Indirect Method vs. Direct Method and Horizontal vs. Vertical Analysis

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13

Financial Analysis: The Big Picture

 CHAPTER PREVIEW 

We can all learn an important lesson from Warren Buffett: Study companies carefully if you wish to invest. Do not get caught up in fads but instead �ind companies that are �inancially healthy. Using some of the basic decision tools presented in this textbook, you can perform a rudimentary analysis on any company and draw basic conclusions about its �inancial health. Although it would not be wise for you to bet your life savings on a company's stock relying solely on your current level of knowledge, we strongly encourage you to practice your new skills wherever possible. Only with practice will you improve your ability to interpret �inancial numbers.

Before we unleash you on the world of high �inance, we present a few more important concepts and techniques as well as one more comprehensive review of corporate �inancial statements. We use all of the decision tools presented in this textbook to analyze a single company, with comparisons to a competitor and industry averages.

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It Pays to Be Patient

A recent issue of Forbes magazine listed Warren Buffett as the second richest person in the world. His estimated wealth was $69 billion, give or take a few million. How much is $69 billion? If you invested $69 billion in an investment earning just 4%, you could spend $7.6 million per day—every day—forever.

So, how does Buffett spend his money? Basically, he doesn't! He still lives in the same house that he purchased in Omaha, Nebraska, in 1958 for $31,500. He still drives his own car (a Cadillac DTS). And, in case you were thinking that his kids are riding the road to Easy Street, think again. Buffett has committed to donate virtually all of his money to charity before he dies.

How did Buffett amass this wealth? Through careful investing. Buffett epitomizes a “value investor.” He applies the basic techniques he learned in the 1950s from the great value investor Benjamin Graham. He looks for companies that have good long-term potential but are currently underpriced. He invests in companies that have low exposure to debt and that reinvest their earnings for future growth. He does not get caught up in fads or the latest trends.

For example, Buffett sat out on the dot-com mania in the 1990s. When other investors put lots of money into �ledgling high-tech �irms, Buffett didn't bite because he did not �ind dot-com companies that met his criteria. He didn't get to enjoy the stock price boom on the way up, but on the other hand, he didn't have to ride the price back down to Earth. When the dot-com bubble burst, everyone else was suffering from investment shock. Buffett swooped in and scooped up deals on companies that he had been following for years.

In 2012, the stock market had again reached near record highs. Buffett's returns had been signi�icantly lagging the market. Only 26% of his investments at that time were in stock, and he was sitting on $38 billion in cash. One commentator noted that “if the past is any guide, just when Buffett seems to look most like a loser, the party is about to end.”

If you think you want to follow Buffett's example and transform your humble nest egg into a mountain of cash, be warned. His techniques have been widely circulated and emulated, but never practiced with the same degree of success. You should probably start by honing your �inancial analysis skills. A good way for you to begin your career as a successful investor is to master the fundamentals of �inancial analysis discussed in this chapter.

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Source: Jason Zweig, “Buffett Is Out of Step,” Wall Street Journal (May 7, 2012).

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LEARNING OBJECTIVE 1

Apply the concepts of sustainable income and quality of earnings. 

SUSTAINABLE INCOME The value of a company like Google is a function of the amount, timing, and uncertainty of its future cash �lows. Google's current and past income statements are particularly useful in helping analysts predict these future cash �lows. In using this approach, analysts must make sure that Google's past income numbers re�lect its sustainable income, that is, do not include unusual (out-of-the-ordinary) revenues, expenses, gains, and losses. Sustainable income is, therefore, the most likely level of income to be obtained by a company in the future. Sustainable income differs from actual net income by the amount of unusual revenues, expenses, gains, and losses included in the current year's income. Analysts are interested in sustainable income because it helps them derive an estimate of future earnings without the “noise” of unusual items.

Fortunately, an income statement provides information on sustainable income by separating operating transactions from nonoperating transactions. This statement also highlights intermediate components of income such as income from operations, income before income taxes, and income from continuing operations. In addition, information on unusual items such as gains or losses on discontinued items and components of other comprehensive income are disclosed.

Illustration 13-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0001) presents a statement of comprehensive income for Cruz Company for the year 2017. A statement of comprehensive income includes not only net income but a broader measure of income called comprehensive income. (Recall that in Chapter 5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) we instead presented comprehensive income in a separate statement called a comprehensive income statement. Both approaches are allowed under GAAP.) The two major unusual items in this statement are discontinued operations and other comprehensive income (highlighted in red). When estimating future cash �lows, analysts must consider the implications of each of these components.

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ILLUSTRATION 13-1 Statement of comprehensive income

In looking at Illustration 13-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0001) , note that Cruz Company's two major types of unusual items, discontinued operations and other comprehensive income, are reported net of tax. That is, Cruz �irst calculates income tax expense before income from continuing operations. Then, it calculates income tax expense related to the discontinued operations and other comprehensive income. The general concept is, “Let the tax follow the income or loss.” We discuss discontinued operations and other comprehensive income in more detail next.

Discontinued Operations

Discontinued operations refers to the disposal of a signi�icant component of a business, such as the elimination of a major class of customers or an entire activity. For example, to downsize its operations, General Dynamics Corp. sold its missile business to Hughes Aircraft Co. for $450 million. In its statement of comprehensive income, General Dynamics reported the sale in a separate section entitled “Discontinued operations.”

Following the disposal of a signi�icant component, the company should report on its statement both income from continuing operations and income (or loss) from discontinued operations. The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component.

To illustrate, assume that during 2017 Acro Energy Inc. has income before income taxes of $800,000. During 2017, Acro discontinued and sold its unpro�itable chemical division. The loss in 2017 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate on income, Illustration 13-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0002) shows Acro's statement of comprehensive income presentation.

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ILLUSTRATION 13-2 Statement presentation of discontinued operations

Note that the statement uses the caption “Income from continuing operations” and adds a new section “Discontinued operations.” The new section reports both the operating loss and the loss on disposal net of applicable income taxes. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income.

INVESTOR INSIGHT   What Does “Non-Recurring” Really Mean?

Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non-recurring” charges, to suggest that they are isolated events, unlikely to occur in future periods. The question for analysts is, are these costs really one-time, “non-recurring events” or do they re�lect problems that the company will be facing for many periods in the future? If they are one-time events, then they can be largely ignored when trying to predict future earnings.

But, some companies report “one-time” restructuring charges over and over again. For example, Procter & Gamble reported a restructuring charge in 12 consecutive quarters, and Motorola had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a 5- or 10-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.

If a company takes a large restructuring charge, what is the effect on the company's current income statement versus future ones? (Go to WileyPLUS for this answer and additional questions.)

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DECISION TOOLS

The discontinued operations section alerts users to the sale of any of a company's major components of its business.

▼ HELPFUL HINT

Observe the dual disclosures: (1) the results of operation of the discontinued division must be eliminated from the results of continuing operations, and (2) the company must also report the disposal of the division.

Comprehensive Income

Most revenues, expenses, gains, and losses are included in net income. However, as discussed in earlier chapters, certain gains and losses that bypass net income are reported as part of a more inclusive earnings measure called comprehensive income. Comprehensive income is the sum of net income and other comprehensive income items.1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13ifrs#c13-note-0003)

ILLUSTRATION OF COMPREHENSIVE INCOME

Accounting standards require that companies adjust most investments in stocks and bonds up or down to their market price at the end of each accounting period. For example, assume that during 2017, its �irst year of operations, Stassi Corporation purchased IBM stock for $10,000 as an investment. At the end of 2017, Stassi was still holding the investment, but the stock's market price was now $8,000. In this case, Stassi is required to reduce the recorded value of its IBM investment by $2,000. The $2,000 difference is an unrealized loss.

Should Stassi include this $2,000 unrealized loss in net income? It depends on whether Stassi classi�ies the IBM stock as a trading security or an available-for-sale security. A trading security is bought and held primarily for sale in the near term to generate income on short-term price differences. Companies report unrealized losses on trading securities in the “Other expenses and losses” section of the income statement. The rationale: It is likely that the company will realize the unrealized loss (or an unrealized gain), so the company should report the loss (gain) as part of net income.

If Stassi did not purchase the investment for trading purposes, it is classi�ied as available-for-sale. Available-for-sale securities are held with the intent of selling them sometime in the future. Companies do not include unrealized gains or losses on available-for-sale securities in net income. Instead, they report them as part of “Other comprehensive income.” Other comprehensive income is not included in net income.

FORMAT

As shown in Chapter 5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch05#ch05) , one format for reporting other comprehensive income is to report a separate comprehensive income

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statement. For example, assuming that Stassi Corporation has a net income of $300,000, the unrealized loss would be reported below net income as follows.

ILLUSTRATION 13-3 Lower portion of combined statement of income and comprehensive income

As discussed in Chapter 11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11#ch11) , companies report the cumulative amount of other comprehensive income from all years as a separate component of stockholders' equity. To illustrate, assume Stassi has common stock of $3,000,000, retained earnings of $300,000, and accumulated other comprehensive loss of $2,000. (To simplify, we are assuming that this is Stassi's �irst year of operations. Since it has only operated for one year, the cumulative amount of other comprehensive income is this year's loss of $2,000.) Illustration 13-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0004) shows the balance sheet presentation of the accumulated other comprehensive loss.

ILLUSTRATION 13-4 Unrealized loss in stockholders' equity section

Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury stock in the stockholders' equity section. (An unrealized gain would be added in this section of the balance sheet.)

COMPLETE STATEMENT OF COMPREHENSIVE INCOME

As seen in Illustration 13-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0001) , as an alternative to preparing a separate comprehensive income statement, many companies report net income and other comprehensive income in a combined statement of comprehensive income. (For your homework in this chapter, use this combined format.) The statement of comprehensive income for Pace Corporation in Illustration 13-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0005) presents the types of items found on this statement, such as net sales, cost of goods sold, operating

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expenses, and income taxes. In addition, it shows how companies report discontinued operations and other comprehensive income (highlighted in red).

ILLUSTRATION 13-5 Complete statement of comprehensive income

Changes in Accounting Principle

For ease of comparison, users of �inancial statements expect companies to prepare their statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. An example is a change in inventory costing methods (such as FIFO to average-cost). Accounting rules permit a change when management can show that the new principle is preferable to the old principle.

Companies report most changes in accounting principle retroactively.2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13ifrs#c13-note-0005) That is, they report both the current period and previous periods using the new principle. As a result, the same principle applies in all periods. This treatment improves the ability to compare results across years.

INVESTOR INSIGHT  

United Parcel Service (UPS)

More Frequent Ups and Downs

In the past, U.S. companies used a method to account for their pension plans that smoothed out the gains and losses on their pension portfolios by spreading gains and

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losses over multiple years. Many felt that this approach was bene�icial because it reduced the volatility of reported net income. However, recently some companies have opted to adopt a method that comes closer to recognizing gains and losses in the period in which they occur. Some of the companies that have adopted this approach are United Parcel Service (UPS), Honeywell International, IBM, AT&T, and Verizon Communications. The CFO at UPS said he favored the new approach because “events that occurred in prior years will no longer distort current-year results. It will result in better transparency by eliminating the noise of past plan performance.” When UPS switched, it resulted in a charge of $827 million from the change in accounting principle.

Source: Bob Sechler and Doug Cameron, “UPS Alters Pension-Plan Accounting,” Wall Street Journal (January 30, 2012).

When predicting future earnings, how should analysts treat the one-time charge that results from a switch to the different approach for accounting for pension plans? (Go to WileyPLUS for this answer and additional questions.)

DECISION TOOLS

Informing users of a change in accounting principle helps them determine the effect of this change on current and prior periods.

QUALITY OF EARNINGS The quality of a company's earnings is of extreme importance to analysts. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the �inancial statements.

Recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. Here are some of the factors affecting quality of earnings.

Alternative Accounting Methods

Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings. For example, suppose one company uses the FIFO method of inventory costing, while another company in the same industry uses LIFO. If inventory is a signi�icant asset to both companies, it is unlikely that their current ratios are comparable. For example, if General

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Motors Corporation used FIFO instead of LIFO for inventory valuation, its inventories in a recent year would have been 26% higher, which signi�icantly affects the current ratio (and other ratios as well).

In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation and amortization. Although these differences in accounting methods might be detectable from reading the notes to the �inancial statements, adjusting the �inancial data to compensate for the different methods is often dif�icult, if not impossible.

Pro Forma Income

Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent years, many companies have been also reporting a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non-recurring. For example, in a recent year, Cisco Systems (a high-tech company) reported a quarterly net loss under GAAP of $2.7 billion. Cisco reported pro forma income for the same quarter as a pro�it of $230 million. This large difference in pro�its between GAAP income numbers and pro forma income is not unusual. For example, during one nine-month period, the 100 largest companies on the Nasdaq stock exchange reported a total pro forma income of $19.1 billion but a total loss as measured by GAAP of $82.3 billion—a difference of about $100 billion!

To compute pro forma income, companies generally exclude any items they deem inappropriate for measuring their performance. Many analysts and investors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the �inancial press noted, pro forma numbers might be called “earnings before bad stuff.” Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non-recurring expenses. “Cisco's technique gives readers of �inancial statements a clear picture of Cisco's normal business activities,” the company said in a statement issued in response to questions about its pro forma income accounting.

Recently, the SEC provided some guidance on how companies should present pro forma information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company's sustainable income. However, many companies have abused the �lexibility that pro forma numbers allow and have used the measure as a way to put their companies in a more favorable light.

Improper Recognition

Because some managers feel pressure from Wall Street to continually increase earnings, they manipulate earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that some companies use is called channel stuf�ing. Offering deep discounts, companies encourage customers to buy early (stuff the channel) rather than later. This boosts earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. To illustrate, Bristol-Myers Squibb at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than they needed. As a result, the company had to issue revised �inancial statements showing corrected revenues and income.

Another practice is the improper capitalization of operating expenses. WorldCom capitalized over $7 billion of operating expenses in order to report positive net income. In other situations, companies fail to report all their liabilities. Enron promised to make payments on certain contracts if �inancial dif�iculty

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developed, but these guarantees were not reported as liabilities. In addition, disclosure was so lacking in transparency that it was impossible to understand what was happening at the company.

DO IT! 1

Unusual Items

In its proposed 2017 income statement, AIR Corporation reports income before income taxes $400,000, unrealized gain on available-for-sale securities $100,000, income taxes $120,000 (not including unusual items), loss from operation of discontinued �lower division $50,000, and loss on disposal of discontinued �lower division $90,000. The income tax rate is 30%. Prepare a correct statement of comprehensive income, beginning with “Income before income taxes.”

Action Plan ✓ Show discontinued operations and other comprehensive

income net of tax.

SOLUTION

Related exercise material: BE13-1, BE13-2, DO IT! 13-1, E13-1, and E13-2.

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LEARNING OBJECTIVE 2

Apply horizontal analysis and vertical analysis. 

As indicated, in assessing the �inancial performance of a company, investors are interested in the core or sustainable earnings of a company. In addition, investors are interested in making comparisons from period to period. Throughout this textbook, we have relied on three types of comparisons to improve the decision-usefulness of �inancial information:

1. Intracompany basis. Comparisons within a company are often useful to detect changes in �inancial relationships and signi�icant trends. For example, a comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. Likewise, a comparison of Kellogg's year-end cash amount with the amount of its total assets at year-end shows the proportion of total assets in the form of cash.

2. Intercompany basis. Comparisons with other companies provide insight into a company's competitive position. For example, investors can compare Kellogg's total sales for the year with the total sales of its competitors in the breakfast cereal area, such as General Mills.

3. Industry averages. Comparisons with industry averages provide information about a company's relative position within the industry. For example, �inancial statement readers can compare Kellogg's �inancial data with the averages for its industry compiled by �inancial rating organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's, or with information provided on the Internet by organizations such as Yahoo! on its �inancial site.

We use three basic tools in �inancial statement analysis to highlight the signi�icance of �inancial statement data:

1. Horizontal analysis

2. Vertical analysis

3. Ratio analysis

In previous chapters, we relied primarily on ratio analysis, supplemented with some basic horizontal and vertical analysis. In the remainder of this section, we introduce more formal forms of horizontal and vertical analysis. In the next section, we review ratio analysis in some detail.

INTERNATIONAL NOTE As more countries adopt IFRS, the ability of analysts to compare companies from different countries should improve. However, IFRSs are open to widely

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varying interpretations. In addition, some countries adopt IFRS “with modi�ications.” As a consequence, most cross-country comparisons are still not as transparent as within-country comparisons.

HORIZONTAL ANALYSIS Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of �inancial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. For example, here are recent net sales �igures (in thousands) of Chicago Cereal Company:

2014 2013 2012 2011 2010 $11,776 $10,907 $10,177 $9,614 $8,812

If we assume that 2010 is the base year, we can measure all percentage increases or decreases relative to this base-period amount with the formula shown in Illustration 13-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0006) .

ILLUSTRATION 13-6 Horizontal analysis—computation of changes since base period

For example, we can determine that net sales for Chicago Cereal increased approximately 9.1% [($9,614− $8,812)÷$8,812] from 2010 to 2011. Similarly, we can also determine that net sales increased by 33.6% [($11,776−$8,812)÷$8,812] from 2010 to 2014.

Alternatively, we can express current-year sales as a percentage of the base period. To do so, we would divide the current-year amount by the base-year amount, as shown in Illustration 13-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0007) .

ILLUSTRATION 13-7 Horizontal analysis—computation of current year in relation to base year

Current-period sales expressed as a percentage of the base period for each of the �ive years, using 2010 as the base period, are shown in Illustration 13-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0008) .

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ILLUSTRATION 13-8 Horizontal analysis of net sales

The large increase in net sales during 2011 would raise questions regarding possible reasons for such a signi�icant change. Chicago Cereal's 2011 notes to the �inancial statements explain that the company completed an acquisition of Elf Foods Company during 2011. This major acquisition would help explain the increase in sales highlighted by horizontal analysis.

To further illustrate horizontal analysis, we use the �inancial statements of Chicago Cereal Company. Its two-year condensed balance sheets for 2014 and 2013, showing dollar and percentage changes, are presented in Illustration 13-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0009) (page 656).

ILLUSTRATION 13-9 Horizontal analysis of balance sheets

The comparative balance sheets show that a number of changes occurred in Chicago Cereal's �inancial position from 2013 to 2014. In the assets section, current assets increased $290,000, or 11.9% ($290÷$2,427), and property assets (net) increased $174,000, or 6.2%. Other assets increased $219,000, or 4.0%. In the liabilities section, current liabilities increased $24,000, or 0.6%, while long-term liabilities increased $202,000, or 4.4%. In the stockholders' equity section, we �ind that retained earnings increased $806,000, or 31.2%.

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Illustration 13-10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig- 0010) presents two-year comparative income statements of Chicago Cereal Company for 2014 and 2013, showing dollar and percentage changes.

ILLUSTRATION 13-10 Horizontal analysis of income statements

Horizontal analysis of the income statements shows the following changes. Net sales increased $869,000, or 8.0% ($869÷$10,907). Cost of goods sold increased $515,000, or 8.5% ($515÷$6,082). Selling and administrative expenses increased $252,000, or 8.2% ($252÷$3,059). Overall, gross pro�it increased 7.3% and net income increased 9.9%. The increase in net income can be attributed to the increase in net sales and a decrease in income tax expense.

The measurement of changes from period to period in percentages is relatively straightforward and quite useful. However, complications can result in making the computations. If an item has no value in a base year or preceding year and a value in the next year, no percentage change can be computed. Likewise, no percentage change can be computed if a negative amount appears in the base or preceding period and a positive amount exists the following year.

DECISION TOOLS

Horizontal analysis helps users compare a company's �inancial position and operating results with those of the previous period.

▼ HELPFUL HINT

When using horizontal analysis, be sure to examine both dollar amount changes and percentage changes. It is not necessarily bad if a company's

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earnings are growing at a declining rate. The amount of increase may be the same as or more than the base year, but the percentage change may be less because the base is greater each year.

▼ HELPFUL HINT

Note that, in a horizontal analysis, while the amount column is additive (the total is $99,000), the percentage column is not additive (9.9% is not a total).

VERTICAL ANALYSIS Vertical analysis, also called common-size analysis, is a technique for evaluating �inancial statement data that expresses each item in a �inancial statement as a percentage of a base amount. For example, on a balance sheet we might express current assets as 22% of total assets (total assets being the base amount). Or, on an income statement we might express selling expenses as 16% of net sales (net sales being the base amount).

Presented in Illustration 13-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0011) are the comparative balance sheets of Chicago Cereal for 2014 and 2013, analyzed vertically. The base for the asset items is total assets, and the base for the liability and stockholders' equity items is total liabilities and stockholders' equity.

ILLUSTRATION 13-11 Vertical analysis of balance sheets

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In addition to showing the relative size of each category on the balance sheets, vertical analysis can show the percentage change in the individual asset, liability, and stockholders' equity items. In this case, current assets increased $290,000 from 2013 to 2014, and they increased from 22.6% to 23.8% of total assets. Property assets (net) decreased from 26.3% to 26.2% of total assets. Other assets decreased from 51.1% to 50.0% of total assets. Also, retained earnings increased by $806,000 from 2013 to 2014, and total stockholders' equity increased from 19.3% to 22.1% of total liabilities and stockholders' equity. This switch to a higher percentage of equity �inancing has two causes. First, while total liabilities increased by $226,000, the percentage of liabilities declined from 80.7% to 77.9% of total liabilities and stockholders' equity. Second, retained earnings increased by $806,000, from 24.1% to 29.7% of total liabilities and stockholders' equity. Thus, the company shifted toward equity �inancing by relying less on debt and by increasing the amount of retained earnings.

Vertical analysis of the comparative income statements of Chicago Cereal, shown in Illustration 13-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0012) , reveals that cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%, and selling and administrative expenses increased from 28.0% to 28.1%. Net income as a percentage of net sales increased from 9.1% to 9.4%. Chicago Cereal's increase in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense as a percentage of sales.

ILLUSTRATION 13-12 Vertical analysis of income statements

Vertical analysis also enables you to compare companies of different sizes. For example, one of Chicago Cereal's competitors is General Mills. General Mills' sales are 1,000 times larger than those of Chicago Cereal. Vertical analysis enables us to meaningfully compare the condensed income statements of Chicago Cereal and General Mills, as shown in Illustration 13-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo2#c13-�ig-0013) .

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ILLUSTRATION 13-13 Intercompany comparison by vertical analysis

Although Chicago Cereal's net sales are much less than those of General Mills, vertical analysis eliminates the impact of this size difference for our analysis. Chicago Cereal has a higher gross pro�it percentage 44.0%, compared to 35.6% for General Mills. But, Chicago Cereal's selling and administrative expenses are 28.1% of net sales, while those of General Mills are 19.4% of net sales. Looking at net income, we see that General Mills' percentage is higher. Chicago Cereal's net income as a percentage of net sales is 9.4%, compared to 10.2% for General Mills.

ANATOMY OF A FRAUD

This �inal Anatomy of a Fraud box demonstrates that sometimes relationships between numbers can be used to detect fraud. Financial ratios that appear abnormal or statistical abnormalities in the numbers themselves can reveal fraud. For example, the fact that WorldCom's line costs, as a percentage of either total expenses or revenues, differed very signi�icantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank's credit card department. The manager's friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write-off balances of less than $5,000 without seeking supervisor approval. The fraud was detected by applying statistical analysis based on Benford's Law. Benford's Law states that in a random collection of numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the �irst two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random.

Total take: Thousands of dollars

THE MISSING CONTROL

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Independent internal veri�ication. While it might be ef�icient to allow employees to write off accounts below a certain level, it is important that these write-offs be reviewed and veri�ied periodically. Such a review would likely call attention to an employee with large amounts of write-offs, or in this case, write-offs that were frequently very close to the approval threshold.

Source: Mark J. Nigrini, “I've Got Your Number,” Journal of Accountancy Online (May 1999).

DO IT! 2

Horizontal Analysis

Summary �inancial information for Rosepatch Company is as follows.

December 31, 2017 December 31, 2016 Current assets $234,000 $180,000 Plant assets (net)  756,000  420,000 Total assets $990,000 $600,000

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

Action Plan ✓ Find the percentage change by dividing the amount of the

increase by the 2016 amount (base year).

SOLUTION

Related exercise material: BE13-4, BE13-6, BE13-7, BE13-9, DO IT! 13-2, E13-3, E13-5, and E13-6.

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DECISION TOOLS

Vertical analysis helps users compare relationships between �inancial statement items with those of last year or of competitors.

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LEARNING OBJECTIVE 3

Analyze a company's performance using ratio analysis. 

In previous chapters, we presented many ratios used for evaluating the �inancial health and performance of a company. Here, we introduce one more ratio, the price-earnings ratio, and then we provide a summary listing of all ratios presented in the textbook. (Page references to prior discussions are provided if you feel you need to review any individual ratios.) Appendix 13A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-app-0001) provides an example of a comprehensive �inancial analysis employing these ratios.

PRICE-EARNINGS RATIO Earnings per share is net income available to common stockholders divided by the average number of common shares outstanding. The market price of a company's stock changes based on investors' expectations about a company's future earnings per share. To compare market prices and earnings across �irms, investors calculate the price-earnings (P-E) ratio. The P-E ratio divides the market price of a share of common stock by earnings per share.

ILLUSTRATION 13-14 Formula for price-earnings (P-E) ratio

The P-E ratio re�lects investors' assessment of a company's future earnings. The ratio of price to earnings will be higher if investors think that earnings will increase substantially in the future and therefore are willing to pay more per share of stock. A low price-earnings ratio often signi�ies that investors think the company's future earnings will not be strong. In addition, sometimes a low P-E ratio re�lects the market's belief that a company has poor-quality earnings.

To illustrate, assume that two identical companies each have earnings per share of $5. Suppose one of the companies manipulated its accounting numbers to achieve the $5 �igure. If investors perceive that �irm has lower-quality earnings, this perception will be re�lected in a lower stock price and, consequently, a lower P-E.

Illustration 13-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig- 0015) shows earnings per share and P-E ratios for �ive companies for a recent year.

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ILLUSTRATION 13-15 Earnings per share and P-E ratios of various companies

LIQUIDITY RATIOS Liquidity ratios (Illustration 13-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig-0016) ) measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.

ILLUSTRATION 13-16 Summary of liquidity ratios

INVESTOR INSIGHT   How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease.

Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities. Its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily in�luenced by management.

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How might management in�luence a company's current ratio? (Go to WileyPLUS for this answer and additional questions.)

SOLVENCY RATIOS Solvency ratios (Illustration 13-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig-0017) ) measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity.

ILLUSTRATION 13-17 Summary of solvency ratios

PROFITABILITY RATIOS Pro�itability ratios (Illustration 13-18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig-0018) on page 662) measure the income or operating success of a company for a given period of time. A company's income, or lack of it, affects its ability to obtain debt and equity �inancing, its liquidity position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating pro�itability. Pro�itability is frequently used as the ultimate test of management's operating effectiveness.

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ILLUSTRATION 13-18 Summary of pro�itability ratios

INVESTOR INSIGHT   High Ratings Can Bring Low Returns

Moody's, Standard & Poor's, and Fitch are three big �irms that perform �inancial analysis on publicly traded companies and then publish ratings of the companies' creditworthiness. Investors and lenders rely heavily on these ratings in making investment and lending decisions. Some people feel that the collapse of the �inancial markets was worsened by inadequate research reports and ratings provided by the �inancial rating agencies. Critics contend that the rating agencies were reluctant to give large companies low ratings because they feared that by offending them they would lose out on business opportunities. For example, the rating agencies gave many so-called mortgage- backed securities ratings that suggested that they were low risk. Later, many of these very securities became completely worthless. Steps have been taken to reduce the con�licts of interest that lead to these faulty ratings.

Source: Aaron Lucchetti and Judith Burns, “Moody's CEO Warned Pro�it Push Posed a Risk to Quality of Ratings,” Wall Street Journal Online (October 23, 2008).

Why are credit rating agencies important to the �inancial markets? (Go to WileyPLUS for this answer and additional questions.)

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DO IT! 3

Ratio Analysis

The condensed �inancial statements of John Cully Company, for the years ended June 30, 2017 and 2016, are presented on the next page.

Compute the following ratios for 2017 and 2016.

(a) Current ratio.

(b) Inventory turnover. (Inventory on 6/30/15 was $599.0.)

(c) Pro�it margin.

(d) Return on assets. (Assets on 6/30/15 were $3,349.9.)

(e) Return on common stockholders' equity. (Stockholders' equity on 6/30/15 was $1,795.9.)

(f) Debt to assets ratio.

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(g) Times interest earned.

Action Plan ✓ Remember that the current ratio includes all current assets.

✓ Use average balances for turnover ratios like inventory, accounts receivable, and return on assets.

Related exercise material: BE13-10, BE13-11, BE13-12, BE13-13, BE13-14, BE13-15, DO IT! 13-3, E13-7, E13-8, E13-9, E13-10, E13-11, E13-12, and E13-13.

USING DECISION TOOLS—KELLOGG COMPANY In analyzing a company, you should always investigate an extended period of time in order to determine whether the condition and performance of the company are changing. The condensed �inancial statements of Kellogg Company for 2014 and 2013 are presented here.

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INSTRUCTIONS

Compute the following ratios for Kellogg for 2014 and discuss your �indings (2013 values are provided for comparison).

1. Liquidity: (a) Current ratio (2013: .85:1).

(b) Inventory turnover (2013: 6.7 times).

2. Solvency: (a) Debt to assets ratio (2013: 77%).

(b) Times interest earned (2013: 12.1 times).

3. Pro�itability: (a) Return on assets (2013: 11.8%).

(b) Pro�it margin (2013: 12.2%).

(c) Return on common stockholders' equity (2013: 60%).

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LEARNING OBJECTIVE *4

APPENDIX 13A: Evaluate a company comprehensively using ratio analysis. 

In previous chapters, we presented many ratios used for evaluating the �inancial health and performance of a company. In this appendix, we provide a comprehensive review of those ratios and discuss some important relationships among them. Since earlier chapters demonstrated the calculation of each of these ratios, in this appendix we instead focus on their interpretation. Page references to prior discussions point you to any individual ratios you feel you need to review.

We used the �inancial information in Illustrations 13A-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0019) through 13A-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0004) to calculate Chicago Cereal Company's 2014 ratios. You can use these data to review the computations.

ILLUSTRATION 13A-1 Chicago Cereal Company's balance sheets

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ILLUSTRATION 13A-2 Chicago Cereal Company's income statements

ILLUSTRATION 13A-3 Chicago Cereal Company's statements of cash �lows

ILLUSTRATION 13A-4 Additional information for Chicago Cereal Company

As indicated in the chapter, we can classify ratios into three types for analysis of the primary �inancial statements:

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1. Liquidity ratios. Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

2. Solvency ratios. Measures of the ability of the company to survive over a long period of time.

3. Pro�itability ratios. Measures of the income or operating success of a company for a given period of time.

As a tool of analysis, ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a particular ratio. But, a single ratio by itself is not very meaningful. Accordingly, in this discussion we use the following three comparisons.

1. Intracompany comparisons covering two years for Chicago Cereal (using comparative �inancial information from Illustrations 13A-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0019) through 13A-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-�ig-0004) ).

2. Intercompany comparisons using General Mills as one of Chicago Cereal's competitors.

3. Industry average comparisons based on MSN.com median ratios for manufacturers of �lour and other grain mill products and comparisons with other sources. For some of the ratios that we use, industry comparisons are not available (denoted “na”).

LIQUIDITY RATIOS Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The measures used to determine the company's short-term debt-paying ability are the current ratio, the accounts receivable turnover, the average collection period, the inventory turnover, and days in inventory.

1. Current ratio.

The current ratio expresses the relationship of current assets to current liabilities, computed by dividing current assets by current liabilities. It is widely used for evaluating a company's liquidity and short-term debt-paying ability. The 2014 and 2013 current ratios for Chicago Cereal and comparative data are shown in Illustration 13A-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0023) .

ILLUSTRATION 13A-5 Current ratio

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What do the measures tell us? Chicago Cereal's 2013 current ratio of .67 means that for every dollar of current liabilities, it has $0.67 of current assets. We sometimes state such ratios as .67:1 to reinforce this interpretation. Its current ratio—and therefore its liquidity—increased signi�icantly in 2014. It is well below the industry average but the same as that of General Mills.

2. Accounts receivable turnover.

Analysts can measure liquidity by how quickly a company converts certain assets to cash. Low values of the previous ratios can sometimes be compensated for if some of the company's current assets are highly liquid.

How liquid, for example, are the receivables? The ratio used to assess the liquidity of the receivables is the accounts receivable turnover, which measures the number of times, on average, a company collects receivables during the period. The accounts receivable turnover is computed by dividing net credit sales (net sales less cash sales) by average net accounts receivable during the year. The accounts receivable turnover for Chicago Cereal is shown in Illustration 13A-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0024) .

ILLUSTRATION 13A-6 Accounts receivable turnover

In computing the rate, we assumed that all Chicago Cereal's sales are credit sales. Its accounts receivable turnover declined slightly in 2014. The turnover of 11.9 times is higher than the industry average of 11.2 times, and slightly lower than General Mills' turnover of 12.2 times.

3. Average collection period.

A popular variant of the accounts receivable turnover converts it into an average collection period in days. This is done by dividing the accounts receivable turnover into 365 days. The average collection period for Chicago Cereal is shown in Illustration 13A-7 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0025) .

ILLUSTRATION 13A-7 Average collection period

Chicago Cereal's 2014 accounts receivable turnover of 11.9 times is divided into 365 days to obtain approximately 31 days. This means that the average collection period for receivables is

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about 31 days. Its average collection period is slightly longer than that of General Mills and shorter than that of the industry.

Analysts frequently use the average collection period to assess the effectiveness of a company's credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (i.e., the time allowed for payment).

4. Inventory turnover.

The inventory turnover measures the number of times average inventory was sold during the period. Its purpose is to measure the liquidity of the inventory. A high measure indicates that inventory is being sold and replenished frequently. The inventory turnover is computed by dividing the cost of goods sold by the average inventory during the period. Unless seasonal factors are signi�icant, average inventory can be computed from the beginning and ending inventory balances. Chicago Cereal's inventory turnover is shown in Illustration 13A-8 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0026) .

ILLUSTRATION 13A-8 Inventory turnover

Chicago Cereal's inventory turnover decreased slightly in 2014. The turnover of 7.5 times is higher than the industry average of 6.7 times and similar to that of General Mills. Generally, the faster the inventory turnover, the less cash is tied up in inventory and the less the chance of inventory becoming obsolete. Of course, a downside of high inventory turnover is that it sometimes results in lost sales because if a company keeps less inventory on hand, it is more likely to run out of inventory when it is needed.

5. Days in inventory.

A variant of the inventory turnover is the days in inventory, which measures the average number of days inventory is held. The days in inventory for Chicago Cereal is shown in Illustration 13A-9 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0027) (page 670).

ILLUSTRATION 13A-9 Days in inventory

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Chicago Cereal's 2014 inventory turnover of 7.5 divided into 365 is approximately 49 days. An average selling time of 49 days is faster than the industry average and similar to that of General Mills. Some of this difference might be explained by differences in product lines across the two companies, although in many ways the types of products of these two companies are quite similar.

Inventory turnovers vary considerably among industries. For example, grocery store chains have a turnover of 10 times and an average selling period of 37 days. In contrast, jewelry stores have an average turnover of 1.3 times and an average selling period of 281 days. Within a company, there may even be signi�icant differences in inventory turnover among different types of products. Thus, in a grocery store the turnover of perishable items such as produce, meats, and dairy products is faster than the turnover of soaps and detergents.

To conclude, nearly all of these liquidity measures suggest that Chicago Cereal's liquidity changed little during 2014. Its liquidity appears acceptable when compared to the industry as a whole and when compared to General Mills.

SOLVENCY RATIOS Solvency ratios measure the ability of the company to survive over a long period of time. Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity. The debt to assets ratio and times interest earned provide information about debt-paying ability. In addition, free cash �low provides information about the company's solvency and its ability to pay additional dividends or invest in new projects.

6. Debt to assets ratio.

The debt to assets ratio measures the percentage of total �inancing provided by creditors. It is computed by dividing total liabilities (both current and long-term debt) by total assets. This ratio indicates the degree of �inancial leveraging. It also provides some indication of the company's ability to withstand losses without impairing the interests of its creditors. The higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations. Thus, from the creditors' point of view, a low ratio of debt to assets is desirable. Chicago Cereal's debt to assets ratio is shown in Illustration 13A-10 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0028) .

ILLUSTRATION 13A-10 Debt to assets ratio

Chicago Cereal's 2014 ratio of 78% means that creditors have provided �inancing suf�icient to cover 78% of the company's total assets. Alternatively, it says that it would have to liquidate 78% of its assets at their book value in order to pay off all of its debts. Its ratio is above the industry

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average of 55%, as well as that of General Mills. This suggests that it is less solvent than the industry average and General Mills. Chicago Cereal's solvency improved slightly during the year.

The adequacy of this ratio is often judged in light of the company's earnings. Generally, companies with relatively stable earnings, such as public utilities, have higher debt to assets ratios than cyclical companies with widely �luctuating earnings, such as many high-tech companies.

Another ratio with a similar meaning is the debt to equity ratio. It shows the relative use of borrowed funds (total liabilities) compared with resources invested by the owners. Because this ratio can be computed in several ways, be careful when making comparisons with it. Debt may be de�ined to include only the noncurrent portion of liabilities, and intangible assets may be excluded from stockholders' equity (which would equal tangible net worth). If debt and assets are de�ined as above (all liabilities and all assets), then when the debt to assets ratio equals 50%, the debt to equity ratio is 1:1.

7. Times interest earned.

The times interest earned (also called interest coverage) indicates the company's ability to meet interest payments as they come due. It is computed by dividing the sum of net income, interest expense, and income tax expense by interest expense. Note that this ratio uses income before interest expense and income taxes because this amount represents what is available to cover interest. Chicago Cereal's times interest earned is shown in Illustration 13A-11 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0029) .

ILLUSTRATION 13A-11 Times interest earned

For Chicago Cereal, the 2014 interest coverage was 5.8, which indicates that income before interest and taxes was 5.8 times the amount needed for interest expense. This is less than the rate for General Mills, but it slightly exceeds the rate for the industry. The debt to assets ratio decreased for Chicago Cereal during 2014, and its times interest earned held constant.

8. Free cash �low.

One indication of a company's solvency, as well as of its ability to pay dividends or expand operations, is the amount of excess cash it generated after investing in capital expenditures and paying dividends. This amount is referred to as free cash �low. For example, if you generate $100,000 of net cash provided by operating activities but you spend $30,000 on capital expenditures and pay $10,000 in dividends, you have $60,000 ($100,000−$30,000−$10,000) to use either to expand operations, pay additional dividends, or pay down debt. Chicago Cereal's free cash �low is shown in Illustration 13A-12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0030) .

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ILLUSTRATION 13A-12 Free cash �low

Chicago Cereal's free cash �low increased slightly from 2013 to 2014. During both years, the net cash provided by operating activities was more than enough to allow it to acquire additional productive assets and maintain dividend payments. It could have used the remaining cash to reduce debt if necessary. Given that Chicago Cereal is much smaller than General Mills, we would expect its free cash �low to be substantially smaller, which it is.

PROFITABILITY RATIOS Pro�itability ratios measure the income or operating success of a company for a given period of time. A company's income, or the lack of it, affects its ability to obtain debt and equity �inancing, its liquidity position, and its ability to grow. As a consequence, creditors and investors alike are interested in evaluating pro�itability. Analysts frequently use pro�itability as the ultimate test of management's operating effectiveness.

Throughout this textbook, we have introduced numerous measures of pro�itability. The relationships among measures of pro�itability are very important. Understanding them can help management determine where to focus its efforts to improve pro�itability. Illustration 13A-13 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0031) diagrams these relationships. Our discussion of Chicago Cereal's pro�itability is structured around this diagram.

ILLUSTRATION 13A-13 Relationships among pro�itability measures

9. Return on common stockholders' equity (ROE).

A widely used measure of pro�itability from the common stockholder's viewpoint is the return on common stockholders' equity (ROE). This ratio shows how many dollars of net income the

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company earned for each dollar invested by the owners. It is computed by dividing net income minus any preferred dividends—that is, income available to common stockholders—by average common stockholders' equity. The return on common stockholders' equity for Chicago Cereal is shown in Illustration 13A-14 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0032) .

ILLUSTRATION 13A-14 Return on common stockholders' equity

Chicago Cereal's 2014 return on common stockholders' equity is unusually high at 48%. The industry average is 19% and General Mills' return is 25%. In the subsequent sections, we investigate the causes of this high return.

10. Return on assets.

The return on common stockholders' equity is affected by two factors: the return on assets and the degree of leverage. The return on assets measures the overall pro�itability of assets in terms of the income earned on each dollar invested in assets. It is computed by dividing net income by average total assets. Chicago Cereal's return on assets is shown in Illustration 13A-15 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0033) .

ILLUSTRATION 13A-15 Return on assets

Chicago Cereal had a 10.0% return on assets in 2014. This rate is signi�icantly higher than that of General Mills and the industry average.

Note that its rate of return on common stockholders' equity (48%) is substantially higher than its rate of return on assets (10%). The reason is that it has made effective use of leverage. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than the rate of return it earns on the assets it purchased with the borrowed funds. Leverage enables management to use money supplied by nonowners to increase the return to owners.

A comparison of the rate of return on assets with the rate of interest paid for borrowed money indicates the pro�itability of trading on the equity. If you borrow money at 8% and your rate of return on assets is 11%, you are trading on the equity at a gain. Note, however, that trading on the

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equity is a two-way street. For example, if you borrow money at 11% and earn only 8% on it, you are trading on the equity at a loss.

Chicago Cereal earns more on its borrowed funds than it has to pay in interest. Thus, the return to stockholders exceeds the return on assets because of the positive bene�it of leverage. Recall from our earlier discussion that Chicago Cereal's percentage of debt �inancing, as measured by the ratio of debt to assets (or debt to equity), was higher than General Mills' and the industry average. It appears that Chicago Cereal's high return on common stockholders' equity is due in part to its use of leverage.

11. Pro�it margin.

The return on assets is affected by two factors, the �irst of which is the pro�it margin. The pro�it margin, or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. It is computed by dividing net income by net sales for the period. Chicago Cereal's pro�it margin is shown in Illustration 13A-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0034) .

ILLUSTRATION 13A-16 Pro�it margin

Chicago Cereal experienced a slight increase in its pro�it margin from 2013 to 2014 of 9.2% to 9.4%. Its pro�it margin was higher than the industry average and that of General Mills.

High-volume (high inventory turnover) businesses such as grocery stores and pharmacy chains generally have low pro�it margins. Low-volume businesses such as jewelry stores and airplane manufacturers have high pro�it margins.

12. Asset turnover.

The other factor that affects the return on assets is the asset turnover. The asset turnover measures how ef�iciently a company uses its assets to generate sales. It is determined by dividing net sales by average total assets for the period. The resulting number shows the dollars of sales produced by each dollar invested in assets. Illustration 13A-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0035) shows the asset turnover for Chicago Cereal.

ILLUSTRATION 13A-17 Asset turnover

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The asset turnover shows that in 2014, Chicago Cereal generated sales of $1.07 for each dollar it had invested in assets. The ratio rose from 2013 to 2014. Its asset turnover is above the industry average and that of General Mills.

Asset turnovers vary considerably among industries. The average asset turnover for utility companies is .45, for example, while the grocery store industry has an average asset turnover of 3.49.

In summary, Chicago Cereal's return on assets increased from 9.4% in 2013 to 10.0% in 2014. Underlying this increase was an increased pro�itability on each dollar of sales (as measured by the pro�it margin) and a rise in the sales-generating ef�iciency of its assets (as measured by the asset turnover). We can analyze the combined effects of pro�it margin and asset turnover on return on assets for Chicago Cereal as shown in Illustration 13A-18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0036) .

ILLUSTRATION 13A-18 Composition of return on assets

13. Gross pro�it rate.

One factor that strongly in�luences the pro�it margin is the gross pro�it rate. The gross pro�it rate is determined by dividing gross pro�it (net sales less cost of goods sold) by net sales. This rate indicates a company's ability to maintain an adequate selling price above its cost of goods sold.

As an industry becomes more competitive, this ratio declines. For example, in the early years of the personal computer industry, gross pro�it rates were quite high. Today, because of increased competition and a belief that most brands of personal computers are similar in quality, gross pro�it rates have become thin. Analysts should closely monitor gross pro�it rates over time. Illustration 13A-19 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0037) shows Chicago Cereal's gross pro�it rate.

ILLUSTRATION 13A-19 Gross pro�it rate

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Chicago Cereal's gross pro�it rate remained constant from 2013 to 2014.

14. Earnings per share (EPS).

Stockholders usually think in terms of the number of shares they own or plan to buy or sell. Expressing net income earned on a per share basis provides a useful perspective for determining pro�itability. Earnings per share is a measure of the net income earned on each share of common stock. It is computed by dividing net income by the average number of common shares outstanding during the year.

The terms “net income per share” or “earnings per share” refer to the amount of net income applicable to each share of common stock. Therefore, when we compute earnings per share, if there are preferred dividends declared for the period, we must deduct them from net income to arrive at income available to the common stockholders. Chicago Cereal's earnings per share is shown in Illustration 13A-20 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0038) .

ILLUSTRATION 13A-20 Earnings per share

Note that no industry average is presented in Illustration 13A-21 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0038) . Industry data for earnings per share are not reported, and in fact the Chicago Cereal and General Mills ratios should not be compared. Such comparisons are not meaningful because of the wide variations in the number of shares of outstanding stock among companies. Chicago Cereal's earnings per share increased 23 cents per share in 2014. This represents a 9.6% increase from the 2013 EPS of $2.40.

15. Price-earnings ratio.

The price-earnings ratio is an oft-quoted statistic that measures the ratio of the market price of each share of common stock to the earnings per share. The price-earnings (P-E) ratio re�lects investors' assessments of a company's future earnings. It is computed by dividing the market price per share of the stock by earnings per share. Chicago Cereal's price-earnings ratio is shown in Illustration 13A-21 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0039) .

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ILLUSTRATION 13A-21 Price-earnings ratio

At the end of 2014 and 2013, the market price of Chicago Cereal's stock was $52.92 and $50.06, respectively.

In 2014, each share of Chicago Cereal's stock sold for 20.1 times the amount that was earned on each share. Chicago Cereal's price-earnings ratio is lower than General Mills' ratio of 24.3 and lower than the industry average of 35.8 times. Its lower P-E ratio suggests that the market is less optimistic about Chicago Cereal than about General Mills. However, it might also signal that Chicago Cereal's stock is underpriced.

16. Payout ratio.

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. It is computed by dividing cash dividends declared on common stock by net income. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. The payout ratio for Chicago Cereal is shown in Illustration 13A-22 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo4#c13-�ig-0040) .

ILLUSTRATION 13A-22 Payout ratio

The 2014 and 2013 payout ratios for Chicago Cereal are slightly lower than that of General Mills (54%) but higher than the industry average (37%).

Management has some control over the amount of dividends paid each year, and companies are generally reluctant to reduce a dividend below the amount paid in a previous year. Therefore, the payout ratio will actually increase if a company's net income declines but the company keeps its total dividend payment the same. Of course, unless the company returns to its previous level of pro�itability, maintaining this higher dividend payout ratio is probably not possible over the long run.

Before drawing any conclusions regarding Chicago Cereal's dividend payout ratio, we should calculate this ratio over a longer period of time to evaluate any trends and also try to �ind out whether management's philosophy regarding dividends has changed recently. The “Selected Financial Data” section of Chicago Cereal's Management Discussion and Analysis shows that over a 5-year period, earnings per share rose 45%, while dividends per share grew only 19%.

In terms of the types of �inancial information available and the ratios used by various industries, what can be practically covered in this textbook gives you only the “Titanic approach.” That is, you are seeing only the tip of the iceberg compared to the vast databases and types of ratio analysis that are available on

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computers. The availability of information is not a problem. The real trick is to be discriminating enough to perform relevant analysis and select pertinent comparative data.

REVIEW AND PRACTICE

LEARNING OBJECTIVES REVIEW 1. Apply the concepts of sustainable income and quality of earnings.

Sustainable income analysis is useful in evaluating a company's performance. Sustainable income is the most likely level of income to be obtained by the company in the future. Discontinued operations and other comprehensive income are presented on the statement of comprehensive income to highlight their unusual nature. Items below income from continuing operations must be presented net of tax.

A high quality of earnings provides full and transparent information that will not confuse or mislead users of the �inancial statements. Issues related to quality of earnings are (1) alternative accounting methods, (2) pro forma income, and (3) improper recognition.

2. Apply horizontal analysis and vertical analysis. Horizontal analysis is a technique for evaluating a series of data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.

Vertical analysis is a technique that expresses each item in a �inancial statement as a percentage of a relevant total or a base amount

3. Analyze a company's performance using ratio analysis. The price-earnings (P- E) ratio re�lects investors' assessment of a company's future earnings potential. Financial ratios are provided in Illustration 13-16 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig- 0016) (liquidity), Illustration 13-17 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig- 0017) (solvency), and Illustration 13-18 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo3#c13-�ig- 0018) (pro�itability).

4. Evaluate a company comprehensively using ratio analysis. To evaluate a company, ratios (liquidity, solvency, and pro�itability) provide clues to underlying conditions, but intracompany, intercompany, and industry average comparisons are also needed.

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DECISION TOOLS REVIEW

GLOSSARY REVIEW *Accounts receivable turnover A measure of the liquidity of receivables; computed as

net credit sales divided by average net accounts receivable.

*Asset turnover A measure of how ef�iciently a company uses its assets to generate sales; computed as net sales divided by average total assets.

Available-for-sale securities Securities that are held with the intent of selling them sometime in the future.

*Average collection period The average number of days that receivables are outstanding; calculated as accounts receivable turnover divided into 365 days.

Change in accounting principle Use of an accounting principle in the current year different from the one used in the preceding year.

Comprehensive income The sum of net income and other comprehensive income items.

*Current ratio A measure used to evaluate a company's liquidity and short-term debt- paying ability; calculated as current assets divided by current liabilities.

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*Days in inventory A measure of the average number of days inventory is held; computed as inventory turnover divided into 365 days.

*Debt to assets ratio A measure of the percentage of total �inancing provided by creditors; computed as total liabilities divided by total assets.

Discontinued operations The disposal of a signi�icant component of a business.

*Earnings per share The net income earned by each share of common stock; computed as net income less preferred dividends divided by the weighted-average common shares outstanding.

*Free cash �low A measure of solvency. Cash remaining from operating activities after adjusting for capital expenditures and dividends paid.

*Gross pro�it rate Gross pro�it expressed as a percentage of sales; computed as gross pro�it divided by net sales.

Horizontal analysis A technique for evaluating a series of �inancial statement data over a period of time to determine the increase (decrease) that has taken place, expressed as either an amount or a percentage.

*Inventory turnover A measure of the liquidity of inventory. Measures the number of times average inventory was sold during the period; computed as cost of goods sold divided by average inventory.

*Leveraging Borrowing money at a lower rate of interest than can be earned by using the borrowed money; also referred to as trading on the equity.

Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

*Payout ratio A measure of the percentage of earnings distributed in the form of cash dividends; calculated as cash dividends declared on common stock divided by net income.

Price-earnings (P-E) ratio A comparison of the market price of each share of common stock to the earnings per share; computed as the market price of the stock divided by earnings per share.

Pro�itability ratios Measures of the income or operating success of a company for a given period of time.

*Pro�it margin A measure of the net income generated by each dollar of sales; computed as net income divided by net sales.

Quality of earnings Indicates the level of full and transparent information that is provided to users of the �inancial statements.

Pro forma income A measure of income that usually excludes items that a company thinks are unusual or non-recurring.

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*Return on assets A pro�itability measure that indicates the amount of net income generated by each dollar of assets; calculated as net income divided by average total assets.

*Return on common stockholders' equity (ROE) A measure of the dollars of net income earned for each dollar invested by the owners; computed as income available to common stockholders divided by average common stockholders' equity.

Solvency ratios Measures of the ability of a company to survive over a long period of time, particularly to pay interest as it comes due and to repay the balance of debt at its maturity.

Sustainable income The most likely level of income to be obtained by a company in the future.

*Times interest earned A measure of a company's solvency and ability to meet interest payments as they come due; calculated as the sum of net income, interest expense, and income tax expense divided by interest expense.

*Trading on the equity See leveraging.

Trading security Securities bought and held primarily for sale in the near term to generate income on short-term price differences.

Vertical analysis A technique for evaluating �inancial statement data that expresses each item in a �inancial statement as a percentage of a base amount.

PRACTICE MULTIPLE-CHOICE QUESTIONS All of the Practice Multiple-Choice Questions in this chapter employ decision tools.

(LO 1)

1. In reporting discontinued operations, the income statement should show in a special section:

(a) gains on the disposal of the discontinued component.

(b) losses on the disposal of the discontinued component.

(c) Neither (a) nor (b).

(d) Both (a) and (b).

(LO 1)

2. Cool Stools Corporation has income before taxes of $400,000 and a loss on discontinued operations of $100,000. If the income tax rate is 25% on all items, the statement of comprehensive income should show income from continuing operations and discontinued operations, respectively, of

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(a) $325,000 and $100,000.

(b) $325,000 and $75,000.

(c) $300,000 and $100,000.

(d) $300,000 and $75,000.

(LO 1)

3. Which of the following would be considered an “Other comprehensive income” item?

(a) Gain on disposal of discontinued operations.

(b) Unrealized loss on available-for-sale securities.

(c) Loss related to �lood.

(d) Net income.

(LO 1)

4. Which situation below might indicate a company has a low quality of earnings?

(a) The same accounting principles are used each year.

(b) Revenue is recognized when the performance obligation is satis�ied.

(c) Maintenance costs are capitalized and then depreciated.

(d) The company's P-E ratio is high relative to competitors.

(LO 2)

5. In horizontal analysis, each item is expressed as a percentage of the:

(a) net income amount.

(b) stockholders' equity amount.

(c) total assets amount.

(d) base-year amount.

(LO 2)

6. Adams Corporation reported net sales of $300,000, $330,000, and $360,000 in the years 2015, 2016, and 2017, respectively. If 2015 is the base year, what percentage do 2017 sales represent of the base?

(a) 77%.

(b) 108%.

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(c) 120%.

(d) 130%.

(LO 2)

7. The following schedule is a display of what type of analysis?

Amount Percent Current assets $200,000 25% Property, plant, and equipment  600,000 75% Total assets $800,000

(a) Horizontal analysis.

(b) Differential analysis.

(c) Vertical analysis.

(d) Ratio analysis.

(LO 2)

8. In vertical analysis, the base amount for depreciation expense is generally:

(a) net sales.

(b) depreciation expense in a previous year.

(c) gross pro�it.

(d) �ixed assets.

(LO 3)

9. Which measure is an evaluation of a company's ability to pay current liabilities?

(a) Accounts receivable turnover.

(b) Current ratio.

(c) Both (a) and (b).

(d) None of the above.

(LO 3)

10. Which measure is useful in evaluating the ef�iciency in managing inventories?

(a) Inventory turnover.

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(b) Days in inventory.

(c) Both (a) and (b).

(d) None of the above.

(LO 3)

11. Which of these is not a liquidity ratio?

(a) Current ratio.

(b) Asset turnover.

(c) Inventory turnover.

(d) Accounts receivable turnover.

(LO 3)

12. Plano Corporation reported net income $24,000, net sales $400,000, and average assets $600,000 for 2017. What is the 2017 pro�it margin?

(a) 6%.

(b) 12%.

(c) 40%.

(d) 200%.

Use the following �inancial statement information as of the end of each year to answer Questions 13-17.

2017 2016 Inventory $ 54,000 $ 48,000 Current assets 81,000 106,000 Total assets 382,000 326,000 Current liabilities 27,000 36,000 Total liabilities 102,000 88,000 Common stockholders' equity 240,000 198,000 Net sales 784,000 697,000 Cost of goods sold 306,000 277,000 Net income 134,000 90,000 Income tax expense 22,000 18,000 Interest expense 12,000 12,000 Dividends paid to preferred stockholders 4,000 4,000 Dividends paid to common stockholders 15,000 10,000

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(LO 3)

13. Compute the days in inventory for 2017.

(a) 64.4 days.

(b) 60.8 days.

(c) 6 days.

(d) 24 days.

(LO 3)

14. Compute the current ratio for 2017.

(a) 1.26:1.

(b) 3.0:1.

(c) 0.80:1.

(d) 3.75:1.

(LO 3)

15. Compute the pro�it margin for 2017.

(a) 17.1%.

(b) 18.1%.

(c) 37.9%.

(d) 5.9%.

(LO 3)

16. Compute the return on common stockholders' equity for 2017.

(a) 54.2%.

(b) 52.5%.

(c) 61.2%.

(d) 59.4%.

(LO 3)

17. Compute the times interest earned for 2017.

(a) 11.2 times.

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(b) 65.3 times.

(c) 14.0 times.

(d) 13.0 times.

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SOLUTIONS

1. (d) Gains and losses from the operations of a discontinued segment and gains and losses on the disposal of the discontinued segment are shown in a separate section immediately after continuing operations in the income statement. Choices (a) and (b) are correct, but (d) is the better answer. Choice (c) is wrong as there is a correct answer.

2. (d) Income tax expense=25%×$400,000=$100,000; therefore, income from continuing operations=$400,000−$100,000=$300,000. The loss on discontinued operations is shown net of tax, $100,000×75%=$75,000. The other choices are therefore incorrect.

3. (b) Unrealized gains and losses on available-for-sale securities are part of other comprehensive income. The other choices are incorrect because (a) a gain on the disposal of discontinued operations is reported as an unusual item, (c) loss related to a �lood is reported among other expenses and losses, and (d) net income is a separate line item.

4. (c) Capitalizing and then depreciating maintenance costs suggests that a company is trying to avoid expensing certain costs by deferring them to future accounting periods to increase current-period income. The other choices are incorrect because (a) using the same accounting principles each year and (b) recognizing revenue when the performance obligation is satis�ied is in accordance with GAAP. Choice (d) is incorrect because a high P-E ratio does not suggest that a �irm has low quality of earnings.

5. (d) Horizontal analysis converts each succeeding year's balance to a percentage of the base year amount, not (a) net income amount, (b) stockholders' equity amount, or (c) total assets amount.

6. (c) The trend percentage for 2017 is 120% ($360,000/$300,000), not (a) 77%, (b) 108%, or (d) 130%.

7. (c) The data in the schedule is a display of vertical analysis because the individual asset items are expressed as a percentage of total assets. The other choices are therefore incorrect. Horizontal analysis is a technique for evaluating a series of data over a period of time.

8. (a) In vertical analysis, net sales is used as the base amount for income statement items, not (b) depreciation expense in a previous year, (c) gross pro�it, or (d) �ixed assets.

9. (c) Both the accounts receivable turnover and the current ratio measure a �irm's ability to pay current liabilities. Choices (a) and (b) are correct but (c) is the better answer. Choice (d) is incorrect because there is a correct answer.

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10. (c) Both inventory turnover and days in inventory measure a �irm's ef�iciency in managing inventories. Choices (a) and (b) are correct but (c) is the better answer. Choice (d) is incorrect because there is a correct answer.

11. (b) Asset turnover is a measure of pro�itability. The other choices are incorrect because the (a) current ratio, (c) inventory turnover, and (d) accounts receivable turnover are all measures of a �irm's liquidity.

12. (a) Pro�it margin=Net income ($24,000)÷Net Sales ($400,000)=6%, not (b) 12%, (c) 40%, or (d) 200%.

13. (b) Inventory turnover=Cost of goods sold/Average inventory $306,000 [($54,000+$48,000)/2]=6 times. Thus, days in inventory=60.8 (365/6), not (a) 64.4, (c) 6, or (d) 24 days.

14. (b) Current ratio=Current assets/Current liabilities ($81,000/$27,000)=3.01:1, not (a) 1.26:1, (c) 0.80:1, or (d) 3.75:1.

15. (a) Pro�it margin=Net income/Net sales ($134,000/$784,000)=17.1%, not (b) 18.1%, (c) 37.9%, or (d) 5.9%.

16. (d) Return on common stockholders' equity=Net income ($134,000)−Dividends to preferred stockholders ($4,000)/Average common stockholders' equity [($240,000+$198,000)/2]=59.4%, not (a) 54.2%, (b) 52.5%, or (c) 61.2%.

17. (c) Times interest earned=Net income+Interest expense+Income tax expense divided by Interest expense [($134,000+$12,000+$22,000)/$12,000]=14.0 times, not (a) 11.2, (b) 65.3, or (d) 13.0 times.

PRACTICE EXERCISES

Prepare horizontal and vertical analysis.

(LO 2)

1. The comparative condensed balance sheets of Roadway Corporation are presented below.

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INSTRUCTIONS (a) Prepare a horizontal analysis of the balance sheet data for Roadway Corporation using

2016 as a base.

(b) Prepare a vertical analysis of the balance sheet data for Roadway Corporation in columnar form for 2017.

SOLUTIONS

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Compute ratios.

(LO 3)

2. Rondo Corporation's comparative balance sheets are presented below.

Rondo's 2017 income statement included net sales of $120,000, cost of goods sold of $70,000, and net income of $14,000.

INSTRUCTIONS (a) Compute the following ratios for 2017.

(b) Current ratio.

(c) Accounts receivable turnover.

(d) Inventory turnover.

(e) Pro�it margin.

(f) Asset turnover.

(g) Return on assets.

(h) Return on common stockholders' equity.

(i) Debt to assets ratio.

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SOLUTION

2. (a) (5,300+$21,200+$9,000)/$10,370=3.42

(b) $120,000/[($21,200+$23,400)/2]=5.38

(c) $70,000/[($9,000+$7,000)/2]=8.8

(d) $14,000/$120,000=11.7%

(e) $120,000/[($110,500+$120,100)/2]=1.04

(f) $14,000/[($110,500+$120,100)/2]=12.1%

(g) $14,000/[($100,130+$89,000)/2]=14.8%

(h) $10,370/$110,500=9.4%

PRACTICE PROBLEMS

Prepare a statement of comprehensive income.

(LO 1)

The events and transactions of Dever Corporation for the year ending December 31, 2017, resulted in the following data.

Cost of goods sold $2,600,000 Net sales 4,400,000 Other expenses and losses 9,600 Other revenues and gains 5,600 Selling and administrative expenses 1,100,000 Income from operations of plastics division 70,000 Gain from disposal of plastics division 500,000 Unrealized loss on available-for-sale securities 60,000

Analysis reveals the following:

1. All items are before the applicable income tax rate of 30%.

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2. The plastics division was sold on July 1.

3. All operating data for the plastics division have been segregated.

INSTRUCTIONS

Prepare a statement of comprehensive income for the year.

WileyPLUS Brief Exercises, DO IT!Exercises, Exercises, Problems, and many additional resources are available for practice in WileyPLUS.

NOTE: All Asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.

QUESTIONS All of the Questions in this chapter employ decision tools.

1. Explain sustainable income. What relationship does this concept have to the treatment of discontinued operations on the income statement?

2. Hogan Inc. reported 2016 earnings per share of $3.26 and had no discontinued operations. In 2017, earnings per share on income from continuing operations was $2.99, and earnings per share on net income was $3.49. Do you consider this trend to be favorable? Why or why not?

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3. Moosier Inc. has been in operation for 3 years and uses the FIFO method of pricing inventory. During the fourth year, Moosier changes to the average-cost method for all its inventory. How will Moosier report this change?

4. What amount did Apple report as “Other comprehensive earnings” in its consolidated statement of comprehensive income ending September 27, 2014? By what percentage did Apple's “Comprehensive income” differ from its “Net income”?

5. Identify and explain factors that affect quality of earnings.

6. Explain how the choice of one of the following accounting methods over the other raises or lowers a company's net income during a period of continuing in�lation. (a) Use of FIFO instead of LIFO for inventory costing.

(b) Use of a 6-year life for machinery instead of a 9-year life.

(c) Use of straight-line depreciation instead of declining-balance depreciation.

7. Two popular methods of �inancial statement analysis are horizontal analysis and vertical analysis. Explain the difference between these two methods.

8. (a) If Erin Company had net income of $300,000 in 2016 and it experienced a 24.5% increase in net income for 2017, what is its net income for 2017?

(b) If 6 cents of every dollar of Erin's revenue is net income in 2016, what is the dollar amount of 2016 revenue?

9. (a) Gina Jaimes believes that the analysis of �inancial statements is directed at two characteristics of a company: liquidity and pro�itability. Is Gina correct? Explain.

(b) Are short-term creditors, long-term creditors, and stockholders interested in primarily the same characteristics of a company? Explain.

10. (a) Distinguish among the following bases of comparison: intracompany, intercompany, and industry averages.

(b) Give the principal value of using each of the three bases of comparison.

11. Name the major ratios useful in assessing (a) liquidity and (b) solvency.

12. Vern Thoms is puzzled. His company had a pro�it margin of 10% in 2017. He feels that this is an indication that the company is doing well. Tina Amos, his accountant, says that more information is needed to determine the company's �inancial well-being. Who is correct? Why?

13. What does each type of ratio measure? (a) Liquidity ratios.

(b) Solvency ratios.

(c) Pro�itability ratios.

14. What is the difference between the current ratio and working capital?

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15. Handi Mart, a retail store, has an accounts receivable turnover of 4.5 times. The industry average is 12.5 times. Does Handi Mart have a collection problem with its receivables?

16. Which ratios should be used to help answer each of these questions? (a) How ef�icient is a company in using its assets to produce sales?

(b) How near to sale is the inventory on hand?

(c) How many dollars of net income were earned for each dollar invested by the owners?

(d) How able is a company to meet interest charges as they fall due?

17. At year-end, the price-earnings ratio of General Motors was 11.3, and the price-earnings ratio of Microsoft was 28.14. Which company did the stock market favor? Explain.

18. What is the formula for computing the payout ratio? Do you expect this ratio to be high or low for a growth company?

19. Holding all other factors constant, indicate whether each of the following changes generally signals good or bad news about a company. (a) Increase in pro�it margin.

(b) Decrease in inventory turnover.

(c) Increase in current ratio.

(d) Decrease in earnings per share.

(e) Increase in price-earnings ratio.

(f) Increase in debt to assets ratio.

(g) Decrease in times interest earned.

20. The return on assets for Ayala Corporation is 7.6%. During the same year, Ayala's return on common stockholders' equity is 12.8%. What is the explanation for the difference in the two rates?

21. Which two ratios do you think should be of greatest interest in each of the following cases? (a) A pension fund considering the purchase of 20-year bonds.

(b) A bank contemplating a short-term loan.

(c) A common stockholder.

22. Keanu Inc. has net income of $200,000, average shares of common stock outstanding of 40,000, and preferred dividends for the period of $20,000. What is Keanu's earnings per share of common stock? Fred Tyme, the president of Keanu, believes that the computed EPS of the company is high. Comment.

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BRIEF EXERCISES All of the Brief Exercises in this chapter employ decision tools.

Prepare a discontinued operations section of an income statement.

(LO 1), AP

BE13-1 On June 30, Flores Corporation discontinued its operations in Mexico. On September 1, Flores disposed of the Mexico facility at a pretax loss of $640,000. The applicable tax rate is 25%. Show the discontinued operations section of Flores's statement of comprehensive income.

Prepare statement of comprehensive income including unusual items.

(LO 1), AP

BE13-2 An inexperienced accountant for Silva Corporation showed the following in the income statement: income before income taxes $450,000 and unrealized gain on available-for-sale securities (before taxes) $70,000. The unrealized gain on available-for-sale securities and income before income taxes are both subject to a 25% tax rate. Prepare a correct statement of comprehensive income.

Indicate how a change in accounting principle is reported.

(LO 1), C

BE13-3 On January 1, 2017, Bryce Inc. changed from the LIFO method of inventory pricing to the FIFO method. Explain how this change in accounting principle should be treated in the company's �inancial statements.

Prepare horizontal analysis.

(LO 2), AP

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BE13-4 Using these data from the comparative balance sheet of Rollaird Company, perform horizontal analysis.

December 31, 2017 December 31, 2016 Accounts receivable $  460,000   $  400,000   Inventory 780,000   650,000   Total assets 3,164,000   2,800,000  

Prepare vertical analysis.

(LO 2), AP

BE13-5 Using the data presented in BE13-4 for Rollaird Company, perform vertical analysis.

Calculate percentage of change.

(LO 2), AP

BE13-6 Net income was $500,000 in 2015, $485,000 in 2016, and $518,400 in 2017. What is the percentage of change from (a) 2015 to 2016, and (b) from 2016 to 2017? Is the change an increase or a decrease?

Calculate net income.

(LO 2), AP

BE13-7 If Coho Company had net income of $382,800 in 2017 and it experienced a 16% increase in net income over 2016, what was its 2016 net income?

Analyze change in net income.

(LO 2), AP

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BE13-8 Vertical analysis (common-size) percentages for Palau Company's sales revenue, cost of goods sold, and expenses are listed here.

Vertical Analysis 2017 2016 2015 Sales revenue 100.0% 100.0% 100.0% Cost of goods sold 60.5 62.9 64.8 Expenses 26.0 26.6 27.5

Did Palau's net income as a percent of sales increase, decrease, or remain unchanged over the 3-year period? Provide numerical support for your answer.

Analyze change in net income.

(LO 2), AP

BE13-9 Horizontal analysis (trend analysis) percentages for Phoenix Company's sales revenue, cost of goods sold, and expenses are listed here.

Horizontal Analysis 2017 2016 2015 Sales revenue 96.2% 104.8% 100.0% Cost of goods sold 101.0  98.0  100.0  Expenses 105.6  95.4  100.0 

Explain whether Phoenix's net income increased, decreased, or remained unchanged over the 3-year period.

Calculate current ratio.

(LO 3), AP

BE13-10 Suppose these selected condensed data are taken from recent balance sheets of Bob Evans Farms (in thousands).

2017 2016 Cash $ 13,606 $  7,669 Accounts receivable 23,045 19,951 Inventory 31,087 31,345 Other current assets 12,522 11,909

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2017 2016 Total current assets $ 80,260 $ 70,874 Total current liabilities $245,805 $326,203

Compute the current ratio for each year and comment on your results.

Evaluate collection of accounts receivable.

(LO 3), AN

BE13-11 The following data are taken from the �inancial statements of Colby Company.

2017 2016 Accounts receivable (net), end of year $  550,000 $  540,000 Net sales on account 4,300,000 4,000,000 Terms for all sales are 1/10, n/45

Compute for each year (a) the accounts receivable turnover and (b) the average collection period. What conclusions about the management of accounts receivable can be drawn from these data? At the end of 2015, accounts receivable was $520,000.

Evaluate management of inventory.

(LO 3), AN

BE13-12 The following data were taken from the income statements of Mydorf Company.

2017 2016 Sales revenue $6,420,000 $6,240,000 Beginning inventory 960,000 840,000 Purchases 4,840,000 4,661,000 Ending inventory 1,020,000 960,000

Compute for each year (a) the inventory turnover and (b) days in inventory. What conclusions concerning the management of the inventory can be drawn from these data?

Calculate pro�itability ratios.

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(LO 3), AN

BE13-13 Staples, Inc. is one of the largest suppliers of of�ice products in the United States. Suppose it had net income of $738.7 million and sales of $24,275.5 million in 2017. Its total assets were $13,073.1 million at the beginning of the year and $13,717.3 million at the end of the year. What is Staples, Inc.'s (a) asset turnover and (b) pro�it margin? (Round to two decimals.) Provide a brief interpretation of your results.

Calculate pro�itability ratios.

(LO 3), AN

BE13-14 Hollie Company has stockholders' equity of $400,000 and net income of $72,000. It has a payout ratio of 18% and a return on assets of 20%. How much did Hollie pay in cash dividends, and what were its average total assets?

Calculate and analyze free cash �low.

(LO 3), AN

BE13-15 Selected data taken from a recent year's �inancial statements of trading card company Topps Company, Inc. are as follows (in millions).

Net sales $326.7 Current liabilities, beginning of year 41.1 Current liabilities, end of year 62.4 Net cash provided by operating activities 10.4 Total liabilities, beginning of year 65.2 Total liabilities, end of year 73.2 Capital expenditures 3.7 Cash dividends 6.2

Compute the free cash �low. Provide a brief interpretation of your results.

DO IT! EXERCISES

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Prepare statement of comprehensive income including unusual items.

(LO 1), AP

DO IT! 13-1 In its proposed 2017 income statement, Hrabik Corporation reports income before income taxes $500,000, income taxes $100,000 (not including unusual items), loss on operation of discontinued music division $60,000, gain on disposal of discontinued music division $40,000, and unrealized loss on available-for-sale securities $150,000. The income tax rate is 20%. Prepare a correct statement of comprehensive income, beginning with income before income taxes.

Prepare horizontal analysis.

(LO 2), AP

DO IT! 13-2 Summary �inancial information for Gandaulf Company is as follows.

Dec. 31, 2017 Dec. 31, 2016 Current assets $  200,000  $  220,000  Plant assets 1,040,000  780,000  Total assets $1,240,000  $1,000,000 

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

Compute ratios.

(LO 3), AP

DO IT! 13-3 The condensed �inancial statements of Murawski Company for the years 2016 and 2017 are presented as follows. (Amounts in thousands.)

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Compute the following ratios for 2017 and 2016.

(a) Current ratio.

(b) Inventory turnover. (Inventory on 12/31/15 was $340.)

(c) Pro�it margin.

(d) Return on assets. (Assets on 12/31/15 were $1,900.)

(e) Return on common stockholders' equity. (Stockholders' equity on 12/31/15 was $900.)

(f) Debt to assets ratio.

(g) Times interest earned.

EXERCISES

Prepare a correct statement of comprehensive income.

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(LO 1), AP

E13-1 For its �iscal year ending October 31, 2017, Haas Corporation reports the following partial data shown below.

Income before income taxes $540,000 Income tax expense (20%×$420,000) 84,000 Income from continuing operations 456,000 Loss on discontinued operations 120,000 Net income $336,000

The loss on discontinued operations was comprised of a $50,000 loss from operations and a $70,000 loss from disposal. The income tax rate is 20% on all items.

Instructions (a) Prepare a correct statement of comprehensive income beginning with income before income taxes.

(b) Explain in memo form why the income statement data are misleading.

Prepare statement of comprehensive income.

(LO 1), AP

E13-2 Trayer Corporation has income from continuing operations of $290,000 for the year ended December 31, 2017. It also has the following items (before considering income taxes).

1. An unrealized loss of $80,000 on available-for-sale securities.

2. A gain of $30,000 on the discontinuance of a division (comprised of a $10,000 loss from operations and a $40,000 gain on disposal).

3. A correction of an error in last year's �inancial statements that resulted in a $20,000 understatement of 2016 net income.

Assume all items are subject to income taxes at a 20% tax rate.

Instructions

Prepare a statement of comprehensive income, beginning with income from continuing operations.

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Prepare horizontal analysis.

(LO 2), AP

E13-3 Here is �inancial information for Glitter Inc.

December 31, 2017 December 31, 2016 Current assets $106,000 $ 90,000 Plant assets (net)  400,000  350,000 Current liabilities   99,000   65,000 Long-term liabilities  122,000   90,000 Common stock, $1 par  130,000  115,000 Retained earnings  155,000  170,000

Instructions

Prepare a schedule showing a horizontal analysis for 2017, using 2016 as the base year.

Prepare vertical analysis.

(LO 2), AP

E13-4 Operating data for Joshua Corporation are presented below.

2017 2016 Sales revenue $800,000 $600,000 Cost of goods sold 520,000 408,000 Selling expenses 120,000 72,000 Administrative expenses 60,000 48,000 Income tax expense 30,000 24,000 Net income 70,000 48,000

Instructions

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Prepare a schedule showing a vertical analysis for 2017 and 2016.

Prepare horizontal and vertical analyses.

(LO 2), AP

E13-5 Suppose the comparative balance sheets of Nike, Inc. are presented here.

Instructions (a) Prepare a horizontal analysis of the balance sheet data for Nike, using 2016 as a base. (Show the

amount of increase or decrease as well.)

(b) Prepare a vertical analysis of the balance sheet data for Nike for 2017.

Prepare horizontal and vertical analyses.

(LO 2), AP

E13-6 Here are the comparative income statements of Delaney Corporation.

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Instructions (a) Prepare a horizontal analysis of the income statement data for Delaney Corporation, using 2016 as a

base. (Show the amounts of increase or decrease.)

(b) Prepare a vertical analysis of the income statement data for Delaney Corporation for both years.

Compute liquidity ratios.

(LO 3), AP

E13-7 Nordstrom, Inc. operates department stores in numerous states. Suppose selected �inancial statement data (in millions) for 2017 are presented below.

End of Year Beginning of Year Cash and cash equivalents $  795   $   72   Accounts receivable (net) 2,035   1,942   Inventory 898   900   Other current assets 326   303   Total current assets $4,054   $3,217   Total current liabilities $2,014   $1,601  

For the year, net credit sales were $8,258 million, cost of goods sold was $5,328 million, and net cash provided by operating activities was $1,251 million.

Instructions

Compute the current ratio, accounts receivable turnover, average collection period, inventory turnover, and days in inventory at the end of the current year.

Perform current ratio analysis.

(LO 3), AP

E13-8 Gwynn Incorporated had the following transactions involving current assets and current liabilities during February 2017.

Feb.  3 Collected accounts receivable of $15,000. 7 Purchased equipment for $23,000 cash. 11 Paid $3,000 for a 1-year insurance policy.

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14 Paid accounts payable of $12,000. 18 Declared cash dividends, $4,000.

Additional information:

As of February 1, 2017, current assets were $120,000 and current liabilities were $40,000.

Instructions

Compute the current ratio as of the beginning of the month and after each transaction.

Compute selected ratios.

(LO 3), AP

E13-9 Lendell Company has these comparative balance sheet data:

Additional information for 2017:

1. Net income was $25,000.

2. Sales on account were $375,000. Sales returns and allowances amounted to $25,000.

3. Cost of goods sold was $198,000.

4. Net cash provided by operating activities was $48,000.

5. Capital expenditures were $25,000, and cash dividends were $10,000.

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Instructions

Compute the following ratios at December 31, 2017.

(a) Current ratio.

(b) Accounts receivable turnover.

(c) Average collection period.

(d) Inventory turnover.

(e) Days in inventory.

(f) Free cash �low.

Compute selected ratios.

(LO 3), AP

E13-10 Suppose selected comparative statement data for the giant bookseller Barnes & Noble are presented here. All balance sheet data are as of the end of the �iscal year (in millions).

2017 2016 Net sales $5,121.8 $5,286.7 Cost of goods sold 3,540.6 3,679.8 Net income 75.9 135.8 Accounts receivable 81.0 107.1 Inventory 1,203.5 1,358.2 Total assets 2,993.9 3,249.8 Total common stockholders' equity 921.6 1,074.7

Instructions

Compute the following ratios for 2017.

(a) Pro�it margin.

(b) Asset turnover.

(c) Return on assets.

(d) Return on common stockholders' equity.

(e) Gross pro�it rate.

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Compute selected ratios.

(LO 3), AP

E13-11 Here is the income statement for Myers, Inc.

Additional information:

1. Common stock outstanding January 1, 2017, was 32,000 shares, and 40,000 shares were outstanding at December 31, 2017.

2. The market price of Myers stock was $14 in 2017.

3. Cash dividends of $21,000 were paid, $5,000 of which were to preferred stockholders.

Instructions

Compute the following measures for 2017.

(a) Earnings per share.

(b) Price-earnings ratio.

(c) Payout ratio.

(d) Times interest earned.

Compute amounts from ratios.

(LO 3), AP

E13-12 Panza Corporation experienced a �ire on December 31, 2017, in which its �inancial records were partially destroyed. It has been able to salvage some of the records and has ascertained the following balances.

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December 31, 2017 December 31, 2016 Cash $  30,000   $  10,000   Accounts receivable (net) 72,500   126,000   Inventory 200,000   180,000   Accounts payable 50,000   90,000   Notes payable 30,000   60,000   Common stock, $100 par 400,000   400,000   Retained earnings 113,500   101,000  

Additional information:

1. The inventory turnover is 3.8 times.

2. The return on common stockholders' equity is 22%. The company had no additional paid-in capital.

3. The accounts receivable turnover is 11.2 times.

4. The return on assets is 18%.

5. Total assets at December 31, 2016, were $605,000.

Instructions

Compute the following for Panza Corporation.

(a) Cost of goods sold for 2017.

(b) Net credit sales for 2017.

(c) Net income for 2017.

(d) Total assets at December 31, 2017.

Compute ratios.

(LO 3), AP

E13-13 The condensed �inancial statements of Ness Company for the years 2016 and 2017 are presented below.

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Compute the following ratios for 2017 and 2016.

(a) Current ratio.

(b) Inventory turnover. (Inventory on December 31, 2015, was $340.)

(c) Pro�it margin.

(d) Return on assets. (Assets on December 31, 2015, were $1,900.)

(e) Return on common stockholders' equity. (Equity on December 31, 2015, was $900.)

(f) Debt to assets ratio.

(g) Times interest earned.

EXERCISES: SET B AND CHALLENGE EXERCISES Visit the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , and choose the Student Companion site to access Exercises: Set B

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and Challenge Exercises.

PROBLEMS: SET A All of the Problems in this chapter employ decision tools.

Prepare vertical analysis and comment on pro�itability.

(LO 2, 3), AN

P13-1A Here are comparative statement data for Duke Company and Lord Company, two competitors. All balance sheet data are as of December 31, 2017, and December 31, 2016.

Instructions (a) Prepare a vertical analysis of the 2017 income statement data for Duke Company and Lord Company.

(b) Comment on the relative pro�itability of the companies by computing the 2017 return on assets and the return on common stockholders' equity for both companies.

Compute ratios from balance sheets and income statements.

(LO 3), AP

P13-2A The comparative statements of Wahlberg Company are presented here.

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All sales were on account. Net cash provided by operating activities for 2017 was $220,000. Capital expenditures were $136,000, and cash dividends were $70,000.

Instructions

Compute the following ratios for 2017.

(a) Earnings per share.

(b) Return on common stockholders' equity.

(c) Return on assets.

(d) Current ratio.

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(e) Accounts receivable turnover.

(f) Average collection period.

(g) Inventory turnover.

(h) Days in inventory.

(i) Times interest earned.

(j) Asset turnover.

(k) Debt to assets.

(l) Free cash �low.

Perform ratio analysis, and discuss changes in �inancial position and operating results.

(LO 3), AN

P13-3A Condensed balance sheet and income statement data for Jergan Corporation are presented here.

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Additional information:

1. The market price of Jergan's common stock was $7.00, $7.50, and $8.50 for 2015, 2016, and 2017, respectively.

2. You must compute dividends paid. All dividends were paid in cash.

Instructions (a) Compute the following ratios for 2016 and 2017.

(1) Pro�it margin.

(2) Gross pro�it rate.

(3) Asset turnover.

(4) Earnings per share.

(5) Price-earnings ratio.

(6) Payout ratio.

(7) Debt to assets ratio.

(b) Based on the ratios calculated, discuss brie�ly the improvement or lack thereof in the �inancial position and operating results from 2016 to 2017 of Jergan Corporation.

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Compute ratios; comment on overall liquidity and pro�itability.

(LO 3), AN

P13-4A The following �inancial information is for Priscoll Company.

Additional information:

1. Inventory at the beginning of 2016 was $115,000.

2. Accounts receivable (net) at the beginning of 2016 were $86,000.

3. Total assets at the beginning of 2016 were $660,000.

4. No common stock transactions occurred during 2016 or 2017.

5. All sales were on account.

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Instructions (a) Indicate, by using ratios, the change in liquidity and pro�itability of Priscoll Company from 2016 to

2017. (Note: Not all pro�itability ratios can be computed nor can cash-basis ratios be computed.)

(b) The following are three independent situations and a ratio that may be affected. For each situation, compute the affected ratio (1) as of December 31, 2017, and (2) as of December 31, 2018, after giving effect to the situation. Net income for 2018 was $54,000. Total assets on December 31, 2018, were $900,000.

Situation Ratio 1.  18,000 shares of common stock were sold at par on July 1, 2018. Return on common

stockholders' equity 2.  All of the notes payable were paid in 2018. Debt to assets ratio 3.  The market price of common stock was $9 and $12 on December 31, 2017 and 2018, respectively.

Price-earnings ratio

Compute selected ratios, and compare liquidity, pro�itability, and solvency for two companies.

(LO 3), AN

P13-5A Suppose selected �inancial data of Target and Wal-Mart for 2017 are presented here (in millions).

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Instructions (a) For each company, compute the following ratios.

(1) Current ratio.

(2) Accounts receivable turnover.

(3) Average collection period.

(4) Inventory turnover.

(5) Days in inventory.

(6) Pro�it margin.

(7) Asset turnover.

(8) Return on assets.

(9) Return on common stockholders' equity.

(10) Debt to assets ratio.

(11) Times interest earned.

(12) Free cash �low.

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(b) Compare the liquidity, solvency, and pro�itability of the two companies.

PROBLEMS: SET B AND SET C Visit the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , and choose the Student Companion site to access Problems: Set B and Set C.

CONTINUING PROBLEM Cookie Creations

(Note: This is a continuation of the Cookie Creations problem from Chapters 1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch01#ch01) through 12 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch12#ch12) .)

CC13 Natalie and Curtis have comparative balance sheets and income statements for Cookie & Coffee Creations Inc. They have been told that they can use these �inancial statements to prepare horizontal and vertical analyses, to calculate �inancial ratios, to analyze how their business is doing, and to make some decisions they have been considering.

Go to the book's companion website, at www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel) , to �ind the completion of this problem.

EXPAND YOUR | CRITICAL THINKING

FINANCIAL REPORTING PROBLEM: Apple Inc.

CT13-1 Your parents are considering investing in Apple Inc. common stock. They ask you, as an accounting expert, to make an analysis of the company for them. Financial statements of Apple are presented in Appendix A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a01#a01) . Instructions for accessing and using the company's complete annual report, including the notes to its �inancial statements, are also provided in Appendix A (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a01#a01) .

AN

Instructions (a) Make a 5-year trend analysis, using 2010 as the base year, of (1) net sales and (2) net

income. Comment on the signi�icance of the trend results.

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(b) Compute for 2014 and 2013 the (1) debt to assets ratio and (2) times interest earned. (See Note 3 for interest expense.) How would you evaluate Apple's long-term solvency?

(c) Compute for 2014 and 2013 the (1) pro�it margin, (2) asset turnover, (3) return on assets, and (4) return on common stockholders' equity. How would you evaluate Apple's pro�itability? Total assets at September 29, 2012, were $176,064 million and total stockholders' equity at September 29, 2012, was $118,210 million.

(d) What information outside the annual report may also be useful to your parents in making a decision about Apple?

COMPARATIVE ANALYSIS PROBLEM: Columbia Sportswear Company vs. VF Corporation

CT13-2 The �inancial statements of Columbia Sportswear Company are presented in Appendix B

(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a02#a02) . Financial statements of VF Corporation are presented in Appendix C (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a03#a03) .

AN

Instructions (a) Based on the information in the �inancial statements, determine each of the following for

each company:

(1) The percentage increase (i) in net sales and (ii) in net income from 2013 to 2014.

(2) The percentage increase (i) in total assets and (ii) in total stockholders' equity from 2013 to 2014.

(3) The basic earnings per share for 2014.

(b) What conclusions concerning the two companies can be drawn from these data?

COMPARATIVE ANALYSIS PROBLEM: Amazon.com, Inc. vs. Wal-Mart Stores, Inc.

CT13-3 The �inancial statements of Amazon.com, Inc. are presented in Appendix D

(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a04#a04) . Financial statements of Wal-Mart Stores, Inc. are presented in Appendix E (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a05#a05) .

AN

Instructions

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(a) Based on the information in the �inancial statements, determine each of the following for each company:

(1) The percentage increase (i) in net sales and (ii) in net income from 2013 to 2014.

(2) The percentage increase (i) in total assets and (ii) in total stockholders' equity from 2013 to 2014.

(3) The basic earnings per share for 2014.

(b) What conclusions concerning the two companies can be drawn from these data?

INTERPRETING FINANCIAL STATEMENTS

CT13-4 The Coca-Cola Company and PepsiCo, Inc. provide refreshments to every corner of the world. Suppose selected data from recent consolidated �inancial statements for The Coca-Cola Company and for PepsiCo, Inc. are presented here (in millions).

AN

Coca-Cola PepsiCo Total current assets $17,551 $12,571 Total current liabilities 13,721 8,756 Net sales 30,990 43,232 Cost of goods sold 11,088 20,099 Net income 6,824 5,946 Average (net) accounts receivable for the year 3,424 4,654 Average inventories for the year 2,271 2,570 Average total assets 44,595 37,921 Average common stockholders' equity 22,636 14,556 Average current liabilities 13,355 8,772 Average total liabilities 21,960 23,466 Total assets 48,671 39,848 Total liabilities 23,872 23,044 Income taxes 2,040 2,100 Interest expense 355 397 Net cash provided by operating activities 8,186 6,796 Capital expenditures 1,993 2,128 Cash dividends 3,800 2,732

Instructions

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(a) Compute the following liquidity ratios for Coca-Cola and for PepsiCo and comment on the relative liquidity of the two competitors.

(1) Current ratio.

(2) Accounts receivable turnover.

(3) Average collection period.

(4) Inventory turnover.

(5) Days in inventory.

(b) Compute the following solvency ratios for the two companies and comment on the relative solvency of the two competitors.

(1) Debt to assets ratio.

(2) Times interest earned.

(3) Free cash �low.

(c) Compute the following pro�itability ratios for the two companies and comment on the relative pro�itability of the two competitors.

(1) Pro�it margin.

(2) Asset turnover.

(3) Return on assets.

(4) Return on common stockholders' equity.

REAL-WORLD FOCUS

CT13-5 Purpose: To employ comparative data and industry data to evaluate a company's performance and �inancial position.

E

Address: http://www.msn.com/en-us/money (http://www.msn.com/en-us/money) , or go to www.wiley.com/college/kimmel (http://www.wiley.com/college/kimmel)

Steps

(1) Identify two competing companies.

(2) Go to the above address.

(3) Type in the �irst company's stock symbol or name. (Use “symbol look-up.”)

(4) Under the “Fundamentals” heading, use the Growth, Pro�itability, Financial health, Price ratios, and Management effectiveness tabs to answer parts (a), (b), and (c) below.

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Instructions (a) Evaluate the company's liquidity relative to the industry averages and to the competitor that

you chose.

(b) Evaluate the company's solvency relative to the industry averages and to the competitor that you chose.

(c) Evaluate the company's pro�itability relative to the industry averages and to the competitor that you chose.

CT13-6 The April 25, 2012, edition of the Wall Street Journal contains an article by Spencer Jakab entitled “Amazon's Valuation Is Hard to Justify.”

E

Instructions

Read the article and answer the following questions.

(a) Explain what is meant by the statement that “On a split-adjusted basis, today's share price is the equivalent of $1,166.”

(b) The article says that Amazon.com nearly doubled its capital spending on items such as ful�illment centers (sophisticated warehouses where it �inds, packages, and ships goods to customers). Discuss the implications that this spending would have on the company's return on assets in the short-term and in the long-term.

(c) How does Amazon's P-E ratio compare to that of Apple, Net�lix, and Wal-Mart? What does this suggest about investors' expectations about Amazon's future earnings?

(d) What factor does the article cite as a possible hurdle that might reduce Amazon's ability to raise its operating margin back to previous levels?

DECISION-MAKING ACROSS THE ORGANIZATION

CT13-7 You are a loan of�icer for White Sands Bank of Taos. Paul Jason, president of P. Jason Corporation, has just left your of�ice. He is interested in an 8-year loan to expand the company's operations. The borrowed funds would be used to purchase new equipment. As evidence of the company's debt- worthiness, Jason provided you with the following facts.

E

2017 2016 Current ratio 3.1 2.1 Asset turnover 2.8 2.2 Net income Up 32% Down 8%

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2017 2016 Earnings per share $3.30 $2.50

Jason is a very insistent (some would say pushy) man. When you told him that you would need additional information before making your decision, he acted offended and said, “What more could you possibly want to know?” You responded that, at a minimum, you would need complete, audited �inancial statements.

Instructions

With the class divided into groups, answer the following.

(a) Explain why you would want the �inancial statements to be audited.

(b) Discuss the implications of the ratios provided for the lending decision you are to make. That is, does the information paint a favorable picture? Are these ratios relevant to the decision?

(c) List three other ratios that you would want to calculate for this company, and explain why you would use each.

COMMUNICATION ACTIVITY

CT13-8 Larry Dundee is the chief executive of�icer of Palmer Electronics. Dundee is an expert engineer but a novice in accounting. Dundee asks you, as an accounting student, to explain (a) the bases for comparison in analyzing Palmer's �inancial statements and (b) the limitations, if any, in �inancial statement analysis.

E

Instructions

Write a memo to Larry Dundee that explains the basis for comparison and the factors affecting quality of earnings.

ETHICS CASE

CT13-9 René Kelly, president of RL Industries, wishes to issue a press release to bolster her company's image and maybe even its stock price, which has been gradually falling. As controller, you have been asked to provide a list of 20 �inancial ratios and other operating statistics for RL Industries' �irst-quarter �inancials and operations.

E

Two days after you provide the data requested, Erin Lourdes, the public relations director of RL, asks you to prove the accuracy of the �inancial and operating data contained in the press release written by the president and edited by Erin. In the news release, the president highlights the sales increase of 25% over last year's �irst quarter and the positive change in the current ratio from 1.5:1 last year to 3:1 this year. She also emphasizes that production was up 50% over the prior year's �irst quarter.

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You note that the release contains only positive or improved ratios and none of the negative or deteriorated ratios. For instance, no mention is made that the debt to assets ratio has increased from 35% to 55%, that inventories are up 89%, and that although the current ratio improved, the accounts receivable turnover fell from 12 to 9. Nor is there any mention that the reported pro�it for the quarter would have been a loss had not the estimated lives of RL plant and machinery been increased by 30%. Erin emphasized, “The Pres wants this release by early this afternoon.”

Instructions (a) Who are the stakeholders in this situation?

(b) Is there anything unethical in the president's actions?

(c) Should you as controller remain silent? Does Erin have any responsibility?

ALL ABOUT YOU

CT13-10 In this chapter, you learned how to use many tools for performing a �inancial analysis of a company. When making personal investments, however, it is most likely that you won't be buying stocks and bonds in individual companies. Instead, when most people want to invest in stock, they buy mutual funds. By investing in a mutual fund, you reduce your risk because the fund diversi�ies by buying the stock of a variety of different companies, bonds, and other investments, depending on the stated goals of the fund.

E

Before you invest in a fund, you will need to decide what type of fund you want. For example, do you want a fund that has the potential of high growth (but also high risk), or are you looking for lower risk and a steady stream of income? Do you want a fund that invests only in U.S. companies, or do you want one that invests globally? Many resources are available to help you with these types of decisions.

Instructions

Go to http://web.archive.org/web/20050210200843/ (http://web.archive.org/web/20050210200843/) , http://www.cnb1.com/invallocmdl.htm (http://www.cnb1.com/invallocmdl.htm) and complete the investment allocation questionnaire. Add up your total points to determine the type of investment fund that would be appropriate for you.

FASB CODIFICATION ACTIVITY

CT13-11 If your school has a subscription to the FASB Codi�ication, go to http://aaahq.org/ascLogin.cfm (http://aaahq.org/ascLogin.cfm) to log in and prepare responses to the following. Use the Master Glossary for determining the proper de�initions.

AP

(a) Discontinued operations.

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(b) Comprehensive income.

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LEARNING OBJECTIVE 5

Compare �inancial statement analysis and income statement presentation under GAAP and IFRS. 

The tools of �inancial statement analysis are the same throughout the world. Techniques such as vertical and horizontal analysis, for example, are tools used by analysts regardless of whether GAAP- or IFRS- related �inancial statements are being evaluated. In addition, the ratios provided in the textbook are the same ones that are used internationally.

The beginning of this chapter relates to the income statement. As in GAAP, the income statement is a required statement under IFRS. In addition, the content and presentation of an IFRS income statement is similar to the one used for GAAP. IAS 1 (revised), “Presentation of Financial Statements,” provides general guidelines for the reporting of income statement information. In general, the differences in the presentation of �inancial statement information are relatively minor.

RELEVANT FACTS

Following are the key similarities between GAAP and IFRS as related to �inancial statement analysis and income statement presentation. There are no signi�icant differences between the two standards.

The tools of �inancial statement analysis covered in this chapter are universal and therefore no signi�icant differences exist in the analysis methods used.

The basic objectives of the income statement are the same under both GAAP and IFRS. As indicated in the textbook, a very important objective is to ensure that users of the income statement can evaluate the sustainable income of the company. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from unusual items in order to better predict a company's future pro�itability.

The basic accounting for discontinued operations is the same under IFRS and GAAP.

The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS.

Both GAAP and IFRS follow the same approach in reporting comprehensive income.

LOOKING TO THE FUTURE

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The FASB and the IASB are working on a project that would rework the structure of �inancial statements. Recently, the IASB decided to require a statement of comprehensive income, similar to what was required under GAAP. In addition, another part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income.

IFRS Practice IFRS SELF-TEST QUESTIONS

1. The basic tools of �inancial analysis are the same under both GAAP and IFRS except that: (a) horizontal analysis cannot be done because the format of the statements is sometimes

different.

(b) analysis is different because vertical analysis cannot be done under IFRS.

(c) the current ratio cannot be computed because current liabilities are often reported before current assets in IFRS statements of position.

(d) None of the above.

2. Presentation of comprehensive income must be reported under IFRS in: (a) the statement of stockholders' equity.

(b) the income statement ending with net income.

(c) the notes to the �inancial statements.

(d) a statement of comprehensive income.

3. In preparing its income statement for 2017, Parmalane assembles the following information.

Sales revenue $500,000

Cost of goods sold 300,000

Operating expenses 40,000

Loss on discontinued operations 20,000

Ignoring income taxes, what is Parmalane's income from continuing operations for 2017 under IFRS?

(a) $260,000.

(b) $250,000.

(c) $240,000.

(d) $160,000.

INTERNATIONAL FINANCIAL REPORTING PROBLEM: Louis Vuitton

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IFRS13-1 The �inancial statements of Louis Vuitton are presented in Appendix F (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a06#a06) . Instructions for accessing and using the company's complete annual report, including the notes to its �inancial statements, are also provided in Appendix F (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/a06#a06) .

Instructions

Use the company's 2014 annual report to answer the following questions.

(a) What was the company's pro�it margin for 2014? Has it increased or decreased from 2013?

(b) What was the company's operating pro�it for 2014?

(c) The company reported comprehensive income of €3,267 billion in 2014. What are the other comprehensive gains and losses recorded in 2014?

Answers to IFRS Self-Test Questions

1. d 2. d 3. d

1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-note-0003a) The FASB'S Conceptual Framework describes comprehensive income as including all changes in stockholders' equity during a period except those changes resulting from investments by stockholders and distributions to stockholders.

2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch13lo1#c13-note-0005a) An exception to the general rule is a change in depreciation methods. The effects of this change are reported in current and future periods. Discussion of this approach is left for more advanced courses.