Chapter 2 Financial Statements and the Accounting System

Question 1

What are the 4 “Building Blocks” of Ratios?

Answer 1

1. Liquidity
2. Solvency
3. Profitability
4. Market Prospects

Question 2

What are ratios?

Answer 2

-help to realize trends
-help analyze performance and results
Compare against
1. Other companies (competitors)
2. Industry averages
3. Our companies prior year ratios

Question 3

What is liquidity?

Answer 3

-Ability of a company to meet its short term obligations (liabilities due in 1 year or less)
-Shows how efficiently a company is using its assets

Question 4

What is the equation for liquidity?

Answer 4

current ratio (short term)= current assets/current liabilities

**higher the ratio the better (>1)
- this means a company is very likely to meet its cash demands

Question 5

What is solvency?

Answer 5

-Ability of a company to meet its long term obligations (liabilities due >1 year) and generate future revenues

Question 6

What is the equation for solvency?

Answer 6

Debt ratio= Total liabilities/Total assets

**lower ratio is better
-the company is “more solvent” since their assets likely exceed their liabilities

Question 7

What is profitability?

Answer 7

-companies ability to provide financial rewards to attract and retain financing
-shows how good a company is at using their assets to make a profit

Question 8

What is the equation for profitability?

Answer 8

Profit margin ratio= Net income (rev-exp)/Net sales

**higher the better

Question 9

What is market prospects?

Answer 9

-ability to generate positive industry expectations
-helpful to obtain investors

Question 10

What is the equation for market prospects?

Answer 10

Price to earning ratio= price per share/earnings per share (EPS)

**Higher the better

Question 11

What are prepaid expenses?

Answer 11

Asset
-prepayments of future expenses to be incurred
-paid in advance, but did not yet receive the good or service
-be specific in type
prepaid______ expense
ex. insurance, rent
- as prepaid expense is used it becomes an expense

Question 12

What is unearned revenue?

Answer 12

Liability
-be specific - unearned ticket/subscription revenue
-received money from another company but we have not yet provided the good or service
-as the good/service is provided, this becomes revenue

Question 13

What are T accounts?

Answer 13

-represents a ledger account that shows the transactions
-Debit on the left, credit on the right

Debit + Debit= account increase
Credit + Credit= account increase
Debit -Credit= account decrease
Credit- Debit= account decrease

Question 14

What is the double entry system?

Answer 14

Debits=Credits
-you will always have at least 1 DR and 1 CR

Question 15

What is normal balance?

Answer 15

-Either a DR or CR
-Whatever the NB is, increases the account
(Not the NB, decreases)

Question 16

What is the accounting cycle?

Answer 16

1. Identify the transaction (business activities/events)
2. Record journal entries into the “general journal”
   -complete listing of all accounts and the balances (by transaction)
3. Post to the “general ledger”
   -By account and shows total
   -Date of transaction
   -Amounts
   -Description of transaction

Question 17

What is a trial balance?

Answer 17

-lists each account and its DR or CR balance at a specific point in time
-Total DR = Total CR
-TB is what the financial statements are built from