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CHAPTER 5BASICS OF ANALYSIS

MULTIPLE CHOICE 1. Statements in which all items are expressed only in relative terms (percentages of a base) are termed: a Vertical Statements . b Horizontal Statements . c !nds Statements . d "ommon#Size Statements . e none of the answers are correct .

$%S: & '. (n financial statement analysis) ratios are: a the only type of analysis where ind!stry data are available . b absol!te n!mbers converted to a common base . c fractions !s!ally expressed in percent or times . d the only indication of the financial position of the firm . e none of the answers are correct .

$%S: " *. &enver &ynamics has net income of +'),,,),,,. -a.land /nterprises has net income of +')0,,),,,. 1hich of the following best compares the profitability of &enver and -a.land2 a -a.land /nterprises is '03 more profitable than &enver &ynamics. . b -a.land /nterprises is more profitable than &enver &ynamics) b!t the comparison can4t . be 5!antified. c -a.land /nterprises is only more profitable if it is smaller than &enver &ynamics. . d !rther information is needed for a reasonable comparison. . e -a.land /nterprises is more profitable if it is a larger firm than &enver &ynamics. .

$%S: & 6. 1hich of the following can offer a type of comparison in financial statement analysis2

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a . b . c . d . e .

past ratios and fig!res ind!stry averages statistics of competitors all of the answers are correct none of the answers are correct

$%S: & 0. 1hich of the following is not a so!rce of ind!stry statistics2 a $nn!al Statement St!dies . b <ergent &ividend 9ecord . c Val!e 8ine . d Standard and =oor4s (nd!stry S!rveys . e :he &epartment of "ommerce inancial 9eport .

$%S: >

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?.

$nn!al Statement St!dies reported the following fig!res for man!fact!rers of screw machine prod!cts for the ratio of c!rrent assets to c!rrent debt. :he following fig!res are for a partic!lar ind!stry4s c!rrent ratio: 1.?@ 1.*@ 1.'. 1hich best describes these three n!mbers2 a -ne third of each of the companies experienced each of the ratios. . b :he average ratio was 1.*. :he best firm had 1.?@ :he worst had 1.'. . c :he median was 1.*. 1.? is the fig!re for the !pper 5!artile@ 1.' is the fig!re for the lower . 5!artile. d :he median was 1.*. 1.? is the fig!re for the lower 5!artile@ 1.' is the fig!re for the !pper . 5!artile. e %one of the answers are correct. .

$%S: " A. $ man!fact!ring firm will most li.ely have the heaviest investment in which type of assets2 a cash . b inventory . c acco!nts receivable . d investments . e plant) property) and e5!ipment .

$%S: / B. $ retailing firm has which type of inventory2 a raw materials . b wor. in process . c merchandise . d raw materials and merchandise . e raw materials) wor. in process) and merchandise .

$%S: " C. 1hich of the following wo!ld not be a !ser of financial statements2 a management . b ban.ers

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. c employee !nions . d investment analysts . e all of the above are !sers .

$%S: / 1,. 1hich of the following is a government doc!ment that provides ind!stry statistics2 a :he 1all Street Do!rnal . b >!siness 1ee. . c &!n4s . d :he &epartment of "ommerce inancial 9eport . e Standard and =oor4s (nd!stry S!rvey .

$%S: &

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11.

S!ppose yo! are comparing two firms in the steel ind!stry. -ne firm is large and the other is small. 1hich type of n!mbers wo!ld be most meaningf!l for statement analysis2 a $bsol!te n!mbers wo!ld be most meaningf!l for both the large and small firm. . b $bsol!te n!mbers wo!ld be most meaningf!l in the large firm@ relative n!mbers wo!ld . be most meaningf!l in the small firm. c 9elative n!mbers wo!ld be most meaningf!l for the large firm@ absol!te n!mbers wo!ld . be most meaningf!l for the small firm. d 9elative n!mbers wo!ld be most meaningf!l for both the large and small firm) especially . for interfirm comparisons. e (t is not meaningf!l to compare a large firm with a small firm. .

$%S: & 1'. Vario!s techni5!es are !sed in the analysis of financial data to emphasize the comparative and relative importance of the data presented and to eval!ate the position of the firm. 1hich of the following is not one of the techni5!es !sed in analysis2 a ratio analysis . b common#size analysis . c theory consistency . d examination of relative size among firms . e review of descriptive material .

$%S: " 1*. 8i5!idity ratios can be !sed: a to meas!re the degree of protection of long#term s!ppliers of f!nds . b to meas!re borrowing capacity . c to meas!re the earning ability of a firm . d to meas!re the firm4s ability to meet its c!rrent obligations . e to meas!re the worth of the firm .

$%S: & 16. 1hich of these statements is false2 a $ ratio can be comp!ted from any pair of n!mbers. .

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b . c . d . e .

Eiven the large 5!antity of variables incl!ded in financial statements) a very long list of meaningf!l ratios can be derived. "omparing ratios comp!ted from income statement and balance sheet n!mbers can create diffic!lties d!e to the timing of the financial statements. inancial ratios are !s!ally expressed in percent or times. (n vertical analysis) a fig!re from the year4s statement is compared with a base selected from the prior statement.

$%S: /

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10. a . b . c . d . e .

1hich of these statements is false2 <any companies will not clearly fit into any one ind!stry. $ financial service !ses its best F!dgment as to which ind!stry the firm best fits. :he analysis of an entity4s financial statements can be more meaningf!l if the res!lts are compared with ind!stry averages and with res!lts of competitors. 1hen !sing ind!stry averages) it is often necessary to !se an ind!stry that the firm best fits. $ company comparison sho!ld not be made with ind!stry averages if the company does not clearly fit into any one ind!stry.

$%S: / 1?. 1hich of the following does not represent a problem with financial analysis2 a inancial statement analysis is an art@ it re5!ires F!dgment decisions on the part of the . analyst. b inancial analysis can be !sed to detect apparent li5!idity problems. . c :here are as many ratios for financial analysis as there are pairs of fig!res. . d Some ind!stry ratio form!las vary from so!rce to so!rce. . e $de5!ate detailed disclos!re of how the ind!stry ratios are comp!ted is often lac.ing. .

$%S: > 1A. 1hich of the following is a false statement as it relates to analysis2 a =rofitability may not be a maFor consideration as long as the reso!rces for repayment can . be proFected. b /5!ity capital provides creditors with a c!shion against loss. . c :here is a difference between the obFectives that are so!ght by short#term grantors of . credit and those so!ght by long#term grantors of credit. d (f merchandise with a ',3 mar.!p is sold on credit) it wo!ld ta.e ten s!ccessf!l sales of . the same amo!nt to ma.e !p for one sale not collected. e :he financial str!ct!re of the entity is of interest to creditors. .

$%S: & 1B. <anagement is a !ser of financial analysis. 1hich of the following comments does not represent a fair statement as to the management perspective2 a <anagement is interested in the view of investors. . b <anagement is interested in the view of creditors. . c <anagement is interested in the financial str!ct!re of the entity.

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. d <anagement is interested in the asset str!ct!re of the entity. . e <anagement is always interested in maxim!m profitability. .

$%S: /

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1C.

1hich of the following statements is incorrect2 a :he %orth $merican (nd!stry "lassification System (%$("S) was created Fointly by the . ;nited States) "anada) and <exico. b or the %$("S) economic !nits with similar prod!ction processes are classified in the . same ind!stry) and the lines drawn between ind!stries demarcate differences in prod!ction processes. c %$("S provides enhanced ind!stry comparability among the three %$ :$ trading . partners. d %$("S divides the economy into twenty sectors. . e (n most sectors) %$("S provides for compatibility at the ind!stry (six#digit) level. .

$%S: / TRUE/FALSE 1. 8i5!idity ratios meas!re the degree of protection of long#term s!ppliers of f!nds. $%S: '. $ given ratio is always comp!ted the same way) no matter what the so!rce. $%S: *. :he ideal way to compare income statement fig!res) s!ch as sales) to balance sheet fig!res) s!ch as receivables) is to !se a meas!re of the average for the balance sheet fig!res. $%S: : 6. (n vertical common#size analysis) the dollar fig!re for an acco!nt is expressed in terms of that same acco!nt fig!re for a selected base year. $%S: 0. $bsol!te fig!res !s!ally have more meaning than ratio comparisons. $%S: ?. (n order to determine the meaning of a ratio) some .ind of comparison) s!ch as an ind!stry average or trend analysis) is helpf!l. $%S: : A. &ifferent acco!nting methods can ca!se some ratios to differ s!bstantially. $%S: : B. &issimilar year ends will have no impact on the res!lts of ratios.

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$%S:

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C. acco!nts receivable. $%S:

:he principal asset of a merchandising firm will !s!ally be

1,. $ service firm will !s!ally have a low amo!nt of inventory) consisting primarily of s!pplies. $%S: : 11. :ypically) the largest expense to a man!fact!ring firm is cost of goods sold. $%S: : 1'. :he descriptive information in ann!al reports is not !sef!l in statement analysis@ only the financial statements themselves are of val!e. $%S: 1*. >ased on the terms of the credit and the p!rpose) the obFectives of financial statement analysis by creditors will vary. $%S: : 16. inancial statement analysis is a F!dgmental process. $%S: : 10. :here is a standard list of ratios. $%S: 1?. "ommon#size analysis involves expressing comparisons in percentages. $%S: : 1A. $bsol!te fig!res and ratios are close to being meaningless !nless compared to another fig!re. $%S: : 1B. 1hen performing year#to#year change analysis) a meaningf!l percent change cannot be comp!ted when one n!mber is positive and the other n!mber is negative. $%S: : 1C. or %$("S) each co!ntry can add additional detailed ind!stries) provided the additional detail aggregates to the %$("S level. $%S: :

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PROBLEMS 1. "omparative income statements for ',1, and ',,C follow. ',1, Sales "ost of Sales Eross =rofit -perating /xpenses -perating (ncome (nterest /xpense /arnings >efore :ax (ncome :axes %et (ncome
$9,434,000 7,075,400 $2,358,60 0 1,367,690 $ 990,910 157,500 $ 833,410 400,000 $ 433,410

',,C
$7,862,000 5,660,640 $2,201,36 0 1,365,060 $ 836,300 126,000 $ 710,300 317,200 $ 393,100

9e5!ired: a =repare a vertical common#size analysis of this statement for each year) !sing sales as the . base. b "omment briefly on the changes between the two years) based on the vertical common#size . statement.

$%S: a. ',1, Sales "ost of Sales Eross =rofit -perating /xpenses -perating (ncome (nterest /xpense /arnings >efore :ax (ncome :axes %et (ncome
100.0% 75.0 25.0 14.5 10.5 1.7 8.8 4.2 4.6%

',,C
100.0% 72.0 28.0 17.4 10.6 1.6 9.0 4.0 5.0%

b .

"ost of sales as a percent of sales have risen s!bstantially. :his increase is nearly offset by a decline in operating expense. (nterest expense and taxes have both risen slightly in relation to sales.

'. :oledo :oy) a man!fact!rer of infantsG bloc.s) presented the following data in its last ann!al report. :his trend analysis begins with the year of formation) ',,A. ',1, Sales "ost of Sales %et (ncome "ases of >loc.s Shipped
$61,000 $41,300 $9,919 33,126

',,C
$41,000 $28,175 $6,412 22,681

',,B
$25,000 $17,201 $3,850 13,900

',,A
$13,000 $9,000 $2,000 7,400

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a . b .

9e5!ired: ;sing ',,A as the base year) perform a horizontal) common#size analysis. "omment on the res!lts of the horizontal analysis.

$%S: a. ',1, Sales "ost of Sales %et (ncome "ases of >loc.s Shipped
469.2 458.9 496.0 447.6

',,C
315.4 313.1 320.6 306.5

',,B
192.3 191.1 192.5 187.8

',,A
100.0% 100.0% 100.0% 100.0%

b .

Sales have risen rapidly. :he cost of sales have risen more slowly than sales. $lso) there has been a m!ch faster rise in net income than in sales. :he cases of bloc.s shipped have increased more slowly than sales dollars) indicating a rise in selling price or an improved mix of sales towards more expensive bloc.s.

*. :he following are simplified) vertical) common#size balance sheets for three firmsHa retailer) a service firm) and a man!fact!rer. $ssets "ash 9eceivables (nventory :otal "!rrent $ssets =lant) =roperty) and /5!ipment (net) (nvestments :otal $ssets 8iabilities and Stoc.holders4 /5!ity :otal "!rrent 8iabilities 8ong#:erm &ebt :otal Stoc.holders4 /5!ity :otal 8iabilities and Stoc.holders4 /5!ity
29.3% 18.1 52.6 100.0% 11.5% 24.8 63.7 100.0% 21.6% 37.8 40.6 100.0%

irm $
6.1% 23.2 31.1 60.4 30.3 9.3 100.0%

irm >
8.1% 4.4 1.5 14.0 83.4 2.6 100.0%

irm "
8.7% 12.1 24.5 45.3 51.8 2.9 100.0%

9e5!ired: <atch the statements to the type of firm and explain yo!r choice. $%S: irm $ is the retailing firm) d!e to the heavy investment in receivables and inventory with limited fixed assets. :he store facilities may be rented.

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irm > is the service firm) d!e to the limited inventory. irm " is the man!fact!ring firm) d!e to the combined heavy investment in inventory and fixed assets. $lso) it !ses s!bstantial long#term debt.

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6. a . 8isted below are three gro!pings of financial ratios. 8i5!idity 8ong#term borrowing ability =rofitability 9e5!ired: >riefly describe what each one meas!res. b . 8isted below are three gro!ps of !sers of financial statements.

S!ppliers of raw materials =otential stoc.holders >ondholders 9e5!ired: or each gro!p) select the type of ratios from part (a) that each gro!p might be most interested in. >riefly explain yo!r choice. $%S: a . 8i5!idity ratios meas!re the firm4s ability to pay its c!rrent obligations. 8ong#term borrowing ability meas!res the degree of protection of long#term s!ppliers of f!nds. =rofitability ratios meas!re the earning ability of the firm. b . S!ppliers of raw materials wo!ld be most interested in li5!idity since their goods and related obligations are primarily short#term. =otential stoc.holders wo!ld be most interested in the earning ability of the firm since they share in resid!al profits. >ondholders wo!ld be most interested in the long#term borrowing capacity since this meas!res the ris. of defa!lt.

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