Chapter 14 – Financial Statement Analysis
Financial and Managerial Accounting, 17e 14-1
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 flow from operating activities and contrasting it with net
income.
Chapter 14 – Financial Statement Analysis
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 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
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
6 Quality of earnings
7 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
5 Debt ratio
Chapter 14 – Financial Statement Analysis
Financial and Managerial Accounting, 17e 14-3
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 633)
7 Liquidity, credit risk, and the law
a Small corporations and loan guarantees
D Measures of profitability
1 Classifications in the income statement – see Your Turn (page 636)
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 641 – 643)
1 Analysis by common stockholders
a Earnings per share of common stock
b Price-earnings ratio
c Dividend yield
d Summary of earnings and dividend data for Seacliff
e 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 647)
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
e Operating cycle
Chapter 14 – Financial Statement Analysis
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 653)
8 International Financial Reporting Standards
9 Summary of analytical measurements – see Ethics, Fraud, & Corporate
Governance (page 656)
F Concluding 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
1
A – B
1, 2, 3, 4
1, 2, 3
1, 2, 3
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:
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.
8 Present a comprehensive analysis of a set of financial statements and the notes to the
statements.
Chapter 14 – Financial Statement Analysis
Financial and Managerial Accounting, 17e 14-5
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.
Chapter 14 – Financial Statement Analysis
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.