CHAPTER 11

ANALYSIS OF FINANCIAL STATEMENTS

OVERVIEW

Financial statement analysis involves a statement analysis to evaluate the attractiveness

comparison of a firm’s performance with that of the firm as an investment by examining its
of other firms in the same line of business. ability to meet its current and expected future
Financial analysis identifies a firm’s relative financial obligations.
strengths and weaknesses and suggests actions Financial statement analysis involves a
the firm might enact to take advantage of its study of the relationships between income
strengths and correct its weaknesses in the statement and balance sheet accounts, how
future. Financial statement analysis is not only these relationships change over time (or trend
important for the firm’s managers, it also is analysis), and how a particular firm compares
important for the firm’s investors and creditors. with other firms in its industry (comparative
Internally, financial managers use the ratio analysis or benchmarking). Although
information provided by financial analysis to financial statement analysis has limitations,
help make financing and investment decisions when used with care and judgment, it can
to maximize the firm’s value. Externally, provide some very useful insights into the
stockholders and creditors use financial operations of a company.

OUTLINE
A firm’s annual report to shareholders presents two important types of information. The
first is a verbal statement of the company’s recent operations and its expectations for the
coming year. The second is a set of quantitative financial statements that report what
actually happened to the firm’s financial position, earnings, and dividends over the past few
years. The information contained in an annual report is used by investors to form
expectations about future earnings and dividends.

 The income statement, often referred to as the profit and loss statement, summarizes the
firm’s revenues and expenses during the accounting period. Earnings per share (EPS) is
called “the bottom line,” denoting that of all the items on the income statement, EPS is the
most important.
 It is important to remember that not all of the amounts shown on the income statement
represent cash flows. Revenues are recognized when they are earned, not when the cash
is received, and expenses are realized when they are incurred, not when the cash is paid.
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 The balance sheet lists the firm’s assets and the claims against those assets. It portrays the
firm’s financial position at a specific point in time.
 Assets, found on the left-hand side of the balance sheet, are typically shown in the order
of their liquidity, or the length of time it typically takes to convert them to cash.
Claims, found on the right-hand side, are generally listed in the order in which they
must be paid.
 Only cash represents actual money. Noncash assets should produce cash flows
eventually, but they do not represent cash in hand, and the amount of cash they would
bring if they were sold today could be higher or lower than the values at which they are
carried on the books.
 Claims against the assets consist of liabilities and common stockholders’ equity, or net
worth, a residual representing the amount stockholders would receive if both assets
could be sold and liabilities paid at book values. Thus, Assets – Liabilities =
Stockholders’ equity.
 The risk of asset value fluctuations is borne by the stockholders.
 Most financial analysts combine preferred stock with debt when evaluating a firm’s
financial position, because the preferred dividend is considered a fixed obligation of the
firm.
 The common equity section of the balance sheet is divided into three accounts:
common stock, paid-in capital, and retained earnings.
 Retained earnings are built up over time as the firm reinvests a part of its earnings
rather than paying all earnings out as dividends.
 Common stock and paid-in capital accounts arise from the issuance of stock to raise
capital.
 The breakdown of the common equity accounts shows whether the company
actually earned the funds reported in its equity accounts or whether the funds came
mainly from selling stock.
 Not every firm uses the same method to determine the account balances shown on the
balance sheet. Thus, users of financial statements must be aware that more than one
accounting alternative is available for constructing financial statements.
 The balance sheet may be thought of as a snapshot of the firm’s financial position at a
point in time (for example, at the end of the year), while the income statement reports
on operations over a period of time (for example, one calendar year).

 The statement of retained earnings reports changes in the common equity accounts
between balance sheet dates.
 The balance sheet account “Retained earnings” represents a claim against assets, not
assets per se.
 Retained earnings as reported on the balance sheet do not represent cash and are not
“available” for the payment of dividends or anything else. Retained earnings represent
funds that have already been reinvested in operating assets of the firm.
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 In finance the emphasis is on the cash flows that the company is expected to generate. The
firm’s net income is important, but cash flows are even more important because dividends
must be paid in cash, and cash is also necessary to pay the firm’s obligations and to
purchase the assets required to continue operations.
 A firm’s cash flows include cash receipts and cash disbursements.
 Depreciation results because we want to match revenues and expenses to compute a
firm’s income, not because we want to match cash inflows and cash outflows.
Depreciation is a noncash charge used to calculate net income, so if net income is used
to obtain an estimate of the net cash flow from operations, depreciation must be added
back to net income.
 A stock’s value is based on the cash flows that investors expect it to provide in the future.
The cash flows provided by the stock itself are the expected future dividends stream, and
that expected dividends stream provides the fundamental basis for the stock’s value.
 Because dividends are paid in cash, a company’s ability to pay dividends depends on its
cash flows, which are generally related to accounting profit, or net income reported on
the income statement.
 The ability to take advantage of growth opportunities often depends on the availability
of the cash needed to buy new assets, and the cash flows from existing assets are often
the primary source of the funds used to make profitable new investments.
 There are two classes of cash flows:
 Operating cash flows arise from normal operations, and they are the difference
between cash collections and cash expenses, including taxes paid.
 Other cash flows arise from borrowing, from the sale of fixed assets, or from the
issuance or repurchase of common stock.

 The statement of cash flows reports the impact of a firm’s operating, investing, and
financing activities on cash flows over an accounting period.
 Net income plus depreciation is the primary operating cash flow.
 In order to adjust the estimate of cash flows obtained from the income statement and to
account for cash flows not reflected in the income statement, one needs to examine the
impact of changes in the balance sheet accounts during the year.
 Sources of cash include an increase in a liability or equity account or a decrease in
an asset account.
 Uses of cash include a decrease in a liability or equity account or an increase in an
asset account.
 Each balance sheet change is classified as resulting from operations (those activities
associated with the production and sale of goods and services), long-term investments
(cash flows arising from the purchase or sale of plant, property, and equipment), or
financing activities (cash flows arising from debt and/or common stock).
 The cash inflows and outflows from these three activities are summed to determine
their impact on the firm’s liquidity position, which is measured by the change in the
cash and marketable securities accounts.
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Financial statements are used to help predict a firm’s future financial position and to
determine expected earnings and dividends. From an investor’s standpoint, predicting the
future is what financial statement analysis is all about. From management’s standpoint,
financial statement analysis is useful both as a way to anticipate future conditions and, more
importantly, as a starting point for planning actions that will influence the future course of
events. An analysis of the firm’s ratios is the first step in a financial analysis. Ratios are
designed to show relationships between financial statement accounts within firms and
between firms.

 A liquid asset can be easily converted to cash without significant loss of its original value.
Converting assets, especially current assets such as inventory and receivables, to cash is the
primary means by which a firm obtains funds needed to pay its current bills.
 Therefore, a firm’s “liquid position” deals with the question of how well the firm is
able to meet its current obligations.

 Liquidity ratios are used to measure a firm’s ability to meet its current obligations as they
come due.
 The current ratio indicates the extent to which the claims of short-term creditors are
covered by short-term assets. It is determined by dividing current assets by current
liabilities.
 The current ratio is the most commonly used measure of short-term solvency.
 The quick, or acid test, ratio is calculated by deducting inventories from current assets
and then dividing the remainder by current liabilities.
 Inventories are excluded because it may be difficult to liquidate them at their full
book value.
 The quick ratio is a variation of the current ratio.
 Asset management ratios measure how effectively a firm is managing its assets and
whether or not the level of those assets is properly related to the level of operations as
measured by sales.
 The inventory turnover ratio is defined as cost of goods sold divided by inventories. It
is often necessary to use the average inventory figure rather than the year-end figure,
especially if a firm’s business is highly seasonal or if there has been a strong upward or
downward sales trend during the year.
 The days sales outstanding (DSO) is used to evaluate the firm’s ability to collect its
credit sales in a timely manner. It is calculated by dividing average daily sales into
accounts receivable to find the number of days’ sales tied up in receivables. Thus, the
DSO represents the average length of time that the firm must wait after making a sale
before receiving cash, which is the average collection period.
 The DSO can also be evaluated by comparison with the terms on which the firm
sells its goods.
 The fixed assets turnover ratio is the ratio of sales to net fixed assets. It measures how
effectively the firm uses its plant and equipment to generate sales.
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 The total assets turnover ratio is calculated by dividing sales by total assets. It
measures the turnover of all the firm’s assets.

 Debt management ratios measure the extent to which a firm is using debt financing, or
financial leverage, and the degree of safety afforded to creditors. Decisions about the use
of debt require firms to balance higher expected returns against increased risk.
 The debt ratio, or ratio of total debt to total assets, measures the percentage of the
firm’s assets financed by creditors.
 The lower the ratio, the greater the protection afforded creditors in the event of
liquidation.
 The owners can benefit from leverage because it magnifies earnings, thus the return
to stockholders. Too much debt often leads to financial difficulty, which eventually
might cause bankruptcy.
 The times-interest-earned (TIE) ratio is determined by dividing earnings before interest
and taxes (EBIT) by interest charges. The TIE measures the extent to which operating
income can decline before the firm is unable to meet its annual interest costs.
 Failure to meet its interest obligation can bring legal action by the firm’s creditors,
possibly resulting in bankruptcy.
 EBIT is used in the numerator. Because interest is paid with pretax dollars, the
firm’s ability to pay current interest is not affected by taxes.
 The fixed charge coverage ratio is similar to the TIE ratio, but it is more inclusive
because it recognizes that many firms lease assets and have debt sinking fund
payments.
 In the numerator of the fixed charge coverage ratio, the lease payments are added to
EBIT because we want to determine the firm’s ability to cover its fixed charges
from the income generated before any fixed charges are deducted.

 Profitability is the net result of a number of policies and decisions. Profitability ratios
show the combined effects of liquidity, asset management, and debt management on
operating results.
 The net profit margin on sales is calculated by dividing net income by sales, and it
gives the profit per dollar of sales.
 The operating profit margin is the ratio of EBIT (operating income) to sales.
 The return on total assets (ROA) is the ratio of net income to total assets; it provides an
idea of the overall return on investments earned by the firm.
 The return on common equity (ROE) measures the rate of return on common
stockholders’ investment. It is equal to net income divided by common equity.

 Market value ratios relate the firm’s stock price to its earnings and book value per share,
and thus give management an indication of what investors think of the company’s past
performance and future prospects. If the firm’s liquidity, asset management, debt
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management, and profitability ratios are all good, then its market value ratios will be high,
and its stock price will probably be as high as can be expected.
 The price/earnings (P/E) ratio, or market price per share divided by earnings per share,
shows how much investors are willing to pay per dollar of reported profits. Other things
held constant, P/E ratios are higher for firms with high growth prospects, but they are
lower for riskier firms.
 The market/book (M/B) ratio, defined as market price per share divided by book value
per share, gives another indication of how investors regard the company. Higher M/B
ratios are generally associated with firms that have a high rate of return on common
equity.

It is important to analyze trends in ratios as well as their absolute levels. Trend analysis can
provide clues as to whether the firm’s financial situation is improving or deteriorating
relative to past performance.

 A simple approach to trend analysis is to construct graphs containing both the firm’s ratios
and the industry averages for the past 5 years. Using this approach, we can examine both
the direction of the movement in, and the relationships between, the firm’s ratios and the
industry averages.

A modified Du Pont chart shows the relationships among return on investment, assets
turnover, net profit margin, and leverage.

 The left side of the chart develops the profit margin on sales. The right side lists the
various categories of assets, totals them, and then divides sales by total assets to find the
total assets turnover ratio.

 Net profit margin times total assets turnover is called the Du Pont equation. This equation
gives the rate of return on assets (ROA): ROA = Net profit margin  Total assets turnover.

 The extended Du Pont equation uses the relationship between ROA and ROE to derive:
ROE = Net profit margin  Total assets turnover  Equity multiplier.

 The firm can use the Du Pont system to analyze ways of improving the firm’s performance.

Comparative ratio analysis (benchmarking) is useful in comparing a firm’s ratios with those
of other firms in the same industry. Sources for such ratios include Dun & Bradstreet,
Robert Morris Associates, the U.S. Commerce Department, and trade associations.

 When you select a comparative data source, you should be sure that your emphasis is
similar to that of the agency whose ratios you plan to use.
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 Additionally, there are often definitional differences in the ratios presented by different
sources, so before using a source, be sure to verify the exact definitions of the ratios to
ensure consistency with your work.

There are some inherent problems and limitations to ratio analysis that necessitate care and
judgment.

 Ratios are often not useful for analyzing the operations of large firms that operate in many
different industries because comparative ratios are not meaningful.

 The use of industry averages may not provide a very challenging target for high-level
performance.

 Inflation might distort firms’ balance sheets. For this reason, the analysis of a firm over
time, or a comparative analysis of firms of different ages, can be misleading.

 Ratios may be distorted by seasonal factors, or manipulated by management to give the

impression of a sound financial condition (“window dressing”).

 Different accounting practices can distort comparisons.

 Many ratios can be interpreted in different ways, and whether a particular ratio is good or
bad should be based upon a complete financial statement analysis rather than the level of a
single ratio at a single point in time.

The Federal Tax Code is separated into two sections: (1) Tax laws that are applicable to
individuals, and (2) tax laws that are applicable to corporations. Businesses that are not
incorporated are subject to the individual tax code. Because of the magnitude of the tax bite,
taxes play an important role in many financial decisions, and business managers and
investors usually rely on tax specialists. Individuals pay taxes on wages and salaries, on
investment income (dividends, interest, and profits from the sale of securities), and on the
profits of proprietorships and partnerships.

 U.S. income taxes are progressive; that is, the higher one’s income, the larger the
percentage paid in taxes. Marginal tax rates begin at 10 percent and range to 35 percent.
 Taxable income is defined as gross income less a set of exemptions and deductions that
are spelled out in the instructions to the tax forms individuals must file.
 The marginal tax rate is the tax on the last unit of income.
 The average tax rate equals taxes paid divided by taxable income.

 Interest on most state and local government securities, which are called municipals, or
“munis,” is not subject to federal income taxes. This creates a strong incentive for
individuals in high tax brackets to purchase these securities.
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 Thus, a lower-yielding muni can provide the same after-tax return as a higher-yielding
corporate bond.
Equivalent pretax yield Yield on tax -free investment
on a taxable investment = 1  Marginal tax rate
.

 The exemption from federal taxes stems from the separation of federal and state
powers, and its primary effect is to help state and local governments borrow at
lower rates than otherwise would be available to them.

 Prior to 2003, dividend income was taxed like ordinary income. Now, the rate at which
dividends are taxed is either 5 or 15 percent, depending on the individual’s marginal tax
rate.

 For the most part, the interest paid by individuals on loans is not tax deductible. The
principal exception to this is the interest paid on mortgage financing used to purchase a
home for personal residence, which is tax deductible.
 The effect of tax-deductible interest payments is to lower the actual cost of the
mortgage to the taxpayer.

 Gains and losses on the sale of capital assets such as stocks, bonds, and real estate have
historically received special tax treatment.
 A capital asset sold within one year of the time it was purchased produces a short-term
capital gain or loss, whereas one held for at least one year produces a long-term capital
gain or loss.
 The tax rate applied to capital gains for assets held less than one year is the taxpayer’s
marginal tax rate, and it is 15 percent for assets held longer than one year (5 percent if
the individual’s marginal tax rate is below 25 percent).

 Individuals pay taxes on the income generated by proprietorships and partnerships they
own—the income passes through to the owners of these types of businesses.
 Business expenses are tax deductible, while personal expenses are not.
 An allowable business expense is a cost incurred to generate business revenues, while
an expense incurred for personal benefit is considered a personal expense.

Corporations pay taxes on profits.

 Corporate tax rates are also progressive. Marginal tax rates range from 15 to nearly 40
percent.

 Interest and dividend income received by a corporation are taxed.

 Interest is taxed as ordinary income at regular corporate tax rates.
 However, 70 percent of the dividends received by one corporation from another is
excluded from taxable income. The remaining 30 percent is taxed at the ordinary rate.
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Thus, the effective tax rate on dividends received by a 35 percent marginal tax bracket
corporation is 0.30(35%) = 10.5%.

 Our tax system favors debt financing over equity financing.

 Interest paid is a tax-deductible business expense.
 Dividends on common and preferred stock are not deductible. Thus, a 35 percent
marginal tax bracket corporation must earn $1/(1.0 – 0.35) = $1/0.65 = $1.54 before
taxes to pay $1 of dividends, but only $1 of pretax income is required to pay $1 of
interest.

 Before 1987, long-term corporate capital gains were taxed at lower rates than ordinary
income. Under current law, however, corporations’ capital gains are taxed as operating
income.

 Ordinary corporate operating losses can be carried back (carryback) to each of the
preceding 2 years and carried over (carryover) for the next 20 years to offset taxable
income in those years. The purpose of permitting this loss treatment is to avoid penalizing
corporations whose incomes fluctuate substantially from year to year.

 The Internal Revenue Code imposes a penalty on corporations that retain earnings if the
purpose of the improper accumulation is to enable stockholders to avoid personal income
tax on dividends.
 A cumulative total of $250,000 of retained earnings is by law exempted from the
accumulated earnings tax for most corporations. This is a benefit primarily to small
corporations.
 The improper accumulation penalty applies only if the retained earnings in excess of
$250,000 are shown to be unnecessary to meet the reasonable needs of the business.

 If a corporation owns 80 percent or more of another corporation’s stock, it can aggregate

income and file a consolidated tax return. Thus, losses of one company can offset profits
of another.
 Tax offsets make it more feasible for large, multidivisional corporations to undertake
risky new ventures or ventures that will suffer losses during a developmental period
and profits thereafter.

 Small businesses that meet certain restrictions may be set up as S corporations that receive
benefits of the corporate form of organization—especially limited liability—yet are taxed
as proprietorships or partnerships rather than as corporations. This treatment would be
preferred by owners of small corporations in which all or most of the income earned each
year is distributed as dividends because the income would be taxed only once at the
individual level.
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10

 Depreciation plays an important role in income tax calculations, as the Tax Code specifies
the life over which assets can be depreciated for tax purposes and the methods of
depreciation that can be used.

Appendix 11A provides the 2003 individual and corporate tax rate schedules.

SELF-TEST QUESTIONS

Definitional

1. Of all its communications with shareholders, a firm’s ________ report is generally the
most important.

2. The income statement reports the results of operations during the past year, the most
important item being __________ _____ _______.

3. The _________ _______ lists the firm’s assets as well as claims against those assets.

4. Typically, assets are listed in order of their ___________, while liabilities are listed in the
order in which they must be paid.

5. Assets – Liabilities = _____ worth, or _______________ equity.

6. The three accounts that normally make up the common equity section of the balance sheet
are common stock, ______-____ capital, and __________ __________.

7. __________ __________ as reported on the balance sheet represent income earned by the
firm in past years that has not been paid out as dividends.

8. Retained earnings are generally reinvested in ___________ ________ and are not held in
the form of cash.

9. In finance the emphasis is on the ______ _______ that the company is expected to
generate.

10. Depreciation is a(n) _________ charge used to calculate net income, so if net income is
used to obtain an estimate of the net cash flow from operations, depreciation must be added
back to net income.

11. ___________ ______ _______ arise from normal operations, and they are the difference
between cash collections and cash expenses, including taxes paid.
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12. The statement of cash flows reports the impact of a firm’s ___________, ___________,
and ___________ activities on cash flows over an accounting period.

13. The current and acid-test ratios are examples of ___________ ratios. They measure a
firm’s ability to meet its _________ obligations as they come due.

14. The days sales outstanding (DSO) ratio is found by dividing average sales per day into
accounts ____________. The DSO is the length of time that a firm must wait after making
a sale before it receives ______, which is the _________ ____________ ________.

15. Debt management ratios are used to evaluate a firm’s use of financial __________.

16. The debt ratio, which is the ratio of total ______ to total ________, measures the
percentage of the firm’s assets financed by creditors. The _______ the ratio, the greater the
protection afforded creditors in the event of liquidation.

17. The _______-__________-________ ratio, calculated by dividing earnings before interest

and taxes by the amount of interest charges, measures the extent to which operating income
can decline before the firm is unable to meet its annual interest costs.

18. The combined effects of liquidity, asset management, and debt management on operating
results are measured by _______________ ratios.

19. Dividing net income by sales gives the _____ ________ ________ on sales.

20. The ________ ____ _______ ________ provides an idea of the overall return on
investments earned by the firm.

21. The ________ ____ ________ ________ measures the rate of return on common
stockholders’ investment.

22. The _______/__________ ratio measures how much investors are willing to pay for each
dollar of a firm’s current income.

23. Firms with higher rates of return on stockholders’ equity tend to sell at relatively high
ratios of ________ price to ______ value.

24. Individual ratios are of little value in analyzing a company’s financial condition. More
important are the _______ of a ratio over time and the comparison of the company’s ratios
to __________ average ratios.

25. A modified ____ ______ chart shows the relationships among return on investment, assets
turnover, net profit margin, and leverage.
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26. Return on assets is a function of two variables, _____ ________ ________ and _______
________ turnover.

27. Analyzing a particular ratio over time for an individual firm is known as _______ analysis.

28. A(n) _____________ tax system is one in which tax rates are higher at higher levels of
income.

29. Interest received on ___________ bonds is generally not subject to federal income taxes.
This feature makes them particularly attractive to investors in ______ tax brackets.

30. In order to qualify as a long-term capital gain or loss, an asset must be held for at least ____
months.

31. Gains or losses on capital assets held less than one year are referred to as _______-______
transactions.

32. Interest income received by a corporation is taxed as __________ income. However, only
____ percent of dividends received from another corporation is subject to taxation.

33. Another important distinction exists between interest and dividends paid by a corporation.
Interest payments are _____ ____________, while dividend payments are not.

34. Ordinary corporate operating losses can first be carried back ___ years and then carried
over ____ years.

35. A firm that refuses to pay dividends in order to help stockholders avoid personal income
taxes may be subject to a penalty for __________ ______________ of earnings.

36. A corporation that owns 80 percent or more of another corporation’s stock may choose to
file ______________ tax returns.

37. The Tax Code permits a corporation (that meets certain restrictions) to be taxed at the
owners’ personal tax rates and to avoid the impact of ________ taxation of dividends. This
type of corporation is called a(n) ___ corporation.

Conceptual

38. A high quick ratio is always a good indication of a well-managed liquidity position.

a. True b. False
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39. The fact that 70 percent of intercorporate dividends received by a corporation is excluded
from taxable income has encouraged debt financing over equity financing.

a. True b. False

40. International Appliances Inc. has a current ratio of 0.5. Which of the following actions
would improve (increase) this ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Sell some of the existing inventory at cost.

41. Refer to Self-Test Question 40. Assume that International Appliances has a current ratio of
1.2. Now, which of the following actions would improve (increase) this ratio?

a. Use cash to pay off current liabilities.

b. Collect some of the current accounts receivable.
c. Use cash to pay off some long-term debt.
d. Purchase additional inventory on credit (accounts payable).
e. Use cash to pay for some fixed assets.

42. Examining the ratios of a particular firm against the same measures for a group of firms
from the same industry, at a point in time, is an example of

a. Trend analysis.
b. Comparative ratio analysis.
c. Du Pont analysis.
d. Simple ratio analysis.
e. Industry analysis.
43. Which of the following statements is correct?

a. Having a high current ratio and a high quick ratio is always a good indication that a
firm is managing its liquidity position well.
b. A decline in the inventory turnover ratio suggests that the firm’s liquidity position is
improving.
c. If a firm’s times-interest-earned ratio is relatively high, then this is one indication that
the firm should be able to meet its debt obligations.
d. Since ROA measures the firm’s effective utilization of assets (without considering how
these assets are financed), two firms with the same EBIT must have the same ROA.
e. If, through specific managerial actions, a firm has been able to increase its ROA, then,
because of the fixed mathematical relationship between ROA and ROE, it must also
have increased its ROE.

44. Which of the following statements is correct?

a. Suppose two firms with the same amount of assets pay the same interest rate on their
debt and earn the same rates of return on their assets and that their ROAs are positive.
However, one firm has a higher debt ratio. Under these conditions, the firm with the
higher debt ratio will also have a higher rate of return on common equity.
b. One of the problems of ratio analysis is that the relationships are subject to
manipulation. For example, we know that if we use some cash to pay off some of our
current liabilities, the current ratio will always increase, especially if the current ratio is
weak initially, for example, below 1.0.
c. Generally, firms with high net profit margins have high asset turnover ratios and firms
with low net profit margins have low turnover ratios; this result is exactly as predicted
by the extended Du Pont equation.
d. Firms A and B have identical earnings and identical dividend payout ratios. If Firm
A’s growth rate is higher than Firm B’s, then Firm A’s P/E ratio must be greater than
Firm B’s P/E ratio.
e. Each of the above statements is false.

45. An individual with substantial personal wealth and income is considering the possibility of
opening a new business. The business will have a relatively high degree of risk, and losses
may be incurred for the first several years. Which legal form of business organization
would probably be best?

a. Proprietorship d. S corporation
b. Corporation e. Limited partnership
c. Partnership
SELF-TEST PROBLEMS

(The following financial statements apply to the next six problems.)

Roberts Manufacturing Balance Sheet

December 31, 2005
(Dollars in Thousands)

Cash $ 200 Accounts payable $ 205

Receivables 245 Notes payable 425
Inventory 625 Other current liabilities 115
Total current assets $1,070 Total current liabilities $ 745
Net fixed assets 1,200 Long-term debt 420
Common equity 1,105
Total assets $2,270 Total liabilities and equity $2,270

Roberts Manufacturing
Income Statement for Year Ended December 31, 2005
(Dollars in Thousands)

Sales $2,400
Cost of goods sold:
Materials $1,000
Labor 600
Heat, light, and power 89
Indirect labor 65
Depreciation 80 1,834
Gross profit $ 566
Selling expenses 175
General and administrative expenses 216
Earnings before interest and taxes (EBIT) $ 175
Less interest expense 35
Earnings before taxes (EBT) $ 140
Less taxes (40%) 56
Net income (NI) $ 84

1. Calculate the liquidity ratios, that is, the current ratio and the quick ratio.

a. 1.20; 0.60 b. 1.20; 0.80 c. 1.44; 0.60 d. 1.44; 0.80 e. 1.60; 0.60
 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
221

2. Calculate the asset management ratios, that is, the inventory turnover ratio, fixed assets
turnover, total assets turnover, and days sales outstanding.

a. 2.93; 2.00; 1.06; 36.75 days d. 2.93; 2.00; 1.24; 34.10 days
b. 2.93; 2.00; 1.06; 35.25 days e. 2.93; 2.20; 1.48; 34.10 days
c. 2.93; 2.00; 1.06; 34.10 days

3. Calculate the debt management ratios, that is, the debt and times-interest-earned ratios.

a. 0.39; 3.16 b. 0.39; 5.00 c. 0.51; 3.16 d. 0.51; 5.00 e. 0.73; 3.16

4. Calculate the profitability ratios, that is, the net profit margin on sales, return on total
assets, and return on common equity.

a. 3.50%; 4.25%; 7.60% d. 3.70%; 3.50%; 8.00%

b. 3.50%; 3.70%; 7.60% e. 4.25%; 3.70%; 7.60%
c. 3.70%; 3.50%; 7.60%

5. Calculate the market value ratios, that is, the price/earnings ratio and the market/book value
ratio. Roberts had an average of 10,000 shares outstanding during 2005, and the stock
price on December 31, 2005, was $40.00.

a. 4.21; 0.36 b. 3.20; 1.54 c. 3.20; 0.36 d. 4.76; 1.54 e. 4.76; 0.36

6. Use the Du Pont equation to determine Roberts’ return on assets.

a. 7.6% b. 7.9% c. 6.2% d. 3.7% e. 4.5%

7. Lewis Inc. has sales of $2 million per year, all of which are credit sales. Its days sales
outstanding is 42 days. What is its average accounts receivable balance?

a. $233,333 b. $266,667 c. $333,333 d. $350,000 e. $366,667

8. Southeast Jewelers Inc. sells only on credit. Its days sales outstanding is 60 days, and its
average accounts receivable balance is $500,000. What are its sales for the year?

a. $1,500,000 b. $3,000,000 c. $2,000,000 d. 2,750,000 e. $3,225,000

9. A firm has total interest charges of $20,000 per year, sales of $2 million, a tax rate of 40
percent, and a net profit margin of 6 percent. What is the firm’s times-interest-earned
ratio?

a. 10 b. 11 c. 12 d. 13 e. 14
10. Refer to Self-Test Problem 9. What is the firm’s TIE, if its net profit margin decreases to 3
percent and its interest charges double to $40,000 per year?

a. 3.0 b. 2.5 c. 3.5 d. 4.2 e. 3.7

11. A fire has destroyed many of the financial records at Anderson Associates. You are
assigned to piece together information to prepare a financial report. You have found that
the firm’s return on equity is 12 percent and its debt ratio is 0.40. What is its return on
assets?

a. 4.90% b. 5.35% c. 6.60% d. 7.20% e. 8.40%

12. Rowe and Company has a debt ratio of 0.50, a total assets turnover of 0.25, and a net profit
margin of 10 percent. The president is unhappy with the current return on assets, and he
thinks it could be doubled. This could be accomplished (1) by increasing the net profit
margin to 14 percent and (2) by increasing asset utilization (turnover). What new total
assets turnover ratio, along with the 14 percent net profit margin, is required to double the
return on assets?

a. 0.50 b. 0.18 c. 0.36 d. 0.70 e. 0.62

13. Altman Corporation has $1,000,000 of debt outstanding, and it pays an interest rate of 12
percent annually. Altman’s annual sales are $4 million, its marginal tax rate is 25 percent,
and its net profit margin on sales is 10 percent. If the company does not maintain a TIE
ratio of at least 5 times, its bank will refuse to renew the loan, and bankruptcy will result.
What is Altman’s TIE ratio?

a. 3.33 b. 4.44 c. 2.50 d. 4.00 e. 5.44

14. Refer to Self-Test Problem 13. What is the maximum amount Altman’s EBIT could
decrease and its bank still renew its loan?

a. $53,333 b. $45,432 c. $66,767 d. $47,898 e. $57,769

15. Pinkerton Packaging’s ROE last year was 2.5 percent, but its management has developed a
new operating plan designed to improve things. The new plan calls for a total debt ratio of
50 percent, which will result in interest charges of $240 per year. Management projects an
EBIT of $800 on sales of $8,000, and it expects to have a total assets turnover ratio of 1.6.
Under these conditions, the marginal tax rate will be 40 percent. If the changes are made,
what return on assets will Pinkerton earn?

a. 6.25% b. 6.72% c. 6.50% d. 7.01% e. 7.28%

 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
223

(The following financial statements apply to the next three problems.)

Baker Corporation Balance Sheet

December 31, 2005

Cash and marketable securities $ 50 Accounts payable $ 250

Accounts receivable 200 Accruals 250
Inventory 250 Notes payable 500
Total current assets $ 500 Total current liabilities $1,000
Net fixed assets 1,500 Long-term debt 250
Common stock 400
Retained earnings 350
Total assets $2,000 Total liabilities and equity $2,000

16. What is Baker Corporation’s current ratio as of December 31, 2005?

a. 0.35 b. 0.65 c. 0.50 d. 0.25 e. 0.75

17. If Baker uses $50 of cash to pay off $50 of its accounts payable, what is its new current
ratio after this action?

a. 0.47 b. 0.44 c. 0.54 d. 0.33 e. 0.62

18. If Baker uses its $50 cash balance to pay off $50 of its long-term debt, what will be its new
current ratio?

a. 0.35 b. 0.50 c. 0.55 d. 0.60 e. 0.45

(The following financial statements apply to the next problem.)

Whitney Inc. Balance Sheet

December 31, 2005

Total current liabilities $100

Long-term debt 250
Common stockholders’ equity 400
Total assets $750 Total liabilities and equity $750
 Whitney Inc. Income Statement
for Year Ended December 31, 2005

Sales $1,000
Cost of goods sold (excluding depreciation) $550
Other operating expenses 100
Depreciation 50
Total operating costs 700
Earnings before interest and taxes (EBIT) $ 300
Less interest expense 25
Earnings before taxes (EBT) $ 275
Less taxes (40%) 110
Net income $ 165

19. What is Whitney Inc.’s ROA?

a. 35% b. 30% c. 15% d. 22% e. 40%

(The following financial statements apply to the next problem.)

Cotner Enterprises Balance Sheet

December 31, 2005

Total current liabilities $ 300

Long-term debt 500
Common stockholders’ equity 450
Total assets $1,250 Total liabilities and equity $1,250

Cotner Enterprises Income Statement

for Year Ended December 31, 2005

Sales $1,700
Cost of goods sold (excluding depreciation) $1,190
Other operating expenses 135
Depreciation 75
Total operating costs 1,400
Earnings before interest and taxes (EBIT) $ 300
Less interest expense 54
Earnings before taxes (EBT) $ 246
Less taxes (34%) 84
Net income $ 162
 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
225

20. What is Cotner Enterprise’s ROA?

a. 9.85% b. 12.96% c. 15.75% d. 17.50% e. 20.50%

21. Dauten Enterprises is just being formed. It will need $2 million of assets, and it expects to
have an EBIT of $400,000. Dauten will own no securities, so all of its income will be
operating income. If it chooses to, Dauten can finance up to 50 percent of its assets with
debt that will have a 9 percent interest rate. Dauten has no other liabilities. Assuming a 40
percent marginal tax rate on all taxable income, what is the difference between the
expected ROE if Dauten finances with 50 percent debt versus the expected ROE if it
finances entirely with common stock?

a. 7.2% b. 6.6% c. 6.0% d. 5.8% e. 9.0%

(The following balance sheets apply to the next two problems.)

American Products Corporation

Balance Sheets
(Dollars in Millions)

December 31, December 31,

2005 2004

Cash $ 42 $ 90
Marketable securities 0 66
Net receivables 180 132
Inventory 450 318
Total current assets $ 672 $606
Gross fixed assets 900 450
Less accumulated depreciation (246) (156)
Net fixed assets 654 294
Total assets $1,326 $900

Accounts payable $ 108 $ 90

Notes payable 18 90
Other current liabilities 90 42
Long-term debt 156 48
Common stock 384 228
Retained earnings 570 402
Total liabilities and equity $1,326 $900

During 2005, the company earned $228 million after taxes, of which $60 million were paid
out as dividends.
22. Looking only at the balance sheet accounts, what are the total sources of funds (that must
equal the total uses of funds) for 2005 (dollars in millions)?

a. $426 b. $572 c. $702 d. $856 e. $1,061

23. What are the cash flows from operations (in millions of dollars) for 2005?

a. -$246 b. $204 c. $246 d. -$114 e. -$204

24. The Carter Company’s taxable income and income tax payments are shown below for 2001
through 2004:
Year Taxable Income Tax Payment
2001 $10,000 $1,500
2002 5,000 750
2003 15,000 2,250
2004 5,000 750
Assume that Carter’s tax rate for all 4 years was a flat 15 percent; that is, each dollar of
taxable income was taxed at 15 percent. In 2005, Carter incurred a loss of $17,000. Using
corporate loss carryback, what is Carter’s adjusted tax payment for 2004?

a. $850 b. $750 c. $610 d. $550 e. $450

25. A firm can undertake a new project that will generate a before-tax return of 20 percent or
it can invest the same funds in the preferred stock of another company that yields 13
percent before taxes. If the only consideration is which alternative provides the highest
relevant (after-tax) return and the applicable tax rate is 35 percent, should the firm invest
in the project or the preferred stock?

a. Preferred stock; its relevant return is 12 percent.

b. Project; its relevant return is 1.36 percentage points higher.
c. Preferred stock; its relevant return is 0.22 percentage points higher.
d. Project; its after-tax return is 20 percent.
e. Either alternative can be chosen; they have the same relevant return.

26. Cooley Corporation has $20,000 that it plans to invest in marketable securities. It is
choosing among MCI bonds that yield 10 percent, state of Colorado municipal bonds that
yield 7 percent, and MCI preferred stock with a dividend yield of 8 percent. Cooley’s
corporate tax rate is 25 percent, and 70 percent of its dividends received are tax exempt.
What is the after-tax rate of return on the highest yielding security?

a. 7.4% b. 7.0% c. 7.5% d. 6.5% e. 6.0%

(Use the following information to answer the next two Self-Test Problems)

Karen Brody, a single taxpayer, has a marginal tax rate of 28 percent.

 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
227

27. What is Karen’s capital gains tax liability if she sold a municipal bond for $1,325, three
years after it was purchased for $895?

a. $64.50 b. $86.00 c. $120.50 d. $225.75 e. $430.00

28. What is Karen’s capital gains tax liability if she sold 100 shares of stock for $20 per
share, 11 months after she purchased them for $15 per share?

a. $0 b. $100 c. $140 d. $155 e. $500

29. A corporation with a marginal tax rate of 35 percent bought 1,000 shares of stock of
another company for $75 per share, and then sold them for $85 per share two years later.
What is the corporation’s capital gains tax liability?

a. $0 b. $1,000 c. $2,000 d. $2,800 e. $3,500

ANSWERS TO SELF-TEST QUESTIONS

1. annual 19. net profit margin

2. earnings per share 20. return on total assets
3. balance sheet 21. return on common equity
4. liquidity 22. price/earnings
5. Net; Stockholders’ 23. market; book
6. paid-in; retained earnings 24. trend; industry
7. Retained earnings 25. Du Pont
8. operating assets 26. net profit margin; total assets
9. cash flows 27. trend
10. noncash 28. progressive
11. Operating cash flows 29. municipal; high
12. operating; investing; financing 30. 12
13. liquidity; current 31. short-term
14. receivable; cash; average collection 32. ordinary; 30
period 33. tax deductible
15. leverage 34. 2; 20
16. debt; assets; lower 35. improper accumulation
17. times-interest-earned 36. consolidated
18. profitability 37. double; S
38. b. Excess cash resulting from poor management could produce a high quick ratio.
Similarly, if accounts receivable are not collected promptly, this could also lead to a
high quick ratio.

39. b. Debt financing is encouraged by the fact that interest payments are tax deductible,
while dividend payments are not.

40. d. This question is best analyzed using numbers. For example, assume current assets
equal $50 and current liabilities equal $100; thus, the current ratio equals 0.5. For
answer a, assume $5 in cash is used to pay off $5 in current liabilities. The new current
ratio would be $45/$95 = 0.47. For answer d, assume a $10 purchase of inventory on
credit (accounts payable). The new current ratio would be $60/$110 = 0.55, which is
an increase over the old current ratio of 0.5. (Self-Test Problems 16 through 18 were
set up to help visualize this question.)

41. a. Again, this question is best analyzed using numbers. For example, assume current
assets equal $120 and current liabilities equal $100; thus, the current ratio equals 1.2.
For answer a, assume $5 in cash is used to pay off $5 in current liabilities. The new
current ratio would be $115/$95 = 1.21, which is an increase over the old current ratio
of 1.2. For answer d, assume a $10 purchase of inventory on credit (accounts payable).
The new current ratio would be $130/$110 = 1.18, which is a decrease over the old
current ratio of 1.2.

42. b. The correct answer is comparative ratio analysis. A trend analysis compares the firm’s
ratios over time, while a Du Pont analysis shows the relationships among return on
investment, assets turnover, net profit margin, and leverage.

43. c. Excess cash resulting from poor management could produce high current and quick
ratios; thus statement a is false. A decline in the inventory turnover ratio suggests that
either sales have decreased or inventory has increased—which suggests that the firm’s
liquidity position is not improving; thus statement b is false. ROA = Net income/Total
assets, and EBIT does not equal net income. Two firms with the same EBIT could
have different financing and different taxes resulting in different net incomes. Also,
two firms with the same EBIT do not necessarily have the same total assets; thus
statement d is false. ROE = ROA × Assets/Equity. If ROA increases because total
assets decrease, then the equity multiplier decreases, and depending on which effect is
greater, ROE may or may not increase; thus statement e is false. Statement c is correct;
the TIE ratio is used to measure whether the firm can meet its debt obligations, and a
high TIE ratio would indicate this is so. (Self-Test Problems 19 and 20 were set up to
help visualize statement d of this question.)

44. a. Ratio analysis is subject to manipulation; however, if the current ratio is less than 1.0
and we use cash to pay off some current liabilities, the current ratio will decrease, not
increase; thus statement b is false. Statement c is just the reverse of what actually
occurs. Firms with high net profit margins have low turnover ratios and vice versa.
Statement d is false; it does not necessarily follow that if a firm’s growth rate is higher
 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
229

that its stock price will be higher. Statement a is correct. From the information given
in statement a, one can determine that the two firms’ net incomes are equal; thus, the
firm with the higher debt ratio (lower equity ratio) will indeed have a higher ROE.

45. d. The S corporation limits the liability of the individual, but permits losses to be deducted
against personal income.

SOLUTIONS TO SELF-TEST PROBLEMS

Current assets $1,070

1. c. Current ratio = = = 1.44.
Current liabilities $745

Current assets  Inventory $1,070  $625

Quick ratio = = = 0.60.
Current liabilities $745

Cost of goods sold $1,834

2. a. Inventory turnover = Inventory
= = 2.93.
$625

Sales $2,400
Fixed assets turnover = = $1,200 = 2.00.
Net fixed assets

Sales $2,400
Total assets turnover = = $2,270 = 1.06.
Total assets

Accounts receivable $245

DSO = = $2,400/360 = 36.75 days.
Sales/360

Total debt $1,165

3. d. Debt ratio = = $2,270 = 0.51 = 51%.
Total assets

EBIT $175
TIE ratio = = = 5.00.
Interest $35

Net income $84

4. b. Net profit margin = = $2,400 = 0.0350 = 3.50%.
Sales

Net income $84

ROA = = $2,270 = 0.0370 = 3.70%.
Total assets
 Net income $84
ROE = Common equity = $1,105 = 0.760 = 7.60%.

Net income $84,000

5. e. EPS = Number shares outstanding = 10,000 = $8.40.

Price $40.00
P/E ratio = = = 4.76.
EPS $8.40

Market price $40(10,000)

Market/book value = = = 0.36.
Book value $1,105,000

6. d. ROA = Net profit margin  Total assets turnover

$84 $2,400
= $2,400  $2,270 = 0.035  1.057 = 0.037 = 3.7%.

Accounts receivable
7. a. DSO =
Sales/360
AR
42 days = $2,000,000/360
AR = $233,333.

8. b. DSO = Accounts receivable/(Sales/360)

60 days = $500,000/(Sales/360)
60(Sales/360) = $500,000
Sales = $3,000,000.

9. b. Net income = $2,000,000(0.06) = $120,000.

Earnings before taxes = $120,000/(1 – 0.4) = $200,000.

EBIT = $200,000 + $20,000 = $220,000.

TIE = EBIT/Interest = $220,000/$20,000 = 11.

10. c. Net income = $2,000,000(0.03) = $60,000.

Earnings before taxes = $60,000/(1 – 0.4) = $100,000.

EBIT = $100,000 + $40,000 = $140,000.

 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
231

TIE = EBIT/Interest = $140,000/$40,000 = 3.5.

11. d. ROE = NI/Equity = 0.12. Total debt/Total assets = 0.40,

so Total equity/Total assets = 0.60, and Total equity = 0.60(Total assets).

NI/[0.60(TA)] = 0.12.

NI = (0.6)(0.12)(TA) = 0.072(TA).

ROA = NI/TA = [0.072(TA)]/TA = 0.072 = 7.2%.

12. c. If Total debt/Total assets = 0.50, then Total equity/Total assets = 0.50.

ROA = Net profit margin  Total assets turnover.

Before: ROA = 10%  0.25 = 2.5%.

After: 5.0% = 14%  Total assets turnover

5.0%
Total assets turnover = = 0.36.
14%

13. e. TIE = EBIT/Interest, so find EBIT and Interest.

Interest = $1,000,000(0.12) = $120,000.

Net income = $4,000,000(0.10) = $400,000.

Taxable income = EBT = $400,000/(1 – T) = $400,000/(0.75) = $533,333.

EBIT = $533,333 + $120,000 = $653,333.

TIE = $653,333/$120,000 = 5.44.

14. a. TIE = EBIT/INT

5 = EBIT/$120,000
EBIT = $600,000.
 From Self-Test Problem 13, EBIT = $653,333, so EBIT could decrease by $653,333 –
$600,000 = $53,333.

15. b. ROE = Net profit margin  Total assets turnover  Equity multiplier
= NI/Sales  Sales/TA  TA/Equity.

Now we need to determine the inputs for the equation from the data that were given.
On the left we set up an income statement, and we put numbers in it on the right:

Sales (given) $8,000

– Cost NA
EBIT (given) $ 800
– Interest (given) 240
EBT $ 560
– Taxes (40%) 224
Net income $ 336

Now we can use some ratios to get some more data:

Total assets turnover = 1.6 = S/TA.
D/A = 50%.

Now we can complete the Du Pont equation to determine ROA:

ROA = $336/$8,000  1.6 = 4.2%  1.6 = 6.72%.

16. c. Baker Corporation’s current ratio equals Total current assets/Total current liabilities =
$500/$1,000 = 0.50.

17. a. Baker Corporation’s new current ratio equals ($500 – $50)/($1,000 – $50) = $450/$950
= 0.47.

18. e. Only the current assets balance is affected by this action. Baker’s new current ratio =
($500 – $50)/$1,000 = $450/$1,000 = 0.45.

19. d. Whitney’s ROA equals Net income/Total assets = $165/$750 = 22%.

20. b. Cotner’s ROA equals Net income/Total assets = $162/$1,250 = 12.96%.

 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
233

21. b. Known data: Total assets = $2,000,000, EBIT = $400,000, kd = 9%, T = 40%.

D/A = 0% D/A = 50%

EBIT $400,000 $400,000
Interest 0 90,000*
Taxable income $400,000 $310,000
Taxes (40%) 160,000 124,000
Net income (NI) $240,000 $186,000

*If D/A = 50%, then half of the assets are financed by debt, so Debt = 0.5($2,000,000)
= $1,000,000. At a 9 percent interest rate, INT = 0.09($1,000,000) = $90,000.

For D/A = 0%, ROE = NI/Equity = $240,000/$2,000,000 = 12%. For D/A = 50%,
ROE = $186,000/$1,000,000 = 18.6%. Difference = 18.6% – 12.0% = 6.6%.

22. c. Total sources and uses of funds = $702 million.

Change
(In millions) Sources Uses

Cash $ 48
Marketable securities 66
Net receivables $ 48
Inventories 132
Gross fixed assets 450
Accumulated depreciation 90

Accounts payable 18
Notes payable 72
Other current liabilities 48
Long-term debt 108
Common stock 156
Retained earnings 168
$702 $702
Note that accumulated depreciation is a contra-asset account, and an increase in this
account is a source of funds. Also note that no total lines such as total current assets
can be used to determine sources and uses since to do so would be to “double count.”
23. b. Cash flows from operations (in millions of dollars):

Operating activities:
Net income $228
Other additions (sources of cash):
Depreciation 90
Increase in accounts payable 18
Increase in other current liabilities 48
Subtractions (uses of cash):
Increase in accounts receivable (48)
Increase in inventories (132)

Net cash flows from operations $204

24. e. Adjusted Adjusted

Year Taxable Income Tax Payment Taxable Income Tax Payment
2003 $15,000 $2,250 $ 0 $ 0
2004 5,000 750 3,000 450

The carryback can go back only 2 years. Thus, there were no adjustments made in
2001 or 2002. After a $15,000 adjustment in 2003, there was a $2,000 loss remaining
to apply to 2004. The 2004 adjusted tax payment is $3,000(0.15) = $450. Thus,
Carter received a total of $2,550 in tax refunds after the adjustment.

25. b. The project is fully taxable; thus, its after-tax return is as follows:

AT = 20%(1 – 0.35) = 20%(0.65) = 13.0%.

But only 30 percent of the preferred stock dividends are taxable; thus, its after-tax yield
is AT = 13%[1 – 0.35(0.30)] = 13%(1 – 0.105) = 13%(0.895) = 11.64%. Therefore, the
new project should be chosen since its after-tax return is 1.36 percentage points higher.

26. c. AT yield on Colorado bond = 7%(1 – 0.0) = 7%.

AT yield on MCI bond = 10% – Taxes = 10% – 10%(0.25) = 7.5%.

Check: Invest $20,000 at 10% = $2,000 interest.

Pay 25% tax, so AT income = $2,000(1 – T) = $2,000(0.75) = $1,500.

AT rate of return = $1,500/$20,000 = 7.5%.

 CHAPTER 11: ANALYSIS OF FINANCIAL STATEMENTS
235

AT yield on MCI preferred stock = 8% – Taxes

= 8% – 0.3(8%)(0.25)
= 8% – 0.6% = 7.4%.

Therefore, invest in MCI bonds.

27. a. Since the purchase was made 3 years ago, the gain on the sale qualifies as a long-term
capital gain and the tax rate applied to the gain is 15 percent. Therefore, the tax
liability is

($1,325 – $895)0.15 = $64.50.

28. c. Since the sale occurred only 11 months after the purchase, the gain on the sale does not
qualify as a long-term capital gain. Therefore, the applicable tax rate is Karen’s
marginal tax rate of 28 percent. Thus, the tax liability is

($20 – $15)100  0.28 = $140.00

29. e. Under current tax law, corporations’ capital gains are taxed at the same rate as their
operating income. Since the firm’s marginal tax rate is 35 percent, the firm’s capital
gains tax liability is

($85 – $75)1,000  0.35 = $3,500.