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Chapter 17: Financial Statement Analysis: Chapter Overview
Financial Statement Analysis: Chapter Objectives
Financial Statement Analysis: Accounting in the Real World: E*Trade
Financial Statement Analysis: Key Terms
Financial Statement Analysis: Chapter Objectives
Learning Objectives
After studying Chapter 17, in addition to defining key terms, you will be able to:
LO1 Analyze an income statement using vertical analysis. LO2 Perform vertical analysis of a balance sheet. LO3 Analyze a balance sheet using vertical analysis. LO4 Perform horizontal analysis on an income statement. LO5 Perform horizontal analysis on a balance sheet. LO6 Calculate earnings per share. LO7 Calculate and interpret market ratios. LO8 Calculate and interpret liquidity ratios.
Financial Statement Analysis: Accounting in the Real World: E*Trade
The Internet revolutionized how individual investors buy and sell stock. Before the Internet, an investor could only trade stock using a stock broker. Through their investment firms, stock brokers had access to financial information not available elsewhere. As a result, most investors relied on their stock brokers for investment advice. When an investor made a decision on an investment, the stock broker would make the purchase on the stock exchange.
Today's investors can manage their own investments using an online investing site. For over 20 years, ETRADE has been a leader in online investing. ETRADE customers have 24/7 access to financial information and the tools to place stock trades. An E*TRADE customer can enter the stock symbol of a corporation and gain instant access to a wealth of information, including:
recent news articles about the corporation, projected earnings, research reports, and charts of the stock prices for one day to over 30 years.
A link on E*TRADE's website opens to a wide range of financial ratios for the selected company. A section for AT&T Inc. (stock symbol, T) is shown.
The financial community has assigned names to the most commonly used vertical analysis ratios. For example, profit margin is the name given to the vertical analysis ratio for net income after federal income taxes. E*TRADE uses two methods to help investors compare AT&T's profit margin to other companies in the same industry. The illustration at the top of the next column indicates, from low to high, how the company's ratios compare to those of other companies. AT&T's profit margin, 17.28%, is in the upper range of other communications services companies.
Below the ratios, ETRADE provides an explanation of the ratios. This statement helps ETRADE's customers make more informed investment decisions.
Financial Statement Analysis: Accounting in the Real World: ETrade
Critical Thinking
Access etrade.com and enter a stock symbol to obtain a current stock quote for a company. Use the available links to view its financial ratios. Identify the four ratios shown in the illustration above.
With this information, compare the company's performance to other companies in its industry group.
Financial Statement Analysis: Key Terms
profitability ratio benchmark comparative financial statements trend analysis profit margin gross margin operating margin operating expense ratio solvency ratio debt ratio
horizontal analysis earnings per share market ratio dividend yield price-earnings ratio liquidity ratio working capital current ratio quick assets quick ratio
Chapter 17: Financial Statement Analysis:
Lesson 17-1: Vertical Analysis of an Income Statement
Vertical Analysis Ratios LO Analyzing Trends with Vertical Analysis Using Vertical Analysis to Analyze Gross Profit Using Vertical Analysis to Analyze Operating Expenses End of Lesson Review
LO1 Analyze an income statement using vertical analysis.
Vertical Analysis Ratios LO
Vertical analysis ratios measure the relationship between one financial statement item and another item on the same financial statement. On the income statement, vertical analysis ratios focus on the ability of a business to earn a profit. A ratio that measures the ability of a business to generate income is called a profitability ratio. Vertical analysis ratios on an income statement are examples of profitability ratios.
Managers use vertical analysis ratios to help make business decisions. For vertical analysis to be an effective tool, a business must set a target, or standard, for each ratio. A standard used to compare financial performance is called a benchmark.
Benchmark ratios can be determined using many factors. These include:
- Actual ratios from prior fiscal periods. Current fiscal period ratios tend to be similar to prior-period ratios.
- Industry standards published by industry organizations. A business can be expected to have ratios similar to other businesses in the same industry.
Most managers and investors watch the vertical analysis ratio for gross profit. The ratio is so widely used that it has been given an alternative name. Gross profit as a percent of net sales is called gross margin. This ratio is also referred to as gross profit margin. Online investing sites and company annual reports report gross margins.
ThreeGreen's benchmark gross margin is between 59.5% and 60.5%. ThreeGreen's gross margin has decreased from 60.9% to 58.8% of net sales—an unfavorable trend. The ratio for the current year is lower than the benchmark—also an unfavorable result. Therefore, ThreeGreen's managers need to investigate why this ratio has decreased below the target range.
Correcting an Unfavorable Gross Margin
Two actions can enable a business to achieve its gross margin benchmark:
(1) Increase unit sales prices. The amount a business adds to the cost of merchandise to establish the selling price is called markup. The markup of an item purchased for $4.00 and sold for $10.00 is $6.00. To increase sales revenue, a business may consider increasing its markups. A business must be cautious when increasing its markups. If a markup is too large, a decrease in sales revenue could occur. The higher sales price may exceed what customers are willing to pay. Or, customers may elect to purchase from competing businesses having lower prices.
(2) Decrease the unit cost of merchandise. Decreasing the unit cost of merchandise will increase the gross margin. To decrease its cost of merchandise, a business should review purchasing practices. For example, the business could purchase items in larger quantities or from other vendors that offer a lower cost.
Management may need to take both actions to achieve its gross margin benchmark.
A business must work to maintain or reduce its cost of merchandise. However, gradual increases in the cost of merchandise are unavoidable. Any increase in merchandise costs reduces the gross margin, leaving less gross profit to cover operating expenses. To maintain its target gross margin when the cost of merchandise rises, a business must increase its unit sales prices. Before deciding to increase prices, a business must try to determine the impact that higher prices will have on its sales. Often, it's possible for a business to absorb a lower gross profit by reducing operating expenses.
Unfavorable ratios serve as a warning that management action is necessary. Vertical analysis ratios are an example of how accounting information can help management planning and decision making. Effective managers rely on the information provided from accounting records.
Using Vertical Analysis to Analyze Operating Expenses
The vertical analysis ratio for income from operations, like the gross margin, has an alternate name. Income from operations as a percent of net sales is called the operating margin. This ratio is also referred to as the rate of return on sales. Investors are interested in the operating margin. This ratio gives the best indication of how effectively a business is earning a profit from its normal business operations. ThreeGreen's normal business operations involve the sale of ecologically friendly merchandise. Its operating margin for the current year, 16.4%, means that ThreeGreen nets 16. cents of every dollar of sales before taxes.
Investors can compare the operating margin to other businesses in the same industry to assist them in making investment decisions. However, managers who want to control operating expenses will be more interested in another ratio. Total operating expenses as a percent of net sales is called the operating expense ratio. Unlike the operating margin, the operating expense ratio does not include the effect of merchandise costs.
ThreeGreen's benchmark total operating expense ratio is between 40.0% and 42.0%. Its actual operating expense ratio has declined from 43.9% to 42.4% of net sales—a favorable trend. The current year's ratio is still higher than the target range—an unfavorable result. Therefore, ThreeGreen's managers need to continue their efforts to decrease operating expenses.
An operating expense ratio that is higher than expected only alerts management that there may be a problem. The ratio does not reveal specific problems nor suggest any solutions. Management must investigate individual expense accounts until the reason for the unfavorable ratio is identified.
ThreeGreen should begin by analyzing its largest operating expense, wages and salaries. Salary expense is 29.4% of net sales. In the prior year, salary expense was 29.9% of sales. The decrease in the ratio suggests that ThreeGreen has been effective in managing its salary expense.
ThreeGreen should evaluate each expense. Several courses of action are possible.
(1) Reduce operating expenses. Having identified which operating expenses are higher than expected, management can take action to reduce them. The actions required are often unique to the business and different for each expense account. For example:
Supplies Expense. Employees can be trained to use supplies more efficiently. Management can also try to obtain lower prices from vendors.
Insurance Expense. Management can try to lower its insurance expense by comparing premiums from other insurance companies. The business can also elect to reduce the amount of coverage.
Credit Card Fee Expense. Management can offer customers incentives to pay with cash rather than using a credit card.
(2) Modify the benchmark. Management may be unable to reduce an expense. ThreeGreen's utilities expense has increased from 0.6% to 0.8% of net sales. The local utility company raised its rates during the current year. ThreeGreen changed its thermostat settings to conserve energy. Still, it was unable to offset the rate increases. ThreeGreen may have to accept that its utility expenses will be higher in future fiscal periods.
(3) Increase net sales. Management can offset an increase in operating expenses by increasing net sales. The business can increase its unit sales prices if customers are willing to pay higher prices. The business can also take actions to increase the number of items sold.
It is natural for management to focus on expenses that exceed the target range. However, it may be as important for managers to focus on expenses that fall short of the target range. Spending too little may have a negative impact on the business. Examples:
A store cuts back on the number of sales clerks to reduce the expense of their wages. The action forces customers to stand in long lines to check out. Eventually, customers avoid shopping at the store.
A café reduces its advertising, but loses sales to other restaurants that do more advertising.
To reduce its depreciation expense, a business does not replace its old computer systems. As a result, its employees are less productive. The business might also be unable to take advantage of business opportunities on the Internet.
End of Lesson Review
LO1 Analyze an income statement using vertical analysis.
Terms Review
profitability ratio benchmark comparative financial statements trend analysis
profit margin gross margin operating margin operating expense ratio
Audit Your Understanding
Most companies today offer their employees a 401(k) retirement plan. Since you are likely to change jobs more than 10 times between the ages of 18 and 44, what happens to your employer-sponsored 401(k) when you leave an employer? What are your options? You can do one of the following:
Leave your 401(k) with your former employer. Although your account will remain active, be aware that many companies impose fees to maintain 401(k) accounts for former employees.
Move your 401(k) funds to a different qualified retirement plan. The movement of funds from one qualified retirement plan to another is called a rollover. For example, funds may be withdrawn from your 401(k) plan with a former employer and deposited to another 401(k) offered by your new employer. Or the funds can be rolled over to an individual retirement account (IRA) at a bank or other financial institution, which can give you more flexibility in managing the invested funds. Funds withdrawn from a qualified retirement plan must be rolled over to another qualified plan within 60 days or the IRS will impose taxes and penalties on the amount withdrawn. Rollovers are important to saving for your retirement because they allow your retirement savings to keep growing tax-free.
Take a lump-sum distribution. Some employers will require 401(k) accounts with small balances ($5,000 or less) to be closed. If the funds are taken in cash (not rolled over), the IRS will require the payment of taxes and penalties for early withdrawal. You will also be subject to additional state and local income taxes. Funds in a qualified retirement plan must be left in the plan until at least age 59½ to avoid penalties.
Understand your 401(k) rollover options and make smart choices about your investment future!
Activities
Determine the best option for the following scenarios:
Nathan will soon leave his employer to return to graduate school. What is the best option for his current 401(k) of $15,000? Ashley was just terminated from her employer of five years and has not found another job. What is the best option for her 401(k)? Courtney just obtained a new job and will begin two weeks after her termination from her former job. Her new employer matches 401(k) employee contributions up to 5%. What is the best option for her 401(k)? Nikki has an IRA with a local financial institution. She is considering cashing in her IRA of $18,000 because she needs the full amount for a down payment on a condo. What would you suggest? Why?
Source: Bureau of Labor Statistics.
Chapter 17: Financial Statement Analysis: Lesson 17-2: Vertical Analysis of a Balance Sheet
Lesson 17-2: Vertical Analysis of a Balance Sheet [Click here to add Bookmark]
Calculating Vertical Analysis Ratios on a Balance Sheet LO
Evaluating Vertical Analysis Asset Ratios LO
Evaluating Vertical Analysis Liability Ratios
End of Lesson Review
LO2 Perform vertical analysis of a balance sheet. LO3 Analyze a balance sheet using vertical analysis.
Calculating Vertical Analysis Ratios on a Balance Sheet LO
Lesson 17-2: Vertical Analysis of a Balance Sheet
Vertical analysis ratios measure the relationship between one financial statement item and another item on the same financial statement. On an income statement, each item is divided by net sales. On a balance sheet, each item is divided by the amount of Total Assets.
ThreeGreen's comparative balance sheet contains columns to report the vertical analysis ratios for each year.
Calculating Vertical Analysis Ratios
1 Divide each asset amount by the amount of Total Assets. Round each percent to the nearest 0.1%. For the current year, dividing Total Current Assets, $185,322.90, by Total Assets, $237,367.19, results in 78.1%.
2 Divide each liability and stockholders' equity amount by the amount of Total Assets. For the current year, dividing Total Current Liabilities, $32,251.78, by Total Assets, $237,367.19, results in 13.6%.
A business determines its benchmark vertical analysis ratios for its balance sheet in the same way it determined its income statement ratios. It uses (1) actual ratios from prior fiscal periods, (2) industry standards published by industry organizations, (3) business plans, and (4) unexpected events.
A business should never make a business decision for the sole purpose of meeting a benchmark ratio. However, if the benchmark ratios correctly reflect the company's financial goals, management should consider whether actions are necessary to bring a ratio within the target range.
A leading publication of industry standards presents vertical analysis ratios for only three asset items: net accounts receivable, merchandise inventory, and net plant assets. These items represent the majority of the total assets of a business. Therefore, ThreeGreen closely monitors its vertical analysis ratios for these items.
Correcting an Unfavorable Vertical Analysis Ratio for Accounts Receivable
ThreeGreen has determined that the vertical analysis ratio for accounts receivable should be between 8.0% and 10.0% of total assets. A favorable trend moves the ratio toward 9.0%, the middle of the target range. A ratio below the favorable target range may indicate that ThreeGreen is restricting customers' ability to purchase on account. Credit sales can be an effective tool to increase the revenue of a business. A ratio above the target range may indicate that ThreeGreen is too freely extending credit to its customers. The company might not be able to collect accounts from less creditworthy customers.
ThreeGreen's ratio for accounts receivable has increased from 6.6% to 7.5%—a favorable trend. The current-year ratio, 7.5%, is still below the target range. That ratio should cause management to reevaluate how the company approves credit customers. Allowing more credit sales will likely increase both sales and uncollectible accounts. But, if managed carefully, sales should increase at a higher rate than uncollectible accounts.
Correcting an Unfavorable Vertical Analysis Ratio for Merchandise Inventory
ThreeGreen determines that its vertical analysis ratio for merchandise inventory should be between 42.0% and 45.0% of total assets. A business should strive to have the lowest possible amount of inventory, while ensuring that merchandise is always available when a customer places an order. A ratio below the target range may indicate that the business is not stocking an adequate supply of goods. Or, the business might not stock the right variety of merchandise. The business will lose sales if the right quantity and selection of merchandise are not available for sale. A ratio above the target range may indicate that the business is stocking more merchandise than it needs. Carrying more merchandise than needed can increase some operating expenses, such as rent, utilities, and insurance.
ThreeGreen's ratio for merchandise inventory ratio has declined from 58.4% to 43.3%. The prior-year ratio was higher than the target range. Thus, the decline in the ratio is a favorable trend. The current year's ratio, 43.3%, is within the target range. ThreeGreen prepared a list of its inventory items having the largest cost. Then it assessed whether the
End of Lesson Review
LO2 Perform vertical analysis of a balance sheet. LO3 Analyze a balance sheet using vertical analysis.
Terms Review
solvency ratio debt ratio
Audit Your Understanding
- Why do many retailers perform vertical analysis on the Accounts Receivable and Merchandise Inventory accounts?
- What may cause a vertical analysis ratio for accounts receivable to be below the target range?
- What may cause a vertical analysis ratio for merchandise inventory to be below the target range?
- What should a company do if the vertical analysis ratio for merchandise inventory is above the target range?
- Why is it risky for a business to have too many liabilities?
Work Together 17-
Analyzing a balance sheet
The comparative balance sheet for Tri-State Pipe and a form for completing this problem are given in the Working Papers. Your instructor will guide you through the following examples.
Complete the vertical analysis of the comparative balance sheet. Round percentage calculations to the nearest 0.1%.
Compare actual vertical analysis ratios to Tri-State Pipe's target ratios. Identify whether each ratio indicates a favorable trend and is within management's target range.
On Your Own 17-
Analyzing a balance sheet
The comparative balance sheet for PBH Corporation and a form for completing this problem are given in the Working Papers. Work this problem independently.
Complete the vertical analysis of the comparative balance sheet. Round percentage calculations to the nearest 0.1%.
Compare actual vertical analysis ratios to PBH Corporation's target ratios. Identify whether each ratio indicates a favorable trend and is within management's target range.
Chapter 17: Financial Statement Analysis: Explore Accounting: Forms of Business Organization
Explore Accounting: Forms of Business Organization
When forming a new business, there are several types of organization to choose from. The factors that must be considered in deciding on a form of organization are state and federal requirements, capital needs, taxation, and owner liability. In Part 1 of this textbook, you learned about sole proprietorships. In Parts 2 and 3, the corporate form of business was illustrated. Part 4 will introduce partnerships.
The standard corporate form is the “C” Corporation, named for Subchapter C of the Internal Revenue Code. Below, three forms of business organization not used in this textbook are compared to the C Corporation.
Corporations that have more than 30 stockholders must organize as C Corporations. These must have a board of directors, conduct annual stockholders meetings, and publish financial reports with the SEC and other government agencies. Since all corporate income is taxed, and dividends (paid after federal income tax) are taxed again to the
stockholders, corporate income distributions are taxed twice. However, there are two big advantages to this form of organization. One is limited liability for the owners, which means they cannot be held individually responsible for the liabilities of the company. Their liability is limited to the amount of their investment. The second is the ability to issue stock to raise capital.
S Corporation. These companies are named for Subchapter S of the Internal Revenue Code. They are regular corporations, with fewer than 100 stockholders, that have elected to be taxed in the same way as proprietorships and partnerships. Like C Corporations, these companies must have boards of directors, conduct annual meetings, and file the same reports. Unlike C Corporations, all corporate earnings (and losses) pass through the corporation to the stockholders in proportion to their ownership to be reported on their individual tax returns. That eliminates “double taxation.”
Limited Liability Company (LLC). Owners of limited liability companies are called members. In most states, LLCs can consist of one, two, or more members. Members enjoy the same limited liability as stockholders in a corporation. These entities are not required to maintain boards of directors, conduct annual meetings, or file returns with the SEC. LLCs are not recognized by the IRS for tax purposes, so each must elect to be taxed as a proprietorship, partnership, or corporation.
Limited Liability Partnership (LLP). Many states that allow LLPs limit them to professional organizations—doctors, dentists, lawyers, CPAs, etc. At least two partners are necessary to form an LLP, and most states restrict the number of partners. As a rule, each partner must be registered as either a general or limited partner. Only limited partners enjoy limited liability. Some states require that at least one partner be registered as a general partner. The primary advantage of forming an LLP is that partners can manage their organization and allocate profits and losses among themselves according to their partnership agreement.
Instructions
You own a small, but growing, retail business organized as a proprietorship. You need to raise capital for expansion. Several family members and friends are eager to invest in your business. Which form of organization would be best for you? For your investors? Why?
Chapter 17: Financial Statement Analysis: Why Accounting?: Architecture for Humanity
Why Accounting?: Architecture for Humanity
Almost every person in the world has benefited from the work of an architect. The homes we live in and the schools we attend were designed by architects. Architects provide planning, design, and construction oversight services.
Architecture for Humanity (AH) is a nonprofit organization that provides services for those who cannot afford the services of an architect. AH provides a network of over 40,000 professionals who are ready to contribute their expertise to help others. AH also helps raise funds to cover the costs of construction. Once a structure is built, the city or a local organization must maintain it. So designing durability into structures is a major focus.
AH provides direct services to thousands of people each year. Perhaps its biggest contribution, though, is its Open Architecture Network. This is a website where hundreds of building plans and designs are shared and can be viewed or downloaded for free by anyone around the world.
Critical Thinking
Go to the website for Architecture for Humanity (http://architectureforhumanity.org ). Research one project (in process or completed). In a written report, list the name, a one-paragraph summary, and the location of the project.
Architecture for Humanity gives the following uses for contributions received: 88% spent on construction and design services, 9% spent on administrative costs, and 3% spent on fundraising. Why might AH's accountants collect and distribute this information?
Net income after federal income tax is typically referred to as net income.
ThreeGreen performs a horizontal analysis on its comparative balance sheet. Accounts receivable and plant assets are presented at book value. The horizontal analysis ratios for a balance sheet are calculated using the same steps illustrated for the income statement.
The ratios show that total assets increased by 27.8% during the current year. The increase resulted from a 51.7% increase in stockholders' equity and a 36.1% decrease in liabilities. While these ratios appear to be favorable, only those can properly evaluate them. For example, ThreeGreen's 5.2% decrease in merchandise inventory might be seen as unfavorable by observers outside the company. However, because ThreeGreen took actions to reduce its inventory, its managers view this trend as favorable.
Managers use horizontal analysis ratios to help identify and explain significant trends. Publicly held corporations must file documents with the Securities and Exchange Commission that contain a section titled Management's Discussion and Analysis of Financial Condition and Results of Operations. Management often cites these ratios to explain the current year's results of operations.
End of Lesson Review
LO4 Perform horizontal analysis on an income statement. LO5 Perform horizontal analysis on a balance sheet.
Term Review
horizontal analysis
Audit Your Understanding
- How could a 2.0% decrease in supplies expense be an unfavorable trend?
- How does a publicly held corporation use horizontal analysis when reporting to the Securities and Exchange Commission?
Work Together 17-
- Analyzing financial statements using horizontal analysis
- The comparative financial statements for Tri-State Pipe are given in the Working Papers. Your instructor will guide you through the following example.
- Complete the horizontal analysis of the income statement. Round percentage calculations to the nearest 0.1%.
On Your Own 17-
- Analyzing financial statements using horizontal analysis
- The comparative financial statements for Tri-State Pipe are given in the Working Papers. Work this problem independently.
- Complete the horizontal analysis of the balance sheet. Round percentage calculations to the nearest 0.1%.
Chapter 17: Financial Statement Analysis: Think Like an Accountant: Financial Analysis
Think Like an Accountant: Financial Analysis
For years, BJ's BBQ has expanded by opening new restaurants in major cities in Tennessee and Kentucky. The company performs a market study to identify a city lacking in the number of barbeque restaurants. The company tries to find a building previously occupied by another restaurant. The building is then renovated to reflect the casual, campfire style that has made BJ's BBQ a regional favorite.
Each month, the company performs a financial analysis of its financial statements. The analysis includes vertical analysis and other classic ratios. The company also calculates a set of ratios unique to restaurants. BJ's strives to increase each of these ratios over time.
Average ticket price: Dollar sales divided by the number of sales tickets. BJ's offers specials that encourage patrons to purchase additional items, such as beverages and desserts.
Sales per square foot: Dollar sales per day divided by square footage in the dining area. This ratio measures how effectively the company's dining area generates sales.
Table turns: The number of tickets per day divided by the number of tables. This ratio indicates how effectively the restaurant is servicing customers. BJ's offers early dinner specials in an effort to attract customers and increase its table turns ratio. BJ's BBQ has a table turns ratio of 4.39, meaning that just over four groups of customers are served daily at each table.
In a surprise move, the chief executive officer has announced his plan to purchase Barbeque Hut, a chain of 16 restaurants in North Carolina and Virginia. Before the deal closes, however, he has asked you to analyze the financial statements of the company.
Open the Spreadsheet TLA_CH
Follow the steps on the Instructions tab. The worksheet on the Analysis tab contains five-year information for Barbeque Hut. Calculate the three ratios described above. On the Charts tab, create charts to contrast the ratios for BJ's BBQ and Barbeque Hut. Use the charts to answer the following questions.
Is Barbeque Hut effective in increasing its ratios over the five-year period? Explain.
Based on the information provided, would you recommend that the company continue to pursue the purchase of Barbeque Hut?
Chapter 17: Financial Statement Analysis: Lesson 17-4: Analyzing Financial Statements Using Financial Ratios Lesson 17-4: Analyzing Financial Statements Using Financial Ratios LO6 Calculate earnings per share. LO7 Calculate and interpret market ratios. LO8 Calculate and interpret liquidity ratios.
Net income after federal income tax divided by the number of outstanding shares of stock is called earnings per share. Earnings per share is often abbreviated as EPS. EPS is the most widely recognized measure of a corporation's financial performance. Corporations must include earnings per share on income statements submitted to the Securities and Exchange Commission.
There are no industry standards for earnings per share. Nor can a corporation's EPS be compared to the EPS of other corporations. Each corporation's EPS is a unique number because corporations can issue any number of shares. The earnings of each corporation are divided by a different number of shares. ThreeGreen's earnings per share would be different if it had issued more shares. ThreeGreen issued 7,500 shares of $10.00 par value stock, raising $75,000 of capital. If ThreeGreen had elected to issue 75,000 shares of $1.00 par value stock, it would still have raised $75,000 of capital. But the decision would have had a dramatic impact on EPS.
A corporation's earnings per share can only be compared to (1) the prior period's earnings per share and (2) projected earnings per share. Many corporations share estimates of their projected earnings per share with investors. A corporation strives to have its actual EPS increase from the prior year and to meet or exceed projections. Horizontal analysis can be used to calculate the change in EPS from prior years.
Working capital should not be confused with cash. ThreeGreen does not have $153,071.12 in cash. The company does have $153,071.12 of assets that are available for use in daily operations of the business.
Current Ratio
A business cannot compare itself to industry standards based on the value of its working capital. Nor is a horizontal analysis of working capital meaningful. A more useful measure is needed.
A ratio that measures the relationship of current assets to current liabilities is called the current ratio. The current ratio measures a company's ability to pay its current liabilities when due.
On December 31 of the current year, ThreeGreen calculated its current ratio at 5.75, as shown below. The current ratio may be stated as 5.75 to 1. ThreeGreen's current assets are 5.75 times its current liabilities. Based on previous experience, industry guidelines, and the need to maintain sufficient merchandise inventory, ThreeGreen wants to maintain a current ratio between 4.0 and 6.0. ThreeGreen's current ratio of 5.75 is within the target range and a favorable indication of its financial strength.
Quick Ratio
The current ratio assumes a business could sell its merchandise inventory quickly to pay its current liabilities. For many businesses, that may not be possible. Thus, some creditors prefer to use a more conservative measure of liquidity. Cash and other current assets that can be quickly converted into cash are called quick assets. Quick assets are also referred to as liquid assets. ThreeGreen's quick assets include cash, petty cash, and the book value of accounts receivable. A ratio that measures the relationship of quick assets to current liabilities is called the quick ratio.
On December 31 of the current year, ThreeGreen's quick ratio was 2.24. The quick ratio may be stated as 2.24 to 1. ThreeGreen's quick assets are 2.24 times its current liabilities. Most businesses strive to have a quick ratio of at least 1.00. ThreeGreen wants to maintain a quick ratio between 2.00 and 3.00, so 2.24 is within the target range and a favorable indication of its liquidity.
Liquidity ratios are used by managers, vendors, and creditors to help determine the ability of a business to meet its current debt obligations.
End of Lesson Review
LO6 Calculate earnings per share. LO7 Calculate and interpret market ratios. LO8 Calculate and interpret liquidity ratios.
Terms Review
earnings per share market ratio dividend yield price-earnings ratio liquidity ratio
working capital current ratio quick assets quick ratio
Audit Your Understanding
- Why can one corporation's earnings per share not be compared to the EPS of other corporations?
- What group is the primary user of market ratios?
- Do income stocks typically have low or high dividend yields?
- Do growth stocks typically have low or high price-earnings ratios?
- What is the primary source of data to calculate liquidity ratios?
- What does working capital measure?
- Why is the current ratio a useful measure of financial strength?
Work Together 17-
Analyzing financial statements using financial ratios
Selected financial information for Eagle Corporation is presented below. A form for completing this problem is given in the Working Papers. Your instructor will guide you through the following example.
Net income after federal income taxes $148,186.
Number of shares outstanding 40,
Dividends per share $2.
Market price $37.
Quick assets $484,943.
Current assets $604,984.
Current liabilities $418,493.
- Calculate the (a) earnings per share, (b) dividend yield, and (c) price-earnings ratio. Round the dividend yield to the nearest 0.01%. Round the P/E ratio to the nearest 0.1.
- Evaluate each ratio relative to prior-year ratios. Investors consider Eagle Corporation to be an income stock.
- Calculate the (a) working capital and (b) current and quick ratios. Round ratios to the nearest 0.01.
- Determine if the liquidity ratios are within management's target range.
On Your Own 17-
Analyzing financial statements using financial ratios
Selected financial information for Mid-State Corporation is presented below. A form for completing this problem is given in the Working Papers. Work this problem independently.
Net income after federal income taxes $6,118,089.
Number of shares outstanding 8,500,
Dividends per share $0.
Market price $42.
Quick assets $2,814,974.
Current assets $4,657,856.
Current liabilities $3,253,053.
- Calculate the (a) earnings per share, (b) dividend yield, and (c) price-earnings ratio. Round the dividend yield to the nearest 0.01%. Round the P/E ratio to the nearest 0.1.
- Evaluate each ratio relative to prior-year ratios. Investors consider Mid-State Corporation to be a growth stock.
- Calculate the (a) working capital and (b) current and quick ratios. Round ratios to the nearest 0.01.
- Determine if the liquidity ratios are within management's target range.
Chapter 17: Financial Statement Analysis: Careers in Accounting
In this chapter, you learned about comparative financial statements and trend analysis. The comparative income statement in the chapter compares the current year to the prior year. While that is a common and useful analysis, managers often need a longer-term view.
Some high-end accounting software systems come with preformatted reports similar to the one illustrated here. However, this report could be created in most accounting systems using the custom report tools supplied in the software. Five-year comparative statements like this one are especially useful to investors and creditors. They are also useful to management for making more accurate projections of future revenue, expenses, and net income.
Some financial analysts argue that a comparison of two sequential periods only indicates the direction of a change. They contend that it requires three or more periods to reveal a trend. Several trends can be seen in this five-year comparative statement. Can you identify some of them?
1 Music Mania, Inc., is a retail merchandising business that sells musical instruments and supplies.
2 This report shows five years of income statements. For each year, it includes columns for a vertical analysis and the percent change from the prior year. Analysts commonly use the symbol Δ (delta) to represent an amount of change.
3 Computerized accounting systems generally put limits on the number of characters or numbers that can be entered in a particular type of field. For example, the account titles on this report are limited to 26 characters, including spaces and punctuation. The reason for limiting field lengths is clear when the fields are displayed in columns on a report such as this one.
4 When a report is being designed, numerical fields, shown here in dollars and cents, can be rounded to the nearest dollar or the nearest thousand dollars (000). The point is to show the amount of detail that will be meaningful to the reader and still be easy to read.
5 The designer of this report chose to use a shaded-bar style. For long reports, the bars aid the reader in following data across the page.
Financial Statement Analysis: Chapter Summary
Financial ratios allow managers to compare the financial performance of a business to established benchmarks. Management can determine benchmark ratios using many factors, including (1) actual ratios from prior fiscal periods, (2) industry standards published by industry organizations, (3) business plans, and (4) unexpected events. Organizations that publish industry standards analyze large numbers of financial statements to develop average financial ratios by industry.
Benchmark ratios are often stated in terms of a target range. When a ratio falls outside the target range, the business should investigate what factors or events resulted in the unfavorable results.
Vertical analysis ratios measure the relationship between one financial statement item and the total that includes that item. For an income statement, the total is net sales. For a balance sheet, total assets or the sum of total liabilities plus stockholder's equity are used. However, since those two totals are equal, total assets can be used to calculate all vertical analysis ratios on the balance sheet. Certain vertical analysis ratios have alternate names, including the gross margin, operating margin, profit margin, and debt ratio.
Horizontal analysis focuses on the percentage change in a financial statement amount between fiscal periods. A horizontal analysis ratio is calculated by dividing the difference of the current- and prior-period amounts by the prior- period amount.
Earnings per share (EPS) is likely the most widely recognized financial ratio. EPS is unique to each corporation. There are no industry benchmarks for EPS. However, managers and investors can use horizontal analysis to compare the current period's EPS to those of prior periods.
Financial ratios can be classified as profitability, solvency, market, and liquidity ratios. Each ratio measures a certain aspect of a corporation's operations. These ratios can be compared to benchmark ratios to measure the corporation's performance.
Financial Statement Analysis: Explore Accounting
Annual Reports—Financial Information and More
Corporations publish annual reports to communicate the results of operations to interested parties, such as stockholders, creditors, and government agencies. The typical annual report is a colorful, soft-cover brochure printed on glossy paper and 40 to 60 pages in length. Most companies encourage their stockholders to register for electronic delivery of the annual report. Other individuals can access the annual report on the corporation's website. The reports are grouped in two sections:
- Management's Analysis and Discussion. This section provides management with an opportunity to promote the corporation. Through the use of pictures, graphs, and narrative, management can highlight the achievements of the past fiscal year and present its plans. Some corporations report on how the volunteer work of their employees is having a positive impact in their communities. They might include discussions of environmental and recycling programs to demonstrate efforts toward social responsibility.
The ultimate objective of any corporation is to increase the market price of its stock, thereby raising stockholders' investment. By “putting its best foot forward” in this section, management can increase the demand for the corporation's products and stock, thus increasing the stock's price.
- Financial Statements. This section contains several items in addition to the basic financial statements. Most of the additional items are required by GAAP or the Securities and Exchange Commission. As a result, these items are similar among corporations.
a. Notes to the Financial Statements. The notes contain additional, detailed information about items presented on the financial statements. For example, the note related to long-term debt would include the projected loan repayments for the next five years.
b. Auditor's Report. The report of the independent auditor states that a public accounting firm has tested the financial statements and found them accurate and free of misrepresentation. The auditor's report is not meant as an endorsement of the corporation's investment quality. It does, however, give the reader confidence to use the financial statements to make business or investment decisions.
c. Financial Analysis. Summary financial information, such as total assets, net income, and common financial ratios, is presented for several years.
Instructions
Access an annual report using a library or the Internet. Prepare a detailed outline of its contents. Summarize the major topics in management's analysis and discussion. Did management do a good job of “putting its best foot forward”? Would you recommend that a friend purchase the corporation's stock? Support your answers.
Financial Statement Analysis: Apply Your Understanding: Application Problem
