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Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-1
14 FINANCIAL STATEMENT ANALYSIS
Chapter Summary
Although earlier chapters have touched on topics from financial statement analysis, we
now present a comprehensive overview of the subject. The chapter is organized into three
sections. We begin by introducing a number of analytical tools. Second, measures of liquidity,
credit risk, and profitability are surveyed in detail. Finally, a comprehensive illustration analyzes
a fictional company from the point of view of stockholders, and short and long-term creditors.
The analytical tools explained include dollar and percentage changes, trend percentages,
component percentages, and ratios. Particular attention is paid to the sensitivity of percentage
computations to the choice of base period. Our treatment of ratios at this point concentrates on
the choice of potential standards of comparison. This first portion of the chapter concludes with
an introduction to the concept of earnings quality.
The examination of measures of liquidity and credit risk begins with a definitional
analysis of liquidity and the balance sheet classifications of current assets and current liabilities.
With these definitions established we introduce working capital, the current ratio, the quick ratio,
and debt ratio. Computation of each measure is illustrated before proceeding to show how each is
used to evaluate liquidity. We identify standards for comparison and sources of data for
individual companies and industries. The usefulness and limitations of these measures are
explained.
A multiple-step income statement provides the foundation for profitability analysis. The
gross profit rate and operating income illustrate the usefulness of income statement subtotals.
Earnings per share, introduced in Chapter 12, is re-examined here and used to explain the
interpretation of the price earnings ratio. Adequacy of net income is addressed via return of
average assets and return on stockholders’ equity.
We end the chapter with a lengthy illustration of a fictitious entity. Analysis of the
example statements begins from the perspective of a stockholder. Measures examined include
EPS, the p/e ratio, dividend yield, the return of assets and the return on equity. A brief discussion
of the advantages of leverage precedes coverage of the debt ratio. The concerns of long-term
creditors are addressed using the interest coverage ratio. The analysis by short-term creditors
reprises the measures of liquidity covered earlier in the chapter. In addition, the accounts
receivable turnover rate and inventory turnover rate are computed and interpreted. We conclude
by analyzing the net cash flow from operating activities and contrasting it with net income.
Chapter 14—Financial Statement Analysis
14-2 Instructor’s Resource Manual
Learning Objectives
1. Explain the uses of dollar and percentage changes, trend percentages, component
percentages, and ratios.
2. Discuss the quality of a company’s earnings, assets, and working capital.
3. Explain the nature and purpose of classifications in financial statements.
4. Prepare a classified balance sheet and compute widely used measures of liquidity and credit
risk.
5. Prepare a multiple-step and a single-step income statement and compute widely used
measures of profitability.
6. Put a company’s net income into perspective by relating it to sales, assets, and stockholders’
equity.
7. Compute the ratios widely used in financial statement analysis and explain the significance
of each.
8. Analyze financial statements from the viewpoints of common stockholders, creditors, and
others.
Brief Topical Outline
A. Financial statements are designed for analysis
B. Tools of analysis
1. Dollar and percentage changes
a. Evaluating percentage changes in sales and earnings
b. Percentages become misleading when the base is small
2. Trend percentages
3. Component percentages
4. Ratios
5. Standards of comparison
a. Past performance of the company
b. Industry standards
6. Quality of earnings
7. Quality of assets and the relative amount of debt
C. Measures of liquidity and credit risk
1. A classified balance sheet
a. Current assets
b. Current liabilities
2. Working capital
3. Current ratio
4. Quick ratio
5. Debt ratio
Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-3
6. Evaluating financial ratios
a. Standards for comparison
b. Annual reports
c. Industry information
d. Usefulness and limitations of financial ratios—see International Case in
Point (page 633)
7. Liquidity, credit risk, and the law
a. Small corporations and loan guarantees
D. Measures of profitability
1. Classifications in the income statement—see Your Turn (page 636)
2. Multiple-step income statements
a. The revenue section
b. The cost of goods sold section
c. Gross profit: a key subtotal
d. The operating expense section
e. Operating income: another key subtotal
f. Nonoperating items
g. Net income
3. Earnings per share
4. Price-earnings ratio
5. Single-step income statements
6. Evaluating the adequacy of net income
7. Return on investment (ROI)
8. Return on assets (ROA)
9. Return on equity (ROE)
E. Comprehensive illustration (pages 641–643)
1. Analysis by common stockholders
a. Earnings per share of common stock
b. Price-earnings ratio
c. Dividend yield
d. Summary of earnings and dividend data for Seacliff
e. Revenue and expense analysis
2. Return on investment (ROI)
a. Return on assets
b. Return on common stockholders’ equity
3. Leverage
a. Debt ratio—see Case in Point (page 648)
4. Analysis by long-term creditors
a. Yield rate on bonds
b. Interest coverage ratio
c. Debt ratio
d. Secured claims
5. Analysis by short-term creditors
a. Amount of working capital
b. Quality of working capital
c. Accounts receivable turnover rate
d. Inventory turnover rate
e. Operating cycle
Chapter 14—Financial Statement Analysis
14-4 Instructor’s Resource Manual
f. Current ratio
g. Quick ratio
h. Unused lines of credit
6. Cash flow analysis
a. Cash flows from operations to current liabilities
7. Usefulness of notes to financial statements—see Your Turn (page 653) and
Pathways Connection (Page 654)
8. International financial reporting standards—see Ethics, Fraud, & Corporate
Governance (page 656)
9. Summary of analytical measurements
F. Concluding remarks
Topical Coverage and Suggested Assignment
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions*
Brief
Exercises*
Exercises*
Problems*
Critical
Thinking
Cases*
1
A – B
1, 2, 3, 4
1, 2, 3
1, 2, 3
1
2
C
8, 9, 10
5, 7
4, 5, 6
3
1
3
D – F
13, 14, 15
9, 10
13, 14, 15
7
*Homework assignment (to be completed prior to class)
Comments and Observations
Teaching Objectives for Chapter 14
In presenting this chapter our objectives are to:
1. Establish the usefulness of accounting information to economic decision-makers.
2. Explain the use of common analytical tools, especially percentage changes and ratios.
3. Introduce the concept of quality of earnings in financial analysis.
4. Describe the basic classifications within financial statements, and explain the usefulness of
these classifications.
5. Present basic ratios used in evaluating liquidity, credit risk, and the return on invested capital.
6. Discuss the usefulness and limitations of ratio analysis.
7. Emphasize the importance of financial leverage to stockholders and creditors.
8. Present a comprehensive analysis of a set of financial statements and the notes to the
statements.
Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-5
General Comments
This chapter exemplifies our continuing goal of increasing emphasis upon the
interpretation and use of accounting information. Throughout the first twelve chapters we have
shown, not only how accounting information is developed, but also how it is interpreted and
used. We feel that it is appropriate at this point in the course to spend some amount of time
concentrating on this theme.
After reviewing some straightforward analytical tools, the chapter introduces statement
classifications and ratios that the student should feel comfortable studying. The illustrations
involve the same merchandising business that was introduced in Chapter 6. Students have little
difficulty understanding that a going-concern must be capable of satisfying its current liabilities
and that the resources to do so will come primarily from current assets. Measures such as the
current and quick ratios and working capital thus have great intuitive appeal. The importance of
return on investment is likewise easily motivated.
When we illustrate the usefulness of accounting information, we find those assignments
based upon “name” companies particularly effective. Exercises 6, 7, and 8 and Problems 4 and 7
all fall into this category. Additionally, Internet Case 5 allows students to research a well-known
company that is of particular interest to them.
We recommend discussing the limitations of financial ratios as well as their usefulness.
For example, we discuss appropriate standards for comparison and stress the need for the analyst
to be familiar with both the company and the environment in which it operates.
An aside. Class discussion of measures of solvency can be enlivened by explaining to students
the nature of restrictive debt covenants. Have students visit several corporate websites and search
the annual reports for restrictive debt covenants.
Chapter 14—Financial Statement Analysis
14-6 Instructor’s Resource Manual
Supplementary Exercises
Group Exercise
Obtain the annual report of a company of your choosing. Carefully review the financial
statements and then the note to the financial statements that describes the company’s accounting
policies. Based on your research, prepare a report explaining areas of concern over the quality of
the company’s reported earnings.
Internet Exercise
the stock price performance of the companies chosen since 2010. Suppose you had invested
$1,000 in each of these companies on January 1, 2010. Calculate the value of this $5,000
portfolio at present.
Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-7
CHAPTER 14 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer to each question in the space provided.
1. The quick ratio is considered more useful than the current ratio for:
a Evaluating the profitability of a business that sells inventory very quickly, such as a
restaurant.
b Evaluating the solvency of a business that turns inventory into cash very slowly, such as a
shipbuilder.
c Evaluating long-term credit risk.
d Evaluating investors’ expectations concerning future earnings.
2. The debt ratio is a measure of:
a Net cash flows relating to financing activities.
b Long-term credit risk.
c Short-term solvency.
d Profitability, independent of the manner in which assets are financed.
3. In the long-run, it is most important for a business to generate an inflow of cash from its:
a Operating activities.
b Stockholders.
c Investing activities.
d Creditors.
4. Return on assets measures the efficiency with which management:
a Generates earnings from the assets under its control, regardless of how these assets are
financed.
b Generates earnings from the assets under its control, giving consideration to any costs of
financing these assets.
c Generates cash from the assets under its control, regardless of accrual-based measures of
profitability.
d Converts its current assets into cash.
5. A transaction that will increase the quick ratio but cause the current ratio to decline is:
a Short-term borrowing.
b Investing cash in plant assets.
c Sale of inventory at a price below cost.
d Collection of an account receivable.
Chapter 14—Financial Statement Analysis
14-8 Instructor’s Resource Manual
CHAPTER 14 NAME #
10-MINUTE QUIZ B SECTION
Shown below are data taken from a recent annual report of Falcon Co. (Dollar amounts in millions.)
Beginning of Year End of Year
Balance sheet data:
Current assets .................................................................. $1,034 $1,120
Total assets ...................................................................... $1,546 $1,822
Current liabilities ............................................................ $379 $318
Total liabilities ................................................................ $546 $605
Total stockholders’ equity .............................................. $1,000 $1,217
Income statement data:
Net sales .......................................................................... $2,759
Gross profit ..................................................................... $1,264
Operating income ........................................................... $574
Net income ...................................................................... $421
Based upon the above information, indicate the best answer in the space provided.
1. The current ratio at year-end (rounded to the nearest tenth) is:
a 2.3 to 1.
b .6 to 1.
c 3.5 to 1.
d Some other answer.
2. The amount of working capital at the beginning of the year (in millions) was:
a $785.
b $1,193.
c $479.
d Some other answer.
3. The gross profit rate for the year (rounded to the nearest 1 percent) was:
a 46%.
b 54%.
c 69%.
d Some other answer.
4. The return on average total assets during the year (rounded to the nearest percent) was:
a 24%.
b 34%.
c 79%.
d Some other answer.
5. The return on average total stockholders’ equity during the year (rounded to the nearest 1 percent)
was:
a 50%.
b 41%.
c 38%.
d Some other answer.
Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-9
CHAPTER 14 NAME #
10-MINUTE QUIZ C SECTION
Shown below are data taken from a recent annual report of, Topaz, Inc. (Dollar amounts in millions.)
Beginning of Year End of Year
Balance sheet data:
Current assets ................................................................. $ 625 $700
Total assets ..................................................................... $1,050 $1,200
Current liabilities ........................................................... $275 $175
Total liabilities ............................................................... $475 $475
Total stockholders’ equity ............................................. $575 $725
Income statement data:
Net sales ......................................................................... $1,900
Gross profit .................................................................... $900
Operating income .......................................................... $450
Net income ..................................................................... $300
Instructions Compute the following:
a. Current ratio at year-end (round to nearest tenth ________ to 1
b. Working capital at the beginning of the year (in millions)
$____________
c. Gross profit rate for the year (round to the nearest 1 percent)
______%
d. Return on average total assets for the year (round to the nearest 1 percent)
______%
e. Return on average total equity for the year (round to the nearest 1 percent)
______%
Chapter 14—Financial Statement Analysis
14-10 Instructor’s Resource Manual
CHAPTER 14 NAME #
10-MINUTE QUIZ D SECTION
Given below are comparative balance sheets and an income statement for the Copper Corporation:
Copper Corporation
Balance Sheets – Current Year
Dec. 31 Jan. 1
Copper Corporation
Income Statement for the
Current Year
Cash
$ 31,600
$ 26,900
Sales
$936,000
Accounts receivable
252,000
216,000
Cost of goods sold
(515,000)
Inventory
173,000
178,000
Gross profit on sales
$421,000
Equipment (net)
129,000
152,000
Operating expenses
(332,000)
$585,600
$572,900
Operating income
$ 89,000
Accounts payable
$135,000
$147,000
Interest expense and
income taxes
(39,000)
Dividends payable
18,000
14,000
Net income
$ 50,000
Capital stock, $9 par
90,000
90,000
Retained earnings
342,600
321,900
$585,600
$572,900
All sales were made on account. Cash dividends declared during the year totaled $29,300. Compute the
following:
a Average accounts receivable turnover ______times
b Book value per share at the end of the current year $______________
c Earnings per share of capital stock $______________
d Return on assets __________%
e Return on common stockholders’ equity is computed by
dividing $ ____________ by $______________
Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-11
SOLUTIONS TO CHAPTER 14 10-MINUTE QUIZZES
QUIZ A
1 B
QUIZ B
QUIZ C
Learning Objective: 4,5, 7
QUIZ D
Chapter 14—Financial Statement Analysis
14-12 Instructor’s Resource Manual
Assignment Guide to Chapter 14
Brief
Exercises
Exercises
Problems
Cases
Net
Item Number
1 – 10
1 – 15
1
2
3
4
5
6
7
8
9
1
2
3
4
5
Time estimate (in minutes)
< 15
< 15
20
25
15
25
35
45
25
25
35
25
15
25
N/
A
N/A
Difficulty rating
E
E
E
M
E
E
M
S
M
M
M
M
E
S
S
S
Learning Objectives:
1, 2, 3
1, 2, 3, 7
1. Explain the uses of dollar
and percentage changes,
trend percentages,
component percentages, and
ratios.
2. Discuss the quality of a
company’s earnings, assets,
and working capital.
3. Explain the nature and
purpose of classifications in
financial statements.
9
Chapter 14—Financial Statement Analysis
Financial and Managerial Accounting, 18e 14-13
8.
Analyze financial statements
from the viewpoints of
common stockholders,
creditors, and others.
