Chapter 12 – Financial Statement Analysis
12-1
Chapter 12
Financial Statement Analysis
INSTRUCTOR’S MANUAL
Learning Objectives
LO12-1 Perform vertical analysis.
LO12-2 Perform horizontal analysis.
LO12-3 Use ratios to analyze a company’s risk.
LO12-4 Use ratios to analyze a company’s profitability.
LO12-5 Distinguish persistent earnings from one-time items.
LO12-6 Distinguish between conservative and aggressive accounting practices.
Chapter 12 – Financial Statement Analysis
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Teaching Suggestions
Chapter 12 adopts an underlying sports theme to demonstrate the basic tools used in financial
statement analysis.
Part A introduces vertical and horizontal analysis using actual financial statements from
Under Armour and Nike. Vertical analysis controls for differences in company size, making
comparisons among companies of different size possible. Horizontal analysis allows users to
analyze trends in financial statement data for a single company over time. The horizontal
analysis of Under Armour’s financial statements demonstrates the large growth in company
operations during the year. The horizontal analysis of Nike’s financial statements is included in a
Let’s Review problem at the end of this section.
Part B uses ratio analysis to provide a detailed assessment of risk and profitability for Under
Armour, comparing the results to the sports apparel industry leader, Nike. We review 14 ratios
separated into two categories: risk ratios and profitability ratios. Ratio analysis is presented in a
separate section at the end of each chapter, beginning in Chapter 5. These same ratios are
included in a comprehensive example here in Chapter 12 to give instructors maximum flexibility
in the coverage of ratios. Instructors can cover ratios chapter by chapter, save the coverage of
ratios until the final chapter, or combine these two approaches by introducing the ratios in each
chapter and then bringing all of the ratios together in this final chapter. Some instructors even
save this chapter for the next semester to include it in the managerial accounting class.
Part C addresses earnings persistence and earnings quality. Discontinued operations are part
of net income in the current year but are not expected to persist beyond the current year. The
decision maker’s perspective near the end of this section, titled “Does Location in the Income
Statement Matter?,” helps students see that sometimes it’s not just the final net income number
that’s important—the location of the item in the income statement matters as well. The final
section on earnings quality was written based on reviewer feedback regarding the need to help
students better recognize conservative versus aggressive accounting practices. Major topics from
Chapters 5, 6, 7, and 8 are used as examples of both conservative accounting practices (as
prepared by Mr. Nadal) and aggressive accounting practices (as prepared by Mr. Djokovic) to
help students better understand the subjectivity inherent within accounting standards.
Chapter 12 – Financial Statement Analysis
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Questions
Learning
Objective(s)
Topic
Time
(Min.)
1
LO12-1, 12-2
Identify types of comparisons commonly used in
financial statement analysis
5
2
LO12-1, 12-2
Explain the difference between vertical and
horizontal analysis
5
3
LO12-1
Describe the base amounts commonly used in
vertical analysis
5
4
LO12-1
Identify the relative age of a company based on the
size of its common stock and retained earnings
balances
5
5
LO12-2
Explain why it is important to look at both the
amount and percentage change in horizontal
analysis
5
6
LO12-3
Explain why some ratios use average rather than
ending balance sheet amounts
5
7
LO12-3
Describe the difference between liquidity and
solvency
5
8
LO12-3
Relate risk ratios with financial questions
5
9
LO12-3
Determine whether each of the following changes in
risk ratios is good news or bad news about a
company
5
10
LO12-3
Describe the effect of a transaction on the current
ratio
5
11
LO12-4
Relate profitability ratios with financial questions
5
12
LO12-4
Determine whether each of the following changes in
profitability ratios is good news or bad news about a
company
5
13
LO12-4
Explain why the return on assets and the return on
equity differ
5
14
LO12-5
Explain how earnings persistence relate to the
reporting of discontinued operations
5
15
LO12-5
Examine a trend in earnings per share before and
after discontinued operations
5
16
LO12-6
Explain the difference between conservative and
aggressive accounting practices
5
17
LO12-6
Explain why an accounting practice is conservative
5
18
LO12-6
Explain why an accounting practice is aggressive
5
19
LO12-6
Examine year-end adjustments for a common trend
5
20
LO12-6
Provide an example of a change in accounting
practice that has no effect on cash flows
5
Chapter 12 – Financial Statement Analysis
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Brief
Exercises
Learning
Objective(s)
Topic
Time
(Min.)
BE12-1
LO12-1
Prepare vertical analysis
15
BE12-2
LO12-2
Prepare horizontal analysis
15
BE12-3
LO12-1
Understand vertical analysis
10
BE12-4
LO12-2
Understand horizontal analysis
5
BE12-5
LO12-2
Understand percentage change
5
BE12-6
LO12-3
Calculate receivables turnover
5
BE12-7
LO12-3
Calculate inventory turnover
5
BE12-8
LO12-3
Understand inventory turnover
5
BE12-9
LO12-3
Understand the current ratio
10
BE12-10
LO12-4
Calculate profitability ratios
15
BE12-11
LO12-4
Calculate profitability ratios
10
BE12-12
LO12-5
Record discontinued operations
10
BE12-13
LO12-5
Classify income statement items
10
BE12-14
LO12-6
Distinguish between conservative and aggressive
accounting practices
10
BE12-15
LO12-6
Distinguish between conservative and aggressive
accounting practices
10
Exercises
Learning
Objective(s)
Topic
Time
(Min.)
E12-1
LO12-1, 12-2,
12-3, 12-4,
12-5, 12-6
Match terms with their definitions
20
E12-2
LO12-1
Prepare vertical analysis
15
E12-3
LO12-2
Prepare horizontal analysis
15
E12-4
LO12-1, 12-2
Prepare vertical and horizontal analyses
30
E12-5
LO12-3
Evaluate risk ratios
30
E12-6
LO12-4
Evaluate profitability ratios
30
E12-7
LO12-3
Calculate risk ratios
30
E12-8
LO12-4
Calculate profitability ratios
30
E12-9
LO12-4
Calculate profitability ratios
30
E12-10
LO12-4
Calculate profitability ratios
20
E12-11
LO12-5
Classify income statement items
15
E12-12
LO12-5
Record discontinued operations
20
E12-13
LO12-5
Record discontinued operations and other expenses
15
E12-14
LO12-6
Distinguish between conservative and aggressive
accounting practices
10
E12-15
LO12-6
Distinguish between conservative and aggressive
accounting practices
10
Chapter 12 – Financial Statement Analysis
12-5
Problems
Learning
Objective(s)
Topic
Time
(Min.)
P12-1A
LO12-1
Perform vertical analysis
20
P12-2A
LO12-2
Perform horizontal analysis
20
P12-3A
LO12-1, 12-2
Perform vertical and horizontal analyses
30
P12-4A
LO12-3
Calculate risk ratios
30
P12-5A
LO12-4
Calculate profitability ratios
20
P12-6A
LO12-3, 12-4
Use ratios to analyze risk and profitability
45
P12-1B
LO12-1
Perform vertical analysis
20
P12-2B
LO12-2
Perform horizontal analysis
20
P12-3B
LO12-1, 12-2
Perform vertical and horizontal analyses
30
P12-4B
LO12-3
Calculate risk ratios
30
P12-5B
LO12-4
Calculate profitability ratios
20
P12-6B
LO12-3, 12-4
Use ratios to analyze risk and profitability
45
Additional
Perspectives
Topic
Time
(Min.)
AP12-1
Continuing Problem: Great Adventures
45
AP12-2
Financial Analysis: American Eagle Outfitters, Inc.
45
AP12-3
Financial Analysis: The Buckle, Inc.
45
AP12-4
Comparative Analysis: American Eagle Outfitters, Inc. vs. The
Buckle, Inc.
50
AP12-5
Ethics
20
AP12-6
Internet Research
20
AP12-7
Written Communication
20
AP12-8
Earnings Management
20
Chapter 12 – Financial Statement Analysis
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Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10
questions at the end of each chapter. Each question covers the same learning objective but with a
little different twist. The correct answer is highlighted in bold for each item.
LO12-1
1. Common size analysis is more often referred to as:
LO12-1
2. When using vertical analysis, we express balance sheet accounts as a percentage of:
d. Sales.
LO12-2
3. Which of the following is an example of horizontal analysis?
LO12-2
4. Which of the following is an example of horizontal analysis?
LO12-3
5. Which of the following ratios is not considered to be a liquidity ratio?
Chapter 12 – Financial Statement Analysis
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LO12-3
6. Which of the following is a negative indicator regarding a company’s ability to turn its
receivables into cash?
LO12-4
7. Performance, Inc., reports net income of $100,000, sales of $800,000, and average assets of
$500,000. The profit margin is:
LO12-4
8. Performance, Inc., reports net income of $100,000, sales of $800,000, and average assets of
$500,000. The asset turnover is:
a. 0.20 times.
LO12-5
9. Power Equipment incurred a material loss due to business restructuring. This loss should be
reported as:
a. Selling expenses.
LO12-6
10. Which of the following is an example of an aggressive accounting practice in relation to the
reporting of net income?
Chapter 12 – Financial Statement Analysis
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Alternate Let’s Review
Problem #1
The income statements and balance sheets for Incredible Sports are as follows:
Incredible Sports
Income Statements
For the Years Ended December 31
(in millions)
2018
2017
Sales
Cost of goods sold
719.9
750.0
Gross profit
524.1
567.8
Operating expenses
436.3
449.1
Operating income
87.8
118.7
Other income (expense)
Income before tax
89.9
126.2
Income tax expense
22.8
31.2
Net income
$67.0
$95.0
Incredible Sports
Balance Sheets
December 31
(in millions)
Assets
2018
2017
Current assets:
Cash
$386.7
$230.6
Net receivables
258.1
333.5
Current investments
22.8
22.4
Inventory
222.2
256.3
Other current assets
32.0
29.7
Total current assets
921.8
872.5
Property and equipment
235.4
229.7
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
179.3
173.2
Long-term liabilities
36.5
31.0
997.2
944.1
Chapter 12 – Financial Statement Analysis
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Required:
Calculate the following risk ratios for the year ended December 31, 2018.
Solution:
Risk Ratios
Calculations
Liquidity
Receivables turnover ratio
$1,244.0
($258.1 + $333.5) / 2
= 4.2 times
Average collection period
= 86.9 days
Inventory turnover ratio
($222.2 + $256.3) / 2
= 3.0 times
Average days in inventory
= 121.7 days
Current ratio
= 5.1 to 1
Acid-test ratio
= 3.7 to 1
Debt to equity ratio
= 21.6%
12-10
Problem #2
The income statements and balance sheets for Incredible Sports are as follows:
Incredible Sports
Income Statements
For the Years Ended December 31
(in millions)
2018
2017
Sales
$1,244.0
$1,317.8
Cost of goods sold
719.9
750.0
Gross profit
524.1
567.8
Operating expenses
436.3
449.1
Operating income
118.7
Other income (expense)
Income before tax
126.2
Income tax expense
Net income
$67.0
$95.0
Incredible Sports
Balance Sheets
December 31
(in millions)
Assets
2018
2017
Current assets:
Cash
$386.7
$230.6
Net receivables
258.1
333.5
Current investments
Inventory
222.2
256.3
Other current assets
Total current assets
921.8
872.5
Property and equipment
235.4
229.7
Intangible assets
Total assets
$1,213.0
$1,148.3
Liabilities and Stockholders’ Equity
Current liabilities
179.3
173.2
Long-term liabilities
Stockholders’ equity
997.2
944.1
$1,213.0
$1,148.3
2018, and the closing stock price on December 31, 2018, was $39.04.
Chapter 12 – Financial Statement Analysis
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Required:
Calculate the six profitability ratios we’ve discussed for Incredible Sports for the year ended
December 31, 2018.
Solution:
Profitability Ratios
Calculations
Gross profit ratio
$524.1
$1,244.0
= 42.1%
Profit margin
$1,244.0
= 5.4%
Asset turnover
= 1.1 times
Return on equity
= 6.9%
Price-earnings ratio
$39.04
= 19.3
Chapter 12 – Financial Statement Analysis
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Problem #3
Required:
Classify each of the following accounting practices as conservative or aggressive.
1. Decrease the allowance for uncollectible accounts.
2. Decrease the useful life for calculating depreciation.
3. Reduce the amount of a contingent liability reported for litigation.
4. Record a larger expense for warranties.
5. When costs are going up, change from LIFO to FIFO.
Solution:
Chapter 12 – Financial Statement Analysis
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Key Points by Learning Objective
LO12-1 Perform vertical analysis.
LO12-2 Perform horizontal analysis.
LO12-3 Use ratios to analyze a company’s risk.
LO12-4 Use ratios to analyze a company’s profitability.
LO12-5 Distinguish persistent earnings from one-time items.
LO12-6 Distinguish between conservative and aggressive accounting practices.
Chapter 12 – Financial Statement Analysis
12-14
Common Mistakes
Common Mistake
In comparing an income statement account with a balance sheet account, some students
incorrectly use the balance sheet account’s ending balance, rather than the average of its
Chapter 12 – Financial Statement Analysis
12-15
Decision Points
Question
Accounting Information
Analysis
Question
Accounting Information
Analysis
How do we compare
income between companies
Common-size income
statements
A vertical analysis using common-
size income statements allows for
Chapter 12 – Financial Statement Analysis
Career Corner
Career Corner
Investors and creditors, as well as suppliers, customers, employees, and the government, among
others, rely heavily on financial accounting information. Who checks big companies like Under
Armour and Nike to make sure they are reporting accurately? Auditors. Many accounting majors
begin their careers in auditing. They then use the experience they gain in auditing to obtain
management and accounting positions in private industry, sometimes even with a company they
previously audited.
Chapter 12 – Financial Statement Analysis
Ethical Dilemma
Ethical Dilemma
Michael Hechtner was recently hired as an assistant controller for Athletic Persuasions, a
recognized leader in the promotion of athletic events. However, the past year has been a difficult
one for the company’s operations. In order to help with slowing sales, the company has extended
credit to more customers and accepted payment over longer time periods, resulting in a
significant increase in accounts receivable. Similarly, with slowing sales, its inventory of
promotional supplies has increased dramatically.
One afternoon, Michael joined the controller, J.P. Sloan, for a visit with their primary lender,
First National Bank. Athletic Persuasions had used up its line of credit and was looking to
borrow additional funds. In meeting with the loan officer at the bank, Michael was surprised at
the positive spin J.P. Sloan put on the company operations. J.P. exclaimed, “Athletic Persuasions
continues to prosper in a difficult environment. Our current assets have significantly increased in
relation to current liabilities, resulting in a much improved current ratio over the prior year. It
seems wherever I look, the company has been successful.”
Is there anything unethical in the controller’s statement to the banker? What should Michael
do in this situation? Is it acceptable for Michael just to keep quiet?
Key Issues
• When does putting a positive spin on a situation become unethical?
• What action, if any, should Michael take in this situation?