662 Chapter 14 Financial Statement Analysis
3. From the viewpoint of a stockholder, which of the following
relationships do you consider of least significance?
a. Net income is greater than the amount of working
capital.
b. The return on assets consistently is higher than the
industry average.
c. The return on equity has increased in each of the past
five years.
d. The return on assets is greater than the rate of interest
being paid to creditors.
4. The following information is available from the annual
report of Frixell, Inc.:
Current Current
assets ........... $ 480,000 liabilities ...... $300,000
Average total Operating
assets ........... 2,000,000 income ........ 240,000
Average total Net income ..... 80,000
equity ............ 800,000
Which of the following statements are correct? (More than
one statement may be correct.)
a. The return on equity exceeds the return on assets.
b. The current ratio is 0.625 to 1.
c. Working capital is $1,200,000.
d. None of the above answers is correct.
ASSIGNMENT MATERIAL Discussion Questions
1. In financial statement analysis, what is the basic objective of
observing trends in data and ratios? Suggest some standards
of comparison.
2. In financial statement analysis, what information is pro-
duced by computing a ratio that is not available in a simple
observation of the underlying data?
3. Distinguish between trend percentages and component per-
centages. Which would be better suited for analyzing the
change in sales over several years?
4. Differentiate between horizontal and vertical analysis.
5. What is the basic purpose of classifications in financial
statements? Identify the classifications widely used in a bal-
ance sheet, a multiple-step income statement, and a state-
ment of cash flows.
6. Distinguish between the terms classified, comparative, and
consolidated as they apply to financial statements. May a
given set of financial statements have more than one of these
characteristics?
7. What is the characteristic common to all current assets?
Many retail stores regularly sell merchandise on installment
5. Evans Corporation’s net income was $400,000 in 2014 and
$160,000 in 2015. What percentage increase in net income
must Evans achieve in 2016 to offset the decline in profits in
2015?
a. 60%.
b. 150%.
c. 600%.
d. 67%.
6. If a company’s current ratio declined in a year during which
its quick ratio improved, which of the following is the most
likely explanation?
a. Inventory is increasing.
b. Receivables are being collected more slowly than in the
past.
c. Receivables are being collected more rapidly than in the
past.
d. Inventory is declining.
7. In financial statement analysis, the most difficult of the fol-
lowing items to predict is whether:
a. The company will be liquid in six months.
b. The company’s market share is increasing or declining.
c. The market price of capital stock will rise or fall over
the next two months.
d. Profits have increased since the previous year.
plans, calling for payments over a period of 24 or 36 months.
Do such receivables qualify as current assets? Explain.
8. Identify four ratios or other analytical tools used to evaluate
profitability. Explain briefly how each is computed.
9. Distinguish between operating income and net income.
10. Why might earnings per share be more significant to a
stockholder in a large corporation than the total amount of
net income?
11. Assume that Congress announces its intention to limit the
prices and profits of pharmaceutical companies as part of
an effort to control health care costs. What effect would you
expect this announcement to have on the p/e ratios and stock
prices of pharmaceutical companies such as Merck and
Bristol-Myers Squibb? Explain.
12. Under what circumstances might a company have a high p/e
ratio even when investors are not optimistic about the com-
pany’s future prospects?
13. Moffett Company earned a 16 percent return on its total
assets. Current liabilities are 10 percent of total assets. Long-
term bonds carrying an 11 percent coupon rate are equal to
Exercises 665

2015 2014

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000 $400,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,000 268,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 170,000 $132,000
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000 116,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 45,000 $ 16,000

LO14-4 Roy’s Toys is a manufacturer of toys and children’s products. The following are selected items
EXERCISE 14.4 appearing in a recent balance sheet (dollar amounts are in millions):
Measures of Liquidity

Cash and short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 47.3

Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159.7
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72.3
Prepaid expenses and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.0
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130.1
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279.4
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344.0

a. Using the information above, compute the amounts of Roy’s Toys (1) quick assets and (2) total
current assets.
b. Compute for Roy’s Toys the (1) quick ratio, (2) current ratio, and (3) dollar amount of working
capital. (Round ratios to one decimal place.)
c. Discuss whether Roy’s Toys appears liquid from the viewpoint of a short-term creditor.

LO14-5 SPINX, INC.

EXERCISE 14.5 STATEMENT OF EARNINGS
Multiple-Step Income FOR THE YEAR ENDED DECEMBER 31, 2015
Statements
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,395,253
Costs and expenses:
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,821,455)
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,004,396)
Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,797
Earnings before income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 585,199
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (204,820)
Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 380,379
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.70

Comparative balance sheets report average total assets for the year of $2,575,000 and average total
equity of $1,917,000 (dollar amounts in thousands, except earnings per share).
a. Prepare an income statement for the year in a multiple-step format.
b. Compute the (1) gross profit rate, (2) net income as a percentage of net sales, (3) return on
assets, and (4) return on equity for the year. (Round computations to the nearest one-tenth of
1 percent.)
c. Explain why interest revenue is not included in the company’s gross profit computation.
678 Chapter 14 Financial Statement Analysis

The company has long-term liabilities that bear interest at annual rates ranging from 8 percent to
12 percent.

Instructions
a. Compute the company’s current ratio at (1) the beginning of the year and (2) the end of the
year. (Carry to two decimal places.)
b. Compute the company’s working capital at (1) the beginning of the year and (2) the end of the
year. (Express dollar amounts in thousands.)
c. Is the company’s short-term debt-paying ability improving or deteriorating?
d. Compute the company’s (1) return on average total assets and (2) return on average stockhold-
ers’ equity. (Round average assets and average equity to the nearest dollar and final computa-
tions to the nearest 1 percent.)
e. As an equity investor, do you think that Rochester’s management is utilizing the company’s
resources in a reasonably efficient manner? Explain.

LO14-5, LO14-7 At the end of the year, the following information was obtained from the accounting records of
PROBLEM 14.8B Solar Systems, Inc.:
Ratios: Consider
Advisability of Incurring Sales (all on credit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,800,000
Long-Term Debt Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000
Average inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000
Average accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280,000
Average investment in assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,600,000
Average stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Instructions
a. From the information given, compute the following:
1. Inventory turnover. 4. Gross profit percentage.
2. Accounts receivable turnover. 5. Return on average stockholders’ equity.
3. Total operating expenses. 6. Return on average assets.
b. Solar Systems has an opportunity to obtain a long-term loan at an annual interest rate of
8 percent and could use this additional capital at the same rate of profitability as indicated by
the given data. Would obtaining the loan be desirable from the viewpoint of the stockholders?
Explain.

LO14-5, LO14-7, LO14-8 Shown below are selected financial data for THIS Star, Inc., and THAT Star, Inc., at the end of the
current year:
PROBLEM 14.9B
Ratios: Evaluation of Two THIS THAT
Companies Star, Inc. Star, Inc.

Net credit sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900,000 $840,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 640,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,000 47,000
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 90,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 160,000
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 110,000

Assume that the year-end balances shown for accounts receivable and for inventory also represent
the average balances of these items throughout the year.
Instructions
a. For each of the two companies, compute the following:
1. Working capital.
2. Current ratio.
Critical Thinking Cases 679

3. Quick ratio.
4. Number of times inventory turned over during the year and the average number of days
required to turn over inventory (round computation to the nearest day).
5. Number of times accounts receivable turned over during the year and the average number
of days required to collect accounts receivable (round computation to the nearest day).
6. Operating cycle.
b. From the viewpoint of a short-term creditor, comment on the quality of each company’s work-
ing capital. To which company would you prefer to sell $50,000 in merchandise on a 30-day
open account?

Critical Thinking Cases

LO14-1 Holiday Greeting Cards is a local company organized late in July of 2014. The company’s net
CASE 14.1 income for each of its first six calendar quarters of operations is summarized below. (Amounts are
stated in thousands of dollars.)
Season’s Greetings

2015 2014

First quarter (Jan. through Mar.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 253 –0–

Second quarter (Apr. through June) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 –0–
Third quarter (July through Sept.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 $ 50
Fourth quarter (Oct. through Dec.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 500
Total for the calendar year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,111 $550

Hal Holcomb reports the business and economic news for a local radio station. On the day that
Holiday Greeting Cards released the above financial information, you heard Holcomb make the
following statement during his broadcast: “Holiday Greeting Cards enjoyed a 350 percent increase
in its profits for the fourth quarter, and profits for the entire year were up by over 100 percent.”

Instructions
a. Show the computations that Holcomb probably made in arriving at his statistics. (Hint:
Holcomb did not make his computations in the manner recommended in this chapter. His
figures, however, can be developed from these financial data.)
b. Do you believe that Holcomb’s percentage changes present a realistic impression of Holiday
Greeting Cards’s rate of growth in 2015? Explain.
c. What figure would you use to express the percentage change in Holiday’s fourth-quarter prof-
its in 2015? Explain why you would compute the change in this manner.

LO14-3, through LO14-5 You are a loan officer with Third Nebraska Bank. Joe West owns two successful restaurants, each
CASE 14.2 of which has applied to your bank for a $250,000 one-year loan for the purpose of opening a sec-
Evaluating ond location. Condensed balance sheets for the two business entities are shown below.
Debt-Paying Ability
NEBRASKA STEAK RANCH
BALANCE SHEET
DECEMBER 31, 2015
Assets Liabilities & Stockholders’ Equity

Current assets . . . . . . . . . . . . . $ 75,000 Current liabilities . . . . . . . . . . $ 30,000

Plant and equipment . . . . . . . . 300,000 Long-term liabilities . . . . . . . . 200,000
Capital stock . . . . . . . . . . . . . 100,000
________ Retained earnings . . . . . . . . . 45,000
Total liabilities &
Total assets . . . . . . . . . . . . . . . $375,000 stockholders’ equity . . . . . $375,000