Financial Analysis & Decision Making: Test Review

Key facts

Where marks get lost

• ×Assuming a profitable business (positive Net Income) must also have positive cash flow — the two can point in opposite directions in the same period. (The Cash Flow Statement)
• ×Classifying the purchase of equipment as an operating activity — it belongs in investing activities, since equipment is a long-term asset. (The Cash Flow Statement)
• ×Classifying dividends paid as an operating expense — dividends are a financing activity, not an expense at all. (The Cash Flow Statement)
• ×Forgetting that cash equivalents (like short-term treasury bills) are tracked together with Cash on this statement. (The Cash Flow Statement)
• ×Assuming a variance is always bad — an unfavourable variance in revenue (revenue below budget) is bad, but an unfavourable variance in EXPENSES actually means spending MORE than planned, and a favourable expense variance means spending LESS. (Budgets)
• ×Building the budgeted income statement before the sales budget — the sales forecast drives everything else, so it has to come first. (Budgets)
• ×Confusing the capital budget (equipment/building purchases) with the sales budget (units and revenue forecast). (Budgets)
• ×Treating a budget as fixed and unchangeable once set — budgets are working plans, revisited as new information (like a supplier price increase) comes in. (Budgets)
• ×Using this year's figure as the denominator in horizontal analysis instead of the base year's figure. (Comparative & Common-Size Statements)
• ×Mixing up horizontal and vertical analysis — horizontal compares the SAME line ACROSS years; vertical compares DIFFERENT lines WITHIN one year. (Comparative & Common-Size Statements)
• ×Picking a base year that was unusually good or bad, which distorts every future comparison. (Comparative & Common-Size Statements)
• ×Forgetting that common-size statements drop dollar figures entirely — a reader cannot recover the actual size of the company from percentages alone. (Comparative & Common-Size Statements)
• ×Including Merchandise Inventory in the quick ratio's numerator — it is deliberately excluded because it is not quickly converted to cash. (Liquidity Ratios)
• ×Reporting Working Capital as a ratio (like "2.3:1") — it is a dollar amount, not a ratio. (Liquidity Ratios)
• ×Assuming a higher current ratio is always better — an extremely high ratio can mean too much cash is sitting idle instead of being invested in growth. (Liquidity Ratios)
• ×Comparing a retailer's ratios directly to a manufacturer's without accounting for how differently their industries typically operate. (Liquidity Ratios)
• ×Forgetting that Equity Ratio and Debt Ratio must add up to exactly 100% of Total Assets — a wrong figure often shows up as a check failure here. (Solvency Ratios)
• ×Assuming more debt is automatically bad — moderate, well-managed leverage is a normal and often smart financing strategy for a healthy business. (Solvency Ratios)
• ×Using Current Liabilities instead of TOTAL Liabilities (current plus long-term) when calculating the Debt Ratio. (Solvency Ratios)
• ×Confusing the Debt Ratio (a solvency measure, long-term view) with the Current Ratio (a liquidity measure, short-term view) — they answer different questions. (Solvency Ratios)
• ×Using ending inventory alone instead of AVERAGE inventory in the merchandise turnover formula. (Activity Ratios)
• ×Using total Net Sales instead of Net CREDIT Sales in the collection period formula — cash sales were never on account, so they never had a collection period. (Activity Ratios)
• ×Assuming a higher turnover is always better with no limit — turnover that is too high can mean a business keeps running out of stock and losing sales. (Activity Ratios)
• ×Forgetting to multiply by 365 when converting the collection period ratio into a number of days. (Activity Ratios)
• ×Comparing Net Profit Margin to Return on Equity as if they measure the same thing — one is against sales, the other is against the owner's investment. (Profitability & Using Accounting for Decisions)
• ×Treating a single ratio from a single year as proof of a trend — one data point cannot show a trend; multiple years or a peer comparison are needed. (Profitability & Using Accounting for Decisions)
• ×Ignoring industry differences — a grocery store's thin margins and a jewellery store's fat margins can both be perfectly healthy for their respective industries. (Profitability & Using Accounting for Decisions)
• ×Assuming a falling ratio always means bad management, when it can also reflect a deliberate strategy (e.g., cutting prices to gain market share). (Profitability & Using Accounting for Decisions)
• ×Treating a memorized CPP or EI percentage as a permanent fact — the CRA/Service Canada adjusts these rates almost every year. (Payroll Accounting)
• ×Forgetting the employer owes its OWN matching CPP and EI, on top of what was withheld from the employee — payroll cost to the employer is always more than gross pay alone. (Payroll Accounting)
• ×Confusing the TD1 (claims tax credits, used to calculate deductions all year) with the T1 (the annual return filed the following spring to settle actual tax owing). (Payroll Accounting)
• ×Calculating commission on the salesperson's take-home pay instead of on the dollar value of sales made. (Payroll Accounting)
• ×Mixing up gross earnings and taxable earnings — taxable earnings are what's left after NON-TAXABLE deductions, and that (not gross pay) is the base used to calculate income tax withheld. (Payroll Accounting)
• ×Assuming a corporation's shareholders are personally liable for corporate debts the same way a sole proprietor is — a corporation's separate legal identity is exactly what limits that liability. (Corporations & Manufacturing Companies)
• ×Confusing common shares (voting, no guaranteed dividend) with preferred shares (no vote, prior claim on assets and income) — their rights are essentially opposite trade-offs. (Corporations & Manufacturing Companies)
• ×Classifying factory rent as Direct Materials or Direct Labour — factory-level costs that are not raw materials or hands-on labour belong in Overhead. (Corporations & Manufacturing Companies)
• ×Treating Retained Earnings as a pile of cash sitting somewhere — it is an equity account, representing accumulated profit that has already been reinvested into the business's actual assets. (Corporations & Manufacturing Companies)
• ×Forgetting that a Limited Partnership still needs at least one GENERAL partner with unlimited liability — not every partner in a limited partnership gets limited liability. (Corporations & Manufacturing Companies)

Practice test

27 questions from across the unit. Each one shows the lesson it comes from.

Endless drill

Fresh numbers every time, for the calculation questions in this unit.