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Chapter 15
Financial Statement Analysis
Review Questions
1. What are the three main ways to analyze financial statements?
2. What is an annual report? Briefly describe the key parts of the annual report.
An annual report (10-K) is a report required by the Securities and Exchange Commission that
provides information about a company’s financial condition. The annual report includes the
3. What is horizontal analysis, and how is a percentage change computed?
The horizontal analysis is the study of percentage changes in line items from comparative
4. What is trend analysis, and how does it differ from horizontal analysis?
The trend analysis is a form of horizontal analysis in which percentages are computed for
5. What is vertical analysis? What item is used as the base for the income statement? What item
is used as the base for the balance sheet?
The vertical analysis of a financial statement shows the relationship of each line item to its
6. Describe a common-size statement and how it might be helpful in evaluating a company.
A common-size statement reports only percentages—the same percentages that appear in a
7. What is benchmarking, and what are the two main types of benchmarks in financial
statement analysis?
Benchmarking is the practice of comparing a company’s performance with its prior
8. Briefly describe the ratios that can be used to evaluate a company’s ability to pay current
liabilities.
The financial measures that are used to evaluate the ability of a company to pay its current
liabilities are:
9. Briefly describe the ratios that can be used to evaluate a company’s ability to sell
merchandise inventory and collect receivables.
The ratios that are used to evaluate a company’s ability to sell merchandise inventory and
collect receivables are:
Inventory turnover—measures the number of times a company sells its average level of
merchandise inventory during a period. Cost of goods sold/ Average merchandise
inventory.
10. Briefly describe the ratios that can be used to evaluate a company’s ability to pay long-term
debt.
The ratios that can be used to evaluate a company’s ability to pay long-term debt are:
Debt ratio—Shows the proportion of assets financed by debt: Total liabilities / Total
11. Briefly describe the ratios that can be used to evaluate a company’s profitability.
The ratios that can be used to evaluate a company’s profitability are:
Profit margin ratio—Shows how much net income is earned on every dollar of sales: Net
income / Net sales revenue.
Rate of return on total assets—Measures the success a company has in using its assets to
12. Briefly describe the ratios that can be used to evaluate a company’s stock as an investment.
The ratios that can be used to evaluate a company’s stock as an investment are:
Price / earnings ratio—The market price of a share of common stock in relation to the
company’s earnings per share. It measures the value that the stock market places on $1 of
13. What are some common red flags in financial statement analysis?
Some of the common red flags in financial statement analysis are:
Short Exercises
S15-1 Explaining financial statements
Learning Objective 1
Caleb King is interested in investing in Orange Corporation. What types of tools should Caleb
use to evaluate the company?
SOLUTION
Caleb should complete a review of the company’s performance across several periods of
S15-2 Performing horizontal analysis
Learning Objective 2
Verifine Corp. reported the following on its comparative income statement:
(In millions) 2019 2018 2017
Revenue $ 9,890 $ 9,690 $ 9,135
Cost of Goods Sold 6,250 6,000 5,890
Prepare a horizontal analysis of revenues and gross profit—both in dollar amounts and in
percentages—for 2019 and 2018.
SOLUTION
S15-3 Calculating trend analysis
Learning Objective 2
Muscateer Corp. reported the following revenues and net income amounts:
(In millions) 2019 2018 2017 2016
Revenue $ 9,610 $ 9,355 $ 9,050 $ 8,950
Net Income 7,290 6,790 5,020 4,300
Requirements
1. Calculate Muscateer’s trend analysis for revenues and net income. Use 2016 as the base year,
and round to the nearest percent.
2. Which measure increased at a higher rate during 2017–2019?
SOLUTION
Requirement 1
S15-4 Performing vertical analysis
Learning Objective 3
Great Value Optical Company reported the following amounts on its balance sheet at December
31, 2018 and 2017:
2018 2017
Cash and Receivables $ 80,640 $ 80,575
Merchandise Inventory 56,840 54,450
Property, Plant, and
Equipment, Net
142,520 139,975
Total Assets $ 280,000 $ 275,000
Prepare a vertical analysis of Great Value’s assets for 2018 and 2017.
SOLUTION
S15-5 Preparing common-size income statement
Learning Objective 3
Data for Connor, Inc. and Alto Corp. follow:
Connor Alto
Net Sales Revenue $ 13,000 $ 22,000
Cost of Goods Sold 7,917 15,730
Other Expenses 4,342 5,170
Net Income $ 741 $ 1,100
Requirements
1. Prepare common-size income statements.
2. Which company earns more net income?
3. Which company’s net income is a higher percentage of its net sales revenue?
SOLUTION
Requirement 1
Use the following information for Short Exercises S15-6 through S15-10.
Accel’s Companies, a home improvement store chain, reported the following summarized
figures:
Accel’s has 10,000 common shares outstanding during 2018.
S15-6 Evaluating current ratio
Learning Objective 4
Requirements
1. Compute Accel’s Companies’ current ratio at May 31, 2018 and 2017.
2. Did Accel’s Companies’ current ratio improve, deteriorate, or hold steady during 2018?
S15-6, cont.
SOLUTION
Requirement 1
S15-7 Computing inventory, gross profit, and receivables ratios
Learning Objective 4
Requirements
1. Compute the inventory turnover, days’ sales in inventory, and gross profit percentage for
Accel’s Companies for 2018.
2. Compute days’ sales in receivables during 2018. Round intermediate calculations to three
decimal places. Assume all sales were on account.
3. What do these ratios say about Accel’s Companies’ ability to sell inventory and collect
receivables?
SOLUTION
S15-7, cont.
