17 Analysis of

Financial
Statements

Chapter Preview

BASICS OF HORIZONTAL VERTICAL RATIO ANALYSIS

ANALYSIS ANALYSIS ANALYSIS AND REPORTING
C1 Analysis purpose P1 Application of: P2 Application of: P3 Liquidity and
efficiency
Building blocks Comparative balance Common-size balance
sheets sheet Solvency
C2 Standards for
comparisons Comparative income Common-size income Profitability
statements statement
Analysis tools Market prospects
Trend analysis Common-size
A1 Analysis reports
graphics

NTK 17-1 NTK 17-2 NTK 17-3

Learning Objectives
CONCEPTUAL ANALYTICAL PROCEDURAL
C1 Explain the purpose and identify the A1 Summarize and report results of analysis. P1 Explain and apply methods of horizontal
building blocks of analysis. analysis.
A2 Appendix 17A—Explain the form and
C2 Describe standards for comparisons in assess the content of a complete income P2 Describe and apply methods of vertical
analysis. statement. analysis.

P3 Define and apply ratio analysis.

Numbers Rule
“Expect to win!”—Carla Harris
NEW YORK—“I grew up as an only child in a no-nonsense, no-
excuses household,” recalls Carla Harris. “My parents gave me
the sense that I was supposed to do well.” Fast-forward and Carla
is now vice chair of Morgan Stanley’s ([Link])
prized Global Wealth Management division and past-chair of the
Morgan Stanley Foundation.
Carla Harris and her colleagues at Morgan Stanley analyze
financial statements for profit. One of Morgan Stanley’s key
tools for analysis is ModelWare. ModelWare is a framework to
analyze the nuts and bolts of companies’ financial statements
and then to compare those companies head-to-head. One of its
key aims is to provide comparable information that focuses on
sustainable performance.
Morgan Stanley uses the accounting numbers in financial
©Jonathan Leibson/Getty Images for AOL
statements to produce comparable metrics using techniques
such as horizontal and vertical analysis. It also computes finan- ­ nalytical!” She says that people do not take full advantage of
a
cial ratios for analysis and interpretation. Those ratios include information available in financial statements.
return on equity, return on assets, asset turnover, profit margin, Carla plays by the rules and asserts that those with account-
price-to-earnings, and many other accounting measures. The ing know-how continue to earn profits from financial statement
focus is to uncover the drivers of profitability and to predict analysis and interpretation. Carla is proud of her success and
future levels of those drivers. adds: “Always start from a place of doing the right thing.”
Carla has experienced much success through analyzing Sources: Morgan Stanley website, January 2019; MorganStanleyIQ, November 2007;
­financial statements. As Carla likes to say, “I’m tough and [Link]/Stories, September 2006; Fortune, August 2013 and March 2016

BASICS OF ANALYSIS
Financial statement analysis applies analytical tools to financial statements and related data
for making business decisions.
C1
Explain the purpose and
identify the building blocks
of analysis.
Purpose of Analysis
Internal users of accounting information manage and operate the company. They include man-
agers, officers, and internal auditors. The purpose of financial statement analysis for internal
users is to provide information to improve efficiency and effectiveness.
External users of accounting information are not directly involved in running the company.
External users use financial statement analysis to pursue their own goals. Shareholders and
creditors assess company performance to make investing and lending decisions. A board of
directors analyzes financial statements to monitor management’s performance. External audi- Point: Financial statement analysis
is a topic on the CPA, CMA, CIA,
tors use financial statements to assess “fair presentation” of financial results. and CFA exams.
The common goal of these users is to evaluate company performance and financial condition.
This includes evaluating past and current performance, current financial position, and future
performance and risk.

Building Blocks of Analysis

Financial statement analysis focuses on one or more of the four building blocks of financial
statement analysis. The four building blocks cover different, but interrelated, aspects
of financial condition or performance.
Profitability
Liquidity and efficiency—ability to meet short-term obligations and to efficiently
generate revenues.
Solvency—ability to meet long-term obligations and generate future revenues. Liquidity
& Solvency Market
Profitability—ability to provide financial rewards to attract and retain financing. efficiency prospects

Market prospects—ability to generate positive market expectations.

613
614 Chapter 17 Analysis of Financial Statements

Information for Analysis

Financial analysis uses general-purpose financial statements that include the (1) income
statement, (2) balance sheet, (3) statement of stockholders’ equity (or statement of retained
earnings), (4) statement of cash flows, and (5) notes to these statements.
Notes
Financial reporting is the communication of financial information useful for making invest-
Statement
Cash Flow
of ment, credit, and other business decisions. Financial reporting includes general-purpose finan-
Statem
Stockholde ent of
s
cial statements, information from SEC 10-K and other filings, press releases, shareholders’
Balance Sh
rs’' Equity
eet
meetings, forecasts, management letters, and auditors’ reports.
Income St
atement Management’s Discussion and Analysis (MD&A) is one example of useful information out-
side usual financial statements. Apple’s MD&A (available at [Link] and “Item 7”
in the annual report) begins with an overview, followed by critical accounting policies and esti-
mates. It then discusses operating results followed by financial condition (liquidity, capital
resources, and cash flows). The final few parts discuss risks. The MD&A is an excellent starting
point in understanding a company’s business.

C2 Standards for Comparisons

Describe standards for When analyzing financial statements, we use the following standards (benchmarks) for com-
comparisons in analysis.
parisons. Benchmarks from a competitor or group of competitors are often best. Intracompany
and industry measures are also good. Guidelines can be applied, but only if they seem reason-
able given recent experience.
Intracompany—The company’s current performance is compared to its prior performance
and its relations between financial items. Apple’s current net income, for example, can be
compared with its prior years’ net income and in relation to its revenues or total assets.
Competitor—Competitors provide standards for comparisons. Coca-Cola’s profit margin
can be compared with PepsiCo’s profit margin.
Point: Each chapter’s Accounting Industry—Industry statistics provide standards of comparisons. Intel’s profit margin can be
Analysis problems cover intra-
company analysis. Comparative compared with the industry’s profit margin.
Analysis problems cover competi-
tor analysis (Apple vs. Google vs.
Guidelines (rules of thumb)—Standards of comparison can develop from experience.
Samsung). Examples are the 2:1 level for the current ratio or 1:1 level for the acid-test ratio.

Tools of Analysis
There are three common tools of financial statement analysis. This chapter describes these anal-
ysis tools and how to apply them.
1. Horizontal analysis—comparison of financial condition and performance across time.
2. Vertical analysis—comparison of financial condition and performance to a base amount.
3. Ratio analysis—measurement of key relations between financial statement items.

Decision Insight
Stock in Trade Blue chips are stocks of big, established companies. The phrase comes from poker, where the most
valuable chips are blue. Brokers execute orders to buy or sell stock. The term comes from wine retailers—individuals
who broach (break) wine casks. ■

HORIZONTAL ANALYSIS
P1 Horizontal analysis is the review of financial statement data across time. Horizontal comes
from the left-to-right (or right-to-left) movement of our eyes as we review comparative financial
Explain and apply methods
of horizontal analysis. statements across time.

Comparative Statements
Comparative financial statements show financial amounts in side-by-side col-
2018 Report 2019 Report
umns on a single statement, called a comparative format. Using Apple’s financial
statements, this section explains how to compute dollar changes and percent
changes for comparative statements.
 Chapter 17 Analysis of Financial Statements 615

Dollar Changes and Percent Changes Comparing financial statements is often

done by analyzing dollar amount changes and percent changes in line items. Both analyses are
relevant because small dollar changes can yield large percent changes inconsistent with their im-
portance. A 50% change from a base figure of $100 is less important than a 50% change from a
base amount of $100,000. We compute the dollar change for a financial statement item as follows.

Dollar change = Analysis period amount − Base period amount

Analysis period refers to the financial statements under analysis, and base period refers to the
financial statements used for comparison. The prior year is commonly used as a base period. We
compute the percent change as follows.

Analysis period amount − Base period amount

Percent change (%) = × 100
Base period amount

We must know a few rules in working with percent changes. Let’s look at four separate cases.
Cases A and B: When a negative amount is in one period and a positive amount is in the Example: When there is a value in
other, we cannot compute a meaningful percent change. the base period and zero in the
analysis period, the decrease
Case C: When no amount is in the base period, no percent change is computable. is 100%. Why isn’t the reverse
situation an increase of 100%?
Case D: When a positive amount is in the base period and zero is in the analysis period, the Answer: A 100% increase of zero
decrease is 100%. is still zero.

Change Analysis
Analysis Base
Case Period Period Dollar Percent

A $ 1,500 $(4,500) $ 6,000 —

B (1,000) 2,000 (3,000) —
C 8,000 — 8,000 —
D 0 10,000 (10,000) (100%)

Comparative Balance Sheets Analysis of comparative financial statements begins

by focusing on large dollar and percent changes. We then identify the reasons and implications
for these changes. We also review small changes when we expected large changes.
Exhibit 17.1 shows comparative balance sheets for Apple Inc. (ticker: AAPL). A few items
stand out on the asset side. Apple’s short-term marketable securities increased by 15.5%, and its
long-term marketable securities increased by 14.2%. This combined for a large $31,505 million
increase in securities. In response, Apple raised its dividend and announced plans to spend at
least $210 billion buying back stock by the end of the next year. Dividends and share repurchase
plans are likely to slow Apple’s growth of short-term securities. Other notable increases occur
with (1) property, plant and equipment, partially related to its new headquarters, and (2) inventories,
which had a high percentage increase but relatively small dollar increase.
On Apple’s financing side, we see its overall 16.7% increase is driven by a 24.7% increase in
liabilities; equity increased only 4.5%. The largest increase is from long-term debt, which
increased by $21,780 million, or 28.9%. Much of this increase results from bond offerings by
Apple to take advantage of low interest rates. We also see a modest increase of 2.0% ($1,966
million) in retained earnings, which was increased by a strong income of $48,351 million and
reduced by cash dividends and stock repurchases.

Comparative Income Statements Exhibit 17.2 shows Apple’s comparative in-

come statements. Apple reports an increase in sales of 6.3%. Cost of sales increased to a greater
extent than sales (7.4%), which is not a positive sign. The 10.7% increase in operating expenses
is primarily driven by the 15.3% increase in research and development costs, from which
­management and investors hope to reap future income. While Apple’s net income increased
just 5.8%, its basic earnings per share increased 11.0%. This is largely due to Apple’s share
­buyback program.
616 Chapter 17 Analysis of Financial Statements

EXHIBIT 17.1
APPLE INC.
Comparative Balance Sheets Comparative Year-End Balance Sheets
APPLE $ millions Current Yr Prior Yr Dollar Change Percent Change

Assets
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 $ 20,484 $  (195) (1.0)%
Short-term marketable securities . . . . . . . . . . . . . . . . . . . . 53,892 46,671 7,221 15.5
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874 15,754 2,120 13.5
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,855 2,132 2,723 127.7
Vendor non-trade receivables . . . . . . . . . . . . . . . . . . . . . . . 17,799 13,545 4,254 31.4
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,936 8,283 5,653 68.2
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,645 106,869 21,776 20.4
Long-term marketable securities . . . . . . . . . . . . . . . . . . . . 194,714 170,430 24,284 14.2
Property, plant and equipment, net . . . . . . . . . . . . . . . . . . 33,783 27,010 6,773 25.1
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,717 5,414 303 5.6
Acquired intangible assets, net . . . . . . . . . . . . . . . . . . . . . 2,298 3,206 (908) (28.3)
Other non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 10,162 8,757 1,405 16.0
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 $321,686 $53,633 16.7
Liabilities
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 $ 37,294 $11,755 31.5%
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,744 22,027 3,717 16.9
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,548 8,080 (532) (6.6)
Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,977 8,105 3,872 47.8
Current portion of long-term debt . . . . . . . . . . . . . . . . . . . 6,496 3,500 2,996 85.6
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,814 79,006 21,808 27.6
Deferred revenue—non-current . . . . . . . . . . . . . . . . . . . . . 2,836 2,930 (94) (3.2)
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,207 75,427 21,780 28.9
Other non-current liabilities . . . . . . . . . . . . . . . . . . . . . . . . 40,415 36,074 4,341 12.0
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,272 193,437 47,835 24.7
Stockholders’ Equity
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 31,251 4,616 14.8
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,330 96,364 1,966 2.0
Accumulated other comprehensive income . . . . . . . . . . . . (150) 634 (784) —
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . 134,047 128,249 5,798 4.5
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . $375,319 $321,686 $53,633 16.7

EXHIBIT 17.2
APPLE INC.
Comparative Income Comparative Income Statements
Statements $ millions, except per share Current Yr Prior Yr Dollar Change Percent Change
APPLE Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 $13,595 6.3%
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 9,672 7.4
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 3,923 4.7
Research and development . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 1,536 15.3
Selling, general and administrative . . . . . . . . . . . . . . . . . . 15,261 14,194 1,067 7.5
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 2,603 10.7
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 1,320 2.2
Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1,397 103.6
Income before provision for income taxes . . . . . . . . . . . . . 64,089 61,372 2,717 4.4
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 53 0.3
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 2,664 5.8
Point: Percent change is also
computed by dividing the current Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . $   9.27 $   8.35 $  0.92 11.0
period by the prior period and Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . $   9.21 $   8.31 $  0.90 10.8
then subtracting 1.0.
 Chapter 17 Analysis of Financial Statements 617

Trend Analysis Financial Results

Millions Rati

Trend analysis is computing trend percents that show patterns in data across periods. Trend
$900
$800
$700
45%

percent is computed as follows.

$600
$500
$400 30%
$300
$200 15%
$100
$0 0.0%
400 600 1,200
2017 2007 2014 2005

Analysis period amount

Trend percent (%) = × 100
Base period amount
Point: Index refers to the compari-
son of the analysis period to the
base period. Percents determined
Trend analysis is shown in Exhibit 17.3 using data from Apple’s current and prior financial for each period are called index
numbers.
statements.

EXHIBIT 17.3
$ millions Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago 4 Yrs Ago
Sales and Expenses
Net sales . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 $233,715 $182,795 $170,910
Cost of sales . . . . . . . . . . . . . . . . . 141,048 131,376 140,089 112,258 106,606
Operating expenses . . . . . . . . . . . 26,842 24,239 22,396 18,034 15,305

The trend percents—using data from Exhibit 17.3—are shown in Exhibit 17.4. The base period
is the number reported four years ago, and the trend percent is computed for each year by divid-
ing that year’s amount by the base period amount. For example, the net sales trend percent for Point: Trend analysis expresses a
percent of base, not a percent of
the current year is 134.1%, computed as $229,234/$170,910. change.

EXHIBIT 17.4
In trend percent Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago 4 Yrs Ago
Trend Percents for Sales
Net sales . . . . . . . . . . . . . . . . . . . . 134.1% 126.2% 136.7% 107.0% 100.0% and Expenses
Cost of sales . . . . . . . . . . . . . . . . . 132.3 123.2 131.4 105.3 100.0
Operating expenses . . . . . . . . . . . 175.4 158.4 146.3 117.8 100.0

Exhibit 17.5 shows the trend 250% EXHIBIT 17.5

percents from Exhibit 17.4 in a Net sales Trend Percent Lines
200% Cost of sales
line graph, which helps us see for Apple’s Sales and
Trend Percent

Operating expenses
trends and detect changes in Expenses
150%
direction or magnitude. It shows
100%
that the trend line for operating
expenses exceeds net sales in 50%
each of the years shown. This is
not positive for Apple. Apple’s 0%
4 Yrs Ago 3 Yrs Ago 2 Yrs Ago 1 Yr Ago Current Yr
net income will suffer if expenses
rise faster than sales.
Exhibit 17.6 compares
Apple’s revenue trend line to
those of Google and Samsung. 250% EXHIBIT 17.6
Google was able to grow revenue Apple Revenue Trend Percent
in each year relative to the base 200% Google
Trend in Revenue

Samsung
Lines—Apple, Google,
year. Apple was able to grow and Samsung
150%
revenue overall in the last five APPLE
years, but at a slower pace than 100%
Google. Samsung’s revenue was GOOGLE
mainly flat. 50%
Samsung
Trend analysis can show rela- 0%
tions between items on different 4 Yrs Ago 3 Yrs Ago 2 Yrs Ago 1 Yr Ago Current Yr
618 Chapter 17 Analysis of Financial Statements

EXHIBIT 17.7 financial statements. Exhibit 17.7

$ millions Current Yr 4 Yrs Ago Change
Sales and Asset Data for compares Apple’s net sales and
Apple Net sales . . . . . . . . . . . . . . $229,234 $170,910 34.1% total assets. The increase in total
Total assets . . . . . . . . . . . . 375,319 207,000 81.3 assets (81.3%) has exceeded the
increase in net sales (34.1%). Is
this result favorable or not? One interpretation is that Apple was less efficient in using its assets
in the current year versus four years ago.

Decision Maker
Auditor Your tests reveal a 3% increase in sales from $200,000 to $206,000 and a 4% decrease in expenses from
$190,000 to $182,400. Both changes are within your “reasonableness” criterion of ±5%, and thus you don’t pursue
additional tests. The audit partner in charge questions your lack of follow-up and mentions the joint relation between
sales and expenses. What is the partner referring to? ■ Answer: Both individual accounts (sales and expenses) yield percent changes
within the ±5% acceptable range. However, a joint analysis shows an increase in sales and a decrease in expenses producing a more than 5% increase in
income. This client’s profit margin is 11.46% ([$206,000 − $182,400]/$206,000) for the current year compared with 5.0% ([$200,000 − $190,000]/$200,000)
for the prior year—a 129% increase!

NEED-TO-KNOW 17-1 Compute trend percents for the following accounts using 3 Years Ago as the base year. Indicate whether
the trend appears to be favorable or unfavorable for each account.
Horizontal Analysis
$ millions Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago
P1
Sales . . . . . . . . . . . . . . . . . . . . . . . $500 $350 $250 $200
Cost of goods sold . . . . . . . . . . . . 400 175 100 50

Solution

$ millions Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago

Sales . . . . . . . . . . . . . . . . . . . . . . . 250% 175% 125% 100%

($500∕$200) ($350∕$200) ($250∕$200) ($200∕$200)

Cost of goods sold . . . . . . . . . . . . 800% 350% 200% 100%

($400∕$50) ($175∕$50) ($100∕$50) ($50∕$50)

Analysis: The trend in sales is favorable; however, we need more information about economic condi-
tions and competitors’ performances to better assess it. Cost of goods sold also is rising (as expected
Do More: QS 17-3, QS 17-4, with increasing sales). However, cost of goods sold is rising faster than the increase in sales, which
E 17-3
is bad news.

VERTICAL ANALYSIS
P2 Vertical analysis, or common-size analysis, is used to evaluate individual financial statement
items or a group of items. Vertical comes from the up-down [or down-up] movement of our eyes
Describe and apply
methods of vertical analysis. as we review common-size financial statements.

Income Statement Common-Size Statements

The comparative statements in Exhibits 17.1 and 17.2 show the change in each item over time.
Sales 10,000
Expenses 6,000 Common-size financial statements show changes in the relative importance of each financial
Income 4,000
statement item. All individual amounts in common-size statements are shown in common-size
percents. A common-size percent is calculated as
Point: Numerator and denominator
in common-size percent are taken
from the same financial statement
and from the same period. Analysis amount
Common-size percent (%) = × 100
Base amount
 Chapter 17 Analysis of Financial Statements 619

Common-Size Balance Sheets Common-size statements show each item as a per-

cent of a base amount, which for a common-size balance sheet is total assets. The base amount
is assigned a value of 100%. (Total liabilities plus equity also equals 100% because this amount
equals total assets.) We then compute a common-size percent for each asset, liability, and equity
item using total assets as the base amount.
Exhibit 17.8 shows common-size comparative balance sheets for Apple. Two results that Point: Common-size statements
stand out on both a magnitude and percentage basis include (1) issuance of long-term debt—a often are used to compare com-
panies in the same industry.
2.5% increase from 23.4% to 25.9%, the largest of any liability, and (2) a 3.8% decrease in
retained earnings and 1% decrease in cash and cash equivalents, largely the result of cash divi-
dends and stock buybacks. The absence of other substantial changes in Apple’s balance sheet
suggests a mature company, but with some lack of focus as evidenced by the large amounts for
securities. This buildup in securities is a concern as the return on securities is historically
smaller than the return on operating assets.

Common-Size Income Statements Analysis also involves the use of a common-

size income statement. Revenue is the base amount, which is assigned a value of 100%. Each
income statement item is shown as a percent of revenue. If we think of the 100% revenue amount

APPLE INC.
EXHIBIT 17.8
Common-Size Comparative Year-End Balance Sheets Common-Size Comparative
Common-Size Percents* Balance Sheets
$ millions Current Yr Prior Yr Current Yr Prior Yr
APPLE
Assets
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,289 $ 20,484 5.4% 6.4%
Short-term marketable securities . . . . . . . . . . . . . . . . . . . . 53,892 46,671 14.4 14.5
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . 17,874 15,754 4.8 4.9
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,855 2,132 1.3 0.7
Vendor non-trade receivables . . . . . . . . . . . . . . . . . . . . . . 17,799 13,545 4.7 4.2
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,936 8,283 3.7 2.6
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128,645 106,869 34.3 33.2
Long-term marketable securities . . . . . . . . . . . . . . . . . . . . 194,714 170,430 51.9 53.0
Property, plant and equipment, net . . . . . . . . . . . . . . . . . . 33,783 27,010 9.0 8.4
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,717 5,414 1.5 1.7
Acquired intangible assets, net . . . . . . . . . . . . . . . . . . . . . 2,298 3,206 0.6 1.0
Other non-current assets . . . . . . . . . . . . . . . . . . . . . . . . . . 10,162 8,757 2.7 2.7
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $375,319 $321,686 100.0% 100.0%
Liabilities
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,049 $ 37,294 13.1% 11.6%
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,744 22,027 6.9 6.8
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,548 8,080 2.0 2.5
Commercial paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,977 8,105 3.2 2.5
Current portion of long-term debt . . . . . . . . . . . . . . . . . . . 6,496 3,500 1.7 1.1
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 100,814 79,006 26.9 24.6
Deferred revenue—noncurrent . . . . . . . . . . . . . . . . . . . . . 2,836 2,930 0.8 0.9
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97,207 75,427 25.9 23.4
Other non-current liabilties . . . . . . . . . . . . . . . . . . . . . . . . . 40,415 36,074 10.8 11.2
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,272 193,437 64.3 60.1
Stockholders’ Equity
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,867 31,251 9.6 9.7
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98,330 96,364 26.2 30.0
Accumulated other comprehensive income . . . . . . . . . . . (150) 634 0.0 0.2
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . 134,047 128,249 35.7 39.9
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . $375,319 $321,686 100.0% 100.0%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.
620 Chapter 17 Analysis of Financial Statements

EXHIBIT 17.9 APPLE INC.

Common-Size Comparative Common-Size Comparative Income Statements
Income Statements Common-Size Percents*

APPLE $ millions Current Yr Prior Yr Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $229,234 $215,639 100.0% 100.0%

Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141,048 131,376 61.5 60.9
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,186 84,263 38.5 39.1
Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,581 10,045 5.1 4.7
Selling, general and administrative . . . . . . . . . . . . . . . . . . . . . . 15,261 14,194 6.7 6.6
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,842 24,239 11.7 11.2
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61,344 60,024 26.8 27.8
Other income, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,745 1,348 1.2 0.6
Income before provision for income taxes . . . . . . . . . . . . . . . . . 64,089 61,372 28.0 28.5
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,738 15,685 6.9 7.3
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48,351 $ 45,687 21.1% 21.2%

*Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

as representing one sales dollar, the remaining items show how each revenue dollar is distrib-
uted among costs, expenses, and income.
Exhibit 17.9 shows common-size comparative income statements for each dollar of Apple’s net
sales. The past two years’ common-size numbers are similar with two exceptions. One is the increase
of 0.4 cents in research and development costs, which can be a positive development if these costs
lead to future revenues. Another is the increase in cost of sales of 0.6 cent and increase in selling,
general and administrative costs of 0.1 cent. We must monitor the growth in these expenses.

EXHIBIT 17.10 Income taxes

Common-Size Graphics
Common-Size Graphic of Exhibit 17.10 is a graphic of Apple’s
6.9%
Research and
Income Statement Net income,
current-year common-size income development
excluding non- statement. This pie chart shows the 5.1%
operating Selling, general, contribution of each cost component
income and administrative, of net sales for net income.
expenses and other income Exhibit 17.11 takes data from
19.8% 6.7%
Cost of Apple’s Segments footnote. The
sales exhibit shows the level of net sales for
61.5%
each of Apple’s five operating seg-
ments. Its Americas segment gener-
ates $96.6 billion net sales, which is roughly 42% of its total sales. Within each bar is that
segment’s operating income margin (Operating income/Segment net sales). The Americas seg-
ment has a 32% operating income margin. This type of graphic can raise questions about the
profitability of each segment and lead to discussion of further expansions into more profitable
segments. For example, the Japan segment has an operating margin of 46%. A natural question
for management is what potential is there to expand sales into the Japan segment and maintain
EXHIBIT 17.11 $100 $96.6

Sales and Operating Segment percentages

Income Margin Breakdown $80 based on: Operating
Net Sales (in bil.)

by Segment income/Net sales

$60 $54.9
$44.8
$40

$20 $17.7 $15.2

32% 30% 38% 46% 35%

$0
Americas Europe China Japan Asia
Pacific
 Chapter 17 Analysis of Financial Statements 621

this operating margin? This type of analysis can EXHIBIT 17.12

Cash and cash equivalents 5%
help determine strategic plans. Common-Size Graphic of
Graphics also are used to identify (1) sources of Short-term marketable Asset Components
financing, including the distribution among current securities 14%

liabilities, noncurrent liabilities, and equity capital, Accounts receivable, net 5%

and (2) focuses of investing activities, including the Inventories 1%

distribution among current and noncurrent assets. Vendor non-trade receivables 5%

Exhibit 17.12 shows a common-size graphic of Other current assets 3%
Apple’s assets, a high percentage of which are in
securities, followed by property, plant and equipment.
Common-size financial statements are useful in
comparing companies. Exhibit 17.13 shows com-
mon-size graphics of Apple, Google, and S ­ amsung Long-term marketable securities 52%
on financing sources. This graphic shows the larger
percent of equity financing for Google versus
Apple and Samsung. It also shows the larger non-
current debt financing of Apple versus Google and Property, plant & equipment, net 9%
Samsung. Comparison of a company’s common- Goodwill 2%
size statements with competitors’ or industry com- Acquired intangible assets, net 1%
mon-size statistics alerts us to differences in the Other long-term assets 3%
structure of its financial statements.

Apple Google Samsung EXHIBIT 17.13

Current liabilities
12% Common-Size Graphic of
27% 22%
1 1% Financing Sources—
Noncurrent liabilities 7% Competitor Analysis
37%
Equity
77%
APPLE
7 1%
36%
GOOGLE
Samsung

Ethical Risk
Truth Be Told In a survey of nearly 200 CFOs of large companies, roughly 20% say that firms use accounting tools
to report earnings that do not fully reflect the firms’ underlying operations. One goal of financial analysis is to
see through such ploys. The top reasons CFOs gave for this were to impact stock price, hit an earnings target, and
influence executive pay (The Wall Street Journal). ■

Express the following comparative income statements in common-size percents and assess whether this NEED-TO-KNOW 17-2
company’s situation has improved in the current year.
Vertical Analysis
Comparative Income Statements
For Years Ended December 31 Current Yr Prior Yr P2
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800 $500
Total expenses . . . . . . . . . . . . . . . . . . . . . 560 400
Net income . . . . . . . . . . . . . . . . . . . . . . . . $240 $100

Solution
Current Yr Prior Yr
Analysis: This company’s situation has improved. This is
Sales . . . . . . . . . . . . . 100% 100%
($800∕$800) ($500∕$500) evident from its substantial increase in net income as a
Total expenses . . . . . 70% 80% percent of sales for the current year (30%) relative to the
($560∕$800) ($400∕$500) prior year (20%). Further, the company’s sales increased
from $500 to $800 (while expenses declined as a percent Do More: QS 17-5, E 17-4,
Net income . . . . . . . . 30% 20%
E 17-5, E 17-6
of sales from 80% to 70%).
622 Chapter 17 Analysis of Financial Statements

RATIO ANALYSIS
P3 Ratios are used to uncover conditions and trends difficult to detect by looking at individual
amounts. A ratio shows a relation between two amounts. It can be shown as a percent, rate, or
Define and apply ratio
analysis. proportion. A change from $100 to $250 can be shown as (1) 150% increase, (2) 2.5 times, or
(3) 2.5 to 1 (or 2.5:1). To be useful, a ratio must show an economically important relation. For
example, a ratio of cost of goods sold to sales is useful, but a ratio of freight costs to patents is not.
This section covers important financial ratios organized into the four building blocks of financial
statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market pros-
Ratios pects. We use four standards for comparison: intracompany, competitor, industry, and guidelines.

Liquidity and Efficiency

Liquidity is the availability of resources to pay short-term cash requirements. It is affected by
the timing of cash inflows and outflows along with prospects for future performance. A lack of
liquidity often is linked to lower profitability. To creditors, lack of liquidity can cause
delays in collecting payments. Efficiency is how productive a company is in using its
assets. Inefficient use of assets can cause liquidity problems. This section covers key
ratios used to assess liquidity and efficiency.
Working Capital and Current Ratio The amount of current assets minus cur-
rent liabilities is called working capital, or net working capital. A company that runs low
on working capital is less likely to pay debts or to continue operating. When evaluating a compa-
ny’s working capital, we look at the dollar amount of current assets minus current liabilities and at
their ratio. The current ratio is defined as follows (see Chapter 4 for additional explanation).

Current assets
Current ratio =
Current liabilities

EXHIBIT 17.14 $ millions Current Yr Prior Yr Apple’s working capital and current
Apple’s Working Capital ratio are shown in Exhibit 17.14. Also,
and Current Ratio Current assets . . . . . . . . . . . . . $128,645 $106,869 Google’s (5.14), Samsung’s (2.19), and the
Current liabilities . . . . . . . . . . . 100,814 79,006 industry’s (2.5) current ratios are shown in
Working capital . . . . . . . . . . . $ 27,831 $ 27,863 the margin. Although its ratio (1.28) is
Current ratio Current ratio lower than competitors’ ratios, Apple is not
Google = 5.14    $128,645/$100,814 = 1.28 to 1 in danger of defaulting on loan payments.
Samsung = 2.19
Industry = 2.5
   $106,869/$79,006 = 1.35 to 1 A high current ratio suggests a strong abil-
ity to meet current obligations. An exces-
sively high current ratio means that the company has invested too much in current assets compared
to current obligations. An excessive investment in current assets is not an efficient use of funds
because current assets normally earn a low return on investment (compared with long-term assets).
Many analysts use a guideline of 2:1 (or 1.5:1) for the current ratio. A 2:1 or higher ratio is con-
sidered low risk in the short run. Analysis of the current ratio, and many other ratios, must consider
type of business, composition of current assets, and turnover rate of current asset components.
Business Type A service company that grants little or no credit and carries few inventories
can probably operate on a current ratio of less than 1:1 if its revenues generate enough cash to
pay its current liabilities. On the other hand, a company selling high-priced clothing or furniture
requires a higher ratio because of difficulties in judging customer demand and cash receipts.
Global: Ratio analysis is unaffected Asset Composition The composition of assets is important to assess short-term liquidity.
by currency but is affected by dif-
ferences in accounting principles.
For instance, cash, cash equivalents, and short-term investments are more liquid than ac-
counts and notes receivable. An excessive amount of receivables and inventory weakens a
company’s ability to pay current liabilities.
Turnover Rate Asset turnover measures efficiency in using assets. A measure of asset
­efficiency is revenue generated.
 Chapter 17 Analysis of Financial Statements 623

Decision Maker
Banker A company requests a one-year, $200,000 loan for expansion. This company’s current ratio is 4:1, with
current assets of $160,000. Key competitors have a current ratio of 1.9:1. Using this information, do you approve the
loan? ■ Answer: The loan application is likely approved for at least two reasons. First, the current ratio suggests an ability to meet short-term obligations.
Second, current assets of $160,000 and a current ratio of 4:1 imply current liabilities of $40,000 (one-fourth of current assets) and a working capital excess
of $120,000. The working capital is 60% of the loan.

Acid-Test Ratio Quick assets are cash, short-term investments, and current receivables.
These are the most liquid types of current assets. The acid-test ratio, also called quick ratio and
introduced in Chapter 5, evaluates a company’s short-term liquidity.

Cash + Short-term investments + Current receivables

Acid-test ratio =
Current liabilities

Apple’s acid-test ratio is computed in $ millions Current Yr Prior Yr

EXHIBIT 17.15
Exhibit 17.15. Apple’s acid-test ratio (0.91) Acid-Test Ratio
is lower than those for Google (4.97), Cash and equivalents . . . . . . . . . . . $ 20,289 $20,484
Samsung (1.71), and the 1:1 common
­ Short-term securities . . . . . . . . . . . . 53,892 46,671
guideline for an acceptable acid-test ratio. Current receivables . . . . . . . . . . . . . 17,874 15,754
As with analysis of the current ratio, we Total quick assets . . . . . . . . . . . . . . $ 92,055 $82,909
must consider other factors. How frequently Current liabilities . . . . . . . . . . . . . . . $100,814 $79,006
a company converts its current assets into Acid-test ratio Acid-test ratio
cash also affects its ability to pay current $92,055/$100,814 = 0.91 to 1 Google = 4.97
Samsung = 1.71
obligations. This means analysis of short- $82,909/$79,006 = 1.05 to 1
Industry = 0.9
term liquidity should consider receivables
and inventories, which we cover next.

Accounts Receivable Turnover Accounts receivable turnover measures how fre-

quently a company converts its receivables into cash. This ratio is defined as follows (see
Chapter 9 for additional explanation). Apple’s accounts receivable turnover is computed next to
the formula ($ millions). Apple’s turnover of 13.6 exceeds Google’s 6.8 and Samsung’s 9.2
Accounts receivable
turnover. Accounts receivable turnover is high when accounts receivable are quickly collected.
turnover
A high turnover is favorable because it means the company does not tie up assets in accounts Google = 6.8
receivable. However, accounts receivable turnover can be too high; this can occur when credit Samsung = 9.2
terms are so restrictive that they decrease sales. Industry = 5.0

Accounts receivable Net sales $229,234

= = = 13.6 times
turnover Average accounts receivable, net ($15,754 + $17,874)/2

Inventory Turnover Inventory turnover measures how long a company holds inventory
before selling it. It is defined as follows (see Chapter 6 for additional explanation). Next to the
formula we compute Apple’s inventory turnover at 40.4. Apple’s inventory turnover is higher
than Samsung’s 6.0 but lower than Google’s 89.6. A company with a high turnover requires a
smaller investment in inventory than one producing the same sales with a lower turnover.
However, high inventory turnover can be bad if inventory is so low that stock-outs occur. Inventory turnover
Google = 89.6
Cost of goods sold $141,048 Samsung = 6.0
Inventory turnover = = = 40.4 times Industry = 7.0
Average inventory ($2,132 + $4,855)/2

Days’ Sales Uncollected Days’ sales uncollected measures how frequently a company
collects accounts receivable and is defined as follows (Chapter 8 provides additional explana-
tion). Apple’s days’ sales uncollected of 28.5 days is shown next to the formula. Both Google’s
days’ sales uncollected of 60.4 days and Samsung’s 48.5 days are more than the 28.5 days for
Apple. Days’ sales uncollected is more meaningful if we know company credit terms. A rough ©VCG/Getty Images
624 Chapter 17 Analysis of Financial Statements

guideline states that days’ sales uncollected should not exceed 11⁄3 times the days in its (1) credit
period, if discounts are not offered, or (2) discount period, if favorable discounts are offered.

Days’ sales uncollected Accounts receivable, net $17,874

Google = 60.4 Days’ sales uncollected = × 365 = × 365 = 28.5 days
Net sales $229,234
Samsung = 48.5

Days’ Sales in Inventory Days’ sales in inventory is used to evaluate inventory liquid-
ity. We compute days’ sales in inventory as follows (Chapter 6 provides additional explanation).
Point: Average collection period is
estimated by dividing 365 by the Apple’s days’ sales in inventory of 12.6 days is shown next to the formula. If the products in
accounts receivable turnover ra- Apple’s inventory are in demand by customers, this formula estimates that its inventory will be
tio. For example, 365 divided by
an accounts receivable turnover converted into receivables (or cash) in 12.6 days. If all of Apple’s sales were credit sales, the
of 12.6 indicates a 29-day aver- conversion of inventory to receivables in 12.6 days plus the conversion of receivables to cash in
age collection period.
28.5 days implies that inventory will be converted to cash in about 41.1 days (12.6 + 28.5).

Days’ sales in inventory

Google = 6.0 Ending inventory $4,855
Samsung = 70.5
Days’ sales in inventory = × 365 = × 365 = 12.6 days
Cost of goods sold $141,048
Industry = 35

Total Asset Turnover Total asset turnover measures a company’s ability to use its as-
sets to generate sales and reflects on operating efficiency. The definition of this ratio follows
(Chapter 10 offers additional explanation). Apple’s total asset turnover of 0.66 is shown next to
the formula. Apple’s turnover is greater than that for Google (0.61), but not Samsung (0.85).

Total asset turnover

Google = 0.61 Net sales $229,234
Samsung = 0.85 Total asset turnover = = = 0.66 times
Average total assets ($375,319 + $321,686)/2
Industry = 1.1

Solvency
Solvency is a company’s ability to meet long-term obligations and generate future revenues.
Analysis of solvency is long term and uses broader measures than liquidity. An important part
of solvency analysis is a company’s capital structure. Capital structure is a company’s makeup
of equity and debt financing. Our analysis here focuses on a company’s ability to both meet its
obligations and provide security to its creditors over the long run.

Debt Ratio and Equity Ratio One part of solvency analysis is to assess a company’s
mix of debt and equity financing. The debt ratio (described in Chapter 2) shows total liabilities
Point: For analysis purposes,
noncontrolling interest is usually
as a percent of total assets. The equity ratio shows total equity as a percent of total assets.
included in equity. Apple’s debt and equity ratios follow. Apple’s ratios reveal more debt than equity. A company is
considered less risky if its capital structure (equity plus debt) has more equity. Debt is consid-
ered more risky because of its required payments for interest and principal. Stockholders cannot
require payment from the company. However, debt can increase income for stockholders if the
company earns a higher return than interest paid on the debt.

Point: Total of debt and equity $ millions Current Yr Ratios

ratios always equals 100%.
Total liabilities . . . . . . . . . . . . . . . . . . . . . $241,272 64.3% [Debt ratio]
Debt ratio :: Equity ratio
Total equity . . . . . . . . . . . . . . . . . . . . . . . . 134,047 35.7% [Equity ratio]
Google = 22.7% :: 77.3%
Samsung = 28.9% :: 71.1% Total liabilities and equity . . . . . . . . . . . . $375,319 100.0%
Industry = 35% :: 65%

Debt-to-Equity Ratio The debt-to-equity ratio is another measure of solvency. We com-

pute the ratio as follows (Chapter 14 offers additional explanation). Apple’s debt-to-equity ratio
of 1.80 is shown next to the formula. Apple’s ratio is higher than those of Google (0.29) and
Samsung (0.41), and greater than the industry ratio of 0.6. Apple’s capital structure has more
 Chapter 17 Analysis of Financial Statements 625

debt than equity. Debt must be repaid with interest, while equity does not. Debt payments can be
burdensome when the industry and/or the economy experience a downturn.
Debt-to-equity
Total liabilities $241,272 Google = 0.29
Debt-to-equity ratio = = = 1.80
Total equity $134,047 Samsung = 0.41
Industry = 0.6

Times Interest Earned The amount of income before subtracting interest expense and in-
come tax expense is the amount available to pay interest expense. The following times interest earned
ratio measures a company’s ability to pay interest (see Chapter 11 for additional explanation).

Income before interest expense and income tax expense

Times interest earned =
Interest expense

The larger this ratio is, the less risky the company is for creditors. One guideline says that
creditors are reasonably safe if the company has a ratio of two or more. Apple’s times interest
earned ratio of 28.6 follows. It suggests that creditors have little risk of nonrepayment.

$48,351 + $2,323 + $15,738 Times interest earned

= 28.6 times Google = 250.5
$2,323 Samsung = 86.7

Profitability
Profitability is a company’s ability to earn an adequate return. This section covers key profit-
ability measures.
Profit Margin Profit margin measures a company’s ability to earn net income from sales
(Chapter 3 offers additional explanation). Apple’s profit margin of 21.1% is shown next to the
formula. To evaluate profit margin, we must consider the industry. For instance, an appliance
company might require a profit margin of 15%, whereas a retail supermarket might require a
profit margin of 2%. Apple’s 21.1% profit margin is better than Google’s 11.4%, Samsung’s
17.6%, and the industry’s 11% margin.
Profit margin
Net income $48,351 Google = 11.4%
Profit margin = = = 21.1%
Net sales $229,234 Samsung = 17.6%
Industry = 11%

Return on Total Assets Return on total assets is defined as follows. Apple’s return on
total assets of 13.9% is shown next to the formula. Apple’s 13.9% return on total assets is higher
than Google’s 6.9% and the industry’s 8%, but lower than Samsung’s 15.0%. We also should
evaluate any trend in the return.
Return on total assets
Net income $48,351 Google = 6.9%
Return on total assets = = = 13.9%
Average total assets ($375,319 + $321,686)/2 Samsung = 15.0%
Industry = 8%

The relation between profit margin, total asset turnover, and return on total assets follows.

Profit margin × Total asset turnover = Return on total assets

Net income Net sales Net income
× =
Net sales Average total assets Average total assets

Both profit margin and total asset turnover affect operating efficiency, as measured by return on
total assets. This formula is applied to Apple as follows. This analysis shows that Apple’s supe-
rior return on assets versus that of Google is driven by its high profit margin and good asset
turnover.
Google = 11.4% × 0.61 ≃ 6.9%
21.1% × 0.66 = 13.9% (with rounding) Samsung = 17.6% × 0.85 ≃ 15.0%
(with rounding)
626 Chapter 17 Analysis of Financial Statements

Return on Common Stockholders’ Equity The most important goal in operating

a company is to earn income for its owner(s). Return on common stockholders’ equity measures
a company’s ability to earn income for common stockholders and is defined as follows.

Net income − Preferred dividends

Return on common stockholders’ equity =
Average common stockholders’ equity

Apple’s return on common stockholders’ equity is computed as follows. The denominator in this
computation is the book value of common equity. Dividends on cumulative preferred stock are
subtracted from income whether they are declared or are in arrears. If preferred stock is non­
cumulative, its dividends are subtracted only if declared. Apple’s 36.9% return on common
stockholders’ equity is superior to Google’s 8.7% and Samsung’s 20.5%.
Return on common equity
Google = 8.7% $48,351 − $0
= 36.9%
Samsung = 20.5% ($128,249 + $134,047)/2
Industry = 15%

Decision Insight
Take It to the Street Wall Street is synonymous with financial markets, but its name comes from the street location
of the original New York Stock Exchange. The street’s name comes from stockades built by early settlers to protect
New York from pirate attacks. ■

23.90
15.00
15.34
17.89
+3.58%
+12.3%
+5.34%
+5.94%
400.20
253.95
285.32
248.20
530.000
320.000
430.000
900.000
Market Prospects
Market measures are useful for analyzing corporations with publicly traded stock. These market
19.45 +2.13% 989.26 600.000
13.67 +6.43% 320.34 380.000
13.60 -11.6% 208.98 220.000
25.65 +23.1% 432.62 750.000
15.45
18.85
23.56
+5.56%
-3.67%
+11.3%
765.23
564.23
256.25
250.000
120.000
158.000
measures use stock price, which reflects the market’s (public’s) expectations for the company.
This includes market expectations of both company return and risk.
18.85 +2.54% 524.65 245.000
17.23 +12.3% 754.62 658.000

Price-Earnings Ratio Computation of the price-earnings ratio follows (Chapter 13

provides additional explanation). This ratio is used to measure market expectations for future
Point: Low expectations = low PE.
High expectations = high PE.
growth. The market price of Apple’s common stock at the start of the current fiscal year was
$154.12. Using Apple’s $9.27 basic earnings per share, we compute its price-earnings ratio as
follows. Apple’s price-earnings ratio is less than that for Samsung and Google, but it is higher
than the industry norm for this period.
PE (year-end)
Google = 57.3 Market price per common share $154.12
Samsung = 22.9
Price-earnings ratio = = = 16.6
Earnings per share $9.27
Industry = 11

Dividend Yield Dividend yield is used to compare the dividend-paying performance of

different companies. We compute dividend yield as follows (Chapter 13 offers additional expla-
nation). Apple’s dividend yield of 1.6%, based on its fiscal year-end market price per share of
$154.12 and its $2.40 cash dividends per share, is shown next to the formula. Some companies,
such as Google, do not pay dividends because they reinvest the cash to grow their businesses in
the hope of generating greater future earnings and dividends.
Dividend yield
Google = 0.0% Annual cash dividends per share $2.40
Samsung = 1.6% Dividend yield = = = 1.6%
Market price per share $154.12

Decision Insight
Bull Session A bear market is a declining market. The phrase comes from bear-skin hunters who sold the skins
before the bears were caught. The term bear was then used to describe investors who sold shares they did not own
in anticipation of a price decline. A bull market is a rising market. This phrase comes from the once-popular sport of
©Partner Media GmbH/Alamy Stock
Photo bear and bull baiting. The term bull means the opposite of bear. ■
 Chapter 17 Analysis of Financial Statements 627

Summary of Ratios
Exhibit 17.16 summarizes the ratios illustrated in this chapter and throughout the book.
EXHIBIT 17.16
Financial Statement Analysis Ratios

Ratio Formula Measure of

Liquidity and Efficiency

Current assets
Current ratio = Short-term debt-paying ability
Current liabilities
Cash + Short-term investments + Current receivables
Acid-test ratio = Immediate short-term debt-paying ability
Current liabilities
Net sales
Accounts receivable turnover = Efficiency of collection
Average accounts receivable, net
Cost of goods sold
Inventory turnover = Efficiency of inventory management
Average inventory
Accounts receivable, net
Days’ sales uncollected = × 365 Liquidity of receivables
Net sales
Ending inventory
Days’ sales in inventory = × 365 Liquidity of inventory
Cost of goods sold
Net sales
Total asset turnover = Efficiency of assets in producing sales
Average total assets

Solvency

Total liabilities
Debt ratio = Creditor financing and leverage
Total assets
Total equity
Equity ratio = Owner financing
Total assets
Total liabilities
Debt-to-equity ratio = Debt versus equity financing
Total equity
Income before interest expense and income tax expense
Times interest earned = Protection in meeting interest payments
Interest expense

Profitability
Net income
Profit margin ratio = Net income in each sales dollar
Net sales
Net sales − Cost of goods sold
Gross margin ratio = Gross margin in each sales dollar
Net sales
Net income
Return on total assets = Overall profitability of assets
Average total assets
Net income − Preferred dividends
Return on common stockholders’ equity = Profitability of owner investment
Average common stockholdersʼ equity
Shareholdersʼ equity applicable to common shares
Book value per common share = Liquidation at reported amounts
Number of common shares outstanding
Net income − Preferred dividends
Basic earnings per share = Net income per common share
Weighted-average common shares outstanding

Market Prospects
Market price per common share
Price-earnings ratio = Market value relative to earnings
Earnings per share
Annual cash dividends per share
Dividend yield = Cash return per common share
Market price per share
628 Chapter 17 Analysis of Financial Statements

NEED-TO-KNOW 17-3 For each ratio listed, identify whether the change in ratio value from the prior year to the current year is
favorable or unfavorable.
Ratio Analysis
Ratio Current Yr Prior Yr Ratio Current Yr Prior Yr
P3
1.  Profit margin . . . . . . . . . . . . 6% 8% 4.  Accounts receivable turnover . . . . . . 8.8 9.4
2.  Debt ratio . . . . . . . . . . . . . . 50% 70% 5.  Basic earnings per share . . . . . . . . . . $2.10 $2.00
3.  Gross margin . . . . . . . . . . . 40% 36% 6.  Inventory turnover . . . . . . . . . . . . . . . 3.6 4.0

Solution
Ratio Current Yr Prior Yr Change

1.  Profit margin ratio . . . . . . . . . . . . . . . . . . . . . . 6% 8% Unfavorable

2.  Debt ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50% 70% Favorable
3.  Gross margin ratio . . . . . . . . . . . . . . . . . . . . . . 40% 36% Favorable
Do More: QS 17-6 through
4.  Accounts receivable turnover . . . . . . . . . . . . . 8.8 9.4 Unfavorable
QS 17-13, E 17-7, E 17-8,
E 17-9, E 17-10, E 17-11, 5.  Basic earnings per share . . . . . . . . . . . . . . . . . $2.10 $2.00 Favorable
P 17-4 6.  Inventory turnover . . . . . . . . . . . . . . . . . . . . . . 3.6 4.0 Unfavorable

Decision Analysis Analysis Reporting

A financial statement analysis report usually consists of six sections.

A1 1. Executive summary—brief analysis of results and conclusions.
Summarize and report
results of analysis.
2. Analysis overview—background on the company, its industry, and the economy.
3. Evidential matter—financial statements and information used in the analysis, including ratios,
trends, comparisons, and all analytical measures used.
4. Assumptions—list of assumptions about a company’s industry and economic environment, and
other assumptions underlying estimates.
5. Key factors—list of favorable and unfavorable factors, both quantitative and qualitative, for com-
pany performance; usually organized by areas of analysis.
6. Inferences—forecasts, estimates, interpretations, and conclusions of the analysis report.
We must remember that the user dictates relevance, meaning that the analysis report should include a
brief table of contents to help readers focus on those areas most relevant to their decisions. Finally, writing
is important. Mistakes in grammar and errors of fact compromise the report’s credibility.

Decision Insight
Short and Sweet Short selling refers to selling stock before you buy it. Here’s an example: You borrow 100 shares
of Nike stock, sell them at $55 each, and receive money from their sale. You then wait. You hope that Nike’s stock
price falls to, say, $50 each and you can replace the borrowed stock for less than you sold it, reaping a profit of $5
each less any transaction costs. ■

NEED-TO-KNOW 17-4 Use the following financial statements of Precision Co. to complete these requirements.
1. Prepare comparative income statements showing the percent increase or decrease for the current year
COMPREHENSIVE in comparison to the prior year.
2. Prepare common-size comparative balance sheets for both years.
Applying Horizontal,
Vertical, and Ratio 3. Compute the following ratios for the current year and identify each one’s building block category for
Analyses financial statement analysis.
a. Current ratio g. Debt-to-equity ratio
b. Acid-test ratio h. Times interest earned
c. Accounts receivable turnover i. Profit margin ratio
d. Days’ sales uncollected j. Total asset turnover
e. Inventory turnover k. Return on total assets
f. Debt ratio l. Return on common stockholders’ equity
 Chapter 17 Analysis of Financial Statements 629

PRECISION COMPANY PRECISION COMPANY

Comparative Income Statements Comparative Year-End Balance Sheets
For Years Ended December 31 Current Yr Prior Yr At December 31 Current Yr Prior Yr

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,486,000 $2,075,000 Assets

Cost of goods sold . . . . . . . . . . . . . . . . . . . . 1,523,000 1,222,000 Current assets
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . 963,000 853,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 79,000 $ 42,000
Operating expenses Short-term investments . . . . . . . . . . . . . . . 65,000 96,000
Advertising expense . . . . . . . . . . . . . . . . 145,000 100,000 Accounts receivable, net . . . . . . . . . . . . . . 120,000 100,000
Sales salaries expense . . . . . . . . . . . . . . 240,000 280,000 Merchandise inventory . . . . . . . . . . . . . . . . 250,000 265,000
Office salaries expense . . . . . . . . . . . . . . 165,000 200,000 Total current assets . . . . . . . . . . . . . . . . . . . 514,000 503,000
Insurance expense . . . . . . . . . . . . . . . . . 100,000 45,000 Plant assets
Supplies expense . . . . . . . . . . . . . . . . . . 26,000 35,000 Store equipment, net . . . . . . . . . . . . . . . . . 400,000 350,000
Depreciation expense . . . . . . . . . . . . . . . 85,000 75,000 Office equipment, net . . . . . . . . . . . . . . . . . 45,000 50,000
Miscellaneous expenses . . . . . . . . . . . . . 17,000 15,000 Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . 625,000 675,000
Total operating expenses . . . . . . . . . . . . 778,000 750,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
Operating income . . . . . . . . . . . . . . . . . . . . 185,000 103,000 Total plant assets . . . . . . . . . . . . . . . . . . . . . 1,170,000 1,175,000
Interest expense . . . . . . . . . . . . . . . . . . . . . 44,000 46,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000
Income before taxes . . . . . . . . . . . . . . . . . . 141,000 57,000
Liabilities
Income tax expense . . . . . . . . . . . . . . . . . . 47,000 19,000
Current liabilities
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,000 $ 38,000
Accounts payable . . . . . . . . . . . . . . . . . . . . $ 164,000 $ 190,000
Earnings per share . . . . . . . . . . . . . . . . . . . . $   0.99 $   0.40 Short-term notes payable . . . . . . . . . . . . . . 75,000 90,000
Taxes payable . . . . . . . . . . . . . . . . . . . . . . . 26,000 12,000
PLANNING THE SOLUTION Total current liabilities . . . . . . . . . . . . . . . . . 265,000 292,000
Set up a four-column income statement; enter the current-year Long-term liabilities
and prior-year amounts in the first two columns and then enter Notes payable (secured by
the dollar change in the third column and the percent change    mortgage on buildings) . . . . . . . . . . . . . 400,000 420,000
from the prior year in the fourth column. Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 665,000 712,000
Set up a four-column balance sheet; enter the current-year and Stockholders’ Equity
prior-year year-end amounts in the first two columns and then com- Common stock, $5 par value . . . . . . . . . . . . . 475,000 475,000
pute and enter the amount of each item as a percent of total assets. Retained earnings . . . . . . . . . . . . . . . . . . . . . . 544,000 491,000
Compute the required ratios using the data provided. Use the Total stockholders’ equity . . . . . . . . . . . . . . . . 1,019,000 966,000
average of beginning and ending amounts when appropriate Total liabilities and equity . . . . . . . . . . . . . . . . $1,684,000 $1,678,000
(see Exhibit 17.16 for definitions).

SOLUTION
1.
PRECISION COMPANY
Comparative Income Statements
For Years Ended December 31 Current Yr Prior Yr Dollar Change Percent Change

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,486,000 $2,075,000 $411,000 19.8%

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . 1,523,000 1,222,000 301,000 24.6
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 963,000 853,000 110,000 12.9
Operating expenses
Advertising expense . . . . . . . . . . . . . . . . . . . 145,000 100,000 45,000 45.0
Sales salaries expense . . . . . . . . . . . . . . . . . 240,000 280,000 (40,000) (14.3)
Office salaries expense . . . . . . . . . . . . . . . . . 165,000 200,000 (35,000) (17.5)
Insurance expense . . . . . . . . . . . . . . . . . . . . 100,000 45,000 55,000 122.2
Supplies expense . . . . . . . . . . . . . . . . . . . . . 26,000 35,000 (9,000) (25.7)
Depreciation expense . . . . . . . . . . . . . . . . . . 85,000 75,000 10,000 13.3
Miscellaneous expenses . . . . . . . . . . . . . . . . 17,000 15,000 2,000 13.3
Total operating expenses . . . . . . . . . . . . . . . 778,000 750,000 28,000 3.7
Operating income . . . . . . . . . . . . . . . . . . . . . . . 185,000 103,000 82,000 79.6
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 44,000 46,000 (2,000) (4.3)
Income before taxes . . . . . . . . . . . . . . . . . . . . . 141,000 57,000 84,000 147.4
Income tax expense . . . . . . . . . . . . . . . . . . . . . 47,000 19,000 28,000 147.4
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   94,000 $   38,000 $ 56,000 147.4
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . $    0.99 $    0.40 $   0.59 147.5
630 Chapter 17 Analysis of Financial Statements

2.
PRECISION COMPANY
Common-Size Comparative Year-End Balance Sheets
Common-Size Percents
At December 31 Current Yr Prior Yr Current Yr* Prior Yr*

Assets
Current assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   79,000 $ 42,000 4.7% 2.5%
Short-term investments . . . . . . . . . . . . . . . 65,000 96,000 3.9 5.7
Accounts receivable, net . . . . . . . . . . . . . . 120,000 100,000 7.1 6.0
Merchandise inventory . . . . . . . . . . . . . . . 250,000 265,000 14.8 15.8
Total current assets . . . . . . . . . . . . . . . . . . 514,000 503,000 30.5 30.0
Plant assets
Store equipment, net . . . . . . . . . . . . . . . . . 400,000 350,000 23.8 20.9
Office equipment, net . . . . . . . . . . . . . . . . 45,000 50,000 2.7 3.0
Buildings, net . . . . . . . . . . . . . . . . . . . . . . . 625,000 675,000 37.1 40.2
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000 5.9 6.0
Total plant assets . . . . . . . . . . . . . . . . . . . . 1,170,000 1,175,000 69.5 70.0
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,684,000 $1,678,000 100.0% 100.0%

Liabilities
Current liabilities
Accounts payable . . . . . . . . . . . . . . . . . . . $ 164,000 $ 190,000 9.7% 11.3%
Short-term notes payable . . . . . . . . . . . . . 75,000 90,000 4.5 5.4
Taxes payable . . . . . . . . . . . . . . . . . . . . . . 26,000 12,000 1.5 0.7
Total current liabilities . . . . . . . . . . . . . . . . 265,000 292,000 15.7 17.4
Long-term liabilities
Notes payable (secured by
   mortgage on buildings) . . . . . . . . . . . . . 400,000 420,000 23.8 25.0
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 665,000 712,000 39.5 42.4

Stockholders’ Equity
Common stock, $5 par value . . . . . . . . . . . . . 475,000 475,000 28.2 28.3
Retained earnings . . . . . . . . . . . . . . . . . . . . . 544,000 491,000 32.3 29.3
Total stockholders’ equity . . . . . . . . . . . . . . . 1,019,000 966,000 60.5 57.6
Total liabilities and equity . . . . . . . . . . . . . . . $1,684,000 $1,678,000 100.0% 100.0%

*Columns do not always exactly add to 100 due to rounding.

3. Ratios:
a. Current ratio: $514,000/$265,000 = 1.9:1 (liquidity and efficiency)
b. Acid-test ratio: ($79,000 + $65,000 + $120,000)/$265,000 = 1.0:1 (liquidity and efficiency)
c. Average receivables: ($120,000 + $100,000)/2 = $110,000
Accounts receivable turnover: $2,486,000/$110,000 = 22.6 times (liquidity and efficiency)
d. Days’ sales uncollected: ($120,000/$2,486,000) × 365 = 17.6 days (liquidity and efficiency)
e. Average inventory: ($250,000 + $265,000)/2 = $257,500
Inventory turnover: $1,523,000/$257,500 = 5.9 times (liquidity and efficiency)
f. Debt ratio: $665,000/$1,684,000 = 39.5% (solvency)
g. Debt-to-equity ratio: $665,000/$1,019,000 = 0.65 (solvency)
h. Times interest earned: $185,000/$44,000 = 4.2 times (solvency)
i. Profit margin ratio: $94,000/$2,486,000 = 3.8% (profitability)
j. Average total assets: ($1,684,000 + $1,678,000)/2 = $1,681,000
Total asset turnover: $2,486,000/$1,681,000 = 1.48 times (liquidity and efficiency)
k. Return on total assets: $94,000/$1,681,000 = 5.6% or 3.8% × 1.48 = 5.6% (profitability)
l. Average total common equity: ($1,019,000 + $966,000)/2 = $992,500
Return on common stockholders’ equity: $94,000/$992,500 = 9.5% (profitability)
 Chapter 17 Analysis of Financial Statements 631

APPENDIX

Sustainable Income
When a company’s activities include income-related events not part of its normal, continuing operations,
A2
17A
it must disclose these events. To alert users to these activities, companies separate the income statement
into continuing operations, discontinued segments, comprehensive income, and earnings per share. Explain the form and assess
the content of a complete
Exhibit 17A.1 shows such an income statement for ComUS. These separations help us measure sustain- income statement.
able income, which is the income level most likely to continue into the future. Sustainable income is com-
monly used in performance measures.

ComUS
EXHIBIT 17A.1
Income Statement Income Statement
For Year Ended December 31 (all-inclusive) for a
⎭ Corporation
⎪ Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,478,000
⎪ Operating expenses
⎪
⎪    Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,950,000
⎪
⎪   Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
⎪
⎪    Other selling, general, and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 515,000
⎪   Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
⎬
1 ⎪    Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,520,000)
⎪
⎪ Other unusual and/or infrequent gains (losses)
⎪    Loss on plant relocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (45,000)
⎪
⎪    Gain on sale of surplus land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000
Income from continuing operations before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,985,000
⎪
⎪
⎪ Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (595,500)
⎫
Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,389,500
⎭
⎪ Discontinued segment
Income from operating Division A (net of $180,000 taxes) . . . . . . . . . . . . . . . . . . . . . . . . 420,000
⎬
2 ⎪
⎫
Loss on disposal of Division A (net of $66,000 tax benefit) . . . . . . . . . . . . . . . . . . . . . . . . (154,000) 266,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,655,500
⎭ Earnings per common share (200,000 outstanding shares)
⎪
   Income from continuing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     6.95
3
⎬
⎪   Discontinued operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.33
⎫
   Net income (basic earnings per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     8.28

1 Continuing Operations Section 1 shows revenues, expenses, and income from continu-
ing operations. This information is used to predict future operations, and most view this section as the
most important.
Gains and losses that are normal and frequent are reported as part of continuing operations. Gains and
losses that are either unusual and/or infrequent are reported as part of continuing operations but after the nor-
mal revenues and expenses. Items considered unusual and/or infrequent include (1) property taken away by a Point: FASB no longer allows
foreign government, (2) condemning of property, (3) prohibiting use of an asset from a new law, (4) losses and extraordinary items.
gains from an unusual and infrequent calamity (“act of God”), and (5) financial effects of labor strikes.
2 Discontinued Segments A business segment is a part of a company that is separated by
its products/services or by geographic location. A segment has assets, liabilities, and financial results of
operations that can be separated from those of other parts of the company. A gain or loss from selling or
closing down a segment is separately reported. Section 2 of Exhibit 17A.1 reports both (a) income from
operating the discontinued segment before its disposal and (b) the loss from disposing of the segment’s net
assets. The income tax effects of each are reported separately from the income tax expense in section 1 .
3 Earnings per Share Section 3 of Exhibit 17A.1 reports earnings per share for both continuing
operations and discontinued segments (when they both exist). Earnings per share is covered in Chapter 13.
Changes in Accounting Principles Changes in accounting principles require retrospec-
tive application to prior periods’ financial statements. Retrospective application means applying a different
 632 Chapter 17 Analysis of Financial Statements

accounting principle to prior periods as if that principle had always been used. Retrospective application
enhances the consistency of financial information between periods, which improves the usefulness of
information, especially with comparative analyses.

Decision Maker
Small Business Owner You own an orange grove near Jacksonville, Florida. A bad frost destroys about one-half of
your oranges. You are currently preparing an income statement for a bank loan. Where on the income statement do
you report the loss of oranges? ■ Answer: The frost loss is likely unusual, meaning it is reported in the nonrecurring section of continuing
operations. Managers would highlight this loss apart from ongoing, normal results so that the bank views it separately from normal operations.

Summary: Cheat Sheet

BASICS OF ANALYSIS Base amount: Comparative balance sheets use total assets, and compara-
tive income statements use net sales.
Liquidity and efficiency: Ability to meet short-term obligations and
­efficiently generate revenues. Apple common-size balance sheet:
Solvency: Ability to meet long-term obligations and generate future revenues. Common-Size Percents
Profitability: Ability to provide financial rewards to attract and retain $ millions Current Yr Prior Yr Current Yr Prior Yr
­financing.
Market prospects: Ability to generate positive market expectations. Goodwill 5,717 5,414 1.5% 1.7%
General-purpose financial statements: Include the (1) income statement, Acquired intangible assets, net 2,298 3,206 0.6 1.0
Other assets 10,162 8,757 2.7 2.7
(2) balance sheet, (3) statement of stockholders’ equity (or statement of re-
Total assets $375,319 $321,686 100.0 100.0
tained earnings), (4) statement of cash flows, and (5) notes to these statements.
Apple common-size income statement:
HORIZONTAL ANALYSIS
Common-Size Percents
Comparative financial statements: Show financial amounts in side-by- $ millions Current Yr Prior Yr Current Yr Prior Yr
side columns on a single statement.
Net sales $229,234 $215,639 100.0% 100.0%
Analysis period: The financial statements under analysis.
Cost of sales 141,048 131,376 61.5 60.9
Base period: The financial statements used for comparison. The prior year Gross margin 88,186 84,263 38.5 39.1
is commonly used as a base period.
Dollar change formula: RATIO ANALYSIS AND REPORTING
Dollar change = Analysis period amount − Base period amount Ratio Formula
Liquidity and Efficiency
Percent change formula: =
Current assets
Current ratio
Current liabilities
Analysis period amount − Base period amount Cash + Short-term investments + Current receivables
Percent change (%) = × 100 Acid-test ratio =
Base period amount Current liabilities
Net sales
Accounts receivable turnover =
Apple comparative balance sheet: The prior year is the base period and Average accounts receivable, net
Cost of goods sold
current year is the analysis period. Inventory turnover =
Average inventory
$ millions Current Yr Prior Yr Dollar Change Percent Change Accounts receivable, net
Days’ sales uncollected = × 365
Net sales
Assets Ending inventory
Cash and cash equivalents . . . . . . . . . . . . $20,289 $20,484 $ (195) (1.0)% Days’ sales in inventory = × 365
Cost of goods sold
Short-term marketable securities . . . . . . . 53,892 46,671 7,221 15.5
Net sales
Accounts receivable, net . . . . . . . . . . . . . 17,874 15,754 2,120 13.5 Total asset turnover =
Average total assets
Solvency
Trend analysis: Computing trend percents that show patterns in data across Total liabilities
Debt ratio =
periods. Total assets
Total equity
Analysis period amount Equity ratio =
Total assets
Trend percent (%) = × 100 Total liabilities
Base period amount Debt-to-equity ratio =
Total equity
Apple trend analysis: 4 years ago is the base period, and each subsequent Times interest earned =
Income before interest expense and income tax expense
Interest expense
year is the analysis period.
Profitability
In trend percent Current Yr 1 Yr Ago 2 Yrs Ago 3 Yrs Ago 4 Yrs Ago Net income
Profit margin ratio =
Net sales . . . . . . . . . . . . . . . . 134.1% 126.2% 136.7% 107.0% 100.0% Net sales
Cost of sales . . . . . . . . . . . . . 132.3 123.2 131.4 105.3 100.0 Net sales − Cost of goods sold
Gross margin ratio =
Operating expenses . . . . . . . 175.4 158.4 146.3 117.8 100.0 Net sales
Net income
Return on total assets =
VERTICAL ANALYSIS Average total assets
Net income − Preferred dividends
Return on common stockholders’ equity =
Common-size financial statements: Show changes in the relative impor- Average common stockholdersʼ equity
tance of each financial statement item. All individual amounts in common- Basic earnings per share =
Net income − Preferred dividends
Weighted-average common shares outstanding
size statements are shown in common-size percents. Market Prospects
Common-size percent formula: Price-earnings ratio =
Market price per common share
Earnings per share
Analysis amount Annual cash dividends per share
Common-size percent (%) = × 100 Dividend yield =
Base amount Market price per share
 Chapter 17 Analysis of Financial Statements 633

Key Terms

Business segment (631) Financial statement analysis (613) Profitability (613)

Common-size financial statement (618) General-purpose financial Ratio analysis (614)
Comparative financial statement (614) statements (614) Solvency (613)
Efficiency (613) Horizontal analysis (614) Vertical analysis (614)
Equity ratio (624) Liquidity (613) Working capital (622)
Financial reporting (614) Market prospects (613)

Multiple Choice Quiz

1. A company’s sales in the prior year were $300,000 and in 2. What is Ella Company’s current ratio?
the current year were $351,000. Using the prior year as the a. 0.69 d. 6.69
base year, the sales trend percent for the current year is b. 1.31 e. 2.39
a. 17%. c. 100%. e. 48%. c. 3.88
b. 85%. d. 117%. 3. What is Ella Company’s acid-test ratio?
Use the following information for questions 2 through 5. a. 2.39 d. 6.69
ELLA COMPANY b. 0.69 e. 3.88
Balance Sheet
c. 1.31
December 31
4. What is Ella Company’s debt ratio?
Assets Liabilities a. 25.78% d. 137.78%
Cash . . . . . . . . . . . . . . . . . . $ 86,000 Current liabilities . . . . . . . . . $124,000 b. 100.00% e. 34.74%
Accounts receivable . . . . . 76,000 Long-term liabilities . . . . . . 90,000
c. 74.22%
Merchandise inventory . . . 122,000 Equity
5. What is Ella Company’s equity ratio?
Prepaid insurance . . . . . . . 12,000 Common stock . . . . . . . . . . 300,000
a. 25.78% d. 74.22%
Long-term investments . . . 98,000 Retained earnings . . . . . . . .  316,000
b. 100.00% e. 137.78%
Plant assets, net . . . . . . . . 436,000
Total assets . . . . . . . . . . . . $830,000 Total liabilities and equity . . . $830,000 c. 34.74%

ANSWERS TO MULTIPLE CHOICE QUIZ

1. d; ($351,000∕$300,000) × 100 = 117% 4. a; ($124,000 + $90,000)∕$830,000 = 25.78%
2. e; ($86,000 + $76,000 + $122,000 + $12,000)∕$124,000 = 2.39 5. d; ($300,000 + $316,000)∕$830,000 = 74.22%
3. c; ($86,000 + $76,000)∕$124,000 = 1.31

A
Superscript letter A denotes assignments based on Appendix 17A.
Icon denotes assignments that involve decision making.

Discussion Questions
1. Explain the difference between financial reporting and 6. Why is working capital given special attention in the
financial statements. process of analyzing balance sheets?
2. What is the difference between comparative financial state- 7. What does the number of days’ sales uncollected
ments and common-size comparative statements? indicate?
3. Which items are usually assigned a 100% value on (a) a 8. What does a relatively high accounts receivable turn-
common-size balance sheet and (b) a common-size income over indicate about a company’s short-term liquidity?
statement?
9. Why is a company’s capital structure, as measured by
4. What three factors would influence your evaluation as debt and equity ratios, important to financial statement
to whether a company’s current ratio is good or bad? ­analysts?
5. Suggest several reasons why a 2:1 current ratio might 10. How does inventory turnover provide information
not be adequate for a particular company. about a company’s short-term liquidity?
634 Chapter 17 Analysis of Financial Statements

11. What ratios would you compute to evaluate manage- 15. Refer to Google’s financial statements in
ment performance? Appendix A to compute its equity ratio as GOOGLE
12. Why would a company’s return on total assets be dif- of December 31, 2017, and December 31, 2016.
ferent from its return on common stockholders’ equity? 16. Refer to Samsung’s financial statements
13. Where on the income statement does a company report an in Appendix A. Compute its debt ratio as Samsung
unusual gain not expected to occur more often than once of December 31, 2017, and December 31, 2016.
every two years or so? 17. Use Samsung’s financial statements in
14. Refer to Apple’s financial statements in Appendix A to compute its return on total Samsung
Appendix A. Compute its profit margin for the APPLE assets for fiscal year ended December 31, 2017.
years ended September 30, 2017, and September 24, 2016.

QUICK STUDY Identify which of the following items are not included as part of general-purpose financial statements but
are part of financial reporting.
QS 17-1 a. Income statement f. Statement of cash flows
Financial reporting b. Balance sheet g. Stock price information and analysis
C1 c. Shareholders’ meetings h. Statement of shareholders’ equity
d. Financial statement notes i. Management discussion and analysis of financial
e. Company news releases performance

QS 17-2 Identify which standard of comparison, (a) intracompany, (b) competitor, (c) industry, or (d) guidelines,
Standard of comparison best describes each of the following examples.
C2 1. Compare Ford’s return on assets to GM’s return on assets.
2. Compare a company’s acid-test ratio to the 1:1 rule of thumb.
3. Compare Netflix’s current-year sales to its prior-year sales.
4. Compare McDonald’s profit margin to the fast-food industry profit margin.

QS 17-3 Compute the annual dollar changes and percent changes for each of the following accounts.
Horizontal analysis
P1 Current Yr Prior Yr

Short-term investments . . . . . . . . . . . . $374,634 $234,000

Accounts receivable . . . . . . . . . . . . . . 97,364 101,000
Notes payable . . . . . . . . . . . . . . . . . . . 0 88,000

QS 17-4 Use the following information to determine the prior-year and current-year trend percents for net sales
Trend percents using the prior year as the base year.
P1
$ thousands Current Yr Prior Yr

Net sales . . . . . . . . . . . . . . . . . . . . . . . $801,810 $453,000

Cost of goods sold . . . . . . . . . . . . . . . . 392,887 134,088

QS 17-5 Refer to the information in QS 17-4. Determine the prior-year and current-year common-size percents for
Common-size analysis P2 cost of goods sold using net sales as the base.

QS 17-6 Pritchett Co. reported the following year-end data: cash of $15,000; short-term investments of $5,000; ac-
Computing current ratio counts receivable (current) of $8,000; inventory of $20,000; prepaid (current) assets of $6,000; and total
and acid-test ratio P3 current liabilities of $20,000. Compute the (a) current ratio and (b) acid-test ratio. Round to one decimal.

QS 17-7 Mifflin Co. reported the following for the current year: net sales of $60,000; cost of goods sold of $38,000;
Computing accounts beginning balance in accounts receivable of $14,000; and ending balance in accounts receivable of $6,000.
receivable turnover and Compute (a) accounts receivable turnover and (b) days’ sales uncollected. Round to one decimal. Hint:
days’ sales uncollected P3 Recall that accounts receivable turnover uses average accounts receivable and days’ sales uncollected uses
the ending balance in accounts receivable.
 Chapter 17 Analysis of Financial Statements 635

SCC Co. reported the following for the current year: net sales of $48,000; cost of goods sold of $40,000; QS 17-8
beginning balance in inventory of $2,000; and ending balance in inventory of $8,000. Compute (a) inven- Computing inventory
tory turnover and (b) days’ sales in inventory. Hint: Recall that inventory turnover uses average inventory turnover and days’ sales
and days’ sales in inventory uses the ending balance in inventory. in inventory P3

Dundee Co. reported the following for the current year: net sales of $80,000; cost of goods sold of QS 17-9
$60,000; beginning balance of total assets of $115,000; and ending balance of total assets of $85,000. Computing total asset
Compute total asset turnover. Round to one decimal. turnover P3

Paddy’s Pub reported the following year-end data: income before interest expense and income tax expense QS 17-10
of $30,000; cost of goods sold of $17,000; interest expense of $1,500; total assets of $70,000; total liabil- Computing debt-to-equity
ities of $20,000; and total equity of $50,000. Compute the (a) debt-to-equity ratio and (b) times interest ratio and times interest
earned. Round to one decimal. earned P3

Edison Co. reported the following for the current year: net sales of $80,000; cost of goods sold of $56,000; QS 17-11
net income of $16,000; beginning balance of total assets of $60,000; and ending balance of total assets of Computing profit margin
$68,000. Compute (a) profit margin and (b) return on total assets. and return on total
assets P3

Franklin Co. reported the following year-end data: net income of $220,000; annual cash dividends QS 17-12
per share of $3; market price per (common) share of $150; and earnings per share of $10. Compute the Computing price-earnings
(a) price-earnings ratio and (b) dividend yield. ratio and dividend
yield P3

For each ratio listed, identify whether the change in ratio value from the prior year to the current year is QS 17-13
usually regarded as favorable or unfavorable. Ratio interpretation
P3
Ratio Current Yr Prior Yr Ratio Current Yr Prior Yr

1.  Profit margin . . . . .  9%  8% 5.  Accounts receivable turnover . . . . . 5.5 6.7
2.  Debt ratio . . . . . . . . 47% 42% 6.  Basic earnings per share . . . . . . . . . $1.25 $1.10
3.  Gross margin . . . . . 34% 46% 7.  Inventory turnover . . . . . . . . . . . . . . 3.6 3.4
4.  Acid-test ratio . . . . 1.00 1.15 8.  Dividend yield . . . . . . . . . . . . . . . . . . 2.0%  1.2%

Morgan Company and Parker Company are similar firms operating in the same industry. Write a half- QS 17-14
page report comparing Morgan and Parker using the available information. Your discussion should in- Analyzing short-term
clude their ability to meet current obligations and to use current assets efficiently. financial condition
A1
Morgan Parker
Current Yr 1 Yr Ago 2 Yrs Ago Current Yr 1 Yr Ago 2 Yrs Ago
Current ratio 1.7 1.6 2.1 3.2 2.7 1.9
Acid-test ratio 1.0 1.1 1.2 2.8 2.5 1.6 Team Project: Assume that the two
companies apply for a one-year
Accounts receivable turnover 30.5 25.2 29.2 16.4 15.2 16.0
loan from the team. Identify
Merchandise inventory turnover 24.2 21.9 17.1 14.5 13.0 12.6 ­additional information the compa-
nies must provide before the
Working capital $70,000 $58,000 $52,000 $131,000 $103,000 $78,000 team can make a loan decision.

Which of the following gains or losses would Organic Foods account for as unusual and/or infrequent? QS 17-15A
a. A hurricane destroys rainwater tanks that result in a loss for Organic Foods. Identifying unusual and/or
b. The used vehicle market is weak and Organic Foods is forced to sell its used delivery truck at a loss. infrequent gains or losses

c. Organic Foods owns an organic farm in Venezuela that is seized by the government. The company A2
records a loss.
636 Chapter 17 Analysis of Financial Statements

EXERCISES Match the ratio to the building block of financial statement analysis to which it best relates.
A. Liquidity and efficiency   B. Solvency   C. Profitability   D. Market prospects
Exercise 17-1 1. Equity ratio 6. Accounts receivable turnover
Building blocks of analysis 2. Return on total assets 7. Debt-to-equity ratio
C1 3. Dividend yield 8. Times interest earned
4. Book value per common share 9. Gross margin ratio
5. Days’ sales in inventory 10. Acid-test ratio

Exercise 17-2 Identify which of the following six metrics a through f best completes questions 1 through 3 below.
Identifying financial ratios a. Days’ sales uncollected d. Return on total assets
C2 b. Accounts receivable turnover e. Total asset turnover
c. Working capital f. Profit margin
1. Which two ratios are key components in measuring a company’s operating efficiency?
Which ratio summarizes these two components?
2. What measure reflects the difference between current assets and current liabilities?
3. Which two short-term liquidity ratios measure how frequently a company collects its accounts?

Exercise 17-3 Compute trend percents for the following accounts using 2015 as the base year. For each of the three
Computing and analyzing accounts, state whether the situation as revealed by the trend percents appears to be favorable or
trend percents ­unfavorable.
P1
2019 2018 2017 2016 2015

Sales . . . . . . . . . . . . . . . . . . . . . . . . $282,880 $270,800 $252,600 $234,560 $150,000

Cost of goods sold . . . . . . . . . . . . . 128,200 122,080 115,280 106,440 67,000
Accounts receivable . . . . . . . . . . . 18,100 17,300 16,400 15,200 9,000

Exercise 17-4 Compute common-size percents for the following comparative income statements (round percents to one
Computing and interpreting decimal). Using the common-size percents, which item is most responsible for the decline in net income?
common-size percents
GOMEZ CORPORATION
P2
Comparative Income Statements
For Years Ended December 31 Current Yr Prior Yr

Sales . . . . . . . . . . . . . . . . . . . . . . . . $740,000 $625,000

Cost of goods sold . . . . . . . . . . . . . 560,300 290,800
Gross profit . . . . . . . . . . . . . . . . . . 179,700 334,200
Operating expenses . . . . . . . . . . . 128,200 218,500
Net income . . . . . . . . . . . . . . . . . . . $ 51,500 $115,700

Exercise 17-5 Common-size and trend percents for Roxi Company’s sales, cost of goods sold, and expenses follow.
Determining income effects Determine whether net income increased, decreased, or remained unchanged in this three-year period.
from common-size and
trend percents Common-Size Percents Trend Percents
P1 P2 Current Yr 1 Yr Ago 2 Yrs Ago Current Yr 1 Yr Ago 2 Yrs Ago

Sales . . . . . . . . . . . . . . . . . . . 100.0% 100.0% 100.0% 105.4% 104.2% 100.0%

Cost of goods sold . . . . . . . . 63.4 61.9 59.1 113.1 109.1 100.0
Total expenses . . . . . . . . . . . 15.3 14.8 15.1 106.8 102.1 100.0

Exercise 17-6 Simon Company’s year-end balance sheets follow. (1) Express the balance sheets in common-size per-
Common-size percents cents. Round percents to one decimal. (2) Assuming annual sales have not changed in the last three years,
P2 is the change in accounts receivable as a percentage of total assets favorable or unfavorable? (3) Is the
change in merchandise inventory as a percentage of total assets favorable or unfavorable?
 Chapter 17 Analysis of Financial Statements 637

At December 31 Current Yr 1 Yr Ago 2 Yrs Ago

Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,800 $ 35,625 $ 37,800
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . 89,500 62,500 50,200
Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 112,500 82,500 54,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,700 9,375 5,000
Plant assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278,500 255,000 230,500
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $523,000 $445,000 $377,500

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . $129,900 $ 75,250 $ 51,250
Long-term notes payable secured by
mortgages on plant assets . . . . . . . . . . . . . . . . . . . 98,500 101,500 83,500
Common stock, $10 par value . . . . . . . . . . . . . . . . . . 163,500 163,500 163,500
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131,100 104,750 79,250
Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . $523,000 $445,000 $377,500

Refer to Simon Company’s balance sheets in Exercise 17-6. (1) Compute the current ratio for each of the Exercise 17-7
three years. Did the current ratio improve or worsen over the three-year period? (2) Compute the acid-test Analyzing liquidity
ratio for each of the three years. Did the acid-test ratio improve or worsen over the three-year period? P3
Round ratios to two decimals.

Refer to the Simon Company information in Exercise 17-6. The company’s income statements for the cur- Exercise 17-8
rent year and one year ago follow. Assume that all sales are on credit and then compute (1) days’ sales Analyzing and interpreting
uncollected, (2) accounts receivable turnover, (3) inventory turnover, and (4) days’ sales in inventory. For liquidity
each ratio, determine if it improved or worsened in the current year. Round to one decimal. P3
For Year Ended December 31 Current Yr 1 Yr Ago

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $673,500 $532,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . $411,225 $345,500
Other operating expenses . . . . . . . . . . . . 209,550 134,980
Interest expense . . . . . . . . . . . . . . . . . . . . 12,100 13,300
Income tax expense . . . . . . . . . . . . . . . . . 9,525 8,845
Total costs and expenses . . . . . . . . . . . . . 642,400 502,625
Net income . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,100 $ 29,375
Earnings per share . . . . . . . . . . . . . . . . . . . $ 1.90 $ 1.80

Refer to the Simon Company information in Exercises 17-6 and 17-8. For both the current year and one Exercise 17-9
year ago, compute the following ratios: (1) debt ratio and equity ratio—percent rounded to one decimal, Analyzing risk and capital
(2) debt-to-equity ratio—rounded to two decimals; based on debt-to-equity ratio, does the company structure
have more or less debt in the current year versus one year ago? and (3) times interest earned—rounded P3
to one decimal. Based on times interest earned, is the company more or less risky for creditors in the
current year versus one year ago?

Refer to Simon Company’s financial information in Exercises 17-6 and 17-8. For both the current year and Exercise 17-10
one year ago, compute the following ratios: (1) profit margin ratio—percent rounded to one decimal; did Analyzing efficiency and
profit margin improve or worsen in the current year versus one year ago? (2) total asset turnover—rounded profitability
to one decimal, and (3) return on total assets—percent rounded to one decimal. Based on return on total P3
assets, did Simon’s operating efficiency improve or worsen in the current year versus one year ago?

Refer to Simon Company’s financial information in Exercises 17-6 and 17-8. Additional information about Exercise 17-11
the company follows. For both the current year and one year ago, compute the following ratios: (1) return on Analyzing profitability
common stockholders’ equity—percent rounded to one decimal, (2) dividend yield—percent rounded to one P3
decimal, and (3) price-earnings ratio on December 31—rounded to one decimal. Assuming Simon’s com-
petitor has a price-earnings ratio of 10, which company has higher market expectations for future growth?

Common stock market price, December 31, current year. . . . . . $30.00 Annual cash dividends per share in current year . . . . $0.29
Common stock market price, December 31, 1 year ago. . . . . . . 28.00 Annual cash dividends per share 1 year ago. . . . . . . . 0.24
638 Chapter 17 Analysis of Financial Statements

Exercise 17-12 Nintendo Company, Ltd., recently reported the following financial information (amounts in millions).
Computing current ratio Compute Nintendo’s current ratio and profit margin. Round to two decimals.
and profit margin
Current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,036 Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,464
P3
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,477 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 871

Exercise 17-13 Following are data for BioBeans and GreenKale, which sell organic produce and are of similar size.
Analyzing efficiency and 1. Compute the profit margin and the return on total assets for both companies.
profitability 2. Based on analysis of these two measures, which company is the preferred investment?
P3
BioBeans GreenKale

Average total assets . . . . . . . . . . $187,500 $150,000

Net sales . . . . . . . . . . . . . . . . . . . 75,000 60,000
Net income . . . . . . . . . . . . . . . . . . 15,000 9,000

Exercise 17-14 Following is an incomplete current-year income statement.

Reconstructing an income
statement with ratios Income Statement

P3 Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  (a)  

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   (b)  
Selling, general, and administrative expenses . . . . . . . . . . 7,000
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   (c)  

Determine amounts a, b, and c. Additional information follows:

∙ Return on total assets is 16% (average total assets is $68,750).
∙ Inventory turnover is 5 (average inventory is $6,000).
∙ Accounts receivable turnover is 8 (average accounts receivable is $6,250).

Exercise 17-15 Roak Company and Clay Company are similar firms that operate in the same industry. Clay began opera-
Analyzing efficiency and tions two years ago and Roak started five years ago. In the current year, both companies pay 6% interest
financial leverage on their debt to creditors. The following additional information is available.
A1
Roak Company Clay Company

Current Yr 1 Yr Ago 2 Yrs Ago Current Yr 1 Yr Ago 2 Yrs Ago

Total asset turnover . . . . . . . . 3.1 2.8 3.0 1.7 1.5 1.1

Return on total assets . . . . . . 7.4% 7.0% 6.9% 4.8% 4.5% 3.2%
Profit margin ratio . . . . . . . . . 2.4% 2.5% 2.3% 2.8% 3.0% 2.9%
Sales . . . . . . . . . . . . . . . . . . . . $410,000 $380,000 $396,000 $210,000 $170,000 $110,000

Write a half-page report comparing Roak and Clay using the available information. Your analysis should
include their ability to use assets efficiently to produce profits. Comment on their success in employing
financial leverage in the current year.

Exercise 17-16 Refer to the information in Exercise 17-15.

Interpreting financial ratios 1. Which company has the better (a) profit margin, (b) asset turnover, and (c) return on assets?
A1 P3 2. Which company has the better rate of growth in sales?
3. Did Roak successfully use financial leverage in the current year? Did Clay?

Exercise 17-17A In the current year, Randa Merchandising, Inc., sold its interest in a chain of wholesale outlets, taking the
Income statement company completely out of the wholesaling business. The company still operates its retail outlets. A list-
categories ing of the major sections of an income statement follows.
A2 A. Net sales less operating expense section
B. Other unusual and/or infrequent gains (losses)
 Chapter 17 Analysis of Financial Statements 639

C. Taxes reported on income (loss) from continuing operations

D. Income (loss) from operating a discontinued segment, or gain (loss) from its disposal
Indicate where each of the following income-related items for this company appears on its current-year
income statement by writing the letter of the appropriate section in the blank beside each item.

Section Item Debit Credit

_______ 1. Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,900,000

_______ 2. Gain on state’s condemnation of company property . . . . . . . . . . . 230,000
_______ 3. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,480,000
_______ 4. Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217,000
_______ 5. Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232,000
_______ 6. Gain on sale of wholesale business segment, net of tax . . . . . . . . 775,000
_______ 7. Loss from operating wholesale business segment, net of tax . . . 444,000
_______ 8. Loss of assets from meteor strike . . . . . . . . . . . . . . . . . . . . . . . . . . 640,000

Use the financial data for Randa Merchandising, Inc., in Exercise 17-17A to prepare its December 31 year- Exercise 17-18A
end income statement. Ignore the earnings per share section. Income statement
presentation A2

Selected comparative financial statements of Haroun Company follow. PROBLEM SET A

Problem 17-1A
HAROUN COMPANY
Comparative Income Statements
Calculating and analyzing
For Years Ended December 31 trend percents
$ thousands 2019 2018 2017 2016 2015 2014 2013 P1
Sales . . . . . . . . . . . . . . . $1,694 $1,496 $1,370 $1,264 $1,186 $1,110 $928
Cost of goods sold . . . . 1,246 1,032 902 802 752 710 586
Gross profit . . . . . . . . . . 448 464 468 462 434 400 342
Operating expenses . . 330 256 234 170 146 144 118
Net income . . . . . . . . . . $ 118 $ 208 $ 234 $ 292 $ 288 $ 256 $224

HAROUN COMPANY
Comparative Year-End Balance Sheets
At December 31, $ thousands 2019 2018 2017 2016 2015 2014 2013

Assets
Cash . . . . . . . . . . . . . . . . . . . . $   58 $   78 $   82 $   84 $   88 $   86 $   89
Accounts receivable, net . . . . 490 514 466 360 318 302 216
Merchandise inventory . . . . . 1,838 1,364 1,204 1,032 936 810 615
Other current assets . . . . . . . 36 32 14 34 28 28 9
Long-term investments . . . . . 0 0 0 146 146 146 146
Plant assets, net . . . . . . . . . . 2,020 2,014 1,752 944 978 860 725
Total assets . . . . . . . . . . . . . . $4,442 $4,002 $3,518 $2,600 $2,494 $2,232 $1,800
Liabilities and Equity
Current liabilities . . . . . . . . . . $1,220 $1,042 $ 718 $ 614 $ 546 $ 522 $ 282
Long-term liabilities . . . . . . . . 1,294 1,140 1,112 570 580 620 400
Common stock . . . . . . . . . . . . 1,000 1,000 1,000 850 850 650 650
Other paid-in capital . . . . . . . 250 250 250 170 170 150 150
Retained earnings . . . . . . . . . 678 570 438 396 348 290 318
Total liabilities and equity . . . $4,442 $4,002 $3,518 $2,600 $2,494 $2,232 $1,800
640 Chapter 17 Analysis of Financial Statements

Required
Check (1) 2019, Total 1. Compute trend percents for all components of both statements using 2013 as the base year. Round
assets trend, 246.8% percents to one decimal.

Analysis Component
2. Refer to the results from part 1. (a) Did sales grow steadily over this period? (b) Did net income as a
percent of sales grow over the past four years? (c) Did inventory increase over this period?

Problem 17-2A Selected comparative financial statements of Korbin Company follow.

Ratios, common-size
statements, and trend
percents
P1 P2 P3
KORBIN COMPANY
Comparative Balance Sheets
At December 31 2019 2018 2017
KORBIN COMPANY
Comparative Income Statements Assets
For Years Ended December 31 2019 2018 2017 Current assets . . . . . . . . . . . . . $ 52,390 $ 37,924 $ 51,748
Long-term investments . . . . . . 0 500 3,950
Sales . . . . . . . . . . . . . . . . . . . . . . $555,000 $340,000 $278,000
Plant assets, net . . . . . . . . . . . 100,000 96,000 60,000
Cost of goods sold . . . . . . . . . . . 283,500 212,500 153,900
Total assets . . . . . . . . . . . . . . . $152,390 $134,424 $115,698
Gross profit . . . . . . . . . . . . . . . . 271,500 127,500 124,100
Selling expenses . . . . . . . . . . . . 102,900 46,920 50,800 Liabilities and Equity
Administrative expenses . . . . . . 50,668 29,920 22,800 Current liabilities . . . . . . . . . . . $ 22,800 $ 19,960 $ 20,300
Total expenses . . . . . . . . . . . . . . 153,568 76,840 73,600 Common stock . . . . . . . . . . . . . 72,000 72,000 60,000
Income before taxes . . . . . . . . . 117,932 50,660 50,500 Other paid-in capital . . . . . . . . 9,000 9,000 6,000
Income tax expense . . . . . . . . . 40,800 10,370 15,670 Retained earnings . . . . . . . . . . 48,590 33,464 29,398
Net income . . . . . . . . . . . . . . . . . $ 77,132 $ 40,290 $ 34,830 Total liabilities and equity . . . . $152,390 $134,424 $115,698

Required
1. Compute each year’s current ratio. Round ratios to one decimal.
2. Express the income statement data in common-size percents. Round percents to two decimals.
Check (3) 2019, Total 3. Express the balance sheet data in trend percents with 2017 as base year. Round percents to two decimals.
assets trend, 131.71%
Analysis Component
4. Refer to the results from parts 1, 2, and 3. (a) Did cost of goods sold make up a greater portion of sales
for the most recent year? (b) Did income as a percent of sales improve in the most recent year? (c) Did
plant assets grow over this period?

Problem 17-3A Plum Corporation began the month of May with $700,000 of current assets, a current ratio of 2.50:1, and
Transactions, working an acid-test ratio of 1.10:1. During the month, it completed the following transactions (the company uses
capital, and liquidity ratios a perpetual inventory system).
P3 May 2 Purchased $50,000 of merchandise inventory on credit.
8 Sold merchandise inventory that cost $55,000 for $110,000 cash.
10 Collected $20,000 cash on an account receivable.
15 Paid $22,000 cash to settle an account payable.
17 Wrote off a $5,000 bad debt against the Allowance for Doubtful Accounts account.
Check May 22: Current ratio, 22 Declared a $1 per share cash dividend on its 50,000 shares of outstanding common stock.
2.19; Acid-test ratio, 1.11 26 Paid the dividend declared on May 22.
27 Borrowed $100,000 cash by giving the bank a 30-day, 10% note.
May 29: Current ratio, 1.80; 28 Borrowed $80,000 cash by signing a long-term secured note.
Working capital, $325,000 29 Used the $180,000 cash proceeds from the notes to buy new machinery.
 Chapter 17 Analysis of Financial Statements 641

Required
Prepare a table, similar to the following, showing Plum’s (1) current ratio, (2) acid-test ratio, and (3) working
capital after each transaction. Round ratios to two decimals.

A B C D E F G
1 Current Quick Current Current Acid-Test Working
2 Transaction Assets Assets Liabilities Ratio Ratio Capital
3 Beginning $700,000 — — 2.50 1.10 —

Selected current year-end financial statements of Cabot Corporation follow. All sales were on credit; Problem 17-4A
selected balance sheet amounts at December 31 of the prior year were inventory, $48,900; total assets, Calculating financial
$189,400; common stock, $90,000; and retained earnings, $33,748. statement ratios
P3
CABOT CORPORATION
Balance Sheet CABOT CORPORATION
December 31 of Current Year Income Statement
For Current Year Ended December 31
Assets Liabilities and Equity
Cash . . . . . . . . . . . . . . . . . $ 10,000 Accounts payable . . . . . . . . . . . . . . . . $ 17,500 Sales . . . . . . . . . . . . . . . . . . $448,600
Short-term investments . . 8,400 Accrued wages payable . . . . . . . . . . . 3,200 Cost of goods sold . . . . . . . 297,250
Accounts receivable, net . 33,700 Income taxes payable . . . . . . . . . . . . . 3,300 Gross profit . . . . . . . . . . . . 151,350
Merchandise inventory . . 32,150 Long-term note payable, secured Operating expenses . . . . . 98,600
Prepaid expenses . . . . . . 2,650   by mortgage on plant assets . . . . . 63,400 Interest expense . . . . . . . . 4,100
Plant assets, net . . . . . . . . 153,300 Common stock . . . . . . . . . . . . . . . . . . . 90,000 Income before taxes . . . . . 48,650
Retained earnings . . . . . . . . . . . . . . . . 62,800 Income tax expense . . . . . 19,598
Total assets . . . . . . . . . . . $240,200 Total liabilities and equity . . . . . . . . . . $240,200 Net income . . . . . . . . . . . . . $ 29,052

Required
Compute the following: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory Check Acid-test ratio, 2.2 to
turnover, (5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin 1; Inventory turnover, 7.3
ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity.
Round to one decimal place; for part 6, round to two decimals.

Summary information from the financial statements of two companies competing in the same industry Problem 17-5A
follows. Comparative ratio analysis
P3

Barco Kyan Barco Kyan

Company Company Company Company

Data from the current year-end balance sheets Data from the current year’s income statement
Assets Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $770,000 $880,200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,500 $ 34,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . 585,100 632,500
Accounts receivable, net . . . . . . . . . . . . . . 46,500 64,600 Interest expense . . . . . . . . . . . . . . . . . . . . . 7,900 13,000
Merchandise inventory . . . . . . . . . . . . . . . 84,440 132,500 Income tax expense . . . . . . . . . . . . . . . . . . 14,800 24,300
Prepaid expenses . . . . . . . . . . . . . . . . . . . 5,000 6,950 Net income . . . . . . . . . . . . . . . . . . . . . . . . . 162,200 210,400
Plant assets, net . . . . . . . . . . . . . . . . . . . . . 290,000 304,400 Basic earnings per share . . . . . . . . . . . . . . 4.51 5.11
Total assets . . . . . . . . . . . . . . . . . . . . . . . . $445,440 $542,450 Cash dividends per share . . . . . . . . . . . . . 3.81 3.93

Liabilities and Equity Beginning-of-year balance sheet data

Current liabilities . . . . . . . . . . . . . . . . . . . . $ 61,340 $ 93,300 Accounts receivable, net . . . . . . . . . . . . . . $ 29,800 $ 54,200
Long-term notes payable . . . . . . . . . . . . . 80,800 101,000 Merchandise inventory . . . . . . . . . . . . . . . . 55,600 107,400
Common stock, $5 par value . . . . . . . . . . 180,000 206,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . 398,000 382,500
Retained earnings . . . . . . . . . . . . . . . . . . . 123,300 142,150 Common stock, $5 par value . . . . . . . . . . . 180,000 206,000
Total liabilities and equity . . . . . . . . . . . . . $445,440 $542,450 Retained earnings . . . . . . . . . . . . . . . . . . . 98,300 93,600
642 Chapter 17 Analysis of Financial Statements

Required
Check (1) Kyan: Accounts 1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts receivable turnover,
receivable turnover, 14.8; (d) inventory turnover, (e) days’ sales in inventory, and ( f ) days’ sales uncollected. Round to one deci-
Inventory turnover, 5.3 mal place. Identify the company you consider to be the better short-term credit risk and explain why.
(2) Barco: Profit margin, 2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total
21.1%; PE, 16.6 assets, and (d) return on common stockholders’ equity. Assuming that each company’s stock can be
purchased at $75 per share, compute their (e) price-earnings ratios and ( f ) dividend yields. Round to
one decimal place. Identify which company’s stock you would recommend as the better investment
and explain why.

Problem 17-6AA Selected account balances from the adjusted trial balance for Olinda Corporation as of its calendar year-
Income statement end December 31 follow.
computations and format
A2 Debit Credit

a. Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,000

b. Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . $ 34,000
c. Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,850
d. Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
e. Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106,400
f. Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . 71,600
g. Gain from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000
h. Accumulated depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . 174,500
i. Loss from operating a discontinued segment (pretax) . . . . . . . . . . . 18,250
j. Gain on insurance recovery of tornado damage . . . . . . . . . . . . . . . . 20,000
k. Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 998,000
l. Depreciation expense—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,000
m. Correction of overstatement of prior year’s sales (pretax) . . . . . . . . 16,000
n. Gain on sale of discontinued segment’s assets (pretax) . . . . . . . . . . 34,000
o. Loss from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,250
p. Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
q. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482,500

Required
Answer each of the following questions by providing supporting computations.
1. Assume that the company’s income tax rate is 30% for all items. Identify the tax effects and after-tax
amounts of the three items labeled pretax.
2. Compute the amount of income from continuing operations before income taxes. What is the amount
of the income tax expense? What is the amount of income from continuing operations?
Check (3) $11,025 3. What is the total amount of after-tax income (loss) associated with the discontinued segment?
(4) $257,425 4. What is the amount of net income for the year?

PROBLEM SET B Selected comparative financial statements of Tripoly Company follow.

Problem 17-1B
TRIPOLY COMPANY
Calculating and analyzing
Comparative Income Statements
trend percents For Years Ended December 31
P1 $ thousands 2019 2018 2017 2016 2015 2014 2013

Sales . . . . . . . . . . . . . . . . . $560 $610 $630 $680 $740 $770 $860

Cost of goods sold . . . . . . 276 290 294 314 340 350 380
Gross profit . . . . . . . . . . . . 284 320 336 366 400 420 480
Operating expenses . . . . 84 104 112 126 140 144 150
Net income . . . . . . . . . . . . $200 $216 $224 $240 $260 $276 $330
 Chapter 17 Analysis of Financial Statements 643

TRIPOLY COMPANY
Comparative Year-End Balance Sheets
At December 31, $ thousands 2019 2018 2017 2016 2015 2014 2013

Assets
Cash . . . . . . . . . . . . . . . . . . . . . . $ 44 $ 46 $ 52 $ 54 $ 60 $ 62 $ 68
Accounts receivable, net . . . . . . 130 136 140 144 150 154 160
Merchandise inventory . . . . . . . 166 172 178 180 186 190 208
Other current assets . . . . . . . . . 34 34 36 38 38 40 40
Long-term investments . . . . . . . 36 30 26 110 110 110 110
Plant assets, net . . . . . . . . . . . . . 510 514 520 412 420 428 454
Total assets . . . . . . . . . . . . . . . . $920 $932 $952 $938 $964 $984 $1,040

Liabilities and Equity

Current liabilities . . . . . . . . . . . . $148 $156 $186 $190 $210 $260 $ 280
Long-term liabilities . . . . . . . . . . 92 120 142 148 194 214 260
Common stock . . . . . . . . . . . . . . 160 160 160 160 160 160 160
Other paid-in capital . . . . . . . . . 70 70 70 70 70 70 70
Retained earnings . . . . . . . . . . . 450 426 394 370 330 280 270
Total liabilities and equity . . . . . $920 $932 $952 $938 $964 $984 $1,040

Required
1. Compute trend percents for all components of both statements using 2013 as the base year. Round Check (1) 2019, Total
percents to one decimal. assets trend, 88.5%

Analysis Component
2. Analyze and comment on the financial statements and trend percents from part 1.

Selected comparative financial statement information of Bluegrass Corporation follows. Problem 17-2B
Ratios, common-size
statements, and trend
percents
BLUEGRASS CORPORATION P1 P2 P3
Comparative Year-End Balance Sheets
At December 31 2019 2018 2017 BLUEGRASS CORPORATION
Comparative Income Statements
Assets
For Years Ended December 31 2019 2018 2017
Current assets . . . . . . . . . . . . . . . . $ 54,860 $ 32,660 $ 36,300
Long-term investments . . . . . . . . . 0 1,700 10,600 Sales . . . . . . . . . . . . . . . . . . . . . . . $198,800 $166,000 $143,800
Plant assets, net . . . . . . . . . . . . . . . 112,810 113,660 79,000 Cost of goods sold . . . . . . . . . . . . 108,890 86,175 66,200
Total assets . . . . . . . . . . . . . . . . . . $167,670 $148,020 $125,900 Gross profit . . . . . . . . . . . . . . . . . 89,910 79,825 77,600
Liabilities and Equity Selling expenses . . . . . . . . . . . . . 22,680 19,790 18,000
Current liabilities . . . . . . . . . . . . . . $ 22,370 $ 19,180 $ 16,500 Administrative expenses . . . . . . . 16,760 14,610 15,700
Common stock . . . . . . . . . . . . . . . . 46,500 46,500 37,000 Total expenses . . . . . . . . . . . . . . . 39,440 34,400 33,700
Other paid-in capital . . . . . . . . . . . 13,850 13,850 11,300 Income before taxes . . . . . . . . . . 50,470 45,425 43,900
Retained earnings . . . . . . . . . . . . . 84,950 68,490 61,100 Income tax expense . . . . . . . . . . 6,050 5,910 5,300
Total liabilities and equity . . . . . . . $167,670 $148,020 $125,900 Net income . . . . . . . . . . . . . . . . . . $ 44,420 $ 39,515 $ 38,600

Required
1. Compute each year’s current ratio. Round ratios to one decimal.
2. Express the income statement data in common-size percents. Round percents to two decimals.
3. Express the balance sheet data in trend percents with 2017 as the base year. Round percents to two Check (3) 2019, Total
decimals. assets trend, 133.18%

Analysis Component
4. Comment on any significant relations revealed by the ratios and percents computed.
644 Chapter 17 Analysis of Financial Statements

Problem 17-3B Koto Corporation began the month of June with $300,000 of current assets, a current ratio of 2.5:1, and an
Transactions, working acid-test ratio of 1.4:1. During the month, it completed the following transactions (the company uses a
capital, and liquidity perpetual inventory system).
ratios P3
June 1 Sold merchandise inventory that cost $75,000 for $120,000 cash.
Check June 3: Current ratio, 3 Collected $88,000 cash on an account receivable.
2.88; Acid-test ratio, 2.40 5 Purchased $150,000 of merchandise inventory on credit.
7 Borrowed $100,000 cash by giving the bank a 60-day, 10% note.
10 Borrowed $120,000 cash by signing a long-term secured note.
12 Purchased machinery for $275,000 cash.
15 Declared a $1 per share cash dividend on its 80,000 shares of outstanding common stock.
19 Wrote off a $5,000 bad debt against the Allowance for Doubtful Accounts account.
22 Paid $12,000 cash to settle an account payable.
June 30: Working capital, 30 Paid the dividend declared on June 15.
$(10,000); Current ratio, 0.97
Required
Prepare a table, similar to the following, showing the company’s (1) current ratio, (2) acid-test ratio, and
(3) working capital after each transaction. Round ratios to two decimals.

A B C D E F G
1 Current Quick Current Current Acid-Test Working
2 Transaction Assets Assets Liabilities Ratio Ratio Capital
3 Beginning $300,000 — — 2.50 1.40 —

Problem 17-4B Selected current year-end financial statements of Overton Corporation follow. (All sales were on credit;
Calculating financial selected balance sheet amounts at December 31 of the prior year were inventory, $17,400; total assets,
statement ratios $94,900; common stock, $35,500; and retained earnings, $18,800.)
P3

OVERTON CORPORATION
OVERTON CORPORATION Balance Sheet
Income Statement December 31 of Current Year
For Current Year Ended December 31
Assets Liabilities and Equity
Sales . . . . . . . . . . . . . . . . . . $315,500 Cash . . . . . . . . . . . . . . . . . . . $  6,100 Accounts payable . . . . . . . . . . . . . . . $ 11,500
Cost of goods sold . . . . . . . 236,100 Short-term investments . . . . 6,900 Accrued wages payable . . . . . . . . . . 3,300
Gross profit . . . . . . . . . . . . 79,400 Accounts receivable, net . . . 15,100 Income taxes payable . . . . . . . . . . . . 2,600
Operating expenses . . . . . 49,200 Merchandise inventory . . . . 13,500 Long-term note payable, secured
Interest expense . . . . . . . . 2,200 Prepaid expenses . . . . . . . . 2,000   by mortgage on plant assets . . . . 30,000
Income before taxes . . . . . 28,000 Plant assets, net . . . . . . . . . . 73,900 Common stock, $5 par value . . . . . . 35,000
Income tax expense . . . . . 4,200 Retained earnings . . . . . . . . . . . . . . . 35,100
Net income . . . . . . . . . . . . . $ 23,800 Total assets . . . . . . . . . . . . . $117,500 Total liabilities and equity . . . . . . . . . $117,500

Required
Check Acid-test ratio, 1.6 to Compute the following: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory
1; Inventory turnover, 15.3 turnover, (5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin
ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity.
Round to one decimal place; for part 6, round to two decimals.

Problem 17-5B Summary information from the financial statements of two companies competing in the same industry
Comparative ratio follows.
analysis P3
 Chapter 17 Analysis of Financial Statements 645

Fargo Ball Fargo Ball

Company Company Company Company

Data from the current year-end balance sheets Data from the current year’s income statement
Assets Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $393,600 $667,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 $ 36,500 Cost of goods sold . . . . . . . . . . . . . . . . . . . 290,600 480,000
Accounts receivable, net . . . . . . . . . . . . . . 88,700 79,500 Interest expense . . . . . . . . . . . . . . . . . . . . . 5,900 12,300
Merchandise inventory . . . . . . . . . . . . . . . 86,800 82,000 Income tax expense . . . . . . . . . . . . . . . . . . 5,700 12,300
Prepaid expenses . . . . . . . . . . . . . . . . . . . 9,700 10,100 Net income . . . . . . . . . . . . . . . . . . . . . . . . . 33,850 61,700
Plant assets, net . . . . . . . . . . . . . . . . . . . . . 176,900 252,300 Basic earnings per share . . . . . . . . . . . . . . 1.27 2.19
Total assets . . . . . . . . . . . . . . . . . . . . . . . . $382,100 $460,400
Liabilities and Equity Beginning-of-year balance sheet data
Current liabilities . . . . . . . . . . . . . . . . . . . . $ 90,500 $ 97,000 Accounts receivable, net . . . . . . . . . . . . . . $ 72,200 $ 73,300
Long-term notes payable . . . . . . . . . . . . . 93,000 93,300 Merchandise inventory . . . . . . . . . . . . . . . . 105,100 80,500
Common stock, $5 par value . . . . . . . . . . 133,000 141,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . 383,400 443,000
Retained earnings . . . . . . . . . . . . . . . . . . . 65,600 129,100 Common stock, $5 par value . . . . . . . . . . . 133,000 141,000
Total liabilities and equity . . . . . . . . . . . . . $382,100 $460,400 Retained earnings . . . . . . . . . . . . . . . . . . . 49,100 109,700

Required
1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts receivable turn- Check (1) Fargo: Accounts
over, (d) inventory turnover, (e) days’ sales in inventory, and ( f ) days’ sales uncollected. Round to receivable turnover, 4.9;
one decimal place. Identify the company you consider to be the better short-term credit risk and Inventory turnover, 3.0
explain why.
2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total (2) Ball: Profit margin, 9.2%;
assets, and (d) return on common stockholders’ equity. Assuming that each company paid cash PE, 11.4
dividends of $1.50 per share and each company’s stock can be purchased at $25 per share, compute
their (e) price-earnings ratios and ( f ) dividend yields. Round to one decimal place; for part b, round
to two decimals. Identify which company’s stock you would recommend as the better investment
and explain why.

Selected account balances from the adjusted trial balance for Harbor Corp. as of its calendar year-end Problem 17-6BA
December 31 follow. Income statement
computations and format
A2
Debit Credit

a. Accumulated depreciation—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000

b. Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
c. Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,640,000
d. Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $       ?
e. Loss on hurricane damage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000
f. Accumulated depreciation—Equipment . . . . . . . . . . . . . . . . . . . . . . . . 220,000
g. Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328,000
h. Depreciation expense—Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
i. Loss from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000
j. Gain from settlement of lawsuit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000
k. Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000
l. Loss from operating a discontinued segment (pretax) . . . . . . . . . . . . 120,000
m. Depreciation expense—Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156,000
n. Correction of overstatement of prior year’s expense (pretax) . . . . . . 48,000
o. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,040,000
p. Loss on sale of discontinued segment’s assets (pretax) . . . . . . . . . . . 180,000
q. Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,000
646 Chapter 17 Analysis of Financial Statements

Required
Answer each of the following questions by providing supporting computations.
1. Assume that the company’s income tax rate is 25% for all items. Identify the tax effects and after-tax
amounts of the three items labeled pretax.
2. What is the amount of income from continuing operations before income taxes? What is the amount of
income tax expense? What is the amount of income from continuing operations?
Check (3) $(225,000) 3. What is the total amount of after-tax income (loss) associated with the discontinued segment?
(4) $522,000 4. What is the amount of net income for the year?

SERIAL PROBLEM This serial problem began in Chapter 1 and continues through most of the book. If previous chapter seg-
Business Solutions ments were not completed, the serial problem can begin at this point.
P3
SP 17 Use the following selected data from Business Solutions’s income statement for the three months
ended March 31, 2020, and from its March 31, 2020, balance sheet to complete the requirements.

Computer services revenue . . . . . . $25,307 Net income . . . . . . . . . $ 18,833 Current liabilities . . . . . $    875
Net sales (of goods) . . . . . . . . . . . . . 18,693 Quick assets . . . . . . . .   90,924 Total liabilities . . . . . . .     875
Total sales and revenue . . . . . . . . . . 44,000 Current assets . . . . . . .   95,568 Total equity . . . . . . . . . 119,393
Cost of goods sold . . . . . . . . . . . . . . 14,052 Total assets . . . . . . . . . 120,268

Required
1. Compute the gross margin ratio (both with and without services revenue) and net profit margin ratio
(round the percent to one decimal).
2. Compute the current ratio and acid-test ratio (round to one decimal).
3. Compute the debt ratio and equity ratio (round the percent to one decimal).
©Alexander Image/Shutterstock
4. What percent of its assets are current? What percent are long term? Round percents to one decimal.

Accounting Analysis

COMPANY AA 17-1 Use Apple’s financial statements in Appendix A to answer the following.
ANALYSIS 1. Using fiscal 2015 as the base year, compute trend percents for fiscal years 2015, 2016, and 2017 for
A1 P1 P2 net sales, cost of sales, operating income, other income (expense) net, provision for income taxes, and
net income. Round percents to one decimal.
APPLE 2. Compute common-size percents for fiscal years 2016 and 2017 for the following categories of assets:
(a) total current assets; (b) property, plant and equipment, net; and (c) goodwill plus acquired intan-
gible assets, net. Round percents to one decimal.
3. Using current assets as a percent of total assets to measure liquidity, did Apple’s asset makeup become
more liquid or less liquid in 2017?

COMPARATIVE AA 17-2 Key figures for Apple and Google follow.

ANALYSIS
C2 P2 $ millions Apple Google $ millions Apple Google

APPLE Cash and equivalents . . . . . . . . . . . . . $20,289 $ 10,715 Cost of sales . . . . . . . . . . $141,048 $ 45,583
Accounts receivable, net . . . . . . . . . . . 17,874 18,336 Revenues . . . . . . . . . . . . 229,234 110,855
GOOGLE Inventories . . . . . . . . . . . . . . . . . . . . . . 4,855 749 Total assets . . . . . . . . . . 375,319 197,295
Retained earnings . . . . . . . . . . . . . . . . 98,330 113,247

Required
1. Compute common-size percents for each of the companies using the data provided. Round percents to
one decimal.
2. If Google decided to pay a dividend, would retained earnings as a percent of total assets increase or
decrease?
3. Which company has a higher gross margin ratio on sales?
 Chapter 17 Analysis of Financial Statements 647

AA 17-3 Key figures for Samsung follow (in ₩ millions). GLOBAL ANALYSIS
A1
Cash and equivalents . . . . . . . . . . . . . . ₩ 30,545,130 Cost of sales . . . . . . . . . . . . . . . . . . . . . . ₩129,290,661
Accounts receivable, net . . . . . . . . . . . . 27,695,995 Revenues . . . . . . . . . . . . . . . . . . . . . . . . 239,575,376
Samsung
Inventories . . . . . . . . . . . . . . . . . . . . . . . 24,983,355 Total assets . . . . . . . . . . . . . . . . . . . . . . 301,752,090
Retained earnings . . . . . . . . . . . . . . . . . 215,811,200

Required
1. Compute common-size percents for Samsung using the data provided. Round percents to one
decimal.
2. What is Samsung’s gross margin ratio on sales?
3. Does Samsung’s gross margin ratio outperform or underperform the industry (assumed) average
of 25%?

Beyond the Numbers

BTN 17-1 As Beacon Company controller, you are responsible for informing the board of directors about ETHICS
its financial activities. At the board meeting, you present the following information. CHALLENGE
A1
2019 2018 2017

Sales trend percent . . . . . . . . . . . . . . . . . . . . . . 147.0% 135.0% 100.0%

Selling expenses to sales . . . . . . . . . . . . . . . . . 10.1% 14.0% 15.6%
Sales to plant assets ratio . . . . . . . . . . . . . . . . . 3.8 to 1 3.6 to 1 3.3 to 1
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.9 to 1 2.7 to 1 2.4 to 1
Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 to 1 1.4 to 1 1.5 to 1
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . 7.8 times 9.0 times 10.2 times
Accounts receivable turnover . . . . . . . . . . . . . . 7.0 times 7.7 times 8.5 times
Total asset turnover . . . . . . . . . . . . . . . . . . . . . . 2.9 times 2.9 times 3.3 times
Return on total assets . . . . . . . . . . . . . . . . . . . . 10.4% 11.0% 13.2%
Return on stockholders’ equity . . . . . . . . . . . . . 10.7% 11.5% 14.1%
Profit margin ratio . . . . . . . . . . . . . . . . . . . . . . . 3.6% 3.8% 4.0%

After the meeting, the company’s CEO holds a press conference with analysts in which she mentions the
following ratios.

2019 2018 2017

Sales trend percent . . . . . . . . . . . . . . . . . . . . . . 147.0% 135.0% 100.0%

Selling expenses to sales . . . . . . . . . . . . . . . . . 10.1% 14.0% 15.6%
Sales to plant assets ratio . . . . . . . . . . . . . . . . . 3.8 to 1 3.6 to 1 3.3 to 1
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.9 to 1 2.7 to 1 2.4 to 1

Required
1. Why do you think the CEO decided to report 4 ratios instead of the 11 prepared?
2. Comment on the possible consequences of the CEO’s reporting of the ratios selected.

BTN 17-2 Each team is to select a different industry, and each team member is to select a different COMMUNICATING
company in that industry and acquire its financial statements. Use those statements to analyze the com- IN PRACTICE
pany, including at least one ratio from each of the four building blocks of analysis. When necessary, use
A1 P3
the financial press to determine the market price of its stock. Communicate with teammates via a meet-
ing, e-mail, or telephone to discuss how different companies compare to each other and to industry
norms. The team is to prepare a single one-page memorandum reporting on its analysis and the conclu-
sions reached.
648 Chapter 17 Analysis of Financial Statements

TAKING IT TO BTN 17-3 Access the February 21, 2017, filing of the December 31, 2016, 10-K report of The Hershey
THE NET Company (ticker: HSY) at [Link] and complete the following requirements.
P3
Required
Compute or identify the following profitability ratios of Hershey for its years ending December 31, 2016,
and December 31, 2015. Interpret its profitability using the results obtained for these two years.
1. Profit margin ratio (round the percent to one decimal).
2. Gross profit ratio (round the percent to one decimal).
3. Return on total assets (round the percent to one decimal). (Total assets at year-end 2014 were
$5,622,870 in thousands.)
4. Return on common stockholders’ equity (round the percent to one decimal). (Total shareholders’ eq-
uity at year-end 2014 was $1,519,530 in thousands.)
5. Basic net income per common share (round to the nearest cent).

TEAMWORK IN BTN 17-4 A team approach to learning financial statement analysis is often useful.
ACTION
Required
P1 P2 P3
1. Each team should write a description of horizontal and vertical analysis that all team members agree
with and understand. Illustrate each description with an example.
2. Each member of the team is to select one of the following categories of ratio analysis. Explain what
the ratios in that category measure. Choose one ratio from the category selected, present its formula,
and explain what it measures.
Hint: Pairing within teams may be a. Liquidity and efficiency c. Profitability
necessary for part 2. Use as an
in-class activity or as an assign- b. Solvency d. Market prospects
ment. Consider presentations
to the entire class using team 3. Each team member is to present his or her notes from part 2 to teammates. Team members are to con-
rotation with slides. firm or correct other teammates’ presentations.

ENTREPRENEURIAL BTN 17-5 Assume that Carla Harris of Morgan Stanley ([Link]) has impressed you with
DECISION the company’s success and its commitment to ethical behavior. You learn of a staff opening at Morgan
A1 P1 P2 P3 Stanley and decide to apply for it. Your resume is successfully screened from those received and you
advance to the interview process. You learn that the interview consists of analyzing the following finan-
cial facts and answering analysis questions below. (The data are taken from a small merchandiser in out-
door recreational equipment.)

2019 2018 2017

Sales trend percents . . . . . . . . . . . . . . . . . . . . . . 137.0% 125.0% 100.0%

Selling expenses to sales . . . . . . . . . . . . . . . . . . 9.8% 13.7% 15.3%
Sales to plant assets ratio . . . . . . . . . . . . . . . . . . 3.5 to 1 3.3 to 1 3.0 to 1
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 to 1 2.4 to 1 2.1 to 1
Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.8 to 1 1.1 to 1 1.2 to 1
Merchandise inventory turnover . . . . . . . . . . . . . 7.5 times 8.7 times 9.9 times
Accounts receivable turnover . . . . . . . . . . . . . . . 6.7 times 7.4 times 8.2 times
Total asset turnover . . . . . . . . . . . . . . . . . . . . . . . 2.6 times 2.6 times 3.0 times
Return on total assets . . . . . . . . . . . . . . . . . . . . . 8.8% 9.4% 11.1%
Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . 9.75% 11.50% 12.25%
Profit margin ratio . . . . . . . . . . . . . . . . . . . . . . . . 3.3% 3.5% 3.7%

Required
Use these data to answer each of the following questions with explanations.
1. Is it becoming easier for the company to meet its current liabilities on time and to take advantage of
any available cash discounts? Explain.
2. Is the company collecting its accounts receivable more rapidly? Explain.
 Chapter 17 Analysis of Financial Statements 649

3. Is the company’s investment in accounts receivable decreasing? Explain.

4. Is the company’s investment in plant assets increasing? Explain.
5. Is the owner’s investment becoming more profitable? Explain.
6. Did the dollar amount of selling expenses decrease during the three-year period? Explain.

BTN 17-6 You are to devise an investment strategy to enable you to accumulate $1,000,000 by age 65. HITTING THE
Start by making some assumptions about your salary. Next, compute the percent of your salary that you ROAD
will be able to save each year. If you will receive any lump-sum monies, include those amounts in your
C1 P3
calculations. Historically, stocks have delivered average annual returns of around 10%. Given this history,
you probably should not assume that you will earn above 10% on the money you invest. It is not necessary
to specify exactly what types of assets you will buy for your investments; just assume a rate you expect to
earn. Use the future value tables in Appendix B to calculate how your savings will grow. Experiment a bit
with your figures to see how much less you have to save if you start at, for example, age 25 versus age
35 or 40. (For this assignment, do not include inflation in your calculations.)

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