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Statement Analysis
An Introduction to
Financial Statement
Analysis
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even if advised of such possibility, for any loss or damage caused or alleged to be caused,
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may return this special report immediately upon purchase for a full refund.
With the exception of companies and organizations whose identities as actual entities
are made clear within the context of the text discussion, all persons, organizations,
and entities in this material, including in illustrations and Practice, are completely fictional. Any resemblance to actual persons, organizations, or entities, past or present, is
purely coincidental.
Table of Contents
Financial Statements Quick Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
GAAP Quick Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Trend Analysis Using a Reference Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financial Ratios and Ratio Analysis Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Solvency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Investment Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Productivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
7
9
16
18
22
26
29
30
Analysis as an Outsider. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Quality of Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Potentially Hidden Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Big, Bad, Sudden Surprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
32
34
39
44
48
51
53
55
64
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iii
The balance sheet is the most basic and essential financial statement. It is
described by the basic accounting equation: A = L + OE, (A means assets,
L means liabilities, and OE means owners equity.) The purpose of the
balance sheet is to show the wealth of a business (assets) and the two possible claims on that wealth, which are the creditors claims (liabilities) and
the owners claim (called owners equity, partners equity, or stockholders
equity.) at a given point in time. There are two main sources of owners
equity: investments by the owner(s) and the business operations.
Key Issues
Example
The example below shows a balance sheet after the close of business on
June 30, 2008. The assets and liabilities are classified by type and by current
compared to long-term (longer than a year). This example shows total
business assets with a value of $410,120. Of that amount, creditors have a
claim of $173,850 and the residual amount of $236,270 is claimed by the
owner. If this were a partnership, owners equity would be called partners
equity and two or more owners names would be shown. If this were a
corporation, the equity would be called stockholders or shareholders
equity. The equity would then be subdivided into sections showing the
sources, such as paid-in capital from stock sold, and retained earnings
from operations.
continued
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$ 41,300
28,250
29,450
69,650
920
$169,570
25,800
6,850
314,500
92,900
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18,950
221,600
$410,120
$ 42,050
131,800
173,850
236,270
$410,120
Income Statement
Purpose
Key Issues
The key issues concerning the income statement are the proper classification, correct amounts, and timing of revenues and expenses into the correct
accounting periods.
Example
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Articulation
$368,900
2,000
370,900
$266,000
45,200
4,000
3,880
3,200
2,960
2,150
1,550
1,450
330,390
$ 40,510
The income statement and balance sheet are closely connected to each
other. Revenues, expenses, and net income or loss on the income statement
affect what is reported on the balance sheet. This is called articulation.
Volume 1 of Basic Accounting Concepts, Principles, and Procedures provides detailed examples of articulation.
2008 Worthy and James Publishing. See front matter: Terms of Use.
The statement of cash flows explains the change in cash for a specific
period of time. This usually corresponds to the same period of time used
for the income statement and statement of owners equity. The change in
cash is explained by three types of business activities: operating, investing,
and financing.
Key Issue
The key issue concerning the statement of cash flows is whether a transaction has been properly classified as an operating, investing, or financing
activity.
Operating Activities
Operating activities relate to the cash effects of the transactions that make
up net income. In effect, the cash flow from operating activities shows the
income statement on a cash basis instead of an accrual basis. Cash flow
from operating activities shows the cash results from the essential recurring operations of a business, and it is the most important part of the
statement of cash flows.
Investing Activities
Investing activities relate to the increases and decreases in cash from transactions that involve buying and selling long-term assets and activities that
involve buying and selling investments, including making and collecting
loans.
Financing Activities
Format
The statement of cash flows presented below is shown in the most popular
format. The operating activities section begins with net income and makes
two types of adjustments to net income to convert it to a cash basis:
Add operating items that increase cash and are not part of the net
income calculation or items that reduced net income but did not use
cash.
Deduct operating items that use cash and are not part of the net
income calculation or items that increased net income but did not
increase cash.
Note: An alternative format is sometimes used. The point here is to
understand the essential components of the statement. The details of
formats and adjustments is a more advanced topic.
continued
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TIP
2008
$167,500
2007
$174,600
58,200
1,400
25,800
35,100
17,800
12,900
(67,400)
(29,800)
$155,700
(165,900)
(4,800)
$ 69,700
(45,000)
(10,000)
$ (55,000)
(5,000)
$ (5,000)
25,500
(30,200)
(55,000)
$ (59,700)
10,500
(40,000)
$ (29,500)
$ 41,000
414,200
$455,200
$ 35,200
379,000
$ 414,200
2008 Worthy and James Publishing. See front matter: Terms of Use.
GAAP Review
GAAP (Generally Accepted Accounting Principles)
What Is GAAP?
In the United States, GAAP is a set of rules and standards that guide
accountants as to when and how to properly record transactions and how to
prepare proper financial statements. GAAP is not like unchanging laws of
physics. GAAP is designed to meet the needs of society. GAAP is always
evolving as the economic environment changes. Also, GAAP only refers to
rules of accounting in the United States. Different countries have different
rules for different purposes.
Broad GAAP
There are a few broad GAAP principles that provide general guidance and
that apply to all types of transactions. These are fundamental accounting
rules. These are like general traffic laws. Example: The historical cost
principle requires that all transactions be recorded at original transaction
value unless a specific GAAP rule creates an exception.
Specific GAAP
Just as with other kinds of rules, GAAP is not perfect. GAAP is often subject to interpretation. Estimates are frequently required. The application
of different methods is allowed, which can make comparability difficult to
achieve. However, despite shortcomings, GAAP is essential to financial
reporting.
continued
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There is no single source or listing of GAAP! There are a number of different sources, some more important than others.
International Standards
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We begin our discussion by assuming that you have just recently taken
over the management of your (imaginary) family business. The business is
a wholesale office supply store that primarily sells office supplies and office
equipment on account to retail merchants. One of the first things that you
need to do is to analyze the financial statements of the business to judge its
condition and to decide if you need to make any changes in the operations
and management.
A Reference Base
Example
Sales
2008
2007
2006
2005
$75,000
$48,000
$55,000
$50,000
Comparing totals: If you want to compare the total sales for each year to
the year 2005, then the 2005 sales of $50,000 is your reference base
amount. Divide each years sales by the base amount.
Sales
2008
2007
2006
2005
150%
96%
110%
100%
Sales
2008
2007
2006
2005
50%
(4%)
10%
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10
Horizontal Analysis
Overview
Balance Sheet
Example
2008
2007
Assets
Current assets
Cash and cash equivalents
Short-term investments
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Property, plant, and equipment
Less: Accumulated depreciation
Net property, plant, and equip.
Intangible assets
Total assets
$ 455,200
35,500
286,200
492,100
52,300
$1,321,300
$ 990,500
365,000
$ 625,500
110,000
$2,056,800
$ 414,200
36,900
255,800
456,900
50,500
$1,214,300
$ 945,500
306,800
$ 638,700
100,000
$1,953,000
$ 41,000
(1,400)
30,400
35,200
1,800
$107,000
$ 45,000
58,200
$ (13,200)
10,000
$103,800
9.9%
(3.8%)
11.9%
7.7%
3.6%
8.8%
4.8%
19.0%
(2.1%)
10.0%
5.3%
$ 414,700
50,000
185,600
$ 650,300
551,400
$1,201,700
$ 388,900
24,500
215,400
$ 628,800
581,600
$1,210,400
$ 25,800
25,500
(29,800)
$ 21,500
(30,200)
$ (8,700)
6.6%
104.1%
(13.8%)
3.4%
(5.2%)
(0.7%)
$ 855,100
$2,056,800
$ 742,600
$1,953,000
$112,500
$103,800
15.1%
5.3%
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11
Sales
Less: Returns and allowances
Net sales
Cost of goods sold
Gross profit
2008
$2,198,600
98,900
2,099,700
1,364,800
$ 734,900
2007
$2,114,100
90,900
2,023,200
1,294,800
$ 728,400
Increase or (decrease)
Amount
Percent
$ 84,500
4.0%
8,000
8.8%
76,500
3.8%
70,000
5.4%
$ 6,500
0.9%
Selling expenses
Administrative expenses
Total operating expenses
Operating income
252,000
283,500
$ 535,500
$ 199,400
222,600
293,400
$ 516,000
$ 212,400
29,400
(9,900)
$ 19,500
$ (13,000)
2,900
2,100
34,800
$ 167,500
39,900
$ 174,600
Analysis
800
(5,100)
($ 7,100)
13.2%
(3.4%)
3.8%
(6.1%)
38.1%
(12.8%)
(4.1%)
Balance sheet: The comparative balance sheets show that some significant changes have occurred between 2007 and 2008. Total current
assets have increased by almost 9%, and Property, Plant, and Equipment increased by almost 5%. We also see that total liabilities have
decreased by almost 1%, so there was no net borrowing. This means
that the increase in total assets must be primarily the result of business
net income unless there were owner investments.
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12
Vertical Analysis
Overview
Balance Sheet
Example
The balance sheet below shows a vertical analysis. Can you find the reference base amounts? They are the items that are 100%the total assets and
the total liabilities and owners equity.
Superior Office Supply Company
Condensed Balance Sheet
December 31
2008
Assets
Current assets
Cash and cash equivalents
Short-term investments
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Property, plant, and equipment
Less: Accumulated depreciation
Net property, plant, and equipment
Intangible assets
Total assets
Liabilities and Owners Equity
Current liabilities
Accounts payable
Short-term notes payable
Other current liabilities
Total current liabilities
Long-term debt
Total liabilities
Your Name, capital
Total liabilities and owners equity
Percent
2007
Percent
$ 455,200
35,500
286,200
492,100
52,300
$1,321,300
$ 990,500
365,000
$ 625,500
110,000
$2,056,800
22.1%
1.7%
13.9%
23.9%
2.5%
64.2%
48.2%
17.7%
30.4%
5.3%
100.0%
$ 414,200
36,900
255,800
456,900
50,500
$1,214,300
$ 945,500
306,800
$ 638,700
100,000
$1,953,000
21.2%
1.9%
13.1%
23.4%
2.6%
62.2%
48.4%
15.7%
32.7%
5.1%
100.0%
$ 414,700
50,000
185,600
$ 650,300
551,400
$1,201,700
20.2%
2.4%
9.0%
31.6%
26.8%
58.4%
$ 388,900
24,500
215,400
$ 628,800
581,600
$1,210,400
19.9%
1.3%
11.0%
32.2%
29.8%
62.0%
$ 855,100
$2,056,800
41.6%
100.0%
$ 742,600
$1,953,000
38.0%
100.0%
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13
Sales
Less: Returns and allowances
Net sales
Cost of goods sold
Gross profit
2008
$2,198,600
98,900
2,099,700
1,364,800
$ 734,900
Percent
104.7%
4.7%
100.0%
65.0%
35.0%
2007
$2,114,100
90,900
2,023,200
1,294,800
$ 728,400
Percent
104.5%
4.5%
100.0%
64.0%
36.0%
Selling expenses
Administrative expenses
Total operating expenses
Operating income
252,000
283,500
$ 535,500
$ 199,400
12.0%
13.5%
25.5%
9.5%
222,600
293,400
$ 516,000
$ 212,400
11.0%
14.5%
25.5%
10.5%
2,900
0.1%
2,100
0.1%
34,800
$ 167,500
1.7%
8.0%
39,900
$ 174,600
2.0%
8.6%
Analysis
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14
Balance sheet: For example, on the balance sheet, it becomes clear that
current assets as a percentage of total assets have increased from about
62% to 64%. At first, this might seem to be a good thing, but notice that
the percentages for Accounts Receivable and Inventory are also increasing. Does this mean that your business is having some trouble collecting
receivables and also that too much inventory has been ordered and is
building up?
Common-Size Statements
Overview
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15
2008
104.7%
4.7%
100.0%
65.0%
35.0%
2007
104.5%
4.5%
100.0%
64.0%
36.0%
12.0%
13.5%
25.5%
9.5%
11.0%
14.5%
25.5%
10.5%
0.1%
0.1%
1.7%
8.0%
2.0%
8.6%
MD&A
Overview
Definition
Features
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16
Ratio Analysis
Overview
Introduction
Business Elements
Analyzed
A great deal of financial data is available that can be used for many possible ratio calculations. In this section, we look at some of the most important and useful ratios, which measure these key aspects of a business:
Research the
Company
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17
Benchmark
Advantages
Disadvantages
Gives no point of reference
outside of our company.
Use in Groups
Coming Up . . .
Analysis and Comparing
to Industry Data
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18
Measures of Liquidity
Overview
Liquidity means the ability to obtain cash needed to pay current liabilities
as they come due and to pay unexpected short-term obligations. If a business cannot pay these immediate obligations, it will cease to operate. Owners, managers, suppliers, and lenders are very concerned with liquidity. We
will examine the following ratios to evaluate liquidity condition: (1) current
ratio, (2) quick ratio, (3) receivables turnover ratio, and (4) inventory turnover ratio.
Current Ratio
2007
$1,321,300
----------------------- = 2.03
$650,300
Industry Average
$1,214,300
----------------------- = 1.93
$628,800
1.4
Interpretation
The current ratio has improved somewhat. At the end of 2008, about
$2.03 of current assets were available for every dollar of current liabilities. The ratio exceeds the industry average benchmark.
Quick Ratio
(Acid-Test Ratio)
The quick ratio is a measure of how well a business could pay current
liabilities if they all came due quickly. This ratio uses only highly liquid
assets (called quick assets) compared to current liabilities. The assets
used are cash, short-term investments, and all current receivables net of
allowances.
+ short term investments + current receivables (net)
The quick ratio is: cash
-----------------------------------------------------------------------------------------------------------------------------------------------total current liabilities
2007
$414,200 + $36,900
+ $255,800
------------------------------------------ = 1.12
$628,800
2008 Worthy and James Publishing. See front matter: Terms of Use.
Industry Average
.5
19
Receivables Turnover
Average Collection
Period
2007
$2,023,200
Industry Average
18 times
Interpretation
Superior Office Supply Company is clearly having problems with its receivables collection. The turnover is getting worse and is clearly below the
industry norm. Lets calculate the average collection period to clarify this.
Note: If there is a significant seasonal variation in sales, the average should
be calculated based on quarterly or monthly Accounts Receivable balances.
continued
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20
2007
Industry Average
365 days
------------------- = 43 days
8.5 times
20 days
Interpretation
In 2008, Superior Office Supply required an average of 47 days to collect
current receivablesmore than twice the industry average. This makes the
current ratio and quick ratio now look much less favorable because of the
uncertainty of when the receivables will be collected and how many are bad.
Inventory Turnover
Average Days to Sell
2007
Industry Average
$1,294,800
--------------------------------- = 3.29 times
($456,900
+ $329,700)/2
5.4 times
Interpretation
Superior Office Supply Company is having problems with inventory
buildup. The inventory has been overstocked, or for some reason it is
not selling well. To clarify the turnover time, lets calculate the average
days to sell.
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21
2007
365 days
---------------------- = 111 days
3.29 times
Industry Average
66 days
Interpretation
In 2008, Superior Office Supply required an average of 127 days to sell
its inventorymore than twice the industry average. The good
current ratio looks more doubtful, because there is now some
question as to the time it will take to sell the inventory and the ability
to sell it at normal prices. Perhaps the cause is simply buying too
much inventory. As a manager, you will have to do some further
investigation by checking the number of units sold, the pricing, and
the inventory purchasing policy.
Caution: The inventory turnover ratio (and days to sell) gives different
answers for companies using different inventory methods such as
FIFO, LIFO, or average, even though the inventory is not actually
moving faster or slower. The current ratio, which includes inventory, is
also affected by the use of different inventory methods. This can make
company comparisons more difficult.
TIP
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22
Measures of Solvency
Overview
Solvency is the ability to remain in business for a long period of time. This
mainly refers to the ability to pay all debts as they come due. It also involves
the ability to raise new capital and to adapt to changing conditions. The
ratios we will use to evaluate solvency are: (1) debt ratio, (2) times interest
earned ratio, (3) asset turnover ratio, (4) cash flow to debt ratio, and
(5) free cash flow.
Note: Profitability also affects solvency; however, we will discuss this in
the next topic when we look at measures of profitability.
Debt Ratio
(Leverage Ratio)
The debt ratio is a measure of the extent to which a company uses debt.
The debt ratio compares the amount of total debt to total assets. The use
of debt is often called financial leverage. Although leverage can be very
useful to a business, the use of leverage also involves danger. As a company incurs more debt, the danger grows, because debt requires regular
fixed payments and often a large principal payment when the debt is due.
Also, lenders may impose additional requirements and restrictions called
debt covenants that, if violated, create the risk of the full loan becoming
immediately due and payable.
total debt
-----------------------------total assets
2007
Industry Average
$1,201,700
----------------------- = .58
$2,056,800
$1,210,400
----------------------- = .62
$1,953,000
.70
Interpretation
The company has both reduced its total debt and increased total assets,
so the debt ratio has declined from 62% to 58%, indicating improved
solvency and a reduction of risk. However, the company is still using
substantial leverage, and the industry norm is also relatively high.
Generally, debt exceeding one-third of total assets should be considered
as substantial. (This can be seen in the bond ratings of large industrial
companies. The median debt ratio at which the ratings change from
investment grade to speculative grade is about 40%.)
It is especially important to know why a debt ratio increases. What was
the money needed forexpansion, operations, to pay old debt? This
can be a key indicator of a companys condition and strategy. The
ability of a company to manage its debt depends on the size and the
stability of its operating cash flow.
2008 Worthy and James Publishing. See front matter: Terms of Use.
23
operating income
----------------------------------------------interest expense
or
2007
Operating Income
$69,700
$212,400
$155,700
$199,400
------------------- = 5.73 times ------------------- = 4.47 times ------------------- = 5.32 times ----------------- = 1.75 times
$39,900
$39,900
$34,800
$34,800
Interpretation
Based on operating income, in 2008 the business shows a multiple of 5.7 times the
amount of interest expense, which shows a safe coverage and far exceeds the industry
average, which is about 2.2 times. However, 2007 demonstrates the importance of
using operating cash flow to calculate the ratio. The ratio based on operating cash flow
is much less favorable than the ratio based on operating income. Remember, it is the
cash that counts when it comes to making interest payments. (Note: In the statement of
cash flows, if interest paid is a subtraction item when calculating operating cash flow, it
should be added back to operating cash flow for the purposes of this calculation.)
TIP
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24
The asset turnover ratio measures how many dollars of sales are created for
every dollar of total assets. This has a direct effect on profitability and is
also a measure of the efficiency of the use of company assets. Asset turnover ratios can vary greatly depending on the type of business. For example, an accounting firm would have a relatively low investment in assets
and a much higher asset turnover ratio than an airline. Also, some analysts
prefer to focus only on gross plant and equipment (excluding accumulated
depreciation) turnover as a measure of the efficient use of productive
assets.
net sales
----------------------------------------------------average total assets
2007
Industry Average
$2,099,700
$2,023,200
--------------------------------------- = 1.05 times ------------------------------------- = 1.06 times
($2,056,800
($1,953,000
+ $1,953,000)/2
+ $1,870,100)/2
3.6
Interpretation
Superior Office Supply is creating only about $1.05 of net sales for every
dollar invested in company assets. This is clearly below the industry average of $3.60. Perhaps the company has over-invested in inventory and
in property, plant, and equipment.
Cash Flow to
Debt Ratio
The cash flow to debt ratio is a good measure of long-term solvency and
shows the ability of a company to pay debt using only the operating cash
flow. The ratio is calculated by dividing operating cash flow by average
total debt.
2007
Industry Average
$69,700
----------------------------------- = .06 times
($1,210,400
+ $1,155,300)/2
Note: Total liabilities from 2006
balance sheet is $1,155,300.
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.3 times
25
Free cash flow is a measure of how much operating cash flow is available
after paying necessary cash outlays for expansion and/or improvements. It
is a good measure of financial stability. Although there is no single definition of free cash flow, the most common definition is: operating cash flow
less capital expenditures.
Free cash flow is: cash flow from operating activities capital expenditures
Example for Superior Office Supply Company
2008
2007
Interpretation
Free cash flow has shown an increase in 2008 of $36,000, or about
56%. However, this may be somewhat misleading because perhaps
2007 was a low number. This should be evaluated against past results
for several years.
continued
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EBITDA sounds like some kind of wild African animal, but it really means
Earnings Before Interest, Taxes, Depreciation, and Amortization. To calculate EBITDA, start with income from continuing operations and add back
depreciation and amortization to obtain an income amount that excludes
these four expenses.
EBITDA is supposed to be an estimate of cash flow from operations, and it
is often used in press releases, business news reports, and even in some
ratio calculations. This is unfortunate because it is a very inferior and misleading estimate for several reasons. I mostly ignore EBITDA and simply
look for cash flow from operating activities on the statement of cash flows.
Measures of Profitability
Overview
The profit margin percentage shows what percent of every dollar of net
sales ends up as net income. This ratio is also sometimes called the rate of
return on net sales. This ratio is calculated as net income divided by net
sales, and is usually expressed as a percentage.
net income
-----------------------------net sales
2007
$174,600
----------------------- = 8.6%
$2,023,200
Industry Average
1.5%
Interpretation
For the last two years, Superior Office Supplys profit percentage has
been greatly in excess of the industry average. This could be good news
or bad news. It is possible the company has some kind of very unusual
advantage. Or it has either temporarily had an unusual amount of sales
or has not been spending enough on necessary expenses. Lets explore
further . . .
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The gross profit ratio is calculated by dividing gross profit by net sales. The
gross profit ratio shows what percentage of each dollar of sales ends up as
gross profit. For merchandising and manufacturing companies this is a
very important ratio because it is affected by some very important things:
the selling price per unit and the number of units sold (sales revenue) and
the cost per unit of the merchandise and the number of units sold (cost of
goods sold). These items have a very powerful effect on net income.
The gross profit ratio is:
gross profit
-----------------------------net sales
2007
$734,900
----------------------- = 35%
$2,099,700
$728,400
----------------------- = 36%
$2,023,200
Industry Average
36%
Interpretation
The gross profit ratio is about the same as the industry norm. In 2008,
$.35 of every dollar remained as gross profit to cover operating expenses
and provide a net income.
So, back to our question: Why is the net income percentage so high? We
now know that the gross profit percentage is about normal, so that only
leaves one other major area on the income statementoperating
expenses. The operating expenses are unusually low. This may be good
if the company is very efficient, but it will not be good if the company is
avoiding necessary and important expenses, such as repairs and maintenance and the cost of high-quality management.
Caution: As discussed above with inventory turnover, FIFO, LIFO,
average, and other inventory methods give different results. This can
make cost of goods sold and gross profit comparisons less reliable.
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Earnings per share (often called EPS) is a calculation that is done only for
a corporation. The basic EPS calculation is:
net income preferred dividends
----------------------------------------------------------------------------------------weighted average number of
common shares outstanding
The EPS shows how much net income is potentially available for each share
of common stock. The EPS number is important because it is a scaling
method that allows the earnings of different size companies to be compared
on a per-share basis. Corporations that have publicly traded stock (stock
that is traded on exchanges like the New York Stock Exchange or Nasdaq
exchange) are required to show earnings per share. The ratio is also important to stock investors who use it as part of a calculation called the price
earnings ratio (PE ratio), which is the price per share divided by the earnings per share. The PE ratio is used as an indicator of relative stock value.
There is no good or bad EPS number; it is an amount that is watched over
time and compared to the EPS of other corporations and measured against
the price of the stock using the PE ratio. (Some analysts prefer to use operating cash flow or free cash flow instead of net income in the calculation.)
Rate of Return
on Total Assets
The rate of return on total assets is calculated by dividing net income (or
sometimes income before interest expense) by average total assets. This
ratio is an indicator of how much profit is being created for each dollar of
assets, usually expressed as a percentage.
The rate of return on total assets is:
net income
----------------------------------------------------average total assets
2007
$167,500
----------------------------------- = 8.4%
($2,056,800
+ $1,953,000)/2
$174,600
----------------------------------- = 11.2%
($1,953,000
+ $1,155,300)/2
Industry Average
7.5%
Interpretation
In 2008, the business had an 8.4% return on assets That is, it had 8.4 of
profit for every dollar of assets. This is less than 2007 but still above the
industry average.
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net income
-------------------------------------------------------------,
average owner s equity
2007
$167,500
-------------------------------- = 21%
($855,100
+ $742,600)/2
Industry Average
$174,600
-------------------------------- = 26%
($742,600
+ $608,000)/2
11%
Interpretation
The return on equity is about twice as much as the industry norm, and
that is primarily because the net income percentage is so high. So again,
we have to be very sure to explain the net income and investigate the
low operating expenses.
Return on Equity
for a Corporation
Dividend Ratio
The dividend ratio is usually calculated only for the common shareholders
of a corporation. The ratio measures the total common shareholder dividends as a percent of the average amount invested by the common shareholders over a designated period of time. The calculation is:
common stock cash dividends
----------------------------------------------------------------------------------------------------,
average common stockholders equity
continued
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Trading on equity refers to the effect that financial leverage (see the debt
ratio discussion) has on the return on equity. The effect of trading on
equity can be seen by comparing the rate of return on total assets of 8.4%
in 2008 with the return on the owners equity in 2008 of 21%. The positive
difference that exceeds the return on total assets happens when a business
borrows money at an interest rate that is less than the rate that the business is able to earn when it uses the borrowed money. Using borrowed
funds (leverage) also means that less of the owners money is needed to
acquire assets. The borrowed money is being put to work to buy assets that
create additional income and that do not require the use of owners
money. If the borrowed money more than pays for itself, this profitability
is a boost that adds directly to net income.
Trading on equity should be used cautiously. The attempt to trade on
equity may result in a much worse rate of return to owners if the situation
reverses and a company cannot earn a rate of return on the borrowed
money that is equivalent to the interest cost. Furthermore, increased debt
always means increased risk. In our discussion of the debt ratio, we saw
that the median level at which debt ratings change from investment to
speculative grade is about 40%. Although many companies in fact operate
at a debt ratio higher than 40%, it does not lessen the increased cash flow
risk and opportunity cost risk when large, sudden, and negative financial
events occur.
Measures of Productivity
Overview
Revenue (or gross profit) per unit of resource shows the amount of revenue (gross profit) created per unit of scarce resource used. Examples:
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Cost per unit of resource shows the cost incurred to obtain or use a unit of
a particular resource. Examples:
Other Good
Indicators
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Analysis as an Outsider
Overview
Insider As Primary
User of Financial
Information
Until this point, our discussion about financial statement analysis has
been from the point of view of someone who has the ability to influence or
control the managementan insider. For example, we analyzed the financial statements of Superior Office Supply Company as if you were assuming management of your own family-owned business. Therefore, the
financial information was primarily for your use, as an insider, to analyze
and improve your business.
As an insider and primary user you want financial statements to be as
accurate and as honestly representative of the real situation as possible.
Your analysis of these statements improves your understanding of what is
happening to the business and improves your decision making, which in
turn results in better profits and cash flow. Your good decisions increase
the value of the business. Moreover, if necessary, the business will be able to
obtain cheaper outside capital (lower interest on loans and lower required
rate of return on new investment money), because the business is secure
and profitable.
Notice the priorities here for use of financial statement information:
(1) create better understanding and decision making, which results in (2) an
increase in real business value, and finally (3) a cheaper cost of capital.
Outsiders As Users
of Financial
Information
Outsiders are people who do not have authority to manage a company. The
most important outsiders are providers of capital: (1) investors, (2) lenders,
and (3) suppliers. For some businesses, outsiders may be a significant and
regular source of capital. This is usually the situation with large corporations. Outsiders are also financial statement users and, of course, want
statements that are reliable and accurate. However, outsiders must rely on
the financial statements that have been prepared by the insidersthe top
management.
Different Priorities
As an outsider, you naturally would like to believe that the financial information priorities of the management are the same as yours, which is to first
create reliable financial statements that result in good decision making.
Then business value increases and cost of capital decreases. Sometimes it
happens this way.
Often however, when outsiders begin to provide a significant amount of
capital, the managements financial information priorities become reversed:
(1) maximize short-term business value and obtain the cheapest possible
capital and (2) create better understanding and decision making.
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Overview, continued
Be Skeptical
Finding Information
Full Disclosure
For publicly traded companies, the law requires that information disclosures to outside parties be made available simultaneously to all outside
parties. Therefore, even as an outsider, you have access to very useful
information, and no other outsider legally has better access to information
than you do.
SEC
Probably the single best source of detailed company information for publicly traded companies is the SEC (Securities and Exchange Commission)
website at www.sec.gov. You can type in a company name (or its trading
ticker symbol) to locate the company and its reports. The key financial
information items to look for are reports 10-K (annual report) and 10-Q
(quarterly report) and 8-K (disclosure of material events).
Annual Reports
Conference Calls
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Quality of Earnings
Overview
Overview
Definition
Earnings
Management
Whenever a company intentionally uses GAAP for the purpose of manipulating the results shown on the income statement, the company is doing
earnings management. This is a major cause of low quality of earnings.
Earnings Management
Example
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Why Is Earnings
Management
Possible?
However, GAAP permits: (1) the use of different methods and (2) the use
of estimates. Whenever transaction (event) analysis is subject to choices
and estimates, the opportunity will always exist for earnings management.
Not the Same
As Fraud
Revenue
Management
There are many opportunities for managing revenue. It is also a frequent form of financial fraud. The table below shows several common
methods of revenue management with descriptions. (Remember: Revenue
either increases assets or decreases liabilities, so revenue management
affects both the balance sheet and the income statement. See revenue recognition principle.)
Method
Description
Doubtful-credit sales
Sales knowingly made to customers who may not have the ability to pay.
Percentage of
completion manipulated
Related-party sales
Offsetting sales
Two companies make equivalent sales to each other really for the
purpose of increasing reported revenues.
Channel stuffing
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The examples below illustrate revenue fraud. Notice that they involve
clear GAAP violation or outright fictitious revenue transactions.
Method
Description
Revenue is recorded for sales transactions with terms that will cause the
merchandise to probably be returned and that allow the customer to
easily return merchandise with no penalty.
Fake revenue
Wrong period
The books are held open at the end of a period to intentionally record
sales from the next period into the current period.
Misclassification
Early shipment
Bill-and-hold sales
Seller bills the customer but delays shipment to the customer (title does
not pass to buyer) thereby recording revenue but not cost of goods sold.
Expense Management
There are also many ways to manage expenses. The table below shows
some common methods. (Remember: An expense either decreases assets
or increases liabilities, so expense management affects the balance sheet as
well as the income statement. Also see the matching principle.)
Method
Uncollectible receivables underestimated
Control depreciation
(and amortization)
Control cost of goods
sold
Description
The estimate of bad receivables is intentionally understated, which
reduces uncollectible account expense (and overstates assets). Different
estimating methods are also available.
Unrealistically long time periods are used. Unrealistically large residual values are used. Different depreciation methods are available.
Different inventory methods are available. LIFO purchase decisions
are made at year end. Subjective inventory write-down replacement
costs are used.
Accrued expenses
underestimated
Expense timing
A business can decide to incur or not incur expenses in any given period,
for example, repairs and maintenance. When earnings management is
involved, this decision is influenced more by how the income statement will
appear than by business necessities or efficient management.
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The examples below illustrate expense fraud. Notice that they involve
clear GAAP violation or outright fictitious transactions.
Method
Description
Capitalize operating
expenses
Misclassification
Unrecorded accruals
Wrong period
TIP
continued
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Numerous other methods for earnings management do not require showing greater revenues or smaller expenses. Here are some examples:
Method
The big bath
Description
After many periods of overstating net income, a company fixes everything by correcting the cumulative overstatement in the current year.
That often involves writing off unproductive (impaired) assets and/or
incurring restructuring costs all in a single year. This results in a very
bad year, which the company knows that most investors will soon forget
because the next year will look much better in comparison.
Companies know that investors like to see a smoothly increasing
income. To achieve this, a company will overstate expenses or understate revenues in good years.
Examples:
Misleading press
releases
Pension plans
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The importance of identifying all liabilities cannot be overstated. Liabilities are a claim on a companys present and future wealth. Furthermore,
many liabilities are created by expenses that significantly impact the
amount of income reported on the income statement and thereby affect
the earnings. The analysis guidelines of classification, valuation, and timing must be applied to all liabilities.
Identifying Liabilities
Some liabilities are easy to identify because they have been recorded as the
result of completed transactions such as the receipt of cash from a bank
loan or by properly recording an adjusting entry for an expense accrual.
These are the liabilities that regularly appear on a balance sheet. But, can
there be liabilities that do not appear the balance sheet? Yes!
Liabilities Not on
the Balance Sheet
Two kinds of liabilities have the potential to disappear from the balance
sheet. These liabilities are:
Contingent liabilities
Off-balance-sheet financing
Contingent Liabilities
Definition
A contingent liability is a potential liability that will become an actual liability only if some other event occurs first.
Product warranty
IRS audit
Defendant in a lawsuit
Issuance of coupons
Guarantee a debt
Frequent-flier miles
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When you look at the list of examples, it becomes clear that not all the contingencies are equally likely to happen. For example, product warranties
require some future expenditures and can be estimated from past experience.
However, the outcome of a lawsuit is very unpredictable. GAAP classifies
contingent liabilities into three categories:
Probable
The amount can be reasonably estimated: Accrue the expense and
liability on the financial statements (use the estimate to debit an
expense and credit a liability).
The amount cannot be reasonably estimated: Disclose in footnotes.
Reasonably Possible: Disclose in footnotes.
Remote: Depending on item, disclose in footnotes or no disclosure
required.
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Warranty liabilities
Coupons issued to customers
Unused refundable tickets sold to customers
All of the items above (1) create probable liabilities and (2) can be estimated based on a companys past experience. Therefore a journal entry is
made to record the liability and to match the related expense against current period revenue to which the liability is related. For example:
Warranty Expense
Estimated Warranty Liability
20,000
20,000
1,000
300
700
Off-Balance-Sheet Financing
Definition
Why It Is Done
Assets are obtained for use but no debt is recorded, making the balance
sheet appear more favorable to investors, lenders, and suppliers.
New debt may violate loan covenants on existing debt.
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The subject of financial risk is huge; we cannot even begin to describe all
the possibilities here. However, what we can still do is have some idea of the
general direction that risks will be coming from, and this can be useful. Of
course, what we are most concerned with are not small losses or the losses
we can see coming. What we are most worried about are those big losses
that take us by surprise. (Big unexpected surprises are sometimes called
Black Swans. A very useful, entertaining, and best-selling book on this
subject is The Black Swan by Nassim Taleb.) So where do we direct our
watchful eyes? We return to balance sheet: we are concerned with sudden
decreases in assets or surprise increases in liabilities.
As you know, the owners claim (Owners Equity) on the wealth of a
business is calculated by the basic accounting equation of A = L + OE. You
can see from this simple equation that a net decrease in assets (A) or net
increase in liabilities (L) will make owners equity decrease.
Note: A material decrease in an asset value that is not recoverable is
called impairment. The word is usually used in connection with longterm tangible assets, but may by used to describe any unrecoverable
asset value loss. Accountants measure and record impairment losses on
financial statements, but by the time this happens, the damage has
already been done.
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When you look at a balance sheet, do you understand the assets? Understanding assets means two key things: 1. Do you know what the assets
are? 2. Do you understand how the assets are valued?
When you can answer these two questions, you will have a general sense of
how quickly the assets could change value, the subjectivity of their values
that appear on the balance sheet, and their utility to the business. The
more that you learn about the asset types the better feel for them you
will develop.
In general, physical assets are usually easier to understand and value than
intangible assets and financial assets. For example, it would probably be
easier to understand and to estimate likely values for a truck and some
merchandise inventory than for a retained interest in a securitized loan or
for an exotic financial market derivative. Especially when complex assets
are a substantial portion of total assets, we need to be extra careful.
Do you understand what these assets are, the reliability of the value measurement, and what could happen to the values? The more complex the assets
are, probably the more complex the business operations are. Remember the
investment method of the famous investor Warren Buffet (who is one of the
richest men in the world). He repeatedly states that if he does not completely
understand a company, he will not invest in it. This is a good basic principle
for all kinds of stakeholders.
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If you think that analyzing assets can be difficult, then predicting unforeseen
liabilities is almost off the scale! This is where real surprises can happen.
Nevertheless a thoughtful analysis can still provide benefits.
Contingent
Liabilities
Review the contingent liabilities. Take a careful look at the notes that relate
to the contingent liabilities. Regardless of what assurances the notes might
provide, what events could increase the contingent liabilities that are
shown on the balance sheet or create new liabilities from possible events
that are described in the notes?
Just as with the assets, read the notes that relate to the liabilities. Do you
understand the liabilities that are recorded on the balance sheet and their
descriptions on the footnotes? Do you understand how amounts could
increase? Here is another actual example:
The Company may provide various products and services to the VIEs. It may provide
liquidity facilities, may be a party to derivative contracts with VIEs, may provide loss
enhancement in the form of letters of credit and other guarantees to the VIEs, may be the
investment manager, and may also have an ownership interest or other investment in certain
VIEs. In general, the investors in the obligations of consolidated VIEs have recourse only
to the assets of the VIEs and do not have recourse to the Company, except where the
Company has provided a guarantee to the investors or is the counterparty to a derivative
transaction involving the VIE. In addition to the VIEs that are consolidated in accordance
with FIN 46-R, the Company has significant variable interests in certain other VIEs that
are not consolidated because the Company is not the primary beneficiary. These include
multi-seller finance companies, collateralized debt obligations (CDOs), structured finance
transactions, and numerous investment funds. In addition to these VIEs, the Company
issues preferred securities to third party investors through trust vehicles as a source of
funding and regulatory capital, which were deconsolidated during the 2004 first quarter.
The Companys liabilities to the deconsolidated trust are included in long-term debt.
(Citigroup 10Q June 30, 2007)
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Review the nature of the business activities. For example, some activities
may be inherently more prone to lawsuits, such as selling prescription
drugs or selling tobacco products. Potential liabilities for some activities
can be very difficult to predict. For example, the note above indicates that
in general investors in the consolidated V.I.E. debt had access only to V.I.E.
assets and not to the Company creating the V.I.E. However, as we discussed
in the previous section about V.I.E.s, despite the fact that when there were
no loan guarantees to V.I.E. lenders, in many cases major losses were still
incurred in order to pay off the lenders simply to preserve a companys
good name and credit standing.
Other Issues
Fraud
Direct Equity
Events That
Affect Investor
Stakeholders
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Conclusions
Financial Statement Usefulness
GAAP Does Matter
GAAP is important. GAAP provides the essential standards for maintaining the integrity of accounting information and financial reporting.
Therefore, you should not conclude from our discussion that GAAP does
not matter. On the contrary, GAAP is the best means presently available
for communicating accounting information.
High Earnings
Quality Is
Not Assured
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Auditing and internal control: Enforce and improve auditing standards and internal control analysis by CPA firms. Significantly
improve internal control procedures used by the reporting companies.
Corporate responsibility: Require personal accountability by top executives (chief executive officer and chief financial officer) for what is
reported on financial statements of their companies. Corporate audit
committees cannot be part of management and must have membership on the board of directors.
Penalties: Enact severe criminal and civil penalties for top executives,
board members, and auditors who knowingly act or fail to act in ways
that cause shareholders and other stakeholders to be defrauded.
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The Sarbanes-Oxley Act removed the final authority over audit and internal control standards and enforcement from the public accounting profession and placed this authority under the control of the PCAOB for all
publicly traded companies.
The PCAOB makes proposals for auditing and reporting rule changes and
submits these proposals to the Securities and Exchange Commission. In
turn, the Commission must approve each proposal for it to become effective as a PCAOB rule. The PCAOB rules serve to implement existing
GAAP and to create improved auditing, internal control, and reporting
standards and, hopefully, to improve the quality of earnings.
To perform audits of public companies, CPA firms must register with the
PCAOB. The PCAOB has broad investigative and disciplinary authority
over these CPA firms. The PCAOB actively investigates potential violations and solicits information and complaints about potential violations.
The Future?
2008 Worthy and James Publishing. See front matter: Terms of Use.
Computation
Interpretation
Measures of Liquidity
Current ratio
Receivables turnover
Average days to
collect
Inventory turnover
Average days to sell
Measures of Solvency
Debt ratio
(leverage ratio)
Times-interest earned
total debt
-----------------------------total assets
operating income
----------------------------------------------Interest expense
or
net sales
----------------------------------------------------average total assets
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Computation
Interpretation
net income
-----------------------------net sales
Gross profit
ratio
gross profit
-----------------------------net sales
Measures of Profitability
net income
----------------------------------------------------average total assets
net income
-------------------------------------------------------------,
average owner s equity
or
Dividend ratio
cost
--------------------------------------------------------------------------------------units of important resource used
Measures of Productivity
Other measures
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QUICK REVIEW
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54
VO C A B U L A RY
Benchmark: a norm or guideline used for the
purpose of comparison
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P RAC T I C E
Use these questions and problems to practice what you have learned.
Multiple Choice
Select the best answer.
1. To evaluate the solvency of a business, which primary measurements would you select?
a. debt ratio, accounts receivable turnover ratio, and times-interest earned
b. gross profit ratio, return on equity ratio, and current ratio
c. quick ratio, inventory turnover ratio and earnings per share
d. debt ratio, asset turnover ratio, and cash flow to debt ratio.
2. To evaluate the profitability of a business, which primary measurements would you select?
a. quick ratio, free cash flow, and asset turnover ratio
b. current ratio, average days to sell inventory, and gross profit ratio
c. free cash flow, return on total assets, and debt ratio
d. earnings per share, gross profit ratio, and return on total assets ratio
3. To evaluate the liquidity of a business, which primary measurements would you select?
a. current ratio, quick ratio, and cash flow to debt ratio
b. current ratio, average days to sell inventory, and average days to collect receivables
c. current ratio, average days to sell inventory, and asset turnover ratio
d. times interest earned ratio, gross profit ratio, and return on total assets ratio
4. Earnings per share is used by investors in what important calculation?
a. price earnings ratio
b. profit ratio
c. return on equity ratio
d. dividend ratio
5. Quality of earnings refers to:
a the reliability of the change in wealth indicated on the income statement.
b. the reliability of the income statement as an indicator of recurring operations.
c. the assurance that properly applied GAAP means unbiased financial statements.
d. both a and b.
6. If Company X is an accounting firm and Company Y is an airline:
a. Company X probably will have a higher gross profit ratio.
b. Company Y probably will have a lower inventory turnover ratio.
c. Company X probably will have a higher asset turnover ratio.
d. Company Y probably will have a higher profit ratio.
7. A large corporation has new management that has promised to quickly stop losses and make
the company profitable. Which earnings management technique would they be most tempted
to immediately use?
a. income smoothing using the cookie jar
b. the big bath
c. capitalizing operating expenses
d. expense timing
8. Two ratios that can be used as measures of potential liquidity as well as operating efficiency are:
a. gross profit and return on total assets ratios.
b. quick and current ratios.
c. accounts receivable turnover and inventory turnover ratios.
d. current and cash flow to debt ratios.
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P RA CTI C E
9. If sales on account have been overstated, what calculation is most likely to detect it?
a. inventory turnover ratio or average days to sell calculation
b. current ratio
c. free cash flow calculation
d. accounts receivable turnover ratio or average days to collect receivables calculation
10. If a company changes from LIFO to FIFO in a period of rising prices, the inventory turnover
ratio:
a. will suddenly look better.
b. will suddenly look worse.
c. will not be affected.
d. cannot be calculated.
11. When analyzing a change in the debt ratio:
a. an increase is usually bad, and a decrease is usually good.
b. an increase usually creates more risk, and a decrease usually reduces risk.
c. When a debt ratio increases, it is essential to know the reason as this can be a good indicator
of a companys condition or strategy; when the ratio decreases, it is usually an indicator of
improvement in financial strength.
d. both b and c.
12. An important audit rule-setting and compliance enforcement organization requiring
registration by accountants who wish to audit publicly traded companies is the:
a. Public Company Accounting Oversight Board (PCAOB).
b. Securities and Exchange Commission (SEC).
c. Financial Accounting Standards Board (FASB).
d. American Institute of Certified Public Accountants (AICPA).
13. Which of the following does not represent a contingent liability?
a. a product that has a 1-year warranty
b. coupons issued by a grocery store
c. an oil tanker that does not have a double hull.
d. a long-term lease-purchase structured so that no debt appears on the balance sheet
14. A problem with contingent liability classification is that:
a. contingent liabilities may be difficult to calculate.
b. it is subjective and sometimes can be easily manipulated.
c. it is difficult to identify a contingent liability.
d. the classification does not apply to all types of companies.
15. If a company is using debt to acquire assets, then the business:
a. will have a high asset turnover ratio.
b. is said to be trading on equity.
c. will usually increase the rate of return on owners equity.
d. both b and c.
16. The federal law that resulted from years of aggressive financial reporting and the sudden
collapse of Enron and Worldcom is:
a. the PCAOB.
b. the Securities and Exchange Commission (SEC).
c. Sarbanes-Oxley.
d. FASB.
2008 Worthy and James Publishing. See front matter: Terms of Use.
P RAC T I C E
Reinforcement Problems
b. Solvency
c. Profitability
d. Investment return
e. Productivity
2. Horizontal analysis.
Instructions: Prepare a horizontal analysis that shows both the dollar and percent changes in 2007
from 2006 and also in 2008 from 2007 using the income statement shown below. Why did net
income increase by a higher percentage than sales in 2007? Why did net income increase by a
lower percentage than sales in 2008?
Grand Forks Company
Comparative Income Statement
Years Ended December 31, 2008, 2007, 2006
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
$605,000
358,000
247,000
165,000
82,000
2,000
$ 80,000
2007
$489,000
276,000
213,000
140,000
73,000
1,000
$ 72,000
2006
$418,000
251,000
167,000
126,000
41,000
2,000
$ 39,000
3. Calculate ratios. Assets and liabilities and selected other financial information from the
financial statements of Ketchikan Corporation are shown below.
Instructions: Compute the following for 2008:
Current ratio
Inventory turnover
Rate of return on total assets
Quick Ratio
2008 Worthy and James Publishing. See front matter: Terms of Use.
57
58
P RA CTI C E
3, continued
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories, yearend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term mortgage payable. . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment, net of depreciation. . . . . . . .
Accounts receivable, year end . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock shares issued and outstanding . . . . . . . . . . . .
(amounts shown were outstanding all year)
2008
$312,000
210,000
24,300
11,000
15,500
14,000
98,700
2,500
278,000
15,700
36,300
12,500
355,000
37,600
210,000
2007
$285,000
195,500
37,800
7,200
16,900
15,200
110,200
1,900
237,500
24,800
25,200
(18,600)
325,700
31,300
150,000
a. current ratio
b. debt ratio
a. current ratio
b. inventory turnover ratio
a. debt ratio
b. cash flow to debt ratio
a.
b.
c.
d.
a. current ratio
b. accounts receivable turnover ratio
a. current ratio
b. accounts receivable turnover ratio
c. inventory turnover ratio
current ratio
accounts receivable turnover ratio
inventory turnover ratio
rate of return on equity
2008 Worthy and James Publishing. See front matter: Terms of Use.
P RAC T I C E
5. Analysis for a loan decision. Melanie Davenport, the owner of Hilo Enterprises, has come to
your bank for a $70,000 loan. Hilo Enterprises has been a long-time customer of the bank. You
are a member of the loan committee reviewing the loan application. The loan officer dealing with
the customer is recommending that the full $70,000 loan be made because the business has
been consistently profitable, maintains a good amount of working capital, has good current and
acid-test ratios, and because Melanie Davenport is a long-term customer of the bank.
Instructions: Use the measures you think are relevant to evaluate the loan application. Do you
agree with the loan officers recommendation? Do you want any other data?
Hilo Enterprises
Comparative Income Statement
Years Ended May 31
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . . . .
Income from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss on sale of land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
$456,000
214,000
242,000
2007
$397,000
188,000
209,000
2006
$344,000
158,000
186,000
37,000
161,000
44,000
2,000
1,000
$ 41,000
28,000
141,000
40,000
24,000
124,000
38,000
2,000
$ 38,000
1,000
$ 37,000
2008
2007
2006
$ 37,000
119,000
2,000
127,000
285,000
125,000
44,000
$ 86,000
49,000
3,000
51,000
189,000
118,000
12,000
10,000
$305,000
$ 97,000
48,000
160,000
$305,000
Hilo Enterprises
Comparative Balance Sheet
May 31
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment. . . . . . . . . . . . . . . . . . . . . .
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . .
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$366,000
$ 70,000
62,000
2,000
78,000
212,000
125,000
28,000
10,000
$319,000
$123,000
47,000
196,000
$366,000
$106,000
58,000
155,000
$319,000
2008 Worthy and James Publishing. See front matter: Terms of Use.
59
60
P RA CTI C E
6. Analysis for an investment decision. De Kalb Decor, Inc. is a small privately held home
remodeling and interior-decorating company that opened in 2005 and sells to both retail and
contractor customers. It is about to sell additional shares of its stock to a limited group of
investors for the purpose of obtaining cash to fund an expansion of its operations and to pay off
half of the short-term debt. You have the opportunity to purchase some of the shares being
offered, and the company provided the audited financial statements that you see below.
Instructions:
a. Prepare a 3-year comparative common-size income statement.
b. Analyze liquidity, solvency, profitability, and investment return.
c. Is there any other important information that you would like to have?
d. Does the investment interest you?
De Kalb Decor, Inc.
Comparative Income Statement
Years Ended December 31
Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative. . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . .
Other revenues and gains and expenses and losses:
Other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss on sale of short-term investments . . . . . . . . . . . . . . .
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . .
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
$1,046,000
607,000
439,000
2007
$865,000
519,000
346,000
159,000
241,000
39,000
137,000
205,000
4,000
95,000
170,000
(25,000)
4,000
(24,000)
(31,000)
(12,000)
0
($12,000)
23,000
(17,000)
12,000
(5,000)
10,000
2,000
$ 8,000
2008 Worthy and James Publishing. See front matter: Terms of Use.
2006
$721,000
481,000
240,000
(18,000)
0
$(18,000)
P RAC T I C E
6, continued
De Kalb Decor, Inc.
Comparative Balance Sheet
December 31
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supplies and prepaid expenses . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment. . . . . . . . . . . . . . . . . . . . . .
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . .
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and owners equity . . . . . . . . . . . . . . . . .
2008
$152,000
25,000
107,000
104,000
13,000
401,000
415,000
95,000
$721,000
$133,000
164,000
297,000
424,000
$721,000
2007
$105,000
68,000
111,000
120,000
10,000
414,000
375,000
54,000
$735,000
$137,000
128,000
265,000
470,000
$735,000
2006
$ 64,000
42,000
84,000
101,000
9,000
300,000
315,000
20,000
$595,000
$ 58,000
75,000
133,000
462,000
$595,000
2008
2007
2006
($12,000)
$8,000
$(18,000)
41,000
12,000
20,000
34,000
20,000
79,000
15,000
10,000
31,000
(3,000)
(4,000)
85,000
(73,000)
48,000
(17,000)
10,000
(40,000)
(60,000)
(92,000)
53,000
30,000
36,000
(34,000)
2,000
47,000
105,000
$152,000
53,000
41,000
64,000
$105,000
2008 Worthy and James Publishing. See front matter: Terms of Use.
30,000
(52,000)
116,000
$64,000
61
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P RA CTI C E
7. Analysis for an investment decision. Financial information for Bedford and Buford companies
is shown below. You are a value investor, so you are interested in purchasing the stock of a
company that has the lowest price earnings ratio and is also in good financial condition. Which
company would you select?
Current year income statement information:
Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bedford, Inc.
$550,000
315,000
235,000
3,000
35,000
95,000
Buford, Inc.
$420,000
273,000
147,000
4,000
15,000
72,000
Bedford, Inc.
$55,000
8,000
42,000
110,000
5,000
590,000
131,000
159,000
100,000 shares
$17.20
Buford, Inc.
$44,000
15,000
28,000
75,000
4,000
432,000
77,000
133,000
100,000 shares
$16.40
Bedford, Inc.
$51,000
99,000
542,000
336,000
Buford, Inc.
$37,000
81,000
409,000
227,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . .
Accounts and short-term notes receivable, net . . . . .
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock issued and outstanding. . . . . . . . . . .
Current market price of stock . . . . . . . . . . . . . . . . . . .
Receivables turnover
Gross profit ratio
Return on equity
2008 Worthy and James Publishing. See front matter: Terms of Use.
P RAC T I C E
8. Use ratios to calculate financial statement values. The condensed income statement and balance
sheet for Mystery Company are shown below. Calculate the values for items, A through R.
Mystery Company
Income Statement
Year Ended June 30, 2008
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other revenues and gains and expenses and losses:
Other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(A)
(B)
(C)
55,000
127,500
(D)
1,500
(11,250)
(E)
Mystery Company
Comparative Balance Sheet
June 30
2008
2007
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . .
Less: accumulated depreciation . . . . . . . . . . . . . . . . . . . .
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
44,000
63,000
3,250
101,000
211,250
286,000
76,000
100,000
(N)
(F)
67,000
3,000
(G)
(H)
246,500
54,000
100,000
(I)
(O)
278,500
(P)
(Q)
(R)
130,000
(J)
(K)
(L)
(M)
Other information:
2008 Worthy and James Publishing. See front matter: Terms of Use.
63
64
SO L U T ION S
Multiple Choice
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
d
d
b
a Earnings per share is also used directly for comparing profitability on a per-share basis.
d
c An airline would have a much greater investment in property, plant, and equipment assets
than an accounting firm. Therefore, the denominator in the fraction will be much bigger,
making the answer for turnover much smaller. A much bigger asset investment is needed
to create a dollar of revenue in an airline. An accounting firm and an airline are service
businesses and do not have merchandise inventory or cost of goods sold.
b First, this focuses blame on the old management. Second, future years results will now look
better when compared to the current large loss year in which the big bath was recorded.
c Both ratios relate to potential near-term cash flow and are also indicators of management
efficiency.
d If sales on account are overstated, the average balance of accounts receivable will also be
overstated. Also, these overstated receivables will remain uncollected. The denominator in
the ratio calculation will increase, which reduces the turnover and increases the days.
Example: Assume correct amounts are: sales 100, beginning A/R 14, and ending A/R 10.
Answer: [100/(14 + 10)]/2 = 8.33. Now assume sales overstated by 20. Answer: [120/(14 + 30)]/
2 = 5.45 (lower turnover). (Note: The gross profit ratio will also provide a clue as it begins to
increase above historical averages.)
b Changing from LIFO to FIFO in a period of rising prices reduces cost of goods sold, and the
numerator of the ratio becomes smaller. As well, the ending inventory becomes greater,
which increases the average inventory in the denominator. These changes decrease the
inventory turnover answer, although items are not actually being sold any slower. Be careful
when comparing companies using different inventory methods!
d
a This organization was created by the Sarbanes-Oxley Act in 2002.
d This is an off-balance sheet financing technique. All the other items represent potential
liability of varying degrees of probability.
b
b Trading on equity can result in either better returns or worse returns and increased risk.
c
2008 Worthy and James Publishing. See front matter: Terms of Use.
SO L U T I O N S
Reinforcement Problems
$116,000
82,000
34,000
25,000
9,000
1,000
$ 8,000
23.7%
29.7
16.0
17.9
12.3
100.0
11.1%
2007 changes
$71,000
25,000
46,000
14,000
32,000
(1,000)
$33,000
16.9%
10.0
27.5
11.1
78.0
(50.0)
84.6%
In 2007, net income increased by a greater percentage than sales because total expenses increased
by a lower percentage than sales. As the biggest expense item, cost of goods sold had the biggest
effect. In 2008, net income increased by a lower percentage than sales because the total expenses
increased by a higher percentage than sales. Cost of goods sold again had the greatest effect, as
operating expenses actually increased by a lesser percentage than sales.
3. Ketchikan Company
Current ratio: 2.13:1
(14,000 + 15,700 + 24,300 + 2,500)/(11,000 + 15,500)
4.
1a. The current ratio improves! (Current assets and current liabilities each decrease by $10,000.)
The new ratio is 2.8:1.
1b. The debt ratio also improves. (Total debt and total assets each decrease by $10,000.) The new
ratio is 33.3%.
2008 Worthy and James Publishing. See front matter: Terms of Use.
65
66
SO L U T ION S
4, continued
2a. The current ratio decreases. (Current assets and current liabilities each increase by $20,000.)
The new ratio is approximately 1.165:1.
2b. The inventory turnover ratio decreases as more inventory is added. (Average inventory
increases.) The new ratio is 5.1 times per year.
3a. The debt ratio increases. (Total assets and total debt each increase by $50,000.) The new ratio
is 43%.
3b. The cash flow to debt percentage decreases. (Operating cash flow is unchanged, but total debt
increases by $50,000.) The new ratio is 23%.
4a. The current ratio increases. (Two items affect the current ratio here! Accounts receivable
increases by $19,000; inventory decreases by $10,000 so there is a net increase in current
assets of $9,000.) The new ratio is 2.47:1.
4b. The accounts receivable turnover ratio decreases as another account receivable is added.
(Accounts receivable and sales increase by $19,000.) The new ratio is 11 times per year.
4c. The inventory turnover ratio increases because cost of goods sold increases $10,000 and
average inventory decreases by $5,000. The new ratio is 8.45 times per year.
4d. The rate of return on equity increases because the sale increases net income by $9,000. The
new ratio is 22%.
5a. The current ratio decreases because less cash is received. The new current ratio is 2:1.
5b. The ratio increases. Normally a discount taken means that a receivable is paid more quickly,
so we can assume that net sales decrease by $500 and ending accounts receivable decrease by
$7,500. The new ratio is 18.9.
6a. The current ratio decreases as follows: current assets decrease by $10,000 for Accounts
Receivable decrease, but current assets increase by $6,000 for inventory returned. This is a net
$4,000 decrease in current assets and the new ratio is 1.98:1.
6b. The accounts receivable turnover ratio is affected as follows: net sales decrease to $302,000 and
average accounts receivable decrease to $15,250. The new ratio increases to 19.8 times per year!
A somewhat misleading result caused only by a return of merchandise. However, the result on
the income statement will be a decrease in net income due to the decrease in net sales.
6c. Average inventory increases by $3,000 and cost of goods sold decreases by $6,000. The new
inventory turnover ratio decreases to 6 times.
7a. The rate of return on equity is reduced because uncollectible accounts expense is debited and
reduces the net income. The rate decreases to 16.9%.
7b. The accounts receivable turnover will actually increase! (Because Allowance for Uncollectible
Accounts is credited, which increases the account, thereby decreasing the net accounts
receivable.) The changed accounts receivable turnover ratio would be 16.2 times per year.
5. Hilo Enterprisesanalysis: The primary concern of a lender is to be paid back the principal and
interest on a loan. Therefore, the primary focus of most loan evaluations will be on liquidity and
cash flow and solvency. The loan officer is correct: Operating and net income have been
increasing, the working capital as of 2008 is $162,000 ($285,000 $123,000), and the current
ratio is good and from 2007 to 2008 has improved from 1.95:1 to 2.3:1. The 2008 acid-test ratio is
good at 1.27:1 and is stable. However, unfortunately the loan officer has not focused on the cash
balance. An essential question is: Why is cash decreasing if the company is profitable?
2008 Worthy and James Publishing. See front matter: Terms of Use.
SO L U T I O N S
5, continued
A further analysis shows that there has been a build-up in both accounts receivable and inventory.
These are unfavorable warning signs that the recorded sales are not easily being collected (or
worsethey are questionable sales) and that much of the inventory being purchased is not being
sold, which ties up cash and also carries the risk of inventory write-offs. The accounts receivable
turnover in 2007 is $397,000/($49,000 + $62,000)/2 = 7.15 times per year, which is about 51 days
average wait for collection. In 2008 this worsened to $456,000/($62,000 + $119,000)/2 = 5.04,
which is about 72 days. The inventory turnover in 2007 is $188,000/($51,000 + $78,000)/2 = 2.92
times per year, which is about 125 days to sell the average level of inventory. In 2008 this worsened
to $214,000/($78,000 + $127,000)/2 = 2.09, which is about 175 days to sell inventory. Liquidity is
definitely worsening. Considering this, it is also interesting that land was sold in 2008. To obtain
cash? The debt ratio trend is 48%, 51%, and 46% in 2006, 2007, and 2008. Although relatively
stable, the ratio is substantial.
Risks: (1) There may be significant losses because of write-offs of accounts receivable and
inventory next year, and (2) the indicators above are early warnings signs that business is
worsening, with unfavorable future cash flow and solvency implications.
Recommendation: (1) Obtain a statement of cash flows to confirm operating cash flow concerns
and also to calculate the solvency measures of cash flow to debt, cash basis times interest earned
and free cash flow. (2) Discuss the situation with the owner and ask about her business plan.
(3) A secured loan at a higher interest rate probably will be justified, as will a reduced loan
amount.
6.
De Kalb Decor, Inc.
Comparative Common-Size Income Statement
Years Ended December 31
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations . . . . . . . . . . . . . . . . . . . .
Other revenues and gains and expenses and losses:
Other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense
Loss on sale of short-term investments . . . . . . . . . . . . .
Income before income taxes . . . . . . . . . . . . . . . . . . . . . .
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
100%
58
42
2007
100%
60
40
2006
100%
67
33
15
23
4
16
24
13
23
(3)
0
(2)
(3)
(1)
(1%)
3
(2)
2
(1)
1%
(2)
(2%)
2008 Worthy and James Publishing. See front matter: Terms of Use.
67
68
SO L U T ION S
6, continued
Ratio
2008
2007
2006
Interpretation
3:1
3:1
5.2:1
Quick Ratio
2.1:1
2.1:1
3.3:1
A/R days to
collect
38 days
41 days
Inventory days
turnover
67 days
78 days
41%
36%
22%
Cash basis
times-interest
earned
3.5
2.8
2.0
Asset turnover
1.4
1.3
30%
24%
$45,000
($12,000)
($82,000)
Profit margin
(1%)
1%
(2.5%)
Gross profit
42%
40%
33%
Liquidity Ratios
Current Ratio
Solvency Ratios
Debt ratio
Cash flow to
debt
Free cash flow
Profitability Ratios
Earnings per
share
(2.7%)
1.7%
7.6%
0%
2008 Worthy and James Publishing. See front matter: Terms of Use.
SO L U T I O N S
6, continued
Analysis: If you were to focus only on the bottom linethe minimal net income and the net losses
of this companyyou would overlook the information that indicates that this appears to be a well
managed and vigorously growing company. Revenue has increased each year and 45% over the last
two years, whereas the cost of goods sold percentage has been decreasing. This is a powerful
combination. Operating expenses have been increasing substantially but have not changed as a
percentage of revenue. In the meantime, the company is handling receivables and inventory efficiently
as indicated by good and improving turnover ratios.
Liquidity and cash flow are good and improving. The company appears to have been financing
much of its growth by increased borrowing; however, the solvency indicators remain strong. These
will also improve if the business uses some of the new cash to pay down liabilities. Consistently
good and improving cash flow also tends to indicate minimal earnings management. Recent net
income and rate of return measures are not really meaningful for a new companyespecially for
one that appears to be coming into profitability. I would be very interested in this company;
however, before reaching a final decision, I would want to obtain more information about industry
norms for comparison. Some detailed productivity data also would be useful.
Analysis: This is not an easy choice. Buford has better liquidity ratios and is managing the
receivables and inventory more efficiently. On the other hand, Bedford has a lower debt ratio and
higher gross profit percentage, which indicate better solvency. Buford apparently has better
control of operating expenses, because it has the same net income profit margin percentage as
Bedford at 17%, even though Bedford has the higher gross profit percentage.
The deciding factor may be the price earnings ratio. Although the stock price of Buford is lower at
$16.50 per share, it is more expensive (higher price earnings ratio) relative to the earnings per
share (probably because of Bufords higher return on equity).
Calculation of PE ratios:
Bedford price earnings ratio: ($17.20 stock price per share)/($.95 earnings per share) = 18 times
Buford price earnings ratio: ($16.40 stock price per share)/($.72 earnings per share) = 23 times
2008 Worthy and James Publishing. See front matter: Terms of Use.
69
70
SO L U T ION S
8. Mystery Company
A. Using accounts receivable turnover: ($63,000 + $67,000)/2 = $65,000 average balance 12 =
$780,000.
B. Using the gross profit percentage: A 40% gross profit means a 60% cost of goods sold.
Therefore, $780,000 .6 = $468,000
C. $780,000 .4 = $312,000
D. $312,000 ($55,000 + $127,500) = $129,500
E. $129,500 + $1,500 $11,250 = $119,750
F. Use acid-test ratio for total quick assets: x/$130,000 = .8 Cash is: $104,000 $67,000 =
$37,000
G. Using the inventory turnover ratio, write the ratio and what it equals in an equation form and
then use some algebra to solve for G in the equation:
[(G + $101,000)/2] 4.5 = $468,000 To solve for G,
[1/2(G) + 1/2($101,000)] 4.5 = $468,000 then,
[1/2 (G) + 50,500] 4.5 = $468,000 then,
2.25 (G) + 227,250 = $468,000 then,
2.25 (G) = $240,750 Therefore, G = $107,000.
H. $37,000 (from F) + $67,000 + $3,000 + $107,000 = $214,000
I. Total assets = H + ($246,500 54,000) + 100,000 = $506,500
J. Calculate (K) first. Then, $329,225 $130,000 = $199,225
K. Total liabilities, using the debt ratio: $506,500 .65 = $329,225
L. Owners equity is total assets total liabilities: $506,500 $329,225 = $177,275
M. M = I = $506,500
N. $211,250 + (286,000 $76,000) + $100,000 = $521,250
O. Using the current ratio: $211,250/x = 2.6 Result: x = $81,250
P. $81,250 + $278,500 = $359,750
Q. $521,250 (from N) $359,750 (from P) = $161,500 (Notice that the owners equity decreased
from 2006 to 2007, even though the business had net income. This means there were owner
withdrawals during 2007.)
R. R = N = $521,250
2008 Worthy and James Publishing. See front matter: Terms of Use.