By Denise Crawford,2014-04-11 23:02
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Chapter Summary

     Although earlier chapters have touched on topics from financial statement analysis, we now present a comprehensive overview of the subject. The chapter is organized into three sections. We begin by introducing a number of analytical tools. Second, measures of liquidity, credit risk, and profitability are surveyed in detail. Finally, a comprehensive illustration analyzes a fictional company from the point of view of stockholders, and short and long-term creditors.

     The analytical tools explained include dollar and percentage changes, trend percentages, component percentages, and ratios. Particular attention is paid to the sensitivity of percentage computations to the choice of base period. Our treatment of ratios at this point concentrates on the choice of potential standards of comparison. This first portion of the chapter concludes with an introduction to the concept of earnings quality.

     The examination of measures of liquidity and credit risk begins with a definitional analysis of liquidity and the balance sheet classifications of current assets and current liabilities. With these definitions established we introduce working capital, the current ratio, the quick ratio, and debt ratio. Computation of each measure is illustrated before proceeding to show how each is used to evaluate liquidity. We identify standards for comparison and sources of data for individual companies and industries. The usefulness and limitations of these measures are explained.

     A multiple-step income statement provides the foundation for profitability analysis. The gross profit rate and operating income illustrate the usefulness of income statement subtotals. Earnings per share, introduced in Chapter 12, is reexamined here and used to explain the interpretation of the price earnings ratio. Adequacy of net income is addressed via return of average assets and return on stockholders’ equity.

     We end the chapter with a lengthy illustration of a fictitious entity. Analysis of the example statements begins from the perspective of a stockholder. Measures examined include EPS, the p/e ratio, dividend yield, the return of assets and the return on equity. A brief discussion of the advantages of leverage precedes coverage of the debt ratio. The concerns of long-term creditors are addressed using the interest coverage ratio. The analysis by short-term creditors reprises the measures of liquidity covered earlier in the chapter. In addition, the accounts receivable turnover ratio and inventory turnover ratio are computed and interpreted. We conclude by analyzing the net cash flow from operating activities and contrasting it with net income.

    McGraw-Hill/Irwin ?The McGraw-Hill Companies, Inc., 2008

    Financial & Managerial Accounting, 14e 14-1

Learning Objectives

    1. Explain the uses of dollar and percentage changes, trend percentages, component

    percentages, and ratios.

2. Discuss the quality of a company’s earnings, assets, and working capital.

    3. Explain the nature and purpose of classifications in financial statements.

    4. Prepare a classified balance sheet and compute widely used measures of liquidity and

    credit risk.

    5. Prepare a multiple-step and single-step income statement and compute widely used

    measures of profitability.

    6. Put a company’s net income into perspective by relating it to sales, assets, and

    stockholders’ equity.

    7. Compute the ratios widely used in financial statement analysis and explain the

    significance of each.

    8. Analyze financial statements from the viewpoints of common stockholders, creditors, and


Brief topical outline

    A Financial statements are designed for analysis

    B Tools of analysis

    1 Dollar and percentage changes

    a Evaluating percentage changes in sales and earnings

    b Percentages become misleading when the base is small

    2 Trend percentages

    3 Component percentages

    4 Ratios

    5 Standards of comparison

    a Past performance of the company

    b Industry standards

    c Quality of earnings

    6 Quality of assets and the relative amount of debt

     C Measures of liquidity and credit risk

     1 A classified balance sheet

     a Current assets

     b Current liabilities

     2 Working capital

     3 Current ratio

     4 Quick ratio

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2008

    14-2 Instructor’s Resource Manual

     5 Debt ratio

     6 Evaluating financial ratios

     a Standards for comparison

     b Annual reports

     c Industry information

     d Usefulness and limitations of financial ratios - see Case in Point (page


    7 Liquidity, credit risk, and the law

    8 Small corporations and loan guarantees

     D Measures of profitability

    1 Classifications in the income statement see Your Turn (page 644)

    2 Multiple-step income statements

    a The revenue section

    b The cost of goods sold section

    c Gross profit: a key subtotal

    d The operating expense section

    e Operating income: another key subtotal

    f Nonoperating items

    g Net income

    3 Earnings per share

    4 Price-earnings ratio

    5 Single-step income statements

    6 Evaluating the adequacy of net income

    7 Return on investment (ROI)

    8 Return on assets (ROA)

    9 Return on equity (ROE)

     E Comprehensive illustration (pages 649 - 651)

    1 Analysis by common stockholders

    a Earnings per share of common stock

    b Price-earnings ratio

    c Dividend yield

    d Revenue and expense analysis

    2 Return on investment (ROI)

    a Return on assets

    b Return on common stockholders' equity

    3 Leverage

    a Debt ratio see Case in Point (page 655)

    4 Analysis by long-term creditors

    a Yield rate on bonds

    b Interest coverage ratio

    c Debt ratio

    d Secured claims

    5 Analysis by short-term creditors

    a Amount of working capital

    b Quality of working capital

    c Accounts receivable turnover rate

    d Inventory turnover rate McGraw-Hill/Irwin ?The McGraw-Hill Companies, Inc., 2008 Financial & Managerial Accounting, 14e 14-3

    e Operating cycle

    f Current ratio

    g Quick ratio

    h Unused lines of credit

    6 Cash flow analysis

    a Cash flows from operations to current liabilities

    7 Usefulness of notes to financial statements - see Your Turn (page 661)

    8 Summary of analytical measurements see Ethics, Fraud, & Corporate

    Governance (page 663)

     F Concluding remarks

Topical coverage and suggested assignment

    Homework Assignment

    (To Be Completed Prior to Class)

     Class Topical Critical

     Meetings O Outline Discussion