Part 2
Financial Tools
Chapters in This Part
Chapter 3 Financial Statements and Ratio Analysis
Chapter 4 Cash Flow and Financial Planning
Chapter 5 Time Value of Money
Integrative Case 2: Track Software, Inc.
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Chapter 3
Financial Statements and Ratio Analysis
Instructor’s Resources
Overview
This chapter examines four key components of the stockholders’ report: the income statement, balance sheet,
statement of retained earnings, and the statement of cash flows. On the income statement and balance sheet, the
major accounts/balances are reviewed for the student. The rules for consolidating a company’s foreign and
domestic financial statements (FASB No. 52) are described. Following the financial statement coverage, the
chapter covers the evaluation of financial statements using the technique of ratio analysis. Ratio analysis is used by
prospective shareholders, creditors, and a firm’s own management to measure the firm’s operating and financial
health. Three types of comparative analysis are defined: cross-sectional analysis, time-series analysis, and
combined analysis. The ratios are divided into five basic categories: liquidity, activity, debt, profitability, and
market. Each ratio is defined and calculated using the financial statements of Bartlett Company. A brief
explanation of the implications of deviation from industry standard ratios is offered, with a complete (cross-sectional
and time-series) ratio analysis of Bartlett Company ending the chapter. The DuPont system of analysis is also
integrated into the example. The importance of understanding financial statements is highlighted through discussions
of how such knowledge will help a student be a more efficient business manager and more effectively make
personal financial decisions.
Suggested Answer to Opener-in-Review Question
For the year ended December 31, 2012, General Dynamics reported sales of $31.5 million and cost of goods
sold of $26.4 million. What was the company’s gross profit margin that year?
Sales Cost of goods sold Gross profits
Gross profit margin Sales Sales
–
= =
Gross profit margin for 2012
$31.5million $26.4million $5.1million 16.19%
$31.5million $31.5million
–
= = =
Answers to Review Questions
1. The role of the Financial Accounting Standards Board (FASB) and Public Company Accounting Oversight
Board (PCAOB) regulatory agencies in the financial reporting of businesses is highly significant. The
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2. The purpose of each of the four major financial statements is as follows:
Income Statement—The purpose of the income statement is to provide a financial summary of a firm’s
Balance Sheet—The purpose of the balance sheet is to present a summary of the assets owned by a firm, its
Statement of Retained Earnings—This statement reconciles the net income earned during the year, and any
Statement of Cash Flows—This statement provides a summary of the cash inflows and the cash outflows
3. The notes to the financial statements are important because they provide detailed information not directly
4. Financial Accounting Standards Board Statement No. 52 describes the rules for consolidating a company’s
5. Current and prospective shareholders place primary emphasis on a firm’s current and future level of risk and
6. Cross-sectional comparisons are made by comparing similar ratios for firms within the same industry, or to an
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Chapter 3 Financial Statements and Ratio Analysis 28
7. An analyst should devote primary attention to any significant deviations from the norm, whether above or
8. Comparing financial statements from different points in the year can result in inaccurate and misleading analysis
9. The current ratio proves to be the better liquidity measure when all of a firm’s current assets are reasonably
10. Large businesses typically have established relationships with banks that can provide access to short-term
11.Additional information is necessary to assess how well a firm collects receivables and meets payables. The
12. Financial leverage is the term used to describe the magnification of risk and return introduced through the
13. The debt ratio and the debt-equity ratio may be used to measure a firm’s degree of indebtedness. Coverage
14. Three ratios of profitability found on a common-size income statement are: (1) the gross profit margin, (2) the
15. Firms that have high gross profit margins and low net profit margins have high levels of expenses other than
16. The owners are probably most interested in the return on equity (ROE) because it indicates the rate of return
17. The price-earnings ratio (P/E) is the market price per share of common stock divided by the earnings per
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Chapter 3 Financial Statements and Ratio Analysis 29
18. Liquidity ratios measure how well a firm can meet its current (short-term) obligations when they come due.
19. The analyst may approach a complete ratio analysis on either a cross-sectional or time-series basis by
20. The DuPont system of analysis combines profitability (the net profit margin), asset efficiency (the total asset
Suggested Answer to Global Focus Box: More Countries Adopt
International Financial Reporting Standards
What costs and benefits might be associated with a switch to IFRS in the United States?
The two key characteristics of the current system of financial markets related to companies following U.S. GAAP
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Chapter 3 Financial Statements and Ratio Analysis 30
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Chapter 3 Financial Statements and Ratio Analysis 31
Suggested Answer to Focus on Ethics Box: Taking Earnings Reports at
Face Value
Why might financial managers be tempted to manage earnings?
Financial managers’ incentive structures might tempt them to manage earnings. For many managers, compensation
Is it unethical for managers to manage earnings if they disclose their activities to investors?
Answers to Warm-Up Exercises
E3-1. Prepare an income statement.
Answer:
a.
Name of Company
Income Statement ($000,000)
Sales revenue $345.0
Less: Cost of goods sold 255.0
right, we see how financial leverage has increased assets over the owners’ original equity. Next, moving
to the left, we see how efficiently the firm used its assets to generate sales. Finally, the net profit margin
shows the measure of profitability on sales. Each component can be compared with industry standards
to see if the firm is underperforming or outperforming in any one of the three areas.
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Chapter 3 Financial Statements and Ratio Analysis 34
Solutions to Problems
P3-1. Reviewing basic financial statements
LG 1; Basic
Income statement: In this one-year summary of the firm’s operations, Technica, Inc., showed a net profit
for 2015 and the ability to pay cash dividends to its stockholders.
Balance sheet: The financial condition of Technica, Inc., at December 31, 2014 and 2015 is shown as a
summary of assets and liabilities. Technica, Inc., has an excess of current assets over current liabilities,
demonstrating liquidity. The firm’s fixed assets represent more than one-half of total assets ($270,000 of
$408,300). The firm is financed by short-term debt, long-term debt, common stock, and retained earnings.
It appears that it repurchased 500 shares of common stock in 2015.
Statement of retained earnings: Technica, Inc., earned a net profit of $42,900 in 2015 and paid out
$20,000 in cash dividends. The reconciliation of the retained earnings account from $50,200 to $73,100
shows the net amount ($22,900) retained by the firm.
P3-2. Financial statement account identification
LG 1; Basic
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Chapter 3 Financial Statements and Ratio Analysis 35
(a) (b)
Account Name Statement Type of Account
Accounts payable BS CL
Accounts receivable BS CA
Accruals BS CL
Accumulated depreciation BS FA*
Administrative expense IS E
Buildings BS FA
Cash BS CA
Common stock (at par) BS SE
Cost of goods sold IS E
Depreciation IS E
Equipment BS FA
General expense IS E
Interest expense IS E
Inventories BS CA
Land BS FA
Long-term debt BS LTD
Machinery BS FA
Marketable securities BS CA
Notes payable BS CL
Operating expense IS E
Paid-in capital in excess of par BS SE
Preferred stock BS SE
Preferred stock dividends IS E
Retained earnings BS SE
Sales revenue IS R
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Chapter 3 Financial Statements and Ratio Analysis 36
Selling expense IS E
Taxes IS E
Vehicles BS FA
* This is really not a fixed asset, but a charge against a fixed asset, better known as a contra-asset.
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Chapter 3 Financial Statements and Ratio Analysis 37
P3-3. Income statement preparation
LG 1; Intermediate
a.
Cathy Chen, CPA
Income Statement
for the Year Ended December 31, 2015
Sales revenue $360,000
Less: Operating expenses
Salaries 180,000
Employment taxes and benefits 34,600
Supplies 10,400
Travel and entertainment 17,000
Lease payment 32,400
Depreciation expense 15,600
Total operating expense 290,000
Operating profits $ 70,000
Less: Interest expense 15,000
Net profits before taxes $ 55,000
Less: Taxes (30%) 16,500
Net profits after taxes $ 38,500
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Chapter 3 Financial Statements and Ratio Analysis 38
b. In her first year of business, Cathy Chen covered all her operating expenses and earned a net profit of
$38,500 on revenues of $360,000.
P3-4. Personal finance: Income statement preparation
LG 1; Intermediate
a.
Adam’s salary $45,000
Arin’s salary 30,000
Interest received 500
Dividends received 150
Total Income $75,650
Expenses
Mortgage payments 14,000
Utility expense 3,200
Groceries 2,200
Auto loan payment 3,300
Home insurance 750
Auto insurance 600
Medical expenses 1,500
Property taxes 1,659
Income tax and social security 13,000
Clothes and accessories 2,000
Gas and auto repair 2,100
Entertainment 2,000
Total Expenses $46,309
Cash Surplus or (Deficit) $29,341
b. Because income exceeds expenses, the Adams have a cash surplus.
c. The cash surplus can be used for a variety of purposes. In the short term, they may replace their car,
buy better furniture, or more quickly pay off their home. Alternatively, they may purchase stocks and
bonds, or increase their savings for future needs. Investments in the stock market are generally
designed to increase an individual’s future wealth, the purchase of bonds typically allows one to at
least retain their purchasing power, while investment in savings accounts provides liquidity.
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