CHAPTER 13
MEASURING AND EVALUATING FINANCIAL PERFORMANCE
Student Learning Objectives and Related Assignment Materials
Student Learning Objectives
Mini–
Exercises
Exercises
Coached
Problems
Problems
(Groups
A & B)
Skills
Development
Cases
Continuing
Case
LO 13-1 Describe the
purposes and uses of
horizontal, vertical, and
ratio analyses.
3
LO 13-2 Use horizontal
(trend) analyses to
recognize financial
changes that unfold
over time.
1*, 6*
1*, 3*
1
A1, B1
3, 7
LO 13-3 Use vertical
(common size) analyses
to understand important
relationships within
financial statements.
2*
1*, 3*
3, 4
A3, A4,
B3, B4
3, 7
LO 13-4 Calculate
financial ratios to assess
profitability, liquidity,
and solvency.
5, 6*, 7,
8, 9, 10^,
11, 12
2, 4*, 5,
6, 7, 8, 9,
10*^, 11,
12, 13*,
14
2, 5, 6
A2, A5,
A6, B1,
B2, B5,
B6
1, 3, 5, 6
1†
LO 13-5 Interpret the
results of financial
analyses.
3, 4, 8,
11, 12
1*, 2, 3*,
4*, 5, 7,
8, 9,
10*^, 11,
12, 13*,
14
1, 2, 3, 4,
5, 6, 7
A1, A2,
A3, A4,
A5, A6,
A7, B1,
B2, B3,
B4, B5,
B6, B7
2, 3, 5, 6
1†
LO 13-6 Describe how
analyses depend on key
accounting decisions
and concepts.
13, 14
15
6
A6, B6
3, 4, 6
LO 13-S1 Describe how
nonrecurring and other
comprehensive income
items are reported.
LO 13-S2 Describe
significant differences
between GAAP and
IFRS.
(Table footnotes on next page.)
Student Learning Objectives and Related Assignment Materials, continued
* Animated solution included in the PowerPoint Slides.
^ Particularly challenging; requires students to combine multiple concepts in order to advance to the
next level of accounting knowledge.
† CC13-1 is a continuing case that builds on the story of Nicole’s Getaway Spa, introduced in earlier
chapters. This case focuses on profitability, liquidity, and solvency ratios.
Overview
This chapter pulls together financial statement analysis, accounting method choices, and accounting
concepts, showing how a difficult economic environment is revealed in Lowe’s financial statements (and,
where appropriate, in those of The Home Depot).
Students learn through a demonstration of horizontal, vertical, and ratio analyses that evaluate the
company’s profitability, liquidity, and solvency.
Chapter supplements discuss nonrecurring and special items (A) and summarize key topics involving
IFRS, referencing specific pages in each chapter where these topics are integrated (B).
Synopsis of Chapter Revisions
• Updated focus company analyses with Lowe’s Companies
• Revised Exhibit 13.5 and related discussion to reflect changes made to all other chapters
• New Spotlight on Business Decisions to discuss impact of supply chain financing on current ratio
• Updated discussion to reflect FASB’s August 2014 going concern standards update
• Reviewed and updated all end-of-chapter material
PowerPoint Slides
Student Learning Objective
PowerPoint® Slides
LO 13-1 Describe the purposes and uses of horizontal, vertical, and ratio
analyses.
13-2 through 13-4
LO 13-2 Use horizontal (trend) analyses to recognize financial changes that
unfold over time.
13-5 through 13-7
LO 13-3 Use vertical (common size) analyses to understand important
relationships within financial statements.
13-8 through 13-9
LO 13-4 Calculate financial ratios to assess profitability, liquidity, and
solvency.
13-10 through 13-14
LO 13-5 Interpret the results of financial analyses.
13-15 through 13-26
LO 13-6 Describe how analyses depend on key accounting decisions and
concepts.
13-27 through 13-31
LO 13-S1 Describe how nonrecurring and other comprehensive income items
are reported.
13-32 through 13-36
LO 13-S2 Describe significant differences between GAAP and IFRS.
13-37 through 13-39
PowerPoint Slides, continued
Animated Builds and Animated Solutions
PowerPoint® Slides
Mini-Exercise 13-1
13-41 through 13-42
Mini-Exercise 13-2
13-43
Mini-Exercise 13-6
13-44
Exercise 13-1
13-45 through 13-47
Exercise 13-3
13-48 through 13-50
Exercise 13-4
13-51 through 13-55
Exercise 13-10
13-56 through 13-57
Exercise 13-13
13-58 through 13-59
Chapter Summary
LO 13-1 Describe the purposes and uses of horizontal, vertical, and ratio analyses.
• Horizontal analyses (also called trend analyses) compare financial statement items to comparable
amounts in prior periods with the goal of identifying sustained changes, or trends.
• Vertical analyses create common size financial statements that express each line of the income
statement (or balance sheet) as a percentage of total sales (or total assets).
• Ratio analyses compare one or more financial statement items to an amount for other items for
the same year. Ratios take into account differences in the size of amounts to allow for evaluations
of performance given existing levels of other company resources.
LO 13-2 Use horizontal (trend) analyses to recognize financial changes that unfold over time.
• Trend analyses involve computing the dollar amount by which each account changes from one
period to the next and expressing that change as a percentage of the balance for the prior period.
LO 13-3 Use vertical (common size) analyses to understand important relationships within financial
statements.
• Vertical (common size) analyses indicate the proportions within each financial statement
category.
LO 13-4 Calculate financial ratios to assess profitability, liquidity, and solvency.
• Financial ratios are commonly classified with relation to profitability, liquidity, or solvency.
Exhibit 13.5 lists common ratios in these three categories and shows how to compute them.
• Profitability ratios focus on measuring the adequacy of a company’s income by comparing it to
other items reported on the financial statements.
• Liquidity ratios measure a company’s ability to meet its current debt obligations.
• Solvency ratios measure a company’s ability to meet its long-term debt obligations.
LO 13-5 Interpret the results of financial analyses.
• Financial analyses are not complete unless they lead to an interpretation that helps financial
statement users understand and evaluate a company’s financial results.
• An understanding of whether a business is successful emerges only after you have learned to
combine analyses into a complete picture or story that depicts the company’s performance.
• To assist in developing this picture or story, most analysts compare to benchmarks such as the
company’s performance in prior years or to competitors’ performance in the current year.
Chapter Summary, continued
LO 13-6 Describe how analyses depend on key accounting decisions and concepts.
• Before comparing across companies or time periods, users should determine the extent to which
differences in accounting decisions (e.g., methods used to account for inventory, depreciation,
contingent liabilities, etc.) might reduce comparability or consistency of the financial information
being compared.
• Many accounting concepts were presented throughout earlier chapters, all of which aim to make
accounting information more useful for creditors and investors. Two new concepts were explained
in this chapter:
• Going-concern (continuity) assumption—a business is assumed to continue to operate into the
foreseeable future.
• Full disclosure principle—a company’s financial statements should provide all information that is
important to users’ decisions.
Accounting Decision Tools
• See Exhibit 13.5 for a summary.
Chapter Outline
Teaching Notes
I. Understand the Business
LO 13-1 Describe the purposes and uses of horizontal, vertical, and ratio analyses.
A. Horizontal, Vertical and Ratio Analysis
1. Horizontal (trend) analyses are conducted to help
financial statement users recognize important financial
changes that unfold over time.
a. Horizontal analysis compares individual financial
statement line items horizontally (from one period to
the next), with the general goal of identifying
significant sustained changes (trends).
b. These changes are typically described in terms of
dollar amounts and year-over-year percentages.
2. Vertical analyses focus on important relationships
between items on the same financial statement.
a. These items are compared vertically (one account
balance versus another).
b. These items are typically expressed as percentages to
reveal the relative contributions made by each
financial statement item.
3. Ratio analyses are conducted to understand relationships
among various items reported in one or more of the
financial statements.
4. No analysis is complete unless it leads to an interpretation
that helps financial statement users understand and
evaluate a company’s financial results.
✓ Supplemental
Enrichment Activity
(Activity) #1
II. Study the Accounting Methods
LO 13-2 Use horizontal (trend) analyses to recognize financial changes that unfold over time.
A. Horizontal (Trend) Computations
1. Horizontal analyses—Comparing across time, often
expressing changes in account balances as a percentage of
prior year balances.
Illustrated in Exhibits 13.1
and 13.2
2. Time-series analyses—Compare changes in account
balances over a series of time periods.
3. Year-to-Year Change (%) = (Change This Year divided
by Prior Year’s Total) ×100 or, in other words,
(Current Year’s Total − Prior Year’s Total) divided by
Prior Year’s Total) × 100.
LO 13-3 Use vertical (common size) analyses to understand important relationships within financial
statements.
B. Vertical (Common Size) Computations
1. Vertical (common size) analyses—Expressing each
financial statement amount as a percentage of another
amount on the same financial statement.
Chapter Outline
Teaching Notes
a. When a company is growing or shrinking overall, it is
difficult to tell from the dollar amounts whether the
proportions within each statement category are
changing.
b. Common size financial statements provide this
information by expressing each financial statement
amount as a percentage of another amount on that
statement.
2. In a common size balance sheet, each asset appears as a
percent of total assets, and each liability or stockholders’
equity item appears as a percent of total liabilities and
stockholders’ equity.
Illustrated in Exhibit 13.3
3. The common size income statement reports each income
statement item as a percentage of sales.
Illustrated in Exhibit 13.4
LO 13-4 Calculate financial ratios to assess profitability, liquidity, and solvency.
C. Ratio Computations
1. Ratio analyses—Help financial statement users to
understand relationships among various items reported in
the financial statements.
2. This type of analysis compares the amounts for one or
more line items to the amounts for other line items in the
same year.
3. Most analysts classify ratios into three categories of
performance:
✓ Activity #2
a. Profitability—The extent to which a company
generates income.
b. Liquidity—The extent to which a company is able to
pay its currently maturing obligations.
c. Solvency—The ability to survive long enough to
repay lenders when debt matures.
4. Profitability Ratios include:
Illustrated in Exhibit 13.5
a. Net profit margin = (Net income divided by Net
sales revenue) × 100
b. Gross profit percentage = (Net sales revenue − Cost
of goods sold) divided by Net sales revenue
c. Fixed asset turnover = Total revenue divided by
Average net fixed assets
d. Return on equity (ROE) = [(Net income − Preferred
dividends) divided by Average common
stockholders’ equity] × 100
e. Earnings per share (EPS) = (Net income −
Preferred dividends) divided by Average number of
common shares
f. Price/earnings (P/E) ratio = Stock price divided by
EPS
✓ Activity #3
Chapter Outline
Teaching Notes
5. Liquidity Ratios include:
Illustrated in Exhibit 13.5
a. Receivables turnover = Net sales revenue divided by
Average net receivables
b. Days to collect = 365 divided by Receivables
turnover ratio
c. Inventory turnover = Cost of good sold divided by
Average inventory
d. Days to sell = 365 divided by Inventory turnover
ratio
e. Current ratio = Current assets divided by Current
liabilities
✓ Activity #3
The “Spotlight on Business
Decisions” feature explains
how Lowe’s helps suppliers
collect on account
6. Solvency Ratios include:
Illustrated in Exhibit 13.5
a. Debt-to-assets = Total liabilities divided by Total
assets
b. Times interest earned = (Net income + Interest
expense + Income tax expense) divided by Interest
expense
✓ Activity #3
III. Evaluate the Results
LO 13-5 Interpret the results of financial analyses.
A. Interpreting Horizontal and Vertical Analyses
1. Financial statement analyses are not complete unless they
lead to interpretations that help users understand and
evaluate a company’s financial results.
2. Goals should be to understand what each analysis is
telling you and then combine your findings into a
coherent “story” that explains the results of the
company’s business activities.
3. Trends Revealed in Horizontal Analyses
a. Horizontal (trend) analysis of a company’s balance
sheet reveals whether a company grew during the year
and indicates whether the company changed its
reliance on debt vs. equity financing.
Refer to Exhibit 13.1
b. Horizontal analysis of a company’s income statement
highlights key changes in its operations.
Refer to Exhibit 13.2
4. Relationships Noted in Vertical Analyses
a. Vertical (common size) analysis of a company’s
balance sheet highlights key elements of the company.
Refer to Exhibit 13.3
b. Vertical (common size) analysis of a company’s
income statement reveals the most important
determinants of the company’s profitability.
Refer to Exhibit 13.4
Chapter Outline
Teaching Notes
B. Interpreting Ratio Analyses
Refer to Exhibit 13.5
1. Benchmarks, which help when interpreting a company’s
ratios, can include the company’s prior year results, as
well as the results of close competitors or the average for
the industry.
2. Industry averages are reported:
a. In the Annual Statement Studies, published by the Risk
Management Association, at statementstudies.org.
b. By reuters.com/finance or google.com/finance.
3. Profitability Ratios—The analyses in this section focus on
the level of profits the company generated during the
period.
4. Liquidity Ratios—The analyses in this section focus on
the company’s ability to survive in the short term, by
converting assets to cash that can be used to pay current
liabilities as they come due.
Refer to Exhibit 13.5
5. Solvency Ratios—The analyses in this section focus on
the company’s ability to survive over the long term—that
is, its ability to repay debt when it matures, pay interest
until that time, and finance the replacement and/or
expansion of long-term assets.
Refer to Exhibit 13.5
LO 13-6 Describe how analyses depend on key accounting decisions and concepts.
C. Underlying Accounting Decisions and Concepts
1. Accounting Decisions
a. Differences between the two companies’ financial
ratios might be caused by differences in their
accounting decisions.
b. Information about a company’s accounting decisions
is presented in a note to the financial statements.
Illustrated in Exhibit 13.6
2. Accounting Concepts
a. The Conceptual Framework for Financial Accounting
and Reporting is summarized in Exhibit 13.7.
i. The primary objective of financial accounting and
reporting is to provide useful financial information
for people external to a company to use in making
decisions about the company.
ii. To be useful, this information must be relevant and
faithfully represent the underlying business.
3. Two additional accounting concepts (not addressed in
previous chapters):
a. Going-concern assumption––A business is assumed
to be capable of continuing its operations long enough
to realize the economic benefits of its assets and meet
its obligations in the normal course of business.
b. Full disclosure principle––The financial statements
should present information needed to understand the
financial results of the company’s business activities.