Chapter 2
Analyzing Financial Statements
and Ratios
Chapter Overview
I. Introduction
II. Accounting basics
III. Financial statements
a. The balance sheet
b. The income statement
c. The statement of cash flows
IV. Financial ratios
a. Liquidity
i. Current ratio
ii. Quick/acid-test ratio
b. Asset management
V. Conclusion
Key Concepts
When reading this chapter, students should focus on the following key concepts:
1. The balance sheet, income statement, and statement of cash flows are vital tools to
2. How to interpret data contained in financial statements.
3. How ratios are used to analyze the financial performance of an organization.
4. How to use data to compare the financial performance of one organization against
another.
Quiz Questions
1. Which of the following is a picture or snapshot of the financial condition of an
organization at a specific point in time?
a. Balance sheet
b. Income statement
2. Which ratio measures how an organization finances its operation with debt and equity?
a. Current ratio
e. Debt ratio
3. Which ratio measures how often an organization sells and replaces its inventory over a
specified period of time?
a. Current ratio
b. Quick ratio
c. Total asset turnover ratio
4. Which of the following is an estimate of how much money investors will pay for each
dollar of the organization’s earnings?
a. Interest coverage ratio
b. Net profit margin
c. Return on equity
5. Which financial statement tracks cash in and cash out of an organization over a specified
period of time?
a. Balance sheet
b. Income statement
c. Statement of cash flows
6. Which of the following measures the return rate an organization’s owners or
shareholders are receiving on their investments?
c. Return on equity
d. Market value
e. Price-to-earnings ratio
7. The __________ shows the organization’s income over a specified period of time.
a. Balance sheet
b. Income statement
c. Statement of cash flows
d. Budget
8. An estimation of an organization’s worth according to the stock market is __________.
a. Interest coverage ratio
b. Net profit margin
c. Return on equity
9. Which of the following is a profitability ratio that measures the percentage of an
organization’s total sales or revenues that was net profit or income?
a. Interest coverage ratio
b. Net profit margin
e. Price-to-earnings ratio
10. Which ratio is an indication of whether an organization can meet its current
liabilities―those due within a year―with its current assets?
a. Current ratio
b. Quick ratio
d. Inventory turnover ratio
e. Debt ratio
Answers to Quiz Questions
Numbers in parentheses represent where, in the text, you’ll find this discussed.
1. a (p. 39)
2. e (p. 49)
3. d (p. 48)
4. e (p. 52)
Responses
1. What are the three major sections of the balance sheet? Provide at least one example of
an item that would be found under each of those sections.
See pages 39–42. The three sections of the balance sheet are Assets, Liabilities, and
Owners’, or Shareholders’, Equity. Assets include what the organization owns, such as
2. What is the primary difference between an income statement and a statement of cash
flows?
See pages 43–44. The income statement shows revenues coming in to and expenses
going out of an organization, whereas the statement of cash flows displays cash coming
in and going out of the organization. Under accrual basis accounting, this difference can
3. What is the purpose of computing financial ratios?
See page 44. Financial ratios provide information about the condition and performance
4. If an organization’s current ratio value is below 1.00, what might that suggest about the
organization?
See pages 46–47. A current ratio value below 1.00 suggest that an organization is
unable to cover its debts with its assets, such as cash and accounts receivable. As such,
5. What information do leverage ratios provide?
See page 49. Leverage ratios show how a company finances its operation with debt and
equity. An organization that relies extensively on borrowing money in order to operate
6. Why is the price-to-earnings ratio so widely used among investors?
See pages 52–53. The price-to-earnings, or P/E, ratio gives an estimate of how much
7. This chapter repeatedly states that financial ratios are most valuable when viewed in
comparison to the organization’s historical ratio values as well as to competitors. Why is
this context valuable when examining financial ratio values?
See page 54. Successful organizations evaluate themselves both internally and
externally. From a financial perspective, companies must know how their status and
performance measures internally compared to their own historical data. Externally,
Response
Using the Nike financial statements provided the text, the ten financial ratios discussed in
the chapter were calculated as shown below:
1. Current ratio = Current assets
Current liabilities
= $13,696,000,000
2. Quick ratio = (Current assets – inventory)
Current liabilities
= ($13,696,000,000 – 3,947,000,000)
3. Total asset turnover ratio = Net sales*
Average total assets
* Note that Nike’s income statement uses “Revenues,” instead, on its income statement.
= $27,799,000,000
4. Inventory turnover ratio = Cost of goods sold*
Average inventory
* Note that Nike’s income statement uses “Cost of sales,” instead, on its income statement.
= 4.13
5. Debt ratio = Total liabilities
Total assets
6. Interest coverage ratio = Earnings Before Interest and Taxes (EBIT)*
Interest expense
* On Nike’s income statement, EBIT is not directly provided. It must be self-calculated by
using the Gross Margin figure and subtracting the subsequent expenses not related to
interest or taxes, which here represent the four lines/values immediately below Gross
Margin.
7. Net profit margin = Net income
Sales
= $2,693,000,000
8. Return on equity = Net income
Shareholders’ equity
= 24.88% (should be expressed as a percentage)
9. Market value= Price per share of common stock number of outstanding
shares*
* The number of shares of outstanding common stock is computed by adding the numbers
of Class A and Class B common stock outstanding presented in the shareholders’ equity
section of Nike’s balance sheet (178,000,000 + 692,000,000 = 870,000,000).
10. Price-to-earnings ratio = Price per share of common stock
Earnings per share*
* Earnings per share = Net income
Number of outstanding shares of common stock
= $76.91
Responses to Questions
The case study at the end of the chapter asks students to compare the financial health of
Nike and Under Armour based on the ten financial ratios discussed in the chapter. The
chapter provides Under Armour’s financial ratio results; students have just calculated Nike’s
financial ratios (see the Practice Problems section in this Instructor’s Manual).
Please note that students are being asked to make a rather simplistic assessment based on
comparing the ratio figures for these two companies and what they’ve just learned about
1. In what ratio areas is Nike stronger than Under Armour?
Inventory turnover ratio, interest coverage ratio, net profit margin, return on equity,
2. In what ratio areas is Under Armour stronger than Nike?
Current ratio, quick ratio, total asset turnover ratio, debt ratio, price-to-earnings ratio
3. If you were an investor considering purchasing stock in either Nike or Under Armour, in
which company would you purchase stock? Explain and support your answer.
This is a challenging question to answer, as each company is stronger than the other in five
of the ten financial ratios. Furthermore, as with any stock investment, it is impossible to
Additional Classroom/Exam Problems
1. The Memphis Redbirds team has earnings before interest and taxes (EBIT) of $2,250,000
and $450,000 in depreciation expenses. It also has an interest expense of $120,000 and a
40% tax rate. How much in taxes will be paid?
EBIT $2,250,000
Interest 120,000
2. See Additional Classroom Problem 1. What is the team’s net income?
EBIT $2,250,000
Interest 120,000
3. See Additional Classroom Problem 1. If the team had no amortization expenses, what is
the team’s operating income?
Operating Income, or EBITDA (earnings before interest, taxes, depreciation, and
amortization), can be found by subtracting expenses from revenues. Here we have no
revenue or expense data other than the depreciation and amortization expense
information. Therefore, we can work backward to calculate operating income.
So, what is known is as follows:
EBITDA ?????
Amortization $0