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# Financial Reporting and Analysis 【Reading 28】Sample

Which of the following reasons is least likely a valid limitation of ratio analysis?
 A) It is difficult to find comparable industry ratios.
 B) Calculation of ratios involves a large degree of subjectivity.
 C) Determining the target or comparison value for a ratio is difficult.

There is not a great deal of subjectivity involved in calculating ratios. The mechanical formulas for the calculations are fairly standard and objective for the activity, liquidity, solvency, and profitability ratios, for instance. On the other hand, determining the target or comparison value for a ratio is difficult as it requires some range of acceptable values and that introduces an element of subjectivity. Conclusions cannot be made from viewing one set of ratios as all ratios must be viewed relative to one another in order to make meaningful conclusions. It can be difficult to find comparable industry ratios, especially when analyzing companies that operate in multiple industries.

Ratio analysis is most useful for comparing companies:
 A) in different industries that use the same accounting standards.
 B) that operate in multiple lines of business.
 C) of different size in the same industry.

Ratio analysis is a useful way of comparing companies that are similar in operations but different in size. Ratios of companies that operate in different industries are often not directly comparable. For companies that operate in several industries, ratio analysis is limited by the difficulty of determining appropriate industry benchmarks.
Comparing a company’s ratios with those of its competitors is best described as:
 A) longitudinal analysis.
 B) cross-sectional analysis.
 C) common-size analysis.

Comparing a company’s ratios with those of its competitors is known as cross-sectional analysis.
To study trends in a company’s cost of goods sold (COGS), an analyst should standardize COGS by dividing it by:
 A) net income.
 B) sales.
 C) prior year COGS.

In a common-size income statement, each income statement account is divided by sales. COGS is then production costs as a percentage of the sales price.
Common size income statements express all income statement items as a percentage of:
 A) net income.
 B) assets.
 C) sales.

Common size income statements express all income statement items as a percentage of sales. Note that common size balance sheets express all balance sheet accounts as a percentage of total assets.
Which of the following statements best describes vertical common-size analysis and horizontal common-size analysis?
Statement #1 – Each line item is expressed as a percentage of its base-year amount.
Statement #2 – Each line item of the income statement is expressed as a percentage of revenue and each line item of the balance sheet is expressed as a percentage of ending total assets.
Statement #3 – Each line item is expressed as a percentage of the prior year’s amount.
 Vertical analysis Horizontal analysis
A)
 Statement #1 Statement #2
B)
 Statement #2 Statement #1
C)
 Statement #2 Statement #3

Horizontal common-size analysis involves expressing each line item as a percentage of the base-year figure. Vertical common-size analysis involves expressing each line item of the income statement as a percentage of revenue and each line item of the balance sheet as a percentage of ending total assets.
Are the following statements about common-size financial statements correct or incorrect?
Statement #1 – Expressing financial information in a common-size format enables the analyst to make better comparisons between two firms of similar size that operate in different industries.
Statement #2 – Common-size financial statements can be used to highlight the structural changes in the firm’s operating results and financial condition that have occurred over time.
With respect to these statements:
 A) both are correct.
 B) only one is correct:
 C) both are incorrect.

Vertical common-size statements enable the analyst to make better comparisons of two firms of different sizes that operate in the same industry. Horizontal common-size financial statements express each line as a percentage of the base year figure; thus, horizontal common-size statements can be used to identify structural changes in a firm’s operating results and financial condition over time.
Given the following income statement and balance sheet for a company:
 Balance Sheet Assets Year 2003 Year 2004 Cash 500 450 Accounts Receivable 600 660 Inventory 500 550 Total CA 1300 1660 Plant, prop. equip 1000 1250 Total Assets 2600 2910 Liabilities Accounts Payable 500 550 Long term debt 700 1102 Total liabilities 1200 1652 Equity Common Stock 400 538 Retained Earnings 1000 720 Total Liabilities & Equity 2600 2910 Income Statement Sales 3000 Cost of Goods Sold (1000) Gross Profit 2000 SG&A 500 Interest Expense 151 EBT 1349 Taxes (30%) 405 Net Income 944

What is the quick ratio for 2004?
 A) 2.018.
 B) 3.018.
 C) 0.331.

Quick ratio = (cash + marketable securities + receivables) / CL = (450 + 0 + 660) / 550 = 2.018
Which of the following is least likely a routinely used operating profitability ratio?
 A) Net income/net sales.
 B) Sales/Total Assets
 C) Gross profit/net sales.

Sales/Total Assets, or Total Asset Turnover is a measure of operating efficiency, not operating profitability.
As of December 31, 2007, Manhattan Corporation had a quick ratio of 2.0, current assets of \$15 million, trade payables of \$2.5 million, and receivables of \$3 million, and inventory of \$6 million. How much were Manhattan’s current liabilities?
 A) \$4.5 million.
 B) \$12.0 million.
 C) \$7.5 million.

Manhattan’s quick assets were equal to \$9 million (\$15 million current assets – \$6 million inventory). Given a quick ratio of 2.0, quick assets were twice the current liabilities. Thus, the current liabilities must have been \$4.5 million (\$9 million quick assets / 2.0 quick ratio).
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