FS and Ratios Addtl Exercises

Financial Statement and Ratio Analysis
Exercise 1: True or False
1. Ratio analysis merely directs the analyst to potential areas of concern; it does not provide
conclusive evidence as to the existence of a problem.
2. a cross-sectional comparison of firms operating in several lines of business, the industry average
ratios of any of the firm’s product lines may be used to analyze the multiproduct firm’s financial
performance.
3. Due to inflationary effects, inventory costs and depreciation write-offs can differ from their true
values, thereby distorting profits.
4. If an analysis is concerned only with certain specific aspects of a firm’s financial position, one or
two ratios may provide sufficient information from which to make a reasonable judgment.
5. In ratio analysis, the financial statements being used for comparison should be dated at the
same point in time during the year. If not, the effect of seasonality may produce erroneous
conclusions and decisions.
6. The use of the audited financial statements for ratio analysis may not be preferable because
there may be no reason to believe that the data contained in them reflect the firm’s true
financial condition.
7. Both present and prospective shareholders are interested in the firm’s current and future level
of risk and return. These two dimensions directly affect share price.
8. The comparison of a particular ratio to the standard (industry average) is made in order to
isolate any deviations from the norm. In the case of ratios for which higher values are preferred,
as long as the firm that is being analyzed has a value in excess of the industry average it can be
viewed favorably.
9. The use of differing accounting treatments—especially relative to inventory and depreciation—

can distort the results of ratio analysis, regardless of whether cross-sectional or time-series
analysis is used.
10. Inflationary effects typically have a greater impact the larger the differences in the age of the
assets of the firms being compared. Without adjustment, inflation tends to cause older firms
(with older fixed assets) to appear more efficient and profitable than newer firms (with newer
fixed assets).
11. Present and prospective shareholders and lenders pay close attention to the firm’s degree of
indebtedness and ability to repay debt. Shareholders are concerned since the claims of creditors
must be satisfied prior to the distribution of earnings to them. Lenders are concerned since the
more indebted the firm, the higher the probability that the firm will be unable to satisfy the
claims of all its creditors.
12. The liquidity of a business firm refers to the solvency of the firm’s overall financial position.
13. The liquidity of a business firm is measured by its ability to satisfy its long-term obligations as
they come due.
14. The current ratio provides a better measure of overall liquidity only when a firm’s inventory
cannot easily be converted into cash. If inventory is liquid, the quick ratio is a preferred measure
of overall liquidity.
15. Since the differences in the composition of a firm’s current assets and liabilities can significantly
affect the firm’s “true” liquidity, it is important to look beyond measures of overall liquidity to
assess the activity (liquidity) of specific current accounts.
16. The average age of inventory is viewed as the average length of time inventory is held by the
firm or as the average number of days’ sales in inventory.
17. Total asset turnover commonly measures the liquidity of a firm’s total assets.
18. The magnification of risk and return introduced through the use of fixed-cost financing such as
debt and preferred stock is called financial leverage.
19. The less fixed-cost debt (financial leverage) a firm uses, the greater will be its risk and return.
20. The higher the value of the times interest earned ratio, the higher the proportion of the firm’s
interest earnings compared to its contractual interest payments.
Exercise 2: Financial Ratios
Balance Sheet
Cole Eagan Enterprises
December 31, 2005
Cash $4,500 Accounts Payable $10,000
Accounts Receivable Notes Payable
Inventory Accruals 1,000
Total Current Assets Total Current Liabilities
Net Fixed Assets Long-Term Debt
Total Assets Stockholders’ Equity
Total Liabilities & S.E.
Information (2005 values)

1. Sales totaled $110,000
2. The gross profit margin was 25 percent.
3. Inventory turnover was 3.0.
4. There are 360 days in the year.
5. The average collection period was 65 days.
6. The current ratio was 2.40.
7. The total asset turnover was 1.13.
8. The debt ratio was 53.8 percent.
Compute for the following:
a. Inventory in 2005
b. Notes Payable in 2005
c. Accounts receivable in 2005
d. Net fixed assets in 2005
e. Total assets in 2005
f. Long-term debt in 2005
Exercise 3: Common Size statements
Key Financial Data

Dreamscape, Inc. Industry Average
Ratio For the Year Ended For the Year Ended
(% of Sales) December 31, 2004 December 31, 2005
Cost of goods sold 74.5% 70.0%
Gross profits 25.5 30.0
Selling expense 8.0 7.0
Gen. & admin. expense 5.1 4.9
Depreciation expense 2.4 2.0
Total operating expense 15.5 13.9
Operating profits 10.0 16.1
Interest expense 1.4 1.0
Net profits before taxes 8.6 15.1
Taxes 2.4 6.0
Net profits after taxes 5.2 9.1
Income Statement, Dreamscape, Inc.
For the Year Ended December 31, 2005
Sales revenue $1,000,000
Less: Cost of goods sold 750,000
Gross profits $ 250,000
Less: Operating expenses
Selling Expense $70,000
Gen. & admin. expense 48,000
Depreciation expense 20,000
Total operating expense $ 138,000
Operating profits $ 112,000
Less: Interest expense $ 20,000
Net profits before taxes $ 92,000
Less: Taxes $ 36,800
Net profits after taxes $ 55,200
Prepare a common-size income statement for Dreamscape, Inc. for the year ended December 31,
2005. Evaluate the company’s performance against industry average ratios and against last year’s
results.
Exercise 4: Financial Ratios
Given the following balance sheet, income statement, historical ratios and industry averages, calculate
the Pulp, Paper, and Paperboard, Inc. financial ratios for the most recent year. Analyze its overall
financial situation for the most recent year. Analyze its overall financial situation from both a
cross-sectional and time-series viewpoint. Break your analysis into an evaluation of the firm’s
liquidity, activity, debt, and profitability.
Income Statement
Pulp, Paper and Paperboard, Inc.
For the Year Ended December 31, 2005
Sales Revenue $2,080,976
Less: Cost of Goods Sold 1,701,000
Gross Profits $379,976
Less: Operating Expenses 273,846
Operating Profits $106,130
Less: Interest Expense 19,296
Net Profits Before Taxes $86,834
Less: Taxes (40%) 34,810
Net Profits After Taxes $52,024
Historical and Industry Average Ratios

Industry
Ratio 2003 2004 2005 2005
Current Ratio 1.6 1.7 — 1.6
Quick Ratio 0.9 1.0 — 0.9
Inventory Turnover 8.1 9.3 — 8.4
Average Collection Period 33 days 37 days — 39 days
Total Asset Turnover 2.3 2.2 — 2.2
Debt Ratio 60% 56% — 58%
Times Interest Earned 2.5 3.5 — 2.3
Gross Profit Margin 21% 19.7% — 20.4%
Operating Profit Margin 4.7% 4.8% — 4.7%
Net Profit Margin 1.8% 1.6% — 1.4%
Return on total assets 4.1% 3.5% — 3.08%
Return on Equity 10.3% 7.9% — 7.3%
Balance Sheet
December 31, 2005
Assets
Cash $ 95,000
Accounts receivable 237,000
Inventories 243,000
Total current assets $ 575,000
Gross fixed assets 500,000
Less: Accumulated depreciation 75,000
Net fixed assets $ 425,000
Total assets $1,000,000
Liabilities and stockholders’ equity
Current liabilities
Accounts payable $ 89,000
Notes payable 169,000
Accruals 87,000
Total current liabilities $ 345,000
Long-term debt 188,000
Total liabilities $ 533,000
Stockholders’ equity
Common stock 255,000
Retained earnings 212,000
Total stockholders’ equity $ 467,000
Total liabilities and stockholders’ equity $1,000,000
Exercise 6: Construct the DuPont system of analysis using the following financial data for Key Wahl
Industries and determine which areas of the firm need further analysis.
Key Financial Data

Key Wahl Industries:
Sales $4,500,000
Net profits after taxes 337,500
Total assets 6,750,000
Total liabilities 3,375,000
Industry Averages:
Total asset turnover 0.71
Debt ratio 33.00%
Financial leverage multiplier 1.50
Return on total assets 6.75%
Return on equity 10.00%
Net profit margin 9.50%

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Financial Statement and Ratio Analysis

Exercise 1: True or False

9. The use of differing accounting treatments—especially relative to inventory and depreciation—

Exercise 2: Financial Ratios

Information (2005 values)

Compute for the following:

Exercise 3: Common Size statements

Key Financial Data

Historical and Industry Average Ratios

Key Financial Data

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