Financial Reporting and Analysis 【Reading 28】Sample following, 2012

LiquidAssets10

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.

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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.

LiquidAssets10

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.

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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.

LiquidAssets10

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.

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Comparing a company’s ratios with those of its competitors is known as cross-sectional analysis.

LiquidAssets10

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.

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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.

LiquidAssets10

Common size income statements express all income statement items as a percentage of:

A) net income.

B) assets.

C) sales.

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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.

LiquidAssets10

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

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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.

LiquidAssets10

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.

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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.