Chapter 14 – Financial Statement Analysis
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 re-examined 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 rate and
inventory turnover rate are computed and interpreted. We conclude by
analyzing the net cash /ow from operating activities and contrasting it with
net income. Learning Objectives
1. Explain the uses of dollar and percentage changes, trend percentages,
component percentages, and ratios.
Chapter 14 – Financial Statement Analysis
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 a 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
AFinancial statements are designed for analysis
BTools of analysis
1Dollar and percentage changes
aEvaluating percentage changes in sales and earnings
bPercentages become misleading when the base is small
2Trend percentages
3Component percentages
4Ratios
5Standards of comparison
aPast performance of the company
bIndustry standards
6 Quality of earnings
7 Quality of assets and the relative amount of debt
CMeasures of liquidity and credit risk
1A classified balance sheet
a Current assets
b Current liabilities
2Working capital
3Current ratio
4Quick ratio
5Debt ratio
6Evaluating financial ratios
aStandards for comparison
Chapter 14 – Financial Statement Analysis
b Annual reports
c Industry information
d Usefulness and limitations of financial ratios
– see Case in Point (page 633)
7Liquidity, credit risk, and the law
a Small corporations and loan guarantees
DMeasures of profitability
1Classifications in the income statement – see Your Turn (page 636)
2Multiple-step income statements
aThe revenue section
bThe cost of goods sold section
cGross profit: a key subtotal
dThe operating expense section
eOperating income: another key subtotal
fNonoperating items
gNet income
3Earnings per share
4Price-earnings ratio
5Single-step income statements
6Evaluating the adequacy of net income
7Return on investment (ROI)
8Return on assets (ROA)
9Return on equity (ROE)
EComprehensive illustration (pages 641 – 643)
1Analysis by common stockholders
aEarnings per share of common stock
bPrice-earnings ratio
cDividend yield
dSummary of earnings and dividend data for Seacliff
eRevenue and expense analysis
2Return on investment (ROI)
aReturn on assets
bReturn on common stockholders’ equity
3Leverage
aDebt ratio – see Case in Point (page 647)
4Analysis by long-term creditors
aYield rate on bonds
bInterest coverage ratio
cDebt ratio
dSecured claims
5Analysis by short-term creditors
aAmount of working capital
bQuality of working capital
cAccounts receivable turnover rate
dInventory turnover rate
eOperating cycle
fCurrent ratio
Financial Accounting, 16e 14- 3
Chapter 14 – Financial Statement Analysis
gQuick ratio
hUnused lines of credit
6Cash flow analysis
aCash flows from operations to current liabilities
7Usefulness of notes to financial statements – see Your Turn (page 653)
8International Financial Reporting Standards
9Summary of analytical measurements – see Ethics, Fraud, & Corporate
Governance (page 656)
FConcluding remarks
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings
on Chapter
Topical
O Outline
C Coverage
Discussion
Questions
Brief
Exercises Exercises Problems
Critical
Thinking
Cases
1 A – B 1, 2, 3, 4 1, 2, 3 1, 2, 3 1 1
2 C 8, 9, 10 5, 7 4, 5, 6 3
3 D – F 13, 14, 15 9, 10 13, 14, 15 7
Comments and observations
Teaching objectives for Chapter 14
In presenting this chapter our objectives are to:
1Establish the usefulness of accounting information to economic decision-makers.
2Explain the use of common analytical tools, especially percentage changes and ratios.
3Introduce the concept of quality of earnings in financial analysis.
4Describe the basic classifications within financial statements, and explain the usefulness of
these classifications.
5Present basic ratios used in evaluating liquidity, credit risk, and the return on invested
capital.
6Discuss the usefulness and limitations of ratio analysis.
7Emphasize the importance of financial leverage to stockholders and creditors.
8Present a comprehensive analysis of a set of financial statements and the notes to the
statements.
Chapter 14 – Financial Statement Analysis
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.
Supplementary Exercises
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.
CHAPTER 14 NAME
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10-MINUTE QUIZ A SECTION
Financial Accounting, 16e 14- 5
Chapter 14 – Financial Statement Analysis
Indicate the best answer to each question in the space provided.
1The quick ratio is considered more useful than the current ratio for:
aEvaluating the profitability of a business that sells inventory very quickly, such as a
restaurant.
bEvaluating the solvency of a business that turns inventory into cash very slowly,
such as a shipbuilder.
cEvaluating long-term credit risk.
dEvaluating investors’ expectations concerning future earnings.
2The debt ratio is a measure of:
aNet cash flows relating to financing activities.
bLong-term credit risk.
cShort-term solvency.
dProfitability, independent of the manner in which assets are financed.
3In the long-run, it is most important for a business to generate an inflow of cash from its:
aOperating activities.
bStockholders.
cInvesting activities.
dCreditors.
4Return on assets measures the efficiency with which management:
aGenerates earnings from the assets under its control, regardless of how these assets
are financed.
bGenerates earnings from the assets under its control, giving consideration to any
costs of financing these assets.
cGenerates cash from the assets under its control, regardless of accrual-based
measures of profitability.
dConverts its current assets into cash.
5A transaction that will increase the quick ratio but cause the current ratio to decline is:
aShort-term borrowing.
bInvesting cash in plant assets.
cSale of inventory at a price below cost.
dCollection of an account receivable.
CHAPTER 14 NAME #
10-MINUTE QUIZ B SECTION
Shown below are data taken from a recent annual report of Falcon Co. (Dollar amounts in millions.)
Beginning End
of Year of Year
Balance sheet data:
Current assets………………………………......................... $1,034 $1,120
Total assets…….……………………………......................... $1,546 $1,822
Current liabilities…..…………………………….................. $379 $318
Total liabilities………………………………………............... $546 $605
Total stockholders’ equity…..……………....................... $1,000 $1,217
Chapter 14 – Financial Statement Analysis
Income statement data:
Net sales………………………………………………………..…. $2,759
Gross profit……………………………………………………….. $1,264
Operating income…….……………………........................ $574
Net income………………………………………………..……... $421
.
Based upon the above information, indicate the best answer in the space provided.
1The current ratio at year-end (rounded to the nearest tenth) is:
a2.3 to 1. c3.5 to 1.
b.6 to 1. dSome other answer.
2The amount of working capital at the beginning of the year (in millions) was:
a$785. c$479.
b$1,193. dSome other answer.
3The gross profit rate for the year (rounded to the nearest 1 percent) was:
a46%. c69%.
b54%. dSome other answer.
4The return on average total assets during the year (rounded to the nearest percent) was:
a24%. c79%.
b34%. dSome other answer.
5The return on average total stockholders’ equity during the year (rounded to the nearest 1
percent) was:
a50%. c38%.
b41%. dSome other answer.
CHAPTER 14 NAME …………………………………..…..…..
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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………………………………………............... $475 $475
Total stockholders’ equity…..……………....................... $575 $725
Income statement data:
Net sales………………………………………………………..…. $1,900
Gross profit……………………………………………………….. $900
Operating income…….……………………........................ $450
Net income………………………………………………..……... $300
.
Chapter 14 – Financial Statement Analysis
Instructions Compute the following:
aCurrent ratio at year-end (round to nearest tenth) . ________ to 1
bWorking capital at the beginning of the year
(in millions) $____________
cGross profit rate for the year (round to the
nearest 1 percent) ______%
dReturn on average total assets for the year
(round to the nearest 1 percent) ______%
eReturn on average total equity for the year
(round to the nearest 1 percent) ______%
CHAPTER 14 NAME #
10-MINUTE QUIZ D SECTION
Given below are comparative balance sheets and an income statement for the Copper Corporation:
Copper Corporation
Balance Sheets – Current Year
Dec. 31 Jan. 1
Copper Corporation
Income Statement for the
Current Year
Cash $ 31,600 $ 26,900 Sales $936,000
Accounts receivable 252,000 216,000 Cost of goods sold (515,000)
Inventory 173,000 178,000 Gross profit on sales $421,000
Equipment (net) 129,000
152,000
Operating expenses (332,000)
$585,600
$572,900 Operating income $ 89,000
Accounts payable $135,000 $147,000 Interest expense and
income taxes (39,000)
Dividends payable 18,000 14,000 Net income $ 50,000
Capital stock, $9 par 90,000 90,000
Retained earnings 342,600
321,900
$585,600
$572,900
All sales were made on account. Cash dividends declared during the year totaled $29,300. Compute
the following:
Chapter 14 – Financial Statement Analysis
aAverage accounts receivable turnover times
bBook value per share at the end of the current year $______________
cEarnings per share of capital stock $______________
dReturn on assets %
eReturn on common stockholders’ equity is computed by
dividing $ ____________ by $______________
SOLUTIONS TO CHAPTER 14 10-MINUTE QUIZZES
QUIZ A QUIZ B
QUIZ C
aCurrent ratio at year-end 4 to 1
$700 $175 = 4
bWorking capital at the beginning of the year (in millions) $350
QUIZ D
aAccounts receivable turnover ($936,000 $234,000) = 4 times
Financial Accounting, 16e 14- 9
Chapter 14 – Financial Statement Analysis
Chapter 14 – Financial Statement Analysis
Assignment Guide to Chapter 14
Brief Exercises Exercises Problems Cases Net
1 – 10 1 – 15 1 2 3 4 5 6 7 8 9 1 2 3 4 5
Time estimate (in minutes) < 15 < 15 40 40 25 30 60 25 25 50 30 25 15 25 25 30
Difficulty rating E E M M S M S E M S M M E S S S
Learning Objectives:
1, 2, 3 1, 2, 3, 7 √
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, 9
4. Prepare a classified balance sheet
and compute widely used measures
of liquidity and credit risk. 4, 5, 6 4, 9, 10
5. Prepare a multiple-step and a
single-step income statement and
compute widely used measures of
profitability. 5
6. Put a company’s net income into
perspective by relating it to sales,
assets, and stockholders’ equity. 7, 8 6, 7, 8, 9,
10, 13, 15
7. Compute the ratios widely used in
financial statement analysis and
explain the significance of each. 9, 10
11, 12, 13,
14, 15 √
8. Analyze financial statements from
the viewpoints of common
stockholders, creditors, and others. √
Financial Accounting, 16e 14- 11