuPont equation looks at the firm’s overall profitability as a function of the profit the
LG6 9. What is the difference between the internal growth rate and the sustainable growth rate?
LG7 10. What is the difference between time series analysis and cross-sectional analysis?
LG7 11. What information does time series and cross-sectional analysis provide for firm managers,
analysts, and investors?
Chapter 03 – Analyzing Financial Statements
LG8 12. Why is it important to know a firm’s accounting rules before making any conclusions about
its performance from ratios analysis?
Firms use different accounting procedures. For example, inventory methods can vary. One firm
LG8 13. What does it mean when a firm window dresses its financial statements?
problems
basic 3-1 Liquidity Ratios You are evaluating the balance sheet for PattyCake’s Corporation. From the
problems balance sheet you find the following balances: cash and marketable securities = $400,000; accounts
receivable = $1,200,000; inventory = $2,100,000; accrued wages and taxes = $500,000; accounts
LG1 payable = $800,000; and notes payable = $600,000. Calculate PattyCakes’ current ratio, quick ratio,
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Chapter 03 – Analyzing Financial Statements
LG1 3-2 Liquidity Ratios The top part of Ramakrishnan, Inc,’s 2015 and 2014 balance sheets is listed as
follows (in millions of dollars).
Current assets: 2015 2014 Current liabilities: 2015 2014
Cash and marketable Accrued wages and
securities $ 34 $ 25 taxes $ 32 $ 31
Accounts receivable 143 128 Accounts payable 87 76
Inventory 206 187 Notes payable 76 68
Total $383 $340 Total $195 $175
Calculate Ramakrishnan, Inc.’s current ratio, quick ratio, and cash ratio for 2015 and 2014.
2015 2014
LG2 3-3 Asset Management Ratios Tater and Pepper Corp. reported sales for 2015 of $23 million. Tater
and Pepper listed $5.6 million of inventory on its balance sheet. Using a 365 day year, how many
days did Tater and Pepper’s inventory stay on the premises? How many times per year did Tater and
Pepper’s inventory turn over?
LG2 3-4 Asset Management Ratios Mr. Husker’s Tuxedos Corp. ended the year 2015 with an average
collection period of 32 days. The firm’s credit sales for 2015 were $56.1 million. What is the year–
end 2015 balance in accounts receivable for Mr. Husker’s Tuxedos?
Accounts receivable x 365
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Chapter 03 – Analyzing Financial Statements
LG3 3-5 Debt Management Ratios Tiggie’s Dog Toys, Inc. reported a debt-to-equity ratio of 1.75 times
at the end of 2015. If the firm’s total debt at year-end was $25 million, how much equity does
LG3 3-6 Debt Management Ratios You are considering a stock investment in one of two firms
(LotsofDebt, Inc. and LotsofEquity, Inc.), both of which operate in the same industry. LotsofDebt,
Inc. finances its $30 million in assets with $29 million in debt and $1 million in equity. LotsofEquity,
Inc. finances its $30 million in assets with $1 million in debt and $29 million in equity. Calculate the
LG4 3-7 Profitability Ratios Maggie’s Skunk Removal Corp.’s 2015 income statement listed net sales =
$12.5 million, gross profit of $6.9 million, EBIT = $5.6 million, net income available to common
stockholders = $3.2 million, and common stock dividends = $1.2 million. The 2015 year-end balance
sheet listed total assets of $52.5 million and common stockholders equity of $21 million with 2
million shares outstanding. Calculate the profit margin, gross profit margin, operating profit margin,
basic earnings power, ROA, ROE, and dividend payout.
Chapter 03 – Analyzing Financial Statements
LG4 3-8 Profitability Ratios In 2015, Jake’s Jamming Music, Inc. announced an ROA of 8.56 percent,
ROE of 14.5 percent, and profit margin of 20.5 percent. The firm had total assets of $9.5 million at
year-end 2015. Calculate the 2015 values of net income available to common stockholders, common
stockholders’ equity, and net sales for Jake’s Jamming Music, Inc.
LG5 3-9 Market Value Ratios You are considering an investment in Roxie’s Bed & Breakfast Corp.
During the last year the firm’s income statement listed an addition to retained earnings of $4.8 million
and common stock dividends of $2.2 million. Roxie’s year-end balance sheet shows common
stockholders’ equity of $35 million with 10 million shares of common stock outstanding. The
common stock’s market price per share was $9.00. What is Roxie’s Bed & Breakfast’s book value per
share and earnings per share? Calculate the market-to-book ratio and PE ratio.