CHAPTER
11
Financial Statement Analysis
CHAPTER OUTLINE:
I. Interpretation of Financial Condition and Results of Operations
A. Liquidity Measures
1. Review of working capital, current ratio, and acid-test ratio
B. Activity Measures
1. Turnover
a. Significance and general model
2. Turnover calculations illustrated
a. Accounts receivable
b. Inventory
C. Profitability Measures
2. Price/earnings ratio (earnings multiple)
3. Dividend yield
5. Preferred dividend coverage ratio
D. Financial Leverage Ratios
2. Debt ratio
4. Times interest earned
E. Book Value Per Share of Common Stock
Chapter 11 Financial Statement Analysis
TEACHING/LEARNING OBJECTIVES:
Principal:
1. To complete the student’s integration of financial accounting concepts and reporting practices
by having the student understand the most frequently used financial ratios.
3. To provide some broad “rules of thumb” so students can form a perspective about the ratio
measurements for specific companies.
Supporting:
4. To emphasize that the trend of a ratio is more important than the ratio itself.
6. To review the concept of financial leverage and the risks associated with long-term debt.
8. To acknowledge that not all judgments about an entity’s operations involve financial data;
other operating statistics are also a source of information.
TEACHING OBSERVATIONS/ASSIGNMENT SUGGESTIONS:
1. This is the third of three chapters (9, 10, and 11) that are designed to help students integrate
2. ROI, ROE, and the liquidity measures were introduced in Chapter 3, and have been used in
3. Students should not be expected to memorize all of the ratio formulas. Instead, try to
Instructor’s Manual / Solutions Manual
TEACHING OBSERVATIONS/ASSIGNMENT SUGGESTIONS: (continued)
4. For examination purposes, emphasis should be placed on interpretation of ratio results, rather
than on the calculation of numbers. You may wish to distribute photocopies of some of the
5. To emphasize the discussion of the price/earnings ratio, use a newspaper stock listing and
6. Refer the students to Moody’s Handbook of Common Stocks or an appropriate online
11-6.
Problem 11-13 provides a straight-forward generic alternative. Mini-exercises 11-1
through 11-4 can also be used to help students learn the mechanics of calculating ratios.
8. Case 11-17 presents an interesting and challenging “puzzle” that helps students to see the
9. Case 11-18 represents the fourth and final installment of the “capstone analytical review”
case series using Gerrard Construction. Although intended as a 4-part case series, it can
be used effectively so long as Case 4-30 was also assigned, and solutions to that case were
previously provided to students.
Chapter 11 Financial Statement Analysis
ASSIGNMENT OVERVIEW:
Note: The primary learning objective in this chapter is to develop an understanding of how
financial statement ratios can be used to facilitate the interpretation of an entity’s financial
position and results of operations; the assignment materials are designed to help develop a basic
understanding of financial statement analysis.
NO.
DIFFICULTY &
TIME
ESTIMATE
OTHER
COMMENTS
M11.2.
Easy-Med., 5–10
min.
Students often have difficulty with these ratios, and should refer
to Exhibits 11-1 and 11-2 or the chapter summary for a review.
M11.4
Easy, 3-5 min.
Simple calculations exercise.
E11.5.
Easy, 5-10 min.
Good discussion starter. Can be used to highlight some of the
E11.6.
Hard, 45-90 min.
Can be used in conjunction with C11.15. See E11.5 and E1.1.
Students may wish to research the firm they have chosen in E1.1.
E11.7.
Med., 7-10 min.
Students should first record the appropriate journal entry, and
then consider the effect on the financial ratio listed opposite of it.
E11.8.
Med., 7-10 min.
Good in-class demonstration problem.
P11.9.
Easy, 12-15 min.
Straight-forward common size balance sheet problem using
Campbell’s data.
P11.10.
Easy, 10-12 min.
See P11.9.
P11.11.
Med., 7-10 min.
Use to reinforce liquidity measures: working capital, current
ratio, and acid-test ratio.
P11.12.
Med., 10-15 min.
P11.13.
Med., 15-25 min.
Straight-forward, comprehensive ratio analysis problem.
C11.15.
Hard, 45-60 min.
Focus company—comprehensive ratio analysis case.
10-15 min.
that financial leverage has on ROE, and the impact that a firm’s
capital structure has on its profitability.
C11.17.
Hard, 30-45 min.
Excel case. Group learning case. Students find this case to be
C11.18.
Med., 20-30 min.
Capstone review.
M11.1.
Cash … ……….. ……….. ……….. ……….. ……….. ……….. ……….. ……….. ……….. $ 16,000
Accounts receivable … ……….. ……….. ……….. ……….. ……….. ……….. ……….. 44,000
M11.2.
a.
b.
Inventory turnover = Cost of goods sold / average inventories
= $292,000 / $73,000 = 4.0 times
Number of days’ sales in inventory =
ROI = Margin * Turnover = 15% * 0.4 = 6%, or
M11.3.
a.
Margin = Net income / Sales
= $60,000 / $400,000 = 15%
Turnover = Sales / Average total assets
M11.4.
a.
Debt ratio = Total liabilities / (Total liabilities and stockholders’ equity)
= $240,000 / $400,000* = 60%
E11.5.
Key data would be the recent (3-5 year) trends in earnings per share, cash dividends per
E11.6.
Other information that students may be interested in knowing include:
1. The results of operations for the most recent quarter or for any period of time that has
passed by since the last balance sheet date.
3. Key qualitative factors such as employment statistics.
5. The availability of financial information about key competitors and/or industry-wide
data for comparative purposes.
E11.7.
Transaction/event
Financial ratio
+/–
Explanation
a.
Split the common stock
2 for 1.
Book value per share
of common stock
–
The denominator doubles so
the BV/share will be ½ of the
original.
b.
Collected accounts
receivable.
Number of days’
sales in accounts
receivable
–
Decrease in accounts
receivable with no effect on
average days’ sales.
c.
Issued common stock for
cash.
Total asset turnover
–
effect on net income.
e.
Accrued interest on a
note receivable.
Current ratio
Increase in current assets for
interest receivable.
account.
(inventory is replaced with
accounts receivable but for a
larger amount).
Wrote off an
Accounts receivable
Net realizable value of
Increase in average total assets
with no effect on sales.
h.
Declared a cash
dividend.
Dividend yield
+
Dividends per share increase
with no determinable effect on
market price per share.
i.
Incurred operating
expenses.
Margin
–
Expenses reduce net income.
j.
Sold equipment at a loss.
Earnings per share
–
Losses reduce net income.
E11.8.
Transaction/event
Financial ratio
+/–
Explanation
a.
Purchased inventory on
account.
Number of days’
sales in inventory
+
Increase in inventory causes
the numerator to increase.
b.
Sold inventory for cash,
at a profit.
Inventory turnover
+
As sales volume increases, so
does cost of goods sold and
inventory turnover.
c.
Issued a 10% stock
dividend.
Earnings per share
–
Increase in the average number
of shares outstanding in the
EPS denominator.
d.
Issued common stock for
cash
Debt ratio
–
Sold land at a gain.
Return on investment
Increase in net income.
Purchased treasury stock
for cash.
Debt/equity ratio
+
Decrease in stockholders’
equity with no change in
h.
Accrued wages that have
been earned by
employees.
Current ratio
Increase in current liabilities.
Equipment was
purchased for cash.
Plant and equipment
turnover
–
The greater the investment in
P,P&E the lower the turnover.
Issued bonds at an
interest rate that is less
Return on equity
+
The company is using financial
leverage to its advantage—
ROE is magnified relative to
ROI.
Increase in total assets with no
change in liabilities.
P11.9.
CAMPBELL SOUP COMPANY
Common Size Balance Sheet
July 28, 2013
Total current assets …. ……….. ……….. ……….. ……….. ……….. ……….. 26.7%
Plant assets, net of depreciation ……… ……….. ……….. ……….. ……….. 27.2
Goodwill …….. ……….. ……….. ……….. ……….. ……….. ……….. ……….. 27.6
P11.10.
CAMPBELL SOUP COMPANY
Common Size Balance Sheet
August 3, 2014
Total current assets …. ……….. ……….. ……….. ……….. ……….. ……….. 25.9%
Plant assets, net of depreciation ……… ……….. ……….. ……….. ……….. 28.6
Goodwill …….. ……….. ……….. ……….. ……….. ……….. ……….. ……….. 30.0
c.
Solution approach:
The journal entry for collecting an account receivable involves a debit to one current
d.
Solution approach:
The journal entry for the payment of an account payable involves a debit to a current
liability (Accounts Payable) and a credit to a current asset (Cash). Thus, current assets
and current liabilities decrease by an equal amount, and there is no effect on working
P11.11.
a.
1. In the current ratio equation, multiply both sides by CL, giving:
Working capital = (current assets – current liabilities) = CA – CL = $900,000
Current ratio = (current assets / current liabilities) = CA / CL = 2.0
Solution approach:
2. In the working capital equation, substitute 2CL for CA, giving:
3. Current assets can be determined as: CA = 2CL = (2 * $900,000) = $1,800,000
b.
Current liabilities = $900,000
Current assets = (Cash + Accounts Receivable + Merchandise Inventory)
= $1,800,000
Solution approach:
1. The difference between the current ratio and the acid-test ratio is that Merchandise
Inventory is excluded from the numerator of the acid-test ratio.