Financial statement analysis and valuation 4th edition easton test bank

Module 1 Framework for Analysis and Valuation

Module 1: Framework for Analysis and Valuation

True/False

Topic: Users of Financial Statement Information

LO: 1

1. Shareholdersdemandfinancialinformationprimarilytoassessprofitabilityandriskwhereasbankers demandinformationprimarilytoassesscashflowstorepayloaninterestandprincipal.

Answer: True

Rationale: Whilebothshareholdersandbankersareinterestedinalltheinformationcompanies provide,shareholderscareaboutmoreaboutacompany’sprofitabilityandbankerscaremoreabout solvencyandcreditworthiness.

Topic: Publicly Available Financial Reports

LO: 1

2. Publiclytradedcompaniesarerequiredtoprovidequarterlyfinancialreportsdirectlytothepublic

Answer: False

Rationale: CompaniesprovideelectronicversionsofquarterlyfinancialstatementstotheSEC,which poststhemtotheInternetforthepublictoaccessthem.

Topic: Users of Financial Statement Information

LO: 1

3. PubliclytradedcompaniesprovidefinancialinformationprimarilytosatisfytheSECandthetax authorities(thatis,theInternalRevenueService)

Answer: False

Rationale: Demandforinformationextendstomanyusers;theregulatorssuchastheSECandthe IRSareonlyoneclassofusers.

Topic: SEC Filings

LO: 1

4. PubliclytradedcompaniesmustprovidetotheSecuritiesExchangeCommissionannualaudited financialstatements(10Kreports)andquarterlyauditedfinancialstatements(10Qreports).

Answer: False

Rationale: Quarterlyreportsdonotneedtobeaudited.

Topic: Balance Sheet

LO: 2

5. Ifacompanyreportsretainedearningsof$175.3milliononitsbalancesheet,itmustalsoreport $175.3millionincash.

Answer: False

Rationale: Theaccountingequationrequirestotalassetstoequaltotalliabilitiesplusstockholders’ equity.Thatdoesnotimply,however,thatliabilityandequityaccountsrelatedirectlytospecific assets.

Topic: Balance Sheet LO: 2

6. Abalancesheetshowsacompany’spositionoveraperiodoftime,whereasanincomestatement, statementofstockholders’equity,andstatementofcashflowsshowitspositionatapointintime.

Answer: False

Rationale: Thestatementisreversed:Abalancesheetshowsacompany’spositionatapointintime, whereasanincomestatement,statementofequity,andstatementofcashflowsshowitsposition overaperiodoftime.

Topic: Accounting Equation LO: 2

7. Assetsmustalwaysequalliabilitiesplusequity.

Answer: True

Rationale: TheaccountingequationisAssets=Liabilities+Equity.Thisrelationmustalwayshold.

Topic: Income Statement LO: 2

8. Theincomestatementreportsnetincomewhichisdefinedasthecompany’sprofitafterallexpenses anddividendshavebeenpaid.

Answer: False

Rationale: Thestatementcontainstwoerrors.First,netincomedoesnotincludeanydividendsduring theperiod;theseareadistributionofprofitsandnotpartofitscalculation.Second,theincome statementispreparedonanaccrualbasisandthusincludesexpensesincurred(asopposedtopaid).

Topic: Statement of Cash Flows LO: 2

9. Astatementofcashflowsreportsoncashflowsforoperating,investingandfinancingactivitiesata pointintime.

Answer: False

Rationale: Astatementofcashflowsreportsoncashflowsforoperating,investing,andfinancing activitiesoveraperiodoftime.

Topic: Statement of Stockholders’ Equity LO: 2

10. Anincreaseintreasurystockwouldbereflectedinthestatementofstockholders’equity.

Answer: True

Rationale: Thestatementofstockholders’equityreportsonchangesintheaccountsthatmakeup stockholders’equity.Thisincludescontributedcapital,retainedearnings,andtreasurystock.

©Cambridge

Publishers,

Test Bank, Module 1

Topic: Financial Accounting and Business Analysis

LO: 3

11. Financialstatementsareinfluencedbyfiveimportantforcesthatdetermineacompany’scompetitive intensity:(A)industrycompetition,(B)buyerpower,(C)supplierpower,(D)productsubstitutes,and (E)threatofentry.

Answer: True

Rationale: Bysystematicallyconsideringthesefivebusinessforces,wecangainbetterinsightsfrom financialstatements.

Topic: Return on Assets

LO: 4

12. ReturnonAssets(ROA)measurestheprofitthecompanymakesoneachdollaroftotalassetsit uses.

Answer: True

Rationale: ReturnonAssetsisaprofitabilitymetricthatmeasureshowmuchprofitthecompany madeforeachdollarofassetsthecompanyholdsonaverageduringtheyear.

Topic: Return on Assets LO: 4

13. ReturnonAssets(ROA)=NetIncome/Sales×AssetTurnover

Answer: True

Rationale: ReturnonAssets=NetIncome/AverageAssets.ThisisthedisaggregationoftheROA intoitscomponents

Topic: Asset Turnover

LO: 4

14. Considertwocompanies(AandB)withequalprofitmarginsof15%.CompanyAhasanasset turnoverof1.2andCompanyBhasanassetturnoverof1.5. Ifallelseisequal,CompanyBwithits higherassetturnover,islessprofitablebecauseitisexpensivetoturnassetsover.

Answer: False

Rationale: Assetturnoverisanefficiencymetric.Thehighertheturnover,themoreefficientthe companyiswithitsassetsandthus,themoreprofitable.Algebraically,ROA=PM×AT.CompanyA aboveislessprofitable:15%×1.2=18%whereasCompanyB’sROAis15%×1.5=22.5%.

Multiple Choice

Topic: Users of Financial Statement Information

LO: 1

1. Whichofthefollowinggroupswouldlikely not beinterestedinthefinancialstatementsofalarge publiccompanysuchasBerkshireHathaway?

A) Shareholders

B) Employees

C) Competitors

D) Taxingagencies

E) Noneoftheabove

Answer: E

Rationale: Allofthesepartieswouldusethefinancialstatements,albeitindifferentwaysandfor differentpurposes.

Topic: Users of Financial Statement Information

LO: 1

2. TheSECadoptedRegulationFD,tocurbpubliccompanies’practiceof:

A) Routinelyfilingextensionsforannualreports(Form10-K)

B) Selectivelydisclosinginformation

C) Reportingproforma(non-GAAP)numbers

D) Hiringauditorsfornon-auditservicessuchasconsultingengagements

E) Noneoftheabove

Answer: B

Rationale: RegFDreadsasfollows:“Wheneveranissuerdisclosesanymaterialnonpublic informationregardingthatissuer,theissuershallmakepublicdisclosureofthatinformation... simultaneously,inthecaseofanintentionaldisclosure;and...promptly,inthecaseofanonintentionaldisclosure.”

Topic: Components of the Balance Sheet

LO: 2

3. Alistofassets,liabilitiesandequitycanbefoundonwhichofthefollowing?

A) BalanceSheet

B) IncomeStatement

C) StatementofAssetsandLiabilities

D) StatementofCashFlows

E) StatementofStockholders’Equity

Answer: A

Rationale: Abalancesheetlistsamountsforassets,liabilitiesandequityatapointintime.

Test Bank, Module 1

Topic: Balance Sheet

LO: 2

4. Whichofthefollowingitemswould not befoundonabalancesheet?(Selectallthatapply)

A) Stockholders’Equity

B) Property,plantandequipment

C) Nonownerfinancing

D) Sales

E) CostofGoodsSold

Answer: DandE

Rationale: Thebalancesheetreportsassets(includingproperty,plantandequipment),liabilities (includingnonownerfinancing)andequity.SalesandCostofGoodsSoldappearontheincome statement.

Topic: Profit and Cash Flow LO: 2

5. Acompany’snetcashflowwillequalitsnetincome…

A) Almostalways

B) Rarely

C) Occasionally

D) Onlywhenthecompanyhasnoinvestingcashflowfortheperiod

E) Onlywhenthecompanyhasnoinvestingorfinancingcashflowfortheperiod

Answer: B

Rationale: Netincomereflectsthecompany’srevenueminusexpensesforthegivenperiod. Net cashflowrepresentstheamountofmoneyreceived(spent)onoperating,investingandfinancing activitiesforthegivenperiod. Thesevaluesarerarelythesame.

Topic: Financial Statement Information LO: 2

6. Whichofthefollowingstatementsarecorrect?(Selectallthatapply)

A) Abalancesheetreportsoninvestingandfinancingactivities.

B) Anincomestatementreportsonfinancingactivities.

C) Thestatementofequityreportsonchangesintheaccountsthatmakeupequity.

D) Thestatementofcashflowsreportsoncashflowsfromoperating,investing,andfinancing activitiesoveraperiodoftime.

E) Abalancesheetreportsonacompany’sassetsandliabilitiesoveraperiodoftime.

Answer: A,C,andD

Rationale: Statement(B)isincorrect–thestatementofcashflowsreportsonfinancingactivitiesthat arereflectedonthebalancesheet.Statement(E)isincorrect–thebalancesheetreportsona company’sassetsandliabilitiesatapointintime

Topic: Balance Sheet – Numerical calculations required LO: 2

7. TheGoodyearTire&RubberCompany’sDecember31,2013financialstatementsreportedthe following(inmillions)

WhatdidGoodyearreportforretainedearningsatDecember31,2013?

A) $1,624million

B) $1,173million

C) $ 523million

D) $2,833million

E) Thereisnotenoughinformationtodeterminetheanswer.

Answer: E

Rationale: Todeterminethebalanceinretainedearningsattheendoftheyearwemustalsoknow theamountofdividends(ifany)paidbythecompanyduringtheyear.

Topic: Balance Sheet – Numerical calculations required LO: 2

8. AmericanAirlines’2012balancesheetreportedthefollowing(inmillions)

WhatwasAmericanAirlines’totalliabilitiesandstockholders’equityatDecember31,2012?

A) $33,226million

B) $25,612million

C) $37,695million

D) $ 4,469million

E) Thereisnotenoughinformationtodeterminetheanswer.

Answer: B

Rationale: Assets=Liabilities+StockholdersEquity.Assets=$25,612sothisisthetotalofliabilities andequitycombined.

Test Bank, Module 1

Topic: Balance Sheet – Numerical calculations required LO: 2

9. OnSeptember29,2013Starbuck’sCorporationreported,onitsForm10-K,thefollowing(inmillions):

WhatdidStarbuck’sreportastotalliabilitiesonSeptember29,2013?

A) $11,516.7million

B) $ 5,377.3million

C) $ 895.0million

D) $ 7,034.4million

E) Noneoftheabove

Answer: D

Rationale: Assets=Liabilities+StockholdersEquity.$11,516.7=Liabilities+$4,482.3. Therefore,Liabilities=$7,034.4onSeptember29,2013.

Topic: Balance Sheet – Numerical calculations required LO: 2

10. Inits2013annualreport,Snap-OnIncorporatedreportedthefollowing(inmillions):

WhatdidSnap-Onreportastotalassetsatyear-end2013?

A) $3,775.8million

B) $1,796.2million

C) $4,110.0million

D) $3,926.6million

E) Noneoftheabove

Answer: C

Rationale: Assets=Liabilities+StockholdersEquity.Assets=$1,979.6+$2,130.4. Therefore,Assets=$4,110.0

Topic: Balance Sheet – Numerical calculations required

LO: 2

11. Inits2013annualreport,Kohl’sCorporationreportedthefollowing(inmillions):

Totalassets $13,905

Totalshareholders’equity $ 6,048

Totalliabilities $ 7,857

WhatproportionofKohl’sCorporationisfinancedbynonowners?

A) 56.5%

B) 54.2%

C) 43.5%

D) 77.0%

E) Noneoftheabove

Answer: A

Rationale: NonownerfinancingforKohl’sassetsisprovidedfromliabilities(theshareholdersarethe owners).$7,857/$13,905=56.5%.

Topic: Balance Sheet – Numerical calculations required (more challenging – requires calculation of total assets before ratio can be calculated.)

LO: 2

12. Inits2013annualreport,MattelInc.reportedthefollowing(inmillions):

Totalliabilities

Totalshareholders’equity

WhatproportionofMattelisfinancedbynonowners?

A) 54.6%

B) 53.0%

C) 88.6%

D) 49.50%

E) Noneoftheabove

Answer: D

$3,188

$3,252

Rationale: NonownerfinancingforMattel’sassetsisprovidedfromliabilities(theshareholdersarethe owners).Assets=Liabilities+Equity.Assets=$3,188+$3,252=$6,440.$3,188/$6,440=49.50%.

Topic: Income Statement – Numerical calculations required LO: 2

13. TheGoodyearTire&RubberCompany’sDecember31,2013financialstatementsreportedthe following(inmillions)

WhatdidGoodyearreportfornetincomefortheyearendingDecember31,2013?

A) $ 4,118million

B) $ 675million

C) $ (675)million

D) $19,238million

E) Thereisnotenoughinformationtodeterminetheanswer.

Answer: B

Rationale: Sales–Costofsales–Otherexpenses=Netincome $19,540–$15,422–$3,443=$675

Topic: Income Statement – Numerical calculations required LO: 2

14. IntelCorporationreportedthefollowingonits2013incomestatement(inmillions)

WhatdidIntelreportforcostofgoodssoldduring2013?

A) $21,187million

B) $ 5,502million

C) $33,478million

D) $12,291million

E) Noneoftheabove

Answer: A

Rationale: Sales–Costofgoodssold=Grossprofit.$52,708–Costofgoodssold=$31,521. Therefore,Costofgoodssold=$21,187.

©Cambridge Business Publishers, 2015

1-10

Topic: Income statement – Numerical calculations required LO: 2

15. OnSeptember29,2013,StarbucksCorporationreported,onitsForm10-K,thefollowing(inmillions):

WhatamountofrevenuesdidStarbucksreportfortheyearendingSeptember29,2013?

A) $14,883.4

B) $15,208.8

C) $14,558.0

D) $14,892.2

E) Noneoftheabove

Answer: D

Rationale: Revenues–Totalexpenses=Netearnings.Revenues–$14,883.4=$8.8.Therefore, Revenueswere$14,892.2

Topic: Income Statement – Numerical calculations required (more challenging, requires calculation of negative “growth” rate.) LO: 2

16. OnSeptember29,2013,StarbucksCorporationreported,onitsForm10-K,thefollowing(inmillions):

Calculateyear-over-yearincreaseor(decrease)innetearnings,inpercentageterms.

A) (83.7)%

B) 32.0%

C) 156.4%

D) (99.4)%

E) Noneoftheabove

Answer: D

Rationale: Duringtheyear,netearningsdecreasedcomparedtotheprior year.Thisdecreaseis calculatedas($8.8–$1,384.7)/$1,384.7=(99.4)%.

Topic: Income Statement – Numerical calculations required (more challenging – requires calculation of gross profit and ratios for two years.)

LO: 2

17. Inits2013annualreport,CaterpillarInc.reportedthefollowing(inmillions):

Asapercentageofsales,didCaterpillar’sgrossprofitincreaseordecreaseduring2013?

A) Grossprofitincreasedfrom26.8%to28.6%

B) Grossprofitdecreasedfrom28.6%to26.8%

C) Grossprofitincreasedfrom71.4%to73.2%

D) Grossprofitdecreasedfrom73.2%to71.4%

E) Thereisnotenoughinformationtoanswerthequestion.

Answer: B

Rationale: Sales–Costofgoodssold=Grossprofit.In2012,grossprofittosaleswas28.6%.This ratiodecreasedto26.8%in2013.

Topic: Statement of Cash Flows – Numerical calculations required LO: 2

18. TheGoodyearTire&RubberCompany’sDecember31,2013,financialstatementsreportedthe following(inmillions).

WhatdidGoodyearreportforcashonitsDecember31,2012balancesheet?

A) $ 2,281million

B) $32,281million

C) $ 3,711million

D) $ 715million

E) Noneoftheabove

Answer: A

Rationale: Cash,beginningofyear+Cashfromoperatingactivities+Cashfrominvestingactivities+ Cashfromfinancingactivities=Cashatendofyear

©Cambridge Business Publishers, 2015

1-12

Topic: Statement of Cash Flows – Numerical calculations required LO: 2

19. Procter&Gamble’sJune30,2013,financialstatementsreportedthefollowing(inmillions):

Cash,beginningofyear $ 4,436

Cash,endofyear $ 5,947

Cashfromoperatingactivities $14,873

Cashfrominvestingactivities $(6,295)

WhatdidProcter&GamblereportforcashfromfinancingactivitiesfortheyearendedJune30, 2013?

A) $ 13,014million

B) $ 18,961million

C) $(18,961)million

D) $ (7,067)million

E) $ 7,067million

Answer: D

Rationale: Cash,beginningofyear+Cashfromoperatingactivities+Cashfrominvestingactivities+ Cashfromfinancingactivities=Cashatendofyear

$4,436+$14,873–$6,295+Cashfromfinancing=$5,947.Cashfromfinancing=$(7,067)

Topic: Five Forces of Competitive Industry

LO: 3

20. Whichofthefollowingare not oneofthefiveforcesthatdetermineacompany’scompetitive intensity?(Selectallthatapply)

A) Bargainingpowerofsuppliers

B) Threatofsubstitution

C) Abilitytoobtainfinancing

D) Threatofentry

E) Threatofregulatoryintervention

Answer: CandE

Rationale: Thefiveforcesofthecompetitiveindustryinclude:industrycompetitors,bargainingpower ofbuyers,bargainingpowerofsuppliers,threatofsubstitution,andthreatofentry.

Topic: Business Environment

LO: 3

21. Whichofthefollowingarerelevantinananalysisofacompany’sbusinessenvironment?(Selectall thatapply)

A) Financing

B) Labor

C) Buyers

D) Governance

E) Alloftheabove

Answer: E

Rationale: Thecomponentsofbusinessanalysisare:lifecycle,outputs,buyers,inputs,competition, financing,labor,governance,andrisk.

Topic: Return on Assets

LO: 4

22. Acompany’sreturnonassets(ROA)canbedisaggregatedtorevealwhichofthefollowing:(Select allthatapply)

A) Financialleverage

B) Profitmargin

C) Salesgrowth

D) Assetgrowth

E) Assetturnover

Answer: BandE

Rationale: ROAcanbedisaggregatedintoprofitmarginandassetturnover.Financialleverageand salesgrowtharenotcomponentsofthisratio.Assetgrowthaffectsthecalculationviathe denominator,butcan’tbedisaggregateddirectly.

Topic: Return on Equity

LO: 4

23. Theratioofnetincometoequityisalsoknownas:

A) Totalnetequityratio

B) Profitmargin

C) Returnonequity

D) Netincomeratio

E) Noneoftheabove

Answer: C

Rationale: TheratioofnetincometoequityiscalledROE,returnonequity,andmeasureshow profitablethecompanywasgiventheshareholders’investment.

Topic: Return on Equity – Numerical calculations required LO: 4

24. Salesfortheyear=$216,588,NetIncomefortheyear=$29,288,Incomefromequityinvestments= $6,618,andaverageEquityduringtheyear=$95,112.Returnonequity(ROE)fortheyearis:

A) 30.8%

B) 12.1%

C) 43.9%

D) 227.6%

E)Thereisnotenoughinformationtoanswerthequestion.

Answer: A

Rationale: Returnonequity=Netincome/AverageEquity=$29,288/$95,112=30.8%.

1-14

Topic: Return on Assets – Numerical calculations required LO: 4

25. Salesfortheyear=$164,458,NetIncomefortheyear=$18,372,andaverageAssetsduringthe year=$104,890.ReturnonAssets(ROA)fortheyearis:

A) 63.8%

B) 17.5%

C) 10.0%

D) ThereisnotenoughinformationtocalculateROA.

E) Noneoftheabove

Answer: B

Rationale: ROA=NetIncome/Averageassets. ThereforeROAequals$18,372/$104,890=17.5%.

Topic: Return on Assets – Numerical calculations required (more challenging because net income is not provided, must be calculated.)

LO: 4

26. Salesfortheyear=$554,044,Profitmargin=24%,andaverageAssetsduringtheyear=$518,216. ReturnonAssets(ROA)fortheyearis:

A) 17.1%

B) 25.7%

C) 84.0%

D) ThereisnotenoughinformationtocalculateROA.

E) Noneoftheabove

Answer: B

Rationale: ROA=NetIncome/Averageassets.WearenotgivenNetincome,butwedoknowthat Profitmarginis24%.Thuswecancalculate:

NetincomeasSales×PM=$132,971. ROA=$132,971/$518,216=25.7%.

Topic: Return on Assets – Numerical calculations required (more challenging because average assets are not provided; must be calculated.)

LO: 4

27. OnDecember31,2013,Harley-Davidson,Inc.reportedthefollowingonitsForm10-K(inmillions):

Calculatereturnonassets(ROA)for2013.

A) 7.9%

B) 62.7% C) 71.5%

D) 8.3%

E) Noneoftheabove

Answer: A

Rationale: Returnonassets=Netincome/Averageassets.Asimplewaytocalculateaverage assetsistotaketheaverageofthebeginningandendingassets:($9,405+$9,171)/2=$9,288. ROA=$734/$9,288=7.9%.

Exercises

Topic: Financial Accounting Vocabulary LO: 2

1. Matchtheitemonthelefttoanumbereditemontherighttocompleteeachsentence.

A) Resourcesthatacompanyownsorcontrolsarecalled _________________.

B) Thedifferencebetweenacompany’sassetsandits equityisequalto_______________.

C) Netincomedividedbyaverageassetsisknownas ____________.

D) Sales,costofgoodssoldandallotherexpensesare necessarytocalculateacompany’s______________.

Answer: A)3 B)1 C)2 D)5

Topic: Financial Accounting Vocabulary LO: 2

1. liabilities

2. returnonassets

3. assets

4. incomestatement

5. netincome

2. Matchtheitemonthelefttoanumbereditemontherighttocompleteeachsentence.

A) Companiesreportassets,liabilities,andequity onthe________________________.

B) Sales,costofgoodssold,andnetincomeare foundonthe______________________.

C) Changesincontributedcapitalduringtheperiod areexplainedonthe_____________________.

D) The______________________reportscash fromfinancingactivities.

Answer: A)2 B)1 C)4 D)3

©Cambridge Business Publishers, 2015

1-16

1. incomestatement

2. balancesheet

3. statementofcashflows

4. statementofshareholders’equity

5. financialstatements

Topic: Income Statement Components LO: 2

3. FillintheblankstocompleteWholeFoods’IncomeStatement($millions).

Topic: Income Statement Components LO: 2

4. FillintheblankstocompleteProcter&Gamble’sIncomeStatement($millions).

Topic: Statement of Cash Flow Components LO: 2

5. FillintheblankstocompleteWholeFood’sStatementofCashFlows($millions).

Topic: Balance Sheet Components LO: 2

6. FillintheblankstocompleteWholeFoods’BalanceSheet($millions).

Topic: Balance Sheet Components LO: 2

7. FillintheblankstocompletetheProcter&GambleBalanceSheet($millions).

Topic: Retained Earnings Reconciliation

LO: 2

8. WholeFoodsreportsthefollowingbalancesinitsstockholders’equityaccounts.Fillintheblanks.

LO: 4

9. Procter&Gamblereportsthefollowingitemsintheirfinancialstatements.Fillintheblanks.

Problems

Topic: Other Financial Information

LO: 1

1. Inadditiontothefourfinancialstatements,listthreesourcesoffinancialinformationavailableto externalstakeholders?

Answer:

Anythreefromthelistbelow

 ManagementDiscussionandAnalysis(MD&A)

 Management’sreportoninternalcontrols

 Annualcorporatereport

 Auditor’sreportandopinion

 Notestofinancialstatements

 Proxystatements

 VariousregulatoryfilingsforSECandIRS,etc.

Topic: Constructing Financial Statements

LO: 2

2. InitsSeptember29,2013annualreport,StarbucksCorporationreportsthefollowingitems.

a. PreparethebalancesheetforStarbucksforSeptember29,2013.

b. PreparetheincomestatementforStarbucksfortheyearendedSeptember29,2013.

c. PreparethestatementofcashflowsforStarbucksfortheyearendedSeptember29,2013.

Test Bank, Module 1

Topic: Constructing Financial Statements

LO: 2

3. InitsDecember31,2013annualreport,Mattel,Inc.reportsthefollowingitems.

a. PreparethebalancesheetforMattel,Inc.forDecember31,2013.

b. PreparetheincomestatementforMattel,Inc.fortheyearendedDecember31,2013.

c. PreparethestatementofcashflowsforMattel,Inc.fortheyearendedDecember31,2013.

1

Topic: Statement of stockholders’ equity from raw data LO: 2

4. InitsDecember31,2013,annualreport,Mattel,Inc.reportsthefollowingitems:

Preparethestatementofstockholders’equityforMattel,Inc.fortheyearendedDecember31,2013. Answer:

Topic: Balance Sheet Relations LO: 2

5. Nike,Inc.hasafiscalyear-endofMay31.OnMay31,2012,Nike,Inc.reported$15,465millionin assetsand$10,381millioninequity. Duringfiscal2013,Nike’sassetsincreasedby$2,119million whileitsequityincreasedby$775million.

WhatwereNike’stotalliabilitiesatMay31,2012,andMay31,2013?

Answer:

Assets=Liabilities+Equity

May31,2012: $15,465=Liabilities+$10,381,Liabilities=$5,084

May31,2013: $15,465+$2,119=Liabilities+$10,381+$775,Liabilities=$6,428.

©Cambridge Business Publishers, 2015

1-24

Topic: Competitive Analysis

LO: 3

6. List three ofthefivecompetitiveforcesthatconfrontthecompanyanddetermineitscompetitive intensity.Brieflyexplaineachforcethatyoulist.

Answer:

Thefollowingarethefiveforcesthatarekeydeterminantsofprofitability:

1) Industrycompetition:Competitionandrivalryraisethecostofdoingbusinessascompaniesmust hireandtraincompetitiveworkers,advertiseproducts,researchanddevelopproducts,andother relatedactivities.

2) Bargainingpowerofbuyers:Buyerswithstrongbargainingpowercanextractpriceconcessions anddemandahigherlevelofserviceanddelayedpaymentterms;thisforcereducesbothprofits fromsalesandtheoperatingcashflowstosellers.

3) Bargainingpowerofsuppliers:Supplierswithstrongbargainingpowercandemandhigherprices andearlierpayments,yieldingadverseeffectsonprofitsandcashflowstobuyers.

4) Threatofsubstitution:Asthenumberofproductsubstitutesincreases,sellershavelesspowerto raisepricesand/orpassoncoststobuyers;accordingly,threatofsubstitutionplacesdownward pressureonprofitsofsellers.

5) Threatofentry:Newmarketentrantsincreasecompetition;tomitigatethatthreat,companies expendmoniesonactivitiessuchasnewtechnologies,promotion,andhumandevelopmentto erectbarrierstoentryandtocreateeconomiesofscale.

Topic: Calculating ROA

LO: 4

7. UseSouthwestAirlines’2013financialstatementinformation,belowtoanswerthefollowing.

a. CalculateSouthwestAirlines’returnonassets(ROA)fortheyearendingDecember31,2013.

b. DisaggregateSouthwestAirlines’ROAintoprofitmargin(PM)andassetturnover(AT). Explain whateachratiomeasures.

Answer:

a. ReturnonAssets=Netincome/Averageassets =$754/[0.5*($18,596+$19,345)]=4.0% Returnonassetsmeasuresprofitabilityofacompany—specifically,howwellacompanyhas employeditsaverageassetsingeneratingnetincome.

b. ProfitMargin=Netincome/Sales =$754/$17,699=4.3% ProfitMarginisanincometosalesratiothatreflectstheprofitabilityofsalesofacompany. SouthwestAirlineshasaprofitmarginof4.3%meaningthecompanyrecords4.3centsofnet income(afterpayingtaxes)foreverydollarofsales.Thisislow–theairlineindustryisperforming somewhatpoorlyin2013.

AssetTurnover=Sales/Averageassets

=$17,699/[0.5*($18,596+$19,345)]=0.93 Assetturnoverreflectstheeffectivenessingeneratingsalesfromassets. SouthwestAirlines’ assetturnoverratioof0.93,meansthatthecompanygenerates$0.93insalesforevery$1.00of assets.

Topic: Calculating ROA and ROE LO: 4

8. Belowareseveralfinancialstatementitemsforfiscalyear2013fortwogrocerychains,WholeFoods Market,anupscaleorganicgrocer,andTheKrogerCo.amainstreamgrocer.($millions)

a. Calculateeachcompany’sreturnonassets(ROA)andreturnonequity(ROE).Commentonany differencesyouobserve.

b. DisaggregatetheROAforeachcompanyintoprofitmargin(PM)andassetturnover(AT).Explain whyWholeFoodshasahigherROA,isitbecauseofPMorATorboth?

Answer:

a. ReturnonAssets=Netincome/Averageassets

WholeFoods=$551/$5,416=10.2% Kroger=$1,508/$24,064=6.3%

Returnonequity=Netincome/Averagestockholders’equity

WholeFoods:=$551/$3,840=14.3%;Kroger=$1,508/$4,090=36.9% WhileWholeFoodshasahigherreturnonassetsthanKroger;Krogerhasahigherreturnon equity.

b. Profitmargin=Netincome/Sales

WholeFoods=$551/$12,917=4.3%;Kroger=$1,508/$96,751=1.6% Assetturnover=Sales/Averageassets

WholeFoods=$12,917/$5,416=2.38;Kroger=$96,751/$24,064=4.02

WholeFoodshasahigherreturnonassetsbecauseitsprofitmarginishigherthatKroger’s. This appearsreasonablesinceWholeFoodsisanupscalegrocer. Kroger’sassetturnoverishigher thanWholeFoodsturnover. ThusKrogerismoreefficient.

©Cambridge Business Publishers, 2015

1-26

Essay Questions

Topic: Costs and Benefits of Disclosure

LO: 1

1. Explainthebenefitsandcostsassociatedwithacompany'sdisclosureofinformation.

Answer:

Supplying information benefits a company by helping it to compete in capital, labor, input, and output markets. A company’s performance hinges on successful business activities and the markets’ awareness of that success. Economic incentives exist for those companies that disclose reliable accountinginformation,especiallywhenthecompanydisclosesgoodnewsaboutproducts,processes, management,etc. Directcosts associated withthedisclosureof informationpertaintoits preparation and dissemination. More significant are other costs including competitive disadvantage, litigation potential, and political costs. Managers must weigh these costs and benefits to determine how much informationtovoluntarilydisclose.

Topic: Demand for Financial Accounting Information

LO: 1

2. List three users of financial accounting information and explain how each might use financial information.

Answer:

Managers and employees – Managers and employees demand financial information on the financial condition, profitability and prospects of their companies for their own well-being and future earnings potential. They also demand comparative financial information on competing companies and other business opportunities. This permits them to conduct comparative analyses to benchmark company performanceandcondition.

Creditors and suppliers –Creditorsandotherlendersdemandfinancialaccountinginformationtohelp decide loan terms, dollar amounts, interest rates and collateral. Suppliers similarly demand financial informationtoestablishcreditsalestermsandtodeterminetheirlong-termcommitmenttosupply-chain relations. Bothcreditorsandsuppliersusefinancialinformationtocontinuouslymonitorandadjusttheir contractsandcommitmentswithadebtorcompany.

Shareholders and directors – Shareholders and directors demand financial accounting information to assess the profitability and risks of companies. Shareholders look for information useful in their investment decisions. Both directors and shareholders use accounting information to evaluate manager performance. Managers similarly use such information to request further compensation and managerialpowerfrom directors. Outsidedirectorsarecrucialtodeterminingwhorunsthecompany, andthesedirectorsuseaccountinginformationtoevaluatemanagerperformance.

Customers and Sales Staffs – Customers and sales staffs demand accounting information to assess the ability of the company to provide products or services as agreed and to assess the company’s staying power and reliability. Customers and sales staffs also wish to estimate the company’s profitabilitytoassessfairnessofreturnsonmutualtransactions.

Regulators and Tax Agencies – Regulators and tax agencies demand accounting information for tax policies, antitrust assessments, public protection, price setting, import-export analyses and various other uses. Timely and reliable information is crucial to effective regulatory policy. Moreover, accountinginformationisoftencentraltosocialandeconomicpolicy.

Voters and their Representatives – Voters and their representatives to national, state and local governments demand accounting information for policy decisions. The decisions can involve economic, social, taxation and other initiatives. Voters and their representatives also use accounting information to monitor government spending. Contributors to nonprofit organizations also demand accountinginformationtoassesstheimpactoftheirdonations.

Topic: Balance Sheet Components LO: 2

3. Whatarethethreebroadgroupsthatmakeupabalancesheet? Listanddefineeach.

Answer:

1. Assets – Investments which are expected to produce revenues, either directly when the asset is soldorindirectly,likeamanufacturingplantthatproducesinventoriesforsaleoracorporateoffice buildingthathouseemployeessupportingrevenue-generatingactivitiesofthecompany.

2. Liabilities – Borrowed funds (accounts payable, accrued liabilities, and obligations to lenders or bondinvestors).

3. Equity – Capital that has been invested by the shareholders, either directly via the purchase of stock (net of any repurchases of stock from its shareholders by the company) or indirectly in the formofretainedearningsthathavebeenreinvestedintothebusinessandnotpaidoutasdividends.

Topic: Owner vs. Nonowner Financing LO: 2

4. Businessesrelyonfinancingactivitiestofundtheir operatingandinvestments. Explainthedifference between owner and nonowner financing, and explain the benefits and risks involved in relying more heavilyoneachtypeoffinancing.

Answer:

Ownerfinancing,alsocalledequity,referstomoneygiventothebusinessinexchangeforpartialcontrol of the company. Stocks are the most common form of owner financing. Companies are not obligated toguaranteeareturnonownerinvestments.However,ifreturnsareunacceptabletoowners,theymay usetheirpowertotakethebusinessindifferentdirections.Insum,ownerfinancingprovidescashinflow to the company without any guarantee of repayment. Control over the company is vested in the shareholders.

Nonowner financing refers to money given to the business in exchange for a guaranteed repayment, usually with interest. Loans and bonds are verycommon examples of nonowner investment. The risk tothecompanylies inpotentialdefaultifoperationsdecline.Thebenefitisthatthecompanydoesnot needtocedeoperationalcontroltoitscreditors,unlessitdefaultsonitsrepayment.Insum,nonowner financingallowsthecurrentownerstomaintainfullcontrolofthecompany,butrequiresrepaymentwith interest.

Companies that rely more heavily on owner financing are said to be financed conservatively. Companiesthatrelymoreheavilyonnonownerfinancingaresaidtobefinancedlessconservatively.

Topic: Usefulness of ROA for Managers

LO: 4

5. Investorsandlendersplacesignificantimportanceonmanagement’seffectivenessingeneratingahigh return on assets (ROA). Explain how ROA is also important for managers’ analysis of its own performance,particularlywhenROAisdisaggregated

Answer:

Returnonassets (ROA) is ahelpfulmeasureof acompany’s profitability.In itsmostbasic form,ROA is a ratio between net income and average assets, i.e. it indicates the return the company is earning from its assets. While ROA is a valuable indicator for investors, it is just as valuable for company managers. This is because ROA indicates how successful managers are in acquiring and using investmentsonbehalfofshareholders.ROAisparticularlyusefulformanagerswhenitisdisaggregated intomorefocused,meaningfulcomponents.

Returnonassetscanbedisaggregatedintoprofitmargin(PM),whichmeasuresprofitabilityandasset turnover(AT),whichmeasuresefficiencyorproductivity.

Theratioofnetincometosalesiscalledprofitmarginandtheratioofsalestoaverageassetsiscalled asset turnover. The profit component reflects the amount of profit from each dollar of sales, and the productivitycomponentreflectstheeffectivenessingeneratingsalesfromassets. ThisdisaggregationyieldsadditionalinsightsintothefactorsthatcauseoverallROAtochangeduring the year. It could be that the company is more or less profitable or that the company is more or less efficient or both. This disaggregation provides more information than just knowing that ROA has increasedordecreasedduringtheyear.