INVESTOR INSIGHT
The apparent simplicity of the current ratio can have real-world
limitations because adding equal amounts to both the numerator
and the denominator causes the ratio to decrease. Conversely,
decreasing both the numerator and the denominator by equal
amounts causes the ratio to increase.
How might management influence a company‘s current ratio?
c. Accounts receivable turnover is used to assess the liquidity of
accounts receivable. Companies compute this ratio by dividing net
credit sales by the average net accounts receivable during the year.
The average collection period in days is computed by dividing the
accounts receivable turnover into 365 days.
d. Inventory turnover measures the number of times, on average, the
inventory was sold during the period. Companies compute the inven–
tory turnover by dividing cost of goods sold by the average inventory
during the year. The average days in inventory is computed by
dividing inventory turnover into 365 days.
6. Profitability ratios.
a. Profit margin is a measure of the percentage of each dollar of sales
that results in net income. It is computed by dividing net income by
net sales.
b. Asset turnover measures how efficiently a company uses its assets
to generate sales. It is computed by dividing net sales by average
assets.
c. An overall measure of profitability is return on assets. This ratio is
computed by dividing net income by average assets.
d. Return on common stockholders’ equity shows how many dollars of
net income the company earned for each dollar invested by the
owners. Companies compute it by dividing net income by average
common stockholders’ equity.
(1) When a company has preferred stock, it must deduct preferred
dividend requirements from net income to compute income
available to common stockholders.
(2) Companies deduct the par value of preferred stock (or call
price) from total stockholders’ equity to determine the amount
of common stock equity used in the denominator.
(3) Trading on the equity at a gain is borrowing money at a lower
rate of interest than can be earned by using the borrowed
money.
e. Earnings per share is a measure of the net income earned on each
share of common stock. It is computed by dividing net income by
the number of weighted-average common shares outstanding during
the year.
f. The price-earnings ratio is a measure of the ratio of the market
price of each share of common stock to the earnings per share. It is
computed by dividing the market price per share of the stock by
earnings per share.
g. The payout ratio measures the percentage of earnings distributed
in the form of cash dividends. Companies compute it by dividing
cash dividends by net income.
7. Solvency ratios.
a. The debt to assets ratio measures the percentage of the total
assets that creditors provide. It is computed by dividing total
liabilities (both current and long-term liabilities) by total assets.
b. Times interest earned (interest coverage ratio) provides an indication
of the company’s ability to meet interest payments as they come due.
Companies compute it by dividing income before interest expense
and income taxes by interest expense.
C. Earning Power and Irregular Items.
Earning power means the normal level of income to be obtained in the future.
Irregular items include (a) discontinued operations, and (b) extraordinary items.
1. Discontinued operations refers to the disposal of a significant component
of a business. Examples involve stopping an entire activity or eliminating
a major class of customers.
a. The income (loss) from discontinued operations consists of the
income (loss) from operations and the gain (loss) on disposal of the
segment.
b. The discontinued operations section reports both the operating
income (loss) and the gain (loss) on disposal net of applicable income
taxes.
2. Extraordinary items are events and transactions that are:
a. Unusual in nature.
b. Infrequent in occurrence.
(1) To be “unusual,” the item should be abnormal and only inciden–
tally related to the company’s customary activities.
(2) To be “infrequent,” the item should not be reasonably expected
to recur in the foreseeable future.
c. Companies report extraordinary items net of taxes in a separate
section of the income statement, immediately below discontinued
operations.
INVESTOR INSIGHT
Many companies incur restructuring charges as they attempt to reduce costs.
They often label these items in the income statement as “non–recurring” charges
to suggest that they are isolated events which are unlikely to occur in future
periods.
If a company takes a large restructuring charge, what is the effect on the
company’s current income statement versus future ones?
3. A change in accounting principle occurs when the principle used in
the current year is different from the one used in the preceding year.
Accounting rules permit a change when management can show that the
new principle is preferable to the old principle.
4. Companies report most changes in accounting principle retroactively.
They report both the current period and previous periods using the new
principle.
5. Comprehensive income includes all changes in stockholders’ equity
during a period except those resulting from investments by stockholders
and distributions to stockholders.
D. Quality of Earnings.
1. In evaluating the financial performance of a company, the quality of a
company’s earnings is of extreme importance to analysts. A high quality
of earnings provides full and transparent information that will not confuse
or mislead users of the financial statements. Issues related to quality of
earnings are:
a. Alternative accounting methods. Variations among companies in the
application of generally accepted accounting principles may hamper
comparability and reduce quality of earnings.
b. Pro forma income. Pro forma income usually excludes items that the
company thinks are unusual or nonrecurring. Many analysts are critical
of using pro forma income because these numbers often make
companies look better than they really are.
c. Improper recognition. Because some managers have felt pressure
from investors to continually increase earnings, they have manipu-
lated the earnings numbers to meet these expectations. The most
common abuse is the improper recognition of revenue.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Intercompany comparison refers to comparison with other companies to provide insight
into competitive position.
True False
2. Vertical analysis determines the percentage increase or decrease that has taken place
over a period of time.
True False
3. A base year is determined when performing horizontal analysis.
True False
4. Liquidity ratios measure the ability of an enterprise to survive over a long period of time.
True False
5. Accounts receivable turnover, inventory turnover, and asset turnover are all common
measures of liquidity.
True False
6. Profit margin, return on assets, and return on common stockholders’ equity are profitability
ratios.
True False
7. The formula for computing times interest earned is income before income taxes and
interest expense divided by interest expense.
True False
8. The debt to assets ratio measures the percentage of total assets provided by long-term
creditors.
True False
9. Extraordinary gains and losses should be disclosed in the income statement immediately
below discontinued operations net of taxes.
True False
10. To compute pro forma income, companies generally can exclude any items they deem
inappropriate for measuring their performance.
True False
Multiple Choice
1. Sales (in millions) for a three year period are: Year 1 $6, Year 2 $6.9, and Year 3 $7.5.
Using Year 1 as the base year the percentage increase in sales in Years 2 and 3 are,
respectively
a. 115% and 125%.
b. 115% and 109%.
c. 115% and 130%.
d. 87% and 80%.
2. An incorrect formula is
a. current ratio = current assets ÷ current liabilities.
b. accounts receivable turnover = net credit sales ÷ average net accounts receivable.
c. asset turnover = net income ÷ average assets.
d. payout ratio = cash dividends ÷ net income.
3. The acid-test ratio
a. is a solvency ratio.
b. measures immediate short-term liquidity.
c. includes inventory in the numerator of the formula.
d. includes total liabilities in the denominator of the formula.
4. The ratio that measures the overall profitability of assets is
a. profit margin.
b. asset turnover.
c. return on common stockholders’ equity.
d. return on assets.
5. Which of the following would least likely be considered an extraordinary item?
a. Loss from fire destruction.
b. Loss from meteorite destruction.
c. Gain on sale of company vehicle.
d. Gain on property taken over by a foreign government.
ANSWERS TO QUIZ
True/False
Multiple Choice