CHAPTER 13
Financial Analysis: The Big Picture
Learning Objectives
1. Explain the concepts of sustainable income and quality of earnings.
2. Apply horizontal analysis and vertical analysis.
3. Analyze a company’s performance using ratio analysis.
Summary of Questions by Learning Objectives and Bloom’s Taxonomy
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Brief Exercises
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Do It! Exercises
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Exercises
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*Continuing Cookie Solutions for this chapter are available online.
ASSIGNMENT CHARACTERISTICS TABLE
Problem
Number
Description
Difficulty
Level
Time
Allotted (min.)
1A
Prepare vertical analysis and comment on profitability.
Moderate
20–30
2A
Compute ratios from balance sheet and income
statements.
Moderate
20–30
3A
Perform ratio analysis, and discuss change in
financial position and operating results.
Moderate
20–30
4A
Compute ratios; comment on overall liquidity and
profitability.
Moderate
40–50
5A
Compute selected ratios, and compare liquidity,
profitability, and solvency for two companies.
Moderate
50–60
ANSWERS TO QUESTIONS
1. Sustainable income is defined as the most likely level of income to be obtained in the future. It is
the amount of regular income that a company can expect to earn from its normal operations.
LO 1 BT: C Difficulty: Medium TOT: 3 min. AACSB: None AICPA FC: Reporting
2. This would not be considered a favorable trend for Hogan Inc. The relevant earnings per share
figures are the $3.26 in 2016 and the $2.99 in 2017. These figures indicate that, unless there was
a sale of common stock, the earnings from the continuing operations of the company decreased
LO 1 BT: AN Difficulty: Medium TOT: 4 min. AACSB: Analytic AICPA FC: Reporting
3. Companies report a change from FIFO to average cost pricing for inventory retroactively. That is,
they report both the current period and any previous periods reported on the face of the state–
4. Apple reported “Other comprehensive income” of $1,553 millions for year ended September 27,
2014. “Comprehensive income” was more than “Net income” by 3.9% [($41,063 – $39,510) ÷
5. (1) Use of alternative accounting methods. Variations among companies in the application of
generally accepted accounting principles may hamper comparability.
(2) Use of pro forma income measures that do not follow GAAP. Pro forma income is calculated by
(3) Improper revenue and expense recognition. Many high–profile cases of inappropriate accounting
6. (a) During a period of inflation, net income will be less under the LIFO inventory costing method
than it will be using the FIFO method because LIFO results in the larger cost of goods sold
amount.
7. Horizontal analysis (also called trend analysis) measures the dollar and percentage increase or
decrease of an item over a period of time. In this approach, the amount of the item on one state–
8. (a) $300,000 X 1.245 = $373,500, 2017 net income.
9. (a) Gina is not correct. There are three characteristics: liquidity, profitability, and solvency.
(b) The three parties are not primarily interested in the same characteristics of a company. Short-
10. (a) Comparison of financial information can be made on an intracompany basis, an inter-
company basis, and an industry average basis.
1. An intracompany basis compares the same item with prior periods, or with other
financial items in the same period.
2. An intercompany basis compares the same item with other companies’ published reports.
3. The industry average compares the item with the industry average as compiled by
Dun & Bradstreet or by trade associations.
11. (a) Liquidity ratios: Working capital, current ratio, inventory turnover, days in inventory, accounts
12. Tina is correct. A single ratio by itself may not be very meaningful and is best interpreted by
comparison with (1) past ratios of the same company, (2) ratios of other companies, or (3) industry
13. (a) Liquidity ratios measure the short-term ability of the company to pay its maturing obligations
and to meet unexpected needs for cash.
14. Working capital and the current ratio both relate current assets to current liabilities. Working
capital produces a dollar amount that indicates the difference between current assets and current
15. Handi Mart does not necessarily have a problem. The accounts receivable turnover can be
misleading in that some companies encourage credit and revolving charge sales and slow
16. (a) Asset turnover.
(b) Inventory turnover and days in inventory.
17. The price earnings (P-E) ratio is a reflection of investors’ assessments of a company’s future
earnings. The P-E ratio takes into account such factors as relative risk, stability of earnings,
18. The payout ratio is cash dividends declared on common stock divided by net income. In a growth
19. (a) The increase in the profit margin is good news because it means that a greater percentage
of net sales is going towards income.
(b) The decrease in inventory turnover signals bad news because it is taking the company longer
to sell the inventory and consequently there is a greater chance of inventory obsolescence.
20.
Return on assets
(7.6%)
=
Net Income
Average Total Ass ets
21. (a) Times interest earned, which is an indication of the company’s ability to meet interest charges,
and the debt to assets ratio, which indicates the company’s ability to withstand losses without
impairing the interests of creditors.
22.
–Net income Preferred dividends
Average common shares outstanding
= Earnings per share.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 13-1
FLORES CORPORATION
Partial Income Statement
Discontinued operations: Loss on disposal of
BRIEF EXERCISE 13-2
SILVA CORPORATION
Partial Statement of Comprehensive Income
Income before income taxes ……………………………………………….. $450,000
Income tax expense ($450,000 X 25%) …………………………………. 112,500
BRIEF EXERCISE 13-3
The change in inventory pricing for Bryce should be reported retroactively.
That is, it should report both the current period and previous periods
BRIEF EXERCISE 13-4
Horizontal analysis:
Increase
or (Decrease)
Dec. 31, 2017
Dec. 31, 2016
Amount
Percentage*
Accounts receivable
$ 460,000
$ 400,000
$ 60,000
15%
BRIEF EXERCISE 13-5
Vertical analysis:
Dec. 31, 2017
Dec. 31, 2016
Amount
Percentage*
Amount
Percentage**
Accounts receivable
$ 460,000
14.5%
$ 400,000
14.3%
BRIEF EXERCISE 13-6
2017
2016
2015
Net income
$518,400
$485,000
$500,000
Increase or (Decrease)
Amount
Percentage*
BRIEF EXERCISE 13-7
2017
2016
Increase
Net income
$382,800
X
16%
.16 =
$382,800 – X
BRIEF EXERCISE 13-8
2017
2016
2015
Sales revenue
Cost of goods sold
100.0
60.5
100.0
62.9
100.0
64.8
BRIEF EXERCISE 13-9
Comparing the percentages presented results in the following conclusions:
The net income for Phoenix increased in 2016 because of the combination
of an increase in sales and a decrease in both cost of goods sold and
BRIEF EXERCISE 13-10
Current ratio:
2017 2016
BRIEF EXERCISE 13-11
Accounts receivable turnover =
Net credit sales
Average net accounts receivable
2017
2016
(b)
Average collection period
365
365
BRIEF EXERCISE 13-12
(a) Inventory turnover =
Cost of goods sold
Average inventory
(b) Days in inventory
365
4.8
= 76 days
365
5.0
= 73 days
BRIEF EXERCISE 13-13
(a) Asset turnover =
Net sales
Average total assets
(b) Profit margin =
Net income
Net sales
BRIEF EXERCISE 13-14
Payout ratio =
Cash dividends declared on common stock
Net income
.18 =
X
$72,000
BRIEF EXERCISE 13-15
Free Cash Flow
= Cash provided by operating activities –
Capital expenditures – Cash dividends
SOLUTIONS TO DO IT! EXERCISES
DO IT! 13-1
HRABIK CORPORATION
Partial Statement of Comprehensive Income
Income before income taxes ………………………………….. $500,000
Income tax expense ………………………………………………. 100,000
Income from continuing operations ……………………….. 400,000
DO IT! 13-2
Increase in 2017
Amount Percent
Current assets $ (20,000) (9.1)% [($ 200,000 – $ 220,000) ÷ $ 220,000]
DO IT! 13-3
2017 2016
(a) Current ratio:
(b) Inventory turnover:
$955/ [($460 + $390) ÷ 2)] = 2.25 times
(c) Profit margin ratio:
$294 ÷ $3,800 = 7.7%
(d) Return on assets:
$294/[($2,340 + $2,210) ÷ 2)] = 12.9%
(e) Return on common stockholders’ equity:
$294/[($1,030 + $1,040) ÷ 2)] = 28.4%
(f) Debt to assets ratio:
$1,310 ÷ $2,340 = 56.0%
SOLUTIONS TO EXERCISES
EXERCISE 13-1
(a) HAAS CORPORATION
Partial Statement of Comprehensive Income
For the Year Ended October 31, 2017
Income before income taxes ………………………………………….. $540,000
Income tax expense ($540,000 X 20%) …………………………….. 108,000
(b) To: Chief Accountant
From: Your name, Independent Auditor
After reviewing your income statement for the year ended 10/31/17, we
believe it is misleading for the following reasons:
EXERCISE 13-2
TRAYER CORPORATION
Partial Statement of Comprehensive Income
For the Year Ended December 31, 2017
Income from continuing operations …………………. $290,000
Discontinued operations
Loss from operations, net of $2,000
income tax savings ……………………………….. $ 8,000