Liquidity Solvency and Leverage Ratios Flashcards
An enterprise is in the process of comparing its current financial performance for Year 3 with the prior 2 years. The enterprise experienced exceptionally strong growth between Years 1 and 2, with a slight decrease in sales between Years 2 and 3.
Year 1
Year 2
Year 3
Net sales Year 1 Year 2 Year 3
Net sales $4,560,000 $30,980,400 $26,583,220
Cost of goods sold 2,378,900 24,655,340 21,444,985
Selling expenses 490,000 1,289,466 2,099,800
G&A expens 290,500 500,000 600,000
Which one of the following statements is correct when using common-size analysis to compare the results?
A. The enterprise’s profitability increased each year due to more efficient production processes.
B. The enterprise experienced the highest proportion of selling expenses in Year 2, which led to the high net sales.
C. The enterprise’s proportion of gross profit was lowest in Year 3 due to high production costs.
D. The enterprise increased the percentage of general and administrative expenses each year in order to manage the company’s growth.
Answer (A) is incorrect.
Although the enterprise’s profitability increased in Years 2 and 3 relative to Year 1, the gross profit proportion in Years 2 and 3 was lower than Year 1.
Answer (B) is incorrect.
The enterprise did not experience the highest proportion of selling expenses in Year 2.
C.
Answer (C) is correct.
Expressing financial statement items as percentages of corresponding base-year figures is a form of common-size (percentage) analysis that is useful for evaluating trends. Net sales represents 100% on a common-size income statement. Although gross profit was higher in Year 3 than in Year 1, its proportion relative to net sales and using common-size analysis is the lowest. Cost of goods sold is the highest proportionally compared to Years 1 and 2.
Answer (D) is incorrect.
Although general and administrative expenses increased, their proportion did not increase.
In assessing the financial prospects for a firm, financial analysts use various techniques. An example of vertical, common-size analysis is
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. Advertising expense is 2% greater compared with the previous year.
D. Advertising expense for the current year is 2% of sales.
Answer (A) is incorrect.
Vertical integration occurs when a corporation owns one or more of its suppliers or customers.
Answer (B) is incorrect.
Vertical, common-size analysis restates financial statements amounts as percentages.
Answer (C) is incorrect.
A statement that advertising expense is 2% greater than in the previous year results from horizontal analysis.
Answer (D) is correct.
Vertical, common-size analysis compares the components within a set of financial statements. A base amount is assigned a value of 100%. For example, total assets on a common-size balance sheet and net sales on a common-size income statement are valued at 100%. Common-size statements permit evaluation of the efficiency of various aspects of operations. An analyst who states that advertising expense is 2% of sales is using vertical, common-size analysis.
Question: 3 A company’s financial statements from the past 2 years have the following values.
Previous year Current year
Sales revenue $ 6,000,000 $ 6,600,000
Net income 500,000 540,000
Total assets 10,000,000 10,500,000
Inventory 600,000 500,000
Using horizontal analysis, what account has the largest percentage change?
A. Inventory.
B. Net income.
C. Total assets.
D. Sales revenue.
Answer (A) is correct.
Inventory decreased by approximately 17% (rounded) in the current year [($600,000 – $500,000) ÷ $600,000]. Relative to the other accounts, inventory had the largest percentage change in the current year.
Answer (B) is incorrect.
Net income increased by 8% in the current year [($540,000 – $500,000) ÷ $500,000]. However, inventory and sales revenue had larger percentage changes.
Answer (C) is incorrect.
Total assets increased by 5% [($10,500,000 – $10,000,000) ÷ $10,000,000]. However, this account had the lowest percentage change.
Answer (D) is incorrect.
Sales revenue increased by 10% in the current year [($6,600,000 – $6,000,000) ÷ $6,000,000]. However, inventory had a larger percentage change.
The dollar value of a company’s ending inventory on its balance sheet was $500,000, $600,000, and $400,000 for Years 1, 2, and 3, respectively. In preparing a horizontal analysis with Year 1 as the base year, the percentage change shown for Year 3 would be A. (20%) B. 20% C. 80% D. (25%)
Answer (A) is correct.
Horizontal analysis is the concept that the amounts for several periods are stated in percentages of a base-year amount. If Year 1 is the base year, the percentage change for Year 3 is negative 20% [($400,000 – $500,000) ÷ $500,000].
Answer (B) is incorrect.
The base year value should be subtracted from the Year 3 value to determine the numerator when calculating percentage change.
C.
Answer (C) is incorrect.
Failing to subtract the base year value from the Year 3 value to determine the numerator results in 80%.
Answer (D) is incorrect.
The base year value should be the denominator when calculating percentage change. Using the Year 3 value as the denominator results in (25%).
Select information from a company’s year-end balance sheet is shown below.
Balance Sheet
As of December 31, Year 1
Cash $ 50,000 Accounts receivable 120,000 Inventory 75,000 Property, plant and equipment, net 250,000 Total assets $495,000
Accounts payable $ 35,000 Long-term debt 100,000 Total liabilities 135,000 Common stock 300,000 Retained earnings 60,000 Total equity 360,000 Total liabilities and equity $495,000 Based on the above information, a common-size balance sheet for the company will show A. Accounts receivables at 24%. B. Long-term debt at 74%. C. Retained earnings at 17%. D. Property, plant and equipment, net at 69%.
Answer (A) is correct.
Items on common-size financial statements are expressed as percentages of total assets on the balance sheet. Thus, the company will record accounts receivables at 24% ($120,000 ÷ $495,000) on a common-size balance sheet.
B.
Answer (B) is incorrect.
Long-term debt should be reported at 20% ($100,000 ÷ $495,000) on a common-size balance sheet.
Answer (C) is incorrect.
Retained earnings should be reported at 12% ($60,000 ÷ $495,000) on a common-size balance sheet.
D.
Answer (D) is incorrect.
Property, plant and equipment, net, should be reported at 51% ($250,000 ÷ $495,000) on a common-size balance sheet.
A company has had the following financial results for the last four years.
Year 1 Year 2 Year 3 Year 4
Sales $1,250,000 $1,300,000 $1,359,000 $1,400,000
CoGS 750,000 785,000 825,000 850,000
Gross profit 500,000 515,000 534,000 550,000
Inflation factor 1.00 1.03 1.07 1.10
The company has analyzed these results using vertical common-size analysis to determine trends. The performance of the company can best be characterized by which one of the following statements?
A. The common-size trend in sales is increasing and is resulting in an increasing trend in the common-size gross profit margin.
B. The common-size trend in cost of goods sold is decreasing which is resulting in an increasing trend in the common-size gross profit margin.
C. The increased trend in the common-size gross profit percentage is the result of both the increasing trend in sales and the decreasing trend in cost of goods sold.
D. The common-size gross profit percentage has decreased as a result of an increasing common-size trend in cost of goods sold.
Answer (A) is incorrect.
In a common-size income statement, sales revenue is used as a base, so its percentage is always 100% on the common-size statement and does not increase.
Answer (B) is incorrect.
The common-size trend in cost of goods sold is increasing, not decreasing. As a result, the gross profit as a percentage of sales is decreasing.
Answer (C) is incorrect.
In a common-size income statement, sales revenue is used as a base, so its percentage is always 100% on the common-size statement and does not increase. As a percentage of sales, cost of goods sold is increasing. Therefore, the common-size gross profit percentage decreases over the years.
Answer (D) is correct.
The common-size gross profit percentage has decreased as a result of an increasing common-size trend in cost of goods sold as shown below.
Year 1 Year 2 Year 3 Year 4
Sales 100% 100% 100% 100%
Cost of goods sold (÷ Sales)
60.0% 60.3% 60.7% 60.7%
Gross profit (÷ Sales)
40.0% 39.6% 39.2% 39.2%
A financial analyst is reviewing a company’s most recent fiscal year financial statements. The relevant data is shown below.
Assets ($000) Liabilities and Equity ($000)
Cash $ 150 Accounts payable $ 300
Accounts receivable 250 Notes payable 200
Inventory 400 Long-term debt 500
Plant and equipment, net 1,200 Common equity 1000
Total
$2,000
Total
$2,000
The analyst would like to examine the company in relation to other firms in the industry utilizing common-size financial statements. The appropriate comparative value for current assets is
A. 25%
B. 35%
C. 40%
D. 20%
Answer (A) is incorrect.
The amount of 25% results from deducting inventory from both assets and current assets.
Answer (B) is incorrect.
The amount of 35% totals the current assets incorrectly.
Answer (C) is correct.
On a common-size balance sheet, total assets equal 100%. Thus, $2,000 represents 100%. Current assets total $800 ($150 + $250 + $400). Thus, current assets would be reported at 40% ($800 ÷ $2,000).
Answer (D) is incorrect.
The amount of 20% fails to include inventory as a current asset.
Question: 8 A financial analyst is reviewing a competitor’s income statements for the past 2 years.
Year 1 Year 2
Sales £250,000 £275,000
Cost of goods sold 155,000 160,000
Gross profit 95,000 115,000
Selling expenses 35,000 40,000
General expenses 45,000 50,000
Operating income before income taxes
15,000 25,000
Taxes related to operations
2,500 3,500
Net income £ 12,500 £ 21,500
The financial analyst is able to conclude that the competitor’s
A. Common size income statements will show taxes related to operations at 16% for Year 2.
B. Common size income statements will show operating income before income taxes at 22% for Year 2.
C. Common base year income statements will show that selling expenses increased by 14% in Year 2 as compared to Year 1.
D. Common base year income statements will show that gross profit increased by 17% in Year 2 as compared to Year 1.
Answer (A) is incorrect.
In Year 2, the taxes related to operations have an applicable percentage of 1.3% (£3,500 ÷ £275,000).
Answer (B) is incorrect.
The common-size income statements will show operating income before income taxes at 9.1%, not 22%, for Year 2 (£25,000 ÷ £275,000 = 0.0909).
Answer (C) is correct.
Selling expenses went from £35,000 in Year 1 to £40,000 in Year 2. Relative to Year 1 selling expenses, the selling expenses increased 14% in Year 2 {[(£40,000 – £35,000) ÷ £35,000] = 0.14 (rounded)}.
Answer (D) is incorrect.
Gross profit increased by 21% in Year 2 compared to the gross profit of Year 1 {[(£115,000 – £95,000) ÷ £95,000] = 0.2105}.
A company has the following balances on its financial statements: Revenue $32,000,000 Cost of sales 16,000,000 Net income 4,000,000 Total assets 80,000,000 Total equity 40,000,000 A common-size income statement would show net income as A. 5.0% B. 12.5% C. 25.0% D. 10.0%
Answer (A) is incorrect.
The amount of 5.0% incorrectly uses total assets as the denominator instead of revenue. Total assets represent 100% on the balance sheet, while net revenue represents 100% on the income statement.
Answer (B) is correct.
A common-size income statement presents income as a percentage of net revenue (i.e., net sales). Thus, dividing $4,000,000 of net income by $32,000,000 of revenue results in common-size net income of 12.5%.
Answer (C) is incorrect.
The amount of 25.0% incorrectly uses cost of sales as the denominator instead of revenue
Answer (D) is incorrect.
The amount of 10.0% incorrectly uses total equity as the denominator instead of revenue.
Question: 10 The accounting manager of a manufacturer of farming equipment was asked by the CFO to analyze the company’s last 5 years of operations. The accounting manager prepared the following analysis:
Common Base Year Income Statement
Base Year = December 31, Year 1
Year 2 Year 3 Year 4 Year 5 Year 6
Sales 1.01 1.03 1.05 1.07 1.10
CoGS 1.05 1.03 1.02 1.00 0.98
Selling and administrative expenses
1.01 1.01 1.01 1.02 1.03
Research and development
1.00 0.98 0.99 1.00 1.01
Income from operations
1.02 1.02 1.03 1.05 1.09
Which one of the following statements is consistent with this analysis?
A. The new marketing strategy has been unsuccessful.
B. The company should decrease research and development expenses.
C. The company should decrease the sales force.
D. The new production process has successfully reduced manufacturing expenses.
Answer (A) is incorrect.
Sales have increased each year. Thus, the marketing strategy has not been unsuccessful.
Answer (B) is incorrect.
Research and development costs have remained steady, moving from 1.00 in Year 2 to 1.01 in Year 6.
Answer (C) is incorrect.
Since selling and administrative expenses have increased from 1.01 to 1.03, the sales force may be increased.
Answer (D) is correct.
Cost of goods sold has decreased each year. Year 2 is 1.05, while Year 6 is only .98.
Shown below are components of a company’s financial statements. Sales revenue $ 600,000 Cost of goods sold 300,000 Total assets 2,400,000 Total equity 1,500,000 Net income 120,000 What percentage value would net income be on a common size financial statement? A. 40% B. 8% C. 5% D. 20%
Answer (A) is incorrect.
Net income should be divided by sales revenue rather than cost of goods sold.
Answer (B) is incorrect.
Net income should be divided by sales revenue rather than total equity
Answer (C) is incorrect.
Net income should be divided by sales revenue rather than total assets.
Answer (D) is correct.
To determine the percentage of net income, total net income is divided by the sales revenue. Thus, the percentage of net income is 20% ($120,000 ÷ $600,000).
An abbreviated common-size income statements for Year 1’s actual results and Year 2’s anticipated results are shown below.
Year 1 Year 2
Sales 100% 100%
Cost of goods sold 50% 50%
Selling and administrative expenses 40% ?
Operating Income 10% ?
The corporation estimates that units sold will increase by 5% in Year 2 with no price increase to its customers and no anticipated cost increases from its vendors. Assume selling and administrative expenses are 5% variable and 95% fixed. If all predictions materialize, the corporation should expect selling and administrative expenses in Year 2 to be
A. 40% of sales.
B. Less than 40% of sales.
C. Greater than 42% of sales.
D. Greater than 40% but no more than 42% of sales.
Answer (A) is incorrect.
Selling and administrative expenses are not the same in Year 2 as they were in Year 1.
Answer (B) is correct.
This question is best answered using actual numbers. Assume that sales in Year 1 are $500. Because total selling and administrative expenses are 40% of Year 1 sales, selling and administrative expenses equal $200 ($500 × 40%). Given that 5% of this is variable and 95% is fixed, variable expense equals $10 ($200 × 5%) and fixed expense equals $190 ($200 × 95%). In relation to sales, variable selling and administrative expenses are equal to 2% ($10 variable ÷ $500 sales) of sales. This percent will help calculate the variable selling and administrative expenses in Year 2.
In Year 2, sales increase by 5%, making Year 2 sales equal to $525 ($500 Year 1 sales × 1.05 increase). The fixed portion of the selling and administrative expenses is equal to $190. The variable portion can be solved by multiplying 2% by sales of $525, which results in $10.50. Therefore, total selling and administrative expenses are equal to $200.50, about 38.20% ($200.50 ÷ $525) of Year 2 sales, which is less than 40%.
Answer (C) is incorrect.
Year 2 selling and administrative expense are not greater than 42% of sales.
Answer (D) is incorrect.
Year 2 selling and administrative expenses are not greater than 40% of sales
In financial statement analysis, expressing all financial statement items as a percentage of base-year amounts is called A. Ratio analysis. B. Vertical common-size analysis. C. Trend analysis. D. Horizontal common-size analysis.
Answer (A) is incorrect.
It is a general term.
Answer (B) is incorrect.
Vertical common-size (percentage) analysis presents figures for a single year expressed as percentages of a base amount on the balance sheet (e.g., total assets) and on the income statement (e.g., sales).
Answer (C) is incorrect.
The term “trend analysis” is most often applied to the quantitative techniques used in forecasting to fit a curve to given data.
Answer (D) is correct.
Expressing financial statement items as percentages of corresponding base-year figures is a horizontal form of common-size (percentage) analysis that is useful for evaluating trends. The base amount is assigned the value of 100%, and the amounts for other years are denominated in percentages compared to the base year.
A company has provided the following data pertaining to one of its products.
Year Unit Sales Unit Sales Price Gross Profit Margin
1 1,000 $50 45%
2 1,200 $55 48%
Which one of the following statements is correct?
A. The dollar amount of gross profit increased by 3% during Year 2.
B. The cost per unit sold decreased 3% during Year 2.
C. The percentage increase in the sales price exceeded the percentage increase in the cost per unit sold during Year 2.
D. The cost per unit increased during Year 2, in line with the increase in unit sales.
Answer (A) is incorrect.
The dollar amount of gross profit increased from $22,500 ($50,000 sales – $27,500 COGS) in Year 1 to $31,680 ($66,000 sales – $34,320 COGS) in Year 2. This represents an increase of 4.08% ($31,680 – $22,500 ÷ $22,500), not 3%.
Answer (B) is incorrect.
The change in cost per unit is not calculated by the difference in gross profit margin from Year 1 to Year 2. The cost per unit sold increased by 4%, not decreased by 3%, in Year 2.
Answer (C) is correct. Gross profit margin can be expressed as sales less COGS (gross profit) divided by sales. The Year 1 gross profit margin is given as 45%. This can be used to calculate the Year 1 COGS as follows: 45% = $50,000 – COGS ÷ $50,000 $22,500 = $50,000 – COGS COGS = $27,500 Because the company sold 1000 units, the COGS per unit is equal to $27.50 ($27,500 ÷ 1000 units). The Year 2 Gross Profit Margin is given as 48%. This can be used to calculate the Year 2 COGS as follows:
48% = $66,000 – COGS ÷ $66,000 $31,680 = $66,000 – COGS COGS = $34,320 Because the company sold 1,200 units, the COGS per unit is equal to $28.60 ($34,320 ÷ 1200 units). Sales price increased by 10% ($55 – $50 ÷ $50) while COGS increased by 4% ($28.60 – $27.50 ÷ $27.50). Thus, the percentage increase in the sales price exceeded the percentage increase in the cost per unit sold during Year 2.
Answer (D) is incorrect.
If sales price increased by 10% ($55 – $50 ÷ $50) while COGS increased by 4% ($28.60 – $27.50 ÷ $27.50), then the percentage increase in the sales price exceeded the percentage increase in the cost per unit sold during Year 2.
he following financial information is given.
Year 1 Year 2
Book value of assets $18,000 $26,000
Market value of equity 18,000 60,000
12 months ended Year 1 12 months ended Year 2
Sales $ 1,000 $ 1,300
Cost of goods sold 500 700
Operating income 500 600
Depreciation expense 200 200
Interest expense 100 100
Pretax income 200 300
Income tax expense 80 120
Net income $ 120 $ 180
Using a common-size income statement, did operating income and net income increase or decrease?
Operating income Net income
A. Increased Increased
B. Increased Decreased
C. Decreased Decreased
D. Decreased Increased
Answer (A) is incorrect.
Although total operating income increased, it decreased when restated in common size.
Answer (B) is incorrect.
Although total operating income increased, it decreased when restated in common size. Furthermore, both actual net income and common-size net income increased.
Answer (C) is incorrect. Both actual net income and common-size net income increased.
Answer (D) is correct.
A common-size income statement restates line items as a percentage of net sales. The table below provides these percentages.
Year 1 Year 2
Sales 100.00% 100.00%
Cost of goods sold 50.00% 53.85%
Operating income 50.00% 46.15%
Depreciation expense 20.00% 15.38%
Interest expense 10.00% 7.69%
Pretax income 20.00% 23.08%
Income tax expense 8.00% 9.23%
Net income 12.00% 13.85%
The common-size operating income decreased, while net income increased.
