CHAPTER 13
Financial Analysis: The Big Picture
Study Objectives
1. Understand the concept of sustainable income.
2. Indicate how irregular items are presented.
3. Explain the concept of comprehensive income.
4. Describe and apply horizontal analysis.
5. Describe and apply vertical analysis.
6. Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.
7. Understand the concept of quality of earnings.
Chapter Outline
Study Objective 1 - Understand the Concept of Sustainable Income
 The value of a company is a function of its future cash flows.
 When analysts use this year’s net income to estimate future cash flows, they must make sure that
this year’s net income does not include irregular (out of the ordinary) revenues, expenses, gains
or losses.
 Net income adjusted for irregular items is referred to as sustainable income.
 Sustainable income is the most likely level of income to be obtained in the future.
 Sustainable income differs from actual net income by the amount of irregular revenues,
expenses, gains, and losses included in this year’s net income.
 Users are interested in sustainable income because it helps them derive an estimate of future
earnings without the “noise” of irregular items.
Study Objective 2 - Understand How Irregular Items are Presented
 Irregular items are identified by type on the income statement. Two types of irregular items are
reported - discontinued operations and extraordinary items.
 Irregular items are reported net of income taxes. Income tax expense is computed for the
income before irregular items. Then, income tax expense is computed for each individual
irregular item.
 Discontinued operations refers to the disposal of a significant component of a business, such as
the elimination of a major class of customers or an entire activity.
 When the disposal of a significant component occurs, the income statement should report the
gain (or loss) from discontinued operations, net of tax.
 To illustrate, assume that Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million
from continuing operations in 2012. The company therefore has income before income taxes
of $800,000. During 2012, the company discontinued and sold its unprofitable chemical
division. The loss on disposal of the chemical operations (net of $90,000 taxes) was $210,000.
Assuming a 30% tax rate on income before income taxes, the income statement presentation
would be as follows:
ROZEK INC.
Income Statement (partial)
For the Year Ended December 31, 2012
Income before income taxes..............................................
Income tax expense ..........................................................
Income before irregular items ............................................
Discontinued operations
Loss from disposal of chemical division,
net of $90,000 income tax saving .............................
Net Income ........................................................................
$800,000
240,000
560,000
(210,000)
$350,000
 Extraordinary items are events and transactions that meet two conditions: They are unusual in
nature and infrequent in occurrence.
 To be considered unusual, the item should be abnormal and only incidentally related to
customary activities of the entity.
 To be regarded as infrequent, the event or transaction should not be reasonably expected to
recur in the foreseeable future.
 Both criteria must be evaluated in terms of the environment in which the entity operates.
 Extraordinary items are reported net of tax in a separate section of the income
statement immediately below discontinued operations.
 Assume that in 2012 a revolutionary foreign government expropriated property held as an
investment by Rozek Inc. If the loss is $70,000 before applicable income taxes of $21,000, the
income statement presentation will show a deduction of $49,000, as illustrated below:
ROZEK INC.
Partial Income Statement
For the Year Ended December 31, 2012
Income before income taxes..............................
Income tax expense ..........................................
Income before irregular items ............................
Discontinued operations: Loss from
disposal of chemical division, net
of $90,000 income tax savings ....................
Extraordinary item: Expropriation of
investment, net of $21,000 income
tax savings..................................................
Net income ........................................................

$800,000
240,000
560,000
(210,000)
(49,000)
$301,000
If a transaction or event meets one but not both of the criteria for an extraordinary item, it
should be reported in a separate line item in the upper portion of the income statement, rather
than being reported in the bottom portion as an extraordinary item.
 Transactions or events meeting only one criteria are usually reported under “Other
revenues and gains” or “Other expenses and losses” at their gross amount (not net of tax).
 In summary, in evaluating a company, it generally makes sense to eliminate all irregular
items in estimating future sustainable income.
 Changes in accounting principle
 For ease of comparison, financial statements are expected to be prepared on a basis
consistent with that used for the preceding period.
 A change in accounting principle occurs when the principle used in the current year is
different from the one used in the preceding year.


A change is permitted when management can show that the new principle is preferable to the
old principle.
 An example is a change in inventory costing methods (such as FIFO to average-cost).
A change in accounting principle is reported retroactively, to improve comparability.
 Companies report both the current period and previous periods reported on the face of the
statements using the new principle.
 As a result, the same principle applies in all periods.
Study Objective 3 – Explain the Concept of Comprehensive Income
 Comprehensive Income - Most revenues, expenses, gains, and losses are included in net
income. However, certain gains and losses now bypass net income. Instead these items are
recorded as direct adjustments to stockholders’ equity.
 Many analysts have expressed concern about this practice because they believe it reduces the
usefulness of the income statement.
 To address this concern, the FASB now requires companies to report not only net income but
also comprehensive income.
 Comprehensive income includes all changes in stockholders’ equity during a period except
those changes resulting from investments by stockholders and distributions to stockholders.
 For example, unrealized gains or losses on available-for-sale securities are excluded from net
income. Instead they are reported as part of “Other comprehensive income.”
 Illustration of comprehensive income:
 Accounting standards require that most investments in stocks and bonds be adjusted up or
down to their market value at the end of each accounting period.
 For example, assume that during 2012, Stassi Company purchased IBM stock for $10,000 as
an investment. At the end of 2012, Stassi was still holding the investment, but the stock’s
market value was now $8,000. In this case, Stassi is required to reduce the recorded value of
its IBM investment by $2,000. The $2,000 difference is an unrealized loss.
 Should Stassi include this $2,000 unrealized loss in net income? It depends on whether the
IBM stock is classified as a trading security or an available-for-sale security.
 A trading security is bought and held primarily for sale in the near term to generate
income on short-term price differences. Unrealized losses on trading securities are reported
in the “Other expenses and losses” section of the income statement.
 Available-for-sale securities are held with the intent of selling them sometime in the
future. Unrealized gains and losses on available-for-sale securities are not included in the
determination of net income. Instead, they are reported as part of “Other comprehensive
income.”
 Format:
 One format for reporting comprehensive income is to report a combined statement of income
and comprehensive income.
STASSI CORPORATION
Combined Statement of Income and
Comprehensive Income (partial)
Net Income ..................................................................
Unrealized loss on available-for-sale securities ...........
Comprehensive income ...............................................

$300,000
2,000
$298,000
The unrealized loss on available-for-sale securities is also reported as a separate component
of stockholders’ equity.
STASSI CORPORATION
Balance Sheet (partial)
Stockholders’ equity
Common stock .......................................................
Retained earnings ..................................................
Total paid-in capital and retained earnings ....
Less: Unrealized loss on available-for-sale
securities ...................................................
Total stockholders’ equity ............................................


$3,000,000
1,500,000
4,500,000
(2,000)
$4,498,000
Note that the presentation of the loss is similar to the presentation of the cost of treasury stock
in the stockholders’ equity section.
 An unrealized gain is added to this section of the balance sheet.
Reporting the unrealized gain or loss in the stockholders’ equity section serves two important
purposes:
1. It reduces the volatility of net income due to fluctuations in fair value.
2. It informs the financial statement user of the gain or loss that would occur if the securities
were sold at fair value.
 Complete Income Statement - The following income statement for Pace Corporation presents
the types of items found on this statement and shows how the irregular items are reported.
PACE CORPORATION
Income Statement and
Statement of Comprehensive Income
For the Year Ended December 31, 2012
Net sales .....................................................................
Cost of goods sold .......................................................
Gross profit ..................................................................
Operating expenses ...............................................
Income from operations .........................................
Other revenues and gains ......................................
Other expenses and losses ....................................
Income before income taxes ..................................
Income tax expense ($66,000 x 30%) ....................
Income before irregular items.................................
Discontinued operations: Gain on disposal
of Plastics Division, net of $15,000
income taxes ($50,000 x 30%) .............................
Extraordinary item: Tornado loss, net
of income tax savings $18,000
($60,000 x 30%) .....................................................
Net Income .................................................................
Add: Unrealized gain on
available-for-sale securities ..................................
Comprehensive income ............................................
$440,000
260,000
180,000
110,000
70,000
$ 5,600
(9,600)
(4,000)
66,000
19,800
46,200
35,000
(42,000)
39,200
10,000
$ 49,200
 Concluding remarks – The computation of the correct net income number can be elusive.
 In assessing the future prospects of a company, some investors focus on income from
operations and therefore ignore all irregular and other items.
 Others use measures such as net income, comprehensive income, or some modified version
of one of these amounts.
Study Objective 4 – Describe and Apply Horizontal Analysis
 In assessing the financial performance of a company, investors are interested in the core or
sustainable earnings of a company. Investors are also interested in making comparisons from
period to period.
 Three types of comparisons have been shown in the text to improve the decision usefulness of
financial information:
1. Intracompany basis. Comparisons within a company are often useful to detect changes in
financial relationships and significant trends. A comparison of Kellogg’s current year’s cash
amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a
comparison of Kellogg’s year-end cash amount with the amount of total assets at year-end
shows the proportion of total assets in the form of cash.
2. Intercompany basis. Comparisons with other companies provide insight into a company’s
competitive position. Kellogg’s total sales for the year can be compared with the total sales of
its competitors in the breakfast cereal area, such as General Mills.
3. Industry averages. Comparisons with industry averages provide information about a
company’s relative position within the industry. Kellogg’s financial data can be compared with
the averages for its industry compiled by financial ratings organizations such as Dun &
Bradstreet, Moody’s, and Standard & Poor’s, or with information provided on the Internet by
organizations such as Yahoo! on its financial site.
 Three basic tools are used in financial statement analysis to highlight the significance of financial
statement data:
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis
 Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of
financial statement data over a period of time.
 Its purpose is to determine the increase or decrease that has taken place.
 The increase or decrease can be expressed as either an amount or a percentage.
TEACHING TIP
Horizontal analysis is just that—horizontal. One looks across the page.

To illustrate horizontal analysis, the most recent net sales figures (in thousands) of Chicago
Cereal Company are given:
2009
$11,776

2008
$10,907
2007
$10,177
2006
$9,614
2005
$8,812
If we assume that 2005 is the base year, we can measure all percentage increases or
decreases from this base-period amount with the following formula:
Change Since Base Period =
Current-Year Amount – Base-Year Amount
Base-Year Amount

For example, we can determine that net sales for Chicago Cereal Company increased
approximately 9.1% [($9,614 - $8,812) / $8,812] from 2005 to 2006.

Alternatively, we can express current-year sales as a percentage of the base period by dividing
the current-year amount by the base-year amount:
Current Results in Relation to Base Period
=
Current-Year Amount
Base Year Amount

Current-period sales expressed as a percentage of the base-period for each of the five years,
assuming 2005 as the base period is:
2009
$11,776
2008
$10,907
2007
$10,177
2006
$9,614
2005
$8,812
133.64%
123.77%
115.49%
109.10%
100%
The financial statements of Chicago Cereal Company are used to further illustrate horizontal analysis:
CHICAGO CEREAL COMPANY, INC.
Condensed Balance Sheets
December 31
(In thousands)
Assets
Current assets
Plant assets (net)
Other assets
Total assets
2009
$ 2,717
2,990
5,690
$11,397
2008
$ 2,427
2,816
5,471
$10,714
Liabilities and Stockholders’ Equity
Current liabilities
$ 4,044
$ 4,020
Long-term liabilities
4,827
4,625
Total liabilities
8,871
8,645
Stockholders’ equity
Common stock
493
397
Retained earnings
3,390
2,584
Treasury stock (cost)
(1,357)
(912)
Total stockholders’ equity
2,526
2,069
Total liabilities and
stockholders’ equity
$11,397
$10,714






Increase (Decrease)
during 2009
Amount
Percent
$290
11.9
174
6.2
219
4.0
$683
6.4
$ 24
202
226
96
806
(445)
457
$683
0.6
4.4
2.6
24.2
31.2
48.8
22.1
6.4
The comparative balance sheet shows a number of changes from 2008 to 2009.
Current assets increased $290,000 or 11.9% ($290/$2,427).
Property assets (net) increased $174,000 or 6.2%.
Other assets increased $219,000 or 4.0%.
Current liabilities increased $24,000 or 0.6% while long-term liabilities increased $202,000, or
4.4%.
Retained earnings increased $806,000 or 31.2%.
TEACHING TIP
Impress upon students the importance of the percentage figures. The percentages allow us
to see the relevance of the increase or decrease.

A 2-year comparative income statement of Chicago Cereal Company for 2009 and 2008 is
given in condensed format:
CHICAGO CEREAL COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In thousands)
2009
Net sales
$11,776
Cost of goods sold
6,597
Gross profit
5,179
Selling and
administrative expenses
3,311
Income from operations
1,868
Interest expense
319
Other income (expense), net
(2)
Income before income taxes
1,547
Income tax expense
444
Net income
$ 1,103


2008
$10,907
6,082
4,825
3,059
1,766
307
13
1,472
468
$ 1,004
Increase (Decrease)
during 2009
Amount
Percent
$869
8.0
515
8.5
354
7.3
252
102
12
(15)
75
(24)
$ 99
8.2
5.8
3.9
(115.4)
5.1
(5.1)
9.9
Horizontal analysis of the income statements shows these changes:
 Net sales increased $869,000 or 8.0% ($869 ÷ $10,907).
 Cost of goods sold increased $515,000 or 8.5% ($515 ÷ $6,082).
 Selling and administrative expenses increased $252,000, or 8.2% ($252 ÷ $3,059).
 Overall, gross profit increased by 7.3% and net income increased by 9.9%.
 The increase in net income can be attributed to the increase in net sales and a decrease in
Income tax expense.
When using horizontal analysis, if an item has no value in a base year or preceding year and a
value in the next year, no percentage change can be computed. And if a negative amount
appears in the base or preceding period and a positive amount exists in the following year, no
percentage change can be computed.
Study Objective 5 - Describe and Apply Vertical Analysis
 Vertical analysis, also called common-size analysis, is a technique for evaluating financial
statement data that expresses each item in a financial statement as a percentage of a base
amount.
 On a balance sheet one might say that current assets are 22% of total assets (total assets
being the base amount.)
 On an income statement one might say that selling expenses are 16% of net sales (net sales
being the base amount.)
 Presented below is the comparative balance sheet of Chicago Cereal for 2009 and 2008,
analyzed vertically.
CHICAGO CEREAL COMPANY, INC.
Condensed Balance Sheets
December 31
(In thousands)
Assets
Current assets
Property assets (net)
Other assets
Total assets
2009
Amount
Percent*
$ 2,717
23.8
2,990
26.2
5,690
50.0
$11,397
100.0
Liabilities and Stockholders’ Equity
Current liabilities
$4,044
Long-term liabilities
4,827
Total liabilities
8,871
Stockholders’ equity
Common stock
493
Retained earnings
3,390
Treasury stock (cost)
(1,357)
Total stockholders’ equity
2,526
Total liabilities and
stockholders’ equity
$11,397
35.5
42.4
77.9
4.3
29.7
(11.9)
22.1
100.0
2008
Amount
$ 2,427
2,816
5,471
$10,714
Percent*
22.6
26.3
51.1
100.0
$ 4,020
4,625
8,645
37.5
43.2
80.7
397
2,584
(912)
2,069
$10,714
3.7
24.1
(8.5)
19.3
100.0
*Numbers have been rounded to total 100%.
 In addition to showing the relative size of each category on the balance sheet, vertical analysis
may show the percentage change in the individual asset, liability, and stockholders’ equity items.
 Chicago Cereal’s current assets increased $290,000 from 2008 to 2009 and they increased
from 22.6% to 23.8% of total assets.
 Property assets (net) decreased from 26.3% to 26.2% of total assets.
 Other assets decreased from 51.1% to 50.0% of total assets.
 Retained earnings increased by $806,000 from 2008 to 2009, and total stockholders’ equity
increased from 19.3% to 22.1% of total liabilities and stockholders’ equity. This switch to a
higher percentage of equity financing has two causes: First, while total liabilities increased by
$226,000 the percentage of liabilities declined from 80.7% to 77.9% of total liabilities and
stockholders’ equity. Second, retained earnings increased by $806,000. Thus, the company
shifted toward a heavier reliance on equity financing both by using less debt and by increasing
the amount of retained earnings.
 Vertical analysis of the comparative income statements of Chicago Cereal, shown below reveals
that:
 Cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%.
 Selling and administrative expenses increased from 28.0% to 28.1%.
 Net income as a percentage of net sales increased from 9.1% to 9.4%.
 The decline in net income as a percentage of sales is due primarily to the decrease in interest
expense and income tax expense as a percentage of sales.
CHICAGO CEREAL COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In thousands)
2009
Amount
Percent*
Net sales
$11,776
Cost of goods sold
6,597
Goss profit
5,179
Selling and admin. expenses
3,311
Income from operations
1,868
Interest expense
319
Other income (expense), net
(2)
Income before income taxes
1,547
Income tax expense
444
Net income
$ 1,103
*Numbers have been rounded to total 100%.
100.0
56.0
44.0
28.1
15.9
2.7
0
13.2
3.8
9.4
2008
Amount
$10,907
6,082
4,825
3,059
1,766
307
13
1,472
468
$ 1,004
Percent*
100.0
55.8
44.2
28.0
16.2
2.8
0
13.4
4.3
9.1
 Vertical analysis enables you to compare companies of different sizes.
 Shown below is a comparison of the income statements of Chicago Cereal and General Mills:
CONDENSED INCOME STATEMENTS
For the Year Ended December 31, 2009
(In thousands)
Net sales
Cost of goods sold
Gross profit
Selling and admin. expenses
Nonrecurring charges
Income from operations
Other expense and revenues
(including income taxes)
Net income
Chicago Cereal.
Amount
Percent*
General Mills, Inc.
Amount
Percent*
$11,776
6,597
5,179
3,311
0
1,868
100.0
56.0
44.0
28.1
—
15.9
$14,691
9,458
5,233
2,954
(43)
2,322
765
$ 1,103
6.5
9.4
1,0108
$ 1,304
100.0
64.4
35.6
20.1
0.3
15.8
6.9
8.9
*Numbers have been rounded to total 100%



Although Chicago Cereal’s net sales are less than the net sales of General Mills, vertical
analysis eliminates the impact of the size difference for the analysis.
Chicago Cereal’s has a higher gross profit, 44.0%, compared to 35.6% for General Mills, but
Chicago Cereal’s selling and administrative expenses are 28.1% of net sales, while those of
General Mills are 20.1% of net sales.
Chicago Cereal’s and General Mills report similar percentages for income from operations as a
percentage of net sales, 9.4% compared to 8.9%, respectively.
Study Objective 6 - Identify and Compute Ratios Used in Analyzing a Company’s
Liquidity, Solvency, and Profitability
 For analysis of the primary financial statements, ratios can be classified into three types:
1. Liquidity ratios measure the short-term ability of the company to pay its maturing obligations
and to meet unexpected needs for cash.
2. Solvency ratios measure the ability of the company to survive over a long period of time.
3. Profitability ratios measure the income or operating success of a company for a given period
of time.
TEACHING TIP
Review the summary listing on pages 700-701 of ratios presented in previous chapters. A
comprehensive illustration of ratio analysis is presented in the Appendix at the end of the
chapter.
Study Objective 7 – Understand the Concept of Quality of Earnings
 A company that has a high quality of earnings provides full and transparent information that will
not confuse or mislead users of financial statements.
 The issue of quality of earnings has taken on increasing importance because recent accounting
scandals suggest that some companies are spending too much time managing their income and
not enough time managing their business.
 Some of the factors affecting quality of earnings include the following:
 Alternative accounting methods – Variations among companies in the application of
generally accepted accounting principles may hamper comparability and reduce quality of
earnings.
 For example, one company may use the FIFO method of inventory costing, while another
company in the same industry may use LIFO.
 If inventory is a significant asset to both companies, it is unlikely that their current ratios
are comparable.
 Differences also exist in reporting such items as depreciation and amortization. Although
these differences in accounting methods might be detected from reading the notes to the
financial statements, adjusting the financial data to compensate for the different methods is
often difficult, if not impossible.
 Pro forma income – Companies whose stock is publicly traded are required to present their
income statement following generally accepted accounting principles (GAAP).
 In recent years, many companies have been also reporting a second measure of income,
called pro forma income.
 Pro forma income is a measure that usually excludes items that the company thinks are
unusual or non-recurring.
 There are no rules as to how to prepare pro forma earnings. Companies generally can
exclude any items they deem inappropriate for measuring their performance.
 Many analysts are critical of the practice of using pro forma income because these
numbers often make companies look better then they really are.



Companies, on the other hand, argue that pro forma numbers more clearly indicate
sustainable income because unusual and non-recurring expenses are excluded.
 Recently, the SEC provided some guidance on how companies should present pro forma
information.
 Everyone seems to agree that pro forma numbers can be useful if they provide insights into
determining a company’s sustainable income. However, many companies have abused the
flexibility that pro forma numbers allow and have used the measure as a way to put their
companies in a more favorable light.
Improper recognition – Because some managers have felt pressure to continually increase
earnings, they have manipulated the earnings numbers to meet these expectations.
 The most common abuse is the improper recognition of revenue.
 One practice that companies are using is called channel stuffing. Offering deep discounts
on their products to customers, companies encourage their customers to buy early (stuff
the channel) rather than later.
 This lets the company report good earnings in the current period, but it often leads to a
disaster in subsequent periods because customers have no need for additional goods.
 Another practice is the improper capitalization of operating expenses. The classic case is
WorldCom which capitalized over $7 billion of operating expenses to ensure that it would
report positive net income.
Price-earnings ratio – In order to make a meaningful comparison of market values and
earnings across firms, investors calculate the price-earnings (P-E) ratio.
 The P-E ratio, divides the market price of a share of common stock by earnings per share.
 The P-E ratio reflects investors’ assessment of a company’s future earnings.
 Higher P-E ratios are associated with a greater willingness of investors to pay more per
share of stock, because they believe the company will have substantial earnings in the
future
 A low price-earnings ratio often signifies that investors think the company’s future earnings
will not be strong or that it has poor-quality earnings.
Appendix – Comprehensive Illustration of Ratio Analysis
 Many ratios used for evaluating the financial health and performance of a company are presented
in the text. This appendix provides a comprehensive review of those ratios, discusses some
important relationships among them, and focuses on their interpretation.
 As indicated in the chapter, for analysis of the primary financial statements, ratios can be
classified into three types:
1. Liquidity ratios: Measures of the short-term ability of the company to pay its maturing
obligations and to meet unexpected needs for cash.
2. Solvency ratios: Measures of the ability of the company to survive over a long period of time.
3. Profitability ratios: Measures of the income or operating success of a company for a given
period of time.
Go over the information presented in Illustrations 13A-1 through 13A-4.
 Ratios can provide clues to underlying conditions that may not be apparent from an inspection of
the individual components of a particular ratio.
 A single ratio by itself is not very meaningful.
 The discussion on ratios uses the following comparisons:
1. Intracompany comparisons covering two years for Chicago Cereal Company.
2. Intercompany comparisons using General Mills as one of Chicago Cereal’s principal
competitors.
3. Industry average comparisons based on MSN.com median ratios for manufacturers of flour
and other grain mill products and comparisons with other sources.
 Liquidity ratios measure the short-term ability of the enterprise to pay its maturing obligations
and to meet unexpected needs for cash.
 Short-term creditors, such as bankers and suppliers, are particularly interested in assessing
liquidity.
 The measures that can be used to determine the enterprise’s short-term debt-paying ability are
the current ratio, the current cash debt coverage ratio, the receivables turnover ratio, the
average collection period, the inventory turnover ratio, and the average days in inventory.
1. The current ratio expresses the relationship of current assets to current liabilities, computed
by dividing current assets by current liabilities.
 The current ratio is widely used for evaluating a company’s liquidity and short-term debtpaying ability.
 Review the information in Illustration 13A-5.
2. Current cash debt coverage ratio is the ratio of cash provided by operating activities to
average current liabilities.
 A disadvantage of the current ratio is that it uses year-end balances of current asset and
current liability accounts.
 Those year-end balances may not be representative of the company’s current position
during most of the year.
 Because it uses cash provided by operating activities rather than a balance at one point in
time, the current cash debt coverage ratio may provide a better representation of liquidity.
 Review the information in Illustration 13A-6.
3. The receivables turnover ratio measures liquidity by determining how quickly certain assets
can be converted to cash.
 The receivables turnover ratio measures the number of times, on average, receivables are
collected during the period.
 The receivables turnover ratio is computed by dividing net credit sales (net sales less cash
sales) by average net receivables during the year.
 Review the information in Illustration 13A-7.
4. The average collection period is a popular variant of the receivables turnover ratio.
 The average collection period converts the receivables turnover into an average collection
period expressed in days.
 The ratio is computed by dividing the receivables turnover ratio into 365 days.
 The general rule is that the collection period should not greatly exceed the credit term
period.
 Review the information in Illustration 13A-8.
TEACHING TIP
Ask students to try not to memorize the information in this chapter. Ask them to think about
the information that is available and about what they are trying to compute. The receivables
turnover ratio tells us how many times receivables are turning over a year. Therefore, if we
divide the receivables turnover ratio into the number of days in a year, we will find the
number of days, on average, accounts receivable are outstanding.
5. The inventory turnover ratio measures the number of times on average the inventory is sold
during the period.
 The purpose of this ratio is to measure the liquidity of the inventory.
 The inventory turnover ratio is computed by dividing the cost of goods sold by the average
inventory during the period.
 Review the information in Illustration 13A-9.
6. Days in inventory is a variant of the inventory turnover ratio.
 The days in inventory measures the average number of days inventory is held.
 It is computed by dividing the inventory turnover ratio into 365 days.
 Review the information in Illustration 13A-10.
 Solvency ratios – measure the ability of the enterprise to survive over a long period of time.
 Long-term creditors and stockholders are interested in a company’s long-run solvency,
particularly its ability to pay interest as it comes due and to repay the face value of debt at
maturity.
 The debt to total assets ratio, the times interest earned ratio, and the cash debt coverage ratio
provide information about debt-paying ability.
 In addition free cash flow provides information about the company’s solvency and its ability to
pay additional dividends or invest in new projects.
7. The debt to total asset ratio measures the percentage of total assets provided by creditors.
 It is computed by dividing total liabilities (both current and long-term) by total assets.
 This ratio indicates the degree of financial leveraging and provides some indication of the
company’s ability to withstand losses without impairing the interests of its creditors.
 The higher the percentage of debt to total assets, the greater the risk that the company
may be unable to meet its maturing obligations.
 The lower the ratio, the more equity “buffer” is available to creditors if the company
becomes insolvent.
 Review the information in Illustration 13A-11.
8. The times interest earned ratio, also called interest coverage, indicates the company’s
ability to meet interest payments as they come due.
 The ratio is computed by dividing income before interest expense and income taxes by
interest expense.
 Review the information in Illustration 13A-12.
TEACHING TIP
Emphasize that income before interest expense and income tax expense is the amount used
in the formula because that is the amount available for paying interest payments. Again,
stress to students to think about what they are trying to compute rather than trying to
memorize the formulas.
9. The cash debt coverage ratio is the ratio of cash provided by operating activities to average
total liabilities.
 This ratio is a cash-basis measure of solvency.
 The cash debt coverage ratio indicates a company’s ability to repay its liabilities from cash
generated from operating activities without having to liquidate the assets used in its
operations.
 Review the information in Illustration 13A-13.
10. Free cash flow is an indication of a company’s solvency and its ability to pay dividends or
expand operations.
 Free cash flow is the amount of excess cash generated after investing in capital
expenditures and paying dividends.
 Review the information in Illustration 13A-14.
 Profitability ratios – measure the income or operating success of an enterprise for a given period
of time.
 A company’s income or lack of it, affects its ability to obtain debt and equity financing, its
liquidity position, and its ability to grow.
 Profitability is frequently used as the ultimate test of management’s operating effectiveness.
11. Return on common stockholders’ equity ratio is a widely used measure of profitability from
the common stockholder’s viewpoint.
 The ratio shows how many dollars of net income were earned for each dollar invested by
the owners.
 Return on common stockholders’ equity ratio is computed by dividing net income minus any
preferred stock dividends—that is, income available to common stockholders—by average
common stockholders’ equity.
 Review the information in Illustration 13A-16.
12. The return on assets ratio measures the overall profitability of assets in terms of the income
earned on each dollar invested in assets.
 The return on common stockholders’ equity ratio is affected by two factors: the return on
assets ratio and the degree of leverage.
 The return on assets ratio is computed by dividing net income by average total assets.
 Review the information in Illustration 13A-17.
13. The profit margin ratio, or rate of return on sales, is a measure of the percentage of each
dollar of sales that results in net income.
 The return on assets ratio is affected by two factors, the first of which is the profit margin
ratio.
 The profit margin ratio is computed by dividing net income by net sales for the period.
 Review the information in Illustration 13A-18.
14. The asset turnover ratio measures how efficiently a company uses its assets to generate
sales.
 The asset turnover ratio is the other factor that affects the return on assets ratio.
 The ratio is determined by dividing net sales by average total assets for the period.
 The resulting number shows the dollar of sales produced by each dollar invested in assets.
 Review the information in Illustration 13A-19.
15. The gross profit rate indicates a company’s ability to maintain an adequate selling price
above its cost of goods sold.
 The profit margin ratio is strongly influenced by the gross profit rate.
 The gross profit rate is found by dividing gross profit (net sales less cost of goods sold) by
net sales.
 Review the information in Illustration 13A-21.
16. Earnings per share (EPS) is a measure of the net income earned on each share of common
stock.
 Expressing net income earned on a per share basis provides a useful perspective for
determining profitability.
 Earnings per share is computed by dividing net income by the average number of common
shares outstanding during the year.
 When one uses “net income per share” or “earnings per share,” it refers to the amount of
net income applicable to each share of common stock.
 Review the information in Illustration 13A-22.
17. The price-earnings (P-E) ratio measures the ratio of the market price of each share of
common stock to the earnings per share.
 The price-earnings ratio is a reflection of investors’ assessments of a company’s future
earnings.
 It is computed by dividing the market price per share of the stock by earnings per share.
 Review the information in Illustration 13A-23.
18. The payout ratio measures the percentage of earnings distributed in the form of cash
dividends.
 Companies that have high growth rates are characterized by low payout ratios because
they reinvest most of their net income in the business.
 The payout ratio is computed by dividing cash dividends declared on common stock by net
income.
 Review the information in Illustration 13A-24.