Question 1

2.A.2.u
tb.profit.eps.019_1711
LOS: 2.A.2.u
Lesson Reference: Profitability – EPS, Yields, and Shareholder Returns
Difficulty: medium
Bloom Code: 3

The Treehouse Company's income statement for December 31, 20x4 reported the following:

The company had 50,000 shares of common stock outstanding during 20x4 with a market price of $18 per
share at year-end. Cash dividends of $45,000 were paid, including $8,000 paid to preferred stockholders.
Calculate the company's earnings per share (EPS) for 20x4.

$2.00 per share

$1.84 per share

$1.26 per share

$1.10 per share

Rationale
 $2.00 per share
Earnings per share is defined as (Net Income – Preferred Dividends) ÷ Weighted-Average Common
Shares Outstanding. The numerator is the amount of income available to common shareholders.
Treehouse's EPS would be $2.00 if the preferred dividends are not subtracted when calculating the
numerator ($100,000 ÷ 50,000). Therefore, this is an incorrect answer.

Rationale
 $1.84 per share
Earnings per share is defined as (Net Income – Preferred Dividends) ÷ Weighted-Average Common
Shares Outstanding. The numerator is the amount of income available to common shareholders.
Treehouse's EPS is $1.84 [($100,000 − $8,000) ÷ 50,000]. Therefore, this is the correct answer.

Rationale
 $1.26 per share
Earnings per share is defined as (Net Income – Preferred Dividends) ÷ Weighted-Average Common
Shares Outstanding. The numerator is the amount of income available to common shareholders.
Treehouse's EPS would be $1.26 if the common stock dividends are subtracted instead of the preferred
stock dividends when calculating the numerator [($100,000 − $37,000) ÷ 50,000]. Therefore, this is an
incorrect answer.

Rationale
 $1.10 per share
Earnings per share is defined as (Net Income – Preferred Dividends) ÷ Weighted-Average Common
Shares Outstanding. The numerator is the amount of income available to common shareholders.
Treehouse's EPS would be $1.10 if both the preferred stock dividends and the common stock dividends
are subtracted when calculating the numerator [($100,000 − $8,000 − $37,000) ÷ 50,000]. Therefore, this
is an incorrect answer.
Question 2
2.A.2.p
tb.profit.vertical.011_1711
LOS: 2.A.2.p
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: medium
Bloom Code: 3

Information from JT Engineering's 20x7 income statement is shown in the accompanying chart. Based on
this information, what was JT's gross profit rate for 20x7? Round to the nearest hundredth.

45.79%

54.21%
Correct

77.47%

64.21%

Rationale
 45.79%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. JT's
total expenses as a percentage of net sales is 45.79% [$43,500 ($21,400 + $12,600 + $9,500) ÷ $95,000].
The question asks about JT's gross profit rate, not its total expenses as a percentage of net sales.
Therefore, this is an incorrect answer.

Rationale
 54.21%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. JT's
return on sales (Net Income ÷ Net Sales) is 54.21% ($51,500 ÷ $95,000). The question asks about JT's
gross profit rate, not its return on sales. Therefore, this is an incorrect answer.

Rationale
 77.47%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. JT's
gross profit rate is 77.47% [$73,600 ($95,000 − $21,400) ÷ $95,000]. Therefore, this is the correct answer.

Rationale
 64.21%
Gross profit is defined as Net Sales – Cost of Goods Sold. Gross profit rate is defined as Gross Profit ÷ Net
Sales. It measures the percentage of sales revenue left after the cost of the inventory is deducted. JT's
operating income as a percentage of net sales (Net Sales – Cost of Goods Sold – Operating Expenses) is
64.21% [$61,000 ($95,000 − $24,000 − $12,600) ÷ $95,000]. The question asks about JT's gross profit
rate, not its operating income as a percentage of net sales. Therefore, this is an incorrect answer.
Question 3
2.A.1.a
tb.common.size.008_1711
LOS: 2.A.1.a
Lesson Reference: Common-Size Financial Statement Analysis (Vertical Analysis)
Difficulty: medium
Bloom Code: 4

Savannah Co. had the following information:

Using vertical analysis for Year 2, what is the percentage of cost of goods sold and net income, respectively?

16.4% and 39.0%

11.8% and 27.8%

61.0% and 22.7%

72.2% and 16.0%

Rationale
 16.4% and 39.0%
In vertical analysis, all values on the income statement are expressed as a percentage of net sales for
the year. In Year 2 the operating expense percentage is 16.4% ($34,400 ÷ $210,000) and the gross profit
percentage (Net sales − Cost of goods sold) is 39.0% ($82,000 ÷ $210,000). However, the question asks
for the cost of goods sold percentage and the net income percentage. Therefore, this is an incorrect
answer.

Rationale
 11.8% and 27.8%
In vertical analysis, all values on the income statement are expressed as a percentage of net sales for
the year. In Year 1 the operating expense percentage is 11.8% ($23,000 ÷ $194,800) and the gross profit
percentage (Net sales − Cost of goods sold) is 27.8% ($54,200 ÷ $194,800). However, the question asks
for the cost of goods sold percentage and the net income percentage and about figures from Year 2.
Therefore, this is an incorrect answer.

Rationale
 61.0% and 22.7%
In vertical analysis, all values on the income statement are expressed as a percentage of net sales for
the year. In Year 2, the cost of goods sold percentage is 61.0% ($128,000 ÷ $210,000) and the net income
percentage is 22.7% ($47,600 ÷ $210,000). Therefore, this is the correct answer.

Rationale
 72.2% and 16.0%
In vertical analysis, all values on the income statement are expressed as a percentage of net sales for
the year. In Year 1, the cost of goods sold percentage is 72.2% ($140,600 ÷ $194,800) and the net income
percentage is 16.0% ($31,200 ÷ $194,800). However, the question asks for Year 2 figures, not Year 1.
Therefore, this is an incorrect answer.
Question 4
2.A.3.a
roa.roe.tb.011_2204
LOS: 2.A.3.a
Lesson Reference: ROA and ROE – A Closer Look
Difficulty: easy
Bloom Code: 2
Which of the following is not a typical way to define “assets” when calculating return on assets?
Correct

Net assets as of a specific date.

Average total assets for a two-year period.

Total assets as of a specific date.

Operating assets as of a specific date.

Rationale
 Net assets as of a specific date.
Correct. There are several different ways to define “assets” when calculating return on assets. Different
measurements are used to capture different aspects of performance. The three most common
measurements are average total assets for a two-year period, total assets as of a specific date, and
operating assets as of a specific date. Net assets as of a specific date are not typically used to calculate
return on assets as net assets is another term for equity.

Rationale
 Average total assets for a two-year period.
This answer is incorrect. Many analysts use average total assets for a two-year period when calculating
return on assets as this provides an asset measurement that is consistent with the time period over
which net income is generated.

Rationale
 Total assets as of a specific date.
This answer is incorrect. Many analysts use total assets as of a specific date (usually the balance sheet
date) when calculating return on assets as this figure is readily available on a balance sheet and is the
simplest way to measure assets.

Rationale
 Operating assets as of a specific date.
This answer is incorrect. Many analysts use operating assets as of a specific date (usually the balance
sheet date) when calculating return on assets as these are the specific assets used to generate income.
Question 5
2.A.2.y
sources.fin.tb.016_2210
LOS: 2.A.2.y
Lesson Reference: Sources of Financial Information and Their Use in Evaluating a Company’s Financial
Strength
Difficulty: medium
Bloom Code: 4

Which of the following ratios are appropriate for evaluating a company’s profitability?

A Gross profit ratio

A, B, and C
Your Answer

A only
Correct

A and B

B and C

Rationale
 A, B, and C
This answer is incorrect. The relationship between interest expense and earnings before interest and
taxes (EBIT) is related to solvency, not profitability.

Rationale
 A only
This answer is incorrect. How a company uses its assets to generate sales can provide important
information about the company’s profitability.

Rationale
 A and B
Correct. Profitability ratios measure a company’s ability to generate sales and manage expenses to
earn profits. One ratio commonly used to assess profitability is the gross profit ratio. This is calculated
by dividing gross profit (Sales revenue − Cost of goods sold) by sales revenue. This determines the
percentage of sales revenue that a company keeps after paying to purchase or make the products it
sells. This can be used to pay other operating expenses, interest, and taxes. Higher values indicate
stronger profitability. The total asset turnover ratio is also used to measure profitability. This is
determined by dividing sales revenue by average total assets. It measures the sales revenue generated
by each dollar of average total assets. Higher levels indicate a greater ability to use assets to generate
sales, which is consistent with stronger profitability. The interest coverage ratio is used to assess
solvency, not profitability, as it relates to the ability to pay interest expense with earnings before
interest and taxes.

Rationale
 B and C
This answer is incorrect. The percentage of sales revenue a company keeps after paying to purchase or
make the products it sells can provide important information about the company’s profitability.
However, the relationship between interest expense and EBIT is related to solvency, not profitability.
Question 6
2.A.3.c
changes.acct.tb.015_2104
LOS: 2.A.3.c
Lesson Reference: Changes in Accounting Treatment
Lesson Reference: Considerations when Measuring Income
Difficulty: easy
Bloom Code: 1
The amount of expense and resulting income reported on the income statement are based on management
decisions. All of the following are factors that influence management decision making except:
Estimates.
Your Answer

Different needs of users.

Disclosure.
Correct

Timing.

Rationale
 Estimates.
This answer is incorrect. Management estimates things like the useful life of a depreciable asset and the
balance that should be in the allowance for doubtful accounts.

Rationale
 Different needs of users.
This answer is incorrect. Management decision making is influenced by the needs of the users of
financial statements.

Rationale
 Disclosure.
This answer is incorrect. The FASB ASC provides the detail of required disclosures. The level of detail
provided by management can range from the minimum required to excessive details.

Rationale
 Timing.
This answer is correct. While timing may determine whether an expense or revenue is recorded in a
period, the date an event occurs is a specific date and not open to management interpretation.
Question 7
2.A.2.q
tb.profit.vertical.031_1711
LOS: 2.A.2.q
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: medium
Bloom Code: 3
Crowley Airways had a return on assets of 4.2% and an asset turnover of 0.65 in 20x7. What was Crowley's
profit margin?
2.73%

15.48
Correct

6.46%

0.69

Rationale
 2.73%
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. One way to measure it, known as DuPont Analysis, is Asset Turnover × Return on Sales. Asset
turnover measures how much sales revenue a company generates per dollar in average total assets. It
is defined as Net Sales ÷ Average Total Assets. Return on sales (ROS), sometimes called profit margin, is
defined as Net Income ÷ Net Sales. It measures how much of every dollar in sales a company keeps as
net income. Rearranging the formula results in profit margin being equal to ROA ÷ Asset Turnover.
Crowley's profit margin would be 2.73% if the figures are multiplied together (4.2% × 0.65). However,
this is not the correct formula. Therefore, this is an incorrect answer.

Rationale
 15.48
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. One way to measure it, known as DuPont Analysis, is Asset Turnover × Return on Sales. Asset
turnover measures how much sales revenue a company generates per dollar in average total assets. It
is defined as Net Sales ÷ Average Total Assets. Return on sales (ROS), sometimes called profit margin, is
defined as Net Income ÷ Net Sales. It measures how much of every dollar in sales a company keeps as
net income. Rearranging the formula results in profit margin being equal to ROA ÷ Asset Turnover.
Crowley's profit margin would be 15.48 if the figures are reversed (0.65 ÷ 4.2%). However, this is not the
correct formula. Therefore, this is an incorrect answer.

Rationale
 6.46%
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. One way to measure it, known as DuPont Analysis, is Asset Turnover × Return on Sales. Asset
turnover measures how much sales revenue a company generates per dollar in average total assets. It
is defined as Net Sales ÷ Average Total Assets. Return on sales (ROS), sometimes called profit margin, is
defined as Net Income ÷ Net Sales. It measures how much of every dollar in sales a company keeps as
net income. Rearranging the formula results in profit margin being equal to ROA ÷ Asset Turnover.
Crowley's profit margin is 6.46% (4.2% ÷ 0.65). Therefore, this is the correct answer.

Rationale
 0.69
Return on assets (ROA) measures how much income a company generates per dollar in average total
assets. One way to measure it, known as DuPont Analysis, is Asset Turnover × Return on Sales. Asset
turnover measures how much sales revenue a company generates per dollar in average total assets. It
is defined as Net Sales ÷ Average Total Assets. Return on sales (ROS), sometimes called profit margin, is
defined as Net Income ÷ Net Sales. It measures how much of every dollar in sales a company keeps as
net income. Rearranging the formula results in profit margin being equal to ROA ÷ Asset Turnover.
Crowley's profit margin would be 0.69 if the figures are added together (0.65 + 4.2%). However, this is
not the correct formula. Therefore, this is an incorrect answer.
Question 8
2.A.3.g
cma11.p2.t1.me.0021_0820
LOS: 2.A.3.g
Lesson Reference: Cost of Sales and the Different Profit Margins
Difficulty: medium
Bloom Code: 4
Ellicott City Manufacturers, Inc., has sales of $6,344,210, and a gross profit margin of 67.3 %. What is the
firm's cost of goods sold? Round your final answer to the nearest dollar.
Correct

$2,074,557

$4,269,653

$3,082,551

None of the above.

Rationale
 $2,074,557

Sales = $6,344,210

Gross profit margin = 67.3

$6, 644, 210−Cost of Goods Sold

Cost of goods sold = $6, 344, 210 − (0.673 × $6, 344, 210)

= $2, 074, 557

Rationale
 $4,269,653
This answer is incorrect. The gross profit is $4,269,653.

Rationale
 $3,082,551
This answer is incorrect. Cost of goods sold would be $3,082,551 if gross profit is $6,344,210 and the
gross profit margin is 67.3%.

Rationale
 None of the above.
This answer is incorrect. The correct answer is one of the other choices.
Question 9
2.A.2.y
sources.fin.tb.022_2210
LOS: 2.A.2.y
Lesson Reference: Sources of Financial Information and Their Use in Evaluating a Company’s Financial
Strength
Difficulty: hard
Bloom Code: 3
Which of the following statements about financial leverage and operating leverage is correct?
Correct

Issuing equity decreases financial leverage and fixed costs increase operating leverage.

Fixed costs increase financial leverage and borrowing increases operating leverage.

Borrowing increases financial leverage and variable costs increase operating leverage.

Variable costs decrease financial leverage and issuing equity decreases operating leverage.

Rationale
 Issuing equity decreases financial leverage and fixed costs increase operating leverage.
Correct. Financial leverage refers to the risk associated with a company’s financial structure.
Specifically, it concerns the relative mix of debt and equity a company uses. Equity is considered less
risky than debt as it does not have to be repaid and there are no mandatory periodic payments like
there are with interest. Operating leverage refers to the risk associated with a company’s cost structure.
Specifically, it concerns the relative mix of variable and fixed costs in a company’s operating costs.
Fixed costs are riskier as they must be paid regardless of how much revenue a company generates. On
the other hand, variable costs fluctuate directly with revenue, resulting in lower risk.

Rationale
 Fixed costs increase financial leverage and borrowing increases operating leverage.
This answer is incorrect. Fixed costs are part of a company’s operating cost structure and borrowing is a
part of a company’s financial structure.

Rationale
 Borrowing increases financial leverage and variable costs increase operating leverage.
This answer is incorrect. Variable costs decrease when sales decrease. Therefore, they are less risky
than fixed costs.

Rationale
 Variable costs decrease financial leverage and issuing equity decreases operating leverage.
This answer is incorrect. Variable costs are part of a company’s operating cost structure and equity is a
part of a company’s financial structure.
Question 10
2.A.2.b
tb.liquid.ratios.042_1711
LOS: 2.A.2.b
Lesson Reference: Liquidity Ratios
Difficulty: hard
Bloom Code: 3
Goodman's has current assets of $2,500,000 and current liabilities of $1,000,000. If Goodman pays $250,000
of its accounts payable, what will the firm's new current ratio be?
2.0:1

1.2:1

4:1
Correct

3:1

Rationale
 2.0:1
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. It measures the amount of current assets available per dollar of current
liabilities. Higher current ratios indicate higher liquidity, as there are more current assets available to
satisfy current liabilities. If the company pays accounts payable of $250,000, current assets will
decrease to $2,250,000 (assuming a current asset such as cash is used to pay the accounts payable) and
current liabilities will decrease to $750,000. The new current ratio will be 2.0 if current liabilities
increase by $250,000 (not decrease) to $1,250,000 and there is no change in current assets ($2,500,000 ÷
$1,250,000). Therefore, this is an incorrect answer.

Rationale
 1.2:1
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. It measures the amount of current assets available per dollar of current
liabilities. Higher current ratios indicate higher liquidity, as there are more current assets available to
satisfy current liabilities. If the company pays accounts payable of $250,000, current assets will
decrease to $2,250,000 (assuming a current asset such as cash is used to pay the accounts payable) and
current liabilities will decrease to $750,000. The new current ratio will be 1.2 if current liabilities
increase by $250,000 (not decrease) to $1,250,000 and working capital of $1,500,000 ($2,500,000 −
$1,000,000) is used as the numerator instead of current assets ($1,500,000 ÷ $1,250,000). Therefore, this
is an incorrect answer.

Rationale
 4:1
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. It measures the amount of current assets available per dollar of current
liabilities. Higher current ratios indicate higher liquidity, as there are more current assets available to
satisfy current liabilities. If the company pays accounts payable of $250,000, current assets will
decrease to $2,250,000 (assuming a current asset such as cash is used to pay the accounts payable) and
current liabilities will decrease to $750,000. The new current ratio will be 4.0 if current liabilities
decrease by $250,000 to $750,000 and current assets increase by $500,000 to $3,000,000 ($3,000,000 ÷
$750,000). Therefore, this is an incorrect answer.

Rationale
 3:1
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. It measures the amount of current assets available per dollar of current
liabilities. Higher current ratios indicate higher liquidity, as there are more current assets available to
satisfy current liabilities. If the company pays accounts payable of $250,000, current assets will
decrease to $2,250,000 ($2,500,000 − $250,000) (assuming a current asset such as cash is used to pay
the accounts payable) and current liabilities will decrease to $750,000 ($1,000,000 − $250,000). The new
current ratio will be 3.0 ($2,250,000 ÷ $750,000). Therefore, this is the correct answer.