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Bug-Be-Gone is a residential pest control company that offers a 12 month home-service contract to eliminate insect infestation. Customers are required to prepay for the service at the beginning of each year. If Bug-Be-Gone erroneously records these payments as revenue and include the estimated cost of performing the service, what is the most likely effect on the firm’s liabilities and equity compared to the correct treatment?
Liabilities Equity
A)
Overstated Overstated
B)
Overstated Understated
C)
Understated Overstated



When payment is received, the firm has an obligation to provide the service. This obligation is reported as a liability ‘unearned revenue’ as a liability, offsetting the increase in cash. If they book the revenue and estimated expenses of providing the service this will overstate equity (assuming revenue greater than expected expense) and liabilities will be understated.

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A key limitation of balance sheets in financial analysis is that:
A)
different balance sheet items may be measured differently.
B)
liquidity and solvency ratios require information from other financial statements.
C)
some items are recognized when they are unlikely to reflect a flow of economic benefits.



Balance sheet values may use a mixture of measurement bases (historical cost, fair value, etc.). As a result, balance sheet values of assets, liabilities, and equity may not reflect their intrinsic values. Balance sheets provide the information necessary to calculate the firm’s solvency and liquidity ratios. Items are recognized on the balance sheet only if a flow of future economic benefits to or from the firm is probable.

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Common size balance sheets express all balance sheet items as a percentage of:
A)
sales.
B)
equity.
C)
assets.



Common size balance sheets express all balance sheet items as a percentage of assets. Note that common size income statements express all income statement items as a percentage of sales.

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The following data is from Delta's common size financial statement:
Earnings after taxes18%
Equity40%
Current assets60%
Current liabilities30%
Sales$300
Total assets$1,400
What is Delta's total-liabilities-to-equity ratio?
A)
1.5.
B)
1.0.
C)
2.0.



If equity = 40% of assets, total liabilities = 60% of assets, thus 60 / 40 = 1.5.

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An analyst has gathered the following information about a company:

Balance Sheet

Assets
Cash100
Accounts Receivable750
Marketable Securities300
Inventory850
Property, Plant & Equip900
Accumulated Depreciation(150)
Total Assets2750
Liabilities and Equity
Accounts Payable300
Short-Term Debt130
Long-Term Debt700
Common Stock1000
Retained Earnings620
Total Liab. and Stockholder's equity2750

Income Statement

Sales1500
COGS1100
Gross Profit400
SG&A150
Operating Profit250
Interest Expense25
Taxes75
Net Income150

What is the quick ratio?
A)
1.53.
B)
2.67.
C)
0.62.



Quick ratio = [100(cash) + 750(AR) + 300(marketable securities)] / [300(AP) + 130(short-term debt)] = (1,150 / 430) = 2.67

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Given the following income statement and balance sheet for a company:

Balance Sheet

AssetsYear 2003Year 2004
Cash500450
Accounts Receivable600660
Inventory500550
Total CA16001660
Plant, prop. equip10001250
Total Assets26002910
Liabilities
Accounts Payable500550
Long term debt7001002
Total liabilities12001552
Equity
Common Stock400538
Retained Earnings1000820
Total Liabilities & Equity26002910

Income Statement

Sales3000
Cost of Goods Sold(1000)
Gross Profit2000
SG&A(500)
Interest Expense(151)
EBT1349
Taxes (30%)(405)
Net Income944

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



Current ratio = (CA / CL) = (1,660 / 550) = 3.018

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