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Chap14_IRM_FinMan14e

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Chap14_IRM_FinMan14e

14 FINANCIAL STATEMENT ANALYSIS

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

    others.

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

     641)

    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 Brief Thinking

     on Chapter C Coverage Questions Exercises Exercises Problems Cases

     1 A B 1, 2, 3, 4 1, 2, 3 1, 2, 3 1 1

     2 C 9, 10, 11, 12 5, 7 4, 5, 6 3

     3 D F 17, 18, 19, 9, 10 13, 14, 15 7

    20

    Comments and observations

    Teaching objectives for Chapter 14

    In presenting this chapter our objectives are to:

    1 Establish the usefulness of accounting information to economic decision-makers.

    2 Explain the use of common analytical tools, especially percentage changes and ratios.

    3 Introduce the concept of quality of earnings in financial analysis.

    4 Describe the basic classifications within financial statements, and explain the usefulness of

    these classifications.

    5 Present basic ratios used in evaluating liquidity, credit risk, and the return on invested

     capital.

    6 Discuss the usefulness and limitations of ratio analysis.

    7 Emphasize the importance of financial leverage to stockholders and creditors.

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

    14-4 Instructor’s Resource Manual

    8 Present a comprehensive analysis of a set of financial statements and the notes to the statements.

New features in Chapter 14

    This material has been reorganized and placed at this point in the text as a logical conclusion to the chapters on financial accounting. In all respects, the treatment of these topics in this edition parallels our earlier work.

General comments

This chapter exemplifies our continuing goal of increasing emphasis upon the interpretation and

    use of accounting information. Throughout the first twelve chapters we have shown not, only how accounting information is developed, but also how it is interpreted and used. We feel that it is appropriate at this point in the course to spend some amount of time concentrating on this theme.

     After reviewing some straightforward analytical tools, the chapter introduces statement classifications and ratios that the student should feel comfortable studying. The illustrations involve the same merchandising business that was introduced in Chapter 5. Students have little difficulty understanding that a going-concern must be capable of satisfying its current liabilities, and that the resources to do so will come primarily from current assets. Measures such as the current and quick ratios and working capital thus have great intuitive appeal. The importance of return on investment is likewise easily motivated.

     When we illustrate the usefulness of accounting information, we find those assignments based upon "name" companies particularly effective. Exercises 7 and 8 and Problems 4, 5, 9,

    and 12 all fall into this category.

     We recommend discussing the limitations of financial ratios as well as their usefulness. For example, we discuss appropriate standards for comparison, and stress the need for the analyst to be familiar with both the company and the environment in which it operates.

    An aside Class discussion of measures of solvency can be enlivened by explaining to students the nature of restrictive debt covenants. Have students visit several corporate websites and search the annual reports for restrictive debt covenants.

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

    Financial & Managerial Accounting, 14e 14-5

Supplementary Exercises

Business Week Exercise

     In “IGT: A Smart Bet on Slot Machines?”, Business Week Online, May 8, 2002,

    Christopher Thomas presents an update on the computer games industry in the US. IGT is the world’s leading maker of slot machines, with a 60% market share. Read the article to see how the September 11 terrorist attack has hurt the casino market.

Group Exercise

     Obtain the annual report of a company of your choosing. Carefully review the financial statements and then the note to the financial statements that describes the company’s accounting policies. Based on your research, prepare a report explaining areas of concern over the quality of the company’s reported earnings.

Internet Exercise

     Choose five well-known corporations. From the site www.pcquote.com obtain an

    analysis of the stock price performance of the companies chosen since 2004. Suppose you had invested $1,000 in each of these companies on January 1, 2004. Calculate the value of this $5,000 portfolio at present.

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

    14-6 Instructor’s Resource Manual

CHAPTER 14 NAME #

10-MINUTE QUIZ A SECTION

     Indicate the best answer to each question in the space provided.

     1 The quick ratio is considered more useful than the current ratio for:

     a Evaluating the profitability of a business that sells inventory very quickly, such as a

    restaurant.

     b Evaluating the solvency of a business that turns inventory into cash very slowly,

    such as a shipbuilder.

     c Evaluating long-term credit risk.

     d Evaluating investors’ expectations concerning future earnings.

     2 The debt ratio is a measure of:

     a Net cash flows relating to financing activities.

     b Long-term credit risk.

     c Short-term solvency.

     d Profitability, independent of the manner in which assets are financed.

     3 In the long-run, it is most important for a business to generate an inflow of cash from its:

     a Operating activities.

     b Stockholders.

     c Investing activities.

     d Creditors.

     4 Return on assets measures the efficiency with which management:

     a Generates earnings from the assets under its control, regardless of how these assets

    are financed.

     b Generates earnings from the assets under its control, giving consideration to any

    costs of financing these assets.

     c Generates cash from the assets under its control, regardless of accrual-based

    measures of profitability.

     d Converts its current assets into cash.

     5 A transaction that will increase the quick ratio but cause the current ratio to decline is:

     a Short-term borrowing.

     b Investing cash in plant assets.

     c Sale of inventory at a price below cost.

     d Collection of an account receivable.

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

    Financial & Managerial Accounting, 14e 14-7

CHAPTER 14 NAME #

10-MINUTE QUIZ B SECTION

Shown below are data taken from a recent annual report of Griffith Co. (Dollar amounts in millions.)

     Beginning End

     of Year of Year

     Balance sheet data:

     Current assets ........................................................... $ 1,014 $ 1,098

     Total assets ............................................................... 1,502 1,786

     Current liabilities ...................................................... 372 312

     Total liabilities.......................................................... 535 468

     Total stockholders’ equity ......................................... 981 1,193

     Income statement data:

     Net sales ................................................................... 2,705

     Gross profit .............................................................. 1,239

     Operating income ..................................................... 563

     Net income ............................................................... 413

     Based upon the above information, indicate the best answer in the space provided.

     1 The current ratio at year-end (rounded to the nearest tenth) is:

     a 2.3 to 1. c 3.5 to 1.

     b .6 to 1. d Some other answer.

     2 The amount of working capital at the beginning of the year (in millions) was:

     a $785 c $479.

     b $1,193. d Some other answer.

     3 The gross profit rate for the year (rounded to the nearest 1 percent) was:

     a 46%. c 69%.

     b 54%. d Some other answer

     4 The return on average total assets during the year (rounded to the nearest percent) was:

     a 24%. c 79%.

     b 34%. d Some other answer.

     5 The return on average total stockholders’ equity during the year (rounded to the nearest 1

    percent) was:

     a 50%. c 38%.

     b 41%. d Some other answer.

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

    14-8 Instructor’s Resource Manual

CHAPTER 14 NAME #

10-MINUTE QUIZ C SECTION

Shown below are data taken from a recent annual report of, Topaz, Inc. (Dollar amounts in millions.)

     Beginning End

     of Year of Year

     Balance sheet data:

     Current assets ........................................................... $ 625 $ 700

     Total assets ............................................................... 1,050 1,200

     Current liabilities ...................................................... 275 175

     Total liabilities.......................................................... 500 600

     Total stockholders’ equity ......................................... 575 725

     Income statement data:

     Net sales ................................................................... 1,900

     Gross profit .............................................................. 900

     Operating income ..................................................... 450

     Net income ............................................................... 300

     Instructions Compute the following:

     a Current ratio at year-end (round to nearest tenth). ........ ________ to 1

     b Working capital at the beginning of the year

     (in millions) $____________

     c Gross profit rate for the year (round to the

     nearest 1 percent) ______%

     d Return on average total assets for the year

     (round to the nearest 1 percent) ______%

     e Return on average total equity for the year

     (round to the nearest 1 percent) ______%

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

    Financial & Managerial Accounting, 14e 14-9

    CHAPTER 14 NAME #

10-MINUTE QUIZ D SECTION

    Given below are comparative balance sheets and an income statement for the Sterling Corporation:

    Sterling Corporation Sterling Corporation

    Balance Sheets Current Year Income Statement for the

     Dec. 31 Jan. 1 Current Year

    Cash $ 24,300 $ 20,700 Sales $720,000

    Accounts receivable 193,500 166,500 Cost of goods sold (396,000)

    Inventory 133,200 136,800 Gross profit on sales $324,000

    Equipment (net) 99,000 117,000 Operating expenses (340,000)

     $450,000 $441,000 Operating income $ 90,000

    Interest expense and Accounts payable 103,500 113,400 income taxes (30,060)

    Dividends payable 13,500 10,800 Net income $ 59,940

    Capital stock, $9 par 90,000 90,000

    Retained earnings 243,000 226,800

     $450,000 $441,000

     All sales were made on account. Cash dividends declared during the year totaled $43,740. Compute

    the following:

    a Average accounts receivable turnover times

    b Book value per share at the end of the current year $______________

    c Earnings per share of capital stock $______________

    d Return on assets %

    e Return on common stockholders’ equity is computed by

     dividing $ ____________ by $______________

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2008 14-10 Instructor’s Resource Manual

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