selected a publicly traded company(Google) and found their annual report. Now that you have their financial information I would like you to perform a ratio analysis on the financial statements. Focus on the financial statement analysis chapter (PDF) you are reading this week. You will want to compute ratios for your company for the last two years. Do not compute each ratio you learned about for your company. There may be some that are not relevant. Rather focus on those eight ratios that you feel are the most important and relevant to analyze how your company is doing. Make sure to justify the ratios that you choose for your analysis. Compare how your company has done to the industry averages. Do you notice any trends that are positive or negative? Does anything look good or bad that is notable? Do you have any suggestions on things they could be doing to improve these ratios? Please analyze what you found for each of the eight ratios. Then organize your findings into a PPT presentation that you will post. Please use the speaker notes to add in information that isn’t in the slides . Be sure to include some background on your company in your presentation.
PDF Link:
https://learn-us-east-1-prod-fleet02-xythos.conten…
21
Chapter Twenty-One
Analyzing Financial
Statements
After completing this chapter, you should be able to:
1
Explain the objectives of financial statement analysis.
2
Describe and use the following four analytical techniques: horizontal analysis, trend
analysis, vertical analysis, and ratio analysis.
3
Explain the importance of comparisons and trends in financial statement analysis.
4
Prepare and interpret common-size financial statements.
5
Define and compute the various financial ratios discussed in the chapter.
CONTEMPORARY INTERIORS TO GO NATIONAL
Chicago, IL—Contemporary
Interiors, a Chicago tradition in
Scandinavian furniture and
contemporary design, has
announced a decision to go
national. Although Contemporary Interiors has opened
stores throughout the Midwest
in recent years, the company
has remained a regional business with the bulk of its sales
in the greater Chicago area.
Yesterday, however, a company
spokesman announced that
Contemporary Interiors’ Board
of Directors had decided the
time was right to make the
next move. Marc Janson,
spokesman for the firm’s president and CEO, pointed to the
strong economy and consumer
confidence as being key to the
decision. “Disposable income
is up, and we’re seeing that in
our business,” said Janson.
“Even more important, though,
is our company’s strong financial position. The analysts tell
us that our financial statements look good. Our working
capital, inventory turnover,
return on assets, and so forth
are all strong. This will be
important, because in order to
expand, the company’s going
to have to raise capital. And
the bankers and potential
investors are going to need to
see those strong financial indicators. The board hasn’t
decided yet how much of our
new capital needs should be
debt and how much should be
in stock. I’m sure they’ll keep a
close eye on the debt-equity
ratio.” When asked where
Contemporary Interiors’ next
store would appear, Janson
replied that New York, Atlanta,
and San Francisco were all
under consideration.
44
Chapter 21 Analyzing Financial Statements
Financial statements provide the primary means for managers to communicate about
the financial condition of their organization to outside parties. Managers, investors,
lenders, financial analysts, and government agencies are among the users of financial
statements. Substantial information is conveyed by financial statements about the
financial strength and current performance of an enterprise. Although financial statements are prepared primarily for users outside an organization, managers also find their
organization’s financial statements useful in making decisions. As managers develop
operating plans, they think about how those plans will affect the performance of the
organization, as conveyed by the financial statements. In this chapter, we explore how
to analyze financial statements to glean the most information about an organization.
Overview
of Financial Statements
Overview of Financial
Statements
There are four primary financial statements:
1.
2.
3.
4.
Balance sheet
Income statement
Retained earnings statement
Statement of cash flows
Exhibit 21–1 presents the basic structure of each of these statements and the relationships between them. The balance sheet presents an organization’s financial position at
a point in time. It shows the balances in the organization’s assets, liabilities, and
owners’ equity, as of the balance sheet date.
The other three financial statements depicted in Exhibit 21–1 relate to a period of
time. The income statement reports the income for the period between two balance
sheet dates. The retained earnings statement shows how income and dividends for the
period have changed the organization’s retained earnings. The statement of cash flows
shows how cash was obtained during the period and how it was used.
In this chapter, we will concentrate on analyzing the data conveyed by the balance
sheet, the income statement, and the retained earnings statement. In the preceding
chapter, we explored how the statement of cash flows is prepared and used.
Objectives
of Financial
Statement Analysis
Objectives of Financial
Statement
Analysis
Financial statements are based on historical accounting information, which
reflects the transactions and other events that have affected the firm.
Managers and other users of the firm’s financial statements are interested in
the future. The objective of financial statement analysis is to use historical accounting
data to help in predicting how the firm will fare in the future. The aspects of an organization’s future performance that are of most interest depend on the needs of the user. A
manager in the firm would be interested in the company’s overall financial strength, its
income and growth potential, and the financial effects of pending decisions. A potential
lender, such as a bank loan officer, would be concerned primarily about the firm’s
ability to pay back the loan. Potential investors would be interested not only in the
company’s ability to repay its loan obligations, but also its future profit potential.
Potential customers would want to assess the firm’s ability to carry out its operations
effectively and meet delivery schedules. Thus, the needs of the analyst dictate the sort
of financial statement analysis that is most appropriate.
LO 1 Explain the objectives of financial
statement analysis.
LO 2 Describe and use the following
four analytical techniques: horizontal
analysis, trend analysis, vertical
analysis, and ratio analysis.
Analytical Techniques Used
Four analytical tools are in widespread use in analyzing financial statements:
1.
2.
Horizontal analysis
Trend analysis
Chapter 21
45
Analyzing Financial Statements
Exhibit 21–1
BALANCE SHEET
12/31/x0
BALANCE SHEET
12/31/x1
Liabilities
Assets
Overview of Financial
Statements
Liabilities
Assets
Owner’s Equity
Owner’s Equity
Time
12/31/x0
12/31/x1
INCOME STATEMENT
For the Year Ended 12/31/x1
Revenues
Expenses
Gains
Losses
Income
RETAINED EARNINGS STATEMENT
For the Year Ended 12/31/x1
Retained earnings on 12/31/x0
Income
Dividends
Retained earnings on 12/31/x1
STATEMENT OF CASH FLOWS
For the Year Ended 12/31/x1
Cash inflows during 20×1
Cash outflows during 20×1
Change in cash during 20×1
These three state ments refer to a
period of time, the
year 20×1. They help
reconcile the
account balances on
the balance sheets
as of 12/31/x0 and
12/31/x1.
3. Vertical analysis
4. Ratio analysis
Each of these techniques is defined, discussed, and illustrated in the following sections
of the chapter.
Importance of Comparisons and Trends
No single measure of a company’s financial condition or performance can
LO 3 Explain the importance of comtell us much. The single most important point to remember about financial
parisons and trends in financial
statement analysis is that every financial measure should be compared
statement analysis.
across time and across other companies to be meaningful. For example, an
airline’s profit for the current year should be compared with the same
company’s profit for several previous years. Moreover, the company’s profit should
be compared with the profit reported by other airlines of similar size and operational
46
Chapter 21 Analyzing Financial Statements
characteristics. Comparing key financial data with industry norms also adds meaning
to the reported profit for the company being analyzed.
To reemphasize the point, every financial measure discussed in this chapter should
be compared with other analogous measures to be meaningful.
Sources of Data
Published financial statements provide the primary source of data about any organization’s financial condition and performance. A company’s annual report, quarterly
reports, and financial news releases provide a wealth of information about the firm.
Other sources of financial information also are available, both for individual companies and for entire industries. The Securities and Exchange Commission requires that
every publicly held company file a detailed financial report with the commission
annually. These reports are available to the public. The financial press, such as The Wall
Street Journal, Barron’s, Business Week, Fortune, Forbes, and various industry trade
publications, provides in-depth coverage of specific companies and industries. Other
important sources of financial data include financial advisory services, such as Dun &
Bradstreet, Moody’s Investors Service, Dow Jones, Standard & Poor’s, and Robert
Morris Associates. A wealth of financial information is also available on the Internet.
Doing a good job of financial statement analysis is not a trivial task. It requires a
solid knowledge of accounting, familiarity with the analytical techniques to be discussed in this chapter, and substantial research using data from a variety of sources.
Comparative Financial
Statements
Comparative
Financial Statements
To illustrate each of the techniques used in analyzing financial statements, we will
focus on a retail business. Contemporary Interiors, Inc., headquartered in Chicago,
operates a chain of furniture stores in the Midwest. The company specializes in contemporary furniture, much of it imported from the Scandinavian countries. The firm
also sells handcrafted furnishings, such as ceramic lamps and handwoven wall
hangings.
Contemporary Interiors’ balance sheets for December 31, 20×0 and 20×1, are displayed in Exhibit 21–2. The company’s income statements and retained earnings statements for 20×0 and 20×1 are presented in Exhibit 21–3.
Horizontal Analysis
Exhibits 21–2 and 21–3 display comparative financial statements, which
show the company’s financial results for two successive years. These statements highlight the change in each financial item between 20×0 and 20×1.
For example, Exhibit 21–2 shows that Contemporary Interiors’ cash balance
increased by $100,000 between December 31, 20×0, and December 31,
20×1. Notice that the changes highlighted in Exhibits 21–2 and 21–3 are
shown in both dollar and percentage form. Thus, Contemporary Interiors’ $100,000
increase in cash represents an increase of 14.3 percent of the December 31, 20×0,
amount (14.3% $100,000 $700,000).
Comparative financial statements and change data enable managers and financial
analysts to do horizontal analysis, which is an analysis of the year-to-year change in
each financial statement item. The purpose of horizontal analysis is to determine how
each item changed, why it changed, and whether the change is favorable or unfavorable. This is a tall order, and it requires substantial additional information. Suppose,
for example, that a business periodical recently published a story about a growing
demand for Danish furniture. A glance at Contemporary Interiors’ comparative balance
LO 2 Describe and use the following
four analytical techniques: horizontal
analysis, trend analysis, vertical
analysis, and ratio analysis.
Comparative financial
statements show the
company’s financial
results for two successive
years and highlight
changes.
Horizontal analysis is an
analysis of the year-toyear change in each
financial statement item.
Chapter 21
Exhibit 21–2
Contemporary Interiors, Inc.
Comparative Balance Sheets
December 31, 20×1 and 20×0
(in thousands)
Comparative Balance Sheets
Year
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . .
Increase or
(Decrease)
20×0
Amount
Percentage
700
300
11,000
17,000
300
$ 100
150
1,000
3,000
(50)
14.3
50.0
9.1
17.6
(16.7)
$ 33,500
$ 29,300
$4,200
14.3
Long-term investments . . . . . . . . . . . . . . . . . . . . . . .
$
$
550
$ (50)
(9.1)
Property, furnishings, and equipment:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equipment and furnishings, net . . . . . . . . . . . . . . .
$ 6,000
55,000
25,000
$ 6,000
52,000
23,000
$ –0–
3,000
2,000
–0–
5.8
8.7
Total property, furnishings, and equipment . . . . .
$ 86,000
$ 81,000
$5,000
6.2
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$120,000
$110,850
$9,150
8.3
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . .
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 7,500
2,200
3,000
$ 7,050
2,100
3,200
$ 450
100
(200)
6.4
4.8
(6.3)
Total current liabilities . . . . . . . . . . . . . . . . . . . .
Long-term liabilities:
Bonds payable ($1,000 face value; 10%) . . . . . . . .
$ 12,700
$ 12,350
$ 350
2.8
37,300
35,700
1,600
4.5
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . .
$ 50,000
$ 48,050
$1,950
4.1
Stockholders’ equity:
Preferred stock ($100 par value; 8%) . . . . . . . . . . .
Common stock ($10 par value)* . . . . . . . . . . . . . . .
Additional paid-in capital . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . .
$ 6,000
25,000
4,000
35,000
$ 6,000
24,000
3,800
29,000
$ –0–
1,000
200
6,000
–0–
4.2
5.3
20.7
Total stockholders’ equity . . . . . . . . . . . . . . . . .
$ 70,000
$ 62,800
$7,200
11.5
Total liabilities and stockholders’ equity . . . . . . . . . . .
$120,000
$110,850
$9,150
8.3
Total current assets . . . . . . . . . . . . . . . . . . . . . .
20×1
$
800
450
12,000
20,000
250
500
47
Analyzing Financial Statements
$
*100,000 shares of common stock were issued on January 1, 20×1. Since these shares were outstanding during the entire year, the
weighted-average number of shares outstanding in 20×1 was 2,500,000 shares.
sheet reveals that its cash, accounts receivable, and inventory have all increased during
20×1. These changes are consistent with expanded operations in response to increased
demand for the company’s goods. The comparative income statement helps to confirm
this supposition, since sales and cost of goods sold increased from 20×0 to 20×1.
Thus the analyst’s job is like putting together a jigsaw puzzle. The analyst first
gathers all the puzzle pieces (financial data) and then tries to fit them together to create
a meaningful picture (the firm’s financial condition and performance).
48
Chapter 21 Analyzing Financial Statements
Exhibit 21–3
Contemporary Interiors, Inc.
Comparative Income and Retained Earnings Statements
For the Years Ended December 31, 20×1 and 20×0
(in thousands)
Comparative Income and
Retained Earnings Statements
Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . .
Increase or
(Decrease)
20×1
$87,000
60,930
20×0
$82,000
56,350
Amount
$5,000
4,580
Percentage
6.1
8.1
$26,070
$25,650
$ 420
1.6
$ 5,000
2,000
$ 4,600
2,100
$ 400
(100)
8.7
(4.8)
Total operating expenses . . . . . . . . . . . . . . . . . .
$ 7,000
$ 6,700
$ 300
4.5
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$19,070
4,030
$18,950
3,890
$ 120
140
.6
3.6
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . .
$15,040
3,760
$15,060
3,800
$ (20)
(40)
(.1)
(1.1)
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$11,280
$11,260
$
20
.2
–0–
–0–
Dividends on preferred stock . . . . . . . . . . . . . . . . . . .
480
480
Net income available to common stockholders . . . . . .
Dividends on common stock . . . . . . . . . . . . . . . . . . .
$10,800
4,800
$10,780
4,600
$
20
200
.2
4.3
Net income added to retained earnings . . . . . . . . . . . .
Retained earnings, January 1 . . . . . . . . . . . . . . . . . . .
$ 6,000
29,000
$ 6,180
22,820
$ (180)
6,180
(2.9)
27.1
Retained earnings, December 31 . . . . . . . . . . . . . . . .
$35,000
$29,000
$6,000
20.7
Trend Analysis
The comparative financial statements in Exhibits 21–2 and 21–3 allow a
comparison of only two years’ data. When the comparison is extended to
three or more years, the technique is called trend analysis. Trends can be
shown in both dollar and percentage form by designating the first year in the
sequence as the base year. Then the amounts in subsequent years are shown
as a percentage of the base-year amount. Exhibit 21–4 displays a trend analysis of
Contemporary Interiors’ sales and net income data over a six-year period.
Contemporary Interiors’ sales and net income both have risen steadily over the sixyear period. However, the growth in sales has been greater than the growth in net
income. The increase in income between year 5 and year 6 is quite small, despite a
large increase in sales. The relationship between the trend in sales and the trend in net
income could be cause for concern. Why has Contemporary Interiors’ management
been unable to convert a relatively larger growth in sales into an equally large growth
in net income? While the trend analysis does not answer this question, it does serve an
attention-directing role for the analyst. An alert financial analyst will delve more
deeply into this issue and try to come up with an explanation.
LO 2 Describe and use the following
four analytical techniques: horizontal
analysis, trend analysis, vertical
analysis, and ratio analysis.
Trend analysis is a
comparison of three or
more years’ data.
Vertical analysis
concentrates on the
relationships between
various financial items on
a financial statement.
Vertical Analysis
LO 2 Describe and use the following
four analytical techniques: horizontal
analysis, trend analysis, vertical
analysis, and ratio analysis.
Horizontal and trend analyses focus on the relationships between the
amounts of each financial item across time. In contrast, vertical analysis
concentrates on the relationships between various financial items on a particular financial statement. To show these relationships, each item on the
Chapter 21
49
Analyzing Financial Statements
Exhibit 21–4
Year 6
Year 5
Year 4
Year 3
Year 2
Year 1
A. Trend Analysis in Dollars
(Measured in Thousands)
Sales . . . . . . . . . . . . . . $87,000
Net income . . . . . . . . . .
11,280
$82,000
11,260
$78,000
11,000
$74,800
10,500
$73,000
10,200
$72,000
9,900
Year 5
Year 4
Year 3
Year 2
Year 1
114†
114
108
111
104
106
101
103
100
100
Year 6
B. Trend Analysis in Percentages
Sales . . . . . . . . . . . . . .
121*
Net income . . . . . . . . . .
114
Trend Analysis: Contemporary
Interiors, Inc.
*121% $87,000 $72,000
†114% $82,000 $72,000
statement is expressed as a percentage of a base item that also appears on the statement.
On the balance sheet, each item is expressed as a percentage of total assets. On the
income statement, each item is stated as a percentage of sales. Financial statements
prepared in terms of percentages of a base amount are called common-size financial Common-size financial
statements. Contemporary Interiors’ common-size balance sheets and income state- statements are prepared
in percentages of a base
ments for 20×0 and 20×1 are displayed in Exhibits 21–5 and 21–6.
Financial analysts use vertical analysis to gain insight into the relative importance amount.
or magnitude of various items on the financial statements. Using common-size statements, prepared in a comparative format, analysts can discern changes in a firm’s
financial condition and performance from year to year.
To illustrate, notice that Contemporary Interiors’ composition of current
LO 4 Prepare and interpret commonassets remained quite stable from 20×0 to 20×1. Although the various asset
size financial statements.
amounts changed, each asset represents roughly the same proportion of total
assets on December 31, 20×1, as on December 31, 20×0. The largest change
is in inventory, which increased from 15.3 percent to 16.7 percent of total assets. This
could be merely a reflection of increased sales, and the required working capital.
Alternatively, it could indicate overstocking.
Ratio Analysis: The Balance Sheet
The balance sheet is like a snapshot. It records the company’s financial
position at an instant in time. Several key relationships between the balance
sheet items can help an analyst gain insight into the strength of a business.
LO 5 Define and compute the various
financial ratios discussed in the chapter.
Working Capital
Current assets are assets that, under normal business operations, will be converted into
cash within a reasonably short time period, usually a year. Contemporary Interiors’
current assets include cash, marketable securities, accounts receivable, inventory, and
prepaid expenses. The expectation is that the inventory will be sold within a year, the
accounts receivable will be collected within a year, and so forth. Current liabilities are
obligations due within a year.
A key financial measure is a company’s working capital, which is defined as
follows:
Working capital Current assets Current liabilities
Contemporary Interiors’ working capital as of December 31, 20×1, amounts to
$20,800,000 ($33,500,000 $12,700,000). Working capital is a key concept in operating a business. It is important to keep a reasonable amount of working capital to
Working capital is
current assets minus
current liabilities.
50
Chapter 21 Analyzing Financial Statements
Exhibit 21–5
Contemporary Interiors, Inc.
Common-Size Balance Sheets
December 31, 20×1 and 20×0
Common-Size Balance Sheets
Common-Size Statements
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×1
20×0
.7
.4
10.0
16.7
.2
.6
.3
9.9
15.3
.3
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
28.0
26.4
Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.4
.5
Property, furnishings, and equipment:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Equipment and furnishings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.0
45.8
20.8
5.4
47.0
20.7
Total property, furnishings, and equipment . . . . . . . . . . . . . . . . .
71.6
73.1
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
100.0
100.0
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.3
1.8
2.5
6.3
1.9
2.9
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term liabilities:
Bonds payable ($1,000 face value; 10%) . . . . . . . . . . . . . . . . . . . .
10.6
11.1
31.1
32.2
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
41.7
43.3
Stockholders’ equity:
Preferred stock ($100 par value; 8%) . . . . . . . . . . . . . . . . . . . . . . .
Common stock ($10 par value) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.0
20.8
3.3
29.2
5.4
21.7
3.4
26.2
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
58.3
56.7
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . .
100.0
100.0
ensure that short-term obligations can be paid on time, opportunities for volume
expansion can be seized, and unforeseen circumstances can be handled easily.
Contemporary Interiors has a comfortable balance of working capital.
Current Ratio
Another way of viewing a company’s working capital position is in terms of the
current ratio, defined as follows:
Current ratio
Current assets
Current liabilities
Chapter 21
Exhibit 21–6
Contemporary Interiors, Inc.
Common-Size Income Statements
For the Years Ended December 31, 20×1 and 20×0
Common-Size Income
Statements
Common-size Statements
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×1
100.0
70.0
20×0
100.0
68.7
30.0
31.3
5.8
2.3
5.6
2.6
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.1
8.2
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
21.9
4.6
23.1
4.7
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
17.3
4.3
18.4
4.6
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
13.0
13.8
Contemporary Interiors’ current ratio as of December 31, 20×1, is computed below:
Current ratio (12/31/x1)
$33,500,000
$12,700,000
51
Analyzing Financial Statements
2.64, or 2.64 to 1
A popular rule of thumb is that a company’s current ratio should be at least 2 to 1.
Thus, Contemporary Interiors’ current ratio is quite healthy. Indeed, it may be too
large, once again indicating a possible excess of inventory. It is naïve and somewhat
dangerous to place too much faith in a rule of thumb such as “Keep a current ratio of 2
to 1.” The appropriate magnitude for this ratio (and all financial ratios) varies widely
among industries, companies, and the specific circumstances of individual firms.
Limitation of the Current Ratio The current ratio does not tell the whole story of a
company’s ability to meet its short-term obligations. Consider the following balance
sheet data for Contemporary Interiors and its chief competitor, Trends in Teak.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Contemporary
Interiors
$ 800
450
12,000
20,000
250
Trends
in Teak
$ 100
150
2,950
30,000
300
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$33,500
$33,500
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$12,700
2.64 to 1
$12,700
2.64 to 1
Each of these companies exhibits a current ratio of 2.64 to 1. However, are the two
firms in equally strong positions regarding payment of their current obligations? The
answer is no. Trends in Teak has most of its current assets tied up in inventory, which
may take close to a year to convert into cash through normal business operations. In
contrast, Contemporary Interiors can cover all of its current debts with cash, marketable securities, and accounts receivable, which typically will be converted to cash
more quickly than inventory.
52
Chapter 21 Analyzing Financial Statements
Acid-Test Ratio
To get a better picture of a company’s ability to meet its short-term obligations, many
analysts prefer the acid-test ratio (or quick ratio), defined as follows:
Acid-test ratio
Quick assets are cash,
marketable securities,
accounts receivable, and
current notes receivable.
Quick assets
Current liabilities
Quick assets are defined as cash, marketable securities, accounts receivable, and
current notes receivable. These assets typically can be converted into cash much more
quickly than inventory or prepaid expenses can. Therefore, inventory and prepaid
expenses are excluded from quick assets. The acid-test ratios for Contemporary
Interiors and Trends in Teak are computed as follows:
Contemporary Interiors
Acid-test ratio
$13,250,000
$12,700,000
Trends in Teak
$3,200,000
1.04 to 1
$12,700,000
.25 to 1
For every dollar of current liabilities, Contemporary Interiors has $1.04 available
in quick assets. In contrast, Trends in Teak has only $.25 in quick assets available to
pay every dollar of its current liabilities.
Accounts Receivable Turnover
This ratio measures the number of times the average balance in accounts receivable has
been converted into cash during the year. The accounts receivable turnover ratio is
defined as follows:
Accounts receivable turnover
Sales on account
Average balance in accounts receivable
For Contemporary Interiors, the ratio is computed as follows:
Accounts receivable turnover
$87,000,000*
$11,500,000†
7.6
*All of Contemporary Interiors’ sales were on account.
†Average balance in accounts receivable ($11,000,000 $12,000,000)/2.
The accounts receivable turnover often is used to assess the effectiveness of a
company’s credit terms and collection policies. The higher the ratio, the more effective
the company is in collecting its receivables. Of course, a firm can establish too
stringent a credit policy, resulting in lost sales.
Another ratio, which is derived from the accounts receivable
turnover, is the average collection period, defined as follows:
Average Collection Period
Average collection period
365 days
Accounts receivable turnover
For Contemporary Interiors, this ratio is computed as follows:
Average collection period
365 days
7.6
48 days
Chapter 21
Analyzing Financial Statements
The average collection period measures the average number of days required to collect
accounts receivable. Contemporary Interiors’ collection period of 48 days is quite long,
particularly if the company’s credit payment terms are the usual 30 days. This relatively long collection period may reflect lax credit terms, ineffective collection
policies, or some accounts receivable of doubtful collectibility.
Inventory Turnover
How much inventory should a company keep? The answer, which requires a delicate
trade-off of ordering, holding, and shortage costs, varies widely among industries. One
measure of the appropriateness of a company’s inventory level is its inventory turnover,
which is defined as follows:
Inventory turnover
Cost of goods sold
Average balance in inventory
For Contemporary Interiors, this ratio is computed as follows:
Inventory turnover
*Average balance in inventory
$17,000,000 $20,000,000
2
$60,930,000
$18,500,000*
3.3
$18,500,000
Contemporary Interiors sold its average inventory 3.3 times during 20×1.
To determine how many days, on
average, are required to sell a piece of furniture, the analyst computes the following
measure.
Average Number of Days per Inventory Turnover
Average number of days
per inventory turnover
365 days
Inventory turnover
For Contemporary Interiors, we have the following computation.
Average number of days
365 days
111 days
per inventory turnover
3.3
It takes 111 days, on average, for Contemporary Interiors to sell a piece of furniture.
This is fairly typical for the quality furniture retail business. What would you expect
this ratio to be in a grocery store? How about an art gallery?1
The sum of the average collection period and the average number of days per
inventory turnover measures how long it takes a dollar invested in inventory to come
back into the cash account. This cash cycle provides management with a gauge of the
company’s effectiveness in carrying its operations through from inventory purchase to
collection of cash. Contemporary Interiors’ cycle is 159 days (48 111).
1 Grocery stores have short periods for the average number of days per inventory turnover. None of us would
want a loaf of bread that has been in the store for 111 days. An art gallery, on the other hand, would require a rather
long period to sell a typical piece of fine art.
53
54
Chapter 21 Analyzing Financial Statements
Book Value of Securities
Contemporary Interiors has three types of securities outstanding: bonds, preferred
stock, and common stock. The number of shares outstanding is calculated as follows
for each type of security.
(a)
Type of
Security
Bonds . . . . . . . . . . . .
Preferred stock . . . . .
Common stock . . . . . .
(b)
Value on
Balance Sheet
$37,300,000
6,000,000
25,000,000
(c)
Face Value per
Bond or
Par Value per
Share of Stock
…………
$1,000
…………
…………
100
…………
…………
10
…………
(d) (b) (c)
Number
of Shares
Outstanding
37,300
60,000
2,500,000
Some analysts compute the book value of each of a company’s securities, as a
measure of the assets available to back up the firm’s debt and ownership obligations.
In the event that a company is liquidated, the short-term creditors and bondholders
typically have legal precedence over the stockholders in the settlement of claims. The
preferred stockholders are next, and the common stockholders come last. Thus, calculation of the book value of securities must be done in steps, as shown in Exhibit 21–7.
First, assume that the short-term debt of $12,700,000 would be paid off. This leaves
$107,300,000 in assets to meet the bondholders’ claims, or $2,877 per $1,000 bond.
Second, after the short-term and long-term debt is repaid, there would be $70,000,000
in assets available to back the preferred stock, or $1,167 for each share of $100 par
value preferred stock. Finally, Contemporary Interiors would have $25.60 remaining to
back each share of $10 par value common stock.
Contemporary Interiors has more than sufficient assets to back its securities.
Capitalization Ratios
A capitalization ratio is the proportion of the face value of a particular type of security
to the company’s total equity. Contemporary Interiors’ capitalization ratios are computed as follows:
Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Preferred stock . . . . . . . . . . . . . . . . . . . . .
Common stock . . . . . . . . . . . . . . . . . . . . .
Additional paid-in capital . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . .
$25,000,000
4,000,000
35,000,000
Total capitalization . . . . . . . . . . . . . . . . . . .
$ 37,300,000
6,000,000
35%*
5%
64,000,000
60%
$107,300,000
100%
*35% $37,300,000/$107,300,000
5% $6,000,000/$107,300,000
60% $64,000,000/$107,300,000
Contemporary Interiors’ capitalization consists of 35 percent debt, 5 percent preferred stock, and 60 percent common stock. Notice that the additional paid-in capital
and retained earnings are combined with the common stock in a single category. In the
event of liquidation, these amounts would be available to back the common stock, after
the claims of bondholders and preferred stockholders were met.
Debt-Equity Ratio
This is another measure of a firm’s capitalization.
Debt-equity ratio
Total liabilities
Total stockholders’ equity
Contemporary Interiors’ debt-equity ratio for 20×1 is computed as follows:
Chapter 21
55
Analyzing Financial Statements
Exhibit 21–7
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$120,000,000
12,700,000
Net assets backing the claims of bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$107,300,000
Book value per bond
Book Value of Securities:
Contemporary Interiors, Inc.
Net assets available
Number of bonds outstanding
$107,300,000
$2,877 per $1,000 bond
37,300
Net assets backing bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$107,300,000
37,300,000
Net assets backing preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 70,000,000
Book value per share
of preferred stock
Net assets available
Number of shares of
preferred stock outstanding
$1,167 per share of $100
$70,000,000
par value preferred stock
60,000
Net assets backing preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 70,000,000
6,000,000
Net assets backing common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 64,000,000
Book value per share
of common stock
Net assets available
Number of shares of
common stock outstanding
$25.60 per share of $10
$64,000,000
par value common stock
2,500,000
Debt-equity ratio
$50,000,000
$70,000,000
.71 to 1
The debt-equity ratio measures the relationship between the firm’s resources provided through debt and those provided through ownership. In general, the greater the
debt-equity ratio is, the riskier the company is as an investment. Greater debt means
larger obligations to be satisfied before the claims of the company’s owners can be met.
Ratio Analysis: The Income Statement
The income statement also provides valuable information that can provide
insight into the financial condition and performance of an enterprise. Some
key income-statement relationships are discussed next.
LO 5 Define and compute the various
financial ratios discussed in the chapter.
Operating Income
Operating income is a key number on the income statement because it represents the
net result of the company’s operations for the period. Financing decisions, which result
in interest expense and income-tax issues, are largely separate from operating decisions. Thus, operating income focuses on the operations of the business, exclusive of
financing and tax considerations. Contemporary Interiors’ operating income for 20×1
was $19,070,000.
56
Chapter 21 Analyzing Financial Statements
Coverage of Interest and Preferred Stock Dividends
Before investing in a company’s bonds, a long-term creditor will want to be assured
that the firm can pay the interest on the debt. Interest coverage provides a measure of
the company’s ability to meet its contractual obligation to pay bond interest.
Interest coverage
Operating income
Interest expense
Contemporary Interiors’ 20×1 interest coverage is computed as follows:
Interest coverage
$19,070,000
$4,030,000
4.7 times
Contemporary Interiors’ interest coverage is healthy, and long-term creditors should be
reassured as to the firm’s ability to pay bond interest.
Preferred stock dividends must be paid
before any dividends can be paid on common stock. Thus, potential investors are interested in whether a company’s net income is sufficient to pay the stated dividend rate on
its preferred stock. The following ratio provides a pertinent measure.
Coverage of Dividends on Preferred Stock
Coverage of dividends on
preferred stock
Net income
Stated dividends on preferred stock
Notice that net income is used in this measure, because interest on bonds and income
taxes must be paid before any dividends can be declared. Contemporary Interiors’ coverage of preferred stock dividends is computed as follows:
Coverage of dividends on
$11,280,000
23.5 times
preferred stock
$480,000
Earnings per Share
Investors in common stock hope to earn a return on their investment through dividends
or increases in the stock price. Both payment of dividends and stock price appreciation
are related to a firm’s ability to earn income. A key measure that relates a company’s
earnings to its common stock is the firm’s earnings per share.
Earnings
Net income available to common stockholders
per share
Weighted-average number of shares of
common stock outstanding
Contemporary Interiors’ earnings per share for 20×1 is computed as follows:2
2 The weighted-average number of shares for the year is computed by weighting the number of shares out-
standing during each portion of the year by the fraction of the year during which the shares were outstanding. To
illustrate, if Example Company had 100 shares outstanding for the first three months and 200 shares outstanding for
the last nine months, the company’s weighted-average number of shares would be (100)(1⁄4) (200)(3⁄4), or 175
shares.
Since Contemporary Interiors had 2,500,000 shares outstanding during the entire year 20×1, its weightedaverage number of shares is 2,500,000 shares. (See Exhibit 21–2.)
Chapter 21
Analyzing Financial Statements
$10,800,000
Earnings
$11,280,000 $480,000
$4.32 per share
per share
2,500,000
2,500,000
Notice that the dividends on the preferred stock ($480,000) are subtracted from net
income to compute net income available to common stockholders.
Extraordinary Items Suppose a company had an extraordinary gain or loss on its
income statement. These gains or losses result from events outside the normal realm of
the firm’s business operations. Examples include losses due to natural disasters, fires,
or the expropriation of assets by a foreign government. Accepted practice requires that
earnings per share be computed exclusive of the effect of any extraordinary gains or
losses and their related tax effect. To illustrate, assume the following set of facts for
Trends in Teak, Inc.
Extraordinary
item
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$70,000,000
49,000,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$21,000,000
5,000,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$16,000,000
3,000,000
Income before taxes and extraordinary item . . . . . . . . . . . . . . . .
Income tax (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$13,000,000
3,900,000
Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . .
Extraordinary item: loss due to flood . . . . . . . . . . $1,000,000
Less applicable income tax reduction (30%) . .
300,000
$ 9,100,000
Net impact on income from extraordinary loss . . . . . . . . . . . . . .
700,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 8,400,000
400,000
Net income available to common stockholders . . . . . . . . . . . . . .
$ 8,000,000
Common stock outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,900,000 shares
It would not be correct to compute the earnings per share for Trends in Teak as
$2.76 ($8,000,000 2,900,000). The $8,000,000 of available income used in this erroneous calculation includes the extraordinary loss due to the flood. This would be misleading to investors, because the flood loss is a rare event that will not likely be
repeated. The correct approach to computing the company’s earnings per share is
shown below.
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Add: Extraordinary loss, net of its tax effect:
Extraordinary loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,000,000
Tax effect (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
300,000
$8,400,000
Net impact on income from extraordinary loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
700,000
Net income, excluding extraordinary loss and related tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$9,100,000
400,000
Net income available to common stockholders, excluding extraordinary loss and related tax effect . . . . .
$8,700,000
Earnings per share
$8,700,000
2,900,000
$3.00 per share
The correct statement of earnings per share for Trends in Teak is $3.00 per share.
57
58
Chapter 21 Analyzing Financial Statements
One other complication often arises in computing earnings
per share. Some securities are convertible, which means that they can be converted into
a specified number of shares of common stock. Suppose, for example, that each share
of Contemporary Interiors’ preferred stock can be converted into 10 shares of common
stock. If all 60,000 of the preferred shares were converted, there would be an additional
600,000 shares of common stock outstanding. To reflect this possibility, diluted
earnings per share is computed under the assumption that all convertible securities are
converted into common shares. This measure is defined as follows:
Diluted Earnings per Share
Diluted earnings
per share
Net income
Weighted-average number of shares of
common stock outstanding, assuming full
conversion of all convertible securities
For Contemporary Interiors we have the following calculation.
Diluted earnings
per share
$11,280,000
2,500,000 600,000
Shares already outstanding
$3.64 per share
Shares that could result
from conversion of preferred stock
Notice that the dividends on the preferred stock were not subtracted from net income
in the numerator. This reflects the assumption that the preferred stock has been converted to common stock. Contemporary Interiors’ diluted earnings per share, $3.64, is
lower than its $4.32 basic earnings per share computed earlier. The $4.32 amount does
not reflect the potential conversion of preferred stock.
Price-Earnings Ratio Of particular interest to investors is the relationship between a
company’s stock price and its income. Income, after all, is the key to both dividends
and stock price appreciation. A common measure of the relationship between stock
price and income is the price-earnings ratio, defined as follows:
Price-earnings ratio
Market price per share
Earnings per share
To illustrate, suppose Contemporary Interiors’ common stock price is $65 per share:
Price-earnings ratio
$65.00 per share
$4.32 per share*
15
*Notice that the basic earnings per share is used rather than the diluted earnings per share.
Thus, Contemporary Interiors’ common stock is currently selling for 15 times the
firm’s earnings per share. Some investors use the price-earnings ratio to help determine
the appropriate price for a company’s stock. Of course, the most critical issues in determining a fair stock price are the investor’s estimates of the company’s future earnings
potential and the riskiness of the stock.
Return on Assets
The management of a company has a responsibility to use the firm’s assets as effectively as possible in generating income for the owners. The rate of return on assets is a
measure of how effectively management has fulfilled this responsibility.
Chapter 21
Return on assets
Analyzing Financial Statements
Net income Interest expense, net of its tax impact
Average total assets
Notice that the interest expense, net of its tax effect, has been added back to net
income. The reason for this is to make a distinction between operating management
and financial management. The operating managers of a business should use total
assets, irrespective of how they have been financed, to generate income. Moreover,
operating managers typically do not make financing decisions that would affect
interest expense. Thus, interest expense is added back to net income to obtain a
measure of the income resulting from the operating management of the business. The
required calculations for Contemporary Interiors are as follows:
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax effect (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,030,000
1,209,000
Interest expense, net of tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$2,821,000
Return on assets
$11,280,000 $2,821,000
$115,425,000*
12.2%
*$115,425,000 ($120,000,000 $110,850,000)/2
Focusing on only the operating part of the business, Contemporary Interiors’ management generated a 12.2 percent return on assets in 20×1.
Return on Equity
A different rate-of-return measure which is commonly used by analysts is the return on
equity (or return on common stockholders’equity). This measure is defined as follows:
Return on equity
Net income available to common stockholders
Average common stockholders’ equity
Notice that the denominator is average common stockholders’ equity, which is found
by subtracting preferred stock from total stockholders’ equity. Contemporary Interiors’
return on equity for 20×1 is computed as follows:
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×0
$62,800,000
6,000,000
20×1
$70,000,000
6,000,000
Common stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$56,800,000
$64,000,000
Average common stockholders’ equity
Return on equity
$60,400,000
$10,800,000
$60,400,000
17.9%
The income available to Contemporary Interiors’ common stockholders provided a
17.9 percent return on their investment in 20×1.
Return on Sales
The proportion of each sales dollar that results in net income is one measure of the efficiency of a business. Return on sales provides such a measure.
Return on sales
Net income
Sales
Contemporary Interiors’ return on sales is computed as follows for 20×1.
59
60
Chapter 21 Analyzing Financial Statements
Return on sales
$11,280,000
$87,000,000
13%
Return on sales, along with all financial ratios, must be compared with the ratios for
other companies in the industry to be meaningful.
Financial Leverage
Financial leverage means
that a relatively small
increase in income
provides a proportionately
much larger increase in
return to common
stockholders.
In physics, leverage means the ability of a relatively small force to move a heavy
object. Likewise, the concept of financial leverage refers to the situation where a relatively small increase in income can provide a proportionately much larger increase in
return to the common stockholders. How is this financial magic worked? It hinges on
having a relatively large proportion of financing through debt or preferred stock, which
pays interest or dividends at a fixed rate. When income increases, the bond interest and
preferred stock dividends remain constant, leaving most of the increase in income
available to the common stockholders.
An illustration will help to clarify the concept of financial leverage. Suppose a
company has $10,000,000 in outstanding bonds payable which bear interest at 5
percent. The company’s operating income is $550,000, and its tax rate is 30 percent.
The calculations for case A in Exhibit 21–8 show that there will be $35,000 of after-tax
income available to the common stockholders.
Now consider what will happen if operating income increases by a modest 10
percent. As case B in Exhibit 21–8 shows, the income available to common stockholders increases to $73,500, a 110 percent increase. By financing a large portion of the
firm with bonds, the company is able to direct the increase in income to the common
stockholders.
Now consider the risky side of financial leverage. What will happen if operating
income declines by 10 percent? As case C demonstrates, the firm cannot even cover its
bond interest, let alone direct any profit to the common stockholders.
In summary, high financial leverage carries with it the possibility of great return,
but it also entails high risk. A glance at Contemporary Interiors’ balance sheet reveals
that the company is not highly leveraged. This fact also is indicated by the company’s
low debt-equity ratio, which was calculated to be .71 to 1.
Ratio Analysis:Ratio
The Statement
of Retained
Earnings
Analysis: The
Statement
of Retained…
LO 5 Define and compute the various
financial ratios discussed in the chapter.
The retained earnings statement reconciles the year’s beginning and ending
balances in retained earnings. Net income increases retained earnings, while
dividends decrease retained earnings. Two ratios often are computed using
data on this statement.
Exhibit 21–8
Financial Leverage
$10,000,000 5% $500,000 in interest expense
Case A
Case B
Status Quo
10% Increase
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . .
$550,000
$605,000
Less: Bond interest . . . . . . . . . . . . . . . . . . . . . . . . . .
500,000
500,000
Bonds payable (5%) . . . . . . . . . .
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . .
$ 50,000
$105,000
Income-tax expense (30%) . . . . . . . . . . . . . . . . . . . .
15,000
31,500
Income available to common stockholders . . . . . . . . .
$ 35,000
$ 73,500
110% increase
Case C
10% Decrease
$495,000
500,000
$ (5,000)
Chapter 21
Analyzing Financial Statements
Dividend Payout Ratio
The dividend payout ratio shows the proportion of earnings per share that is paid to the
common stockholders in the form of dividends.
Dividend payout ratio
Dividends per share of common stock
Earnings per share
Contemporary Interiors paid dividends of $1.92 per share of common stock in 20×1
($4,800,000 2,500,000.) The company’s dividend payout ratio is computed as
follows:
Dividend payout ratio
$1.92 per share
$4.32 per share*
44.4%
*Notice that the regular earnings per share is used rather than the diluted earnings per share.
Contemporary Interiors paid out to its common stockholders almost half of the income
available for that purpose. The remainder was reinvested in the business. The dividend
payout ratio that is best for a company depends on its opportunities for growth, the
needs of the company for reinvestment funds, and the ease with which the firm can
attract capital.
Dividend Yield Ratio
One of the factors affecting a company’s stock price is the amount of dividends paid on
the stock. The dividend yield ratio focuses on the relationship between dividends and
stock price:
Dividends per share of common stock
Dividend yield ratio
Market price per share
Contemporary Interiors’ common stock sells for $65.00 per share, so the following calculation is made.
Dividend yield ratio
$1.92 per share
$65.00 per share
3.0%
By comparing dividend payout ratios and dividend yield ratios across companies,
investors can judge whether a firm’s stock is fairly priced, given the dividends paid.
Notes to Financial Statements
Published financial statements almost always are accompanied by notes. These narratives provide greater detail about much of the information that is included very
concisely in the financial statements. Many people find the notes to be dull and complicated. Nevertheless, they can be extremely important and should be viewed as an
integral part of the financial statements. Information typically disclosed in the notes
includes:
Details of the inventory and depreciation methods used.
Contingent liabilities and pending lawsuits.
Long-term leases.
Terms of executive employment contracts, profit-sharing programs, pension plans,
and stock options granted to employees.
61
62
Chapter 21 Analyzing Financial Statements
Remember, if you want to analyze a set of financial statements thoroughly, don’t
pass over the notes.
Summary of Financial Statement Analysis
M.A.P.
Exhibit 21–9 summarizes the key financial ratios discussed in the chapter.
Management
Accounting
Practice
Corning Glass
Concepts from financial statement analysis often are used by management in setting goals for an enterprise. The
following example of financial goals comes from a Corning Glass annual report.
Performance: We will be consistently in the top 25 percent of the Fortune 500 in financial performance as
measured by return on equity.
Growth: We will grow at an annual rate in excess of 5 percent in real terms.
We will maintain a debt-to-capital ratio of approximately 25 percent and a long-term dividend payout of 33
percent.
We will issue new shares of stock on a limited basis in connection with employee ownership programs and
acquisitions with a clear strategic fit.
Exhibit 21–9
Summary of Key Financial
Ratios
Ratio
Definition
Analyzing the Balance Sheet
Acid-test ratio (or quick ratio)
Quick assets current liabilities
Accounts receivable turnover
Sales on account average balance in accounts receivable
Average collection period
365 days accounts receivable turnover
Average number of days per inventory turnover
365 days inventory turnover
Capitalization ratio
Proportion of the face value of a particular type of security to the
company’s total equity (e.g., bonds payable total liabilities and
stockholders’ equity)
Current ratio
Current assets current liabilities
Debt-equity ratio
Total liabilities total stockholders’ equity
Inventory turnover
Cost of goods sold average balance in inventory
Coverage of dividends on preferred stock
Earnings per share (also called basic
earnings per share)
Diluted earnings per share
Interest coverage
Price-earnings ratio
Return on assets
Return on equity
Return on sales
Dividend payout ratio
Dividend yield ratio
Analyzing the Income Statement
Net income stated dividends on preferred stock
Net income available to common stockholders weighted-average
number of shares of common stock outstanding
Net income weighted-average number of shares of common
stock outstanding, assuming full conversion of all convertible
securities
Operating income interest expense
Market price per share earnings per share
(Net income interest expense net of income-tax effect)
average total assets
Net income available to common stockholders average common
stockholders’ equity
Net income sales
Analyzing the Retained Earnings Statement
Dividends per share of common stock earnings per share
Dividends per share of common stock market price per share
Chapter 21
Analyzing Financial Statements
63
Limitations of Financial Statement Analysis
Financial statements and the financial ratios derived from them are but a single source
of information about a company. As is true of any managerial-accounting information,
financial ratios serve only as an attention-directing device. The ratios raise questions
more often than they answer them. An analyst must follow up the financial statement
analysis with in-depth research on a company’s management, its history and trends, the
industry, and the national and international economies in which the firm operates.
Financial statement analysis is subject to the limitations inherent in financial statements. First, financial statements are based on historical accounting data, which may
not be indicative of the future. Second, historical cost values provide the basis for
accounting valuation, even though price levels are constantly changing. Third,
although comparisons across companies are critical to meaningful financial statement
analysis, such comparisons are not always easy. Generally accepted accounting principles allow considerable flexibility in accounting for many financial events. When
companies use different accounting methods, their accounting numbers may not be
comparable.
Chapter Summary
Financial statements provide the primary means for communicating financial information about a
company to interested parties outside the organization. The purpose of financial statement analysis is to
highlight key relationships between various accounting numbers in the financial statements to provide
insight into the financial condition and performance of the firm. The objective is to assist analysts in predicting the future performance of the company. A company’s managers also use tools from financial
statement analysis to help them understand the implications of their decisions for the company’s financial
condition and performance.
Horizontal analysis and trend analysis are two of the analytical techniques used in financial statement
analysis. Both of these tools involve comparisons of accounting data across time. Another widely used
analytical tool is vertical analysis, in which component percentages are computed for the numbers on the
balance sheet and income statement. Financial statements prepared in terms of these percentages are called
common-size statements. Ratio analysis involves the calculation of numerous ratios between the numbers
on the financial statements to indicate the relationships between those numbers. For ratio analysis to be
meaningful, the analyst should draw comparisons across time and across other companies in the industry.
Key Terms
For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. Note: The various ratios defined
in the chapter are summarized in Exhibit 21–9.
common-size financial
statements, pg. 49
comparative financial
statements, pg. 46
financial leverage, pg. 60
horizontal analysis, pg. 46
quick assets, pg. 52
trend analysis, pg. 48
vertical analysis, pg. 48
working capital, pg. 49
Review Questions
21–1. Why would a company’s management be interested
in the information conveyed in the firm’s financial
statements published for outside parties? How could
management use the tools of financial statement
analysis?
21–2. List the four major financial statements, and briefly
describe the relationships between them.
21–3. What is wrong with these statements? “The company’s
cash for 20×0 was $50,000. Its income on December
31, 20×0, was $150,000.”
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Chapter 21 Analyzing Financial Statements
21–4. Explain why comparisons and trends are important in
financial statement analysis.
21–5. What other sources of financial data are available in
addition to published financial statements?
21–6. How are comparative financial statements used in
financial statement analysis? What is meant by horizontal analysis?
21–7. What is meant by vertical analysis? How are commonsize financial statements used by analysts?
21–8. What is the significance of a company’s current ratio?
21–9. What is the main limitation of the current ratio?
21–10. What is the significance of the acid-test ratio?
21–11. Alpha Company has an accounts receivable turnover
ratio of 5.1. Beta Company, in the same industry, has a
ratio of 2.2. What can you conclude about these two
firms?
21–12. What does it imply for a company to have a low
inventory turnover? Would you expect this ratio to
differ much across industries? Why?
21–13. What is the significance of a high debt-equity ratio?
21–14. Jeffries Corporation covered its bond interest 1.2 times.
What does this mean, and what conclusion can you
draw?
21–15. Briefly explain the treatment of extraordinary items in
the calculation of earnings per share. Do you agree
with this treatment? Why?
21–16. What is meant by diluted earnings per share?
21–17. Contrast the following two ratios and their interpretations: return on assets versus return on equity.
21–18. What kinds of information are conveyed in the notes to
financial statements?
21–19. Briefly describe three limitations of financial statements which are reflected in financial statement
analysis.
21–20. Assume you are deciding whether your bank should
make a short-term loan to a company. List the financial
ratios in which you would be most interested. Then
assume instead that you are a potential investor in the
company’s stock.
Exercises
Exercises
Exercise 21–21
Trend Analysis
(LO 2, LO 3)
The following data are available for Slattery Corporation, a manufacturer of scientific equipment. The
amounts refer to December 31 of each year.
Year 5
Current assets . . . . $2,842,000
Inventory . . . . . . . . 2,042,000
Current liabilities . . . 1,100,000
Year 4
$2,200,000
1,300,000
1,000,000
Year 3
$1,900,000
1,150,000
900,000
Year 2
$1,600,000
820,000
790,000
Year 1
$1,400,000
700,000
700,000
Required:
1. Restate the trend data in terms of percentages, using Year 1 as the base year.
2. Prepare a table showing the trend in the company’s current ratio and acid-test ratio from Year 1
through Year 5. The firm has no prepaid expenses.
3. What conclusions can you draw from the trend data? Explain your answer.
Exercise 21–22
Trend Analysis
(LO 2, LO 3)
The following data are available for The Gridiron, a small sandwich shop located near the Los Angeles
Coliseum.
Sales . . . . . . . . . . .
Net income . . . . . . .
Year 5
$52,000
15,100
Year 4
$47,200
12,600
Year 3
$44,520
11,450
Year 2
$42,000
10,600
Year 1
$40,000
10,000
Required:
1. Restate the trend data in terms of percentages using Year 1 as the base year.
2. Comment on the trends in the company’s sales and net income.
Exercise 21–23
Ratio Analysis
(LO 2, LO 5)
Party Animal Company produces frozen pizzas, which are sold primarily on college campuses. The
firm’s financial statements provide the following information.
Balance Sheet
December 31, 20×1 and 20×0
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×1
$ 60,000
220,000
260,000
$
20×0
50,000
200,000
230,000
65
Chapter 21 Analyzing Financial Statements
20×1
$ 730,000
(330,000)
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×0
$ 650,000
(260,000)
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 940,000
$ 870,000
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 270,000
670,000
$ 330,000
540,000
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 940,000
$ 870,000
Income Statement
For the Year Ended December 31, 20×1
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,200,000
780,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 420,000
240,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 180,000
Required:
1. Assuming that all sales are on account, what is the company’s accounts receivable turnover for
20×1?
2. What is the rate of return on assets for 20×1? The company had no interest expense in 20×1.
(CPA, adapted)
Exercise 21–24
Common-size Financial
Statements
(LO 4)
Refer to the data given in the preceding exercise for Party Animal Company.
Required:
1. Restate the comparative balance sheet and the income statement in common-size format.
2. For what purpose are common-size statements useful?
Selected data for two companies in the soccer equipment industry are as follows (all data in thousands).
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Terry
Corporation
$ 400
200
4,500
9,000
1,000
Habecker
Enterprises
$ 1,400
1,200
8,000
3,700
800
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$15,100
$15,100
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued expenses payble . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 2,000
4,000
1,000
$ 4,000
2,100
900
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 7,000
$ 7,000
Exercise 21–25
Current and Acid-Test
Ratios; Comparing Firms
(LO 2, LO 5)
Required:
1. Calculate each company’s working capital amount, current ratio, and acid-test ratio.
2. Comment on each firm’s ability to pay its short-term debts.
The following selected financial data pertain to Across the Miles, Inc., a manufacturer of greeting cards.
(The information is continued on the next page.)
December 31, 20×1 and 20×0
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$
20×1
10,000
30,000
50,000
$
20×0
80,000
10,000
150,000
Exercise 21–26
Ratio Analysis
(LO 2, LO 5)
66
Chapter 21 Analyzing Financial Statements
Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Land and buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mortgage payable (no current portion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
For the Year Ended December 31, 20×1 and 20×0
Cash sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Credit sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×1
90,000
345,000
275,000
70,000
20,000
20×0
$ 150,000
360,000
280,000
110,000
40,000
$1,800,000
500,000
1,000,000
$1,600,000
800,000
1,400,000
$
Required:
Compute the following ratios.
1.
2.
3.
4.
Acid-test ratio as of December 31, 20×1.
Accounts receivable turnover for 20×1.
Inventory turnover for 20×1.
Current ratio as of December 31, 20×1.
(CPA, adapted)
Exercise 21–27
Financial Leverage
(LO 2, LO 5)
The following data relate to Sky World, Inc., a theme park located near Kitty Hawk, North Carolina.
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Bond interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$680,000
600,000*
Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax expense (25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 80,000
20,000
Income available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 60,000
*Bonds payable, $5,000,000; interest rate, 12%; bond interest, $600,000 $5,000,000 12%.
Required:
1. Calculate the percentage change in income available to the common stockholders if operating
income (a) increases by 10 percent or (b) decreases by 10 percent.
2. Is Sky World a heavily leveraged company? Explain.
Exercise 21–28
Earnings per Share
(LO 2, LO 5)
The following facts relate to Contented Critters, Inc., a manufacturer of cat food and pet supplies.
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$60,000,000
40,000,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$20,000,000
7,000,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$13,000,000
1,000,000
Income before taxes and extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income tax (25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$12,000,000
3,000,000
Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Extraordinary item: loss due to fire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$800,000
Less applicable income tax reduction (25%) . . . . . . . . . . . . . . . . . . . . . . .
200,000
$ 9,000,000
Net impact on income from extraordinary loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
600,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 8,400,000
1,100,000
Net income available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 7,300,000
Common stock outstanding (weighted-average) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1,825,000 shares
67
Chapter 21 Analyzing Financial Statements
Tom Katz, the company president, made a calculation of earnings per share, as follows:
$7,300,000
Earnings per share 1,825,000 $4 per share
Required:
Did Katz make the earnings per share calculation correctly? If not, prepare an analysis determining the
correct earnings per share.
Problems
Living History Travel Guides, Inc. publishes travel books focusing on historical sites in the United States
and Canada. The firm’s condensed financial statements for 20×0 are as follows:
Living History Travel Guides, Inc.
Income Statement
For the Year Ended December 31, 20×0
(in thousands)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,190
690
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 500
250
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 250
50
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 200
100
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 100
Living History Travel Guides, Inc.
Balance Sheet
December 31, 20×0
(in thousands)
Assets
Liabilities and Stockholders’ Equity
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 100
Accounts payable . . . . . . . . . . . . . . . . . . . . .
$ 120
Marketable securities . . . . . . . . . . . . . . . . . .
150
Short-term note payable . . . . . . . . . . . . . . . .
180
Accounts receivable (net of $15
Accrued liabilities . . . . . . . . . . . . . . . . . . . . .
100
allowance for uncollectible accounts) . . . . .
200
Bonds payable . . . . . . . . . . . . . . . . . . . . . . .
400
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . .
400
Preferred stock . . . . . . . . . . . . . . . . . . . . . . .
200
Prepaid expenses . . . . . . . . . . . . . . . . . . . . .
50
Common stock . . . . . . . . . . . . . . . . . . . . . . .
200
Property, plant, and equipment (net of
Additional paid-in capital . . . . . . . . . . . . . . . .
100
$220 accumulated depreciation) . . . . . . . .
530
Retained earnings . . . . . . . . . . . . . . . . . . . . .
200
Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . .
70
Total assets . . . . . . . . . . . . . . . . . . . . . . .
$1,500
Total liabilities and stockholders’ equity . . .
$1,500
Additional Information
Gross accounts receivable amounted to $200,000, and the allowance for uncollectible accounts
was $20,000 as of January 1, 20×0.
Total assets amounted to $1,300,000, and common stockholders’ equity amounted to $300,000 on
January 1, 20×0.
The liquidation value of the preferred stock is equal to par value. Preferred dividends are paid at
the rate of 8 percent.
The company’s income tax rate was 50 percent.
Problem 21–29
Ratio Analysis
(LO 2, LO 5)
68
Chapter 21 Analyzing Financial Statements
Required:
Compute the following ratios.
1.
2.
3.
4.
5.
6.
Current ratio on December 31, 20×0.
Debt-equity ratio on December 31, 20×0.
Return on assets for 20×0.
Return on equity for 20×0.
Interest coverage for 20×0.
Average collection period in 20×0. (Assume that all sales were on account.)
(CMA, adapted)
Problem 21–30
Ratio Analysis
(LO 2, LO 5)
The balance sheet and income statement for Jason’s of Chicago, Inc., a clothing manufacturer, for 20×1
are as follows:
Jason’s of Chicago, Inc.
Balance Sheet
December 31, 20×1
(in thousands)
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$47,900
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11,400
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Stockholders’ Equity
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonds payable (due in 20×4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock ($10 par value; 4,500,000 shares authorized; 2,500,000 shares
issued and outstanding during the entire year) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$12,000
12,000
5,000
36,500
$65,500
$10,700
5,300
9,500
25,000
5,000
10,000
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$65,500
Jason’s of Chicago, Inc.
Income Statement
For the Year Ended December 31, 20×1
(in thousands)
Sales in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sales on account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$10,000
60,000
Total sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold:
Inventory of finished goods 1/1/x1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 4,000
Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50,000
Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory of finished goods 12/31/x1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$54,000
5,000
$70,000
49,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 3,000
Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10,800
$21,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 7,200
13,800
69
Chapter 21 Analyzing Financial Statements
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1,200
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 6,000
2,400
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 3,600
Required:
Compute the following ratios for Jason’s of Chicago, Inc.
1. Current ratio.
2. Average collection period. (Assume there was no change in the accounts receivable balance
between January 1 and December 31, 20×1.)
3. Inventory turnover.
4. Ratio of total debt to stockholders’ equity.
5. Earnings per share.
6. Return on equity. (Assume there was no change in total stockholders’ equity during 20×1.)
7. Interest coverage.
(CMA, adapted)
Kazarinoff Corporation manufactures ukuleles. The company’s recent financial statements are presented
here.
Kazarinoff Corporation
Balance Sheet
December 31, 20×1 and 20×0
(in thousands)
Assets
20×1
20×0
Current assets:
Cash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 400
1,700
2,200
$ 380
1,500
2,120
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,300
$4,000
Long-lived assets:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings and equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 500
4,700
$ 500
4,000
Total long-lived assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$5,200
$4,500
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$9,500
$8,500
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current portion of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,400
1,000
$ 700
500
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$2,400
3,000
$1,200
4,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$5,400
$5,200
Stockholders’ equity:
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
1,100
$3,000
300
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,100
$3,300
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$9,500
$8,500
Problem 21–31
Ratio Analysis
(LO 2, LO 5)
70
Chapter 21 Analyzing Financial Statements
Kazarinoff Corporation
Income and Retained Earnings Statement
For the Year Ended December 31, 20×1
(in thousands)
Sales (all on account) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$15,120
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7,180
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4,100
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
400
Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
800
$28,800
27,600
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 1,200
300
Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash dividends declared and paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 1,500
400
Retained earnings, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 1,100
Required:
Compute the following ratios for 20×1.
1.
2.
3.
4.
5.
6.
Acid-test ratio on December 31, 20×1.
Average collection period.
Interest coverage.
Inventory turnover.
Operating income as a percentage of sales.
Dividend payout ratio.
(CMA, adapted)
Problem 21–32
Common-Size Financial
Statements
(LO 4)
Refer to the data given in the preceding problem for Kazarinoff Corporation.
Problem 21–33
Financial Statement
Analysis; Multiple Choice
(LO 2, LO 5)
Several of Ballard Company’s transactions during the most recent year are described below. Assume that
total quick assets exceeded total current liabilities both before and after each transaction described.
Further, assume that Ballard has positive net income for the year and a credit balance throughout the year
in its retained earnings account.
Required:
Prepare a common-size balance sheet as of December 31, 20×1, and a common-size income statement
for 20×1.
Required:
Choose the best answer to complete each statement.
1. Payment of accounts payable of $59,000 would
a. increase the current ratio, but the acid-test ratio would not be affected
b. increase the acid-test ratio, but the current ratio would not be affected
c. increase both the current and acid-test ratios
d. decrease both the current and acid-test ratios
e. have no effect on the current and acid-test ratios
2. The purchase of raw materials for $78,000 on account would
a. increase the current ratio
b. decrease the current ratio
c. increase working capital
d. decrease working capital
e. increase both the current ratio and working capital
71
Chapter 21 Analyzing Financial Statements
3. The collection of current accounts receivable of $31,000 would
a. increase the current ratio
b. decrease the current ratio
c. increase the acid-test ratio
d. decrease the acid-test ratio
e. not affect the current and acid-test ratios
4. Obsolete inventory of $95,000 was written off. This would
a. decrease the acid-test ratio
b. increase the acid-test ratio
c. increase working capital
d. decrease the current ratio
e. decrease both the current and acid-test ratios
5. The early liquidation of a long-term note with cash would
a. affect the current ratio to a greater degree than the acid-test ratio
b. affect the acid-test ratio to a greater degree than the current ratio
c. affect the current and acid-test ratios to the same degree
d. affect the current ratio but not the acid-test ratio
e. affect the acid-test ratio but not the current ratio
(CMA, adapted)
Yucatan Imports, Inc., imports and distributes ceramic pottery and woven goods handcrafted in Mexico.
Comparative balance sheets and income statements covering the last two years are shown here. The
market price of Yucatan’s common stock was $20 per share on December 31, 20×1.
Yucatan Imports, Inc.
Comparative Balance Sheets
December 31, 20×1 and 20×0
(in thousands)
Assets
20×1
20×0
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 3,000
1,000
14,000
24,000
$ 2,000
1,000
11,000
16,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 42,000
68,000
10,000
$ 30,000
60,000
10,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$120,000
$100,000
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 5,000
1,000
$ 4,000
1,000
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonds payable (10%, due 20×9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 6,000
20,000
$ 5,000
20,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 26,000
$ 25,000
Stockholders’ equity:
Common stock (10,000,000 shares, no par value) . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 25,000
69,000
$ 25,000
50,000
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 94,000
$ 75,000
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$120,000
$100,000
Problem 21–34
Ratio Analysis
(LO 2, LO 5)
72
Chapter 21 Analyzing Financial Statements
Yucatan Imports, Inc.
Comparative Income Statements
For the Years Ended December 31, 20×1 and 20×0
(in thousands)
Sales (all made on account) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×1
$200,000
120,000
20×0
$140,000
80,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 80,000
38,000
$ 60,000
30,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 42,000
2,000
$ 30,000
2,000
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 40,000
15,000
$ 28,000
11,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 25,000
$ 17,000
Required:
Compute the following ratios.
1.
2.
3.
4.
5.
6.
7.
8.
Current ratio as of December 31, 20×1.
Acid-test ratio as of December 31, 20×1.
Accounts receivable turnover for 20×1.
Inventory turnover for 20×1.
Interest coverage for 20×1.
Book value per share of common stock as of December 31, 20×1.
Dividend yield ratio for 20×1.
Return on equity for 20×1.
(CMA, adapted)
Problem 21–35
Interpretation and Use of
Financial Ratios
(LO 1, LO 5)
Radatron, Inc. is a manufacturer of highly specialized electronic components used in radar systems. The
company’s financial position is being reviewed by its bank, an important potential customer, and a new
supplier of raw materials. As part of the review process, Radatron was required to provide its latest
financial statements, along with information on selected financial ratios. A summary of the information
provided by Radatron follows.
Selected Financial Ratios
Radatron, Inc.
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net profit as a percentage of sales . . . . . . . . . . . . . . . . . . . . . . . . . .
Debt-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20×1
2.02
4.9
13.2%
1.16
20×0
2.11
3.8
12.1%
1.04
Current
Industry
Average
2.16
4.5
12.0%
1.10
Radatron, Inc.
Income Statement
For the Year Ended December 31, 20×2
(in thousands)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …
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