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Chapter 17

Analysis of Financial Statements

QUESTIONS

1. With comparative statements, financial statement items for two or more successive accounting periods are placed side by side on a single statement, with the change in each item expressed as both a dollar amount and a percent. Common-size comparative statements express each financial statement item as a percent of some base amount that is assigned a value of 100%.
2. Total assets (or equivalently, the total of liabilities plus equity) are assigned a value of 100% on a common-size balance sheet. Net sales (revenues) are assigned a value of 100% on a common-size income statement.
3. Financial reporting includes the entire process of preparing and issuing financial information about a company. Financial statements are an important part of financial reporting but they are less than the whole.
4. The nature of a company's business, the composition of its current assets, and the turnover of its current assets are three important factors that should be considered in deciding whether a current ratio is good or bad.
5. A 2-to-1 current ratio may not be adequate if the company's current assets consist of a large proportion of slow-turning accounts, notes, and merchandise inventory. The general nature of the business also may make the 2-to-1 rule of thumb inadequate.
6. Adequate working capital enables a company to carry sufficient inventories, meet current debts, take advantage of cash discounts, and extend favorable terms to customers. Working capital is a major factor in determining the short-term liquidity position of a company.
7. When evaluated in light of a company's credit terms, the number of days' sales uncollected indicates how quickly accounts receivable are converted into cash. This provides information about the relevance of accounts receivable balances in meeting the current obligations of the business.
8. A high accounts receivable turnover implies that accounts are collected quickly, thereby providing cash that can be used to meet obligations. A high turnover also means that a given sales volume can be supported with a lower investment in accounts receivable.
9. Users are interested in the capital structure of a company, as measured by debt and equity ratios, for at least two reasons. First, as a company includes more debt in its capital structure, the risk that it will be unable to meet interest and principal payments increases. Second, the existence of debt introduces financial leverage. If the company can earn a rate of return on its investments that exceeds the rate of interest paid to creditors, the debt will increase the rate of return to stockholders.
10. Inventory turnover reflects on the efficiency of inventory management. That is, a high inventory turnover means that a given sales volume can be supported with a smaller investment in inventory. This insight into the speed with which inventory is sold determines the