CHAPTER
14
FINANCIAL STATEMENT
ANALYSIS
LEARNING OBJECTIVES
After studying Chapter 14, you
should be able to
1
Prepare and interpret financial
statements in comparative and
common-size form.
2
Compute and interpret financial
ratios that would be useful to a
common shareholder.
3
Compute and interpret financial
ratios that would be useful to a
short-term creditor.
4
Compute and interpret financial
ratios that would be useful to a
long-term creditor.
A
ll financial statements are historical documents. They summarize what
has happened during a particular period of time. However, most users
of financial statements are concerned about what will happen in the
future. For example, shareholders are concerned with future earnings and dividends. Creditors are concerned with the company’s future ability to repay its
debts. Managers are concerned with the company’s ability to finance future
expansion and how statement users will view their performance. Despite the
fact that financial statements are historical documents, they can still provide
valuable information about all of these concerns. Financial statement analysis
involves using select data from financial statements for the primary purpose of
forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data across companies,
and analyzing key financial ratios. In this chapter, we consider some of the
more important ratios and other analytical tools that analysts use.
Managers are also vitally concerned with the financial ratios discussed in
this chapter. First, the ratios provide indicators of how well the company and
its business units are performing. Some of these ratios would ordinarily be
used as part of a comprehensive performance measurement system, such as the
balanced scorecard approach discussed in Chapter 11 in the textbook. The
specific ratios selected depend on the company’s strategy. For example, a company that wants to emphasize responsiveness to customers may closely monitor the inventory turnover ratio discussed later in this chapter. Second, since
managers must report financial results to shareholders and may wish to raise
funds from external sources, they must pay attention to the financial ratios
used by external investors and creditors.
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Chapter 14 Financial Statement Analysis
LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS
Although financial statement analysis is a highly useful tool, it has two limitations that should
be mentioned before proceeding any further. These two limitations involve the comparability
of financial data between companies and the need to look beyond ratios.
Comparison of Financial Data
Comparisons of one company with another can provide valuable clues about the financial
health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies’ financial data. For example, if one
firm values its inventories by the FIFO method and another firm by the average cost method,
then direct comparisons between the two firms of financial data such as inventory valuations
and cost of goods sold may be misleading. Sometimes enough data are presented in footnotes
to the financial statements to restate data on a comparable basis. Also, as discussed in Chapter 1,
many countries have already adopted a common set of International Financial Reporting
Standards (IFRS). Recall that the purpose of IFRS is to enhance the comparability of financial
information on a global basis. Despite the adoption of IFRS, reporting differences will still
exist across companies because the standards permit choices regarding the specific depreciation method to use, the inventory valuation approach to adopt, and so on. Consequently, the
analyst should keep in mind the potential lack of comparability of the data before drawing any
definite conclusions. Even with this limitation in mind, comparisons of key ratios with other
companies and with industry averages often suggest avenues for further investigation.
The Need to Look beyond Ratios
Ratios should not be viewed as an end, but rather as a starting point. They raise many questions
and point to opportunities for further analysis, but they rarely answer any questions by themselves. In addition to ratios, analysts should evaluate industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself.
LEARNING
OBJECTIVE
STATEMENTS IN COMPARATIVE AND
COMMON-SIZE FORM
1
Prepare and
interpret financial
statements in
comparative and
common-size form.
Few figures on the financial statements have much significance on their own. Instead, it is the
relationship of one figure to another and the amount and direction of change over time that are
important in financial statement analysis. How does the analyst identify significant relationships and recognize the important trends and changes in a company? Three analytical techniques are widely used:
1.
2.
3.
Horizontal or trend
analysis
A year-to-year
comparison of two or
more years’ financial
statement items in dollar
and percentage terms.
Dollar and percentage changes on statements (horizontal analysis).
Common-size statements (vertical analysis).
Ratios.
The first and second techniques are discussed in this section; the third technique is discussed in
the next section. To illustrate these analytical techniques, we analyze the financial statements
of McGraw Electronics, a supplier of computer and smartphone components. Horizontal and
vertical analysis will be used by potential and existing investors as well as a company’s creditors as a means of assessing historical performance and future prospects for profitability.
Dollar and Percentage Changes on Statements
Horizontal analysis (also known as trend analysis) involves analyzing financial data over
time. This consists of showing year-to-year changes in each financial statement item in both
dollar and percentage terms.
669
Chapter 14 Financial Statement Analysis
Examples of financial statements in comparative form are given in Exhibits 14–1 and
14–2. The data in these statements are used as a basis for discussion throughout the remainder
of this chapter.
Showing changes in dollar form helps the analyst focus on key factors that have affected
profitability or financial position. For example, observe in Exhibit 14–2 that sales for 2021
were up $4 million over 2020, but that this increase in sales was more than negated by a
$4.5 million increase in cost of goods sold.
Showing changes between years in percentage form helps the analyst to gain perspective
and develop a feel for the significance of the changes that are taking place. A $1 million increase in sales is much more significant if the prior year’s sales were $2 million than if the
EXHIBIT 14–1
MCGRAW ELECTRONICS
Comparative Balance Sheet
December 31, 2021 and 2020
(dollars in thousands)
Comparative
Balance Sheet
Increase
(Decrease)
2021
2020
Amount Percentage
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . .
Property and equipment:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings and equipment, net . . . . . . . . . . . .
Total property and equipment . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 1,200
6,000
8,000
300
15,500
$ 2,350
4,000
10,000
120
16,470
$(1,150)
2,000
(2,000)
180
(970)
(48.9)%*
50.0%
(20.0)%
150.0%
(5.9)%
4,000
12,000
16,000
$31,500
4,000
8,500
12,500
$28,970
–0–
3,500
3,500
$ 2,530
–0–%
41.2%
28.0%
8.7%
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . .
Accrued payables . . . . . . . . . . . . . . . . . . . . .
Notes payable, short term . . . . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . . . . .
Long-term liabilities:
Bonds payable, 8% . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Preferred shares, $6 no par,
$100 liquidation value . . . . . . . . . . . . . . . .
Common shares, 500 no par . . . . . . . . . . . . .
Total paid-in capital . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . .
Total liabilities and
shareholders’ equity . . . . . . . . . . . . . . . . .
$ 5,800
900
300
7,000
$ 4,000
400
600
5,000
$ 1,800
500
(300)
2,000
45.0%
125.0%
(50.0)%
40.0%
7,500
14,500
8,000
13,000
(500)
1,500
(6.3)%
11.5%
2,000
7,000
9,000
8,000
17,000
2,000
7,000
9,000
6,970
15,970
–0–
–0–
–0–
1,030
1,030
–0–%
–0–%
–0–%
14.8%
6.4%
$31,500
$28,970
$ 2,530
8.7%
*Since we are measuring the amount of change between 2020 and 2021, the dollar amounts for 2020
become the base figures for expressing these changes in percentage form. For example, Cash decreased
by $1,150 between 2020 and 2021. This decrease expressed in percentage form is computed as follows:
$1,150 ÷ $2,350 = 48.9%. Other percentage figures in this exhibit and Exhibit 14–2 are computed in
the same way.
670
EXHIBIT 14–2
Comparative Income
Statement and
Reconciliation of
Retained Earnings
Chapter 14 Financial Statement Analysis
MCGRAW ELECTRONICS
Comparative Income Statement and Reconciliation
of Retained Earnings
For the Years Ended December 31, 2021 and 2020
(dollars in thousands)
Increase
(Decrease)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . .
Total operating expenses . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . .
Less income taxes (30%). . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends to preferred shareholders,
$6 per share (see Exhibit 14–1) . . . . . . .
Net income remaining for common
shareholders . . . . . . . . . . . . . . . . . . . . . .
Dividends to common shareholders,
$1.20 per share . . . . . . . . . . . . . . . . . . . .
Net income added to
retained earnings . . . . . . . . . . . . . . . . . . .
Retained earnings, beginning
of year . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings, end of year . . . . . . . . . .
Trend percentages
The expression of
several years’ financial
data as a percentage
of a base year.
2021
2020
Amount
Percentage
$52,000
36,000
16,000
$48,000
31,500
16,500
$4,000
4,500
(500)
8.3%
14.3%
(3.0)%
7,000
5,860
12,860
3,140
640
2,500
750
1,750
6,500
6,100
12,600
3,900
700
3,200
960
2,240
500
(240)
260
(760)
(60)
(700)
(210)
$ (490)
7.7%
(3.9)%
2.1%
(19.5)%
(8.6)%
(21.9)%
(21.9)%
(21.9)%
120
120
1,630
2,120
600
600
1,030
1,520
6,970
$ 8,000
5,450
$ 6,970
prior year’s sales were $20 million. Horizontal analysis can be even more useful when data
from a number of years are used to compute trend percentages. To compute trend percentages, a base year is selected and the data for all years are stated as a percentage of that base.
To illustrate, we use the following data for Example Company:
Income Statement ($ millions)
Example Company
2020
2019
Total revenues. . . . . . . . . . . . . . . . . . . . $12,000
Net income . . . . . . . . . . . . . . . . . . . . . .
740
$12,400
640
2018
2017
2016
$11,800
560
$11,425
500
$10,400
470
By simply looking at these data, one can see that revenues and net income increased
nearly every year since 2016. But are the increases in revenues and net income similar? By
looking at the raw data alone, it is difficult to answer these questions. The increases in revenues and net income can be put into better perspective by stating them in terms of trend
percentages, with 2016 as the base year. These percentages (all rounded) are given below:
Income Statement (%)
2020
2019
2018
2017
2016
Total revenues. . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . .
115.4
157.4
119.2
136.2
113.5
119.1
109.9
106.4
100
100
671
Chapter 14 Financial Statement Analysis
The trend analysis shows that Example Company’s sales growth has been relatively modest since 2016, with a total increase of 15% over the entire period. By comparison the growth
in net income has been very strong, with nearly a 57% increase since 2016. An analyst would
likely want to further investigate why net income is growing faster than sales. One possibility
is that there are unusual or non-recurring items in net income that have resulted in an increase.
Common-Size Statements
Key changes and trends can also be highlighted by the use of common-size statements. A
common-size statement is one that shows each item in percentage and dollar terms. On the
income statement, all items are usually expressed as a percentage of sales. On the balance
sheet, all items are usually expressed as a percentage of total assets. The preparation of common-size statements is known as vertical analysis.
A common-size balance sheet for McGraw Electronics is shown in Exhibit 14–3, and a
common-size income statement is shown in Exhibit 14–4.
2021
2020
3.8%*
19.0%
25.4%
1.0%
49.2%
8.1%
13.8%
34.5%
0.4%
56.9%
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . .
Property and equipment:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings and equipment, net . . . . . . . . .
Total property and equipment . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . .
$ 1,200
6,000
8,000
300
15,500
$ 2,350
4,000
10,000
120
16,470
4,000
12,000
16,000
$31,500
4,000
8,500
12,500
$28,970
12.7%
38.1%
50.8%
100.0%
13.8%
29.3%
43.1%
100.0%
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . .
Accrued payables . . . . . . . . . . . . . . . . . .
Notes payable, short term . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . .
Long-term liabilities:
Bonds payable, 8% . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Preferred shares, $6 no par,
$100 liquidation value . . . . . . . . . . . . . . .
Common shares, 500 no par . . . . . . . . . . . .
Total paid-in capital . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . .
Total liabilities and
shareholders’ equity . . . . . . . . . . . . . . . .
Vertical analysis
The presentation of a
company’s financial
statements in commonsize format.
Common-Size
Balance Sheet
Common-Size
Percentages
2020
A statement that
shows all items in
both percentage
and dollar terms.
EXHIBIT 14–3
MCGRAW ELECTRONICS
Common-Size Comparative Balance Sheet
December 31, 2021 and 2020
(dollars in thousands)
2021
Common-size
statement
$ 5,800
900
300
7,000
$ 4,000
400
600
5,000
18.4%
2.8%
1.0%
22.2%
13.8%
1.4%
2.1%
17.3%
7,500
14,500
8,000
13,000
23.8%
46.0%
27.6%
44.9%
2,000
7,000
9,000
8,000
17,000
2,000
7,000
9,000
6,970
15,970
6.4%
22.2%
28.6%
25.4%
54.0%
6.9%
24.2%
31.1%
24.0%
55.1%
$31,500
$28,970
100.0%
100.0%
*Each asset account on a common-size statement is expressed in terms of total assets, and each liability
and equity account is expressed in terms of total liabilities and shareholders’ equity. For example, the
percentage amount shown for Cash in 2021 is computed as follows: $1,200 ÷ $31,500 = 3.8%.
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Chapter 14 Financial Statement Analysis
EXHIBIT 14–4
Common-Size
Income Statement
MCGRAW ELECTRONICS
Common-Size Comparative Income Statement
For the Years Ended December 31, 2021 and 2020
(dollars in thousands)
Common-Size
Percentages
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . .
Total operating expenses . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . .
Income taxes (30%) . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . .
2021
2020
2021
2020
$52,000
36,000
16,000
$48,000
31,500
16,500
100.0%
69.2%
30.8%
100.0%
65.6%
34.4%
7,000
5,860
12,860
3,140
640
2,500
750
$ 1,750
6,500
6,100
12,600
3,900
700
3,200
960
$ 2,240
13.5%
11.3%
24.7%
6.0%
1.2%
4.8%
1.4%
3.4%
13.5%
12.7%
26.2%
8.1%
1.5%
6.7%
2.0%
4.7%
*Note that the percentage figures for each year are expressed in terms of total sales for the year. For
example, the percentage figure for cost of goods sold in 2020 is computed as follows: $36,000 ÷
$52,000 = 69.2%.
Notice from Exhibit 14–3 that placing all assets in common-size form clearly shows the
relative importance of the current assets as compared to the non-current assets. It also shows
that significant changes have taken place in the composition of the current assets over the last
year. For example, receivables have increased in relative importance and both cash and inventory have declined in relative importance. Judging from the sharp increase in receivables, the
deterioration in the cash position may be a result of an inability to collect from customers.
Focusing now on the income statement in Exhibit 14–4, the cost of goods sold as a percentage of sales increased from 65.6% in 2020 to 69.2% in 2021. Or, looking at this from a different
viewpoint, the gross margin percentage declined from 34.4% in 2020 to 30.8% in 2021. Managers
and analysts often pay close attention to the gross margin percentage because it is considered to
be an important indicator of profitability. The gross margin percentage is computed as follows:
Gross margin
percentage
A measure of
profitability calculated
by dividing the gross
margin by sales.
LEARNING
OBJECTIVE
2
Compute and
interpret financial
ratios that would be
useful to a common
shareholder.
Gross margin
Gross margin percentage = ___________
Sales
The gross margin percentage tends to be more stable for retailing companies than for other
service companies and for manufacturers, since the cost of goods sold in retailing excludes
fixed costs. When fixed costs are included in the cost of goods sold figure, the gross margin
percentage tends to increase and decrease with sales volume changes. With increases in sales
volume, the fixed costs are spread across more units and the gross margin percentage improves.
RATIO ANALYSIS—THE COMMON SHAREHOLDER
(PROFITABILITY RATIOS)
A number of financial ratios are used to assess how well the company is doing from the standpoint
of the shareholders. These ratios naturally focus on net income, dividends, and shareholders’
equity. Potential and existing investors will use these ratios, as will short- and long-term creditors
of the company, since profitability affects a company’s ability to meet its debt obligations.
Chapter 14 Financial Statement Analysis
673
Earnings per Share
An investor buys a share in the hope of realizing a return in the form of either dividends or
future increases in the value of the share. Since earnings form the basis for dividend payments, as well as the basis for future increases in the value of shares, investors are always interested in a company’s reported earnings per share. Probably no single statistic is more
widely quoted or relied on by investors than earnings per share, although it has some inherent
limitations, as discussed below.
Earnings per share is computed by dividing net income available for common shareholders by the average number of common shares outstanding during the year. “Net income
available for common shareholders” is net income less dividends paid to the owners of the
company’s preferred shares:1
Net income − Preferred dividends
Earnings per share = _______________________________________
Average number of common shares outstanding
Using the data in Exhibits 14–1 and 14–2, we see that the earnings per share for McGraw
Electronics for 2021 are computed as follows:
$1,750,000 − $120,000
______________________________
= $3.26
(500,000 shares + 500,000 shares)∕2
Note that the denominator in the earnings per share formula uses the weighted-average number of common shares outstanding for the year. Using a weighted average is appropriate because it recognizes that common shareholders may contribute varying amounts of capital at
different points in time.
Price–Earnings Ratio
The relationship between the market price of a share and the share’s current earnings per share
is often quoted in terms of a price–earnings ratio. If we assume that the current market price
for McGraw Electronics’ shares is $40 each, the company’s price–earnings ratio is computed
as follows:
Market price per share
Price–earnings ratio = ___________________
Earnings per share
$40
_____
= 12.3
$3.26
The price–earnings ratio is 12.3; that is, the shares are selling for about 12.3 times current
earnings.
The price–earnings ratio is widely used by investors as a general guideline in evaluating
share values. A high price–earnings ratio means that investors are willing to pay a premium
for the company’s shares—presumably because the company is expected to have higher than
average future earnings growth. Conversely, if investors believe a company’s earnings growth
prospects are limited, the company’s price–earnings ratio will be relatively low.
Dividend Payout and Yield Ratios
Investors in a company’s shares make money in two ways—(1) increases in the market
value of the shares and (2) dividend payments. In general, earnings should be retained in a
company and not paid out in dividends as long as the rate of return on funds invested inside
the company exceeds the rate of return that shareholders could earn on alternative investments outside the company. Therefore, companies with excellent prospects of profitable
growth often pay low or no dividends. Examples of such companies include Amazon,
Google, and Yahoo. Conversely, companies with little opportunity for profitable growth,
but with steady, dependable earnings, tend to pay out a higher percentage of their cash flow
from operations as dividends.
Earnings per share
Net income available for
common shareholders
divided by the average
number of common
shares outstanding
during the year.
674
Chapter 14 Financial Statement Analysis
The Dividend Payout Ratio
Dividend payout ratio
A ratio showing the
percentage of earnings
being paid out in
dividends.
The dividend payout ratio represents the portion of current earnings being paid out in dividends. Investors who seek growth in the market price of their shares would like this ratio to be
small, whereas investors who seek dividends prefer it to be large. This ratio is computed by
relating dividends per share to earnings per share for common shares:
Dividends per share
Dividend payout ratio = _________________
Earnings per share
For McGraw Electronics, the dividend payout ratio for 2021 is computed as follows:
$1.20 (see Exhibit 14–2)
____________________
= 36.8%
$3.26
There is no such thing as an “optimal” payout ratio, although it should be noted that the ratio
tends to be similar for companies within the same industry. Industries with ample opportunities for growth at high rates of return tend to have low payout ratios, whereas payout ratios
tend to be high in industries with limited reinvestment opportunities.
The Dividend Yield Ratio
Dividend yield ratio
The ratio of the current
dividends per share to
the current market price
per share.
The dividend yield ratio is obtained by dividing the current dividends per share by the current market price per share:
Dividends per share
Dividend yield ratio = ___________________
Market price per share
Because the market price for McGraw Electronics shares is $40 each, the dividend yield is
computed as follows:
$1.20
_____
= 3.0%
$40
The dividend yield ratio measures the rate of return (in the form of cash dividends only) that
would be earned by an investor who buys the common shares at the current market price. A
low dividend yield ratio is neither bad nor good by itself. As discussed above, a company may
pay out very little in dividends because it has ample opportunities for reinvesting funds within
the company at high rates of return.
Return on Total Assets
Return on total assets
A measure of the return
generated by the assets
employed.
The return on total assets is a measure of operating performance that shows how well assets
have been employed. It is defined as follows:
Net income + [Interest expense × (1 − Tax rate)]
Return on total assets = ________________________________________
Average total assets
Adding interest expense back to net income results in an adjusted earnings figure that shows
what earnings would be if the company had no debt. With this adjustment, the return on total
assets can be compared for companies with differing amounts of debt or for a single company
that has changed its mix of debt and equity over time. Notice that the interest expense is
placed on an after-tax basis by multiplying it by the factor (1 – Tax rate).
The return on total assets for McGraw Electronics for 2021 is computed as follows (from
Exhibits 14–1 and 14–2):
$1,750,000 + [$640,000 × (1 − 0.30)]
Return on total assets = _______________________________ = 7.3%
$31,500,000 + $28,970,000
_______________________
2
McGraw Electronics earned a return of 7.3% on average assets employed over the last year.
Chapter 14 Financial Statement Analysis
675
Return on Common Shareholders’ Equity
One of the primary reasons for operating a corporation is to generate income for the benefit of
the common shareholders. One measure of a company’s success in this regard is the return
on common shareholders’ equity, which divides the net income available for common
shareholders by the book value of average common shareholders’ equity for the year. The
formula is as follows:
Net income − Preferred dividends
Return on common shareholders = ____________________________
Average common shareholders
Return on common
shareholders’ equity
Income available to
common shareholders
divided by the book value
of average common
shareholders’ equity.
where
Average common
= Average total shareholders’ equity − Average preferred shares
shareholders’ equity
For McGraw Electronics, the return on common shareholders’ equity for 2021 is computed as
follows:
($17,000,000 + $15,970,000)
Average total shareholders’equity = ________________________ = $16,485,000
2
($2,000,000 + $2,000,000)
Average preferred shares = ______________________ = $2,000,000
2
Average common shareholders’ equity = $16,485,000 − $2,000,000 = $14,485,000
$1,750,000 − $120,000
Return on common shareholders’ equity = ____________________ = 11.3%
$14,485,000
Compare the return on common shareholders’ equity above (11.3%) with the return on total
assets computed previously (7.3%). Why is the return on common shareholders’ equity so
much higher? The answer lies in financial leverage.
Financial Leverage
Financial leverage results from the difference between the rate of return the company earns
on investments in its own assets and the rate of return that the company must pay its creditors.
If the company’s rate of return on total assets exceeds the rate of return the company pays its
creditors, financial leverage is positive. If the rate of return on total assets is less than the rate
of return the company pays its creditors, financial leverage is negative.
We can see this concept in operation in the case of McGraw Electronics. Notice from
Exhibit 14–1 that the company’s bonds payable have a fixed interest rate of 8%. The after-tax
interest cost of these bonds is only 5.6% [8% × (1 − 0.30)]. As shown earlier, the company’s
assets are generating an after-tax return of 7.3%. Since this return on assets is greater than the
after-tax interest cost of the bonds, leverage is positive, and the difference goes to the benefit
of the common shareholders. This explains in part why the return on common shareholders’
equity (11.3%) is greater than the return on total assets (7.3%).
Unfortunately, leverage is a two-edged sword. If assets do not earn a high enough rate to
cover the interest costs of debt and preferred share dividends, then the common shareholder
suffers. In that case, we have negative financial leverage.
Book Value per Share
Book value per share measures the amount that would be distributed to holders of each common share if all assets were sold at their balance sheet carrying amounts (i.e., book values)
and if all creditors were paid off. Book value per share is based entirely on historical costs.
The formula for computing it is as follows:
Total shareholders’ equity − Preferred shares
Book value per share = _____________________________________
Number of common shares outstanding
Financial leverage
The effects on profitability
that arise when the rate of
return on total assets
differs from the rate
paid to the company’s
creditors. Financial
leverage effects can be
positive or negative.
Book value per share
The amount that would
be distributed to holders
of common shares if all
assets were sold at their
balance sheet carrying
amounts and if all
creditors were paid off.
676
Chapter 14 Financial Statement Analysis
The book value per share of McGraw Electronics common shares for 2021 is computed as follows:
$17,000,000 − $2,000,000
Book value per share = ______________________ = $30 per share
500,000 shares
If this book value is compared with the $40 market value of McGraw Electronics’ shares, then
the shares may appear to be overpriced. However, as we discussed earlier, market prices reflect expectations about future earnings and dividends, whereas book value largely reflects
the results of events that have occurred in the past. Ordinarily, the market value of a share
exceeds its book value.
LEARNING
OBJECTIVE
3
Compute and
interpret financial
ratios that would be
useful to a shortterm creditor.
RATIO ANALYSIS—THE SHORT-TERM CREDITOR
(LIQUIDITY RATIOS)
Short-term creditors, such as suppliers, want to be repaid on time. Therefore, they focus on the
company’s cash flows and on its working capital since these are the company’s primary
sources of cash in the short run. Long-term creditors will also find these ratios useful, as they
will be indicative of a company’s ability to meet the current portion of long-term debt.
Working Capital
The excess of current assets over current liabilities is known as working capital. The working
capital for McGraw Electronics is computed below:
Working capital = Current assets − Current liabilities
Current assets . . . . . . . . . . . . . . . . . . . . . . . .
Current liabilities . . . . . . . . . . . . . . . . . . . . .
Working capital . . . . . . . . . . . . . . . . . . . . . . .
2021
2020
$15,500,000
7,000,000
$ 8,500,000
$16,470,000
5,000,000
$11,470,000
Ample working capital provides some assurance to short-term creditors that they will be
paid by the company. However, maintaining large amounts of working capital has a cost.
Working capital must be financed with long-term debt and equity—both of which are expensive. Therefore, managers often want to minimize working capital.
A large and increasing working capital balance is not necessarily a good sign. For
example, it could be the result of unnecessary growth in inventories. Therefore, to put the
working capital figure into perspective, it must be supplemented with the following four
ratios: the current ratio, the acid-test (quick) ratio, the accounts receivable turnover, and the
inventory turnover, each of which will be discussed in turn.
Current Ratio
Current ratio
The elements involved in the computation of working capital are frequently expressed in ratio
form. A company’s current assets divided by its current liabilities is known as the current ratio:
Current assets divided
by current liabilities.
Current assets
Current ratio = _______________
Current liabilities
For McGraw Electronics, the current ratios for 2021 and 2020 are computed as follows:
2021
2020
$15,500,000
___________
= 2.21 to 1
$7,000,000
$16,470,000
___________
= 3.29 to 1
$5,000,000
Chapter 14 Financial Statement Analysis
677
Although widely regarded as a measure of short-term debt-paying ability, the current
ratio must be interpreted with great care. A declining ratio, as above, might be a sign of a
deteriorating financial condition. On the other hand, it might be the result of eliminating obsolete inventories or other stagnant current assets. An improving ratio might be the result of
growing inventory levels, or it might indicate an improving financial situation. In short, the
current ratio is useful but complex to interpret.
The general rule of thumb calls for a current ratio of 2 to 1. This rule is subject to many
exceptions, depending on the industry and the firm involved. Some industries can operate
quite successfully on a current ratio of slightly more than 1 to 1. The adequacy of a current
ratio depends heavily on the composition of the assets involved. For example, as we see in the
table below, both Worthington Corporation and Greystone Inc. have current ratios of 2 to 1.
However, they are not in comparable financial condition. Greystone is likely to have difficulty
meeting its current financial obligations since almost all of its current assets consist of inventory rather than more liquid assets such as cash and accounts receivable.
Worthington
Corporation
Greystone
Inc.
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . .
$ 25,000
60,000
85,000
5,000
$175,000
2,000
8,000
160,000
5,000
$175,000 (a)
Current liabilities . . . . . . . . . . . . . . . . . . . . . .
$ 87,500
$ 87,500 (b)
Current ratio, (a) ÷ (b). . . . . . . . . . . . . . . . . . .
2 to 1
$
2 to 1
Acid-Test (Quick) Ratio
The acid-test (quick) ratio is a more stringent test of a company’s ability to meet its shortterm debts. Inventories and prepaid expenses are excluded from total current assets, leaving
only the more liquid (or “quick”) assets to be divided by current liabilities:
Cash + Temporary investments + Current receivables*
Acid-test ratio = _____________________________________________
Current liabilities
*Current receivables include both accounts receivable and any short-term notes receivable.
The acid-test ratio measures how well a company can meet its obligations without having
to liquidate or depend too heavily on its inventory. Preferably, each dollar of liabilities should
be backed by at least $1 of quick assets. Thus, an acid-test ratio of 1 to 1 is broadly viewed as
being adequate in many firms.
The acid-test ratios for McGraw Electronics for 2021 and 2020 are computed below:
2021
2020
Cash (see Exhibit 14–1) . . . . . . . . . . . . . . . .
Accounts receivable (see Exhibit 14–1) . . . .
Total quick assets . . . . . . . . . . . . . . . . . . . . .
$1,200,000
6,000,000
$7,200,000
$2,350,000
4,000,000
$6,350,000 (a)
Current liabilities (see Exhibit 14–1) . . . . . .
$7,000,000
$5,000,000 (b)
Acid-test ratio, (a) ÷ (b) . . . . . . . . . . . . . . . .
1.03 to 1
1.27 to 1
Although McGraw Electronics has an acid-test ratio for 2021 that is within the acceptable
range, an analyst might be concerned about several trends revealed in the company’s balance
sheet. Notice in Exhibit 14–1 that short-term debts are rising, while the cash balance is declining.
Perhaps the lower cash balance is a result of the large increase in accounts receivable. In short, as
with the current ratio, the acid-test ratio should be interpreted in light of its basic components.
Acid-test (quick) ratio
Current assets (less
inventories and prepaid
expenses) divided by
current liabilities. This is a
more stringent test of a
company’s ability to meet
its short-term obligations.
678
Chapter 14 Financial Statement Analysis
Accounts Receivable Turnover
Accounts receivable
turnover
A measure of how many
times a company’s credit
sales have been turned
into cash during the year.
The accounts receivable turnover and average collection period are used to measure how
quickly credit sales are converted into cash. The accounts receivable turnover is computed
by dividing sales on account (i.e., credit sales) by the average accounts receivable balance for
the year:
Sales on account
Accounts receivable turnover = ______________________________
Average accounts receivable balance
Assuming that all sales for the year were on account, the accounts receivable turnover for
McGraw Electronics for 2021 is computed as follows:
$52,000,000
Sales on account
______________________________
= ___________ = 10.4 times
Average accounts receivable balance $5,000,000*
*$4,000,000 + $6,000,000 = $10,000,000; $10,000,000 ÷ 2 = $5,000,000 average
Average collection
period
The average number of
days taken to collect an
account receivable.
The accounts receivable turnover figure can then be divided into 365 to determine the
average number of days required to collect an account (known as the average collection
period).
365 days
Average collection period = ________________________
Accounts receivable turnover
The average collection period for McGraw Electronics for 2021 is computed as follows:
365
_________
= 35 days
10.4 times
This means that on average it takes 35 days to collect a credit sale. Whether the average of 35
days taken to collect an account is good or bad depends on the credit terms that McGraw
Electronics is offering its customers. If the credit terms are 30 days, then a 35-day average
collection period would usually be viewed as good. On the other hand, if the company’s credit
terms are 10 days, then a 35-day average collection period is worrisome. A long collection
period may result from having too many old unpaid accounts, failing to bill promptly or follow up on late accounts, lax credit checks, and so on.
Inventory Turnover
Inventory turnover
ratio
A measure of how many
times a company’s
inventory has been
sold and replaced
during the year.
The inventory turnover ratio measures how many times a company’s inventory has been
sold and replaced during the year. It is computed by dividing the cost of goods sold by the
average level of inventory on hand:
Cost of goods sold
Inventory turnover = ______________________
Average inventory balance
McGraw Electronics’ inventory turnover for 2021 is computed as follows:
$36,000,000
Inventory turnover = ______________________ = 4.0
$8,000,000
+ $10,000,000
______________________
2
Average sale period
A measure of the number
of days taken to sell the
entire inventory one time.
The number of days taken to sell the entire inventory one time (called the average sale period)
can be computed by dividing 365 by the inventory turnover figure:
365 days
Average sale period = ________________
Inventory turnover
McGraw Electronics’ average sale period for 2021 is computed as follows:
365 days
________
= 91¼ days
4 times
679
Chapter 14 Financial Statement Analysis
The average sale period varies from industry to industry. Grocery stores, with significant
perishable items, tend to turn over their inventory very quickly, as often as every 12 to 15 days.
On the other hand, jewellery stores tend to turn over their inventory very slowly, perhaps only
a couple of times each year.
A firm whose turnover ratio is much slower than the average for its industry may have
obsolete goods on hand or inventory levels that are too high. Some managers argue that they
must buy in large quantities to take advantage of quantity discounts. But these discounts must
be carefully weighed against the added costs of insurance, taxes, and financing and the risks
of obsolescence and deterioration that result from carrying added inventories.
Inventory turnover has been increasing in recent years as more companies adopt just-intime (JIT) methods. Under JIT, inventories are purposely kept low, so a company utilizing JIT
methods may have a very high inventory turnover when compared to other companies. Indeed,
one of the goals of JIT is to increase inventory turnover by systematically reducing the amount
of inventory on hand.
RATIO ANALYSIS—THE LONG-TERM CREDITOR
(SOLVENCY RATIOS)
Long-term creditors differ from short-term creditors in that they are concerned with both the
short-term and the long-term ability of a firm to meet its commitments. They are concerned
with the short term since the interest on the funds they have provided is normally paid on a
current basis. They are concerned with the long term because they want the loans they have
extended to be fully repaid on schedule.
Since the long-term creditor is usually faced with greater risks than the short-term creditor,
firms are often required to agree to various restrictive covenants, or rules, for the long-term creditor’s protection. Examples of such restrictive covenants are the maintenance of minimum working
capital levels and restrictions on payment of dividends to common shareholders. Although restrictive covenants are widely used, they do not ensure that creditors will be paid when loans come
due. The company must still generate sufficient earnings and cash flow to cover payments.
LEARNING
OBJECTIVE
4
Compute and
interpret financial
ratios that would be
useful to a longterm creditor.
Times Interest Earned Ratio
A common measure of the company’s ability to provide protection to the long-term creditor is
the times interest earned ratio. It is computed by dividing earnings before interest expense
and income taxes (i.e., operating income) by the yearly interest charges that must be met:
Times interest earned
ratio
Earnings before interest expense and income taxes
Times interest earned ratio = _________________________________________
Interest expense
A measure of a company’s
ability to make interest
payments.
For McGraw Electronics, the times interest earned ratio for 2021 is computed as follows:
$3,140,000
__________
= 4.9 times
$640,000
Earnings before income taxes must be used in the computation, since interest expense
deductions come before income taxes are computed; creditors have first claim on earnings.
Only those earnings remaining after all interest charges have been provided for are subject to
income taxes. Generally, earnings are viewed as adequate to protect long-term creditors if the
times interest earned ratio is 2 or more.
Debt-to-Equity Ratio
Long-term creditors are also concerned with keeping a reasonable balance between the
amount of assets being provided by creditors through total debt and the amount being provided by shareholders. This balance is measured by the debt-to-equity ratio:
Total liabilities
Debt-to-equity ratio = _________________
Shareholders’ equity
Debt-to-equity ratio
The ratio of total assets
being provided by
creditors through debt
to those being provided
by shareholders.
680
Chapter 14 Financial Statement Analysis
Total liabilities . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity . . . . . . . . . . . . . . . . . . .
Debt-to-equity ratio, (a) ÷ (b) . . . . . . . . . . . .
2021
2020
$14,500,000
17,000,000
0.85 to 1
$13,000,000 (a)
15,970,000 (b)
0.81 to 1
In 2020, creditors of McGraw Electronics were providing 81 cents of assets for each $1 of
assets being provided by shareholders; the figure increased only slightly to 85 cents by 2021.
Creditors and shareholders have different views about the optimal debt-to-equity ratio.
Ordinarily, shareholders would like a lot of debt to take advantage of positive financial leverage. However, because equity represents the excess of total assets over total liabilities and
hence a buffer of protection for the creditors, they would like to see less debt and more equity.
In most industries, norms have developed over the years that guide firms in their decisions as to the right amount of debt to include in the capital structure. Different industries
face different risks. For this reason, the level of debt that is appropriate for firms in one industry is not necessarily indicative of the level of debt that is appropriate for firms in a
different industry.
BEYOND THE BOTTOM LINE
Ratio analysis is also relevant to non-profit organizations, but compared to forprofit organizations there are some unique ratios often used to assess operations
given the existence of different stakeholders such as donors. For example, current
and potential donors will be interested in fundraising efficiency, which is calculated as fundraising expenses divided by contributions raised. A smaller ratio is
better as it indicates efficiency in generating donations.
Program efficiency is another important metric which is calculated as total program expenses divided by total expenses. Here a higher ratio is better as it indicates that most expenses are directly related to programs being delivered by
the organization. A lower ratio would indicate a higher proportion of administrative expenses that typically do not substantively contribute to delivering on the
organization’s mission.
SUMMARY OF RATIOS AND SOURCES OF
COMPARATIVE INFORMATION
The Learning Aid below summarizes the ratios discussed in this chapter. The formula for each
ratio and a summary comment on each ratio’s significance are included in the aid.
Exhibit 14–5 lists some sources that provide comparative information organized by industry. These sources are used extensively by managers, investors, and analysts in doing comparative analyses and in attempting to assess the well-being of companies. The Internet also
contains a wealth of financial and other data. A search engine such as Google can be used to
find information on individual companies. Most public companies also have their own websites on which they post their latest financial reports and news of interest to potential investors. The SEDAR and EDGAR databases listed in Exhibit 14–5 are particularly rich sources of
data. EDGAR contains copies of all reports filed by companies with the agencies since about
1995—including U.S. annual reports filed as Form 10-K. SEDAR contains copies of reports
filed with Canadian securities regulators since 1997.
681
Chapter 14 Financial Statement Analysis
Source
Content
Internet Resources
http://www.morningstar.co.uk/
http://www.hoovers.com/
http://www.ic.gc.ca/
http://www.rmahq.org/
http://www.sec.gov/
http://www.edgar-online.com/
http://www.sedar.com/
http://www.statcan.gc.ca/
A British service where financial reports and other
news items are available.
A site that provides summary profiles for over
10,000 U.S. companies, with links to company
websites, annual reports, stock charts, news
articles, and other industry information.
The Innovation, Science and Economic
Development Canada site, which publishes studies
of various industry groups and also provides a
benchmarking service.
A site maintained by the Risk Management
Association that contains extensive financial studies
of industries; these studies must be purchased.
The U.S. Securities and Exchange Commission
(SEC) site, which provides an exhaustive Internet
database that contains reports filed by companies
with the SEC; these reports can be downloaded.
EDGAR Online, a site that allows searches of SEC
filings; financial information can be downloaded
directly into Microsoft Excel worksheets.
The System for Electronic Document Analysis and
Retrieval (SEDAR) site, which provides the annual
and quarterly accounting reports for Canadian public
companies. Canadian Depository for Securities Inc.
operates this website on behalf of Canadian
Securities Administrators. This site is similar
to the SEC site except that filings are not in a
specified form.
The Statistics Canada site, which contains survey
information about industry groups in terms of
prospects and ratios.
Library Internet Resources
Public and university libraries often have access to some or all of the following services,
where extensive details on financial and other information related to companies and industries
can be found:
ABI/INFORM
A database containing business-related articles
published in practitioner and academic journals or
periodicals.
CBCA
A Canadian business reference source.
EBSCO/Host
An extensive database of references and
journal articles.
Financial Post INFOMART
A resource containing financial, market, and other
information for 4,500 public Canadian companies.
Industry-level data are also available.
Mergent Online
A source of financial and textual information on
companies and risk ratings, as well as information
on their officers and directors.
LexisNexis
An extensive database of legal, regulatory, and
financial information.
Compustat
A database of financial information for public
companies worldwide.
EXHIBIT 14–5
Sources of Financial
Information
682
Chapter 14 Financial Statement Analysis
LEARNING AID
Summary of Ratios
Ratio
Profitability
Gross margin percentage
Earnings per share (of
common shares)
Price–earnings ratio
Formula
Significance
Gross margin ÷ Sales
(Net income − Preferred dividends) ÷
Average number of common shares
outstanding
Market price per share ÷ Earnings
per share
A broad measure of profitability
Affects the market price per share,
as reflected in the price–earnings
ratio
An index of whether a share is relatively
cheap or expensive in relation to
current earnings
An index showing whether a company
pays out most of its earnings in
dividends or reinvests the earnings
internally
Shows the return in terms of cash
dividends being provided by a share
Measures how well assets have been
employed by management
When compared to the return on total
assets, measures the extent to which
financial leverage is working for or
against common shareholders
Measures the amount that would be
distributed to holders of common
shares if all assets were sold at their
balance sheet carrying amounts and if
all creditors were paid off
Dividend payout ratio
Dividends per share ÷ Earnings per share
Dividend yield ratio
Dividends per share ÷ Market price
per share
{Net income + [Interest expense ×
(1 − Tax rate)]} ÷ Average total assets
(Net income − Preferred dividends) ÷
Average common shareholders’ equity
(Average total shareholders’ equity −
Average preferred shares)
(Total shareholders’ equity − Preferred
shares) ÷ Number of common
shares outstanding
Return on total assets
Return on common
shareholders’ equity
Book value per share
Liquidity
Working capital
Current ratio
Acid-test (quick) ratio
Accounts receivable turnover
Average collection period
(age of receivables)
Inventory turnover
Average sale period (turnover
in days)
Solvency
Times interest earned ratio
Debt-to-equity ratio
Current assets − Current liabilities
Current assets ÷ Current liabilities
(Cash + Temporary investments +
Current receivables) ÷ Current
liabilities
Sales on account ÷ Average accounts
receivable balance
365 days ÷ Accounts receivable turnover
Cost of goods sold ÷ Average
inventory balance
365 days ÷ Inventory turnover
Earnings before interest expense and
income taxes ÷ Interest expense
Total liabilities ÷ Shareholders’ equity
Measures the company’s ability to repay
current liabilities using only current
assets.
Tests short-term debt-paying ability
Tests short-term debt-paying ability
without having to rely on inventory
Measures how many times a company’s
accounts receivable have been turned
into cash during the year
Measures the average number of days
taken to collect an account receivable
Measures how many times a company’s
inventory has been sold during the year
Measures the average number of days
taken to sell the inventory one time
Measures the company’s ability to make
interest payments
Measures the amount of assets being
provided by creditors relative to the
amount being provided by the
shareholders
Chapter 14 Financial Statement Analysis
KNOWLEDGE IN ACTION
Managers can apply their knowledge of financial statement
analysis when
•
•
•
Identifying areas to target for improvement, such as cost management and
working capital management
Comparing the company’s performance to leading competitors
Determining plans for financing future growth in operations
Creditors can apply their knowledge of financial statement analysis when
•
•
Evaluating a company’s ability to repay its existing debts and any new borrowing
Setting the interest rate for loans extended to the company
Potential or existing investors can apply their knowledge of financial statement
analysis when
•
•
•
Deciding whether or not to invest in a company
Deciding whether or not to hold or sell an existing investment in a company
Estimating future dividends to be paid by the company
SUMMARY
•
•
The data contained in financial statements represent a quantitative summary of a firm’s operations
and activities. Someone who is skilful at analyzing these statements can learn much about a company’s strengths, weaknesses, emerging problems, operating efficiency, profitability, and so forth.
Many techniques are available to analyze financial statements and to assess the direction and
importance of trends and changes. In this chapter, we have discussed three such analytical
techniques—dollar and percentage changes in statements, common-size statements, and ratio
analysis. Refer to the Learning Aid for a detailed listing of the ratios, including a brief statement as
to the significance of each ratio. [LO1, LO2, LO3, LO4]
REVIEW PROBLEM: SELECTED RATIOS AND
FINANCIAL LEVERAGE
Coffee Break is a leading retailer of specialty coffee in North America, selling freshly brewed coffee,
pastries, lunch food, and coffee beans. Data from the company’s financial statements are as follows:
COFFEE BREAK
Comparative Balance Sheet
(dollars in millions)
This Year
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . .
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 281
157
288
692
278
1,696
2,890
758
$5,344
Last Year
$ 313
141
224
636
216
1,530
2,288
611
$4,429
(continued)
683
684
Chapter 14 Financial Statement Analysis
COFFEE BREAK
Comparative Balance Sheet
(dollars in millions)
This Year
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term bank loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Preferred shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common shares and additional paid-in capital . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . .
Last Year
$ 391
710
757
298
2,156
904
3,060
$ 341
700
662
233
1,936
265
2,201
0
40
2,244
2,284
$5,344
0
40
2,188
2,228
$4,429
COFFEE BREAK
Income Statement
(dollars in millions)
This Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Store operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . .
Total selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plus interest and other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes (about 36%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Required:
1.
2.
3.
4.
5.
6.
7.
8.
Compute the return on total assets.
Compute the return on common shareholders’ equity.
Is Coffee Break’s financial leverage positive or negative? Explain.
Compute the current ratio.
Compute the acid-test ratio.
Compute the inventory turnover.
Compute the average sale period.
Compute the debt-to-equity ratio.
$9,411
3,999
5,412
3,216
294
467
489
4,466
946
110
0
1,056
384
$ 672
Chapter 14 Financial Statement Analysis
Solution to Review Problem
1.
Net income + (Interest expense × (1 − Tax rate))
Return on total assets = ________________________________________
Average total assets
$672 + ($0 × (1 − 0.36))
Return on total assets = _____________________ = 13.8% (rounded)
($5,344 + $4,429)∕2
2.
Net income − Preferred dividends
Return on common shareholders’ equity = ____________________________
Average common shareholders
$672 − $0
Return on common shareholders = _________________ = 29.8% (rounded)
($2,284 + $2,228)∕2
3.
The company has positive financial leverage because the return on common shareholders’ equity of
29.8% is greater than the return on total assets of 13.8%. The positive financial leverage was obtained from current and long-term liabilities.
4.
Current assets
Current ratio = _______________
Current liabilities
5.
$1,696
Current ratio = ______ = 0.79 (rounded)
$2,156
Cash + Marketable securities + Accounts receivable + Short-term notes receivable
Acid-test = ___________________________________________________________________
ratio
Current liabilities
$281 + $157 + $288 + $0
Acid-test ratio = ______________________ = 0.34 (rounded)
$2,156
6.
Cost of goods sold
Inventory turnover = ______________________
Average inventory balance
$3,999
Inventory turnover = ______________ = 6.02 (rounded)
($692 + $636)∕2
7.
365 days
Average sale period = ________________
Inventory turnover
365 days
Average sale period = ________ = 61 days (rounded)
6.02
8.
Total liabilities
Debt-to-equity ratio = _________________
Shareholders’ equity
$2,156 + $904
Debt-to-equity ratio = _____________ = 1.34 (rounded)
$2,284
DISCUSSION CASE
DISCUSSION CASE 14–1
Critics of financial statement analysis argue that it is of limited value because it is based on historical
amounts, which are not necessarily indicative of how well a company is likely to perform in the future.
For example, ratio or trend analysis of the strong results posted by BlackBerry during their growth period would have given little indication of the trouble the company would face in 2011 and thereafter.
Required:
Do you agree with critics of financial statement analysis who claim that it is of limited value? Why or
why not?
685
686
Chapter 14 Financial Statement Analysis
QUESTIONS
14–1 Distinguish between horizontal and vertical analysis of financial statement data.
14–2 What is the basic purpose for examining trends in a company’s financial ratios and other data?
What other kinds of comparisons might an analyst make?
14–3 Assume that two companies in the same industry have equal earnings. Why might these companies have different price–earnings ratios? If a company has a price–earnings ratio of 20 and reports earnings per share for the current year of $4, at what price would you expect to find the
share selling on the market?
14–4 Armcor Inc. is in a rapidly growing technological industry. Would you expect the company to
have a high or low dividend payout ratio?
14–5 What is meant by the dividend yield on a common share investment?
14–6 The president of a medium-sized plastics company was recently quoted in a business journal as
follows, “We haven’t had a dollar of interest-paying debt in over 10 years. Not many companies
can say that.” As a shareholder in this firm, how would you feel about its policy of not taking on
interest-paying debt?
14–7 “If a share’s market value exceeds its book value, then the share is overpriced.” Do you agree?
Explain.
14–8 A company seeking a line of credit at a bank was turned down. Among other things, the bank
stated that the company’s 2 to 1 current ratio was not adequate. Give reasons why a 2 to 1 current
ratio might not be adequate.
®
FOUNDATIONAL EXERCISES
[LO2, LO3, LO4]
Markus Company’s common stock sold for $2.75 per share at the end of this year. The average number
of common shares outstanding during the year is 120,000. The company also paid a common stock dividend of $0.55 per share this year. It also provided the following data excerpts from this year’s financial
statements.
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . .
Current liabilities . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . .
Common shareholders’ equity . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . .
Total liabilities and common
shareholders’ equity . . . . . . . . . . . . . . . . . . .
Ending
Balance
Beginning
Balance
$ 35,000
$ 60,000
$ 55,000
$150,000
$ 60,000
$130,000
$120,000
$320,000
$ 30,000
$ 50,000
$ 60,000
$140,000
$ 40,000
$120,000
$120,000
$340,000
$450,000
$460,000
This Year
Sales (all on account) . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$700,000
$400,000
$300,000
$140,000
$ 8,000
$ 92,400
Chapter 14 Financial Statement Analysis
687
Required:
14–1
14–2
14–3
14–4
14–5
14–6
14–7
14–8
14–9
14–10
14–11
14–12
14–13
14–14
What is the earnings per share?
What is the price–earnings ratio?
What is the dividend payout ratio and the dividend yield ratio?
What is the return on total assets (assuming a 30% tax rate)?
What is the return on equity?
What is the book value per share at the end of this year?
What is the amount of working capital and the current ratio at the end of this year?
What is the acid-test ratio at the end of this year?
What is the accounts receivable turnover and the average collection period?
What is the inventory turnover?
What is the average sale period?
What is the total asset turnover?
What is the times interest earned ratio?
What is the debt-to-equity ratio at the end of this year?
®
EXERCISES
EXERCISE 14–1 Common-Size Income Statement [LO1]
A comparative income statement is given below for McKenzie Sales Ltd., of Toronto:
McKENZIE SALES LTD.
Comparative Income Statement
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total selling and administrative expenses . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
This Year
Last Year
$8,000,000
4,984,000
3,016,000
$6,000,000
3,516,000
2,484,000
1,480,000
712,000
2,192,000
824,000
96,000
$ 728,000
1,092,000
618,000
1,710,000
774,000
84,000
$ 390,000
Members of the company’s board of directors are surprised to see that net income increased by only
$38,000 when sales increased by $2 million.
Required:
1.
2.
Express each year’s income statement in common-size percentages. Carry computations to one
decimal place.
Comment briefly on the changes between the two years.
EXERCISE 14–2 Financial Ratios for Common Shareholders [LO2]
Classic Vinyl Limited is a record wholesaler selling new and used vinyl records to record stores and
antique shops throughout Canada. The company’s comparative financial statements for the fiscal year
ending December 31 appear below. The company did not issue any new common or preferred shares
during the year. A total of 600,000 common shares were outstanding. The interest rate on the bond payable was 5%, the income tax rate was 30%, and the dividend per common share was $1.25. The market
value of the company’s common shares at the end of the year was $150. All of the company’s sales are
on account:
688
Chapter 14 Financial Statement Analysis
CLASSIC VINYL LIMITED
Comparative Balance Sheet
(dollars in thousands)
This Year
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property and equipment:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . .
Total property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes payable, short term . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term liabilities:
Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Preferred shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . .
$
2,160
18,000
24,000
1,200
45,360
Last Year
$
2,420
11,000
18,720
1,000
33,140
18,000
73,600
91,600
$136,960
18,000
76,000
94,000
$127,140
$ 37,000
1,800
—
38,800
$ 34,800
1,400
200
36,400
16,000
54,800
16,000
52,400
2,000
12,000
14,000
68,160
82,160
$136,960
2,000
12,000
14,000
60,740
74,740
$127,140
CLASSIC VINYL LIMITED
Comparative Income Statement and Reconciliation of Retained Earnings
(dollars in thousands)
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total selling and administrative expenses . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends to preferred shareholders . . . . . . . . . . . . . . . . . . . . . .
Net income remaining for common shareholders . . . . . . . . . . . .
Dividends to common shareholders . . . . . . . . . . . . . . . . . . . . . .
Net income added to retained earnings . . . . . . . . . . . . . . . . . . . .
Retained earnings, beginning of year . . . . . . . . . . . . . . . . . . . . .
Retained earnings, end of year . . . . . . . . . . . . . . . . . . . . . . . . . .
This Year
Last Year
$198,000
129,000
69,000
$192,000
126,000
66,000
34,500
22,200
56,700
12,300
800
11,500
3,450
8,050
180
7,870
450
7,420
60,740
$ 68,160
33,000
21,000
54,000
12,000
800
11,200
3,360
7,840
800
7,040
750
6,290
54,450
$ 60,740
Chapter 14 Financial Statement Analysis
689
Required:
Compute the following financial ratios for this year:
1.
2.
3.
4.
5.
6.
7.
8.
Gross margin percentage.
Earnings per share.
Price–earnings ratio.
Dividend payout ratio.
Dividend yield ratio.
Return on total assets.
Return on common shareholders’ equity.
Book value per share.
EXERCISE 14–3 Financial Ratios for Short-Term Creditors [LO3]
Refer to the data in Exercise 14–2 for Classic Vinyl Limited.
Required:
Compute the following financial data for this year:
1.
2.
3.
4.
5.
6.
7.
Working capital.
Current ratio.
Acid-test ratio.
Accounts receivable turnover. (Assume that all sales are on account.)
Average collection period.
Inventory turnover.
Average sale period.
CHECK FIGURE
Working capital =
$6,560; Accounts
receivable turnover =
13.6; Average sale
period = 60.4 days.
EXERCISE 14–4 Financial Ratios for Long-Term Creditors [LO4]
Refer to the data in Exercise 14–2 for Classic Vinyl Limited.
Required:
Compute the following financial ratios for this year:
1.
2.
Times interest earned ratio.
Debt-to-equity ratio.
EXERCISE 14–5 Trend Percentages [LO1]
Rotorua Products Ltd. of New Zealand markets agricultural products for the burgeoning Asian consumer
market. The company’s current assets, current liabilities, and sales have been reported as follows over
the last five years (Year 5 is the most recent year):
Year 1
Year 2
Year 3
Year 4
Year 5
Sales . . . . . . . . . . . . . . . . . . . .
$1,800,000 $1,980,000 $2,070,000
$2,160,000
$2,250,000
Cash. . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . .
Inventory . . . . . . . . . . . . . . .
Total current assets . . . . . . . . .
$
50,000 $ 65,000 $ 48,000
300,000
345,000
405,000
600,000
660,000
690,000
$ 950,000 $1,070,000 $1,143,000
$
40,000
510,000
720,000
$1,270,000
$
Current liabilities . . . . . . . . . .
$ 400,000 $ 440,000 $ 520,000
$ 580,000
$ 640,000
30,000
570,000
750,000
$1,350,000
Required:
1.
2.
Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each
item.) Use year 1 as the base year, and carry computations to one decimal place.
Comment on the results of your analysis.
EXERCISE 14–6 Selected Financial Ratios for Common Shareholders [LO2]
Financial data from the December 31 year-end statements of Sunrise Fashions are given below:
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000,000
Long-term debt (4% interest rate) . . . . . . . . . . . . . . . . . . . . .
1,000,000
Preferred shares, 7,000, $12 no par. . . . . . . . . . . . . . . . . . . .
1,200,000
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . .
6,000,000
Interest paid on long-term debt . . . . . . . . . . . . . . . . . . . . . . .
40,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
952,000
690
Chapter 14 Financial Statement Analysis
Total assets at the beginning of the year were $9,600,000; total shareholders’ equity was $5,700,000.
There has been no change in preferred shares during the year. The company’s tax rate is 30%.
Required:
1.
2.
3.
Compute the return on total assets.
Compute the return on common shareholders’ equity.
Is the company’s financial leverage positive or negative? Explain.
EXERCISE 14–7 Selected Financial Measures for Short-Term Creditors [LO3]
Norsk Optronics, ALS, of Bergen, Norway, had a current ratio of 2.5 on June 30 of the current year. On
that date, the company’s assets were:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plant and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$
90,000
260,000
490,000
10,000
800,000
$1,650,000
Required:
1.
2.
3.
What was the company’s working capital on June 30?
What was the company’s acid-test ratio on June 30?
The company paid an account payable of $40,000 immediately after June 30.
a. What effect did this transaction have on working capital? Show computations.
b. What effect did this transaction have on the current ratio? Show computations.
EXERCISE 14–8 Selected Financial Ratios [LO2, LO3, LO4]
Recent financial statements for Madison Company are given below. Account balances at the beginning
of the company’s fiscal year were accounts receivable, $140,000, and inventory, $260,000. All sales
were on account.
MADISON COMPANY
Balance Sheet
June 30
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . .
Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property and equipment, net . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Shareholders’ Equity
Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonds payable, 10% . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Common shares, 20,000 . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . .
$
21,000
160,000
300,000
9,000
490,000
810,000
$1,300,000
$ 200,000
300,000
500,000
$100,000
700,000
800,000
$1,300,000
Chapter 14 Financial Statement Analysis
691
MADISON COMPANY
Income Statement
For the Year Ended June 30
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,100,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,260,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
840,000
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . .
660,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
180,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
30,000
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
150,000
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
45,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 105,000
Required:
Compute the following financial ratios:
1.
2.
3.
4.
5.
6.
7.
8.
Gross margin percentage.
Current ratio.
Acid-test ratio.
Average collection period.
Average sale period.
Debt-to-equity ratio.
Times interest earned ratio.
Book value per share.
EXERCISE 14–9 Selected Financial Ratios for Common Shareholders [LO2]
Refer to the financial statements for Madison Company in Exercise 14–8. In addition to the data in these
statements, assume that Madison Company paid dividends of $3.15 per share during the year. Also assume that the company’s common shares had a market price of $63 per share on June 30 and there was
no change in the number of outstanding common shares during the fiscal year.
Required:
Compute the following:
1.
2.
3.
4.
Earnings per share.
Dividend payout ratio.
Dividend yield ratio.
Price–earnings ratio.
EXERCISE 14–10 Selected Financial Ratios for Common Shareholders [LO2]
Refer to the financial statements for Madison Company in Exercise 14–8. Assets at the beginning of the
year totalled $1,100,000, and the shareholders’ equity totalled $725,000.
Required:
1.
2.
3.
Compute the return on total assets.
Compute the return on common shareholders’ equity.
Was financial leverage positive or negative for the year? Explain.
PROBLEMS
PROBLEM 14–11 Common-Size Statements and Financial Ratios for Creditors
[LO1, LO3, LO4]
Modern Building Supply sells various building materials to retail outlets. The company has just approached Linden Bank requesting a $300,000 loan to strengthen the cash account and to pay certain
CHECK FIGURE
Return on total
assets = 10.5%;
Return on common
shareholders’
equity = 13.8%.
®
692
Chapter 14 Financial Statement Analysis
pressing short-term obligations. The company’s financial statements for the most recent two years are
shown below.
MODERN BUILDING SUPPLY
Comparative Balance Sheet
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Temporary investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plant and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Shareholders’ Equity
Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonds payable, 12% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Preferred shares, 4,000, $4 no par. . . . . . . . . . . . . . . . . . . . . .
Common shares, 50,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . .
This Year
Last Year
$
90,000
0
650,000
1,300,000
20,000
2,060,000
1,940,000
$4,000,000
$ 200,000
50,000
400,000
800,000
20,000
1,470,000
1,830,000
$3,300,000
$1,100,000
750,000
1,850,000
$ 600,000
750,000
1,350,000
200,000
500,000
1,450,000
2,150,000
$4,000,000
200,000
500,000
1,250,000
1,950,000
$3,300,000
MODERN BUILDING SUPPLY
Comparative Income Statement and Reconciliation of Retained Earnings
This Year
Last Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes (40%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$7,000,000
5,400,000
1,600,000
970,000
630,000
90,000
540,000
216,000
324,000
$6,000,000
4,800,000
1,200,000
710,000
490,000
90,000
400,000
160,000
240,000
Dividends paid:
Preferred dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income retained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings, beginning of year . . . . . . . . . . . . . . . . . . . . .
Retained earnings, end of year . . . . . . . . . . . . . . . . . . . . . . . . . .
16,000
108,000
124,000
200,000
1,250,000
$1,450,000
16,000
60,000
76,000
164,000
1,086,000
$1,250,000
During the past year, the company has expanded the number of lines that it carries in order to
stimulate sales and increase profits. It has also moved aggressively to acquire new customers. Sales
terms are 2/10, n/30. All sales are on account.
Chapter 14 Financial Statement Analysis
Assume that the following ratios are typical of companies in the building supply industry:
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Average collection period . . . . . . . . . . . . . . . . . . . . . . . . . . .
Average sale period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Debt-to-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Times interest earned ratio . . . . . . . . . . . . . . . . . . . . . . . . . .
Return on total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Price–earnings ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5
1.2
18 days
50 days
0.75
6.0
10%
9
Required:
1.
2.
3.
Management at Linden Bank is uncertain whether the loan should be made. To assist in making the
decision, you have been asked to compute the following amounts and ratios for both this year and
last year:
a. Working capital.
b. Current ratio.
c. Acid-test ratio.
d. Average collection period. (The accounts receivable at the beginning of last year totalled
$350,000.)
e. Average sale period. (The inventory at the beginning of last year totalled $720,000.)
f. Debt-to-equity ratio.
g. Times interest earned ratio.
For both this year and last year (carry computations to one decimal place):
a. Present the balance sheet in common-size format.
b. Present the income statement in common-size format down through net income.
From your analysis in (1) and (2) above, what problems or strengths do you see for Modern
Building Supply? Recommend whether the loan should be approved.
PROBLEM 14–12 Financial Ratios for Common Shareholders [LO2]
Refer to the financial statements and other data in Problem 14–11. Assume that you have just inherited
several hundred shares of Modern Building Supply. Not being acquainted with the company, you decide
to do some analytical work before making a decision about whether to retain or sell the shares you have
inherited.
Required:
1.
2.
3.
You decide first to assess how well the company is doing from the perspective of the common
shareholders. For both this year and last year, compute the following:
a. The earnings per share.
b. The dividend yield ratio for common shares. The company’s common shares are currently
selling for $45 per share; last year they sold for $36 per share.
c. The dividend payout ratio for common shares.
d. The price–earnings ratio. How do investors regard Modern Building Supply as compared to
other companies in the industry? Explain.
e. The book value per common share. Does the difference between market value and book value
suggest that the shares at their current price are too high? Explain.
You decide to assess the company’s rate of return next.
a. Compute the return on total assets for both this year and last year. (Total assets at the beginning of last year were $2,700,000.)
b. Compute the return on common shareholders’ equity for both this year and last year.
(Shareholders’ equity at the beginning of last year was $1,786,000.)
c. Is the company’s financial leverage positive or negative? Explain.
Based on your analysis (and assuming that you have no immediate need for cash), would you retain
or sell the shares you have inherited? Explain.
693
694
Chapter 14 Financial Statement Analysis
PROBLEM 14–13 Effects of Transactions on Various Ratios [LO3]
Denna Company’s working capital accounts at the beginning of the year follow:
Account
Amount
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes due within one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 50,000
30,000
200,000
210,000
10,000
150,000
30,000
20,000
During the year, the company completed the following transactions (the first item, lettered “x,” is used
below as an example in the requirements):
x.
Paid a cash dividend previously declared, $12,000.
a. Issued additional shares of common stock for cash, $100,000.
b. Sold inventory costing $50,000 for $80,000, on account.
c. Wrote off uncollectible accounts in the amount of $10,000, reducing the accounts receivable
balance accordingly.
d. Declared a cash dividend, $15,000.
e. Paid accounts payable, $50,000.
f. Borrowed cash on a short-term note with the bank, $35,000.
g. Sold inventory costing $15,000 for $10,000 cash.
h. Purchased inventory on account, $60,000.
i. Paid off all short-term notes due, $30,000.
j. Purchased equipment for cash, $15,000.
k. Sold marketable securities costing $18,000 for cash, $15,000.
l. Collected cash on accounts receivable, $80,000.
Required:
1.
2.
Compute the following amounts and ratios as of the beginning of the year:
a. Working capital.
b. Current ratio.
c. Acid-test ratio.
Indicate the effect of each of the transactions given above on working capital, the current ratio, and
the acid-test ratio. Give the effect in terms of increase, decrease, or none. Item (x) is given as an
example of the format to use:
Transaction
(x) Paid a cash dividend previously declared . . . . .
Working
Capital
None
The Effect On…
Current
Acid-Test
Ratio
Ratio
Increase
Increase
PROBLEM 14–14 Comprehensive Ratio Analysis [LO2, LO3, LO4]
You have just been hired as a loan officer at Westmount Bank. Your supervisor has given you a
file containing a request from Hill Company, a manufacturer of computer components, for a
Chapter 14 Financial Statement Analysis
$2,000,000 five-year loan. Financial statement data on the company for the past two years are
given below:
HILL COMPANY
Comparative Balance Sheet
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Temporary investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plant and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Shareholders’ Equity
Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonds payable, 10% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Preferred shares, 20,000, $2.40 no par value . . . . . . . . . . . . .
Common shares, 50,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . .
This Year
Last Year
$ 240,000
0
675,000
975,000
60,000
1,950,000
2,325,000
$4,275,000
$ 315,000
75,000
450,000
600,000
45,000
1,485,000
2,235,000
$3,720,000
$ 975,000
900,000
1,875,000
$ 690,000
750,000
1,440,000
450,000
1,500,000
450,000
2,400,000
$4,275,000
450,000
1,500,000
330,000
2,280,000
$3,720,000
HILL COMPANY
Comparative Income Statement and Reconciliation of Retained Earnings
This Year
Last Year
Sales (all on account) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,937,500
3,150,000
787,500
397,500
390,000
90,000
300,000
90,000
210,000
$3,120,000
2,475,000
645,000
390,000
255,000
75,000
180,000
54,000
126,000
Dividends paid:
Preferred shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income retained . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings, beginning of year . . . . . . . . . . . . . . . . . . . . .
Retained earnings, end of year . . . . . . . . . . . . . . . . . . . . . . . . . .
36,000
54,000
90,000
120,000
330,000
$450,000
36,000
27,000
63,000
63,000
267,000
$330,000
695
696
Chapter 14 Financial Statement Analysis
Pat Smith, who just three years ago was appointed president of Hill Company, admits that the
company has been inconsistent in its performance over the past several years. But Smith argues that
the company has its costs under control and is now experiencing strong sales growth, as evidenced by
the more than 25% increase in sales over the past year. Smith also argues that investors have recognized the improving situation at Hill Company, as shown by the jump in the price of its common
shares from $15 per share last year to $27 per share this year. Smith believes that with strong leadership and with the modernized equipment that the $2,000,000 loan will permit the company to buy,
profits will be even stronger in the future.
Anxious to impress your supervisor, you decide to generate all the information you can about
the company. You determine that the following ratios are typical of companies in Hill Company’s
industry:
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3
Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2
Average collection period . . . . . . . . . . . . . . . . . . . . . . . . . .
31 days
Average sale period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60 days
Return on assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.5%
Debt-to-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.65
Times interest earned ratio . . . . . . . . . . . . . . . . . . . . . . . . . 5.7
Price–earnings ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Required:
1.
2.
CHECK FIGURE
Earnings per share
= $3.48 (this year)
and $1.80 (last year);
Book value per
share = $39 (this
year) and $36.60
(last year); Current
ratio = 2.0 (this
year) and 2.15
(last year); Times
interest earned =
4.3 (this year) and
3.4 (last year).
3.
4.
You decide to assess the rate of return that the company is generating first.
a. Compute the return on total assets for both this year and last year. (Total assets at the beginning of last year were $3,240,000.)
b. Compute the return on common shareholders’ equity for both this year and last year.
(Shareholders’ equity at the beginning of last year totalled $2,217,000. There has been no
change in preferred or common shares over the past two years.)
c. Is the company’s financial leverage positive or negative? Explain.
You decide to assess how well the company is doing from the perspective of the common shareholders next. For both this year and last year, compute
a. The earnings per share.
b. The dividend yield ratio for common shares.
c. The dividend payout ratio for common shares.
d. The price–earnings ratio. How do investors regard Hill Company as compared to other companies in the industry? Explain.
e. The book value per common share. Does the difference between market value per share and
book value per share suggest that the shares at their current price are a bargain? Explain.
f. The gross margin percentage.
You decide, finally, to assess creditor ratios to determine both short-term and long-term debtpaying ability. For both this year and last year, compute
a. Working capital.
b. The current ratio.
c. The acid-test ratio.
d. The average collection period. (The accounts receivable at the beginning of last year totalled
$390,000.)
e. The average sale period. (The inventory at the beginning of last year totalled $480,000.)
f. The debt-to-equity ratio.
g. The times interest earned.
Recommend to your supervisor whether the loan should be approved.
PROBLEM 14–15 Common-Size Financial Statements [LO1]
Required:
Refer to the financial statement data for Hill Company given in Problem 14–14.
1.
2.
3.
For both this year and last year, present the balance sheet in common-size format.
For both this year and last year, present the income statement in common-size format down through
net income.
Comment on the results of your analysis.
Chapter 14 Financial Statement Analysis
PROBLEM 14–16 Effects of Transactions on Various Financial Ratios [LO2, LO3, LO4]
In the right-hand column below, certain financial ratios are listed. To the left of each ratio is a business
transaction or event relating to the operating activities of Graham Company:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Inventory was sold for cash at a profit.
Land was purchased for cash.
Inventory was sold on account at cost.
Some accounts payable were paid off.
A customer paid an overdue bill.
A cash dividend was declared, but not yet paid.
A previously declared cash dividend was paid.
The company’s common share price increased to $50
from $45.
Dividends per share remained the same but the market price
per share increased to $50 from $45.
Property was sold for a profit.
Obsolete inventory was written off as a loss.
Bonds were sold with an interest rate less than the company’s
return.
The market price per share of the company’s common share
decreased from $22 to $20.
The company’s net income decreased since last year, but
long-term debt remained unchanged.
An uncollectible account was written off against the
Allowance for Bad Debts.
Inventory was purchased on credit.
The company’s common share price increased by $3 per
share, while earnings per share remained unchanged.
The company paid off some accounts payable.
Debt-to-equity ratio
Earnings per share
Acid-test ratio
Working capital
Average collection period
Current ratio
Current ratio
Book value per share
Dividend yield ratio
Return on total assets
Inventory turnover ratio
Return on common
shareholders’ equity
Dividend payout ratio
Times interest earned ratio
Current ratio
Acid-test ratio
Price–earnings ratio
Debt-to-equity ratio
Required:
Indicate the effect that each transaction or event would have on the ratio listed opposite to it. State the
effect in terms of increase, decrease, or no effect on the ratio involved, and give the reason for your
choice. In all cases, assume that current assets exceed current liabilities both before and after the event
or transaction. Use the following format for your answers:
Effect on Ratio
Reason for Increase, Decrease, or No Effect
1.
2.
Etc.
PROBLEM 14–17 Interpretation of Financial Ratios [LO2, LO3]
Pecunious Products Inc.’s financial results for the past three years are summarized below:
Sales trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable turnover . . . . . . . . . . . . . . . . . . . . . . . .
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividends yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividend payout ratio* . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Return on total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Return on common shareholders’ equity . . . . . . . . . . . . . . .
Dividends paid per share* . . . . . . . . . . . . . . . . . . . . . . . . . . .
Year 3
Year 2
Year 1
128.0
2.5
0.8
9.4
6.5
7.1%
40%
12.5%
14.0%
$1.50
115.0
2.3
0.9
10.6
7.2
6.5%
50%
11.0%
10.0%
$1.50
100.0
2.2
1.1
12.5
8.0
5.8%
60%
9.5%
7.8%
$1.50
*There were no changes in common shares outstanding over the three-year period.
697
698
Chapter 14 Financial Statement Analysis
Your boss has asked you to review these results and then answer the following questions:
a.
b.
c.
d.
e.
f.
g.
h.
Is it becoming easier for the company to pay its bills as they come due?
Are customers paying their bills at least as fast now as they did in year 1?
Is the total of the accounts receivable increasing, decreasing, or remaining constant?
Is the level of inventory increasing, decreasing, or remaining constant?
Is the market price of the company’s stock going up or down?
Is the earnings per share increasing or decreasing?
Is the price–earnings ratio going up or down?
Is the company employing financial leverage to the advantage of the common shareholders?
Required:
Provide answers to each of the questions raised by your boss.
PROBLEM 14–18 Ethics and the Manager [LO3]
Longboards Inc. was founded by Riley Thomas to produce a longboard he had designed for cruising.
Longboards are catching up to skateboards in popularity because of their speed and durability. Up to this
point, Thomas has financed the company with his own savings, an injection of cash from his parents,
and earnings generated by his business. However, Thomas now faces a cash crisis. In the year just ended,
an acute shortage of a vital tungsten steel alloy developed just as the company was beginning production
for the summer season. Thomas had been assured by his suppliers that the steel would be delivered in
time to make summer shipments, but the suppliers had been unable to fully deliver on this promise. As
a consequence, Longboard Inc. had a large inventory of unfinished longboards at the end of the year and
was unable to fill all of the orders that had come in from retailers for the summer season. Consequently,
sales were below expectations for the year, and Thomas does not have enough cash to pay his creditors.
Thomas would like to apply to the bank for a $200,000 one-year loan bearing an interest rate of 4%
per year. The loan officer at Thomas’s bank indicated that to qualify for a loan, Longboards Inc. must
have a current ratio higher than 2.0, an acid-test ratio higher than 1.0, and times interest earned must be
at least 5.
The unaudited financial balance sheet and income statement of the company appear below:
LONGBOARDS INC.
Comparative Balance Sheet
As of December 31, This Year and Last Year
(in thousands of dollars)
Assets
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued payables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity:
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . .
This Year
Last Year
$ 210
150
480
30
870
810
$1,680
$ 450
120
300
36
906
540
$1,446
$ 462
30
492
0
492
$ 270
30
300
0
300
300
888
1,188
$1,680
300
846
1,146
$1,446
Chapter 14 Financial Statement Analysis
LONGBOARDS INC.
Income Statement
For the Year Ended December 31, This Year
(in thousands of dollars)
Sales (all on account) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total selling and administrative expenses . . . . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,260
870
390
126
204
330
60
0
60
18
$ 42
Required:
1.
2.
Based on the above unaudited financial statements and the criteria identified by the loan officer,
would the company qualify for the loan? Calculate times interest earned as if the $200,000 loan has
been granted by the bank.
Last year Thomas purchased and installed new, more efficient equipment to replace equipment he
had originally acquired second-hand. He had originally planned to sell the old equipment but found
that it is still needed whenever the heat-treating process is a bottleneck. When Thomas discussed
his cash flow problems with his brother-in-law, he suggested to Thomas that the old equipment be
sold or at least reclassified as inventory on the balance sheet since it could be readily sold. At
present, the equipment is carried in the Property and Equipment account and could be sold for its
net book value of $136,000. The bank does not require audited financial statements. What advice
would you give to Thomas concerning the equipment?
PROBLEM 14–19 Incomplete Statements; Analysis of Ratios [LO2, LO3, LO4]
Incomplete financial statements for Pepper Industries are given below:
PEPPER INDUSTRIES
Income Statement
For the Year Ended March 31
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . .
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,200,000
?
?
?
?
80,000
?
?
$
?
699
700
Chapter 14 Financial Statement Analysis
PEPPER INDUSTRIES
Balance Sheet
March 31
Current assets:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plant and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bonds payable, 10% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shareholders’ equity
Common shares, 140,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . .
$
$
?
?
?
?
?
?
$320,000
?
?
$700,000
?
?
$ ?
The following additional information about the company is available:
a.
Selected financial ratios computed from the statements are shown below:
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable turnover . . . . . . . . . . . . . . . . . . . . . . . .
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Debt-to-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Times interest earned ratio . . . . . . . . . . . . . . . . . . . . . . . . . .
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Return on total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b.
c.
d.
e.
CHECK FIGURE
Cost of goods sold
= $2,730,000; Net
income = $322,000;
Total assets =
$2,400,000;
Retained earnings =
$580,000.
2.75
1.25
14.0
6.5
0.875
6.75
$2.30
18%
All sales during the year were on account.
The interest expense on the income statement relates to the bonds payable; the amount of bonds
outstanding did not change throughout the year.
There were no changes in the number of common shares outstanding during the year.
Selected balances at the beginning of the current year (January 1) were as follows:
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ 270,000
$ 360,000
$1,800,000
Required:
Compute the missing amounts on the company’s financial statements. (Hint: You may find it helpful to
think about the difference between the current ratio and the acid-test ratio.)
ENDNOTES
1.
Another complication can arise when a company has issued securities such as executive stock options or warrants that can be converted into common shares. If these conversions were to take place,
the same earnings would have to be distributed among a greater number of common shares.
Therefore, a supplemental earnings per share figure, called diluted earnings per share, may have to
be computed.