Chapter 12 – Financial Statement Analysis
12-1
Chapter 12
Financial Statement Analysis
INSTRUCTOR’S MANUAL
Authors’ Perspectives
PART A: Comparison of Financial Accounting Information
LO12-1 Perform vertical analysis.
Vertical and Horizontal Analysis – We can first remind students that ratios are used to make
comparisons every day. Batting averages provide feedback in baseball about how well a player is
hitting. Basketball and football fans use points per game to compare teams’ offensive and
defensive performance. The cost per ounce of meat at the grocery store matters to shoppers. In
PART B: Using Ratios to Assess Risk and Profitability
LO12-3 Use ratios to analyze a company’s risk.
LO12-4 Use ratios to analyze a company’s profitability.
Risk Ratios – Part B begins with a detailed assessment of risk for Under Armour, comparing the
company’s risk ratios to the sports apparel industry leader, Nike. The coverage includes eight
risk ratios, distinguished by liquidity and solvency.
Chapter 12 – Financial Statement Analysis
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causes investors to bid the price of a stock upward. At the same time, as risk increases, stock
prices generally decline. Most investors are risk averse. This risk aversion decreases the demand
for riskier stocks, lower the price. So, risk and profitability are key factors in the investment
decision, and accounting ratios provide important insights into those factors.
Common Mistake: For computing risk and profitability ratios, students get confused as to
whether to use (1) the average of ending and beginning amounts or (2) the ending amounts
an equivalent time basis.
Flexibility in Coverage – Some instructors prefer to cover ratios with each chapter as they move
through the topics in the course. This chapter-by-chapter approach allows instructors to reinforce
immediately how the chapter’s measurement/communication topics lead to decision-making.
Other instructors prefer to cover ratios in a final summary chapter, such as Chapter 12’s
PART C: Earnings Persistence and Earnings Quality
LO12-5 Distinguish persistent earnings from one-time items.
LO12-6 Distinguish between conservative and aggressive accounting practices.
Earnings Persistence – Part C begins with the concept of earnings persistence. Discontinued
Conservative versus Aggressive – The final section on earnings quality reinforces the idea that
Chapter 12 – Financial Statement Analysis
12-3
assumptions and estimates are inherent in financial accounting. As a result, management can
affect amounts reported in the financial statements by applying conservative or aggressive
accounting practices. Major topics from Chapters 5, 6, 7, and 8 are used as examples of both
• Illustration 12-28 shows the impact of conservative versus aggressive accounting choices
in the income statement.
• Illustration 12-29 shows the impact of conservative versus aggressive accounting choices
in the balance sheet.
One potentially enlightening aspect of this topic is that conservative versus aggressive
Self-Study Materials
■ Let’s Review—Horizontal analysis (p. 604).
■ Let’s Review—Risk ratios (p. 611).
Chapter 12 – Financial Statement Analysis
12-4
Key Points by Learning Objective
Throughout the chapter, Key Points provide quick synopses of the critical pieces of information
LO12-1 Perform vertical analysis.
For vertical analysis, we express each item as a percentage of the same base amount, such as a
percentage of sales in the income statement or as a percentage of total assets in the balance sheet.
LO12-2 Perform horizontal analysis.
LO12-3 Use ratios to analyze a company’s risk.
We divide risk ratios into liquidity ratios and solvency ratios. Liquidity ratios focus on the
company’s ability to pay current liabilities, whereas solvency ratios include long-term liabilities.
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.
Changes in accounting estimates and practices alter the appearance of amounts reported in
Chapter 12 – Financial Statement Analysis
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Questions
Learning
Objective(s)
Topic
Time
(Min.)
1
LO12-1, 12-2
financial statement analysis
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
size of its common stock and retained earnings
balances
amount and percentage change in horizontal
analysis
Identify types of comparisons commonly used in
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
LO12-4
Relate profitability ratios with financial questions
5
profitability ratios is good news or bad news about a
company
LO12-4
Explain why the return on assets and the return on
equity differ
5
LO12-5
Explain how earnings persistence relate to the
reporting of discontinued operations
5
LO12-5
Examine a trend in earnings per share before and
after discontinued operations
5
LO12-6
Explain the difference between conservative and
aggressive accounting practices
5
LO12-6
Explain why an accounting practice is conservative
5
LO12-6
Explain why an accounting practice is aggressive
5
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
12-6
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
LO12-4
Calculate profitability ratios
15
LO12-4
Calculate profitability ratios
10
LO12-5
10
LO12-5
Classify income statement items
10
accounting practices
accounting practices
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
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
LO12-4
Calculate profitability ratios
20
LO12-5
Classify income statement items
15
LO12-5
20
LO12-5
15
accounting practices
accounting practices
Chapter 12 – Financial Statement Analysis
12-7
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
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
P12-5B
LO12-4
Calculate profitability ratios
20
P12-6B
LO12-3, 12-4
Use ratios to analyze risk and profitability
45
Additional
Perspectives
Topic
AP12-1
Continuing Problem: Great Adventures
AP12-2
Financial Analysis: American Eagle Outfitters, Inc.
AP12-3
Financial Analysis: The Buckle, Inc.
Buckle, Inc.
AP12-5
Ethics
AP12-6
Internet Research
AP12-7
Written Communication
AP12-8
Earnings Management
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)
2021
2020
Sales revenue
$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
2021
2020
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
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
179.3
173.2
Long-term liabilities
Stockholders’ equity
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, 2021.
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
$179.3
= 5.1 to 1
Acid-test ratio
$179.3
= 3.7 to 1
Solvency
Debt to equity ratio
$179.3 + $36.5
$997.2
= 21.6%
Chapter 12 – Financial Statement Analysis
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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)
2021
2020
Sales revenue
$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
2021
2020
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
In addition, the company reported earnings per share of $2.02 for the year ended December 31,
2021, and the closing stock price on December 31, 2021, was $39.04.
Chapter 12 – Financial Statement Analysis
Required:
Solution:
Profitability Ratios
Calculations
Gross profit ratio
$524.1
$1,244.0
= 42.1%
Return on assets
$67.0
($1,213.0 +$1,148.3) / 2
= 5.7%
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
12-13
Common Mistakes
Common Mistakes made by students are highlighted in each of the chapters. With greater
awareness of the potential pitfalls, student can avoid making the same mistakes and gain a deeper
understanding of the chapter material.
Common Mistake
In comparing an income statement account with a balance sheet account, some students
Chapter 12 – Financial Statement Analysis
12-14
Decision Points and Decision Maker’s Perspective
Decision Points and Decision Maker’s Perspectives are provided throughout each chapter to give
insight into how measurement and communication of financial accounting information help
decision makers.
Decision Points
Question
Accounting Information
Analysis
Question
Accounting Information
Analysis
How do we compare
Common-size income
A vertical analysis using common-
Chapter 12 – Financial Statement Analysis
12-15
Decision Maker’s Perspective
How Warren Buffett Interprets Financial Statements
Warren Buffett is one of the world’s wealthiest individuals, with investments in the billions. As
founder and CEO of Berkshire Hathaway, an investment company located in Omaha,
Nebraska, he is also highly regarded as one of the world’s top investment advisors. So, what’s
the secret to his success? Warren Buffett is best known for his attention to details, carefully
examining each line in the financial statements.
Does Location in the Income Statement Matter?
As manager of a company, would you prefer to show an expense as part of continuing operations
or as a part of discontinued operations? Your first response might be that it really doesn’t matter,
since the choice affects only the location in the income statement and has no effect on the final
Look Out for Earnings Management at Year-End
Let’s assume you’re an auditor and all four of the final changes to the accounting records near
year-end increase income. Wouldn’t you be just a little concerned? It may be that all four
Chapter 12 – Financial Statement Analysis
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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
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?
Option 1: Keep quiet and give full support to his boss, J.P. Sloan
• This is the easiest alternative.