Module 4

Analyzing and Interpreting Financial

Statements

Learning Objectives – coverage by question

True/False Multiple Choice Exercises Problems Essays

LO1 – Compute return on

equity (ROE) and
disaggregate it into 1-6 1-9 1-7 1-4 1, 2
components of operating and
nonoperating returns.

LO2 – Disaggregate
operating return (RNOA) into
1, 7-9 10-14 8, 9 5, 6 1-3
components of profitability
and asset turnover.

LO3 – Explain nonoperating

return and compute it from 1, 2,
15-17 10 1-3, 7, 8 1, 2, 4
return on equity and the 10, 11
operating return.

LO4 – Compute and interpret

1, 2,
measures of liquidity and 1, 12, 13 18-24 11-13 9, 10
5, 6
solvency.

LO5 – Describe and illustrate

traditional DuPont 1, 14, 15 25 14, 15 11 1, 2, 7
disaggregation of ROE.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-1
Module 4: Analyzing and Interpreting Financial Statements

True/False

Topic: Use of Ratios

LO: 1-5
1. Ratios provide one way to compare companies in the same industry regardless of their size.

Answer: True
Rationale: Ratios mitigate problems arising from different sizes of companies.

Topic: Financial Leverage and RNOA

LO: 1, 3
2. Highly leveraged firms have higher RNOA than firms with lower leverage.

Answer: False
Rationale: Financial leverage does not affect the RNOA computation because it is based on operating
profit. Financial leverage will increase ROE, however.

Topic: Return on Equity and Treasury Stock

LO: 1
3. Repurchasing shares near year-end will increase a firm’s return on equity (ROE).

Answer: True
Rationale: Repurchasing shares will decrease equity because treasury stock is a contra-account (it
reduces total equity). If the repurchases happen at year-end, there are likely no significant profit
impacts and thus, the numerator in the ROE ratio will be unaffected. Thus, the ratio will increase.

Topic: Nonoperating Return

LO: 1
4. All else equal, when investors consider a firm’s return on equity (ROE) they consider less risky a firm
that earns proportionately more of that return from operating activities as opposed to nonoperating
activities.

Answer: True
Rationale: Financial leverage will increase nonoperating return and ROE; however this adds risk to
the investment. For equal returns, investors typically prefer less risk.

Topic: Tax on Operating Profit

LO: 1
5. To determine tax on net operating profit, we begin with total tax expense and deduct taxes related to
net nonoperating expenses.

Answer: False
Rationale: We begin with total tax expense and add back any taxes related to net nonoperating
expenses (NNE).

©Cambridge Business Publishers, 2015

4-2 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: NOPAT
LO: 1
6. NOPAT is equivalent to income from operating activities.

Answer: False
Rationale: NOPAT is income from operating activities after tax which excludes nonoperating
expenses such as interest expense. Income from operating activities often includes interest expense
and is before tax.

Topic: Asset Turnover Effect on RNOA/ROE

LO: 2
7. Increasing a company’s net operating asset turnover (NOAT) increases both RNOA and ROE.

Answer: True.
Rationale: ROE = RNOA + FLEV × Spread. RNOA is further disaggregated into profit margin × asset
turnover. Therefore an increase in asset turnover will yield an increase in RNOA, which will result in
an increase in ROE if all other variables remain constant.

Topic: Profitability and RNOA

LO: 2
8. If Company A has a higher net operating profit margin (NOPM) than Company B, then Company A’s
RNOA will be higher.

Answer: False
Rationale: RNOA depends on NOPM but also depends on operating asset productivity (NOAT). If
Company B had a much higher operating asset productivity, its RNOA could be higher despite the
lower profitability.

Topic: Net Operating Asset Turnover

LO: 2
9. Net operating asset turnover (NOAT) measures a company’s profitability.

Answer: False
Rationale Net operating asset turnover is a productivity or efficiency concept.

Topic: Financial Leverage and Debt Ratings

LO: 3
10. All else being equal, higher financial leverage will decrease a company’s debt rating and increase the
interest rate it must pay.

Answer: True
Rationale: Higher levels of financial leverage increase the probability of default and of bankruptcy.
This reduces credit ratings and increases costs for borrowed funds.

Topic: Return on Equity (ROE)

LO: 3
11. ROE can be disaggregated into operating and nonoperating returns. Nonoperating return will be
positive as long as Spread is positive.

Answer: False
Rationale: The nonoperating return can be negative (which reduces ROE) if spread is positive and
financial leverage (FLEV) is negative.
©Cambridge Business Publishers, 2015
Test Bank, Module 4 4-3
Topic: Current Ratio
LO: 4
12. A current ratio greater than 1.0 is generally desirable for a company.

Answer: True
Rationale: A company with a current ratio greater than 1.0 indicates positive working capital. In
general, companies prefer greater levels of current assets than current liabilities.

Topic: Solvency
LO: 4
13. Solvency ratios measure a company’s ability to meet its debt obligations.

Answer: True
Rationale: A solvent company is one that can meet its debt obligations including principal and interest
payments as they come due.

Topic: ROA versus RNOA

LO: 5
14. The only difference between adjusted return on assets (ROA) and return on net operating assets
(RNOA) is that the denominator in RNOA is typically smaller than the denominator in ROA because
the former is net of operating liabilities.

Answer: False
Rationale: It is true that the denominator in RNOA is typically smaller but the other difference between
the ratios is that the numerators are different. ROA includes all net income whereas RNOA includes
only net profits from operating activities.

Topic: Basic DuPont Analysis

LO: 5
15. The DuPont analysis disaggregates return on equity into profitability, efficiency and leverage
components.

Answer: True
Rationale: The DuPont disaggregation of return on equity is: ROE = Profit margin (PM) × Asset
turnover (AT) × Financial leverage (FL). These three terms measure profitability, efficiency and
leverage respectively.

©Cambridge Business Publishers, 2015

4-4 Financial & Managerial Accounting for MBAs, 4th Edition
Multiple Choice

Topic: ROE Computation

LO: 1
1. ROE is computed as:
A) Net income attributable to controlling interest / Average equity attributable to controlling interest
B) Net income attributable to controlling interest / Net sales
C) RNOA + (FLEV × Spread) x NCI ratio
D) A and B
E) A and C

Answer: E
Rationale: ROE = Net income attributable to controlling interest / Average equity attributable to
controlling interest. This is the most straightforward way to calculate ROE, so A is correct. Answer C
is a disaggregation of ROE into its operating and nonoperating components. Thus, the correct
answer is E: A and C.

Topic: ROE Computation (Numerical calculations required)

LO: 1
2. The 2013 balance sheet of E.I. du Pont de Nemours and Company shows average DuPont
shareholders’ equity attributable to controlling interest of $13,219 million, net operating profit after tax
of $3,145 million, net income attributable to DuPont of $4,848 million, and common shares issued of
1,014 million.

Assume the company has no preferred shares issued. DuPont’s return on equity (ROE) for the year
is:
A) 20.9%
B) 36.7%
C) 23.8%
D) 36.4%
E) There is not enough information to calculate the ratio.

Answer: B
Rationale: ROE = Net income/Average shareholders’ equity = $4,848 / $13,219 = 36.7%

Topic: ROE Computation (Numerical calculations required)

LO: 1
3. The 2013 financial statements of The New York Times Company reveal average shareholders’ equity
attributable to controlling interest of $752,618 thousand, net operating profit after tax of $97,898
thousand, net income attributable to The New York Times Company of $65,105 thousand, and
average net operating assets of $ 402,427 thousand.

The company’s return on equity (ROE) for the year is:

A) 8.7%
B) 13.0%
C) 16.2%
D) 24.3%
E) There is not enough information to calculate the ratio.

Answer: A
Rationale: ROE = Net income / Average shareholders’ equity = $65,105 / $752,618 = 8.7%

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-5
Topic: NOA Computation (Numerical calculations required)
LO: 1
4. The 2014 balance sheet of Staples, Inc. shows total assets of $11,174,876 thousand, operating
assets of $10,682,344 thousand, operating liabilities of $3,929,854 thousand, and shareholders’
equity of $6,132,263 thousand.

Staples’ 2014 net operating assets are:

A) $ 7,245,022 thousand
B) $10,682,344 thousand
C) $ 6,752,490 thousand
D) $ 6,132,263 thousand
E) None of the above

Answer: C
Rationale: NOA = Operating assets – Operating liabilities = $10,682,344 – $3,929,854 = $6,752,490

Topic: Average NOA Computation (Numerical calculations required)

LO: 1
5. The 2013 balance sheet of Whole Foods Market reports operating assets of $4,102 million, operating
liabilities of $1,596 million, and total liabilities of $1,660 million.

Whole Food’s average net operating assets for the year are:
A) $2,506 million
B) $2,442 million
C) $3,256 million
D) $2,051 million
E) There is not enough information to calculate the amount.

Answer: E
Rationale: Average net operating assets requires two years of balance sheet data. The question only
provided one year’s data, thus, there is not enough information to calculate the amount.

Topic: Tax Shield Computation (Numerical calculations required)

LO: 1
6. Mattel Inc.’s 2013 financial statements show operating profit before tax of $1,168,103 thousand, net
income of $903,944 thousand, provision for income taxes of $195,184 thousand and net
nonoperating expense before tax of $68,975 thousand.

Assume Mattel’s statutory tax rate for 2013 is 37%. Mattel’s 2013 tax shield is:
A) $ 43,454 thousand
B) $ 25,521 thousand
C) $264,159 thousand
D) $238,638 thousand
E) None of the above

Answer: B
Rationale: Tax shield = Net nonoperating expense before tax × statutory tax rate = $68,975 × 37%
= $25,521 thousand.

©Cambridge Business Publishers, 2015

4-6 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Effective Tax Rate Computation (Numerical calculations required)
LO: 1
7. Mattel Inc.’s 2013 financial statements show operating profit before tax of $1,168,103 thousand, net
income of $903,944 thousand, provision for income taxes of $195,184 thousand and net
nonoperating expense before tax of $68,975 thousand.

Assume Mattel’s statutory tax rate for 2013 is 37%. Mattel’s 2013 effective tax rate is:
A) 17.8%
B) 37.0%
C) 19.4%
D) 16.7%
E) None of the above

Answer: A
Rationale: Effective tax rate = Provision for income taxes / Income before tax = $195,184 / ($903,944
+ $195,184) = 17.8%

Topic: NOPAT Definition

LO: 1
8. Net operating profit after tax (NOPAT) includes operating revenues less expenses such as:
A) Cost of goods sold (COGS)
B) Taxes on operating income
C) Selling, general and administrative expenses (SG&A)
D) After-tax earnings from investments and interest expenses
E) All of the above
F) A, B and C only

Answer: F
Rationale: NOPAT is net operating profit after tax. After-tax earnings from investments and interest
expenses are not included because they are nonoperating items.

Topic: RNOA Computation (Numerical calculations required)

LO: 1
9. The 2013 balance sheet of The New York Times Company shows average shareholders’ equity
attributable to controlling interest of $752,618 thousand, net operating profit after tax of $97,898
thousand, net income attributable to The New York Times Company of $65,105 thousand, and
average net operating assets of $ 402,427 thousand.

The company’s return on net operating assets (RNOA) for the year is:
A) 13.0%
B) 16.2%
C) 24.3%
D) 8.7%
E) There is not enough information to calculate the ratio.

Answer: C
Rationale: RNOA = NOPAT / average NOA = $97,898 / $402,427 = 24.3%

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-7
Topic: Nonoperating Return Computation (Numerical calculations required)
LO: 2, 3
10. The fiscal 2013 financial statements of Baker Hughes Inc. shows net operating profit margin (NOPM)
of 5.59%, net operating asset turnover (NOAT) of 1.06, return on equity of 6.30%, and adjusted return
on assets of 4.58%.

What is the company’s nonoperating return?

A) 0.37%
B) 0.71%
C) 1.45%
D) 1.01%
E) There is not enough information to calculate the ratio.

Answer: A
Rationale: ROE = RNOA + nonoperating return = 6.30% – (5.59% × 1.06) = 0.3746%

Topic: Nonoperating Return Computation (Numerical calculations required)

LO: 2, 3
11. The 2013 balance sheet of The New York Times Company shows net operating profit margin
(NOPM) of 6.2%, net operating asset turnover (NOAT) of 3.35, return on equity of 8.7%, and adjusted
return on assets of 2.4%.

What is the company’s nonoperating return?

A) -12.1%
B) 0.7%
C) -1.8%
D) 2.5%
E) None of the above

Answer: A
Rationale: ROE = RNOA + nonoperating return = 8.7% – (6.2% × 3.35) = -12.07% = -12.1%

Topic: Net Operating Profit Margin (NOPM) Computation (Numerical calculations required)
LO: 2
12. The fiscal year-end 2014 financial statements for Staples, Inc. report revenues of $23,114,263
thousand, net operating profit after tax of $779,262 thousand, net operating assets of $6,752,490
thousand. The fiscal year-end 2013 balance sheet reports net operating assets of $6,920,568
thousand.

Staples’ 2014 net operating profit margin is:

A) 29.2%
B) 11.5%
C) 3.4%
D) 12.7%
E) There is not enough information to calculate the ratio.

Answer: C
Rationale: NOPM = NOPAT / Revenues = $779,262 / $23,114,263 = 3.4%

©Cambridge Business Publishers, 2015

4-8 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Net Operating Asset Turnover (NOAT) Computation (Numerical calculations required)
LO: 2
13. The fiscal 2013 financial statements for Walgreen, Inc., report net sales of $72,217 million, net
operating profit after tax of $2,478 million, net operating assets of $21,556 million. The 2012 balance
sheet reports net operating assets of $21,465 million.

Walgreen’s 2013 net operating asset turnover is:

A) 11.5%
B) 3.24
C) 3.43%
D) 3.36
E) There is not enough information to calculate the ratio.

Answer: D
Rationale: NOAT = Net sales / Average NOA = $72,217 / [($21,556 + $21,465) / 2] = 3.36

Topic: Net Operating Asset Turnover (NOAT) Computation (Numerical calculations required)
LO: 2
14. Kroger’s 2013 financial statements show net operating profit after tax of $1,799 million, net income of
$1,497 million, sales of $96,751 million, and average net operating assets of $11,529 million.

Kroger’s net operating asset turnover for the year is:

A) 1.9%
B) 8.11
C) 8.39
D) 11.9%
E) There is not enough information to calculate the ratio.

Answer: C
Rationale: Net operating asset turnover = Sales / Average net operating assets = $96,751 million /
$11,529 million = 8.39.

Topic: NNO Computation (Numerical calculations required)

LO: 3
15. The 2013 balance sheet of Microsoft Corp. reports total assets of $142,431 million, operating
liabilities of $47,242 million, and total shareholders’ equity of $78,944 million. Microsoft 2013
nonoperating liabilities are:
A) $63,487 million
B) $16,245 million
C) $95,189 million
D) $31,702 million
E) There is not enough information to calculate the amount.

Answer: B
Rationale: Total assets = Operating liabilities + Nonoperating liabilities + Shareholders’ equity
Nonoperating liabilities = $142,431 million – $47,242 million – $78,944 million = $16,245 million

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-9
Topic: Computing Financial Leverage (FLEV) (Numerical calculations required)
LO: 3
16. The fiscal 2013 financial statements of Baker Hughes Inc. shows average net operating assets (NOA)
of $21,034 million, average net nonoperating obligations (NNO) of $3,442 million, average total
liabilities of $9,722 million, and average equity of $17,391 million.

The company’s 2013 financial leverage (FLEV) is:

A) 0.462
B) 0.559
C) 0.164
D) 0.198
E) There is not enough information to determine the ratio.

Answer: D
Rationale: FLEV = Average NNO / Average equity = $3,442 / $17,391 = 0.198

Topic: Computing Financial Leverage (FLEV) (Numerical calculations required)

LO: 3
17. The fiscal 2014 financial statements of Barney Services shows average net operating assets (NOA)
of $6,315 million, average net nonoperating obligations (NNO) of $506 million, average total liabilities
of $2,618 million, and equity of $4,050 million.

The company’s 2014 financial leverage (FLEV) is:

A) 0.087
B) 0.334
C) 0.125
D) 0.080
E) There is not enough information to determine the ratio.

Answer: A
Rationale: FLEV = Average NNO / Average equity = $506 / ($6,315 – $506) = 0.087

Topic: Liquidity
LO: 4
18. Liquidity refers to:
A) The life cycle of the company
B) The amount of receivables the company has in the balance sheet
C) The amount of financial leverage
D) None of the above

Answer: D
Rationale: Liquidity refers to cash, the amount on hand, the amount generated from operating
activities, and the amount that can be raised on relatively short notice.

©Cambridge Business Publishers, 2015

4-10 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Current Ratio
LO: 4
19. The current ratio is a measure of:
A) Solvency
B) Bankruptcy position
C) Short-term debt paying ability
D) Leverage

Answer: C
Rationale: The current ratio is a measure of short-term debt paying ability.

Topic: Liquidity Measure

LO: 4
20. Which of the following is a measure of liquidity?
A) Liabilities-to-Equity Ratio = Total Liabilities / Stockholder’s Equity
B) Times Interest Earned = Earnings before interest and taxes / Interest Expense
C) Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
D) Return on net operating assets (RNOA)
E) All of the above

Answer: C
Rationale: The only measure of liquidity listed above is c (Quick Ratio) which is simply a variation of
the Current Ratio (Current Ratio = Current Assets / Current Liabilities) to focus on quick assets (cash,
securities, and receivables).

Topic: Computing Current Ratio (Numerical calculations required)

LO: 4
21. The fiscal 2013 balance sheet for Whole Foods Market reports the following data (in millions). What is
the company’s current ratio?

Cash and cash Accounts Merchandise Current Current

equivalents receivable inventories assets liabilities

$290 $188 $414 $1,980 $1,088

A) 0.82
B) 1.55
C) 0.44
D) 1.82
E) None of the above

Answer: D
Rationale: Current ratio = Current assets / Current liabilities = $1,980 / $1,088 = 1.82

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-11
Topic: Computing Quick Ratio (Numerical calculations required)
LO: 4
22. The fiscal 2013 balance sheet for Whole Foods Market reports the following data (in millions). What is
the company’s quick ratio?

Cash and cash Accounts Merchandise Current Current

equivalents receivable inventories assets liabilities
$290 $188 $414 $1,980 $1,088

A) 0.82
B) 1.55
C) 0.44
D) 1.82
E) None of the above

Answer: C
Rationale: Quick ratio = (Cash + Accounts receivable) / Current liabilities = ($290 + $188) / $1,088
= 0.44

Topic: Computing Times Interest Earned Ratio (Numerical calculations required)

LO: 4
23. Selected income statement data follow for Harley Davidson, Inc., for the year ended December 31,
2013 (in thousands). What is the company’s times interest earned ratio?

Income before
Interest Statutory Provision for
provision for Net income
expense tax rate income taxes
income taxes

$1,114,305 $45,256 37% $380,312 $733,993

A) 16.2
B) 1.6
C) 17.2
D) 25.6
E) None of the above

Answer: D
Rationale: Times interest earned = ($1,114,305 + $45,256) / $45,256 = 25.6

©Cambridge Business Publishers, 2015

4-12 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Computing Liabilities-to-Equity Ratio (Numerical calculations required)
LO: 4
24. Selected balance sheet data follow for Goodyear Tire & Rubber Company for the year ended
December 31, 2013 (in millions). What is the company’s liabilities-to-equity ratio?

Total Total Total Total liabilities

Total
operating nonoperating current and
liabilities
liabilities liabilities liabilities shareholders’ equity

$8,847 $6,235 $5,025 $15,082 $17,527

A) 6.17
B) 2.06
C) 3.62
D) 0.86
E) None of the above

Answer: A
Rationale: Liabilities-to-equity ratio = $15,082 / ($17,527 – $15,082) = 6.17

Topic: Computing Traditional DuPont Ratios (Numerical calculations required)

LO: 5
25. Selected ratios follow for Baker Hughes Inc. for the year ended December 31, 2013 (in millions).
What is the company’s return on equity (ROE) for the year?

Return on Net operating Financial

Profit margin Asset turnover
net operating profit margin leverage
(PM) (AT)
assets (RNOA) (NOPM) (FL)

5.94% 4.90% 5.59% 0.82 1.57

A) 7.20%
B) 7.65%
C) 6.31%
D) 3.83%
E) None of the above

Answer: C
Rationale: ROE = PM × AT × FL = 4.90% × 0.82 × 1.57 = 6.31%

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-13
Exercises

Topic: Use financial statements to compute ROE and disaggregate into operating and
nonoperating components
LO: 1
1. Selected balance sheet and income statement data follow for E.I. DuPont de Nemours and Company
(in millions). Use the data to calculate the following:

a. Return on equity (ROE)

b. Return on net operating assets (RNOA)
c. The company’s nonoperating return

2013 2013 2013 2013 2012 2013

Net income Net Average DuPont
attributable to Operating Operating operating shareholders’
DuPont NOPAT assets liabilities assets equity
$4,862 $3,145 $42,413 $22,751 $15,640 $13,219

Answer:
a. ROE = Net income / Average shareholders’ equity = $4,862 / $13,219 = 36.8%

b. RNOA = NOPAT / Average net operating assets = $3,145 / [($42,413 - $22,751 + $15,640) / 2] = 17.8%

c. Nonoperating return = ROE – RNOA = 36.8% – 17.8% = 19.0%

Topic: Use financial statements to compute ROE and disaggregate into operating and
nonoperating components
LO: 1
2. Selected balance sheet and income statement data follow for The New York Times Company for
fiscal 2013 (in thousands). Use the data to calculate the following:

a. Return on equity (ROE)

b. Return on net operating assets (RNOA)
c. The company’s nonoperating return

2013 2013 2013 2012 2013 2012

Net income attributable Net Net
to New York Times operating operating Common Common
common stockholders NOPAT assets assets equity equity
$65,105 $97,898 $506,896 $302,401 $842,910 $662,325

Answer:
a. ROE = Net income / Average equity = $65,105 / [($842,910 + $662,325) / 2] = 8.7%

b. RNOA = NOPAT / Average net operating assets = $97,898 / [($506,896 + $302,401) / 2] = 24.2%

c. Nonoperating return = ROE – RNOA = 8.7% – 24.2% = -15.5%

©Cambridge Business Publishers, 2015

4-14 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to compute tax shield and NOPAT.
Note to instructor: In this fiscal year (2013), Staples has net nonoperating expense (the usual
situation). The next exercise is for a Staples’ prior year (fiscal 2007) and involves negative
nonoperating expense (atypical situation).
LO: 1
3. Use the income statement for Staples, Inc. to compute the following:

a. The tax shield

b. NOPAT

The company’s combined federal and state statutory tax rate is 37.0%.

STAPLES, INC. AND SUBSIDIARIES

Consolidated Statement of Income for February 1, 2014

(in thousands)
Sales $23,114,263
Cost of goods sold and occupancy costs 17,081,978
Gross profit 6,032,285
Selling, general, and administrative 4,735,294
Restructuring charges 64,085
Amortization of intangibles 55,405
Total operating expenses 4,854,784
Operating income 1,177,501
Other nonoperating income (expense):
Interest income 4,733
Interest expense (119,329)
Miscellaneous expense (100)
Income from continuing operations
before income taxes 1,062,805
Income tax expense 355,801
Net income 707,004
Loss from discontinued operations (86,935)
Net income attributed to Staples, Inc. $ 620,069

Answer:
a. ($119,329 + $100 – $4,733) × 0.370 = $42,438

b. $1,177,501 – ($355,801 + $42,438) = $779,262

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-15
Topic: Use financial statements to compute tax shield and NOPAT.
Note to instructor: In this fiscal year (2007), Staples has negative net nonoperating expense (the
atypical situation). The prior exercise uses Staples’ fiscal 2013 information and involves
nonoperating expense (the usual situation).
LO: 1
4. Use the income statement for Staples, Inc., to compute the following:

a. The tax shield

b. NOPAT

The company’s combined federal and state statutory tax rate is 37.0%.

STAPLES, INC. AND SUBSIDIARIES

Consolidated Statement of Income for February 2, 2008

(in thousands)
Sales $19,372,682
Cost of goods sold and occupancy costs 13,822,011
Gross profit 5,550,671
Operating and selling expenses 3,131,774
General and administrative expenses 854,984
Amortization of intangibles 15,664
Total operating expenses 4,002,422
Operating income 1,548,249
Other nonoperating income (expense):
Interest income 46,726
Interest expense (28,335)
Miscellaneous expense (2,158)
Income before income taxes and minority interest 1,564,482
Income tax expense 559,614
Income before minority interests 1,004,868
Minority interest income 802
Net Income $ 1,005,670

Answer:
a. ($28,335 + $2,158 – $46,726) × 0.370 = -$6,006

b. $1,548,249 – ($559,614 – $6,006) = $994,641

©Cambridge Business Publishers, 2015

4-16 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to compute net operating assets (NOA).
LO: 1
5. Use the balance sheets for the fiscal 2013 (year ended February 1, 2014) for Staples, Inc. to compute
the following:

a. Operating assets
b. Operating liabilities
c. Net operating assets (NOA)

STAPLES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets
(in thousands)
February 1, 2014
Cash and cash equivalents $ 492,532
Receivables, net 1,838,714
Merchandise inventories, net 2,328,299
Deferred income tax asset 179,566
Prepaid expenses and other current assets 400,447
Total current assets 5,239,558
Net property and equipment 1,870,719
Intangible assets, net 382,700
Goodwill 3,233,597
Other assets 448,302
Total assets $11,174,876

Accounts payable $ 1,997,494

Accrued expenses and other current liabilities 1,266,974
Debt maturing within one year 103,982
Total current liabilities 3,368,450
Long-term debt 1,000,205
Other long-term obligations 665,386

Common stock 563

Additional paid-in capital 4,866,467
Accumulated other comprehensive loss (507,154)
Retained earnings 7,001,755
Treasury stock (5,229,368)
Total Staples, Inc. stockholders' equity 6,132,263
Noncontrolling interests 8,572
Total stockholders’ equity 6,140,835
Total liabilities and stockholders' equity $11,174,876

Answer:
a. $11,174,876 - $492,532 = $10,682,344

b. $1,997,494 + $1,266,974 + $665,386 = $3,929,854

c. $10,682,344 - $3,929,854 = $6,752,490

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-17
Topic: Use financial statements to compute tax amounts.
LO: 1
6. Use the following income statement for Mattel Inc. ($ thousands) to compute the following:

a. Tax shield
b. Taxes on operating profit
c. Tax rate on operating profit

The company’s statutory tax rate is 37%.

Mattel Inc. and Subsidiaries

Consolidated Statement of Income
For the year ended December 31, 2013
Net sales $ 6,484,892
Cost of sales 3,006,009
Gross profit 3,478,883
Advertising and promotion expenses 750,205
Other selling and administrative expenses 1,560,575
Operating income 1,168,103
Interest expense 78,505
Interest (income) (5,555)
Other nonoperating (income), net (3,975)
Income before income taxes 1,099,128
Provision for income taxes 195,184
Net income $ 903,944

Answer:
a. ($78,505 - $5,555 – $3,975) × 37% = $68,975 × 37% = $25,521

b. $195,184 + $25,521 = $220,705

c. $220,705 / $1,168,103 = 18.9%

©Cambridge Business Publishers, 2015

4-18 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to compute tax amounts.
Note to instructor: Microsoft has negative nonoperating items and thus a negative tax shield.
LO: 1
7. Use the following income statement for Microsoft Corporation to compute the following:

a. Tax shield
b. Taxes on operating profit
c. Tax rate on operating profit

The company’s statutory tax rate is 37%.

Microsoft Corporation
Income Statement
For the fiscal year ended June 30, 2013
(in millions)
Revenue $77,849
Cost of revenue 20,249
Research and development 10,411
Sales and marketing 15,276
General and administrative 5,149
Total operating expenses 51,085
Income from operations 26,764
Investment income and other 288
Income before income taxes 27,052
Provision for income taxes 5,189
Net income $21,863

Answer:
a. -$288 × 37% = -$107

b. $5,189 – $107 = $5,082

c. $5,082 / $26,764 = 0.1899 = 19.0%

Topic: Use financial statement data to compute RNOA, NOPM, and NOAT.
LO: 2
8. Selected balance sheet and income statement data follow for Staples, Inc. (in thousands). Use the
data to calculate a) return on net operating assets (RNOA), b) net operating profit margin (NOPM),
and c) net operating asset turnover (NOAT) for fiscal 2013.

2013 2013 2013 2013 2012

Revenues NOPAT Operating assets Operating liabilities Net operating assets

$23,114,263 $779,262 $10,682,344 $3,929,854 $6,749,749

Answer:
a. RNOA = NOPAT / Average NOA = $779,262 / [($10,682,344 - $3,929,854 + $6,749,749) / 2] =
11.5%

b. NOPM = NOPAT / Revenues = $779,262 / $23,114,263 = 3.4%

c. NOAT = Revenues / Average NOA = $23,114,263 / [($10,682,344 - $3,929,854 + $6,749,749) / 2]

= 3.42
©Cambridge Business Publishers, 2015
Test Bank, Module 4 4-19
Topic: Use financial statement data to compute RNOA, NOPM, and NOAT, and confirm RNOA.
LO: 2
9. Selected balance sheet and income statement data follow for Walgreen Co. for the year ended
August 31, 2013 (in millions). Use the data to calculate a) return on net operating assets (RNOA), b)
net operating profit margin (NOPM), and c) net operating asset turnover (NOAT). Confirm that RNOA
= NOPM × NOAT.

2013 2013 2013 2013 2013 2012

Operating Operating Net operating
Net Sales NOPAT Net earnings assets liabilities assets

$72,217 $2,478 $2,450 $32,536 $10,980 $21,465

Answer:
a. RNOA = NOPAT / Average NOA = $2,478 / [($32,536 - $10,980 + $21,465) / 2] = 11.5%

b. NOPM = NOPAT / Net sales = $2,478 / $72,217 = 3.4%

c. NOAT = Net sales / Average NOA = $72,217/ [($32,536 - $10,980 + $21,465) / 2] = 3.4

Confirm RNOA: 3.4% × 3.4.4 = 11.6% (0.1% difference due to rounding)

Topic: Use financial statements to compute FLEV and Spread.

Note to instructor: More challenging because students must infer total shareholders’ equity from
NNO and NOA.
LO: 3
10. Selected income statement and balance sheet data follow for Snap-On Incorporated for fiscal 2013
and 2012. Use these data to calculate a) FLEV, b) spread, and c) return on equity (ROE) for fiscal
2013 only.

(in millions) 2013 2012

Net nonoperating expenses, after tax (NNE) $ 47.0 $ 41.3
Net operating assets (NOA) $2,884.8 $2,580.1
Net nonoperating obligations (NNO) $ 754.4 $ 761.1
Return on net operating assets (RNOA) 14.5% 14.1%

Answer:
a. FLEV = Average NNO / Average shareholders’ equity = [($754.4 + $761.1) / 2] / [(($2,884.8 –
$754.4) + ($2,580.1 – $761.1)) / 2] = 0.38

b. Spread = RNOA – (NNE / Average NNO) = 14.5% - $47 / [($754.4 + $761.1) / 2] = 8.3%

c. ROE = RNOA + (FLEV × Spread) = 14.5% + (0.38 × 8.3%) = 17.7%

©Cambridge Business Publishers, 2015

4-20 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statement data to compute measures of liquidity.
Note to Instructor: this is more challenging as it requires students to assess whether “Restricted
cash” is a quick asset. It is not because it cannot be used to satisfy ordinary current liabilities.
LO: 4
11. Selected balance sheet income statement data follow for Whole Foods Market, Inc. for the year
ended September 29, 2013 (in millions). Use the data to calculate the company’s current ratio and
quick ratio.

Cash and
Short-term Restricted Accounts Merchandise Current Current
cash
investments cash receivable inventories assets liabilities
equivalents
$290 $733 $111 $188 $414 $1,980 $1,088

Answer:
Current ratio = $1,980 / $1,088 = 1.82

Quick ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities

= ($290 + $733 + $188) / $1,088 = 1.11

Topic: Use financial statement data to compute measures of solvency

LO: 4
12. Selected balance sheet income statement data follow for Harley Davidson, Inc. for the year ended
December 31, 2013 (in thousands). Use the data to calculate a) times interest earned, and b)
liabilities-to-equity ratio

Income before Total

Interest Statutory Total
provision for shareholders’
expense tax rate liabilities
income taxes equity

$1,114,305 $45,256 37.0% $6,395,554 $3,009,486

Answer:
a. Times interest earned = ($1,114,305 + $45,256) / $45,256 = 25.6 times

b. Liabilities-to-equity ratio = $6,395,554 / $3,009,486 = 2.13

Topic: Use financial statement data to compute measures of liquidity and solvency.
LO: 4
13. Selected balance sheet and income statement data follow for Goodyear Tire & Rubber Company for
the year ended December 31, 2013 (in millions). Use the data to calculate the company’s current ratio
and liabilities-to-equity ratio.

Cash and Total liabilities

Accounts Total current Total current Total
cash and shareholders’
receivable assets liabilities liabilities
equivalents equity

$2,996 $2,435 $8,644 $5,025 $15,082 $17,527

Answer:
Current ratio = $8,644 / $5,025 = 1.72
Liabilities-to-equity ratio = $15,082 / ($17,527 - $15,082) = 6.17

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-21
Topic: Use financial statements to compute and interpret traditional DuPont ROE ratio and
components.
LO: 5
14. Use the following selected balance sheet and income statement data for Mattel Inc. (in $ thousands)
to compute a) return on equity, b) profit margin (PM), c) asset turnover (AT), and d) financial leverage
(FL) for fiscal 2013. Show that ROE = PM × AT × FL.

(in thousands) 2013 2012

Net sales $ 6,484,892 $ 6,420,881
Operating income 1,168,103 1,021,015
Interest expense 5,555 6,841
Net income 903,944 776,464
Total assets 6,439,626 6,526,785
Total liabilities 3,188,067 3,459,741

Answer:
a. ROE = Net income / Average stockholders’ equity
= $903,944 / {[($6,439,626 + $6,526,785) / 2] – [($3,188,067 + $3,459,741) / 2]} = 28.61%

b. PM = Net income / Net sales = $903,944 / $6,484,892 = 13.94%

c. AT = Net sales / Average assets = $6,484,892 / [($6,439,626 + $6,526,785) / 2] = 1.00

d. FL = Average assets / Average stockholders’ equity

= [($6,439,626 + $6,526,785) / 2] / {[($6,439,626 + $6,526,785) / 2] – [($3,188,067 + $3,459,741) / 2]}
= 2.05

ROE = 13.94% × 1.00 × 2.05 = 28.58% (off by 0.03% due to rounding)

Topic: Use financial statements to compute and interpret traditional DuPont ROE ratio and
components.
LO: 5
15. Use the following selected balance sheet and income statement data for Valero Energy Corporation
(in $ millions) to compute a) return on equity, b) profit margin (PM), c) asset turnover (AT), and d)
financial leverage (FL) for fiscal 2013. Show that ROE = PM × AT × FL.

(Millions of Dollars) 2013 2012

Operating revenues $138,074 $ 139,250
Interest expense 365 313
Net income attributable to Valero stockholders 2,720 2,090
Total assets 47,260 44,477
Total Valero stockholders’ equity 19,460 18,032
Statutory tax rate 37% 37%

Answer:
a. ROE = Net income / Average stockholders’ equity = $2,720 / [($19,460 + $18,032) / 2 ] = 14.51%

b. PM = Net income / Revenue = $2,720 / $138,074 = 1.97%

c. AT = Revenue / Average assets = $138,074 / [($47,260 + $44,477) / 2] = 3.01

d. FL = Average assets / Average stockholders’ equity

= [($47,260 + $44,477) / 2] / [($19,460 + $18,032) / 2 ] = 2.45

ROE = 1.97% × 3.01 × 2.45 = 14.53% (off by 0.02% due to rounding)

©Cambridge Business Publishers, 2015
4-22 Financial & Managerial Accounting for MBAs, 4th Edition
Problems

Topic: Use financial statements to compute ROE and disaggregate into operating and non-
operating components
LO: 1, 3
1. Income statements and balance sheets follow for The New York Times Company. Refer to these
financial statements to answer the requirements.

The New York Times Company

Consolidated Statements of Income

Fiscal year ended

(in thousands) Dec. 29, 2013 Dec. 30, 2012
Operating revenues
Circulation $ 824,277 $ 795,037
Advertising 666,687 711,829
Other 86,266 88,475
Total revenues 1,577,230 1,595,341
Production Costs
Raw materials 92,886 106,381
Wages and benefits 332,085 331,321
Other 201,942 213,616
Total production costs 626,913 651,318
Selling, general and administrative expenses 706,354 711,112
Depreciation and amortization 78,477 78,980
Total operating costs 1,411,744 1,441,410
Pension settlement expense 3,228 47,657
Multiemployer pension plan withdrawal expense 6,171 0
Other expense 0 2,620
Operating profit 156,087 103,654
Gain on sale of investments 0 220,275
Impairment of investments 0 5,500
(Loss)/income from joint ventures (3,215) 2,936
Premium on debt redemption 0 0
Interest expense, net 58,073 62,808
Income from continuing operations before income
taxes 94,799 258,557
Income tax expense 37,892 94,617
Income from continuing operations 56,907 163,940
Discontinued operations:
(Loss) from discontinued operations, net of tax (20,413) (113,447)
Gain on sale, net of tax 28,362 85,520
Income/(loss) from discontinued operations, net of
tax 7,949 (27,927)
Net income/(loss) 64,856 136,013
Net (income)/loss attributable to the
noncontrolling interest 249 (166)
Net income/(loss) attributable to New York Times
Company common stockholders 65,105 135,847

Continued next page

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-23
 continued
The New York Times Company
Consolidated Balance Sheets
As of
(in thousands) Dec. 29, 2013 Dec. 30, 2012
Cash and cash equivalents $ 482,745 $ 820,490
Short-term investments 364,880 134,820
Accounts receivable, net 202,303 197,589
Deferred income taxes 65,859 58,214
Prepaid assets 20,250 23,085
Other current assets 36,230 26,320
Assets held for sale 0 137,050
Total current assets 1,172,267 1,397,568
Long-term marketable securities 176,155 4,444
Investments in joint ventures 40,213 40,872
Property plant and equipment, net 713,356 773,469
Goodwill, net 125,871 122,691
Deferred income taxes 179,989 302,212
Miscellaneous assets 164,701 166,214
Total assets $2,572,552 $2,807,470
Accounts payable $ 90,982 $ 88,990
Accrued payroll and other related liabilities 91,629 86,772
Unexpired subscriptions 58,007 57,336
Accrued expenses 107,755 118,753
Accrued incomes taxes 138 38,932
Liabilities held for sale 0 32,373
Total current liabilities 348,511 423,156
Long-term debt and capital lease obligations 684,142 696,752
Pension benefits obligation 444,328 737,889
Postretirement benefits obligation 90,602 110,347
Other 158,435 173,690
Total other liabilities 1,377,507 1,718,678
Stockholders’ equity
Common stock of $0.10 par value:
Class A common stock 15,129 15,027
Class B convertible 82 82
Additional paid-in capital 33,045 25,610
Retained earnings 1,283,518 1,230,450
Common stock held in treasury, at cost (86,253) (96,278)
Accumulated other comprehensive income loss), net
of tax (402,611) (512,566)
Total New York Times Company stockholders’ equity 842,910 662,325
Noncontrolling interest 3,624 3,311
Total stockholders’ equity 846,534 665,636
Total liabilities and stockholders’ equity $2,572,552 $2,807,470

Continued next page

©Cambridge Business Publishers, 2015
4-24 Financial & Managerial Accounting for MBAs, 4th Edition
 continued

Required:
a. Compute net operating profit after tax (NOPAT) for 2013 and 2012. Assume that combined
federal and state statutory tax rates are 37% for both years.
b. Compute net operating assets (NOA) for 2013 and 2012.
c. Compute return on net operating assets (RNOA) for 2013 and 2012. Net operating assets are
$412,630 thousand in 2011.
d. Compute return on common shareholders equity (ROE) for 2013 and 2012. Stockholders’ equity
attributable to New York Times Company in 2011 is $506,360 thousand.
e. What is nonoperating return component of ROE for 2013 and 2012?
f. Comment on the difference between ROE and RNOA. What inference do you draw from this
comparison?

Answer:
a. (in thousands) 2013 2012
Income from operations $156,087 $ 103,654
Income/(loss) from joint ventures (3,215) 2,936
Provision for income taxes (37,892) (94,617)
Tax shelter on nonoperating items (21,487) 56,228
NOPAT $ 93,493 $68,201

b. (in thousands) 2013 2012

Total assets $2,572,552 $2,807,470
Less Cash and cash equivalents (482,745) (820,490)
Less Short-term marketable securities (364,880) (134,820)
Less Assets held for sale 0 (137,050)
Less Long-term marketable securities (176,155) (4,444)
Operating assets 1,548,772 1,710,666

Total current liabilities 348,511 423,156

Less Liabilities held for sale 0 (32,373)
Plus Pension benefits obligation 444,328 737,889
Plus Postretirement benefits obligation 90,602 110,347
Plus Other liabilities 158,435 173,690
Operating liabilities 1,041,876 1,412,709
Net operating assets (NOA) $506,896 $297,957

c. 2013: $93,493 / [($506,896 + $297,957) / 2] = 23.2%

2012: $68,201 / [($297,957 + $412,630) / 2] = 19.2%

d. 2013: $65,105 / [($842,910 + $662,325) / 2] = 8.7%

2012: $135,847 / [($662,325 + $506,360) / 2] = 23.2%

e. ROE = RNOA + Nonoperating return

2013: 8.7% = 23.2% – 14.5%
2012: 23.2% = 19.2% + 4.0%

f. The company had a positive nonoperating return in 2012, implying the company made effective
use of leverage. For 2013, the company’s nonoperating return is negative as its investment in
marketable securities exceeds its nonoperating debt.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-25
Topic: Use financial statements to compute ROE and disaggregate into operating and
nonoperating components
LO: 1, 3
2. Income statements and balance sheets follow for Snap-On Incorporated. Refer to these financial
statements to answer the requirements.

Snap-On Incorporated
Consolidated Statements of Earnings

(Amounts in millions) For the fiscal year ended

2013 2012
Net sales $ 3,056.5 $ 2,937.9
Cost of goods sold (1,583.6) (1,547.9)
Gross profit 1,472.9 1,390.0
Operating expenses (1,012.4) (980.3)
Operating earnings before financial services 460.5 409.7

Financial services revenue 181.0 161.3

Financial services expenses (55.3) (54.6)
Operating income from financial services 125.7 106.7
Operating earnings 586.2 516.4
Interest expense (56.1) (55.8)
Other income (expense) -- net (3.9) (0.4)
Earnings before income taxes and equity earnings 526.2 460.2
Income tax expense (166.7) (148.2)
Earnings before equity earnings 359.5 312.0
Equity earnings, net of tax 0.2 2.6
Net earnings 359.7 314.6
Net earnings attributable to noncontrolling interests (9.4) (8.5)
Net earnings attributable to Snap-on Incorporated $ 350.3 $ 306.1

Continued next page

©Cambridge Business Publishers, 2015

4-26 Financial & Managerial Accounting for MBAs, 4th Edition
 continued
Snap-On Incorporated
Consolidated Balance Sheets
Fiscal Year End
(Amounts in millions) 2013 2012

Cash and cash equivalents $ 217.6 $ 214.5

Trade and other accounts receivable - net 531.6 497.9
Finance receivables - net 374.6 323.1
Contract receivables - net 68.4 62.7
Inventories - net 434.4 404.2
Deferred income tax assets 85.4 81.8
Prepaid expenses and other assets 84.2 84.8
Total current assets 1,796.2 1,669.0
Property and equipment - net 392.5 375.2
Deferred income tax assets 57.1 110.4
Long-term finance receivables - net 560.6 494.6
Long-term contract receivables - net 217.1 194.4
Goodwill 838.8 807.4
Other intangibles - net 190.5 187.2
Other assets 57.2 64.1
Total assets $4,110.0 $ 3,902.3

Notes payable and current maturities of long-term debt $ 113.1 $ 5.2

Accounts payable 155.6 142.5
Accrued benefits 48.1 50.6
Accrued compensation 95.5 88.3
Franchisee deposits 59.4 54.7
Other accrued liabilities 243.7 247.9
Total current liabilities 715.4 589.2
Long-term debt 858.9 970.4
Deferred income tax liabilities 143.8 127.1
Retiree health care benefits 41.7 48.4
Pension liabilities 135.8 260.7
Other long-term liabilities 84.0 87.5
Total liabilities 1,979.6 2,083.3

Preferred stock – –
Common stock 67.4 67.4
Additional paid-in capital 225.1 204.6
Retained earnings 2,324.1 2,067.0
Accumulated other comprehensive income (loss) (44.8) (124.2)
Treasury stock at cost (458.6) (412.7)
Total shareholders’ equity attributable to Snap-on Inc. 2,113.2 1,802.1
Noncontrolling interests 17.2 16.9
Total shareholders’ equity 2,130.4 1,819.0
Total liabilities and shareholders’ equity $ 4,110.0 $ 3,902.3

Continued next page

©Cambridge Business Publishers, 2015
Test Bank, Module 4 4-27
 continued

Required:
a. Compute net operating profit after tax (NOPAT) for 2013 and 2012. Assume that combined
federal and state statutory tax rates are 37% for fiscal 2013 and 2012.
b. Compute net operating assets (NOA) for 2013 and 2012.
c. Compute return on net operating assets (RNOA) for 2013 and 2012. Net operating assets are
$2,329.6 million in 2011.
d. Compute return on equity (ROE) for 2013 and 2012. (Stockholders’ equity attributable to Snap-On
in 2011 is $1,530.9 million.)
e. What is nonoperating return component of ROE for 2013 and 2012?
f. Comment on the difference between ROE and RNOA. What inference do you draw from this
comparison?

Answer:
a. (Amounts in millions) 2013 2012
Income from operations $ 586.2 $ 516.4
Equity in earnings (losses) of affiliates 0.2 2.6
Provision for income taxes (166.7) (148.2)
Tax shelter on nonoperating items (22.2) (20.8)
NOPAT $ 397.5 $ 350.0

b. (Amounts in millions) 2013 2012

Operating assets (Total assets - Cash and cash
equiv.) 3,892.4 $3,687.8
Total liabilities 1,979.6 2,083.3
Nonoperating liabilities 972.0 975.6
Operating liabilities 1,007.6 1,107.7

Net operating assets (NOA) $2,884.8 $2,580.1

c. 2013: $397.5 / [($2,884.8 + $2,580.1) / 2] = 14.5%

2012: $350.0 / [($2,580.1 + $2,329.6) / 2] = 14.3%

d. 2013: $350.3 / [($2,113.2 + $1,802.1) / 2] = 17.9%

2012: $306.1 / [($1,802.1 + $1,530.9) / 2] = 18.4%

e. ROE = RNOA + Nonoperating return

2013: 17.9% = 14.5% + 3.4%
2012: 18.4% = 14.3% + 4.1%

f. The company has a positive nonoperating return both years, which implies that the company
makes effective use of leverage. The company’s debt costs less (in percentage terms) than the
operating assets earn, therefore, shareholders’ return is increased.

©Cambridge Business Publishers, 2015

4-28 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to compute ROE and disaggregate into operating and
nonoperating components
LO: 1, 3
3. Income statements and balance sheets follow for E.I. DuPont de Nemours and Company. Refer to
these financial statements to answer the requirements.

E. I. du Pont de Nemours and Company

Consolidated Income Statements
For The Year Ended December 31,

($ millions) 2013 2012

Net sales $ 35,734 $ 34,812

Other income, net 410 498
Total 36,144 35,310

Cost of goods sold and other operating charges 26,386 25,615

Selling, general and administrative expenses 3,554 3,527
Research and development expense 2,153 2,123
Interest expense 448 464
Employee separation/asset related
charges(income), net 114 493
Total expenses 32,655 32,222
Income from continuing operations before
income taxes 3,489 3,088
Provision for income taxes on continuing
operations 626 616
Income from continuing operations after income
taxes 2,863 2,472
Income from discontinued operations after
income taxes 1,999 308
Net income 4,862 2,780
Less: Net income attributable to noncontrolling
interests 14 2
5
Net income attributable to DuPont $ 4,848 $ 2,755

Continued next page

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-29
 continued
E. I. du Pont de Nemours and Company
Consolidated Balance Sheets
As of December 31,
($ millions) 2013 2012
Current assets
Cash and cash equivalents $ 8,941 $ 4,284
Marketable securities 145 123
Accounts and notes receivable, net 6,047 5,452
Inventories 8,042 7,565
Prepaid expenses 206 204
Deferred income taxes 775 613
Assets held for sale 228 3,076
Total current assets 24,384 21,317

Net property, plant and equipment 12,993 12,741

Goodwill 4,713 4,616
Other intangible assets 5,096 5,126
Investment in affiliates 1,011 1,163
Deferred income taxes 2,353 3,936
Other assets 949 960
Total assets $ 51,499 $ 49,859
Current liabilities
Accounts payable $ 5,180 $ 4,853
Short-term borrowings and capital lease
obligations 1,721 1,275
Income taxes 247 343
Other accrued liabilities 6,219 5,997
Liabilities related to assets held for sale 0 1,084
Total current liabilities 13,367 13,552
Long-term borrowings and capital lease
obligations 10,741 10,465
Other liabilities 10,179 14,687
Deferred income taxes 926 856
Total liabilities 35,213 39,560
Common stock– 1,004,351,000 304 306
Additional paid-in capital 11,072 10,655
Reinvested earnings 16,784 14,383
Accumulated other comprehensive loss (5,441) (8,646)
Common stock held in treasury (6,727) (6,727)
Total DuPont stockholders’ equity 16,229 10,208
Noncontrolling interests 57 91
Total equity 16,286 10,299
Total liabilities and stockholders’ equity $ 51,499 $ 49,859

Continued next page

©Cambridge Business Publishers, 2015

4-30 Financial & Managerial Accounting for MBAs, 4th Edition
 continued

Required
a. Compute net operating profit after tax (NOPAT) for 2013 and 2012. Assume that combined
federal and state statutory tax rate is 37% for both years.
b. Compute net operating assets (NOA) for 2013 and 2012.
c. Compute return on net operating assets (RNOA) for 2013 and 2012. Net operating assets are
$17,596 million in 2011.
d. Compute return on equity (ROE) for 2013 and 2012. DuPont Stockholders’ equity in 2011 is
$8,593 million.
e. What is nonoperating return component of ROE for 2013 and 2012?
f. Comment on the difference between ROE and RNOA. What inference do you draw from this
comparison?

Answer:
a. ($ millions) 2013 2012
Income from continuing operations before interest
and taxes $3,937 $3,552
Provision for income taxes (626) (616)
Tax shelter on interest expense (166) (172)
NOPAT $3,145 $2,764

b. ($ millions) 2013 2012

Operating assets
Total assets $51,499 $49,859
Less Cash and cash equivalents 8,941 4,284
Less Marketable securities 145 123
Less Assets held for sale 228 3,076
Operating assets 42,185 42,376

Total liabilities 35,213 39,560

Less Short-term borrowings and capital leases 1,721 1,275
Less Liabilities related to assets held for sale 0 1,084
Less Long-term borrowings and capital leases 10,741 10,456
Operating liabilities 22,751 26,745
Net operating assets (NOA) $19,434 $15,631

c. 2013: $3,145 / [($19,434 + $15,631) / 2] = 17.9%

2012: $2,764 / [($15,631 + $17,596) / 2] = 16.6%

d. 2013: $4,848 / [($16,229 + $10,208) / 2] = 36.7%

2012: $2,755 / [($10,208 + $8,593) / 2] = 29.3%

e. ROE = RNOA + Nonoperating return

2013: 36.7% = 17.9% + 18.8%
2012: 29.3% = 16.6% + 12.7%

f. The company has a positive nonoperating return both years, which implies that the company
makes effective use of leverage. The company’s debt costs less (in percentage terms) than the
operating assets earn; therefore, shareholders’ return is increased. However, nearly one-third of
the total ROE comes from nonoperating return. This could mean that the company has very high
debt levels. Alternatively, it could mean that equity is comparatively low (perhaps due to extensive
stock buybacks).

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-31
Topic: Use financial statements to compute ROE and disaggregate into operating and non-
operating components.
LO: 1
4. Income statements and balance sheets follow for Microsoft Corporation. Refer to these financial
statements to answer the requirements.

Microsoft Corporation
Income Statements
Year ended June 30,
(in millions) 2013 2012
Revenue $77,849 $73,723
Cost of revenue 20,249 17,530
Gross profit 57,600 56,193
Research and development 10,411 9,811
Sales and marketing 15,276 13,857
General and administrative 5,149 4,569
Goodwill impairment 0 6,193
Total operating expenses 30,836 34,430
Operating income 26,764 21,763

Other income 288 504

Income before income taxes 27,052 22,267
Provision for income taxes 5,189 5,289
Net income $21,863 $16,978

Microsoft Corporation
Balance Sheets
As of June 30,
($ millions) 2013 2012
Cash and cash equivalents $ 3,804 $ 6,938
Short-term investments 73,218 56,102
Accounts receivable, net 17,486 15,780
Inventories 1,938 1,137
Deferred income taxes 1,632 2,035
Other current assets 3,388 3,092
Total current assets 101,466 85,084

Property plant and equipment, net 9,991 8,269

Equity and other investments 10,844 9,776
Goodwill 14,655 13,452
Intangible assets, net 3,083 3,170
Other long-term assets 2,392 1,520
Total assets $142,431 $121,271

Table continued next page

©Cambridge Business Publishers, 2015

4-32 Financial & Managerial Accounting for MBAs, 4th Edition
 table continued
Microsoft Corporation
Balance Sheets (continued)
As of June 30,
($ millions) 2013 2012
Accounts payable $ 4,828 $ 4,175
Short-term debt 2,999 1,231
Accrued compensation 4,117 3,875
Income taxes 592 789
Short-term unearned revenue 20,639 18,653
Securities lending payable 645 814
Other 3,597 3,151
Current liabilities 37,417 32,688
Long-term debt 12,601 10,713
Long-term unearned revenue 1,760 1,406
Deferred income taxes 1,709 1,893
Other long-term liabilities 10,000 8,208
Total liabilities 63,487 54,908

Common stock and paid-in capital 67,306 65,797

Retained earnings/(deficit) 9,895 (856)
Accumulated other comprehensive income 1,743 1,422
Total equity 78,944 66,363
Total liabilities and equity $142,431 $ 121,271

Required:
a. Compute net operating profit after tax (NOPAT) for 2013 and 2012. Assume that combined
federal and state statutory tax rates are 37% for both years.
b. Compute net operating assets (NOA) for 2013 and 2012. Assume Equity and other investments
are operating assets.
c. Compute return on net operating assets (RNOA) for 2013 and 2012. Net operating assets are
$17,440 million in 2011.
d. Compute return on equity (ROE) for 2013 and 2012. (Stockholders’ equity in 2011 is $57,083
million.)
e. What is nonoperating return component of ROE for 2013 and 2012?
f. Comment on the difference between ROE and RNOA. What inference do you draw from this
comparison?

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-33
 Answer:
a. ($ millions) 2013 2012
Operating income $ 26,764 $ 21,763
Provision for income taxes (5,189) (5,289)
Tax shelter on nonoperating items 107 186
NOPAT $ 21,682 $ 16,660

b. ($ millions) 2013 2012

Total assets $142,431 $121,271
Less cash and cash equivalents 3,804 6,938
Less short-term investments 73,218 56,102
Operating assets 65,409 58,231

Total liabilities 63,487 54,908

Less short-term debt 2,999 1,231
Less securities lending payable 645 814
Less long-term debt 12,601 10,713
Operating liabilities 47,242 42,150
Net operating assets (NOA) $ 18,167 $ 16,081

c. 2013: $21,682 / [($18,167 + $16,081) / 2] = 126.6%

2012: $16,660 / [($16,081 + $17,440) / 2] = 99.4%

d. 2013: $21,863 / [($78,944 + $66,363) / 2] = 30.1%

2012: $16,978 / [($66,363 + $57,083) / 2] = 27.5%

e. Return on equity = RNOA + Nonoperating return

2013: 30.1% = 126.6% - 96.5%
2012: 27.5% = 99.4% - 71.9%

f. Nonoperating return is negative. This implies that Microsoft has no nonoperating liabilities, the
concept of leverage works in reverse. By holding significant levels of marketable securities, the
company reduces shareholder return because the nonoperating assets earn a lower return as
compared to the operating assets. But, the marketable securities afford the company liquidity so
that it can respond to investment opportunities and weather economic downturns.

©Cambridge Business Publishers, 2015

4-34 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to compute RNOA and disaggregate into components of
profitability and asset turnover
LO: 2
5. Income statements and balance sheets follow for The New York Times Company. Refer to these
financial statements to answer the requirements.

The New York Times Company

Consolidated Statements of Income

Fiscal year ended

(in thousands) Dec. 29, 2013 Dec. 30, 2012
Operating revenues
Circulation $ 824,277 $ 795,037
Advertising 666,687 711,829
Other 86,266 88,475
Total revenues 1,577,230 1,595,341
Production Costs
Raw materials 92,886 106,381
Wages and benefits 332,085 331,321
Other 201,942 213,616
Total production costs 626,913 651,318
Selling, general and administrative expenses 706,354 711,112
Depreciation and amortization 78,477 78,980
Total operating costs 1,411,744 1,441,410
Pension settlement expense 3,228 47,657
Multiemployer pension plan withdrawal expense 6,171 0
Other expense 0 2,620
Operating profit 156,087 103,654
Gain on sale of investments 0 220,275
Impairment of investments 0 5,500
(Loss)/income from joint ventures (3,215) 2,936
Premium on debt redemption 0 0
Interest expense, net 58,073 62,808
Income from continuing operations before income
taxes 94,799 258,557
Income tax expense 37,892 94,617
Income from continuing operations 56,907 163,940
Discontinued operations:
(Loss) from discontinued operations, net of tax (20,413) (113,447)
Gain on sale, net of tax 28,362 85,520
Income/(loss) from discontinued operations, net of
tax 7,949 (27,927)
Net income/(loss) 64,856 136,013
Net (income)/loss attributable to the
noncontrolling interest 249 (166)
Net income/(loss) attributable to New York Times
Company common stockholders 65,105 135,847

Continued next page

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-35
 continued
THE NEW YORK TIMES COMPANY
CONSOLIDATED BALANCE SHEETS
As of
(in thousands) Dec. 29, 2013 Dec. 30, 2012
Cash and cash equivalents $ 482,745 $ 820,490
Short-term investments 364,880 134,820
Accounts receivable, net 202,303 197,589
Deferred income taxes 65,859 58,214
Prepaid assets 20,250 23,085
Other current assets 36,230 26,320
Assets held for sale 0 137,050
Total current assets 1,172,267 1,397,568
Long-term marketable securities 176,155 4,444
Investments in joint ventures 40,213 40,872
Property, plant and equipment, net 713,356 773,469
Goodwill, net 125,871 122,691
Deferred income taxes 179,989 302,212
Miscellaneous assets 164,701 166,214
Total assets $2,572,552 $2,807,470
Accounts payable $ 90,982 $ 88,990
Accrued payroll and other related liabilities 91,629 86,772
Unexpired subscriptions 58,007 57,336
Accrued expenses 107,755 118,753
Accrued incomes taxes 138 38,932
Liabilities held for sale 0 32,373
Total current liabilities 348,511 423,156
Long-term debt and capital lease obligations 684,142 696,752
Pension benefits obligation 444,328 737,889
Postretirement benefits obligation 90,602 110,347
Other 158,435 173,690
Total other liabilities 1,377,507 1,718,678
Stockholders’ equity
Common stock of $0.10 par value:
Class A common 15,129 15,027
Class B - convertible 82 82
Additional paid-in capital 33,045 25,610
Retained earnings 1,283,518 1,230,450
Common stock held in treasury, at cost (86,253) (96,278)
Accumulated other comprehensive income (loss), net
of tax (402,611) (512,566)
Total New York Times Company stockholders’ equity 842,910 662,325
Noncontrolling interest 3,624 3,311
Total stockholders’ equity 846,534 665,636
Total liabilities and stockholders’ equity $2,572,552 $2,807,470

Continued next page

©Cambridge Business Publishers, 2015

4-36 Financial & Managerial Accounting for MBAs, 4th Edition
 continued

Required:
a. Compute net operating profit after tax (NOPAT) for 2013 and 2012. Assume that combined
federal and state statutory tax rates are 37% for both years.
b. Compute net operating assets (NOA) for 2013 and 2012.
c. Compute return on net operating assets (RNOA) for 2013 and 2012. Comment on the year-over-
year change. Net operating assets are $412,630 thousand in 2011.
d. Disaggregate RNOA into profitability and asset turnover components (NOPM and NOAT,
respectively). What explains the year-over-year change in RNOA?

Answer:
a. (in thousands) 2013 2012
Income from operations $156,087 $ 103,654
Income/(loss) from joint ventures (3,215) 2,936
Provision for income taxes (37,892) (94,617)
Tax shelter on nonoperating items (21,487) 56,228
NOPAT $ 93,493 $68,201

b. (in thousands) 2013 2012

Total assets $2,572,552 $2,807,470
Less Cash and cash equivalents (482,745) (820,490)
Less Short-term marketable securities (364,880) (134,820)
Less Assets held for sale 0 (137,050)
Less Long-term marketable securities (176,155) (4,444)
Operating assets 1,548,772 1,710,666

Total current liabilities 348,511 423,156

Less Liabilities held for sale 0 (32,373)
Plus Pension benefits obligation 444,328 737,889
Plus Postretirement benefits obligation 90,602 110,347
Plus Other liabilities 158,435 173,690
Operating liabilities 1,041,876 1,412,709
Net operating assets (NOA) $506,896 $297,957

c. 2013: $93,493 / [($506,896 + $297,957) / 2] = 23.2%

2012: $68,201 / [($297,957 + $412,630) / 2] = 19.2%
RNOA increased in 2013, from 19.2% to 23.2%.

d. Net operating profit margin (NOPM)

2013: $93,493 / $1,577,230 = 5.9%
2012: $68,201 / $1,595,341 = 4.3%

Net operating asset turnover (NOAT)

2013: $1,577,230 / [($506,896 + $297,957) / 2] = 3.92
2012: $1,595,341 / [($297,957 + $412,630) / 2] = 4.49

RNOA increased in 2013 from 19.2% to 23.2%. The increase can be contributed in part to the
increase in profit margin from 4.3% to 5.9%. The company was more profitable in 2013 as
compared to 2012, but less efficient, based on the decrease in NOAT in 2013.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-37
Topic: Use financial statements to compute RNOA and disaggregate into components of
profitability and asset turnover
LO: 2
6. Income statements and balance sheets follow for Snap-On Incorporated. Refer to these financial
statements to answer the requirements.

Snap-On Incorporated
Consolidated Statements of Earnings

(Amounts in millions) For the fiscal year ended

2013 2012
Net sales $ 3,056.5 $ 2,937.9
Cost of goods sold (1,583.6) (1,547.9)
Gross profit 1,472.9 1,390.0
Operating expenses (1,012.4) (980.3)
Operating earnings before financial services 460.5 409.7

Financial services revenue 181.0 161.3

Financial services expenses (55.3) (54.6)
Operating income from financial services 125.7 106.7
Operating earnings 586.2 516.4
Interest expense (56.1) (55.8)
Other income (expense) -- net (3.9) (0.4)
Earnings before income taxes and equity earnings 526.2 460.2
Income tax expense (166.7) (148.2)
Earnings before equity earnings 359.5 312.0
Equity earnings, net of tax 0.2 2.6
Net earnings 359.7 314.6
Net earnings attributable to noncontrolling interests (9.4) (8.5)
Net earnings attributable to Snap-on Incorporated $ 350.3 $ 306.1

Continued next page

©Cambridge Business Publishers, 2015

4-38 Financial & Managerial Accounting for MBAs, 4th Edition
 continued
Snap-On Incorporated
Consolidated Balance Sheets
Fiscal Year End
(Amounts in millions) 2013 2012

Cash and cash equivalents $ 217.6 $ 214.5

Trade and other accounts receivable - net 531.6 497.9
Finance receivables - net 374.6 323.1
Contract receivables - net 68.4 62.7
Inventories - net 434.4 404.2
Deferred income tax assets 85.4 81.8
Prepaid expenses and other assets 84.2 84.8
Total current assets 1,796.2 1,669.0
Property and equipment - net 392.5 375.2
Deferred income tax assets 57.1 110.4
Long-term finance receivables - net 560.6 494.6
Long-term contract receivables - net 217.1 194.4
Goodwill 838.8 807.4
Other intangibles - net 190.5 187.2
Other assets 57.2 64.1
Total assets $4,110.0 $ 3,902.3

Notes payable and current maturities of long-term debt $ 113.1 $ 5.2

Accounts payable 155.6 142.5
Accrued benefits 48.1 50.6
Accrued compensation 95.5 88.3
Franchisee deposits 59.4 54.7
Other accrued liabilities 243.7 247.9
Total current liabilities 715.4 589.2
Long-term debt 858.9 970.4
Deferred income tax liabilities 143.8 127.1
Retiree health care benefits 41.7 48.4
Pension liabilities 135.8 260.7
Other long-term liabilities 84.0 87.5
Total liabilities 1,979.6 2,083.3

Preferred stock – –
Common stock 67.4 67.4
Additional paid-in capital 225.1 204.6
Retained earnings 2,324.1 2,067.0
Accumulated other comprehensive income (loss) (44.8) (124.2)
Treasury stock at cost (458.6) (412.7)
Total shareholders’ equity attributable to Snap-on Inc. 2,113.2 1,802.1
Noncontrolling interests 17.2 16.9
Total shareholders’ equity 2,130.4 1,819.0
Total liabilities and shareholders’ equity $ 4,110.0 $ 3,902.3

Continued next page

©Cambridge Business Publishers, 2015
Test Bank, Module 4 4-39
 continued

Required:
a. Compute net operating profit after tax (NOPAT) for 2013 and 2012. Assume that combined
federal and state statutory tax rate is 37% for both fiscal years.
b. Compute net operating assets (NOA) for 2013 and 2012.
c. Compute return on net operating assets (RNOA) for 2013 and 2012. Comment on the year-over-
year change. Net operating assets are $2,329.6 million in 2011.
d. Disaggregate RNOA into profitability and asset turnover components (NOPM and NOAT,
respectively). Remember to include both net sales and financial services revenue in total
revenue. What explains the year-over-year change in RNOA?

Answer:
a. (Amounts in millions) 2013 2012
Income from operations $ 586.2 $ 516.4
Equity in earnings (losses) of affiliates 0.2 2.6
Provision for income taxes (166.7) (148.2)
Tax shelter on nonoperating items (22.2) (20.8)
NOPAT $ 397.5 $ 350.0

b. (Amounts in millions) 2013 2012

Operating assets (Total assets - Cash and cash
equiv.) 3,892.4 $3,687.8
Total liabilities 1,979.6 2,083.3
Nonoperating liabilities 972 975.6
Operating liabilities 1,007.6 1,107.7

Net operating assets (NOA) $2,884.8 $2,580.1

c. 2013: $397.5 / [($2,884.8 + $2,580.1) / 2] = 14.5%

2012: $350.0 / [($2,580.1 + $2,329.6) / 2] = 14.3%
RNOA slightly increased in 2013 from 14.3% to 14.5%.

d. Net operating profit margin (NOPM)

2013: $397.5 / $3,237.5 = 12.2%
2012: $350.0 / $3,099.2 = 11.3%

Net operating asset turnover (NOAT)

2013: $3,237.5 / [($2,884.8 + $2,580.1) / 2] = 1.18
2012: $3,099.2 / [($2,580.1 + $2,329.6) / 2] = 1.26

RNOA slightly increased in 2013 from 14.3% to 14.5%. Overall return increased due to improved
profit margin (from 11.3% to 12.2%) despite the slight decrease in asset turnover (from 1.26 to
11.18). The company was more profitable and slightly less efficient in 2013 as compared to 2012.

©Cambridge Business Publishers, 2015

4-40 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to compute FLEV and Spread and reconcile to ROE for two years
LO: 3
7. Income statements and balance sheets follow for Snap-On Incorporated. Refer to these financial
statements to answer the requirements.

Snap-On Incorporated
Consolidated Statements of Earnings

(Amounts in millions) For the fiscal year ended

2013 2012
Net sales $ 3,056.5 $ 2,937.9
Cost of goods sold (1,583.6) (1,547.9)
Gross profit 1,472.9 1,390.0
Operating expenses (1,012.4) (980.3)
Operating earnings before financial services 460.5 409.7

Financial services revenue 181.0 161.3

Financial services expenses (55.3) (54.6)
Operating income from financial services 125.7 106.7
Operating earnings 586.2 516.4
Interest expense (56.1) (55.8)
Other income (expense) -- net (3.9) (0.4)
Earnings before income taxes and equity earnings 526.2 460.2
Income tax expense (166.7) (148.2)
Earnings before equity earnings 359.5 312.0
Equity earnings, net of tax 0.2 2.6
Net earnings 359.7 314.6
Net earnings attributable to noncontrolling interests (9.4) (8.5)
Net earnings attributable to Snap-on Incorporated $ 350.3 $ 306.1

Continued next page

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-41
 continued
Snap-On Incorporated
Consolidated Balance Sheets
Fiscal Year End
(Amounts in millions) 2013 2012

Cash and cash equivalents $ 217.6 $ 214.5

Trade and other accounts receivable - net 531.6 497.9
Finance receivables - net 374.6 323.1
Contract receivables - net 68.4 62.7
Inventories - net 434.4 404.2
Deferred income tax assets 85.4 81.8
Prepaid expenses and other assets 84.2 84.8
Total current assets 1,796.2 1,669.0
Property and equipment - net 392.5 375.2
Deferred income tax assets 57.1 110.4
Long-term finance receivables - net 560.6 494.6
Long-term contract receivables - net 217.1 194.4
Goodwill 838.8 807.4
Other intangibles - net 190.5 187.2
Other assets 57.2 64.1
Total assets $4,110.0 $ 3,902.3

Notes payable and current maturities of long-term debt $ 113.1 $ 5.2

Accounts payable 155.6 142.5
Accrued benefits 48.1 50.6
Accrued compensation 95.5 88.3
Franchisee deposits 59.4 54.7
Other accrued liabilities 243.7 247.9
Total current liabilities 715.4 589.2
Long-term debt 858.9 970.4
Deferred income tax liabilities 143.8 127.1
Retiree health care benefits 41.7 48.4
Pension liabilities 135.8 260.7
Other long-term liabilities 84.0 87.5
Total liabilities 1,979.6 2,083.3

Preferred stock – –
Common stock 67.4 67.4
Additional paid-in capital 225.1 204.6
Retained earnings 2,324.1 2,067.0
Accumulated other comprehensive income (loss) (44.8) (124.2)
Treasury stock at cost (458.6) (412.7)
Total shareholders’ equity attributable to Snap-on Inc. 2,113.2 1,802.1
Noncontrolling interests 17.2 16.9
Total shareholders’ equity 2,130.4 1,819.0
Total liabilities and shareholders’ equity $ 4,110.0 $ 3,902.3

Continued next page

©Cambridge Business Publishers, 2015
4-42 Financial & Managerial Accounting for MBAs, 4th Edition
 continued

Required:
a. Compute net nonoperating expenses (NNE) for 2013 and 2012. Assume that combined federal
and state statutory tax rate is 37% for both fiscal years.
b. Compute net nonoperating obligations (NNO) for 2013 and 2012.
c. Compute Spread for 2013 and 2012. Return on net operating assets is 14.5% and 14.3% in 2013
and 2012, respectively. In 2011, net nonoperating obligations were $798.5 million.
d. Compute FLEV for 2013 and 2012. In 2011, net nonoperating obligations were $798.5 million and
total shareholders’ equity was $1,547.3 million.
e. Calculate return on equity (ROE) for both years. Show that ROE = RNOA + (FLEV × Spread) x
NCI ratio. Interpret the year-over-year change in ROE. In 2011, shareholders’ equity attributable
to Snap-On was $1,530.9. Hint: consider the changes in both FLEV and Spread)

Answer:
a. (Amounts in millions) 2013 2012
Interest expense $56.1 $55.8
Other expenses (income) net 3.9 0.4
Nonoperating expense, before tax 60.0 56.2
Tax on nonoperating expense (22.2) (20.8)
Nonoperating expenses, after tax (NNE) $37.8 $35.4

b. (Amounts in millions) 2013 2012

Notes payable and current maturities of long-term debt $ 113.1 $ 5.2
Long-term debt 858.9 970.4
Less Nonoperating assets 217.6 214.5
Net nonoperating obligations (NNO) $754.4 $761.1

c. Spread = RNOA – (NNE / Average NNO)

2013: 14.5% – $37.8 / [($754.4 + $761.1) / 2] = 14.5% – 5.0% = 9.5%
2012: 14.3% – $35.4 / [($761.1 + $798.5) / 2] = 14.3% – 4.5% = 9.8%

d. FLEV = Average NNO / Average shareholders’ equity

2013: [($754.4 + $761.1) / 2] / [($2,130.4 + $1,819.0) / 2] = 0.38
2012: [($761.1 + $798.5) / 2] / [($1,819.0 + $1,547.3) / 2] = 0.46

e. ROE = Net income attributable to Snap-on / Average Snap-on shareholders’ equity

2013: $350.3 / [($2,113.2 + $1,802.1) / 2] = 17.9%
2012: $306.1 / [($1,802.1 + $1,530.9) / 2] = 18.4%

ROE = RNOA + (FLEV × Spread) x NCI ratio

2013: [14.5% + (0.38 × 9.5%)] x [(350.3/359.7) / (1,957.65/1,974.7)] = 17.8% (0.1% rounding difference)
2012: [14.3% + (0.46 × 9.8%) x [(306.1/314.6) / (1,666.5/1,683.15)] = 18.5% (0.1% rounding difference)

The company’s ROE decreased during the year because spread decreased slightly from 9.8% to
9.5% and the financial leverage (FLEV) decreased from 0.46 to 0.38.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-43
Topic: Use financial statements to compute ROE and disaggregate into operating and non-
operating components.
Note to instructor: FLEV is negative because Microsoft holds significant levels of marketable
securities and has little debt; thus, ROE is less than RNOA.
LO: 3
8. Income statements and balance sheets follow for Microsoft Corporation. Refer to these financial
statements to answer the requirements.

Microsoft Corporation
Income Statements
Year ended June 30,
(in millions) 2013 2012
Revenue $ 77,849 $ 73,723
Cost of revenue 20,249 17,530
Gross profit 57,600 56,193
Research and development 10,411 9,811
Sales and marketing 15,276 13,857
General and administrative 5,149 4,569
Goodwill impairment 0 6,193
Total operating expenses 30,836 34,430
Operating income 26,764 21,763

Other income 288 504

Income before income taxes 27,052 22,267
Provision for income taxes 5,189 5,289
Net income $ 21,863 $ 16,978

Microsoft Corporation
Balance Sheets
As of June 30,
($ millions) 2013 2012
Cash and cash equivalents $ 3,804 $ 6,938
Short-term investments 73,218 56,102
Accounts receivable, net 17,486 15,780
Inventories 1,938 1,137
Deferred income taxes 1,632 2,035
Other current assets 3,388 3,092
Total current assets 101,466 85,084

Property plant and equipment, net 9,991 8,269

Equity and other investments 10,844 9,776
Goodwill 14,655 13,452
Intangible assets, net 3,083 3,170
Other long-term assets 2,392 1,520
Total assets $142,431 $121,271

Continued next page

©Cambridge Business Publishers, 2015

4-44 Financial & Managerial Accounting for MBAs, 4th Edition
 continued
icrosoft Corporation
Balance Sheets (continued)
As of June 30,
($ millions) 2013 2012
Accounts payable $ 4,828 $ 4,175
Short-term debt 2,999 1,231
Accrued compensation 4,117 3,875
Income taxes 592 789
Short-term unearned revenue 20,639 18,653
Securities lending payable 645 814
Other 3,597 3,151
Current liabilities 37,417 32,688
Long-term debt 12,601 10,713
Long-term unearned revenue 1,760 1,406
Deferred income taxes 1,709 1,893
Other long-term liabilities 10,000 8,208
Total liabilities 63,487 54,908

Common stock and paid-in capital 67,306 65,797

Retained earnings/(deficit) 9,895 (856)
Accumulated other comprehensive income 1,743 1,422
Total equity 78,944 66,363
Total liabilities and equity $142,431 $ 121,271

Required:
a. Compute net nonoperating expenses (NNE) for 2013 and 2012. Assume that combined federal
and state statutory tax rates are 37% for both years.
b. Compute net nonoperating obligations (NNO) for 2013 and 2012.
c. Compute Spread for 2013 and 2012. Return on net operating assets (RNOA) is 126.6% and
99.4% in 2013 and 2012, respectively. NNO were $(39,643) million in 2011.
d. Compute FLEV for 2013 and 2012. In 2011, net nonoperating obligations (assets) were $(39,643)
million and shareholders’ equity was $57,083 million.
e. Calculate return on equity (ROE) for both years. Show that ROE = RNOA + (FLEV × Spread).
Interpret the year-over-year change in ROE.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-45
 Answer:
a 2013 2012
.
Other income 288 504
Less Tax on nonoperating items (at 37%) 107 186
Net nonoperating items after tax (NNE) (181) (318)

b. 2013 2012
Short-term debt $ 2,999 $1,231
Securities lending payable 645 814
Long-term debt 12,601 10,713
Less Short-term investments (73,218) (56,102)
Less Cash and cash equivalents (3,804) (6,938)
Net nonoperating obligations $(60,777) $(50,282)

c. Spread = RNOA – (NNE / Average NNO)

2013: 126.6% – [$(181) / [(-$60,777 – $50,282) / 2]] = 126.6% – 0.3% = 126.3%
2012: 99.4% – [$(318) / [(-$50,282 – $39,643) / 2]] = 99.4% – 0.7% = 98.7%

d. FLEV = Average NNO / Average equity

2013: [(-$60,777 – $50,282) / 2] / [($78,944 + $66,363) / 2] = -0.76
2012: [(-$50,282 – $39,643) / 2] / [($66,363 + $57,083) / 2] = -0.73

e. ROE = Net income / Average equity

2013: $21,863 / [($78,944 + $66,363) / 2] = 30.1%
2012: $16,978 / [($66,363 + $57,083) / 2] = 27.5%

ROE = RNOA + (FLEV × Spread)

2013: 126.6% + (-0.76 × 126.3%) = 30.6% (off 0.5% due to rounding)
2012: 99.4% + (-0.73 × 98.7%) = 27.3% (off 0.2% due to rounding)

The company’s ROE increased during the year primarily because RNOA increased from 99.4% to
126.6%.

©Cambridge Business Publishers, 2015

4-46 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Use financial statements to calculate and interpret liquidity and solvency ratios
LO: 4
9. Income statements and balance sheets follow for Snap-On Incorporated. Refer to these financial
statements to answer the requirements.

Snap-On Incorporated
Consolidated Statements of Earnings

(Amounts in millions) For the fiscal year ended

2013 2012
Net sales $ 3,056.5 $ 2,937.9
Cost of goods sold (1,583.6) (1,547.9)
Gross profit 1,472.9 1,390.0
Operating expenses (1,012.4) (980.3)
Operating earnings before financial services 460.5 409.7

Financial services revenue 181.0 161.3

Financial services expenses (55.3) (54.6)
Operating income from financial services 125.7 106.7
Operating earnings 586.2 516.4
Interest expense (56.1) (55.8)
Other income (expense) -- net (3.9) (0.4)
Earnings before income taxes and equity earnings 526.2 460.2
Income tax expense (166.7) (148.2)
Earnings before equity earnings 359.5 312.0
Equity earnings, net of tax 0.2 2.6
Net earnings 359.7 314.6
Net earnings attributable to noncontrolling interests (9.4) (8.5)
Net earnings attributable to Snap-on Incorporated $ 350.3 $ 306.1

Continued next page

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-47
 continued
Snap-On Incorporated
Consolidated Balance Sheets
Fiscal Year End
(Amounts in millions) 2013 2012

Cash and cash equivalents $ 217.6 $ 214.5

Trade and other accounts receivable - net 531.6 497.9
Finance receivables - net 374.6 323.1
Contract receivables - net 68.4 62.7
Inventories - net 434.4 404.2
Deferred income tax assets 85.4 81.8
Prepaid expenses and other assets 84.2 84.8
Total current assets 1,796.2 1,669.0
Property and equipment - net 392.5 375.2
Deferred income tax assets 57.1 110.4
Long-term finance receivables - net 560.6 494.6
Long-term contract receivables - net 217.1 194.4
Goodwill 838.8 807.4
Other intangibles - net 190.5 187.2
Other assets 57.2 64.1
Total assets $ 4,110.0 $ 3,902.3

Notes payable and current maturities of long-term debt $ 113.1 $ 5.2

Accounts payable 155.6 142.5
Accrued benefits 48.1 50.6
Accrued compensation 95.5 88.3
Franchisee deposits 59.4 54.7
Other accrued liabilities 243.7 247.9
Total current liabilities 715.4 589.2
Long-term debt 858.9 970.4
Deferred income tax liabilities 143.8 127.1
Retiree health care benefits 41.7 48.4
Pension liabilities 135.8 260.7
Other long-term liabilities 84.0 87.5
Total liabilities 1,979.6 2,083.3

Preferred stock – –
Common stock 67.4 67.4
Additional paid-in capital 225.1 204.6
Retained earnings 2,324.1 2,067.0
Accumulated other comprehensive income (loss) (44.8) (124.2)
Treasury stock at cost (458.6) (412.7)
Total shareholders’ equity attributable to Snap-on Inc. 2,113.2 1,802.1
Noncontrolling interests 17.2 16.9
Total shareholders’ equity 2,130.4 1,819.0
Total liabilities and shareholders’ equity $ 4,110.0 $ 3,902.3

Continued next page

©Cambridge Business Publishers, 2015
4-48 Financial & Managerial Accounting for MBAs, 4th Edition
 continued

Required:
a. Compute the company’s current ratio and quick ratio for fiscal 2013 and 2012. Comment on any
observed trend.
b. Compute the company’s times interest earned and liabilities-to-equity ratio for 2013 and 2012.
Comment on any observed trend.
c. Summarize your findings in a conclusion about the company’s liquidity and solvency. Do you
have any concerns about the company’s ability to meet its debt obligations?

Answer:
a. Current ratio
2013: $1,796.2 / $715.4 = 2.51
2012: $1,669.0 / $589.2 = 2.83
The current ratio weakened during 2013, however, the company’s liquidity is very strong.

Quick ratio
2013: ($217.6 + 531.6 + 374.6 + 68.4) / $715.4 = 1.67
2012: ($214.5 + 497.9 + 323.1 + 62.7) / $589.2 = 1.86
Quick ratio weakened during 2013. The company has more quick assets, but current liabilities
increased, thus, the ratio decreased.

b. Times interest earned

2013: ($526.2 + $56.1) / $56.1 = 10.38
2012: ($460.2 + $55.8) / $55.8 = 9.25
The company more than covered fixed (interest) payments in both years. The 2013 ratio is larger,
which implies the company’s solvency has improved during the year.

Liabilities-to-equity
2013: $1,979.6 / $2,130.4 = 0.93
2012: $2,083.3 / $1,819.0 = 1.15
The level of liabilities to equity decreased during 2013, thus the company is slightly less
leveraged this year as compared to last year.

c. Overall, Snap-On seems to be quite liquid and solvent. We would want to compare these ratios to
other manufacturers to make a more informed assessment. But, the ratios above are strong and
there are no concerns about the company’s liquidity of solvency at this time.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-49
Topic: Use financial statements to calculate and interpret liquidity and solvency ratios for two
companies in the same industry
LO: 4
10. Income statements and balance sheets follow for Microsoft Corporation and Apple Inc. Refer to these
financial statements to answer the requirements.

Microsoft Corporation
Income Statements
Year ended June 30,
(in millions) 2013 2012
Revenue 77,849 73,723
Cost of revenue 20,249 17,530
Gross profit 57,600 56,193
Research and development 10,411 9,811
Sales and marketing 15,276 13,857
General and administrative 5,149 4,569
Goodwill impairment 0 6,193
Total operating expenses 30,836 34,430
Operating income 26,764 21,763
Dividend and interest income 677 800
Interest expense (429) (380)
Other income, net 40 84
Income before income taxes 27,052 22,267
Provision for income taxes 5,189 5,289
Net income 21,863 16,978

Microsoft Corporation
Balance Sheets
As of June 30,
($ millions) 2013 2012
Cash and cash equivalents $ 3,804 $ 6,938
Short-term investments 73,218 56,102
Accounts receivable, net 17,486 15,780
Inventories 1,938 1,137
Deferred income taxes 1,632 2,035
Other current assets 3,388 3,092
Total current assets 101,466 85,084

Property plant and equipment, net 9,991 8,269

Equity and other investments 10,844 9,776
Goodwill 14,655 13,452
Intangible assets, net 3,083 3,170
Other long-term assets 2,392 1,520
Total assets $142,431 $121,271

Table continued next page

©Cambridge Business Publishers, 2015

4-50 Financial & Managerial Accounting for MBAs, 4th Edition
 table continued
Microsoft Corporation
Balance Sheets (continued)
As of June 30,
($ millions) 2013 2012
Accounts payable $ 4,828 $ 4,175
Short-term debt 2,999 1,231
Accrued compensation 4,117 3,875
Income taxes 592 789
Short-term unearned revenue 20,639 18,653
Securities lending payable 645 814
Other 3,597 3,151
Current liabilities 37,417 32,688
Long-term debt 12,601 4,939
Long-term unearned revenue 1,760 1,178
Deferred income taxes 1,709 229
Other long-term liabilities 10,000 7,445
Total liabilities 63,487 39,938

Common stock and paid-in capital 67,306 62,856

Retained earnings/(deficit) 9,895 (16,681)
Accumulated other comprehensive income 1,743 1,422
Total equity 78,944 66,363
Total liabilities and equity $142,431 $ 121,271

Apple Inc.
Consolidated Statement of Operations

Fiscal year ended

(in millions) Sept. 28, 2013 Sept. 29, 2012
Net sales $ 170,910 $ 156,508
Cost of sales 106,606 87,846
Gross margin 64,304 68,662
Operating expenses
Research and development 4,475 3,381
Selling, general and administrative 10,830 10,040
Total operating expenses 15,305 13,421
Operating income 48,999 55,241
Interest and dividend income 1,616 1,088
Interest expense (136) 0
Other expense, net (324) (566)
Income before provision for income taxes 50,155 55,763
Provision for income taxes 13,118 14,030
Net income $ 37,037 $ 41,733

Continued next page

©Cambridge Business Publishers, 2015
Test Bank, Module 4 4-51
 continued
Apple Inc.
Consolidated Balance Sheets
As of
(in thousands) Sept. 28, 2013 Sept. 29, 2012

Cash and cash equivalents $ 14,259 $ 10,746

Short-term investments 26,287 18,383
Accounts receivable, net 13,102 10,930
Inventories 1,764 791
Deferred tax assets 3,453 2,583
Vendor non-trade receivables 7,539 7,762
Other current assets 6,882 6,458
Total current assets 73,286 57,653
Long-term marketable securities 106,215 92,122
Property plant and equipment, net 16,597 15,452
Goodwill, net 1,577 1,135
Acquired intangible assets, net 4,179 4,224
Other assets 5,146 5,478
Total assets $ 207,000 $ 176,064

Accounts payable $ 22,367 $ 21,175

Accrued expenses 13,856 11,414
Deferred revenue 7,435 5,923
Total current liabilities 43,658 38,542

Deferred revenue – non-current 2,625 2,648

Long-term debt 16,960 0
Other non-current liabilities 20,208 16,664
Total liabilities 83,451 57,854

Stockholders’ equity
Common stock no par value 19,764 16,422
Retained earnings 104,256 101,289
Accumulated other comprehensive income (loss) (471) 499
Total stockholders’ equity 123,549 118,210
Total liabilities and stockholders’ equity $ 207,000 $ 176,064

Continued next page

©Cambridge Business Publishers, 2015

4-52 Financial & Managerial Accounting for MBAs, 4th Edition
 continued

Required:
a. Compute the current ratio and quick ratio for both firms for fiscal 2013. Compare the ratios and
determine which company is more liquid.
b. Compute the times interest earned and liabilities-to-equity ratios for both firms for fiscal 2013.
Which company is more solvent?
c. Do you have any concerns about either company’s ability to meet its debt obligations? Explain.

Answer:
a. Current ratio
Microsoft: $101,466 / $37,417 = 2.71
Apple: $73,286 / $43,658 = 1.68

Quick ratio
Microsoft: ($3,804 + $73,218 + $17,486) / $37,417 = 2.53
Apple: ($14,259 + $26,287 + $13,102) / $43,658 = 1.23

Microsoft is more liquid as both its current ratio and quick ratios exceed the Apple ratios.
However, ratios for both companies exceed 1.0, so both companies appear liquid.

b. Times interest earned

Microsoft: ($27,052 + $429) / $429 = 64.06
Apple: ($50,155 + $136) / $136 = 369.79

Liabilities-to-equity
Microsoft: $63,487 / $78,944 = 0.80
Apple: $83,451 / $123,549= 0.68

Apple is more solvent than Microsoft, however both companies are highly solvent with very
healthy times interest earned ratios and liabilities-to-equity ratios under the industry average of
1.5.

c. Both companies are very profitable and there are no concerns regarding either company’s ability
to meet its debt obligations. Microsoft and Apple have cash available or can raise cash on short
notice to meet its short-term debt obligations. Additionally, they are both extremely solvent with
the ability to pay both periodic interest payments and repayment of long-term debt.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-53
Topic: Use financial statements to compute and interpret traditional DuPont ROE ratios.
LO: 5
11. Use the following balance sheets and income statements for Valero Energy Corporation to answer
the requirements.

Valero Energy Corporation and Subsidiaries

Consolidated Statements of Income

(Millions of Dollars) 2013 2012

Operating revenues $138,074 $ 139,250
Costs and expenses:
Cost of sales 127,316 127,268
Refining expenses 3,704 3,668
Retail expenses 226 686
Ethanol expenses 387 332
General and administrative expenses 758 698
Depreciation and amortization expense 1,720 1,574
Asset impairment losses 0 1,014
Total costs and expenses 134,111 135,240
Operating income 3,963 4,010
Gain on disposition of retained interest in CST
Brands, Inc. 325 0
Other income, net 59 9
Interest and debt expense (365) (313)
Income from continuing operations before income
tax expense 3,982 3,706
Income tax expense 1,254 1,626
Net income (loss) 2,728 2,080
Less: Net income (loss) attributable to
noncontrolling interests 8 (3)
Net income attributable to Valero Energy
stockholders $ 2,720 $ 2,083

Continued next page

©Cambridge Business Publishers, 2015

4-54 Financial & Managerial Accounting for MBAs, 4th Edition
 continued
Valero Energy Corporation and Subsidiaries
Consolidated Balance Sheets

(Millions of Dollars) 2013 2012

Cash and temporary cash investments $ 4,292 $ 1,723
Receivables, net 8,751 8,167
Inventories 5,758 5,973
Income taxes receivable 72 169
Deferred income taxes 266 274
Prepaid expenses and other 138 154
Total current assets 19,277 16,460

Property, plant and equipment, net 25,707 26,300

Intangible assets, net 156 213
Deferred charges and other assets, net 2,120 1,504
Total assets $47,260 $44,477

Current portion of debt and capital lease

obligations $ 303 $ 586
Accounts payable 9,931 9,348
Accrued expenses 522 590
Taxes other than income taxes 1,345 1,026
Income taxes payable 773 1
Deferred income taxes 249 378
Total current liabilities 13,123 11,929

Debt and capital lease obligations, less current

portion 6,261 6,463
Deferred income taxes 6,601 5,860
Other long-term liabilities 1,329 2,130
Total liabilities 27,314 26,382
Common stock, $0.01 par value; 1,200,000,000
shares authorized; 627,501,593 and
627,501,593 shares issued 7 7
Additional paid-in capital 7,187 7,322
Treasury stock; 111,290,436 and 90,841,602
shares (7,054) (6,437)
Retained earnings 18,970 17,032
Accumulated other comprehensive income (loss) 350 108
Total Valero Energy stockholders’ equity 19,460 18,032
Noncontrolling interest 486 63
Total equity 19,946 18,095
Total liabilities and stockholders’ equity $47,260 $44,477

Continued next page

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-55
continued

Required:
a. Compute Valero’s return on equity (ROE) for 2013 and 2012. Valero Energy stockholders’ equity
in 2011 was $16,423 million.
b. Compute the profit margin (PM), asset turnover (AT), and financial leverage (FL) components of
the basic DuPont model. Show that ROE = PM × AT × FL for 2013. Total assets were $42,783
million in 2011. Which component(s) explain the year over year change in Valero’s ROE?
c. Compute adjusted return on assets (ROA) for 2013 and 2012. Assume a tax rate of 37% for both
years.

Answers:
a. ROE = Net income attributable to Valero / Average Valero stockholders’ equity
2013: $2,720 / [($19,460 + $18,032) / 2] = 14.5%
2012: $2,083 / [($18,032 + $16,423) / 2] = 12.1%

b. PM = Net income / Revenue

2013: $2,720 / $138,074 = 2.0%
2012: $2,083 / $139,250 = 1.5%

AT = Revenue / Average total assets

2013: $138,074 / [($47,260 + $44,477) / 2] = 3.01
2012: $139,250 / [($44,477 + $42,783) / 2] = 3.19

FL = Average total assets / Average stockholders’ equity

2013: [($47,260 + $44,477) / 2] / [($19,460 + $18,032) / 2] = 2.45
2012: [($44,477 + $42,783) / 2] / [($18,032 + $16,423/ 2] = 2.53

ROE = 2.0% × 3.01 × 2.45 = 14.7% (0.2% difference due to rounding)

The increase in ROE in 2013, from 12.1% to 14.5%, was due to an increase in profit margin.

c. Adjusted ROA = (Net income + after tax interest expense) / Average total assets
2013: [$2,728 + ($365 × 63%)] / [($47,260 + $44,477) / 2] = 6.5%
2012: [$2,080 + ($313 × 63%)] / [($44,477 + $42,783) / 2] = 5.2%

©Cambridge Business Publishers, 2015

4-56 Financial & Managerial Accounting for MBAs, 4th Edition
Essay Questions

Topic: Factors Limiting Usefulness of Ratio Analysis

LO: 1 - 5
1. Discuss factors that limit the usefulness of financial accounting information for ratio analysis.

Answer:
The first limitation arises from GAAP concepts such as non-measurable values, non-capitalized costs,
and the irrelevance of historical costs. The second limitation arises when companies experience
significant year over year changes. For example, a company may acquire or divest a subsidiary, thus
throwing the numbers off. The final limitation is the impact of conglomerates. Most companies actually
comprise several smaller companies. Taken as a whole, their combined numbers impair the ability to
compare ratios with other competitors.

Topic: Conglomerates and Ratio Analysis

LO: 1 - 5
2. Ratio analysis is more complicated when a company is a conglomerate. Why?

Answer:
Conglomerates are difficult to analyze because they are a blend of several businesses under one
parent company. Since the different companies operating under the conglomerate may participate in
a wide variety of industries, it is difficult to compare the conglomerate’s consolidated financial
statements with its competitors.

Topic: Margin and Turnover

LO: 2
3. Explain the trade-off between net operating profit margin and net operating asset turnover.

Answer:
There are an infinite number of combinations of margin and turnover that yield a given RNOA.
Typically companies with higher NOPM have lower NOAT. To attract investors, companies need to
demonstrate an ability to earn an acceptable return on capital. Service companies can operate on a
lower profit margin since they achieve a high turnover of net operating assets. Manufacturers,
however, require higher profit margins in order to offset the lower asset turn.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-57
Topic: Disaggregation of ROE
LO: 3
4. Explain how return on net operating assets (RNOA) and financial leverage (FLEV) affect Return on
Equity (ROE). Is greater FLEV always better?

Answer:
ROE is the return on equity and is the ultimate performance measurement from the investor’s
standpoint. ROE is computed by taking a company’s net income attributable to controlling interests
(less preferred dividends) and dividing by the stockholders equity attributable to controlling interests.
The ROE equation can also be disaggregated into RNOA + (FLEV × Spread) x NCI ratio. RNOA is
the return on net operating assets and is a ratio of a company’s net operating profit after tax to net
operating assets. RNOA measures the return on the company’s main operations, it shows how a
company uses its operating capital and how much profit it is able to realize from these resources.
FLEV is a measure of a company’s leverage (how much debt the company uses compared to
shareholders’ investment), and Spread measures the difference between the company’s operating
return and the cost of debt. If the RNOA is higher than the cost of debt, leverage will increase a
company’s overall profits.

Too much financial leverage can be risky. Debt is a contractual obligation that must be fulfilled
regardless of the financial situation of the company. Therefore, creditors can force a company into
bankruptcy and liquidate its assets, and this can cause shareholders to lose their entire investments.
The higher the amount of debt, the higher the risk of bankruptcy. Therefore, shareholders expect a
higher rate of return which increases the minimum ROE for company survival. On the other hand, too
little financial leverage results in shareholders’ equity not being optimally utilized, resulting in a lower
stock price. When a firm first takes on debt the stock price increases, reflecting the positive benefits
of low cost financing, as their interest rates will be low due to low amounts of debt. However, there is
a point when the cost of the loan covenants, increased bankruptcy risk, and increased costs offset the
positive effects of financial leverage. There is an optimal amount of financial debt to shareholder
equity that will maximize the stock price and the ROE.

Topic: Liquidity
LO: 4
5. What is liquidity? Identify and discuss two ways to measure a company’s liquidity.

Answer:
Liquidity is a term used to describe how much cash a company has at its disposal and how easily it
can convert other assets to cash. Since most companies settle their obligations with cash, liquidity is
a measure of how easily a company can fulfill its financial obligations and is necessary for survival.

There are several methods used to measure a company’s liquidity. One method is to calculate a
company’s current ratio. The current ratio is the ratio of current assets to current liabilities and is a
measure of working capital. Most companies prefer a current ratio greater than 1 as it is indicative of
positive working capital. However, it is possible to have a liquid company and have a current ratio
less than 1. For instance, cash and carry companies have significant operating cash inflows but very
few current assets and, therefore, a low ratio. However, they are still liquid due to the large inflows of
cash. Another example is companies that effectively manage their working capital by decreasing their
inventories (current assets) and maximizing their accounts payable (current liabilities) by negotiating
favorable credit terms. Although their current ratio is less than 1, they are liquid companies.

Another measure of liquidity is the quick ratio. The quick ratio focuses on specific current assets that
can be converted to cash very quickly such as cash, marketable securities and accounts receivables,
and it finds the ratio between these assets and the current liabilities. The quick ratio measures a
company’s ability to fulfill its current liabilities without having to sell its inventories at a potentially
lower price in order to quickly liquidate. Therefore, it is a stricter test of liquidity.

©Cambridge Business Publishers, 2015

4-58 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Solvency
LO: 4
6. What is solvency? Identify and discuss two ways a company’s solvency is measured.

Answer:
Solvency measures a company’s ability to meet its financial commitments.

One of the most common measurements of solvency is the liabilities-to-equity ratio, which is the ratio
of total liabilities to stockholders’ equity. The higher the liabilities-to-equity ratio, the larger the
percentage of debt in a company’s structure, indicating a higher amount of financial leverage and
greater risk. This ratio gives insight into how a company is financed. For instance, a high liabilities-to-
equity ratio indicates the company aggressively uses debt instead of financing the company with
shareholders’ contributions. A lower liabilities-to-equity ratio indicates a conservatively managed and
relatively stable company.

A second solvency metric is the times-interest-earned. This calculation takes into account how much
profit is available to pay interest given the current level of debt and the repayment plan. Times
interest earned is calculated as earnings before interest and taxes divided by interest expense. A high
ratio is desirable as it indicates little chance of default on the loan agreements.

Topic: Traditional ROE (DuPont) analysis compared to RNOA analysis

LO: 5
7. What is the difference between the traditional ROA measure (part of the traditional DuPont analysis)
and the return on net operating assets (RNOA)?

Answer:
The traditional ROA includes net income in the numerator and adjusts for interest expense. Thus, the
ROA numerator includes all the profits (losses) from operating and nonoperating sources except for
interest expense. The denominator (average total assets) includes all assets – this is different from
the RNOA denominator in two ways. First, the ROA denominator it is not net of any liabilities, ROA
includes only assets. In contrast, the denominator in RNOA is net of operating liabilities. Second, the
ROA denominator includes all assets, both operating and nonoperating. The ROA measures total
profit from all sources generated by all the resources (regardless of how the resources were financed)
whereas RNOA measures operating profits generated from net operating assets. The two measures
are useful but it is important to remember that they measure different things.

©Cambridge Business Publishers, 2015

Test Bank, Module 4 4-59