week 8 exercises

674

Chapter

Financial Statement Analysis After studying this chapter, you should be able to: 1 Discuss the need for comparative analysis. 2 Identify the tools of financial statement

analysis. 3 Explain and apply horizontal analysis. 4 Describe and apply vertical analysis. 5 Identify and compute ratios used in

analyzing a firm’s liquidity, profitability, and solvency.

6 Understand the concept of earning power, and how irregular items are presented.

7 Understand the concept of quality of earnings.

S T U D Y O B J E C T I V E S

Feature Story

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14

IT PAYS TO BE PATIENT

In 2008 Forbes magazine listed Warren Buffett as the richest person in the world. His estimated wealth was $62 billion, give or take a few million. How much is $62 billion? If you invested $62 billion in an investment earning just 4%, you could spend $6.8 million per day—every day—forever. How did Mr. Buffett amass this wealth? Through careful investing.

You think you might want to follow Buffett’s example and transform your humble nest-egg into a mountain of cash. His techniques have been widely circulated and emulated, but never practiced with the same degree of success. Buffett epitomizes a “value investor.” To this day he applies the same basic techniques he learned in the 1950s from the great value investor

Scan Study Objectives ■

Read Feature Story ■

Read Preview ■

Read text and answer p. 681 ■ p. 694 ■ p. 699 ■ p. 701 ■

Work Comprehensive p. 703 ■

Review Summary of Study Objectives ■

Answer Self-Study Questions ■

Complete Assignments ■

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Do it!

Do it!

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675

Benjamin Graham. That means he spends his time looking 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 trend. Instead, he looks for companies in industries with sound economics and ones that have high returns on stockholders’ equity. He looks for steady earnings trends and high margins.

Buffett sat out on the dot-com mania in the 1990s, when investors put lots of money into fledgling high- tech firms, because he did not find dot-com compa- nies 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. Instead, when the dot-com bubble burst, and nearly everyone else was suffering from investment shock, he swooped in and scooped up deals on companies that he had been following for years.

So, how does Mr. 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 giving virtually all of his money to charity before he dies.

So, given that neither you nor anyone else will be inheriting Mr. Buffett’s riches, you should start honing your financial analysis skills as soon as possible. A good way for you to begin your career as a successful investor is to master the fundamentals of financial analysis discussed in this chapter.

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Inside Chapter 14...

• How to Manage the Current Ratio (p. 685)

• Keeping Up to Date as an Investor (p. 693)

• What Does “Non-Recurring” Really Mean? (p. 698)

• All About You: Should I Play the Market Yet? (p. 702)

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BASICS OF FINANCIAL STATEMENT ANALYSIS

Preview of Chapter 14

We can learn an important lesson from Warren Buffett. The lesson: Study companies carefully if you wish to invest. Do not get caught up in fads, but instead find companies that are financially healthy. Using some of the basic decision tools presented in this book, you can perform a rudimentary analysis on any U.S. com- pany and draw basic conclusions about its financial 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 financial numbers.

Before unleashing you on the world of high finance, we will present a few more important concepts and techniques, as well as provide you with one more comprehensive review of corporate financial statements. We use all of the decision tools presented in this text to analyze a single company—J.C. Penney Company, one of the country’s oldest and largest retail store chains.

The content and organization of Chapter 14 are as follows.

676

Analyzing financial statements involves evaluating three characteristics: a com- pany’s liquidity, profitability, and solvency. A short-term creditor, such as a bank, is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in eval- uating the safety of a loan. A long-term creditor, such as a bondholder, looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long-term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments. Similarly, stockholders look at the profitability and solvency of the com- pany. They want to assess the likelihood of dividends and the growth potential of the stock.

Need for Comparative Analysis Every item reported in a financial statement has significance. When J.C. Penney Company, Inc. reports cash of $2,471 million on its balance sheet, we know the company had that amount of cash on the balance sheet date. But, we do not know whether the amount represents an increase

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Financial Statement Analysis

Basics of Financial Statement Analysis

• Need for comparative analysis

• Tools of analysis

Ratio Analysis

• Liquidity • Profitability • Solvency • Summary

Horizontal and Vertical Analysis

• Balance sheet • Income statement • Retained earnings

statement

Earning Power and Irregular Items

• Discontinued operations

• Extraordinary items • Changes in

accounting principle • Comprehensive

income

Quality of Earnings

• Alternative accounting methods

• Pro forma income • Improper

recognition

Discuss the need for comparative analysis.

S T U D Y O B J E C T I V E 1

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over prior years, or whether it is adequate in relation to the company’s need for cash. To obtain such information, we need to compare the amount of cash with other financial statement data.

Comparisons can be made on a number of different bases.Three are illustrated in this chapter:

1. Intracompany basis. This basis compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. For example, J.C. Penney can compare its cash balance at the end of the current year with last year’s balance to find the amount of the in- crease or decrease. Likewise, J.C. Penney can compare the percentage of cash to current assets at the end of the current year with the percentage in one or more prior years. Intracompany comparisons are useful in detecting changes in financial relationships and significant trends.

2. Industry averages. This basis compares an item or financial relationship of a company with industry averages (or norms) published by financial ratings organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s. For example, J.C. Penney’s net income can be compared with the average net income of all companies in the retail chain-store industry. Comparisons with in- dustry averages provide information as to a company’s relative performance within the industry.

3. Intercompany basis. This basis compares an item or financial relationship of one company with the same item or relationship in one or more competing companies. Analysts make these comparisons on the basis of the published fi- nancial statements of the individual companies. For example, we can compare J.C. Penney’s total sales for the year with the total sales of a major competitor such as Kmart. Intercompany comparisons are useful in determining a com- pany’s competitive position.

Tools of Analysis We use various tools to evaluate the significance of financial statement data. Three commonly used tools are these:

• Horizontal analysis evaluates a series of financial statement data over a period of time.

• Vertical analysis evaluates financial statement data by expressing each item in a financial statement as a percent of a base amount.

• Ratio analysis expresses the relationship among selected items of financial statement data.

Horizontal analysis is used primarily in intracompany comparisons. Two fea- tures in published financial statements facilitate this type of comparison: First, each of the basic financial statements presents comparative financial data for a mini- mum of two years. Second, a summary of selected financial data is presented for a series of five to ten years or more. Vertical analysis is used in both intra- and inter- company comparisons. Ratio analysis is used in all three types of comparisons. In the following sections, we explain and illustrate each of the three types of analysis.

Horizontal Analysis 677

Identify the tools of financial statement analysis.

S T U D Y O B J E C T I V E 2

XYZ Co.

Industry averages

A Co.

B Co.

C Co.

A + B + C 3

⎫ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎭

XYZ Co.

2011 ↔ 2012

Intracompany

XYZ Co.

A Co.

Intercompany

HORIZONTAL ANALYSIS

Horizontal analysis, also called trend analysis, is a technique for evaluat- ing a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. This change

Explain and apply horizontal analysis.

S T U D Y O B J E C T I V E 3

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may be expressed as either an amount or a percentage. For example, the recent net sales figures of J.C. Penney Company are as follows.

678 Chapter 14 Financial Statement Analysis

J.C. PENNEY COMPANY Net Sales (in millions)

2007 2006 2005

$19,860 $19,903 $18,781

If we assume that 2005 is the base year, we can measure all percentage increases or decreases from this base period amount as follows.

Illustration 14-1 J.C. Penney Company’s net sales

Current Results in �

Current Year Amount Relation to Base Period Base Year Amount

For example, we can determine that net sales for J.C. Penney increased from 2005 to 2006 approximately 6% [($19,903 � $18,781) � $18,781]. Similarly, we can de- termine that net sales increased from 2005 to 2007 approximately 5.7% [($19,860 � $18,781) � $18,781].

Alternatively, we can express current year sales as a percentage of the base period.We do this by dividing the current year amount by the base year amount, as shown below.

Change Since �

Current Year Amount � Base Year Amount Base Period Base Year Amount

Illustration 14-4 presents this analysis for J.C. Penney for a three-year period using 2005 as the base period.

J.C. PENNEY COMPANY Net Sales (in millions)

in relation to base period 2005

2007 2006 2005

$19,860 $19,903 $18,781 105.7% 106.0% 100.0%

Illustration 14-2 Formula for horizontal analysis of changes since base period

Illustration 14-3 Formula for horizontal analysis of current year in relation to base year

Balance Sheet To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store Inc., a fictional retailer. Illustration 14-5 (page 679) presents a horizontal analysis of its two-year condensed balance sheets, showing dollar and percentage changes.

Illustration 14-4 Horizontal analysis of J.C. Penney Company’s net sales in relation to base period

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The comparative balance sheets in Illustration 14-5 show that a number of sig- nificant changes have occurred in Quality Department Store’s financial structure from 2006 to 2007:

• In the assets section, plant assets (net) increased $167,500, or 26.5% ($167,500 � $632,500).

• In the liabilities section, current liabilities increased $41,500, or 13.7% ($41,500 � $303,000).

• In the stockholders’ equity section, retained earnings increased $202,600, or 38.6% ($202,600 � $525,000).

These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming addi- tional long-term debt.

Income Statement Illustration 14-6 (page 680) presents a horizontal analysis of the two-year condensed income statements of Quality Department Store Inc. for the years 2007 and 2006. Horizontal analysis of the income statements shows the following changes:

• Net sales increased $260,000, or 14.2% ($260,000 � $1,837,000). • Cost of goods sold increased $141,000, or 12.4% ($141,000 � $1,140,000). • Total operating expenses increased $37,000, or 11.6% ($37,000 � $320,000).

Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.

Horizontal Analysis 679

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets

December 31

Increase or (Decrease) during 2007

2007 2006 Amount Percent

Assets

Current assets $1,020,000 $ 945,000 $ 75,000 7.9% Plant assets (net) 800,000 632,500 167,500 26.5% Intangible assets 15,000 17,500 (2,500) (14.3%)

Total assets $1,835,000 $1,595,000 $240,000 15.0%

Liabilities

Current liabilities $ 344,500 $ 303,000 $ 41,500 13.7% Long-term liabilities 487,500 497,000 (9,500) (1.9%)

Total liabilities 832,000 800,000 32,000 4.0%

Stockholders’ Equity

Common stock, $1 par 275,400 270,000 5,400 2.0% Retained earnings 727,600 525,000 202,600 38.6%

Total stockholders’ equity 1,003,000 795,000 208,000 26.2%

Total liabilities and stockholders’ equity $1,835,000 $1,595,000 $240,000 15.0%

Illustration 14-5 Horizontal analysis of balance sheets

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Retained Earnings Statement Illustration 14-7 presents a horizontal analysis of Quality Department Store’s com- parative retained earnings statements.Analyzed horizontally, net income increased $55,300, or 26.5%, whereas dividends on the common stock increased only $1,200, or 2%. We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.

680 Chapter 14 Financial Statement Analysis

H E L P F U L H I N T Note that though the amount column is additive (the total is $55,300), the percentage column is not additive (26.5% is not the total). A separate percentage has been calculated for each item.

QUALITY DEPARTMENT STORE INC. Condensed Income Statements

For the Years Ended December 31

Increase or (Decrease) during 2007

2007 2006 Amount Percent

Sales $2,195,000 $1,960,000 $235,000 12.0% Sales returns and allowances 98,000 123,000 (25,000) (20.3%)

Net sales 2,097,000 1,837,000 260,000 14.2% Cost of goods sold 1,281,000 1,140,000 141,000 12.4%

Gross profit 816,000 697,000 119,000 17.1%

Selling expenses 253,000 211,500 41,500 19.6% Administrative expenses 104,000 108,500 (4,500) (4.1%)

Total operating expenses 357,000 320,000 37,000 11.6%

Income from operations 459,000 377,000 82,000 21.8% Other revenues and gains

Interest and dividends 9,000 11,000 (2,000) (18.2%) Other expenses and losses

Interest expense 36,000 40,500 (4,500) (11.1%)

Income before income taxes 432,000 347,500 84,500 24.3% Income tax expense 168,200 139,000 29,200 21.0%

Net income $ 263,800 $ 208,500 $ 55,300 26.5%

QUALITY DEPARTMENT STORE INC. Retained Earnings Statements

For the Years Ended December 31

Increase or (Decrease) during 2007

2007 2006 Amount Percent

Retained earnings, Jan. 1 $525,000 $376,500 $148,500 39.4% Add: Net income 263,800 208,500 55,300 26.5%

788,800 585,000 203,800 Deduct: Dividends 61,200 60,000 1,200 2.0%

Retained earnings, Dec. 31 $727,600 $525,000 $202,600 38.6%

Horizontal analysis of changes from period to period is relatively straight- forward and is quite useful. But complications can occur in making the computa- tions. If an item has no value in a base year or preceding year but does have a value in the next year, we cannot compute a percentage change. Similarly, if a negative

Illustration 14-6 Horizontal analysis of income statements

Illustration 14-7 Horizontal analysis of retained earnings statements

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before you go on...

amount appears in the base or preceding period and a positive amount exists the following year (or vice versa), no percentage change can be computed.

Vertical Analysis 681

Related exercise material: BE14-2, BE14-3, BE14-5, BE14-6, BE14-7, E14-1, E14-3, E14-4, and 14-1.Do it!

Action Plan

• Find the percentage change by dividing the amount of the increase by the 2010 amount (base year).

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Do it! Summary financial information for Rosepatch Company is as follows.

December 31, 2011 December 31, 2010

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 2011 using horizontal analysis, assuming 2010 is the base year.

Solution

Increase in 2011

Amount Percent

Current assets $ 54,000 30% [($234,000 � $180,000) � $180,000] Plant assets (net) 336,000 80% [($756,000 � $420,000) � $420,000]

Total assets $390,000 65% [($990,000 � $600,000) � $600,000]

Horizontal Analysis

Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. On a balance sheet we might say that current assets are 22% of total assets— total assets being the base amount. Or on an income statement, we might say that selling expenses are 16% of net sales—net sales being the base amount.

Balance Sheet Illustration 14-8 (page 682) presents the vertical analysis of Quality Department Store Inc.’s comparative balance sheets. The base for the asset items is total assets. The base for the liability and stockholders’ equity items is total liabilities and stockholders’ equity.

Vertical analysis shows the relative size of each category in the balance sheet. It also can show how the percentage in the individual asset, liability, and stockholders’ equity items changes from year to year. For example, we can see that current assets decreased from 59.2% of total assets in 2006 to 55.6% in 2007 (even though the ab- solute dollar amount increased $75,000 in that time). Plant assets (net) have in- creased from 39.7% to 43.6% of total assets. Retained earnings have increased from 32.9% to 39.7% of total liabilities and stockholders’ equity. These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt.

Income Statement Illustration 14-9 (page 682) shows vertical analysis of Quality’s income statements. Cost of goods sold as a percentage of net sales declined 1% (62.1% vs. 61.1%), and total operating expenses declined 0.4% (17.4% vs. 17.0%). As a result, it is not surprising

VERTICAL ANALYSIS

Describe and apply vertical analysis.

S T U D Y O B J E C T I V E 4

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682 Chapter 14 Financial Statement Analysis

QUALITY DEPARTMENT STORE INC. Condensed Income Statements

For the Years Ended December 31

2007 2006

Amount Percent Amount Percent

Sales $2,195,000 104.7% $1,960,000 106.7% Sales returns and allowances 98,000 4.7% 123,000 6.7%

Net sales 2,097,000 100.0% 1,837,000 100.0% Cost of goods sold 1,281,000 61.1% 1,140,000 62.1%

Gross profit 816,000 38.9% 697,000 37.9%

Selling expenses 253,000 12.0% 211,500 11.5% Administrative expenses 104,000 5.0% 108,500 5.9%

Total operating expenses 357,000 17.0% 320,000 17.4%

Income from operations 459,000 21.9% 377,000 20.5% Other revenues and gains

Interest and dividends 9,000 0.4% 11,000 0.6%

Other expenses and losses Interest expense 36,000 1.7% 40,500 2.2%

Income before income taxes 432,000 20.6% 347,500 18.9% Income tax expense 168,200 8.0% 139,000 7.5%

Net income $ 263,800 12.6% $ 208,500 11.4%

QUALITY DEPARTMENT STORE INC. Condensed Balance Sheets

December 31

2007 2006

Amount Percent Amount Percent

Assets

Current assets $1,020,000 55.6% $ 945,000 59.2% Plant assets (net) 800,000 43.6% 632,500 39.7% Intangible assets 15,000 0.8% 17,500 1.1%

Total assets $1,835,000 100.0% $1,595,000 100.0%

Liabilities

Current liabilities $ 344,500 18.8% $ 303,000 19.0% Long-term liabilities 487,500 26.5% 497,000 31.2%

Total liabilities 832,000 45.3% 800,000 50.2%

Stockholders’ Equity

Common stock, $1 par 275,400 15.0% 270,000 16.9% Retained earnings 727,600 39.7% 525,000 32.9%

Total stockholders’ equity 1,003,000 54.7% 795,000 49.8%

Total liabilities and stockholders’ equity $1,835,000 100.0% $1,595,000 100.0%

Illustration 14-8 Vertical analysis of balance sheets

Illustration 14-9 Vertical analysis of income statements

to see net income as a percent of net sales increase from 11.4% to 12.6%. Quality appears to be a profitable enterprise that is becoming even more successful.

An associated benefit of vertical analysis is that it enables you to compare com- panies of different sizes. For example, Quality’s main competitor is a J.C. Penney store in a nearby town. Using vertical analysis, we can compare the condensed

H E L P F U L H I N T The formula for calculat- ing these balance sheet percentages is:

= % Each item on B/S

Total assets

H E L P F U L H I N T The formula for calculating these income statement percentages is: Each item on I/S

Net sales = %

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income statements of Quality Department Store Inc. (a small retail company) with J.C. Penney Company, Inc. (a giant international retailer), as shown in Illustration 14-10.

Ratio Analysis 683

CONDENSED INCOME STATEMENTS (in thousands)

Quality Department J.C. Penney Store Inc. Company1

Dollars Percent Dollars Percent

Net sales $2,097 100.0% $19,860,000 100.0% Cost of goods sold 1,281 61.1% 12,189,000 61.4%

Gross profit 816 38.9% 7,671,000 38.6% Selling and administrative expenses 357 17.0% 5,357,000 27.0%

Income from operations 459 21.9% 2,314,000 11.6% Other expenses and revenues

(including income taxes) 195 9.3% 1,203,000 6.0%

Net income $ 264 12.6% $ 1,111,000 5.6%

J.C. Penney’s net sales are 9,471 times greater than the net sales of relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality’s and J.C. Penney’s gross profit rates were comparable at 38.9% and 38.6%. However, the percentages related to income from operations were significantly different at 21.9% and 11.6%. This disparity can be attributed to Quality’s selling and administrative expense percentage (17%) which is much lower than J.C. Penney’s (27.0%).Although J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 44% of Quality’s (12.6%).

Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion.To illustrate, in 2007 Nike, Inc., had current assets of $8,839.3 million and current liabilities of $3,321.5 million. We can find the relationship between these two measures by dividing cur- rent assets by current liabilities. The alternative means of expression are:

Percentage: Current assets are 266% of current liabilities. Rate: Current assets are 2.66 times current liabilities.

Proportion: The relationship of current assets to current liabilities is 2.66:1.

To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability, and solvency. Illustration 14-11 (page 684) describes these classifications.

RATIO ANALYSIS

Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

S T U D Y O B J E C T I V E 5

12007 Annual Report J.C. Penney Company, Inc. (Dallas, Texas).

Illustration 14-10 Intercompany income statement comparison

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Current Assets Current Ratio �

Current Liabilities

Quality Department Store

2007 2006

$1,020,000 � 2.96�1

$945,000 $344,500 $303,000

� 3.12�1

Industry average J.C. Penney Company 1.06�1 2.02�1

Ratios can provide clues to underlying conditions that may not be ap- parent from individual financial statement components. However, a single ratio by itself is not very meaningful. Thus, in the discussion of ratios we will use the following types of comparisons.

1. Intracompany comparisons for two years for Quality Department Store. 2. Industry average comparisons based on median ratios for department

stores. 3. Intercompany comparisons based on J.C. Penney Company as Quality

Department Store’s principal competitor.

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 ratios we can use to determine the enterprise’s short-term debt-paying ability are the current ratio, the acid-test ratio, re- ceivables turnover, and inventory turnover.

1. CURRENT RATIO The current ratio is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability.The ratio is computed by dividing current assets by current liabilities. Illustration 14-12 shows the 2007 and 2006 current ratios for Quality Department Store and comparative data.

684 Chapter 14 Financial Statement Analysis

Solvency Ratios

Measure the ability of the company to survive over a long period of time

Profitability Ratios

Measure the income or operating success of a company for a given period of time– =

Net incomeRevenues Expenses

XYZ Co.

Founded in 1892

Liquidity Ratios

Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

INTERNATIONAL NOTE As more countries adopt in-

ternational accounting standards, the ability of analysts to compare companies from different countries should improve. However, inter- national standards are open to widely varying interpretations. In addition, some countries adopt international standards “with modifications.” As a consequence, most cross-country comparisons are still not as transparent as within-country comparisons.

E T H I C S N O T E

Companies can affect the current ratio by speeding up or withholding payments on accounts payable just before the balance sheet date. Management can alter the cash balance by increasing or decreasing long-term assets or long-term debt, or by issuing or purchasing equity shares.

Illustration 14-11 Financial ratio classifications

Illustration 14-12 Current ratio

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QUALITY DEPARTMENT STORE INC. Balance Sheet (partial)

2007 2006

Current assets Cash $ 100,000 $155,000 Short-term investments 20,000 70,000 Receivables (net*) 230,000 180,000 Inventory 620,000 500,000 Prepaid expenses 50,000 40,000

Total current assets $1,020,000 $945,000

*Allowance for doubtful accounts is $10,000 at the end of each year.

What does the ratio actually mean? The 2007 ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. Quality’s cur- rent ratio has decreased in the current year. But, compared to the industry average of 1.06:1, Quality appears to be reasonably liquid. J.C. Penney has a current ratio of 2.02 which indicates it has adequate current assets relative to its current liabilities.

The current ratio is sometimes referred to as the working capital ratio; working capital is current assets minus current liabilities. The current ratio is a more de- pendable indicator of liquidity than working capital.Two companies with the same amount of working capital may have significantly different current ratios.

The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow- moving inventory. A dollar of cash would be more readily available to pay the bills than a dollar of slow-moving inventory.

Ratio Analysis 685

H E L P F U L H I N T Can any company operate successfully without working capital? Yes, if it has very predictable cash flows and solid earnings. A number of companies (e.g., Whirlpool, American Standard, and Campbell’s Soup) are pursuing this goal. The rationale: Less money tied up in working capital means more money to invest in the business.

ACCOUNTING ACROSS THE ORGANIZATION How to Manage the Current Ratio

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

the ratio to change. 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 will decrease 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, and its current ratio will increase to 3:1. Thus, any trend analysis should be done with care, because the ratio is suscep- tible to quick changes and is easily influenced by management.

How might management influence the company’s current ratio?

2. ACID-TEST RATIO The acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity.We compute this ratio by dividing the sum of cash, short-term investments, and net receivables by current liabilities.Thus, it is an important complement to the current ratio. For example, assume that the current assets of Quality Department Store for 2007 and 2006 consist of the items shown in Illustration 14-13.

Illustration 14-13 Current assets of Quality Department Store

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Cash � Short-Term Investments � Receivables (Net) Acid-Test Ratio �

Current Liabilities

Quality Department Store

2007 2006

$100,000 � $20,000 � $230,000 � 1.02�1

$155,000 � $70,000 � $180,000 � 1.34�1

$344,500 $303,000

Industry average J.C. Penney Company

0.29�1 0.87�1

Net Credit Sales Receivables Turnover �

Average Net Receivables

Quality Department Store

2007 2006

$2,097,000 $1,837,000 $180,000 � $230,000

� 10.2 times $200,000 � $180,000

� 9.7 times

2 2

Industry average J.C. Penney Company 28.2 times 57 times

Cash, short-term investments, and receivables (net) are highly liquid compared to inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Thus, the acid-test ratio measures immediate liquidity. The 2007 and 2006 acid-test ratios for Quality Department Store and comparative data are as follows.

686 Chapter 14 Financial Statement Analysis

Illustration 14-14 Acid-test ratio

The ratio has declined in 2007. Is an acid-test ratio of 1.02:1 adequate? This depends on the industry and the economy. When compared with the industry average of 0.29:1 and Penney’s of 0.87:1, Quality’s acid-test ratio seems adequate.

3. RECEIVABLES TURNOVER We can measure liquidity by how quickly a company can convert certain assets to cash. How liquid, for example, are the receivables? The ratio used to assess the liquidity of the receivables is receivables turnover. It measures the number of times, on average, the company collects receivables during the period.We compute receivables turnover by dividing net credit sales (net sales less cash sales) by the average net receivables. Unless seasonal factors are significant, average net receivables can be computed from the beginning and ending balances of the net receivables.2

Assume that all sales are credit sales.The balance of net receivables at the begin- ning of 2006 is $200,000. Illustration 14-15 shows the receivables turnover for Quality Department Store and comparative data. Quality’s receivables turnover improved in 2007. The turnover of 10.2 times is substantially lower than J.C. Penney’s 57 times, and is also lower than the department store industry’s average of 28.2 times.

2If seasonal factors are significant, the average receivables balance might be determined by using monthly amounts.

[ [ [ [

Illustration 14-15 Receivables turnover

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Cost of Goods Sold Inventory Turnover � Average Inventory

Quality Department Store

2007 2006

$1,281,000 $1,140,000 $500,000 � $620,000

� 2.3 times $450,000 � $500,000

� 2.4 times

2 2

Industry average J.C. Penney Company 7.0 times 3.5 times

Average Collection Period. A popular variant of the receivables turnover ratio is to convert it to an average collection period in terms of days. To do so, we divide the receivables turnover ratio into 365 days. For example, the receivables turnover of 10.2 times divided into 365 days gives an average collection period of approxi- mately 36 days.This means that receivables are collected on average every 36 days, or about every 5 weeks.Analysts frequently use the average collection period to as- sess 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 (the time allowed for payment).

4. INVENTORY TURNOVER Inventory turnover measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. We compute the inventory turnover by dividing cost of goods sold by the average inventory. Unless seasonal factors are significant, we can use the beginning and ending inventory balances to compute average inventory.

Assuming that the inventory balance for Quality Department Store at the beginning of 2006 was $450,000, its inventory turnover and comparative data are as shown in Illustration 14-16. Quality’s inventory turnover declined slightly in 2007. The turnover of 2.3 times is relatively low compared with the industry average of 7.0 and J.C. Penney’s 3.5. Generally, the faster the inventory turnover, the less cash a company has tied up in inventory and the less the chance of inventory obsolescence.

Ratio Analysis 687

Days in Inventory. A variant of inventory turnover is the days in inventory. We calculate it by dividing the inventory turnover into 365. For example, Quality’s 2007 inventory turnover of 2.3 times divided into 365 is approximately 159 days. An average selling time of 159 days is also relatively high compared with the industry average of 52.1 days (365 � 7.0) and J.C. Penney’s 104.3 days (365 � 3.5).

Inventory turnover ratios 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.

Profitability Ratios Profitability ratios measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. It also affects the company’s liquidity position and the company’s ability to grow. As a consequence, both creditors and investors are interested in evaluating earning power—profitability.Analysts frequently use prof- itability as the ultimate test of management’s operating effectiveness.

Illustration 14-16 Inventory turnover

[ [ [ [

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Net Sales Asset Turnover �

Average Assets

Quality Department Store

2007 2006

$2,097,000 $1,837,000 $1,595,000 � $1,835,000

� 1.22 times $1,446,000 � $1,595,000

� 1.21 times

2 2

Industry average J.C. Penney Company 2.14 times 1.47 times

Net Income Profit Margin �

Net Sales

Quality Department Store

2007 2006

$263,800 $208,500 $2,097,000

� 12.6% $1,837,000

� 11.4%

Industry average J.C. Penney Company 3.7% 5.6%

5. PROFIT MARGIN Profit margin is a measure of the percentage of each dollar of sales that results in net income.We can compute it by dividing net income by net sales. Illustration 14-17 shows Quality Department Store’s profit margin and comparative data.

688 Chapter 14 Financial Statement Analysis

A L T E R N A T I V E T E R M I N O L O G Y

Profit margin is also called the rate of return on sales.

Quality experienced an increase in its profit margin from 2006 to 2007. Its profit margin is unusually high in comparison with the industry average of 3.7% and J.C. Penney’s 5.6%.

High-volume (high inventory turnover) enterprises such as grocery stores (Safeway or Kroger) and discount stores (Kmart or Wal-Mart) generally experi- ence low profit margins. In contrast, low-volume enterprises such as jewelry stores (Tiffany & Co.) or airplane manufacturers (Boeing Co.) have high profit margins.

6. ASSET TURNOVER Asset turnover measures how efficiently a company uses its assets to generate sales. It is determined by dividing net sales by average assets.The resulting number shows the dollars of sales produced by each dollar invested in assets. Unless seasonal factors are significant, we can use the beginning and ending balance of total assets to determine average total assets. Assuming that total assets at the beginning of 2006 were $1,446,000, the 2007 and 2006 asset turnover for Quality Department Store and comparative data are shown in Illustration 14-18.

Illustration 14-17 Profit margin

Illustration 14-18 Asset turnover

Asset turnover shows that in 2007 Quality generated sales of $1.22 for each dollar it had invested in assets.The ratio changed little from 2006 to 2007. Quality’s asset turnover is below the industry average of 2.14 times and J.C. Penney’s ratio of 1.47 times.

Asset turnover ratios vary considerably among industries. For example, a large utility company like Consolidated Edison (New York) has a ratio of 0.49 times, and the large grocery chain Kroger Stores has a ratio of 4.34 times.

[ [ [ [

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Return on Common Net Income Stockholders’ Equity

� Average Common Stockholders’ Equity

Quality Department Store

2007 2006

$263,800 $208,500 $795,000 � $1,003,000

� 29.3% $667,000 � $795,000

� 28.5%

2 2

Industry average J.C. Penney Company 19.2% 23.1%

Net Income Return on Assets �

Average Assets

Quality Department Store

2007 2006

$263,800 $208,500 $1,595,000 � $1,835,000

� 15.4% $1,446,000 � $1,595,000

� 13.7%

2 2

Industry average J.C. Penney Company 7.9% 8.2%

7. RETURN ON ASSETS An overall measure of profitability is return on assets.We compute this ratio by di- viding net income by average assets.The 2007 and 2006 return on assets for Quality Department Store and comparative data are shown below.

Ratio Analysis 689

Quality’s return on assets improved from 2006 to 2007. Its return of 15.4% is very high compared with the department store industry average of 7.9% and J.C. Penney’s 8.2%.

8. RETURN ON COMMON STOCKHOLDERS’ EQUITY Another widely used profitability ratio is return on common stockholders’ equity. It measures profitability from the common stockholders’ viewpoint. This ratio shows how many dollars of net income the company earned for each dollar in- vested by the owners. We compute it by dividing net income by average common stockholders’ equity.Assuming that common stockholders’ equity at the beginning of 2006 was $667,000, Illustration 14-20 shows the 2007 and 2006 ratios for Quality Department Store and comparative data.

Illustration 14-19 Return on assets

Illustration 14-20 Return on common stockholders’ equity

Quality’s rate of return on common stockholders’ equity is high at 29.3%, considering an industry average of 19.2% and a rate of 23.1% for J.C. Penney.

With Preferred Stock. When a company has preferred stock, we must deduct preferred dividend requirements from net income to compute income available to common stockholders. Similarly, we deduct the par value of preferred stock (or call price, if applicable) from total stockholders’ equity to determine the amount of common stockholders’ equity used in this ratio. The ratio then appears as follows.

[ [ [ [ [ [ [ [

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Earnings Net Income per Share � Weighted-Average Common Shares Outstanding

Quality Department Store

2007 2006

$263,800 $208,500 � $0.77

270,000 � 275,400 � $0.97

270,000 2

690 Chapter 14 Financial Statement Analysis

Return on Common �

Net Income � Preferred Dividends Stockholders’ Equity Average Common Stockholders’ Equity

Illustration 14-21 Return on common stockholders’ equity with preferred stock

Note that Quality’s rate of return on stockholders’ equity (29.3%) is substantially higher than its rate of return on assets (15.4%). The reason is that Quality 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 it is able to earn by using the borrowed money. Leverage enables Quality Department Store to use money supplied by nonowners to increase the return to the owners. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money in- dicates the profitability of trading on the equity. Quality Department Store earns more on its borrowed funds than it has to pay in the form of interest.Thus the return to stock- holders exceeds the return on the assets, due to benefits from the positive leveraging.

9. EARNINGS PER SHARE (EPS) Earnings per share (EPS) is a measure of the net income earned on each share of common stock. It is computed by dividing net income by the number of weighted- average common shares outstanding during the year. A measure of net income earned on a per share basis provides a useful perspective for determining prof- itability. Assuming that there is no change in the number of outstanding shares during 2006 and that the 2007 increase occurred midyear, Illustration 14-22 shows the net income per share for Quality Department Store for 2007 and 2006.

Illustration 14-22 Earnings per share

Note that no industry or J.C. Penney data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares of out- standing stock among companies. The only meaningful EPS comparison is an in- tracompany trend comparison: Quality’s earnings per share increased 20 cents per share in 2007. This represents a 26% increase over the 2006 earnings per share of 77 cents.

The terms “earnings per share” and “net income per share” refer to the amount of net income applicable to each share of common stock. Therefore, in computing EPS, if there are preferred dividends declared for the period, we must deduct them from net income to determine income available to the common stockholders.

10. PRICE-EARNINGS RATIO The price-earnings (P-E) ratio is an oft-quoted measure of the ratio of the market price of each share of common stock to the earnings per share. The price-earnings (P-E) ratio reflects investors’ assessments of a company’s future earnings.We com- pute it by dividing the market price per share of the stock by earnings per share. Assuming that the market price of Quality Department Store Inc. stock is $8 in 2006 and $12 in 2007, the price-earnings ratio computation is as follows.

[ [

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Cash Dividends Payout Ratio �

Net Income

Quality Department Store

2007 2006

$61,200 $60,000 $263,800

� 23.2% $208,500

� 28.8%

Industry average J.C. Penney Company 16.1% 15.7%

Market Price per Share of Stock Price-Earnings Ratio �

Earnings per Share

Quality Department Store

2007 2006

$12.00 $8.00 $0.97

� 12.4 times $0.77

� 10.4 times

Industry average J.C. Penney Company 17.1 times 9.7 times

Illustration 14-23 Price-earnings ratio

In 2007 each share of Quality’s stock sold for 12.4 times the amount that the company earned on each share. Quality’s price-earnings ratio is lower than the industry average of 17.1 times, but 28% higher than the ratio of 9.7 times for J.C. Penney. The average price-earnings ratio for the stocks that constitute the Standard and Poor’s 500 Index (500 largest U.S. firms) in early 2007 was approxi- mately 19.1 times.

11. PAYOUT RATIO The payout ratio measures the percentage of earnings distributed in the form of cash dividends. We compute it by dividing cash dividends by net income. Companies that have high growth rates generally have low payout ratios because they reinvest most of their net income into the business. The 2007 and 2006 payout ratios for Quality Department Store are computed as shown in Illustration 14-24.

Illustration 14-24 Payout ratio

Ratio Analysis 691

Quality’s payout ratio is higher than J.C. Penney’s payout ratio of 15.7%. As indicated earlier (page 681), Quality funded its purchase of plant assets through retention of earnings but still is able to pay dividends.

Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and stockholders are particularly interested in a com- pany’s ability to pay interest as it comes due and to repay the face value of debt at maturity. Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability.

12. DEBT TO TOTAL ASSETS RATIO The debt to total assets ratio measures the percentage of the total assets that credi- tors provide. We compute it by dividing total debt (both current and long-term

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Times Interest Income before Income Taxes and Interest Expense Earned

� Interest Expense

Quality Department Store

2007 2006

$468,000 � 13 times

$388,000 � 9.6 times

$36,000 $40,500

Industry average J.C. Penney Company 10.7 times 12.3 times

Total Debt Debt to Total Assets Ratio �

Total Assets

Quality Department Store

2007 2006

$832,000 $800,000 $1,835,000

� 45.3% $1,595,000

� 50.2%

Industry average J.C. Penney Company 40.1% 62.9%

liabilities) by total assets. This ratio indicates the company’s degree of leverage. It also provides some indication of the company’s ability to withstand losses without impairing the interests of creditors.The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations.The 2007 and 2006 ratios for Quality Department Store and comparative data are as follows.

692 Chapter 14 Financial Statement Analysis

A ratio of 45.3% means that creditors have provided 45.3% of Quality Department Store’s total assets. Quality’s 45.3% is above the industry average of 40.1%. It is considerably below the high 62.9% ratio of J.C. Penney. The lower the ratio, the more equity “buffer” there is available to the creditors. Thus, from the creditors’ point of view, a low ratio of debt to total assets is usually desirable.

The adequacy of this ratio is often judged in the light of the company’s earn- ings. Generally, companies with relatively stable earnings (such as public utilities) have higher debt to total assets ratios than cyclical companies with widely fluctuat- ing earnings (such as many high-tech companies).

13. TIMES INTEREST EARNED Times interest earned provides an indication of the company’s ability to meet interest payments as they come due. We compute it by dividing income before interest expense and income taxes by interest expense. Illustration 14-26 shows the 2007 and 2006 ratios for Quality Department Store and comparative data. Note that times interest earned uses income before income taxes and interest expense. This represents the amount available to cover interest. For Quality Department Store the 2007 amount of $468,000 is computed by taking the income before in- come taxes of $432,000 and adding back the $36,000 of interest expense.

Illustration 14-25 Debt to total assets ratio

A L T E R N A T I V E T E R M I N O L O G Y

Times interest earned is also called interest coverage.

Illustration 14-26 Times interest earned

Quality’s interest expense is well covered at 13 times, compared with the indus- try average of 10.7 times and J.C. Penney’s 12.3 times.

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Ratio Analysis 693

If you want to keep current with the financial and operating developments of a com- pany in which you own shares, what are some ways you can do so?

I N V E S T O R I N S I G H T Keeping Up to Date as an Investor

Today, investors have access to information provided by corporate managers that used to be available only to professional analysts. Corporate managers have always made them- selves available to security analysts for questions at the end of every quarter. Now, because of a combination of new corporate disclosure requirements by the Securities and Exchange Commission and technologies that make communication to large numbers of people possible at a very low price, the average investor can listen in on these discussions. For example, one in- dividual investor, Matthew Johnson, a Nortel Networks local area network engineer in Belfast, Northern Ireland, “stayed up past midnight to listen to Apple Computer’s Internet conference call. Hearing the company’s news ‘from the dog’s mouth,’ he says ‘gave me better information’ than hunting through chat-rooms.”

Source: Jeff D. Opdyke, “Individuals Pick Up on Conference Calls,” Wall Street Journal, November 20, 2000.

Summary of Ratios Illustration 14-27 summarizes the ratios discussed in this chapter. The summary in- cludes the formula and purpose or use of each ratio.

Ratio Formula Purpose or Use Liquidity Ratios

1. Current ratio Current assets Current liabilities Measures short-term debt-paying ability.

Cash � Short-term 2. Acid-test (quick) ratio investments � Receivables (net) Measures immediate short-term liquidity.

Current liabilities

3. Receivables turnover Net credit sales Average net receivables Measures liquidity of receivables.

4. Inventory turnover Cost of goods sold Average inventory Measures liquidity of inventory.

Profitability Ratios

5. Profit margin Net income Measures net income generated by each dollar Net sales of sales.

6. Asset turnover Net sales Measures how efficiently assets are used to Average assets generate sales.

7. Return on assets Net income Average assets Measures overall profitability of assets.

8. Return on common

Net income � Preferred dividends

stockholders’ equity Average common Measures profitability of owners’ investment.

stockholders’ equity

Illustration 14-27 Summary of liquidity, profitability, and solvency ratios

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before you go on...

694 Chapter 14 Financial Statement Analysis

Ratio Formula Purpose or Use

9. Earnings per share (EPS)

Net income � Preferred dividends

Weighted-average common Measures net income earned on each share of

shares outstanding common stock.

10. Price-earnings (P-E) ratio Market price

per share of stock Measures the ratio of the market price per share to Earnings per share earnings per share.

11. Payout ratio Cash dividends Measures percentage of earnings distributed in the Net income form of cash dividends.

Solvency Ratios

12. Debt to total assets ratio Total debt Measures the percentage of total assets provided Total assets by creditors.

13. Times interest earned Income before income taxes

and interest expense Measures ability to meet interest payments as they Interest expense come due.

Illustration 14-27 (continued)

Do it! The condensed financial statements of John Cully Company, for the years

ended June 30, 2011 and 2010, are presented below. Ratio Analysis

JOHN CULLY COMPANY Balance Sheets

June 30

(in thousands) Assets 2011 2010

Current assets Cash and cash equivalents $ 553.3 $ 611.6 Accounts receivable (net) 776.6 664.9 Inventories 768.3 653.5 Prepaid expenses and other current assets 204.4 269.2

Total current assets 2,302.6 2,199.2 Property, plant, and equipment (net) 694.2 647.0 Investments 12.3 12.6 Intangibles and other assets 876.7 849.3

Total assets $3,885.8 $3,708.1

Liabilities and Stockholders’ Equity

Current liabilities $1,497.7 $1,322.0 Long-term liabilities 679.5 637.1 Stockholders’ equity—common 1,708.6 1,749.0

Total liabilities and stockholders’ equity $3,885.8 $3,708.1

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Ratio Analysis 695

Compute the following ratios for 2011 and 2010.

(a) Current ratio. (b) Inventory turnover. (Inventory on 6/30/09 was $599.0.) (c) Profit margin. (d) Return on assets. (Assets on 6/30/09 were $3,349.9.) (e) Return on common stockholders’ equity. (Stockholders’ equity on 6/30/09 was $1,795.9.) (f) Debt to total assets ratio. (g) Times interest earned.

JOHN CULLY COMPANY Income Statements

For the Years Ended June 30

(in thousands) 2011 2010

Revenues $6,336.3 $5,790.4 Costs and expenses

Cost of goods sold 1,617.4 1,476.3 Selling and administrative expenses 4,007.6 3,679.0 Interest expense 13.9 27.1

Total costs and expenses 5,638.9 5,182.4

Income before income taxes 697.4 608.0 Income tax expense 291.3 232.6

Net income $ 406.1 $ 375.4

The Navigator✓

Solution

2011 2010 (a) Current ratio:

$2,302.6 � $1,497.7 � 1.5�1 $2,199.2 � $1,322.0 � 1.7�1

(b) Inventory turnover: $1,617.4 � [($768.3 � $653.5) � 2] � 2.3 times $1,476.3 � [($653.5 � $599.0) � 2] � 2.4 times

(c) Profit margin: $406.1 � $6,336.3 6.4% $375.4 � $5,790.4 6.5%

(d) Return on assets: $406.1 � [($3,885.8 � $3,708.1) � 2] � 10.7% $375.4 � [($3,708.1 � $3,349.9) � 2] � 10.6%

(e) Return on common stockholders’ equity: $406.1 � [($1,708.6 � $1,749.0) � 2] � 23.5% $375.4 � [($1,749.0 � $1,795.9) � 2] � 21.2%

(f) Debt to total assets ratio: ($1,497.7 � $679.5) � $3,885.8 � 56.0% ($1,322.0 � $637.1) � $3,708.1 � 52.8%

(g) Times interest earned: ($406.1 � $291.3 � $13.9) � $13.9 � 51.2 times ($375.4 � $232.6 � $27.1) � $27.1 � 23.4 times

Related exercise material: BE14-9, BE14-10, BE14-11, BE14-12, BE14-13, E14-5, E14-6, E14-7, E14-8, E14-9, E14-10, E14-11, and 14-2.Do it!

Action Plan

• Remember that the current ratio includes all current assets. The acid-test ratio uses only cash, short-term investments, and net receivables.

• Use average balances for turnover ratios like inventory, receivables, and assets.

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696 Chapter 14 Financial Statement Analysis

Users of financial statements are interested in the concept of earning power. Earning power means the normal level of income to be obtained in the future. Earning power differs from actual net income by the amount of irregular revenues, expenses, gains, and losses. Users are interested in earning power because it helps them derive an estimate of future earnings

without the “noise” of irregular items. For users of financial statements to determine earning power or regular in-

come, the “irregular” items are separately identified on the income statement. Companies report two types of “irregular” items.

1. Discontinued operations. 2. Extraordinary items.

These “irregular” items are reported net of income taxes. That is, the income state- ment first reports income tax on the income before “irregular” items. Then the amount of tax for each of the listed “irregular” items is computed.The general con- cept is “let the tax follow income or loss.”

Discontinued Operations Discontinued operations refers to the disposal of a significant component of a busi- ness. Examples involve stopping an entire activity or eliminating a major class of customers. For example, Kmart reported as discontinued operations its decision to terminate its interest in four business activities, including PACE Membership Warehouse and PayLess Drug Stores Northwest.

Following the disposal of a significant component, the company should report on its income 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 segment.

To illustrate, assume that during 2011 Acro Energy Inc. has income before in- come taxes of $800,000. During 2011 Acro discontinued and sold its unprofitable chemical division. The loss in 2011 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 14-28 shows Acro’s income statement presentation.

EARNING POWER AND IRREGULAR ITEMS

Understand the concept of earning power, and how irregular items are presented.

S T U D Y O B J E C T I V E 6

ACRO ENERGY INC. Income Statement (partial)

For the Year Ended December 31, 2011

Income before income taxes $800,000 Income tax expense 240,000

Income from continuing operations 560,000 Discontinued operations

Loss from operations of chemical division, net of $60,000 income tax saving $140,000

Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000

Net income $350,000

H E L P F U L H I N T Observe the dual disclosures: (1) The results of operations of the discontinued division must be eliminated from the results of continuing operations. (2) The company must also report the disposal of the operation.

Illustration 14-28 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

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presentation clearly indicates the separate effects of continuing operations and dis- continued operations on net income.

Extraordinary Items Extraordinary items are events and transactions that meet two conditions:They are (1) unusual in nature, and (2) infrequent in occurrence.To be unusual, the item should be abnormal and only incidentally related to the company’s customary activities.To be in- frequent, the item should not be reasonably expected to recur in the foreseeable future.

A company must evaluate both criteria in terms of its operating environment.Thus, Weyerhaeuser Co. reported the $36 million in damages to its timberland caused by the volcanic eruption of Mount St. Helens as an extraordinary item.The eruption was both unusual and infrequent.In contrast, Florida Citrus Company does not report frost dam- age to its citrus crop as an extraordinary item, because frost damage is not infrequent. Illustration 14-29 shows the classification of extraordinary and ordinary items.

Earning Power and Irregular Items 697

Extraordinary items

1. Effects of major natural casualties, if rare in the area.

2. Expropriation (takeover) of property by a foreign government.

3. Effects of a newly enacted law or regulation, such as a property condemnation action.

Ordinary items

1. Effects of major natural casualties, not uncommon in the area.

2. Write-down of inventories or write-off of receivables.

3. Losses attributable to labor strikes.

4. Gains or losses from sales of property, plant, or equipment.

unco llectib

le XYZ

INVOICE

Illustration 14-29 Examples of extraordinary and ordinary items

Companies report extraordinary items net of taxes in a separate section of the income statement, immediately below discontinued operations. To illustrate, assume that in 2011 a foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000, as shown in Illustration 14-30 (page 698). When there is an extraordinary item to report, the company adds the caption “Income before extraordinary item” immediately before the section for the extraordinary item. This presentation clearly indicates the effect of the extraordinary item on net income.

What if a transaction or event meets one (but not both) of the criteria for an extraordinary item? In that case the company reports it under either “Other revenues and gains” or “Other expenses and losses” at its gross amount (not net of tax).This is true, for example,of gains (losses) resulting from the sale of property,plant,and equip- ment, as explained in Chapter 9. It is quite common for companies to use the label “Non-recurring charges” for losses that do not meet the extraordinary item criteria.

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698 Chapter 14 Financial Statement Analysis

H E L P F U L H I N T If there are no discontinued operations, the third line of the income statement would be labeled “Income before extraordinary item.”

ACRO ENERGY INC. Income Statement (partial)

For the Year Ended December 31, 2011

Income before income taxes $800,000 Income tax expense 240,000

Income from continuing operations 560,000 Discontinued operations

Loss from operations of chemical division, net of $60,000 income tax saving $140,000

Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000

Income before extraordinary item 350,000 Extraordinary item

Expropriation of investment, net of $21,000 income tax saving 49,000

Net income $301,000

Illustration 14-30 Statement presentation of extraordinary items

If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones?

I N V E S T O R I N S I G H T 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 which are unlikely to occur in future periods. The question for analysts is, are these costs really one-time, “non-recurring” events, or do they reflect problems that the company will be facing for many periods in the future? If they are one-time events, 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, toothpaste and other consumer-goods giant Procter & Gamble Co. reported a re- structuring charge in 12 consecutive quarters. Motorola had “special” charges in 14-consecutive quarters. On the other hand, other companies have a restructuring charge only once in a five- or ten-year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.

Changes in Accounting Principle For ease of comparison, users of financial statements expect companies to prepare such 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. Accounting rules permit a change when management can show that the new principle is preferable to the old principle.An example is a change in inventory costing methods (such as FIFO to average-cost).

Companies report most changes in accounting principle retroactively. 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.

E T H I C S N O T E

Changes in accounting principle should result in financial statements that are more informative for statement users. They should not be used to artificially improve the reported performance or financial position of the corporation.

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Quality of Earnings 699

Comprehensive Income The income statement reports most revenues, expenses, gains, and losses recog- nized during the period. However, over time, specific exceptions to this general practice have developed. Certain items now bypass income and are reported di- rectly in stockholders’ equity.

For example, in Chapter 12 you learned that companies do not include in income any unrealized gains and losses on available-for-sale securities. Instead, they report such gains and losses in the balance sheet as adjustments to stockholders’ equity. Why are these gains and losses on available-for-sale securities excluded from net income? Because disclosing them separately (1) reduces the volatility of net income due to fluctuations in fair value, yet (2) informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value.

Many analysts have expressed concern over the significant increase in the number of items that bypass the income statement. They feel that such reporting has reduced the usefulness of the income statement. To address this concern, in ad- dition to reporting net income, a company must also report comprehensive income. Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stock- holders. A number of alternative formats for reporting comprehensive income are allowed. These formats are discussed in advanced accounting courses.

In its proposed 2011 income statement, AIR Corporation reports income before income taxes $400,000, extraordinary loss due to earthquake $100,000, income taxes $120,000 (not including irregular items), loss on operation of discontinued flower division $50,000, and loss on disposal of discontinued flower division $90,000. The income tax rate is 30%. Prepare a correct income statement, beginning with “Income before income taxes.”

Solution

Irregular Items Do it!

Action Plan

• Recall that a loss is extraordinary if it is both unusual and infrequent.

• Disclose the income tax effect of each component of income, beginning with income before any irregular items.

• Show discontinued operations before extraordinary items.

AIR CORPORATION Income Statement (partial)

For the Year Ended December 31, 2011

Income before income taxes $400,000 Income tax expense 120,000

Income from continuing operations 280,000 Discontinued operations

Loss from operation of flower division, net of $15,000 tax saving $35,000

Loss on disposal of flower division, net of $27,000 tax saving 63,000 98,000

Income before extraordinary item 182,000 Extraordinary earthquake loss, net of

$30,000 tax saving 70,000

Net income $112,000

Related exercise material: BE14-14, BE14-15, E14-12, E14-13, and 14-3.Do it!

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In evaluating the financial performance of a company, 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 financial statements.

QUALITY OF EARNINGS

Understand the concept of quality of earnings.

S T U D Y O B J E C T I V E 7

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700 Chapter 14 Financial Statement Analysis

The issue of quality of earnings has taken on increasing importance because recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. 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, one company may use the FIFO method of inventory costing, while another com- pany in the same industry may use LIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable. For example, if General Motors Corporation had used FIFO instead of LIFO for inventory valua- tion, its inventories in a recent year would have been 26% higher, which signifi- cantly 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, depletion, and amortization. Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the differ- ent methods is often difficult, if not impossible.

Pro Forma Income Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent years, many companies have also reported a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or nonrecurring. For example, at one time, Cisco Systems (a high-tech company) reported a quarterly net loss under GAAP of $2.7 billion. Cisco re- ported pro forma income for the same quarter as a profit of $230 million.This large difference in profits between GAAP income numbers and pro forma income is not unusual these days. For example, during one 9-month period the 100 largest firms 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 can exclude any items they deem inappropriate for measuring their performance. Many analysts and in- vestors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the financial press noted, pro forma numbers might be called EBS, which stands for “earnings before bad stuff.” Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and nonrecurring expenses.“Cisco’s technique gives readers of financial statements a clear picture of Cisco’s normal business activities,” the company said in a statement issued in re- sponse to questions about its pro forma income accounting.

The SEC has 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 flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a good light.

Improper Recognition Because some managers have felt pressure from Wall Street to continually increase earnings, they have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is channel stuffing: Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel)

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rather than later.This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods.To illustrate, Bristol-Myers Squibb at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than needed to meet patients’ demands. As a result, the company had to issue revised financial statements showing corrected revenues and income.

Another practice is the improper capitalization of operating expenses. The classic case is WorldCom. It capitalized over $7 billion dollars of operating ex- penses so that it would report positive net income. In other situations, companies fail to report all their liabilities. Enron had promised to make payments on certain contracts if financial difficulty developed, but these guarantees were not reported as liabilities. In addition, disclosure was so lacking in transparency that it was im- possible to understand what was happening at the company.

Quality of Earnings 701

Match each of the following terms with the phrase that it best matches.

Comprehensive income Vertical analysis Quality of earnings Pro forma income Solvency ratio Extraordinary item

1. ______ Measures the ability of the company to survive over a long period of time.

2. ______ Usually excludes items that a company thinks are unusual or non-recurring.

3. ______ Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

4. ______ Indicates the level of full and transparent information provided to users of the financial statements.

5. ______ Describes events and transactions that are unusual in nature and infrequent in occurrence.

6. ______ Expresses each item within a financial statement as a percent of a base amount.

Solution

Quality of Earnings, Financial Statement Analysis

1. Solvency ratio: Measures the ability of the company to survive over a long period of time.

2. Pro forma income: Usually excludes items that a company thinks are unusual or non-recurring.

3. Comprehensive income: Includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

4. Quality of earnings: Indicates the level of full and transparent information provided to users of the financial statements.

5. Extraordinary item: Describes events and transactions that are unusual in nature and in- frequent in occurrence.

6. Vertical analysis: Expresses each item within a financial statement as a percent of a base amount.

Related exercise material: 14-4.Do it!

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Action Plan

• Develop a sound understanding of basic methods used for financial reporting.

• Understand the use of fundamental analysis techniques.

Do it!

Should I Play the Market Yet?

on page 702 for informa- tion on how topics in this

chapter apply to you.

all about Y U* Be sure to read

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Some Facts* * 83.4 million Americans own stock investments,

either through mutual funds or individual stocks; 89% of stock investors own stock mutual funds.

* 44% of the people who own stock bought their first stock before 1990.

* The typical equity investor is in his or her late 40s, is married, is employed, and has a household income in the low $60,000s.

* 58% of people who own stock said that they rely on professional financial advisors when making decisions regarding the purchase and sale of stock.

* 46% of people who own stock used the Internet to check stock prices, and 38% use it to read online financial publications.

*all about Y U*

Source: “Equity Ownership in America,” Investment Company Institute and the Securities Industry Association, 2002, p. 1.

0

10

20

30

40

60

50

U.S. Households (millions) 15.9 30.2 34.6 40.6 49.2 52.7

Equity Ownership in the U.S., 1983–2002, Selected Years (number and percent of U.S. households)

19.0%

1983 1989 1992 1995 1999 2002

32.5%

36.6%

41.0%

48.2% 49.5%

IIn this chapter you learned how to use many toolsfor performing a financial analysis of a company. Sometimes companies fail even though they have a good product and good sales growth. All too often the cause of failure is something that should have caused only momentary discomfort. But if a company lacks sufficient liquidity, a momentary hiccup can be fatal. This is true for individual investors as well.

For example, the decision to invest in common stock can be risky. As a company’s net income changes, its stock price can be volatile. You must take this into consideration when deciding whether to buy stock. You don’t want to be in a situation where you have to sell a stock whose price has fallen in order to raise cash to pay your bills.

What Do You Think?* Rachael West has been working at her new job for six months. She has a good salary, with lots of opportunities for growth. She has already accumulated $8,000 in savings, which right now is sitting in a bank savings account earning very little interest. She has decided to take $7,000 out of this savings account and buy common stock of her employer, a young company that has been in business for two years. Rachael’s liquid assets, including her savings account, total $10,000. Her monthly expenses are approximately $3,000. Should Rachael make this investment?

YES: She has a good income, and this is a great opportunity for her to get in on the ground floor of her employer’s fast-growing company.

NO: She shouldn’t invest all of her money in one company, particularly the company at which she works.

* The authors’ comments on this situation appear on p. 725.

Source: “Equity Ownership in America,” Investment Company Institute and the Securities Industry Association, 2002.

Should I Play the Market Yet?

702

About the Numbers* The percentage of Americans who buy stock, either through mutual funds or individ- ual shares, has increased significantly in recent years. A big part of this increase is due to the increasing prevalence of employer-sponsored retirement plans, such as 401(k) plans.

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The events and transactions of Dever Corporation for the year ending December 31, 2011, 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 Loss from tornado disaster (extraordinary loss) 600,000

Analysis reveals that:

1. All items are before the applicable income tax rate of 30%. 2. The plastics division was sold on July 1. 3. All operating data for the plastics division have been segregated.

Instructions Prepare an income statement for the year.

Solution to Comprehensive Do it!

Do it!

Action Plan • Report material items not

typical of continuing operations in separate sections, net of taxes.

• Associate income taxes with the item that affects the taxes.

• Apply the corporate tax rate to income before income taxes to determine tax expense.

• Recall that all data presented in determining income before income taxes are the same as for unincorporated companies.

Comprehensive

DEVER CORPORATION Income Statement

For the Year Ended December 31, 2011

Net sales $4,400,000 Cost of goods sold 2,600,000

Gross profit 1,800,000 Selling and administrative expenses 1,100,000

Income from operations 700,000 Other revenues and gains $ 5,600 Other expenses and losses 9,600 4,000

Income before income taxes 696,000 Income tax expense ($696,000 � 30%) 208,800

Income from continuing operations 487,200 Discontinued operations

Income from operations of plastics division, net of $21,000 income taxes ($70,000 � 30%) 49,000

Gain from disposal of plastics division, net of $150,000 income taxes ($500,000 � 30%) 350,000 399,000

Income before extraordinary item 886,200 Extraordinary item

Tornado loss, net of $180,000 income tax saving ($600,000 � 30%) 420,000

Net income $ 466,200

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Comprehensive Do it! 703

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1 Discuss the need for comparative analysis. There are three bases of comparison: (1) Intracompany, which com- pares an item or financial relationship with other data within a company. (2) Industry, which compares company data with industry averages. (3) Intercompany, which com- pares an item or financial relationship of a company with data of one or more competing companies.

2 Identify the tools of financial statement analysis. Financial statements can be analyzed horizontally, verti- cally, and with ratios.

3 Explain and apply horizontal analysis. Horizontal analy- sis 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.

4 Describe and apply vertical analysis. Vertical analysis is a technique that expresses each item within a financial statement in terms of a percentage of a relevant total or a base amount.

5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. The formula and purpose of each ratio was presented in Illustration 14-27 (page 693).

6 Understand the concept of earning power, and how irregular items are presented. Earning power refers to a company’s ability to sustain its profits from operations. “Irregular items”—discontinued operations and extraordi- nary items—are presented net of tax below income from continuing operations to highlight their unusual nature.

7 Understand the concept of quality of earnings. A high quality of earnings provides full and transparent informa- tion that will not confuse or mislead users of the financial statements. Issues related to quality of earnings are (1) al- ternative accounting methods, (2) pro forma income, and (3) improper recognition.

SUMMARY OF STUDY OBJECTIVES

The Navigator✓

Acid-test (quick) ratio A measure of a company’s immedi- ate short-term liquidity; computed by dividing the sum of cash, short-term investments, and net receivables by cur- rent liabilities. (p. 685).

Asset turnover A measure of how efficiently a company uses its assets to generate sales; computed by dividing net sales by average assets. (p. 688).

Change in accounting principle The use of a principle in the current year that is different from the one used in the preceding year. (p. 698).

Comprehensive income Includes all changes in stockhold- ers’ equity during a period except those resulting from investments by stockholders and distributions to stock- holders. (p. 699).

Current ratio A measure used to evaluate a company’s liquidity and short-term debt-paying ability; computed by dividing current assets by current liabilities. (p. 684).

Debt to total assets ratio Measures the percentage of total assets provided by creditors; computed by dividing total debt by total assets. (p. 691).

Discontinued operations The disposal of a significant segment of a business. (p. 696).

Earnings per share (EPS) The net income earned on each share of common stock; computed by dividing net income minus preferred dividends (if any) by the number of weighted-average common shares outstanding. (p. 690).

Extraordinary items Events and transactions that are un- usual in nature and infrequent in occurrence. (p. 697).

Horizontal analysis A technique for evaluating a series of financial statement data over a period of time, to determine

the increase (decrease) that has taken place, expressed as either an amount or a percentage. (p. 677).

Inventory turnover A measure of the liquidity of inven- tory; computed by dividing cost of goods sold by average inventory. (p. 687).

Leveraging See Trading on the equity. (p. 690).

Liquidity ratios Measures of the short-term ability of the company to pay its maturing obligations and to meet un- expected needs for cash. (p. 684).

Payout ratio Measures the percentage of earnings distrib- uted in the form of cash dividends; computed by dividing cash dividends by net income. (p. 691).

Price-earnings (P-E) ratio Measures the ratio of the market price of each share of common stock to the earnings per share; computed by dividing the market price of the stock by earnings per share. (p. 690).

Profit margin Measures the percentage of each dollar of sales that results in net income; computed by dividing net income by net sales. (p. 688).

Profitability ratios Measures of the income or operating success of a company for a given period of time. (p. 687).

Pro forma income A measure of income that usually ex- cludes items that a company thinks are unusual or nonre- curring. (p. 700).

Quality of earnings Indicates the level of full and transpar- ent information provided to users of the financial state- ments. (p. 699).

Ratio An expression of the mathematical relationship between one quantity and another.The relationship may be expressed either as a percentage, a rate, or a simple proportion. (p. 683).

GLOSSARY

704 Chapter 14 Financial Statement Analysis

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Self-Study Questions 705

Ratio analysis A technique for evaluating financial state- ments that expresses the relationship between selected financial statement data. (p. 683).

Receivables turnover A measure of the liquidity of receiv- ables; computed by dividing net credit sales by average net receivables. (p. 686).

Return on assets An overall measure of profitability; com- puted by dividing net income by average assets. (p. 689).

Return on common stockholders’ equity Measures the dollars of net income earned for each dollar invested by the owners; computed by dividing net income minus preferred dividends (if any) by average common stockholders’ equity. (p. 689).

Solvency ratios Measures of the ability of the company to survive over a long period of time. (p. 691).

Times interest earned Measures a company’s ability to meet interest payments as they come due; computed by dividing income before interest expense and income taxes by interest expense. (p. 692).

Trading on the equity Borrowing money at a lower rate of interest than can be earned by using the borrowed money. (p. 690).

Vertical analysis A technique for evaluating financial state- ment data that expresses each item within a financial state- ment as a percent of a base amount. (p. 681).

SELF-STUDY QUESTIONS

Answers are at the end of the chapter.

1. Comparisons of data within a company are an example of the following comparative basis: a. Industry averages. b. Intracompany. c. Intercompany. d. Both (b) and (c).

2. In horizontal analysis, each item is expressed as a percent- age of the: a. net income amount. b. stockholders’ equity amount. c. total assets amount. d. base year amount.

3. In vertical analysis, the base amount for depreciation ex- pense is generally: a. net sales. b. depreciation expense in a previous year. c. gross profit. d. fixed assets.

4. 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.

5. Sammy Corporation reported net sales of $300,000, $330,000, and $360,000 in the years, 2009, 2010, and 2011, respectively. If 2009 is the base year, what is the trend per- centage for 2011? a. 77%. b. 108%. c. 120%. d. 130%.

6. Which of the following measures is an evaluation of a firm’s ability to pay current liabilities? a. Acid-test ratio. b. Current ratio. c. Both (a) and (b). d. None of the above.

7. A measure useful in evaluating the efficiency in managing inventories is: a. inventory turnover. b. average days to sell inventory. c. Both (a) and (b). d. None of the above.

Use the following financial statement information as of the end of each year to answer Self-Study Questions 8–12.

2011 2010

Inventory $ 54,000 $ 48,000 Current assets 81,000 106,000 Total assets 482,000 426,000 Current liabilities 27,000 36,000 Total liabilities 102,000 88,000 Common stockholders’ equity 280,000 238,000 Preferred stock 100,000 100,000 Net sales 784,000 697,000 Cost of goods sold 306,000 277,000 Net income 134,000 90,000 Tax expense 22,000 18,000 Interest expense 12,000 12,000 Dividends paid to preferred

stockholders 20,000 20,000 Dividends paid to common

stockholders 15,000 10,000

8. Compute the days in inventory for 2011. a. 64.4 days. c. 6 days. b. 60.8 days. d. 24 days.

9. Compute the current ratio for 2011. a. 1.26:1. c. .80:1. b. 3.0:1. d. 3.75:1.

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706 Chapter 14 Financial Statement Analysis

10. Compute the profit margin for 2011. a. 17.1%. c. 37.9%. b. 18.1%. d. 5.9%.

11. Compute the return on common stockholders’ equity for 2011. a. 47.9%. c. 40.7%. b. 51.7%. d. 44.0%.

12. Compute the times interest earned for 2011. a. 11.2 times. c. 14.0 times. b. 65.3 times. d. 13.0 times.

13. In reporting discontinued operations, the income state- ment should show in a special section: a. gains and losses on the disposal of the discontinued

segment. b. gains and losses from operations of the discontinued

segment. c. Both (a) and (b). d. Neither (a) nor (b).

14. Scout Corporation has income before taxes of $400,000 and an extraordinary loss of $100,000. If the income tax rate is 25% on all items, the income statement should show income before extraordinary items and extraordi- nary items, respectively, of: a. $325,000 and $100,000. b. $325,000 and $75,000. c. $300,000 and $100,000 d. $300,000 and $75,000.

15. 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 earned. c. Maintenance costs are expensed as incurred. d. The company is continually reporting pro forma income

numbers.

Go to the book’s companion website, www.wiley.com/college/weygandt, for Additional Self-Study Questions.

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QUESTIONS

1. (a) Juan Marichal believes that the analysis of financial statements is directed at two characteristics of a com- pany: liquidity and profitability. Is Juan correct? Explain.

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

2. (a) Distinguish among the following bases of comparison: (1) intracompany, (2) industry averages, and (3) inter- company.

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

3. Two popular methods of financial statement analysis are horizontal analysis and vertical analysis. Explain the difference between these two methods.

4. (a) If Leonard Company had net income of $360,000 in 2011 and it experienced a 24.5% increase in net in- come for 2012, what is its net income for 2012?

(b) If six cents of every dollar of Leonard revenue is net income in 2011, what is the dollar amount of 2011 revenue?

5. What is a ratio? What are the different ways of expressing the relationship of two amounts? What information does a ratio provide?

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

7. Raphael Ochoa is puzzled. His company had a profit margin of 10% in 2011. He feels that this is an indication that the company is doing well. Cindy Lore, his accountant, says that more information is needed to determine the firm’s financial well-being. Who is correct? Why?

8. What do the following classes of ratios measure? (a) Liquidity ratios. (b) Profitability ratios. (c) Solvency ratios.

9. What is the difference between the current ratio and the acid-test ratio?

10. Donte Company, a retail store, has a receivables turnover of 4.5 times. The industry average is 12.5 times. Does Donte have a collection problem with its receivables?

11. Which ratios should be used to help answer the following questions? (a) How efficient is a company in using its assets to pro-

duce 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?

12. The price-earnings ratio of General Motors (automobile builder) was 8, and the price-earnings ratio of Microsoft (computer software) was 38.Which company did the stock market favor? Explain.

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

14. Holding all other factors constant, indicate whether each of the following changes generally signals good or bad news about a company. (a) Increase in profit margin. (b) Decrease in inventory turnover. (c) Increase in the current ratio. (d) Decrease in earnings per share.

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Brief Exercises 707

(e) Increase in price-earnings ratio. (f) Increase in debt to total assets ratio. (g) Decrease in times interest earned.

15. The return on assets for Tresh Corporation is 7.6%. During the same year Tresh’s return on common stock- holders’ equity is 12.8%. What is the explanation for the difference in the two rates?

16. Which two ratios do you think should be of greatest inter- est to: (a) A pension fund considering the purchase of 20-year

bonds? (b) A bank contemplating a short-term loan? (c) A common stockholder?

17. Why must preferred stock dividends be subtracted from net income in computing earnings per share?

18. (a) What is meant by trading on the equity? (b) How would you determine the profitability of trading

on the equity?

19. Hillman Inc. has net income of $160,000, weighted-average shares of common stock outstanding of 50,000, and pre- ferred dividends for the period of $40,000.What is Hillman’s earnings per share of common stock? Kate Hillman, the president of Hillman Inc., believes the computed EPS of the company is high. Comment.

20. Why is it important to report discontinued operations separately from income from continuing operations?

21. You are considering investing in Shawnee Transportation. The company reports 2011 earnings per share of $6.50 on income before extraordinary items and $4.75 on net in- come. Which EPS figure would you consider more rele- vant to your investment decision? Why?

22. STL Inc. reported 2010 earnings per share of $3.20 and had no extraordinary items. In 2011, EPS on income before extraordinary items was $2.99, and EPS on net in- come was $3.49. Is this a favorable trend?

23. Indicate which of the following items would be reported as an extraordinary item in Mordica Corporation’s in- come statement. (a) Loss from damages caused by volcano eruption. (b) Loss from sale of temporary investments. (c) Loss attributable to a labor strike. (d) Loss caused when manufacture of a product was pro-

hibited by the Food and Drug Administration. (e) Loss from flood damage. (The nearby Black River

floods every 2 to 3 years.) (f) Write-down of obsolete inventory. (g) Expropriation of a factory by a foreign government.

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

25. Identify the specific sections in PepsiCo’s 2008 annual report where horizontal and vertical analyses of fi- nancial data are presented.

BRIEF EXERCISES

Follow the rounding procedures used in the chapter.

BE14-1 You recently received a letter from your Uncle Frank. A portion of the letter is pre- sented below.

You know that I have a significant amount of money I saved over the years. I am thinking about starting an investment program. I want to do the investing myself, based on my own research and analysis of financial statements. I know that you are studying accounting, so I have a couple of questions for you. I have heard that different users of financial statements are interested in dif- ferent characteristics of companies. Is this true, and, if so, why? Also, some of my friends, who are already investing, have told me that comparisons involving a company’s financial data can be made on a number of different bases. Can you explain these bases to me?

Instructions Write a letter to your Uncle Frank which answers his questions.

BE14-2 Drew Carey Corporation reported the following amounts in 2010, 2011, and 2012.

2010 2011 2012

Current assets $200,000 $230,000 $240,000 Current liabilities $160,000 $168,000 $184,000 Total assets $500,000 $600,000 $620,000

Instructions (a) Identify and describe the three tools of financial statement analysis. (b) Perform each of the three types of analysis on Drew Carey’s current assets.

Discuss need for comparative analysis.

(SO 1)

Identify and use tools of financial statement analysis.

(SO 2, 3, 4, 5)

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BE14-3 Using the following data from the comparative balance sheet of Rodenbeck Company, illustrate horizontal analysis.

December 31, 2012 December 31, 2011

Accounts receivable $ 520,000 $ 400,000 Inventory $ 840,000 $ 600,000 Total assets $3,000,000 $2,500,000

BE14-4 Using the same data presented above in BE14-3 for Rodenbeck Company, illustrate vertical analysis.

BE14-5 Net income was $500,000 in 2010, $450,000 in 2011, and $522,000 in 2012. What is the percentage of change from (a) 2010 to 2011 and (b) 2011 to 2012? Is the change an increase or a decrease?

BE14-6 If Soule Company had net income of $585,000 in 2012 and it experienced a 30% in- crease in net income over 2011, what was its 2011 net income?

BE14-7 Horizontal analysis (trend analysis) percentages for Epstein Company’s sales, cost of goods sold, and expenses are shown below.

Horizontal Analysis 2012 2011 2010

Sales 96.2 106.8 100.0 Cost of goods sold 102.0 97.0 100.0 Expenses 109.6 98.4 100.0

Did Epstein’s net income increase, decrease, or remain unchanged over the 3-year period?

BE14-8 Vertical analysis (common size) percentages for Charles Company’s sales, cost of goods sold, and expenses are shown below.

Vertical Analysis 2012 2011 2010

Sales 100.0 100.0 100.0 Cost of goods sold 59.2 62.4 64.5 Expenses 25.0 25.6 27.5

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

BE14-9 Selected condensed data taken from a recent balance sheet of Perkins Inc. are as follows.

PERKINS INC. Balance Sheet (partial)

Cash $ 8,041,000 Short-term investments 4,947,000 Accounts receivable 12,545,000 Inventories 14,814,000 Other current assets 5,571,000

Total current assets $45,918,000

Total current liabilities $40,644,000

What are the (a) working capital, (b) current ratio, and (c) acid-test ratio?

BE14-10 McLaren Corporation has net income of $11.44 million and net revenue of $80 mil- lion in 2010. Its assets are $14 million at the beginning of the year and $18 million at the end of the year. What are McLaren’s (a) asset turnover and (b) profit margin?

BE14-11 The following data are taken from the financial statements of Morino Company.

2012 2011

Accounts receivable (net), end of year $ 550,000 $ 520,000 Net sales on account 3,960,000 3,100,000 Terms for all sales are 1/10, n/60.

(a) Compute for each year (1) the receivables turnover and (2) the average collection period. At the end of 2010, accounts receivable (net) was $480,000.

708 Chapter 14 Financial Statement Analysis

Prepare vertical analysis.

(SO 4)

Calculate percentage of change.

(SO 3)

Calculate net income.

(SO 3)

Calculate change in net income.

(SO 3)

Calculate change in net income.

(SO 4)

Calculate liquidity ratios.

(SO 5)

Prepare horizontal analysis.

(SO 3)

Calculate profitability ratios.

(SO 5)

Evaluate collection of accounts receivable.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 708

(b) What conclusions about the management of accounts receivable can be drawn from these data?

BE14-12 The following data are from the income statements of Huntsinger Company.

2012 2011 Sales $6,420,000 $6,240,000 Beginning inventory 980,000 860,000 Purchases 4,340,000 4,661,000 Ending inventory 1,020,000 980,000

(a) Compute for each year (1) the inventory turnover and (2) the average days to sell the inventory. (b) What conclusions concerning the management of the inventory can be drawn from

these data?

BE14-13 Gladow Company has stockholders’ equity of $400,000 and net income of $66,000. It has a payout ratio of 20% and a rate of return on assets of 15%. How much did Gladow pay in cash dividends, and what were its average assets?

BE14-14 An inexperienced accountant for Ming Corporation showed the following in the income statement: income before income taxes and extraordinary item $400,000, and extraordi- nary loss from flood (before taxes) $70,000. The extraordinary loss and taxable income are both subject to a 30% tax rate. Prepare a correct income statement.

BE14-15 On June 30, Reeves Corporation discontinued its operations in Mexico. During the year, the operating loss from the Mexico facility was $300,000 before taxes. On September 1, Reeves disposed of the Mexico facility at a pretax loss of $120,000. The applicable tax rate is 30%. Show the discontinued operations section of the income statement.

Do it! Review 709

Evaluate management of inventory.

(SO 5)

Calculate profitability ratios.

(SO 5)

Prepare income statement including extraordinary items.

(SO 6)

Prepare discontinued operations section of income statement.

(SO 6)

14-1 Summary financial information for Holland Company is as follows.

December 31, 2012 December 31, 2011

Current assets $ 199,000 $ 220,000 Plant assets 821,000 780,000

Total assets $1,020,000 $1,000,000

Compute the amount and percentage changes in 2012 using horizontal analysis, assuming 2011 is the base year.

14-2 The condensed financial statements of Eau Fraîche Company for the years 2010 and 2011 are presented below.

EAU FRAÎCHE COMPANY Balance Sheets December 31

2011 2010 Current assets

Cash and cash equivalents $ 330 $ 360 Accounts receivable (net) 470 400 Inventories 460 390 Prepaid expenses 120 160

Total current assets 1,380 1,310 Property, plant, and equipment 420 380 Investments 10 10 Intangibles and other assets 530 510

Total assets $2,340 $2,210

Current liabilities $ 900 $ 790 Long-term liabilities 410 380 Stockholders’ equity—common 1,030 1,040

Total liabilities and stockholders’ equity $2,340 $2,210

Do it!

Do it!

ReviewDo it! Prepare horizontal analysis.

(SO 3)

Compute ratios.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 709

EAU FRAÎCHE COMPANY Income Statements

For the Years Ended December 31

2011 2010

Revenues $3,800 $3,460

Costs and expenses Cost of goods sold 970 890 Selling & administrative expenses 2,400 2,330 Interest expense 10 20

Total costs and expenses 3,380 3,240

Income before income taxes 420 220 Income tax expense 168 132

Net income $ 252 $ 88

Compute the following ratios for 2010 and 2011. (a) Current ratio. (b) Inventory turnover. (Inventory on 12/31/09 was $340.) (c) Profit margin. (d) Return on assets. (Assets on 12/31/09 were $1,900.) (e) Return on common stockholders’ equity.(Stockholders’ equity—common on 12/31/09 was $900.) (f) Debt to total assets ratio. (g) Times interest earned.

14-3 In its proposed 2011 income statement, Supply Corporation reports income before income taxes $500,000, extraordinary loss due to earthquake $150,000, income taxes $200,000 (not including irregular items), loss on operation of discontinued music division $60,000, and gain on disposal of discontinued music division $40,000.The income tax rate is 40%. Prepare a correct income statement, beginning with income before income taxes.

14-4 Match each of the following terms with the phrase that it best matches.

(a) Quality of earnings (d) Pro forma income (b) Current ratio (e) Discontinued operations (c) Horizontal analysis (f) Comprehensive income

1. ______ A measure used to evaluate a company’s liquidity. 2. ______ Usually excludes items that a company thinks are unusual or nonrecurring. 3. ______ Indicates the level of full and transparent information provided to users of the finan-

cial statements. 4. ______ The disposal of a significant segment of a business. 5. ______ Determines increases or decreases in a series of financial statement data. 6. ______ Includes all changes in stockholders’ equity during a period except those resulting

from investments by stockholders and distributions to stockholders.

Do it!

Do it!

710 Chapter 14 Financial Statement Analysis

Prepare income statement, including irregular items.

(SO 6)

Match terms relating to quality of earnings and financial statement analysis.

(SO 3, 4, 5, 6, 7)

Follow the rounding procedures used in the chapter.

E14-1 Financial information for Blevins Inc. is presented below.

December 31, 2012 December 31, 2011

Current assets $125,000 $100,000 Plant assets (net) 396,000 330,000 Current liabilities 91,000 70,000 Long-term liabilities 133,000 95,000 Common stock, $1 par 161,000 115,000 Retained earnings 136,000 150,000

Instructions Prepare a schedule showing a horizontal analysis for 2012 using 2011 as the base year.

EXERCISES

Prepare horizontal analysis.

(SO 3)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 710

E14-2 Operating data for Gallup Corporation are presented below.

2012 2011

Sales $750,000 $600,000 Cost of goods sold 465,000 390,000 Selling expenses 120,000 72,000 Administrative expenses 60,000 54,000 Income tax expense 33,000 24,000 Net income 72,000 60,000

Instructions Prepare a schedule showing a vertical analysis for 2012 and 2011.

E14-3 The comparative condensed balance sheets of Conard Corporation are presented below.

CONARD CORPORATION Comparative Condensed Balance Sheets

December 31 2012 2011

Assets Current assets $ 74,000 $ 80,000 Property, plant, and equipment (net) 99,000 90,000 Intangibles 27,000 40,000

Total assets $200,000 $210,000

Liabilities and stockholders’ equity Current liabilities $ 42,000 $ 48,000 Long-term liabilities 143,000 150,000 Stockholders’ equity 15,000 12,000

Total liabilities and stockholders’ equity $200,000 $210,000

Instructions (a) Prepare a horizontal analysis of the balance sheet data for Conard Corporation using 2011

as a base. (b) Prepare a vertical analysis of the balance sheet data for Conard Corporation in columnar

form for 2012.

E14-4 The comparative condensed income statements of Hendi Corporation are shown below.

HENDI CORPORATION Comparative Condensed Income Statements

For the Years Ended December 31

2012 2011

Net sales $600,000 $500,000 Cost of goods sold 483,000 420,000

Gross profit 117,000 80,000 Operating expenses 57,200 44,000

Net income $ 59,800 $ 36,000

Instructions (a) Prepare a horizontal analysis of the income statement data for Hendi Corporation using

2011 as a base. (b) Prepare a vertical analysis of the income statement data for Hendi Corporation in columnar

form for both years.

E14-5 Nordstrom, Inc. operates department stores in numerous states. Selected financial statement data for the year ending January 31, 2009, are shown on the next page.

Exercises 711

Prepare vertical analysis.

(SO 4)

Prepare horizontal and vertical analyses.

(SO 3, 4)

Prepare horizontal and vertical analyses.

(SO 3, 4)

Compute liquidity ratios and compare results.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 711

For the year, net credit sales were $8,272, and cost of goods sold was $5,417 (in millions).

Instructions (a) Compute the four liquidity ratios at the end of the year. (b) Using the data in the chapter, compare Nordstrom’s liquidity with (1) that of J.C. Penney

Company, and (2) the industry averages for department stores.

E14-6 Leach Incorporated had the following transactions occur involving current assets and current liabilities during February 2011.

Feb. 3 Accounts receivable of $15,000 are collected. 7 Equipment is purchased for $28,000 cash.

11 Paid $3,000 for a 3-year insurance policy. 14 Accounts payable of $12,000 are paid. 18 Cash dividends of $5,000 are declared.

Additional information:

1. As of February 1, 2011, current assets were $130,000, and current liabilities were $50,000. 2. As of February 1, 2011, current assets included $15,000 of inventory and $2,000 of prepaid

expenses.

Instructions (a) Compute the current ratio as of the beginning of the month and after each transaction. (b) Compute the acid-test ratio as of the beginning of the month and after each transaction.

E14-7 Bennis Company has the following comparative balance sheet data.

BENNIS COMPANY Balance Sheets December 31

2012 2011

Cash $ 15,000 $ 30,000 Receivables (net) 70,000 60,000 Inventories 60,000 50,000 Plant assets (net) 200,000 180,000

$345,000 $320,000

Accounts payable $ 50,000 $ 60,000 Mortgage payable (15%) 100,000 100,000 Common stock, $10 par 140,000 120,000 Retained earnings 55,000 40,000

$345,000 $320,000

Additional information for 2012:

1. Net income was $25,000. 2. Sales on account were $410,000. Sales returns and allowances were $20,000. 3. Cost of goods sold was $198,000. 4. The allowance for doubtful accounts was $2,500 on December 31, 2012, and $2,000 on

December 31, 2011.

712 Chapter 14 Financial Statement Analysis

NORDSTROM, INC. Balance Sheet (partial)

(in millions) End-of-Year Beginning-of-Year

Cash and cash equivalents $ 72 $ 358 Accounts receivable (net) 1,942 1,788 Merchandise inventory 900 956 Prepaid expenses 93 78 Other current assets 210 181 Total current assets $3,217 $3,361

Total current liabilities $1,601 $1,635

Perform current and acid-test ratio analysis.

(SO 5)

Compute selected ratios.

(SO 5)

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Instructions Compute the following ratios at December 31, 2012.

(a) Current. (b) Acid-test. (c) Receivables turnover. (d) Inventory turnover.

E14-8 Selected comparative financial statement data for Willingham Products Company are presented below. All balance sheet data are as of December 31.

2012 2011

Net sales $760,000 $720,000 Cost of goods sold 480,000 440,000 Interest expense 7,000 5,000 Net income 50,000 42,000 Accounts receivable 120,000 100,000 Inventory 85,000 75,000 Total assets 580,000 500,000 Total common stockholders’ equity 430,000 325,000

Instructions Compute the following ratios for 2012.

(a) Profit margin. (b) Asset turnover. (c) Return on assets. (d) Return on common stockholders’ equity.

E14-9 The income statement for Christensen, Inc., appears below.

CHRISTENSEN, INC. Income Statement

For the Year Ended December 31, 2011

Sales $400,000 Cost of goods sold 230,000

Gross profit 170,000 Expenses (including $16,000 interest and $24,000 income taxes) 105,000

Net income $ 65,000

Additional information:

1. The weighted-average common shares outstanding in 2011 were 30,000 shares. 2. The market price of Christensen, Inc. stock was $13 in 2011. 3. Cash dividends of $26,000 were paid, $5,000 of which were to preferred stockholders.

Instructions Compute the following ratios for 2011.

(a) Earnings per share. (b) Price-earnings. (c) Payout. (d) Times interest earned.

E14-10 Rees Corporation experienced a fire on December 31, 2012, in which its financial records were partially destroyed. It has been able to salvage some of the records and has ascer- tained the following balances.

December 31, 2012 December 31, 2011

Cash $ 30,000 $ 10,000 Receivables (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

Compute selected ratios.

(SO 5)

Compute selected ratios.

(SO 5)

Compute amounts from ratios.

(SO 5)

Exercises 713

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 713

Additional information:

1. The inventory turnover is 3.5 times. 2. The return on common stockholders’ equity is 24%. The company had no additional paid-in

capital. 3. The receivables turnover is 8.8 times. 4. The return on assets is 20%. 5. Total assets at December 31, 2011, were $605,000.

Instructions Compute the following for Rees Corporation.

(a) Cost of goods sold for 2012. (b) Net sales (credit) for 2012. (c) Net income for 2012. (d) Total assets at December 31, 2012.

E14-11 Scully Corporation’s comparative balance sheets are presented below.

SCULLY CORPORATION Balance Sheets December 31

2011 2010 Cash $ 4,300 $ 3,700 Accounts receivable 21,200 23,400 Inventory 10,000 7,000 Land 20,000 26,000 Building 70,000 70,000 Accumulated depreciation (15,000) (10,000)

Total $110,500 $120,100

Accounts payable $ 12,370 $ 31,100 Common stock 75,000 69,000 Retained earnings 23,130 20,000

Total $110,500 $120,100

Scully’s 2011 income statement included net sales of $100,000, cost of goods sold of $60,000, and net income of $15,000.

Instructions Compute the following ratios for 2011.

(a) Current ratio. (b) Acid-test ratio. (c) Receivables turnover. (d) Inventory turnover. (e) Profit margin. (f) Asset turnover. (g) Return on assets. (h) Return on common stockholders’ equity. (i) Debt to total assets ratio.

E14-12 For its fiscal year ending October 31, 2011, Molini Corporation reports the following partial data.

Income before income taxes $540,000 Income tax expense (30% � $390,000) 117,000

Income before extraordinary items 423,000 Extraordinary loss from flood 150,000

Net income $273,000

The flood loss is considered an extraordinary item. The income tax rate is 30% on all items.

714 Chapter 14 Financial Statement Analysis

Compute ratios.

(SO 5)

Prepare a correct income statement.

(SO 6)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 714

Instructions (a) Prepare a correct income statement, beginning with income before income taxes. (b) Explain in memo form why Molini’s reported income statement data are incorrect.

E14-13 Yadier Corporation has income from continuing operations of $290,000 for the year ended December 31, 2011. It also has the following items (before considering income taxes).

1. An extraordinary loss of $80,000. 2. A gain of $30,000 on the discontinuance of a division. 3. A correction of an error in last year’s financial statements that resulted in a $20,000 under-

statement of 2010 net income.

Assume all items are subject to income taxes at a 30% tax rate.

Instructions (a) Prepare an income statement, beginning with income from continuing operations. (b) Indicate the statement presentation of any item not included in (a) above.

Problems 715

EXERCISES: SET B AND CHALLENGE EXERCISES

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Exercise Set B and a set of Challenge Exercises.

w w

w .wiley.com

/c o

ll e

g e /w

ey gandt

Prepare income statement.

(SO 6)

Follow the rounding procedures used in the chapter.

P14-1 Comparative financial statement data for Douglas Company and Maulder Company, two competitors, appear below. All balance sheet data are as of December 31, 2012, and December 31, 2011.

Douglas Company Maulder Company

2012 2011 2012 2011

Net sales $1,549,035 $339,038 Cost of goods sold 1,080,490 241,000 Operating expenses 302,275 79,000 Interest expense 8,980 2,252 Income tax expense 54,500 6,650 Current assets 325,975 $312,410 83,336 $ 79,467 Plant assets (net) 521,310 500,000 139,728 125,812 Current liabilities 65,325 75,815 35,348 30,281 Long-term liabilities 108,500 90,000 29,620 25,000 Common stock, $10 par 500,000 500,000 120,000 120,000 Retained earnings 173,460 146,595 38,096 29,998

Instructions (a) Prepare a vertical analysis of the 2012 income statement data for Douglas Company and

Maulder Company in columnar form. (b) Comment on the relative profitability of the companies by computing the return

on assets and the return on common stockholders’ equity ratios for both companies.

PROBLEMS

Prepare vertical analysis and comment on profitability.

(SO 4, 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 715

P14-2 The comparative statements of Villa Tool Company are presented below.

VILLA TOOL COMPANY Income Statements

For the Years Ended December 31

2012 2011

Net sales $1,818,500 $1,750,500 Cost of goods sold 1,011,500 996,000

Gross profit 807,000 754,500 Selling and administrative expense 516,000 479,000

Income from operations 291,000 275,500 Other expenses and losses

Interest expense 18,000 14,000

Income before income taxes 273,000 261,500 Income tax expense 81,000 77,000

Net income $ 192,000 $ 184,500

VILLA TOOL COMPANY Balance Sheets December 31

Assets 2012 2011

Current assets Cash $ 60,100 $ 64,200 Short-term investments 69,000 50,000 Accounts receivable (net) 117,800 102,800 Inventory 123,000 115,500

Total current assets 369,900 332,500

Plant assets (net) 600,300 520,300

Total assets $970,200 $852,800

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $160,000 $145,400 Income taxes payable 43,500 42,000

Total current liabilities 203,500 187,400

Bonds payable 200,000 200,000

Total liabilities 403,500 387,400

Stockholders’ equity Common stock ($5 par) 280,000 300,000 Retained earnings 286,700 165,400

Total stockholders’ equity 566,700 465,400

Total liabilities and stockholders’ equity $970,200 $852,800

Instructions Compute the following ratios for 2012. (Weighted-average common shares in 2012 were 57,000, and all sales were on account.)

(a) Earnings per share. (f) Receivables turnover. (b) Return on common stockholders’ equity. (g) Inventory turnover. (c) Return on assets. (h) Times interest earned. (d) Current. (i) Asset turnover. (e) Acid-test. (j) Debt to total assets.

716 Chapter 14 Financial Statement Analysis

Compute ratios from balance sheet and income statement.

(SO 5)

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P14-3 Condensed balance sheet and income statement data for Kersenbrock Corporation appear below.

KERSENBROCK CORPORATION Balance Sheets December 31

2012 2011 2010

Cash $ 25,000 $ 20,000 $ 18,000 Receivables (net) 50,000 45,000 48,000 Other current assets 90,000 95,000 64,000 Investments 75,000 70,000 45,000 Plant and equipment (net) 400,000 370,000 358,000

$640,000 $600,000 $533,000

Current liabilities $ 75,000 $ 80,000 $ 70,000 Long-term debt 80,000 85,000 50,000 Common stock, $10 par 340,000 310,000 300,000 Retained earnings 145,000 125,000 113,000

$640,000 $600,000 $533,000

KERSENBROCK CORPORATION Income Statements

For the Years Ended December 31

2012 2011

Sales $740,000 $700,000 Less: Sales returns and allowances 40,000 50,000

Net sales 700,000 650,000 Cost of goods sold 420,000 400,000

Gross profit 280,000 250,000 Operating expenses (including income taxes) 235,000 220,000

Net income $ 45,000 $ 30,000

Additional information:

1. The market price of Kersenbrock’s common stock was $4.00, $5.00, and $8.00 for 2010, 2011, and 2012, respectively.

2. All dividends were paid in cash.

Instructions (a) Compute the following ratios for 2011 and 2012.

(1) Profit margin. (2) Asset turnover. (3) Earnings per share. (Weighted-average common shares in 2012 were 32,000 and in 2011

were 31,000.) (4) Price-earnings. (5) Payout. (6) Debt to total assets.

(b) Based on the ratios calculated, discuss briefly the improvement or lack thereof in financial position and operating results from 2011 to 2012 of Kersenbrock Corporation.

Problems 717

Perform ratio analysis, and evaluate financial position and operating results.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 717

P14-4 Financial information for Hanshew Company is presented below.

HANSHEW COMPANY Balance Sheets December 31

Assets 2012 2011

Cash $ 70,000 $ 65,000 Short-term investments 52,000 40,000 Receivables (net) 98,000 80,000 Inventories 125,000 135,000 Prepaid expenses 29,000 23,000 Land 130,000 130,000 Building and equipment (net) 180,000 175,000

$684,000 $648,000

Liabilities and Stockholders’ Equity

Notes payable $100,000 $100,000 Accounts payable 48,000 42,000 Accrued liabilities 50,000 40,000 Bonds payable, due 2015 150,000 150,000 Common stock, $10 par 200,000 200,000 Retained earnings 136,000 116,000

$684,000 $648,000

HANSHEW COMPANY Income Statements

For the Years Ended December 31 2012 2011

Sales $850,000 $790,000 Cost of goods sold 620,000 575,000

Gross profit 230,000 215,000 Operating expenses 187,000 173,000

Net income $ 43,000 $ 42,000

Additional information:

1. Inventory at the beginning of 2011 was $118,000. 2. Receivables (net) at the beginning of 2011 were $88,000. 3. Total assets at the beginning of 2011 were $630,000. 4. No common stock transactions occurred during 2011 or 2012. 5. All sales were on account.

Instructions (a) Indicate, by using ratios, the change in liquidity and profitability of Hanshew Company from

2011 to 2012. (Note: Not all profitability ratios can be computed.) (b) Given below are three independent situations and a ratio that may be affected. For each

situation, compute the affected ratio (1) as of December 31, 2012, and (2) as of December 31, 2013, after giving effect to the situation. Net income for 2013 was $50,000. Total assets on December 31, 2013, were $700,000.

Situation Ratio

(1) 18,000 shares of common stock were sold Return on common stockholders’ at par on July 1, 2013. equity

(2) All of the notes payable were paid in 2013. Debt to total assets The only change in liabilities was that the notes payable were paid.

(3) Market price of common stock was $9 Price-earnings ratio on December 31, 2012, and $12.80 on December 31, 2013.

718 Chapter 14 Financial Statement Analysis

Compute ratios, and comment on overall liquidity and profitability.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 718

P14-5 Selected financial data of Target and Wal-Mart for a recent year are presented here (in millions).

Target Wal-Mart Corporation Stores, Inc.

Income Statement Data for Year

Net sales $61,471 $374,526 Cost of goods sold 41,895 286,515 Selling and administrative expenses 16,200 70,847 Interest expense 647 1,798 Other income (expense) 1,896 4,273 Income tax expense 1,776 6,908

Net income $ 2,849 $ 12,731

Balance Sheet Data (End of Year)

Current assets $18,906 $ 47,585 Noncurrent assets 25,654 115,929

Total assets $44,560 $163,514

Current liabilities $11,782 $ 58,454 Long-term debt 17,471 40,452 Total stockholders’ equity 15,307 64,608 Total liabilities and stockholders’ equity $44,560 $163,514

Beginning-of-Year Balances

Total assets $37,349 $151,587 Total stockholders’ equity 15,633 61,573 Current liabilities 11,117 52,148 Total liabilities 21,716 90,014

Other Data

Average net receivables $ 7,124 $ 3,247 Average inventory 6,517 34,433 Net cash provided by operating activities 4,125 20,354

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

(1) Current. (7) Asset turnover. (2) Receivables turnover. (8) Return on assets. (3) Average collection period. (9) Return on common stockholders’ equity. (4) Inventory turnover. (10) Debt to total assets. (5) Days in inventory. (11) Times interest earned. (6) Profit margin.

(b) Compare the liquidity, profitability, and solvency of the two companies.

P14-6 The comparative statements of Dillon Company are presented below and on the next page.

DILLON COMPANY Income Statements

For the Years Ended December 31

2012 2011

Net sales (all on account) $600,000 $520,000

Expenses Cost of goods sold 415,000 354,000 Selling and administrative 120,800 114,800 Interest expense 7,800 6,000 Income tax expense 18,000 14,000

Total expenses 561,600 488,800

Net income $ 38,400 $ 31,200

Problems 719

Compute selected ratios, and compare liquidity, profitability, and solvency for two companies.

(SO 5)

Compute numerous ratios.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 719

DILLON COMPANY Balance Sheets December 31

Assets 2012 2011

Current assets Cash $ 21,000 $ 18,000 Short-term investments 18,000 15,000 Accounts receivable (net) 86,000 74,000 Inventory 90,000 70,000

Total current assets 215,000 177,000

Plant assets (net) 423,000 383,000

Total assets $638,000 $560,000

Liabilities and Stockholders’ Equity

Current liabilities Accounts payable $122,000 $110,000 Income taxes payable 23,000 20,000

Total current liabilities 145,000 130,000

Long-term liabilities Bonds payable 120,000 80,000

Total liabilities 265,000 210,000

Stockholders’ equity Common stock ($5 par) 150,000 150,000 Retained earnings 223,000 200,000

Total stockholders’ equity 373,000 350,000

Total liabilities and stockholders’ equity $638,000 $560,000

Additional data:

The common stock recently sold at $19.50 per share. The year-end balance in the allowance for doubtful accounts was $3,000 for 2012 and $2,400 for 2011.

Instructions Compute the following ratios for 2012.

(a) Current. (h) Return on common stockholders’ equity. (b) Acid-test. (i) Earnings per share. (c) Receivables turnover. (j) Price-earnings. (d) Inventory turnover. (k) Payout. (e) Profit margin. (l) Debt to total assets. (f) Asset turnover. (m) Times interest earned. (g) Return on assets.

P14-7 Presented below and on the next page is an incomplete income statement and an in- complete comparative balance sheet of Cotte Corporation.

COTTE CORPORATION Income Statement

For the Year Ended December 31, 2012

Sales $11,000,000 Cost of goods sold ?

Gross profit ? Operating expenses 1,665,000

Income from operations ? Other expenses and losses

Interest expense ?

Income before income taxes ? Income tax expense 560,000

Net income $ ?

720 Chapter 14 Financial Statement Analysis

Compute missing information given a set of ratios.

(SO 5)

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COTTE CORPORATION Balance Sheets December 31

Assets 2012 2011

Current assets Cash $ 450,000 $ 375,000 Accounts receivable (net) ? 950,000 Inventory ? 1,720,000

Total current assets ? 3,045,000

Plant assets (net) 4,620,000 3,955,000

Total assets $ ? $7,000,000

Liabilities and Stockholders’ Equity

Current liabilities $ ? $ 825,000 Long-term notes payable ? 2,800,000

Total liabilities ? 3,625,000

Common stock, $1 par 3,000,000 3,000,000 Retained earnings 400,000 375,000

Total stockholders’ equity 3,400,000 3,375,000

Total liabilities and stockholders’ equity $ ? $7,000,000

Additional information:

1. The receivables turnover for 2012 is 10 times. 2. All sales are on account. 3. The profit margin for 2012 is 14.5%. 4. Return on assets is 22% for 2012. 5. The current ratio on December 31, 2012, is 3.0. 6. The inventory turnover for 2012 is 4.8 times.

Instructions Compute the missing information given the ratios above. Show computations. (Note: Start with one ratio and derive as much information as possible from it before trying another ratio. List all missing amounts under the ratio used to find the information.)

P14-8 Cheaney Corporation owns a number of cruise ships and a chain of hotels. The hotels, which have not been profitable, were discontinued on September 1, 2011. The 2011 operating re- sults for the company were as follows.

Operating revenues $12,850,000 Operating expenses 8,700,000

Operating income $ 4,150,000

Analysis discloses that these data include the operating results of the hotel chain, which were: operating revenues $2,000,000 and operating expenses $2,400,000.The hotels were sold at a gain of $200,000 before taxes. This gain is not included in the operating results. During the year, Cheaney suffered an extraordinary loss of $800,000 before taxes, which is not included in the operating results. In 2011, the company had other revenues and gains of $100,000, which are not included in the operating results. The corporation is in the 30% income tax bracket.

Instructions Prepare a condensed income statement.

P14-9 The ledger of LaRussa Corporation at December 31, 2011, contains the following sum- mary data.

Net sales $1,700,000 Cost of goods sold $1,100,000 Selling expenses 120,000 Administrative expenses 150,000 Other revenues and gains 20,000 Other expenses and losses 28,000

Problems 721

Prepare income statement with discontinued operations and extraordinary loss.

(SO 6)

Prepare income statement with nontypical items.

(SO 6)

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Financial Reporting Problem: PepsiCo, Inc. BYP14-1 Your parents are considering investing in PepsiCo, common stock. They ask you, as an accounting expert, to make an analysis of the company for them. Fortunately, excerpts from a current annual report of PepsiCo are presented in Appendix A of this textbook. Note that all dollar amounts are in millions.

Instructions (Follow the approach in the chapter for rounding numbers.)

(a) Make a 5-year trend analysis, using 2004 as the base year, of (1) net sales and (2) net income. Comment on the significance of the trend results.

(b) Compute for 2008 and 2007 the (1) profit margin, (2) asset turnover, (3) return on assets, and (4) return on common stockholders’ equity. How would you evaluate PepsiCo’s profitabil- ity? Total assets at December 31, 2006, were $29,930, and total stockholders’ equity at December 31, 2006, was $15,447.

(c) Compute for 2008 and 2007 the (1) debt to total assets and (2) times interest earned ratio. How would you evaluate PepsiCo’s long-term solvency?

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

FINANCIAL REPORTING AND ANALYSIS

B R O A D E N I N G Y O U R P E R S P E C T I V E

Your analysis reveals the following additional information that is not included in the above data.

1. The entire puzzles division was discontinued on August 31. The income from operations for this division before income taxes was $20,000. The puzzles division was sold at a loss of $90,000 before income taxes.

2. On May 15, company property was expropriated for an interstate highway. The settlement resulted in an extraordinary gain of $120,000 before income taxes.

3. The income tax rate on all items is 30%.

Instructions Prepare an income statement for the year ended December 31, 2011. Use the format illustrated in the Comprehensive (p. 703).Do it!

722 Chapter 14 Financial Statement Analysis

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the Student Companion site, to access Problem Set B.

PROBLEMS: SET B ww w

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CCC14 Natalie and Curtis have comparative balance sheets and income statements for Cookie & Coffee Creations Inc.They have been told that they can use these financial statements to prepare horizontal and vertical analyses, and to calculate financial ratios, to analyze how their business is doing and to make some decisions they have been considering.

CONTINUING COOKIE CHRONICLE

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Comparative Analysis Problem: PepsiCo, Inc. vs. The Coca-Cola Company BYP14-2 PepsiCo’s financial statements are presented in Appendix A. Financial statements of The Coca-Cola Company are presented in Appendix B.

Instructions (a) Based on the information contained in these financial statements, determine each of the fol-

lowing for each company. (1) The percentage increase (decrease) in (i) net sales and (ii) net income from 2007 to 2008. (2) The percentage increase in (i) total assets and (ii) total common stockholders’ (share-

holders’) equity from 2007 to 2008. (3) The basic earnings per share and price-earnings ratio for 2008. (For both PepsiCo and

Coca-Cola, use the basic earnings per share.) Coca-Cola’s common stock had a market price of $45.27 at the end of fiscal-year 2008.

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

Broadening Your Perspective 723

Decision Making Across the Organization BYP14-3 As the CPA for Carismo Manufacturing Inc., you have been asked to develop some key ratios from the comparative financial statements. This information is to be used to convince creditors that the company is solvent and will continue as a going concern. The data requested and the computations developed from the financial statements follow.

2011 2010 Current ratio 3.1 times 2.1 times Acid-test ratio .8 times 1.4 times Asset turnover 2.8 times 2.2 times Net income Up 32% Down 8% Earnings per share $3.30 $2.50

Instructions With the class divided into groups, answer the following.

Carismo Manufacturing Inc. asks you to prepare a list of brief comments stating how each of these items supports the solvency and going-concern potential of the business. The company wishes to use these comments to support its presentation of data to its creditors. You are to prepare the comments as requested, giving the implications and the limitations of each item separately. Then prepare a collective inference that may be drawn from the individual items about Carismo’s solvency and going-concern potential.

BYP14-4 General Dynamics develops, produces, and supports innovative, reliable, and highly sophisticated military and commercial products. In July of a recent year, the corporation an- nounced that its Quincy Shipbuilding Division (Quincy) will be closed following the comple- tion of the Maritime Prepositioning Ship construction program.

Prior to discontinuance, the operating results of Quincy were net sales $246.8 million, income from operations before income taxes $28.3 million, and income taxes $12.5 million. The corpora- tion’s loss on disposition of Quincy was $5.0 million, net of $4.3 million income tax benefits.

From its other operating activities, General Dynamics’ financial results were net sales $8,163.8 million, cost of goods sold $6,958.8 million, and selling and administrative expenses $537.0 million. In addition, the corporation had interest expense of $17.2 million and interest revenue of $3.6 million. Income taxes were $282.9 million.

General Dynamics had an average of 42.3 million shares of common stock outstanding during the year.

CRITICAL THINKING

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Instructions With the class divided into groups, answer the following.

(a) Prepare the income statement for the year, assuming that the year ended on December 31, 2010. Show earnings per share data on the income statement. All dollars should be stated in millions, except for per share amounts. (For example, $8 million would be shown as $8.0)

(b) In the preceding year, Quincy’s earnings were $51.6 million before income taxes of $22.8 million. For comparative purposes, General Dynamics reported earnings per share of $0.61 from discontinued operations for Quincy in the preceding year. (1) What was the average number of common shares outstanding during the preceding year? (2) If earnings per share from continuing operations was $7.47, what was income from contin-

uing operations during the preceding year? (Round to two decimals.)

Communication Activity BYP14-5 Beth Harlan is the CEO of Lafferty’s Electronics. Harlan is an expert engineer but a novice in accounting. She asks you to explain (1) the bases for comparison in analyzing Lafferty’s financial statements, and (2) the factors affecting quality of earnings.

Instructions Write a letter to Beth Harlan that explains the bases for comparison and factors affecting qual- ity of earnings.

Ethics Case BYP14-6 Jack McClintock, president of McClintock Industries, wishes to issue a press release to bolster his 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 twenty financial ratios along with some other operating statistics relative to McClintock Industries’ first quarter financials and operations.

Two days after you provide the ratios and data requested, Jeremy Phelps, the public rela- tions director of McClintock, asks you to prove the accuracy of the financial and operating data contained in the press release written by the president and edited by Jeremy. In the press re- lease, the president highlights the sales increase of 25% over last year’s first quarter and the positive change in the current ratio from 1.5:1 last year to 3:1 this year. He also emphasizes that production was up 50% over the prior year’s first quarter.

You note that the press release contains only positive or improved ratios and none of the neg- ative or deteriorated ratios. For instance, no mention is made that the debt to total assets ratio has increased from 35% to 55%, that inventories are up 89%, and that while the current ratio improved, the acid-test ratio fell from 1:1 to .5:1. Nor is there any mention that the reported profit for the quar- ter would have been a loss had not the estimated lives of McClintock’s plant and machinery been increased by 30%. Jeremy emphasized, “The prez wants this release by early this afternoon.”

Instructions (a) Who are the stakeholders in this situation? (b) Is there anything unethical in president McClintock’s actions? (c) Should you as controller remain silent? Does Jeremy have any responsibility?

“All About You” Activity BYP14-7 In this chapter you learned how to use many tools for performing a financial analy- sis 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 diversifies by buying the stock of a variety of different companies, bonds, and other investments, depending on the stated goals of the fund.

Before you invest in a fund, you will need to decide what type of fund you want. For ex- ample, 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.

724 Chapter 14 Financial Statement Analysis

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Instructions Go to http://web.archive.org/web/20050210200843/http://www.cnb1.com/invallocmdl.htm and com- plete 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 BYP14-9 Access the FASB Codification at http://asc.fasb.org to prepare responses to the following. Use the Master Glossary for determining the proper definitions.

(a) Discontinued operations. (b) Extraordinary items. (c) Comprehensive income.

Answers to Insight and Accounting Across the Organization Questions p. 685 How to Manage the Current Ratio Q: How might management influence the company’s current ratio? A: Management can affect the current ratio by speeding up or withholding payments on accounts

payable just before the balance sheet date. Management can alter the cash balance by increasing or decreasing long-term assets or long-term debt, or by issuing or purchasing equity shares.

p. 693 Keeping Up to Date as an Investor Q: If you want to keep current with the financial and operating developments of a company in

which you own shares, what are some ways you can do so? A: You can obtain current information on your investments through a company’s website, financial

magazines and newspapers, CNBC television programs, investment letters, and a stockbroker. p. 698 What Does “Non-Recurring” Really Mean? Q: If a company takes a large restructuring charge, what is the effect on the company’s current

income statement versus future ones? A: The current period’s net income can be greatly diminished by a large restructuring charge, while

the net income in future periods can be enhanced because they are relieved of costs (i.e., depre- ciation and labor expenses) that would have been charged to them.

Authors’ Comments on All About You: Should I Play the Market Yet?, p. 702 For a number of reasons, it is probably a bad idea for Rachael to buy her employer’s stock. First, if Rachael is going to invest in the stock market, she should diversify her investments across a number of different companies. Second, you should never have more than a small portion of your total investment portfolio invested in your employer. Suppose that your employer starts to do poorly, the stock price falls, and you get laid off. You lose on two counts: You don’t have income, and your net worth has been affected adversely by the drop in the stock price. (This exact situa- tion happened to thousands of Enron employees, who not only lost their jobs, but their retire- ment savings as well, as Enron’s stock plummeted.) Third, after purchasing her employer’s stock, Rachael’s liquidity would be negatively affected: She would have only $3,000 of remaining liquid assets.

If Rachel invests $7,000, she actually has only enough liquid assets to cover one month’s worth of expenses. It is true that she could sell her stock, but if it has fallen in value, she will be reluctant to sell. In short, if she were to buy the stock, her financial flexibility would be very limited.

The bottom line is that we think that Rachael should invest in something that offers a higher return than her bank savings account, but we question whether she has enough liquidity to invest in individual stocks. We would recommend that she put some money in a stock mutual fund, some in a short-term CD, and the rest in a money-market fund.

Answers to Self-Study Questions 1. b 2. d 3. a 4. c 5. c 6. c 7. c 8. b 9. b 10. a 11. d 12. c 13. c 14. d 15. d

Broadening Your Perspective 725

Remember to go back to the Navigator box on the chapter-opening page and check off your completed work.✓

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