1. A company reported a goodwill impairment of USD 800 million for the first quarter ending 20X2.

Based on only this information, it is most likely

that:

A. net income was unaffected by the impairment.

B. investing cash flow was reduced by the amount of impairment.

 C. management overpaid for one or more acquisitions in the past.

Explanation

Goodwill is the difference between the price an acquiring company pays for a target company and the fair market value of the target company's
identifiable net assets (ie, fair value of assets minus fair value of liabilities). Goodwill impairments result from the loss of value of those assets,
which ultimately did not live up to initial expectations and must be written down. There may be many reasons (eg, a decline in competitiveness,
political instability) why the acquisition, and thus the goodwill it generated, has not maintained its value. In hindsight, the assets have proven to be
less valuable than expected, and it is likely that management overpaid for them.

Goodwill is capitalized on the acquiring company's balance sheet as a noncurrent intangible asset. Since it has no finite life, it is not amortized;
instead, it is evaluated annually for possible impairment. If an impairment is deemed appropriate, an impairment loss affects the financial
statements in the period when it is identified, reducing total assets and flowing through the income statement, impacting earnings as a noncash
charge.

(Choice A) Net income is directly affected by goodwill impairment since a charge must be taken against income in the current period.

(Choice B) Goodwill impairment is a noncash charge and therefore does not impact the cash flow statement.

Things to remember:
Goodwill impairments may result from overpaying for assets that do not live up to initial expectations and must be written down.

Explain the financial reporting and disclosures related to goodwill

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2. An analyst compiles the following common-size balance sheet items for a company:

20X9 20X8

Cash and cash equivalents 4 5

Accounts receivable 15 14

Inventory 28 25

Total current assets 47 44

Property, plant & equipment 50 56

Goodwill 3 0

Total assets 100 100

Accounts payable 12 9

Short-term debt 8 10

Total current liabilities 20 19

Long-term debt 57 59

Total liabilities 77 78

Total shareholders' equity 23 22

Total liabilities and shareholders' equity 100 100

Based only on the data above, the most appropriate conclusion the analyst can draw is that compared to 20X8, in 20X9 the company has:

A. increasing solvency risk.

 B. a more liquid asset base.

C. not made any acquisitions.

Explanation

A common-size balance sheet shows all a company's assets and liabilities as a percentage of its total assets. Converting to a common-size
balance sheet can be useful for analyzing trends for a single company over time, as well as comparing companies of different sizes to each other.

Since common-size balance sheet items are proportional to a company's asset value, an analyst could determine whether the company is shifting
its asset base to become more liquid. In this scenario, the company's current assets have increased from 44% of the company's asset base to
47%, indicating that it may be shifting to a greater proportion of more liquid assets.

(Choice A) Based on the company's common-size balance sheet, its solvency risk measures are declining, suggesting decreasing solvency risk.

(Choice C) The company has goodwill on its balance sheet in 20X9 and none in 20X8, suggesting that it made an acquisition during 20X9.

Things to remember:
Common-size balance sheets show a company's assets and liabilities as a percentage of its total assets. This can be useful for analyzing trends
for a single company over time or comparing companies to each other at a specific point in time.

Calculate and interpret common-size balance sheets and related financial ratios
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3. An analyst gathers the following data:

Which of the following companies most likely has the greatest ability to pay its current liabilities based on the quick ratio?

A. Company A

B. Company B

 C. Company C

Explanation

The quick ratio is a liquidity ratio that measures a company's ability to meet its short-term obligations (ie, due within a year). It is a conservative
liquidity measure because it includes only cash, marketable securities, and accounts receivable.

In the context of calculating the quick ratio, marketable securities are considered short-term. Inventory, excluded from the quick ratio, is a less
liquid current asset as it takes longer to convert to cash. Prepaid expenses are not included in the quick ratio since they are rarely converted to
cash.

Here, add the quick assets and divide this sum by total current liabilities. Company C has the greatest ability to pay with a quick ratio of 0.778.

Things to remember:
The quick ratio is equal to the sum of cash, marketable securities, and accounts receivable divided by the current liabilities (ie, due within a year).
Inventory is excluded from the quick ratio since it takes longer to convert to cash than other current assets (eg, lower liquidity). A company that
has a greater quick ratio has a greater ability to meet its short-term obligations.

Calculate and interpret common-size balance sheets and related financial ratios
LOS
4. An analyst forecasts the upcoming year's fixed charge coverage ratio (FCCR) to be 2. Within the forecast:

EBIT is AUD 10 million,

tax expense is AUD 1.5 million, and
interest expense is AUD 4 million.

The forecasted lease amount (in AUD millions) is closest to:

A. 1.0

 B. 2.0

C. 3.5

Explanation

A fixed charge coverage ratio (FCCR) is a coverage ratio that measures a company's ability to cover its interest and lease (ie, rent) obligations
with its profits. In the numerator, EBIT (earnings before interest and taxes) is sometimes called EBITDAR (earnings before interest, taxes,
depreciation, amortization, and rent), since it captures profits before interest and lease amounts. Lease amounts are added to EBIT in the
numerator, and the denominator contains both the interest and lease amounts.

(Choice A) 1.0 results from not including the lease variable in the numerator.

(Choice C) 3.5 results from including taxes in the numerator.

Things to remember:
A fixed charge coverage ratio (FCCR) measures a company's ability to cover its interest and lease (ie, rent) obligations with its profits. The
numerator equals EBIT (earnings before interest and taxes) plus the lease amounts. The denominator equals interest plus the lease amounts.

Calculate and interpret common-size balance sheets and related financial ratios
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5. An analyst collects the following year-end information on three companies:

On its common-size balance sheet, which company most likely reports the highest percentage of inventory?

A. Company X

B. Company Y

 C. Company Z

Explanation

A common-size balance sheet reports accounts (ie, assets and liabilities) on the balance sheet as a percentage of total assets. It is a useful
tool for comparing companies of various sizes at the same point in time. To convert a balance sheet to a common-size balance sheet, divide each
asset account balance by the company's total assets.

Here, divide each company's inventory by its total assets to determine which company has the highest percentage of inventory on its common-size
balance sheet. Company Z's inventory as a percentage of total assets is 38.1%, the greatest of the three companies.

(Choice A) Company X would have the highest percentage of inventory if common-size balance sheets were based on current assets, not total
assets.

(Choice B) Company Y has the highest amount of inventory in currency terms, but not as a percentage of total assets.

Things to remember:
A common-size balance sheet reports each asset as a percentage of total assets. To convert a balance sheet to a common-size balance sheet,
divide each account balance by the total assets.

Calculate and interpret common-size balance sheets and related financial ratios
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6. Which of the following is most likely a disclosure for PPE that is required under IFRS but not under US GAAP?

 A. Useful lives

B. Gross carrying amounts

C. Estimated depreciation over the next five years

Explanation

Required disclosures of property, plant, and equipment (PPE) vary between IFRS and US GAAP. Under US GAAP, required disclosures are
much less detailed as compared to IFRS. PPE includes tangible assets with useful lives of greater than one year. The costs (ie, measurement
base) to obtain them are capitalized. Each year, part of the PPE cost is expensed as depreciation. Disclosures help analysts identify how different
companies determine original costs and calculate depreciation expenses.

The disclosure of assets' useful lives is required exclusively under IFRS. Useful life is an estimate of the time remaining in which an asset
continues to provide economic benefit (eg, generate revenue).

(Choice B) Both IFRS and US GAAP require the disclosure of the gross carrying amount. The gross carrying amount is the value of an asset
prior to accounting for deprecation.

(Choice C) The disclosure of estimated depreciation over the next five years is required under US GAAP, not IFRS.

Things to remember:
Required disclosures of PPE vary between IFRS and US GAAP. The disclosure of assets' useful lives is required exclusively under IFRS. Useful
life is the time remaining in which an asset continues to provide economic benefit.

Explain the financial reporting and disclosures related to intangible assets

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7. An airline company reports the following information for 20X8:

£ thousands

Gross profit 2,900

Finance lease payments (900)

Other operating expenses (500)

Interest payments (800)

Earnings before tax (EBT) 700

Tax (30%) (210)

Net income 490

The fixed charge coverage ratio for 20X8 is closest to:

A. 1.29

 B. 1.41

C. 1.88

Explanation

Solvency ratios evaluate a company's ability to satisfy its long-term debt obligations. Coverage ratios such as the fixed charge coverage ratio
are one category of solvency ratios. Coverage ratios focus on income statement items and cash from operations (CFO) and illustrate a company's
ability to satisfy periodic payments related to debt and debt-like obligations such as leases.

Lease payments and interest on debt are two common types of fixed charges. The fixed charge coverage ratio measures the company's ability to
satisfy its fixed obligations from operating earnings. The company's fixed charge coverage ratio is shown below:

(Choice A) 1.29 results from using net income instead of EBIT to calculate the fixed charge coverage ratio.

(Choice C) 1.88 is the interest coverage ratio, which does not include lease payments.

Things to remember:
The fixed charge coverage ratio is a solvency ratio that measures a company's ability to pay interest and lease payments from operating earnings.
It is a more conservative measure than the interest coverage ratio when the company acquires operating assets through leases.

Calculate and interpret common-size balance sheets and related financial ratios
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8. An analyst compiles the following financial data for two companies:

Selected Financial Data

Company A ($ millions)

Cash and cash equivalents 300 Accounts payable 140

Marketable securities 60 Taxes payable 40

Accounts receivable 90 Short-term debt 420

Inventories 240

Company B

Cash ratio 0.56

Quick ratio 0.85

Current ratio 1.09

Based only on this data, which ratio indicates that Company A has a greater risk of being unable to meet its short-term obligations than Company
B?

A. Cash ratio

 B. Quick ratio

C. Current ratio

Explanation

Balance sheet ratios such as liquidity ratios can provide some insights into a company's short-term and long-term financial health. Liquidity
ratios address a company's ability to meet its short-term liabilities using its short-term assets.

In this scenario, two companies' liquidity ratios are being compared. Lower ratios indicate greater risk that a company may struggle to meet its
short-term obligations (ie, the company has more liquidity risk since it has fewer assets available to "cover" its liabilities). Company A's ratios can
be calculated as:

Company A's quick ratio of 0.75 is less than Company B's quick ratio of 0.85. This suggests Company A has less short-term asset value relative to
its short-term obligations and greater risk of being unable to meet its short-term obligations than Company B.

Calculate and interpret common-size balance sheets and related financial ratios
LOS
9. Over multiple fiscal years, a company's historical common-size balance sheets most likely reflect a change in:

 A. financial leverage.

B. operating cash flow.

C. cross-sectional profitability.

Explanation

A time series of data based on common-size balance sheets shows changes in the composition of all balance sheet items over time. Since a
balance sheet reports assets, liabilities (ie, debt), and equity, it is a useful tool for analyzing how a company's leverage changes over time.
Leverage is the amount of debt the company uses to obtain assets. By examining total debt as a percentage of total assets, analysts can
identify changes in leverage over many periods.

(Choice B) While a common-size balance sheet does show cash as a percentage of total assets, that amount is the company's total cash from
operating, investing, and financing activities. A common-size cash flow statement, not a balance sheet, discloses information regarding historical
operating cash flow.

(Choice C) Cross-sectional analysis is a comparison of one company against many of its competitors. Comparisons of profitability can be made
when examining historical common-size income statements from a company and its competitors.

Things to remember:
A common-size balance sheet reports all balance sheet items as a percentage of total assets. Since a balance sheet reports assets, liabilities (ie,
debt), and equity, it is a useful tool for analyzing how a company's leverage changes over time.

Calculate and interpret common-size balance sheets and related financial ratios
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10. A portfolio manager gathers the following data:

If the company has no other long-term debts, its long-term debt-to-equity ratio is closest to:

 A. 0.38

B. 0.48

C. 1.08

Explanation

Long-term-debt to equity is a solvency ratio that measures a company's ability to pay its long-term obligations and helps gauge a company's
financial risk. The long-term debt-to-equity ratio signifies the level of long-term, interest-bearing debt relative to the amount of equity. The greater
a company's ratio, the weaker the company's solvency. In this scenario:

Long-term debt includes bonds payable but does not include noncurrent deferred revenue. Bonds payable is considered long-term since payment
is due in more than 12 months. Some analysts include all long-term liabilities, which would include noncurrent deferred revenue, but CFAI limits
"liabilities" to those that are interest-bearing. In this case, noncurrent deferred revenue is not included since it is not interest-bearing.

Equity includes common stock and retained earnings. Retained earnings represents the accumulated portion of net income (after paying for
dividends) that is reinvested back into the company each year.

(Choice B) 0.48 results from including the noncurrent deferred revenue as part of long-term debt.

(Choice C) 0.68 results from incorrectly including interest payable as part of long-term debt. Interest payable is a current liability that is due in
less than 12 months and is not included in long-term debt.

Things to remember:
Long-term debt to equity measures a company's ability to pay its long-term obligations. The greater the company's ratio, the more leverage it has
and the weaker the company's solvency.

Calculate and interpret common-size balance sheets and related financial ratios
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11. An acquiring company purchases a target company. The goodwill created from the transaction is best described as the difference between the
acquirer's purchase price and the target company's:

A. book value of equity.

 B. fair value of net assets.

C. market value of common stock.

Explanation

Goodwill is the difference between the price the acquiring company pays for the target company and the fair value of identifiable (eg, tangible,
intangible) net assets of the target company (ie, fair value of assets minus fair value of liabilities). It is recorded on the acquiring company's
balance sheet as a long-term intangible asset. Goodwill represents the additional value management believes it can generate in the future by
purchasing the target company now.

Estimates of fair value are based on management's judgment. Corroborating the fair value of some assets may prove to be difficult. Management
bases the purchase price on its expectations and estimates, but the value of goodwill may or may not be realized in the future. Each year
subsequent to the acquisition, management reassesses the current value of goodwill.

(Choices A and C) The initial value of goodwill is the difference between the price paid by the acquiring company and the fair value of the target
company's net assets, not the book or market value of the target company's common stock (equity).

Things to remember:
Goodwill is the difference between the price paid by the acquiring company and the fair value of identifiable net assets of the target company. It
represents the additional value the company believes it can generate.

Explain the financial reporting and disclosures related to goodwill

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12. An analyst gathers the following information for a company:

20X8 (€ thousands)

Assets 5,000

Short-term debt 500

Long-term debt 2,000

Deferred tax liabilities 300

Deferred revenue 100

Accounts payable 100

Based on this information, the company's debt-to-capital ratio for 20X8 is closest to:

A. 0.50

 B. 0.56

C. 0.60

Explanation

Solvency ratios evaluate a company's ability to satisfy its long-term debt obligations. Leverage ratios are one category of solvency ratios and
show how much debt a company uses to finance its assets. Analysts use these ratios for side-by-side comparisons among companies, as well
as changes in a company's ability to pay debt over time.

The debt-to-capital ratio is a leverage ratio that shows the percentage of a company's debt relative to all its capital sources. "Debt" includes both
short- and long-term debt obligations but excludes liabilities such as accounts payable, deferred tax liabilities, and deferred revenue, which are not
interest-bearing. The calculation is shown below:

Calculate and interpret common-size balance sheets and related financial ratios
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13. A company provides the following balance sheet information:

Compared to the prior year, a current year common-size balance sheet would most likely show a(n):

A. increase in current assets.

B. increase in common stock.

 C. decrease in current liabilities.

Explanation

Common-size balance sheets display each line item as a percentage of total assets. Analysts often construct common-size balance sheets to
compare the composition of items over time or across companies.

In this question, the respective percentages are determined by dividing the items by total assets. The output shows that current liabilities
decreased from the prior year as a percentage of total assets from 13.8% to 12.5% despite increasing in amount. Similarly, current assets and
common stock increased from the prior year on an absolute basis but decreased as a percentage of total assets (Choices A and B).

Things to remember:
Common-size balance sheets display each item as a percentage of total assets. Analysts often construct common-size balance sheets to
compare the composition of items over time or across companies.

Calculate and interpret common-size balance sheets and related financial ratios
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14. An analyst collects the following information (in ¥ millions) for a company:

Cash 1,900

Marketable securities 500

Accounts receivable 200

Accounts payable 6,000

If there are no other current liabilities, compared with the industry average cash ratio of 0.4, the company's cash ratio is most likely:

A. less than the industry average.

 B. equal to the industry average.

C. greater than the industry average.

Explanation

Liquidity refers to how quickly and easily an asset can be converted to cash at its current value. Liquidity ratios assess a company's ability to
satisfy its current liabilities. The cash ratio is the most conservative liquidity ratio since it includes only the most liquid assets.

The cash ratio is the sum of cash (including cash equivalents) and marketable securities as a percentage of the company's current liabilities.
Current liabilities are debts due within 12 months. A higher cash ratio suggests better liquidity. In this scenario, the cash ratio is calculated as
follows:

(Choice A) The cash ratio is less than the industry average when it excludes marketable securities from the numerator.

(Choice C) The cash ratio is greater than the industry average when it erroneously includes accounts receivable in the numerator. Accounts
receivable is not considered as liquid as cash or marketable securities.

Things to remember:
The cash ratio is the most conservative liquidity ratio since it includes only the most liquid current assets. The cash ratio is cash (including cash
equivalents) plus marketable securities as a percentage of current liabilities.

Calculate and interpret common-size balance sheets and related financial ratios
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15. An analyst collects the following selected financial statement items for a company:

Based on this information, and assuming straight-line depreciation, the estimated remaining useful life of the company's noncurrent assets is
closest to:

A. 3 years.

 B. 13 years.

C. 16 years.

Explanation

From a company's age of noncurrent assets, analysts can determine if, and by how much, the company is reinvesting in noncurrent assets.
Although neither US GAAP nor IFRS require that companies disclose the age of their noncurrent assets, the diagram allows analysts to estimate it
based on income statement and balance sheet entries. The one caveat is that the equation can only be used for straight-line depreciation.

The variables used to calculate the remaining useful life are as follows:

Historic cost is the amount paid for an asset, shown above as the gross amount for property, plant, and equipment. Accumulated depreciation is
the total depreciation expense since the asset was acquired, and the net book value is the difference between the historic cost and accumulated
depreciation. The steps for calculating the total asset life, current age, and remaining asset life are as follows:

Explain the financial reporting and disclosures related to intangible assets

LOS
16. An analyst gathers the following information about a company:

In 20X1, the company borrowed using a 20-year mortgage.

In May 20X3, the company received cash for services to be delivered in 20X5.
In November 20X3, the company purchased inventory and will pay suppliers in February 20X4.

In 20X3, which of the following is most likely classified as a long-term liability?

 A. The unearned revenue

B. The current portion of long-term debt

C. The debt payable from the inventory purchase

Explanation

Liabilities are debts that a company owes to others. Noncurrent liabilities are debts due in more than 12 months. If a debt is due to be paid in
12 months or less, it is classified as a current liability.

Unearned revenue is a liability recorded when a company receives cash in advance of the delivery of goods or services; only when the company
delivers the goods can it consider the revenue earned. In this scenario, since the company received cash in 20X3 and will not deliver the goods
until 20X5, the time elapsed between cash received and delivery is greater than 12 months.

(Choice B) The current portion of long-term debt represents the amount of repayment due (in less than 12 months) in the current period, so it is a
current, not a noncurrent, liability.

(Choice C) If a company buys inventory in the second half of the year and repays it in the first half of the following year, the debt is considered
current, not noncurrent, since it is paid within 12 months.

Things to remember:
Liabilities are debts that a company owes to others. Noncurrent liabilities are debts due in more than 12 months. Current liabilities are debts due
in 12 months or less.

Explain the financial reporting and disclosures related to non-current liabilities

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17. An analyst evaluates the solvency of three companies and gathers the following information:

Company X Company Y Company Z

Total assets 6,340 3,460 7,030

Common stock 750 140 470

Additional paid-in capital 2,800 1,890 3,900

Retained earnings 900 310 110

Treasury stock (50) (100) (110)

Based on the companies' financial leverage ratios, which company has the greatest ability to meet long-term obligations?

 A. Company X

B. Company Y

C. Company Z

Explanation

The financial leverage ratio (ie, total assets to total equity) is one of several solvency ratios analysts use to measure a company's ability to
meet its long-term obligations and understand its financial risk. The greater the ratio, the more the company uses debt to finance its assets.
Therefore, a lower financial ratio implies greater solvency, and vice versa.

In this scenario, calculate the financial leverage ratios of each company as follows:

Company X has the lowest financial leverage ratio and therefore the greatest ability to meet long-term obligations.

(Choice B) Company Y has the least amount of total assets. However, compared with Company X, its total equity is lower in relation to its total
assets; therefore, Company Y has a higher financial leverage ratio than Company X.

(Choice C) Company Z has the highest financial leverage ratio; therefore, of the three companies, it is least able to meet its long-term obligations.

Things to remember:
The financial leverage ratio (ie, total assets to total equity) is a solvency ratio that analysts use to measure a company's ability to meet its long-
term obligations. The greater the ratio, the more the company uses debt to finance its assets. Therefore, a lower financial ratio implies greater
solvency and ability to meet obligations.

Calculate and interpret common-size balance sheets and related financial ratios
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18. A bank examiner collects the following data:

Which company has the greatest value of assets?

A. Company X

B. Company Y

 C. Company Z

Explanation

Solvency ratios, such as the long-term debt-to-equity and financial leverage ratios, assess a company's ability to pay its long-term obligations and
gauge financial risk. The long-term debt-to-equity ratio measures long-term debt with respect to equity. The financial leverage ratio
indicates the relationship of assets to owner's equity. For both ratios, the greater the ratio, the more debt the company used to acquire its assets.

To determine which of the given companies has the greatest value of assets, first find the equity from the given long-term debts and long-term
debt-to-equity ratios. Rearrange the long-term debt-to-equity ratios to solve for equity. Then, find the assets using the companies' equity and
financial leverage ratios, rearranging the ratios to solve for assets. Company Z has the greatest value of assets, with €11,000.

(Choice A) Company X has the greatest value of assets if the assets are incorrectly calculated using the inverse of the financial leverage ratio
(eg, total equity ÷ total assets).

(Choice B) Company Y has the greatest value of assets if the equity is incorrectly calculated using the inverse of the long-term debt-to-equity
ratio (eg, total equity ÷ long-term debt).

Things to remember:
The long-term debt-to-equity ratio (long-term debt ÷ total equity) measures long-term debt with respect to equity. The financial leverage ratio (total
assets ÷ total equity) indicates the relationship of assets to owner's equity.

Calculate and interpret common-size balance sheets and related financial ratios
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19. An analyst gathers the following information:

Selected Financial Statement Items

Company

Accounts X Y Z

Cash 50 50 20

Marketable securities 20 100 120

Accounts receivable 80 40 50

Inventory 60 20 430

Unearned revenue 790 850 930

Accounts payable 220 350 130

Dividends payable 210 320 450

Taxes payable 110 250 540

Based on the cash ratio, the company least able to meet its short-term obligations is:

 A. Company X

B. Company Y

C. Company Z

Explanation

Liquidity ratios measure a company's ability to pay its short-term obligations. Among liquidity ratios, the cash ratio is considered the most
conservative since it includes only items that are cash equivalents or marketable securities, which can both be quickly converted to cash. The
cash ratio is the ratio of a company's total cash equivalents and marketable securities to its current liabilities.

In this scenario, the cash ratio of each company can be calculated as:

Company X Company Y Company Z

Cash 50 + 20 50 + 100 20 + 120

+ Marketable securities = 70 = 150 = 140

Unearned revenue
+ Accounts payable 790 + 220 + 850 + 350 + 930 + 130 +
+ Dividends payable 210 + 110 320 + 250 450 + 540
+ Taxes payable = 1,330 = 1,770 = 2,050
= Current liabilities

Cash ratio 70 / 1,330 ≈ 0.05 150 / 1,770 ≈ 0.08 140 / 2,050 ≈ 0.07

Company X has the lowest cash ratio. Therefore, of the three companies, Company X is least able to pay its short-term obligations.

Things to remember:
Liquidity ratios measure a company's ability to pay its short-term obligations. The cash ratio is the ratio of a company's total cash equivalents and
marketable securities to its current liabilities. It is considered the most conservative liquidity ratio since it includes only items that can be quickly
converted to cash.

Calculate and interpret common-size balance sheets and related financial ratios
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20. A company reports under US GAAP. The company's common-size balance sheet for 20X6 and 20X5 is listed below:

Assuming total assets remained the same from 20X5 to 20X6, which statement most accurately describes what occurred during 20X6?

A. Working capital increased

 B. The company made an acquisition

C. The financial leverage ratio decreased

Explanation

A common-size balance sheet reports all items on the balance sheet as a percentage of total assets. It is a useful tool for comparing
companies of different sizes at a specific point in time.

In this instance, goodwill increased 5.3% on a year-over-year basis as a percentage of total assets. The only scenario for goodwill to increase
would be if the company had made an acquisition because goodwill revaluation or impairment reversals are not allowed under US GAAP.

(Choice A) Working capital is the amount needed to support day-to-day business operations and is the difference between current assets and
current liabilities. The company's 20X6 working capital decreased to 28.4% (eg, 56.3 – 27.9) from 35.5% (eg, 59.4 – 23.9) in 20X5. Since the
amount of total assets remained constant and working capital as a percentage of assets decreased, the amount of working capital decreased.

(Choice C) The financial leverage ratio increased in 20X6 to 1.92 (eg, 100 ÷ 52.1) from 1.85 in 20X5 (eg, 100 ÷ 54).

Things to remember:
A common-size approach is useful when comparing similar companies and can quickly identify material changes to a company's balance sheet
when conducting company-specific, time-series analysis. In addition, acquisitions will be recorded in goodwill when the transaction is done above
the fair value of net assets.

Calculate and interpret common-size balance sheets and related financial ratios
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21. A company discloses its required depreciation expense for five years:

20X3–20X7 depreciation expense (in USD)

20X3 52,000

20X4 60,000

20X5 75,000

20X6 87,000

20X7 101,000

The company uses units of production to calculate depreciation expense. Based only on this data, the company most likely expects an increase
in:

A. unit cost.

B. net margin.

 C. units produced.

Explanation

The units-of-production depreciation method expenses an asset's cost based on its use during each period. Depreciation expense is
calculated by multiplying the units produced each year by the depreciable unit cost, which is calculated as the asset's depreciable value (ie, initial
cost less salvage value) divided by the total number of units expected to be produced over the asset's life.

The depreciable unit cost is constant since the asset's cost is known, and the salvage value and the total number of units expected to be produced
are estimated at the beginning of the asset's life (Choice C). Therefore, the only variable that can change the depreciation expense will be the
actual number of units produced. Using the units-of-production method, if the depreciation expense increases each year, the number of units
produced is also expected to grow.

(Choice B) Net margin (ie, net profit margin) is a measure of profitability, and it increases only if profit increases or revenue decreases. In this
scenario, although production and COGS are expected to grow, that does not suggest the net margin will increase.

Things to remember:
The units-of-production depreciation method expenses an asset's cost based on its use during each period, measured by the number of units
produced. Depreciation expense is calculated by multiplying the units produced each year by the depreciable unit cost, which is constant. If
depreciation expense is expected to increase each year, the number of units produced is also expected to increase.

Explain the financial reporting and disclosures related to intangible assets

LOS

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22. An analyst gathers the following selected information for a company:

(€ millions) 20X5 20X4

Cash 380 410

Marketable securities 210 230

Accounts receivable 490 205

Inventory 1,010 540

Total assets 5,300 4,450

Current liabilities 1,750 1,410

Common stock 420 140

Additional paid-in capital 1,760 1,700

Retained earnings 280 310

Treasury stock (50) (90)

Based on only this information, which of the following ratios most likely suggests decreased financial risk in 20X5?

A. Cash ratio

 B. Current ratio

C. Financial leverage ratio

Explanation

Balance sheet ratios include solvency and liquidity ratios. Liquidity ratios (eg, cash ratio, current ratio) measure a company's ability to meet short-
term obligations, and solvency ratios (eg, financial leverage ratio) measure a company's ability to meet long-term obligations. Both indicate a
company's financial risk.

In this scenario:

Current assets = Cash + Marketable securities + Accounts receivable + Inventory

Total equity = Common stock + Additional paid-in capital + Retained earnings + Treasury stock

Note: Treasury stock is always presented as a negative number since it is a contra-equity account on the balance sheet.

Therefore, the ratios for Years 20X4 and 20X5 are calculated as follows:
Since a current ratio higher than the prior year's indicates the company is better able to meet its short-term obligations, the current ratio
indicates lower financial risk in 20X5.

(Choice A) A decrease in the cash ratio indicates increased financial risk since it suggests less ability to meet short-term obligations.

(Choice C) An increase in the financial leverage ratio indicates increased financial risk since it suggests less ability to meet long-term obligations.

Things to remember:
Balance sheet ratios include solvency and liquidity ratios. Liquidity ratios (eg, cash ratio, current ratio) measure a company's ability to meet short-
term obligations, and solvency ratios (eg, financial leverage ratio) measure a company's ability to meet long-term obligations. Both indicate a
company's financial risk.

Calculate and interpret common-size balance sheets and related financial ratios
LOS

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23. An analyst gathers the following information:

Based on this information, and assuming there are no other current assets, the company with the largest quick ratio is most likely:

 A. Company X

B. Company Y

C. Company Z

Explanation

The quick ratio is a liquidity ratio that indicates a company's ability to pay its short-term obligations using its most liquid assets. It is the ratio of a
company's current assets less inventory to its current liabilities. The items in the numerator are the current assets that can be quickly
converted to cash; therefore, inventory is excluded:

Current assets − Inventory = Cash + Marketable securities + Accounts receivable

In this scenario, Company X has the largest quick ratio:

(Choice B) Company Y has the largest current ratio [ie, (Current assets ÷ Current liabilities)].

(Choice C) Company Z has the largest cash ratio [ie, (Cash + Marketable securities) ÷ Current liabilities].

Things to remember:
The quick ratio is the ratio of a company's current assets less inventory to its current liabilities. It is a liquidity ratio that indicates a company's
ability to pay its short-term obligations using its most liquid assets; therefore, inventory is excluded.

Calculate and interpret common-size balance sheets and related financial ratios
LOS

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