Question 1

Jones Company's current ratio is higher than the average for its industry, while its quick ratio is below the industry average. One possible interpretation for these results is that Jones carries more inventory than most companies in its industry.

Accepted Answer

Inventory is not included in the quick ratio numerator, but it is included in the numerator for current ratio. Since the denominator, current liabilities, doesn't change the difference in these ratios could be due to a large amount of inventory.

Question 2

The accounting profession assumes that financial statement users have a reasonable knowledge of business.

Accepted Answer

Current reporting standards target users that have a reasonably informed knowledge of business, though that level of sophistication is difficult to define.

Question 3

In terms of solvency, the smaller the number of times interest is earned, the better.

Accepted Answer

The number of times interest is earned ratio is: Earnings before interest and taxes (EBIT)/interest expense. This ratio measures the burden a company's interest payments represent. Users often consider times interest is earned along with the debt ratios when evaluating financial risk. Dividing EBIT by interest expense indicates how many times the company could have made its interest payments. The more times it could be paid, the bigger the company's safety net.

Question 4

Financial ratio analysis is a form of horizontal analysis in that comparisons are made between different accounts in the same set of financial statements.

Accepted Answer

Horizontal analysis is a form of financial ratio analysis, not the other way around. Horizontal analysis compares items over many time periods and vertical analysis compares many items within the same time period

Question 5

Liquidity ratios are used to analyze the long-term debt-paying ability and the composition of the financing structure of the firm.

Accepted Answer

Liquidity ratios indicate a firm's short-term ability to pay its bills. Liquidity ratios include: working capital, current ratio, acid test (quick) ratio, accounts receivable turnover, average days to collect ratio, inventory turnover and average days to sell inventory.

Question 6

The most frequently quoted measure of earnings performance is the stockholders' equity ratio.

Accepted Answer

The most frequently quoted measure of earnings performance is earnings per share (EPS).

Question 7

A company has an obligation to provide highly detailed information on its financial statements.

Accepted Answer

Companies typically provide very broad, summarized information on their financial statements.

Question 8

Vertical analysis involves comparing amounts in the financial statements for a single period, but an analyst may usefully compare vertical analysis results for two or more periods.

Accepted Answer

When performing vertical analysis on an income statement, each item on the income statement is divided by sales. All items are presented as a percentage of sales. When performing vertical analysis on the balance sheet, each item on the balance sheet is divided by total assets. All items are presented as a percentage of total assets. Horizontal analysis can be done using the percentages calculated from vertical analysis.

Question 9

A vertical analysis uses percentages to compare each of the parts of an individual statement to the whole. For example, on an income statement each item would be shown as a percentage of net sales.

Accepted Answer

When performing vertical analysis on an income statement, each item on the income statement is divided by sales. All items are presented as a percentage of sales. When performing vertical analysis on the balance sheet, each item on the balance sheet is divided by total assets. All items are presented as a percentage of total assets.

Question 10

The only requirement involved in communicating useful information is that the information be accurate.

Accepted Answer

The primary objective of accounting is to provide information useful for decision making. Accountants must consider the intended users, the types of decisions users make with financial statement information, and available means of analyzing the information. Accountants must provide useful information while avoiding information overload.

Question 11

A banker may perform a financial ratio analysis to assess a firm's ability to repay debt in a timely manner.

Accepted Answer

Creditors would be interested in liquidity and solvency ratios which indicate a firm's short-term and long-term ability to pay its debt.

Question 12

While horizontal analysis examines one item over many time periods, vertical analysis examines many items in the same interval of time.

Accepted Answer

Horizontal analysis is also called trend analysis. It is the study of the behavior of individual financial statement items over several accounting periods. The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages.

Question 13

Financial analysis typically involves some form of comparison such as changes in the same item over a number of years.

Accepted Answer

Financial statement analysis should focus primarily on isolating information useful for making a particular decision. The information required can take many forms but usually involves comparisons, such as comparing changes in the same item for the same company over a number of years, comparing key relationships within the same year, or comparing the operations of several different companies in the same industry.

Question 14

The debt to equity ratio can be used to asses a firm's solvency.

Accepted Answer

Solvency ratios are used to assess a firm's long-term ability to pay its debts. Solvency ratios include: debt to assets, debt to equity, number of times interest earned and plant assets to long-term liabilities.

Question 15

The quick ratio although similar to the current ratio is more conservative.

Accepted Answer

The quick ratio, also known as the acid-test ratio, is a conservative variation of the current ratio. The quick ratio measures a company's immediate debt-paying ability. Only cash, receivables, and current marketable securities (quick assets) are included in the numerator. Less liquid current assets, such as inventories and prepaid expenses, are omitted.

Question 16

When debt is used to finance purchase of assets, the term or time span of the debt should be similar to the lifespan of the assets.

Accepted Answer

Effective financial management principles dictate that asset purchases should be financed over a time span about equal to the expected lives of the assets. Short-term assets should be financed with short-term liabilities.

Question 17

Working capital is current assets divided by current liabilities.

Accepted Answer

For formula for working capital is: current assets - current liabilities.

Question 18

Profitability ratios attempt to assess the company's ability to generate earnings.

Accepted Answer

Profitability ratios assess the firm's ability to generate earnings.

Question 19

The drawback of studying absolute amounts reported in financial statements is the problem of differing materiality levels.

Accepted Answer

Comparing only absolute amounts has drawbacks because materiality levels differ from company to company or even from year to year for a given company. The materiality of information refers to its relative importance. An item is considered material if knowledge of it would influence the decision of a reasonably informed user.

Question 20

The current ratio is one of the most common measures of liquidity.

Accepted Answer

Liquidity has to do with the company's ability to pay its obligations in the short-term. The current ratio (current assets/current liabilities) indicates the amount of current assets available for every dollar of debt.

Quiz 13: Financial Statement Analysis Available Online in the Connect Library