CHAPTER I

FINANCIAL STATEMENT
ANALYSIS

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LEARNING OBJECTIVES:
After studying this chapter, you should be able to:
1. Identify the tools for financial statement analysis.
2. Explain why financial analysts use ratios to evaluate
companies.
3. Explain liquidity and show how ratios can measure a
company’s liquidity.
4. Explain profitability and show how ratios can measure a
company’s profitability.
4. Explain solvency and show how ratios can measure a
company’s solvency.
5. Explain some limitations of ratio analysis.
6. Discuss the need for comparative analysis.

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FINANCIAL STATEMENTS ANALYSIS
Financial Statement Analysis involves the evaluation of the firm’s past
performance, present condition, and business potentials. The analysis provides
information about the following, among others:

 Profitability of the business firm

 Ability to meet company obligations
 Safety of investment in the business
 Effectiveness of management in running the firm

FINANCIAL STATEMENT ANALYSIS TOOLS AND

TECHNIQUES
Some of the evaluative tools and techniques used in the financial statement
analysis include the following:

1. Horizontal Analysis (Trend or index analysis)

2. Vertical Analysis (Common-size FS)
3. Financial ratios
4. Gross profit variation analysis
5. Cash flow analysis

HORIZONTAL ANALYSIS
Horizontal or index analysis involves comparison of figures shown in the financial
statements of two or more consecutive periods. The difference of the amount
between two periods is calculated, and the percentage change from one period
to the next is computed using the earlier period as the base.

Percentage Most Recent Value – Base Period Value

Change (∆ %) = Base Period Value

Comparisons can be between an actual amount compared against a budgeted

amount, with the ‘budget’ serving as the base or pattern of performance.

NOTE: If a negative or a zero amount appears in the base year, percentage

change cannot be computed.

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VERTICAL ANALYSIS
Vertical Analysis is the process of comparing figures in the financial statements of
a single period. It involves conversion of figures in the statements to a common
base. This is accomplished by expressing all figures in the statements as
percentages of an important item such as total assets (in the balance sheet) or
net sales (in the income statement). These converted statements are called
common-size statements or percentage composition statements.

Percentage composition statements are used for comparing:

1. Multiple years of data from the same firm.
2. Companies that is different in size.
3. Company to industry averages.

RATIO ANALYSIS
Ratio analysis involves development of mathematical relationships among
accounts in the financial statements. Ratios calculated from these statements
provide users and analysts with relevant information about the firm’s liquidity,
solvency and profitability.

BASIC RULES ON RATIO CALCULATIONS

1. When calculating a ratio using balance sheet numbers only, the numerator and
denominator should be from the same balance sheet date. The same are true for
ratios using only income statement numbers.

NOTE: Except if growth ratio is calculated.

2. If an income statement account and a balance sheet account are both used to
calculate a ratio, the balance sheet account should be expressed as an average for
the time period represented by the income statement account.

3. If the beginning balance of a balance sheet account is not available, the ending
balance is normally used to represent the average balance of the account.

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4. If sales and/ or purchases are given without making distinction as to whether
made in cash or on credit, assumptions are made depending on the ratio being
calculated:

 Turnover ratios: Sales and purchases are made on credit.

 Cash flow ratios: Sales and purchases are made on cash.

5. Generally, the number of days in a month or year is not critical to the analysis:
a year may have 360 days, 52 weeks, and 12 months; alternatively, a year may be
comprised of 365 calendar days, 300 working days or any appropriate number of
days.

LIQUIDITY RATIOS
LIQUIDITY refers to the company’s ability to pay its current liabilities as they fall
due.

1. Current Ratio/ Banker’s Ratio/ Working Capital Ratio

It is a measure of adequacy of working capital. It is the primary test of solvency to
meet current obligations from current assets.

Computed as follows:

Current Ratio = Current Assets ÷ Current Liabilities.

2. Quick Ratio/ Acid Test Ratio

It measures the number of times that the current liabilities could be paid with the
available cash and near-cash assets (ex. Cash, marketable securities and current
receivables).

Computed as follows:

Quick Ratio = Quick Assets ÷ Current Liabilities

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WORKING CAPITAL ACTIVITY RATIOS/ EFFICIENCY
RATIOS
1. Receivables Turnover
It is the time required to complete one collection cycle from the time receivables
are recorded, and then collected, to the time new receivables are recorded again.

Computed as follows:

Receivable Turnover = Net Credit Sales ÷ Average Receivables

2. Average Age of Receivables/ Average Collection Period/ Days’ Sales

in Receivables
It indicates the average number of days during which the company must wait
before receivables are collected.

Computed as follows:

Average Collection Period = # of Working Days ÷ Receivables Turnover

3. Inventory Turnover
It measures the number of times that the inventory is replaced during the period.

Computed as follows:

Inventory Turnover = Cost of Goods Sold ÷ Average Merchandise

Inventory

4. Average Age of Inventory/ Inventory Conversion Period/ Days’ Sales

in Inventory
It indicates the average number of days during which the company must wait
before the inventories are sold.

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 Computed as follows:

Average Age of Inventory = # of Working Days ÷ Inventory Turnover

5. Raw Materials Turnover

The number of times raw materials are replaced or revolved during an accounting
period.

Computed as follows:

R Turnover = Cost of Materials Used ÷ Ave. Raw Materials Inventory

6. Work in Process Turnover

The number of times work in process inventory revolved during the accounting
period.

Computed as follows:

WIP Turnover = Cost of goods manufactured ÷ Ave. WIP inventory

7. Finished goods turnover

The number of times finished goods inventory revolved or are replaced during the
accounting period.

Computed as follows:

FG Turnover = Cost of goods sold ÷ Ave. FG inventory

8. Normal Operating Cycle

The period of time required to convert cash into raw materials, raw materials
into inventory finished goods, finished good inventory into sales and accounts
receivable, and accounts receivable into cash.

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Computed as follows:

Normal Operating Cycle = Ave. Age of Invty. + Ave. Age of Rec.

9. Trade Payables Turnover

It is the time required to complete one payment cycle from the time trade
payables are recorded, and then paid, to the time new trade payables are
recorded again.

Computed as follows:

TP Turnover = Net Credit Purchases ÷ Ave. Trade Payables

10. Average Age of Trade Payables/ Payable Deferral Period/ Days’ Purchases in
Payables
It indicates the length of time during which payables remain unpaid.

Computed as follows:

AD Period = # of working days ÷ Payables Turnover

11. Current Assets Turnover

It measures the movement and utilization of current assets to meet operating
requirements

Computed as follows:

CA Turnover = Cost of Sales + Operating Expenses** ÷ Ave. Current Assets

**NOTE: These exclude depreciation, amortization and other expenses

related to long-term assets.

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SOLVENCY RATIOS
SOLVENCY refers to the ability of the company to pay its debts. These ratios
involve leverage ratios. LEVERAGE refers to how much of company’s resources
are financed by debt and/or preferred equity, both of which require fixed
payment of interests and dividends.

1. Times Interest Earned

It determines the extent to which operations cover interest expense.

Computed as follows:

Times Interest Earned = EBIT ÷ Int. Expense

2. Debt to Equity Ratio

This refers to the proportion of assets provided by creditors compared to that
provided by owners.

Computed as follows:

Debt to Equity Ratio = Total Liabilities ÷ Total SHE

3. Debt Ratio
Refers to the proportion of total assets provided by the creditors.

Computed as follows:

Debt Ratio = Total Liabilities ÷ Total Assets

4. Equity Ratio
Refers to the proportion of total assets provided by owners.

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Computed as follows:

Equity Ratio = Total SHE ÷ Total Assets

PROFITABILITY RATIOS
1. Return on Sales
This determines the portion of sales that went into the company’s earnings.

Computed as follows:

ROS = Income ÷ Net Sales

2. Return on Assets
This refers to the efficiency with which assets are used to operate the business.

Computed as follows:

ROA = Income ÷ Ave. Assets

What INCOME figure should be used?

 If the intention is to measure OPERATIONAL PERFORMANCE, income is
expressed as before interest and tax; alternatively, income before ‘after-
tax’ interest may be used to exclude the effect of capital structure.

 If the intention is to evaluate TOTAL MANAGERIAL EFFORTS, income is

expressed after interest and tax.

 If used in DuPont Technique, income must be after interests, taxes and

preferred stock dividends.

3. Return on Equity
Measures the amount earned on the owners’ or stockholders’ investment.
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Computed as follows:

ROE = Income ÷ Ave. Equity

4. Earnings per Share

Measures the amount of net income earned by each common share.

Computed as follows:

EPS = Net Income – P/S Div. ÷ WACSO

MARKETABILITY RATIOS
1. Price-Earnings Ratio
It indicates the number of pesos required to buy P1 of earnings.

Computed as follows:

P/E Ratio = Price Per Share ÷ EPS

2. Dividend Yield Ratio

Measures the rate of return in the investor’s common stock investments.

Computed as follows:

Div. Yield Ratio = Div. Per Share ÷ Price per Share

3. Dividend Payout Ratio

It indicates the proportion of earnings distributed as dividends

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Computed as follows:

Div. Payout Ratio = Div. per Share ÷ EPS

STABILITY RATIOS
1. Fixed Asset to Total Equity
Measures the proportion of owners’ equity to fixed assets. This indicates whether
investments by owners are over or under and also shows weakness in leverage.

Computed as follows:

Fixed Assets to Total Equity = Fixed Assets ÷ Total Equity

2. Fixed Assets to Total Assets

Indicates possible over-expansion of plant and equipment.

Computed as follows:

Fixed Asset to Total Assets = Fixed Assets ÷ Total Assets

3. Sales to Fixed Assets (Plant Turnover)

Test roughly the efficiency of management in keeping plant properties employed.

Computed as follows:

Sales to Fixed Assets = Net Sales ÷ Fixed Assets

4. Book Value Per Share

Measures recoverable amount by common stockholders in the event of
liquidation if assets are realized at their book values.

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Computed as follows:

BVPS = Common SHE ÷ CS outstanding

5. Times Preferred Dividends Earned

It indicates ability to provide dividends to preferred stockholders.

Computed as follows:

Times PS Div. Earned = Net Income after Tax ÷ PS Div.

6. Capital Intensity Ratio

Measures efficiency of the firm to generate sales through employment of its
resources.

Computed as follows:

Capital Intensity Ratio = Total Assets ÷ Net Sales

7. Times Fixed Charges Earned

Measures ability to meet fixed charges.

Computed as follows:

TFCE = Net Income before taxes & charges ÷ Fixed charges + sinking fund
payment**

** Fixed charges shall include rent, interests and other relevant fixed
expenses; sinking fund payment must be expressed before tax.

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SOLVENCY RATIOS
1. Working Capital Turnover
Indicates adequacy of working capital to support operations (sale).

Computed as follows:

WC Turnover = Net Sales ÷ Ave. Working Capital

2. Defensive Interval Ratio

Measures coverage of current liabilities

Computed as follows:

DIR = Current Liabilities ÷ Cash & Cash Equivalents

3. Payable Turnover
Measures efficiency of the company in meeting the accounts payable.

Computed as follows:

Payable Turnover = Net Purchases ÷ Ave. Accounts Payable

4. Fixed Asset to Long-term Liabilities

Reflects extent of the utilization of resources from long-term debt. Indicative of
sources of additional funds.

Computed as follows:

FA to LTL = Fixed Assets ÷ Long-term Liabilities

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RATIOS INDICATIVE OF INCOME POSITION
1. Rate of return on Average Current Asset
Measures profitability of current assets invested.

Computed as follows:

RoR on ACA = Income ÷ Ave. Current Assets

2. Operating profit margin

Measures profit generated after consideration of operating costs.

Computed as follows:

OPM = Operating Profit ÷ Net Sales

3. Cash Flow Margin

Measures the ability of the firm to translate sales to cash

Computed as follows:

CFM = Operating Cash Flow ÷ Net Sales

GROSS PROFIT VARIANCE ANALYSIS

Analysis of variation in gross profit is an indispensable tool in controlling
operations; the adequacy or inadequacy of gross profit determines the final
results of operations (net income). Gross profit must be adequate to cover
operating expenses, financing, income taxes and a desired amount of profit. At
times, the gross profit figure is also being used as a basis for performance
evaluation.

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Gross profit is the difference between sales and cost of goods sold. It is a very
important figure in the income statement because it is one of the factors that
determine the final result of operations.

Changes in the financial statement may be attributed to the change in any, or a

combination of the following factors:

1. Selling price
2. Volume or quantity of products sold.
3. Cost of product sold

GP variance may be analyzed through the following:

 GP (Actual) vs. GP (Budget)
 GP (Current) vs. GP (Prior Period)

NOTE:
FAVORABLE if actual (current) GP is greater than budgeted (prior-period) GP.
UNFAVORABLE if actual (current) GP is less than budgeted (prior-period) GP.

There are different ways of analyzing gross profit variances. Presented here are 4-
way, 6-way and 3-way analyses.

4-WAY ANALYSIS:

Sales Variance:
Price factor = (Change in SP x Actual Volume or quantity)
Volume/quantity factor = (Change in units x Standard/Budgeted SP)

Cost Variance:
Price factor = (Change in CP x Actual Volume or quantity)
Volume/quantity factor = (Change in units x Standard/Budgeted CP)

Note: The above procedures are the same as the one used in 2-way analysis for
materials and labor variances.

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6-WAY ANALYSIS:

Sales Variance:
Price factor = (Change in SP x Standard/Budgeted Volume/quantity)
Volume/quantity factor = (Change in units/volume x Standard/Budgeted SP)
Price-volume factor = (Change in SP x Change in Units)

Cost Variance:
Price factor = (Change in CP x Standard/Budgeted Volume/quantity)
Volume/quantity factor = (Change in units/volume x Standard/Budgeted CP)
Price-volume factor = (Change in CP x Change in Units)

Note:
The price factor refers to the change in Selling or cost prices assuming that there
has been no change in units sold.
The quantity or volume factor refers to the change in the number of units sold
assuming that there has been no change in the selling or cost prices.
The price-volume factor refers to the sales or cost of sales variances due to the
combined effect of the differences in price and units sold.

3-WAY ANALYSIS:

Quantity/volume factor = (Change in units x Standard/Budgeted GP/unit)

Price factor = (Change in SP x Actual Volume/quantity)

Cost factor = (Change in CP x Actual Volume/quantity)

Note: The quantity factor refers to the change in gross profit due to the difference
in units sold.
The price factor refers to the change in gross profit due to the difference in
selling price.

GROSS PROFIT VARIANCE – TWO OR MORE PRODUCTS

The sales price, sales volume, cost price and cost volume variances are first
computed using the approach similar to the one used for 4-way analysis. Then,

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the sales volume and cost volume variances are analyzed further, which results in
the computation of a sales mix variance and final sales volume variance. The
formulas for these last two variances are as follows:

Sales mix variance:

Actual units @ Standard/Budgeted SP xx
Less: Actual units @ Standard CP (xx)
Difference xx
Less: Actual units @ Standard Average GP (xx)
SALES MIX VARIANCE xx

Final Sales Volume Variance:

Actual units @ Standard/Budgeted Ave. GP xx
Less: Standard/Budgeted GP (xx)
FINAL SALES VOLUME VARIANCE xx

ILLUSTRATIVE EXERCISES
VERTICAL AND HORIZONTAL ANALYSIS
The comparative balance sheets of Philip Morris Companies, Inc. are presented
below.

PHILIP MORRIS COMPANIES, INC.

Comparative Balance Sheets
December 31
(In million Dollars)
2014 2013
ASSETS
Current Assets 21,382 17,441
Property, plant and equipment (net) 16,067 14,846
Other Assets 58,726 55,253
Total Assets 96,175 87,540

LIABILITIES and SHE

Current Liabilities 21,393 19,082
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 Long-term Liabilities 49,705 48,980
Stockholders’ Equity 25,077 19,478
Total Liabilities and SHE 96,175 87,540

Required: (Round all computations to 2 decimal places).

1. Prepare a horizontal analysis of the balance sheet data for Philip Morris
using 2013 as a base.
2. Prepare a vertical analysis of the balance sheet data for Philip Morris for
2013 and 2014.

VERTICAL AND HORIZONTAL ANALYSIS

Here are the comparative income statements of Viking Corporation

VIKING CORPORATION
Comparative Income Statements
For the years ended December 31
(In million Dollars)
2014 2013
Net Sales 550,000 550,000
Cost of goods sold 440,000 450,000
Gross Profit 110,000 100,000
Operating Expenses 58,000 55,000
Net Income 52,000 45,000

Required: (Round all computations to 2 decimal places)

1. Prepare a horizontal analysis of the income statement data for Viking
Corporation using 2013 as a base.
2. Prepare a vertical analysis of the income statement data for Viking
Corporation for both years.

LIQUIDITY ANALYSIS
Indicate the effects of each of the following transactions on the company’s (A)
current ratio and (B) acid-test ratio. There are the possible answers: (+) increase,
(-) decrease, and (0) no effect. Before each transaction takes place, both ratios
are greater than 1 to 1.

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 Effects on
Transactions Current ratio Acid-test ratio
Example: Sell merchandise for cash. + +
1. Buy inventory on account.
2. Pay an account payable.
3. Borrow cash on a short-term loan.
4. Issue long-term bonds payable.
5. Collect an accounts receivable.
6. Record accrued expenses payable.
7. Sell a plant asset for cash at a profit.
8. Sell a plant asset for cash at a loss.
9. Buy marketable securities, for cash.
10. Sell merchandise on credit.

FINANCIAL RATIOS
Leen has 1,000,000 common shares outstanding. The price of the stock is P8. Leen
declared dividends per share of P0.10. The balance sheet at the end of 2013
showed approximately the same amounts as that at the end of 2014.

The financial statements for Leen Merchandising are as follows:

Leen Company, Income Statement for 2014 (in thousands)

Sales 4,700
Cost of goods sold 2,300
Gross profit 2,400
Operating expenses:
Depreciation 320
Other 1,230 1,550
Income before interest and taxes 850
Interest expense 150
Income before taxes 700
Income taxes 280
Net income 420

Leen Company, Balance Sheet at December 31, 2014 (in thousands)

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 Assets Liabilities
and SHE
Cash 220 Accounts payable 190
Accounts receivable 440 Accrued expenses 180
Inventory 410 Total current liabilities 370
Total current assets 1,070 Long-term debt 1,960
Plant and equipment 5,600 Common stock 1,810
Accumulated depreciation (2,100) Retained earnings 430
Total assets 4,570 Total liabilities and SHE 4,570

Required: (Round all computations to 2 decimal places.)

1. Current ratio 11. EPS
2. Acid-test ratio 12. P/E ratio
3. Accounts receivable turnover 13. Dividend yield
4. Inventory turnover 14. Payout ratio
5. Gross profit margin 15. Debt ratio
6. Operating profit margin 16. Debt-equity ratio
7. Return on sales 17. Times interest earned
8. ROA – operational performance 18. Defensive interval
ratio
9. ROA – total management effort 19. Cash flow to total
debt
10. Return on equity 20. Cash flow margin

FINANCIAL RATIOS
(Interpreting Financial Statements)

The Coca-Cola Company and PepsiCo, Inc. provide refreshments to every corner
of the world. Selected data from the 2003 consolidated financial statements for
The Coca-Cola Company and for PepsiCo, Inc. are presented here (in millions of
Dollars).

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 Coca-Cola PepsiCo
Total current assets 8,396 6,930
Total current liabilities 7,886 6,415
Net sales 21,044 26,971
Cost of goods sold 7,762 12,379
Net income 4,347 3,568
Average receivables for the year 2,094 2,681
Average inventories for the year 1,273 1,377
Average total assets 25,874 24,401
Average common shareholders’ equity 12,945 10,713
Average current liabilities 7,614 6,234
Average total liabilities 12,929 13,702
Total assets 27,342 25,327
Total liabilities 13,252 13,453
Income taxes 1,148 1,424
Interest expense 178 163
Cash provided by operating activities 5,456 4,328

Required: (Round all computations to 2 decimal places).

1. Compute the following liquidity ratios for 2003 for Coca-Cola and for
PepsiCo and comment on the relative liquidity of the two competitors.
a. Current ratio
b. Receivables turnover
c. Average collection period
d. Inventory turnover
e. Days in inventory
f. Current cash debt coverage

2. Compute the following solvency ratios for the two companies and
comment on the relative solvency of the two competitors.
a. Debt to total assets.
b. Times interest earned.
c. Cash debt coverage ratio.

3. Compute the following profitability ratios for the two companies and
comment on the relative profitability of the two competitors.
a. Profit margin
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 b. Asset turnover
c. Return on assets
d. Return on common stockholders’ equity

GROSS PROFIT ANALYSIS (SINGLE PRODUCT)

KOYOT CORPORATION has the following data:
2014 2013
Sales volume in units 5,000 8,000
Selling price per unit P10 P8
Cost per unit P7 P6

Required: (Round all computations to 2 decimal places).

Compute for the Gross Profit Variance using:

1. 4-way analysis
2. 6-way analysis
3. 3-way analysis

GROSS PROFIT ANALYSIS (SINGLE PRODUCT)

(FULL INFORMATION)

Panda Company prepared the following budgetary information for January of

2014 for its toy gun:

Sales (12,000 units) 432,000

Cost of goods sold 288,000
Gross profit 144,000

In January, actual operations resulted in the production and sale of 13,000 units
at an average selling price of P34 per unit. The cost of goods sold per unit
increased by P3.

Required: (Round all computations to 2 decimal places).

1. Overall GP variance.
2. Sales price variance.
3. Sales volume variance.

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 4. Cost price variance.
5. Cost volume variance.

GROSS PROFIT ANALYSIS (SINGLE PRODUCT)

(INCOMPLETE INFORMATION)

Spaniard Company has requested you to determine the cause of the difference
between its 2013 and 2014 gross profit based on the following data:

2013 2014
Sales 200,000 252,000
Cost of Goods Sold 120,000 180,000
Gross Profit 80,000 72,000

No additional data was made available except that unit sales increased by 20% in
2014.

Required: (Round all computations to 2 decimal places).

1. Overall GP variance.
2. Price factor.
3. Cost factor.
4. Volume factor.

GROSS PROFIT ANALYSIS (MULTIPLE PRODUCTS)

The following are the data for ARIUS LUKE ANGELO CORPORATION:

2014 2013
Product Product Product Product Product Product
A L R A L R
Sales volume 400 350 1,000 500 200 1,000
in units
Selling prices P4 P5 P3 P4.50 P4.20 P2.80
per unit
Cost per unit P1.60 P2 P1.20 P1.68 P1.80 P1.12

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Required: (Round all computations to 2 decimal places).
Compute for the sales mix variance and final sales volume variance

GROSS PROFIT ANALYSIS (MULTIPLE PRODUCTS)

The following data were given for Vamos Company:

2013 2014
Product Product Product Product
A B A B
Sales volume 6,000 4,000 3,000 5,000
Unit selling price 10 6 9 5
Unit cost 6 3 4 3

Required: (Round all computations to 2 decimal places).

1. Overall GP variance 4. Volume factor
2. Price factor 5. Mix factor
3. Cost factor

PRACTICE EXERCISES
(Sources: CMA/CIA/RPCPA/AICPA/Various test banks)

THEORIES
1. A high sales-to-working capital ratio could indicate
a. Unprofitable use of working capital
b. Sales are not adequate relative to available working capital.
c. The firm is undercapitalized.
d. The firm is not susceptible to liquidity problems.

2. Rice Inc. uses the allowance method to account for uncollectible

accounts. An account receivable that was previously determined
uncollectible and written off was collected during May. The effect of the
collection on Rice’s current ratio and total working capital is
Current Ratio Working Capital
a. None None
b. Increase Increase
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 c. Decrease Decrease
d. None Increase

3. Accounts receivable turnover ratio will normally decrease as a result of

a. The write-off of an uncollectible account (assume the use of the
allowance for doubtful accounts method).
b. A significant sales volume decrease near the end of the accounting
period.
c. An increase in cash sales in proportion to credit sales.
d. A change in credit policy to lengthen the period of cash discounts.

4. The days’ sales-in-receivables ratio will be understated if the company

a. Uses a natural business year for its accounting period.
b. Uses a calendar year for its accounting period.
c. Uses average receivables in the ratio calculation.
d. Does not use average receivables in the ratio calculation

Questions 5 through 11are based on the following information.

Depoole Company is a manufacturer of Industrial products and uses a calendar
year for financial reporting purposes. These questions present several of
Depoole’s transactions during the year. Assume that the total quick assets
exceeded total current liabilities both before and after each transaction
described. Further assume that Depoole has positive profits during the year and a
credit balance throughout the year in its retained earnings account.

5. Payment of a trade account payable of P64,500 would

a. Increase the current ratio, but the quick ratio would not be affected.
b. Increase the quick ratio, but the current ratio would not be affected.
c. Increase both the current and quick ratios.
d. Decrease both the current and quick ratios.

6. The purchase of raw materials for P85,000 on open account would

a. Increase the current ratio.
b. Decrease the current ratio.
c. Increase net working capital.
d. Decrease net working capital.

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7. The collection of a current account receivable of P29,000 would
a. Increase the current ratio
b. Decrease the current ratio and the quick ratio
c. Increase the quick ratio
d. Not affect the current or quick ratio

8. Obsolete inventory of P125,000 was written off during the year. This
transaction
a. Decreased the quick ratio.
b. Increased the quick ratio.
c. Increased net working capital.
d. Decreased the current ratio.

9. The issuance of new shares in a five-for-one split of common stock

a. Decreases the book value per share of common stock.
b. Increases the book value per share of common stock.
c. Increases total shareholders’ equity.
d. Decreases total shareholders’ equity.

10. The issuance of a serial bonds in exchange for an office building, with the
first installment of the bonds due late this year,
a. Decreases net working capital.
b. Decreases the current ratio.
c. Decreases the quick ratio.
d. Affects all of the answers as indicated.

11. Refer to the information preceding question 1. The early liquidation of a

long-term note with cash affects the
a. Current ratio to a greater degree than the quick ratio.
b. Quick ratio to a greater degree than the current ratio.
c. Current and quick ratio to the same degree.
d. Current ratio but not the quick ratio.

12. To determine the operating cycle for a retail department store, which one
of the following pairs of items is needed?
a. Days sales in accounts receivable and average merchandise inventory.
b. Cash turnover and net sales.
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 c. Accounts receivable turnover and inventory turnover.
d. Asset turnover and return on sales.

13. If the ratio of total liabilities to shareholders’ equity increases, a ratio that
must also increase is
a. Times interest earned.
b. Total liabilities to total assets.
c. Return on equity.
d. The current ratio.

14. Return on investment may be calculated by multiplying total asset

turnover by
a. Average collection period.
b. Profit margin.
c. Debt ratio.
d. Fixed-charge coverage.

15. If a company is profitable and is effectively using leverage, which one of

the following ratios is likely to be the largest?
a. Return on total assets.
b. Return on operating assets.
c. Return on common equity.
d. Return on total equity.

16. A drop in the market price of a firm’s common stock will immediately
increase its
a. Return on equity.
b. Dividend payout ratio.
c. Market-to-book ratio.
d. Dividend yield.

17. A debt-to-equity ratio is

a. About the same as the debt-to-assets ratio.
b. Higher than the debt-to-assets ratio.
c. Lower than the debt-to-assets ratio.
d. Not correlated with the debt-to-assets ratio.

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18. Which of the following is not a limitation of ratio analysis affecting
comparability among firms?
a. Different accounting policies.
b. Different fiscal years.
c. Different sources of information.
d. All of the above are limitations of ratio analysis.

19. Which of the following is the worst limitation of ratio analysis affecting
comparability from one interim period to the next within the firm?
a. Management has an incentive to window dress financial statements
to improve results.
b. In a seasonal business, inventory and receivables may vary widely
with year-end balances not reflecting the averages for the period.
c. Comparability is impaired if different firms use different accounting
policies.
d. Generalizations about which ratios are strong indicators of a firm’s
financial position may change from industry to industry and firm to
firm.

20. In assessing the financial prospects for a firm, financial analysts use
various techniques. Which of the following is an example of vertical
common-size analysis?
a. An assessment of the relative stability of a firm’s level of vertical
integration.
b. A comparison in financial ratio form between two or more firms in
the same industry.
c. A statement that current advertising expense is 2% greater than in
the prior year.
d. A statement that current advertising expense is 2% of sales.

21. Under the direct method of determining net cash provided by operating
activities on the statement of cash flows, a gain on sale of plant assets
would be:
a. Added to the amount of operating expenses reported under the accrual
basis.
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 b. Deducted from the amount of the operating expenses reported under
the accrual basis.
c. Deducted from the amount of sales reported under the accrual basis.
d. Totally ignored since the gain is not a part of sales, cost of goods sold,
or operating expenses.

22. Which of the following account changes would be classified as a use of

funds?
a. An increase in accounts payable c. A decrease in bonds payable
b. An increase in retained earnings d. A decrease in accounts
receivable
23. Shakey’s Corporation has an acid test ratio of 1.5 to 1.0. Which of the
following will cause this ratio to deteriorate?
a. Payment of cash dividends previously declared.
b. Borrowing short-term loan from a bank.
c. Sale of inventory on account.
d. Sale of equipment at a loss

24. A Company has a current ratio greater than 1:1 and a quick ratio less than
1:1. Soon thereafter, all cash was used to reduce accounts payable. How
did these cash payments affect (1) current ratio (2) quick ratio?
a. (1) Decreased (2) Decreased c. (1) Increased (2) Decreased
b. (1) Decreased (2) Increased d. (1) Increased (2) Increased

25. If Jonas Co. decides to change from FIFO to LIFO inventory method during
the period of rising prices, its
a. Current ratio would be reduced c. Inventory turnover will be
reduced
b. Debt-to-equity ratio would be reducedd. Cash flow would be reduced

26. How is the average inventory balance used in the calculation of each of
the following?
Acid-test ratio Inventory turnover
a. Numerator Numerator
b. Numerator Denominator
c. Not used Denominator
d. Not used Numerator
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 27. A company’s return on investment is affected by a change in
Capital turnover Profit margin on sales
a. Yes Yes
b. Yes No
c. No No
d. No Yes

28. Return on investment (ROI) is a term often used to express income

earned on capital invested in a business unit. A company’s ROI is
increased if
a. Sales increase by the same peso amount as expenses and total assets.
b. Sales remain the same and expenses are reduced by the same peso
amount that total assets
increase.
c. Sales decrease by the same dollar amount that expenses increase.
d. Net profit margin on sales increases by the same percentage as total
assets.

29. ROA and ROE are measures of

a. Solvency c. Profitability
b. Liquidity d. Current asset activity

30. A fire has destroyed many of the financial records of National & Co. You
are assigned to put together a financial report. You have found out that
the return on equity to be 12% and the debt ratio was 0.40.
What was the return on assets?
a. 5.35% c. 6.60%
b. 8.4% d. 7.20%

PROBLEMS
1. Windham Company has current assets of P400,000 and current liabilities
of P500,000. Windham Company’s current ratio would be increased by
a. The purchase of P100,000 of inventory on account.
b. The payment of P100,000 of accounts payable.

30
 c. The collection of P100,000 of accounts receivable.
d. Refinancing a P100,000 long-term loan with short-term debt.

Questions 2 through 5 are based on the following information.

Tosh Enterprises reported the following account information.

Accounts receivable 400,000

Accounts payable 160,000
Bonds payable, due in 10 years 600,000
Cash 200,000
Interest payable, due in 3 months 20,000
Inventory 800,000
Notes payable, due in 6 months 100,000
Prepaid expenses 80,000
The company has a normal operating cycle of 6 months.

2. The current ratio for Tosh Enterprise is

a. 1.68
b. 2.14
c. 5.00
d. 5.29

3. What is the company’s quick ratio?

a. 0.68
b. 1.68
c. 2.14
d. 2.31

4. What will happen to the ratios below if Tosh Enterprises uses cash to pay
25% of the accounts payable?
Current Ratio Quick Ratio
a. Increase Increase
b. Decrease Decrease
c. Increase Decrease
d. Decrease Increase

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 5. The amount of working capital is
a. 600,000
b. 1,120,000
c. 1,200,000
d. 1,220,000

Questions 6 through 8 are based on the following information.

The selected data pertain to a company at December 31.

Quick asset ratio P203,000

Acid test ratio 2.6 to 1
Current ratio 3.5 to 1
Net sales for the year P1,800,000
Cost of sales for the year P990,000
Average total assets for the year P1,200,000

6. The company’s current liabilities at December 31 equal

a. 59,429
b. 80,000
c. 134,857
d. 187,200

7. The company’s inventory balance at December 31 is

a. 72,000
b. 187,200
c. 231,111
d. 282,857

8. The company’s asset turnover ratio for the year is

a. .675
b. .825
c. 1.21
d. 1.50

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9. Watson Corporation computed the following items from its financial
records for the year:
Price earnings ratio 12
Payout ratio .6
Asset turnover ratio .9

The dividend yield on Watson’s common stock is

a. 5.0%
b. 7.2%
c. 7.5%
d. 10.8%

10. The following information is provided about the common stock of

Evergreen Inc., at the end of the fiscal year:
Number of shares outstanding 1,800,000
Par value per share 10.00
Dividends paid per share(last 12 months) 12.00
Market price per share 108.00
Basic earnings per share 36.00
Diluted earnings per share 24.00

The price-earnings ratio for Evergreen’s common stock is

a. 3.0 times
b. 4.5 times
c. 9.0 times
d. 10.8 times

11. Baylor Company paid out one-half of last year’s earnings in dividends.
Baylor’s earnings increased by 20%, and the amount of its dividends
increased by 15% in the current year. Baylor’s dividend payout ratio for
the current year was
a. 50%
b. 57.5%
c. 47.9%
d. 78%

33
 12. Selected data from Starbucks are presented below. The difference
between average and ending inventories is immaterial. Current assets are
comprised mainly of cash, receivables and inventories.

Current ratio 2.0

Quick ratio 1.5
Current liabilities 600,000
Inventory turnover (based on cost of sales) 8 times
Gross profit margin 40%

Starbuck’s net sales for the year were

a. 2.4 million c. 1.2 million
b. 4.0 million d. 6.0 million

13. Based on the data presented below, what is Goldilocks Corporation’s cost
of sales for the year?

Current ratio 3.5

Acid test ratio 3.0
Year end current liabilities 600,000
Beginning inventory 500,000
Inventory turnover 8.0
a. 1,600,000 c. 3,200,000
b. 2,400,000 d. 6,400,000

Items 14 - 16 are based on the following information

2012 2013 2014
Accounts receivable, net 40,000 42,500 45,000
Inventory 40,000 50,000 45,000
Current assets 120,000 140,000 130,000
Total assets, net 700,000 750,000 725,000
Current liabilities 70,000 80,000 50,000
Cash sales 400,000 420,000 450,000
Credit sales 120,000 125,000 131,250
Cost of sales 310,000 324,000 345,000

34
 14. What would be the age of receivables in 2014?
a. 110 days c. 130 days
b. 120 days d. None of these

15. Determine the number of days in inventory for 2013?

a. 50 days c. 70 days
b. 60 days d. None of these

16. Turnover of (net) working capital for 2014 is

a. 9.9 c. 7.15
b. 8.3 d. None of these

17. Selected information for 2014 for Tokyo Company is as follows:

Cost of goods sold 5,400,000

Average inventory 1,800,000
Net sales 7,200,000
Average receivables 960,000
Net income 720,000

Assuming 360 days in a year, what was the average number of days in
operating cycle for 2014?
a. 72 days c. 144 days
b. 84 days d. 168 days

Questions 18 through 23 are based on the following information.

The statement of financial position for King Products Corporation for the fiscal
years ended June 30, 2014 and June 30, 2013 is presented below. Net sales and
cost of goods sold for the year ended June 30, 2014 were P600,000 and P440,000
respectively.

35
 King Products Corporation
Statement of Financial Position
(In Thousands)
June 30, June 30,
2014 2013
Cash 60 50
Trading securities (at Fair Value) 40 30
Accounts receivable (net) 90 60
Inventories (at lower of cost or market) 120 100
Prepaid items 30 40
Total current assets 340 280

Land (at cost) 200 190

Building (net) 160 180
Equipment 190 200
Patents (net) 70 34
Goodwill (net) 40 26
Total long-term assets 600 630
TOTAL ASSETS 1,000 910

Notes payable 46 24
Accounts payable 94 56
Accrued interest 30 30
Total current liabilities 170 110
Notes payable, 10% due 12/31/19 20 20
Bonds payable, 12% due 6/30/21 30 30
Total long-term debt 50 50
Total Liabilities 220 160
Preferred stock-5% cumulative, P100 par,
nonparticipating, authorized, issued and 200 200
outstanding 2,000 shares
Common stock-P10 par, 40,000 shares
authorized, 30,000 shares issued and 300 300
outstanding
Additional paid in capital 150 150
Retained earnings 130 100
36
Total Equity 780 750
TOTAL LIABILITIES AND EQUITY 1,000 910

18. King Products Corporation’s inventory turnover ratio for the fiscal year at
June 2014 was
a. 3.7
b. 4.0
c. 4.4
d. 6.0

19. King Products Corporation’s receivables turnover ratio for this period was
a. 4.9
b. 5.9
c. 6.7
d. 8.0

20. King Products Corporation’s average collection period for the fiscal year
ended June 30, 2014 using a 360-day year was
a. 36 days
b. 45 days
c. 54 days
d. 61 days

21. King Products Corporation’s quick ratio at June 30, 2014 was
a. 0.6
b. 1.1
c. 1.8
d. 2.0

22. Assuming that King Products Corporation’s net income for the year ended
June 30, 2014 was P70,000 and there are no preferred stock dividends in
arrears, King Products’ return on common equity was
a. 7.8%
b. 10.6%
c. 10.9%
d. 12.4%

37
 23. Assuming that there are no preferred stock dividends in arrears, King
Products Corporation’s book value per share of common stock at June 30,
2014 was
a. 10.00
b. 14.50
c. 18.33
d. 19.33

24. Given an acid test ratio of 2.0, current assets of P5,000 and inventory of
P2,000, the value of current liabilities is
a. 1,500
b. 2,500
c. 3,500
d. 6,000

Questions 25 through 30 are based on the following information about Devlin

Company.
Statement of Financial Position as of May 31
(In Thousands)
2014 2013
Assets
Current assets
Cash 45 39
Trading securities 30 20
Accounts receivable (net) 68 48
Inventory 90 80
Prepaid expenses 22 30
Total current assets 255 216
Investments, at equity 38 30
Property, plant, and equipment (net) 375 400
Intangible assets (net) 80 45
TOTAL ASSETS 748 691

38
 Liabilities and equity
Current liabilities
Notes payable 36 18
Accounts payable 70 42
Accrued expenses 5 4
Income taxes payable 15 16
Total current liabilities 125 80
Long-term debt 35 35
Deferred taxes 3 2
Total liabilities 163 117
Equity
Preferred stock, 6%, P100 par value 150 150
cumulative
Common stock, P10 par value 225 195
Additional paid-in capital common stock 114 100
Retained earnings 96 129
Total equity 585 574
TOTAL LIABILITIES AND EQUITY 748 691

Income Statement for the year ended May 31

(in thousands)
2014 2013
Net sales 480 460
Costs and expenses
Cost of goods sold 330 315
Selling, general and administrative 52 51
Interest expense 8 9
Income before taxes 90 85
Income taxes 36 34
Net income 54 51

25. Devin Company’s acid-test ratio at May 31, 2014 was

a. 0.60 to 1
b. 0.90 to 1
c. 1.14 to 1
d. 1.86 to 1

39
 26. Assuming there are no preferred stock dividends in arrears, Devlin
Company’s return on common equity for the year ended May 31, 2014
was
a. 6.3%
b. 7.5%
c. 7.8%
d. 10.5%

27. Devlin Company’s inventory turnover for the year ended May 31, 2014
was
a. 3.67 times
b. 3.88 times
c. 5.33 times
d. 5.65 times

28. Devlin Company’s asset turnover for the year ended May 31, 2014
a. 0.08 times
b. 0.46 times
c. 0.67 times
d. 0.83 times

29. Devlin Company’s rate of return on assets for the year ended May 31,
2014
a. 7.2%
b. 7.5%
c. 7.8%
d. 11.2%

30. Devlin Company’s time-interest-earned ratio for the year ended May 31,
2014 was
a. 6.75 times
b. 11.25 times
c. 12.25 times
d. 18.75 times

 Don't follow your dreams; chase them! 

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