ADMS 2500 Chapter Notes -Inventory Turnover, Cae Inc., Business Communication

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Financial Statement Analysis Practice Problems Solutions
PROBLEM 1 – MULTIPLE CHOICE
1. d
Explanation:
Note: Keep the balance sheet equation in mind when doing these types of problems.
Assets = Liabilities + Equity
a) Collects accounts receivable - Has no affect on ratio, because a current asset increases
(cash) and a current asset decreases (accounts receivable) by the same amount, so no
affect on equity and the debt/equity ratio.
Assets = Liabilities + Equity
Equity = Assets - Liabilities
Equity = Assets (and by the same amount) – Liabilities
So no change in the equation and no affect on the ratio
b) Borrows cash giving a short-term note payable Will not change the ratio, because
borrowing cash will increase current assets and current liabilities by the same amount, thus
no affect on equity or long-term liabilities.
Equity = Assets - Liabilities
Equity = Assets (by the same amount as liabilities) – Liabilities (by the same amount as assets)
So no change in equity, but and increase in total debt causes an increase in the ratio
c) Purchases land for cash – Has no affect on ratio, because an asset increases (land) and
an asset decreases (cash) by the same amount, so no affect on equity and the debt/equity ratio.
Assets = Liabilities + Equity
Equity = Assets - Liabilities
Equity = Assets (and by the same amount) – Liabilities
So no change in the equation and no affect on the ratio
d) Issues stock for cash – Will decrease the ratio, because issuing stock will increase an
asset (cash) and increase and equity account (stock). This has no affect on total debt, but
increases equity, thus causing a decrease in the debt/equity ratio.
Equity = Assets - Liabilities
Equity (by the same amount as assets) = Assets (by the same amount as equity) – Liabilities
So increase in equity, but and no increase in total debt causes an decrease in the ratio
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2. e
Explanation: See explanation above.
3. b
Explanation:
a) declaring a cash dividend – Will decrease the ratio, because declaring a dividend will
increase a current liability (dividend payable) and decrease and equity account (retained
earnings). This has no affect on current assets, thus causing a decrease in the current ratio.
b) issuing long-term debt - Will increase the ratio, because a current asset increases (cash)
with no affect on current liabilities, thus causing a increase in the current ratio.
c) making a mortgage payment – Will decrease the ratio, because a current asset (cash) and
a long-term liability (mortgage) decreases, with no affect on current liabilities, thus causing a
increase in the current ratio.
d) collecting an accounts receivable - Has no affect on ratio, because a current asset
increases (cash) and an current asset decrease (accounts receivable) by the same amount, so
no affect on the current ratio.
4. c
Explanation: The issuing of shares for cash and repaying half of the mortgage has no affect
on average assets. This is because issuing shares increases assets, but using the cash
received from issuing the shares to repay a portion of the mortgage decrease assets by the
same amount, thus having no affect on average assets. Since EBITA is a earnings
performance measure that ignores interest, EBITA will also be unchanged and the ratio
EBITA/average assets will remain unchanged.
5. c
Explanation:
a) would not maximize the return to shareholders, as no return would be seen for 2 years.
b) would dilute the shareholders return.
c) would maximize the return to shareholders, as it has a minimal affect (assuming low interest
rate on the borrowed funds).
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