Chapter 17

Financial Statement Analysis

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website, in whole or in part.
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CHAPTER
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17 Financial Statement
Analysis

Accounting
27e

human/iStock/360/Getty Images
Warren
Reeve 2
Duchac
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Financial 7
Statement
Analysis

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After studying this chapter, you should
be able to:
1. List basic financial statement
analytical procedures.
2. Apply financial statement analysis to
assess the solvency of a business.
3. Apply financial statement analysis to
stress the profitability of a business.
4. Describe the contents of corporate
4
annual reports.
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17-
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Objective
Objective 11

List basic financial

statement analytical
procedures.

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Click Basics
to edit of Analysis
Master title style
Financial Statement analysis applies analytical tools to general-purpose
financial statements and related data for making business decisions. It involves
transforming data into more useful information. It also reduces our reliance on
hunches, guesses and intuitions as well as our uncertainty in decision making.
Application
of analytical
tools

Reduces Involves
uncertainty transforming
data 6
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The Value of Financial Statement

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Information
• General-purpose financial statements are distributed to a wide
range of potential users, providing each group with valuable
information about a company’s economic performance and
financial condition.
• Users typically evaluate this information along three
dimensions:
– Liquidity
– Solvency
– Profitability
– Market
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 8

Click Purpose
to edit of Analysis
Master title style
Financial statement analysis helps users
Financial
Financial statement
statement analysis
analysis helps
helps users
users
make
make better
better decisions.
decisions.

Internal Users External Users

Managers Shareholders
Officers Lenders
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Internal Auditors Customers
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Building Blocks of Analysis

Liquidity and
Solvency
efficiency

Market
Profitability prospects

© McGraw-Hill Education 9
Learning Objective C1: Explain the purpose and identify the building blocks of analysis.
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Building
to edit
Blocks
Master
of Analysis
title style
Ability to meet
short-term Ability to
obligations and Liquidity generate future
to efficiently
generate
and Solvency revenues and
meet long-term
revenues Efficiency obligations

Ability to provide
financial rewards
sufficient to Ability to
generate
attract and retain Profitability Market positive
financing 10
market
expectations
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Liquidity
Master title style
• Short-term creditors such as banks and
financial institutions are primarily concerned
with whether a company will be able to repay
short-term borrowings such as loans and notes.
• As such, they are most interested in evaluating
a company’s ability to convert assets into cash,
which is called liquidity.

11

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Solvency
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• Long-term creditors, such as bondholders, loan
money for long periods of time.
• Thus, they are interested in evaluating a
company’s ability to make its periodic interest
payments and repay the face amount of debt at
maturity, which is called solvency.

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Profitability
Master title style
• Investors, such as stockholders, are interested
in evaluating the potential for the price of the
company’s stock to increase.
• As such, investors focus on evaluating a
company’s ability to generate earnings, which
is called profitability.

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 14

Techniques for Analyzing

ClickFinancial
to edit Master title
Statements style
(slide 1 of 2)
• Financial statement users rely on the following techniques to
analyze and interpret a company’s financial performance and
condition:
– Analytical methods examine changes in the amount and
percentage of financial statement items within and across
periods.
– Ratios express a financial statement item or set of financial
statement items as a percentage of another financial
statement item, in order to measure an important economic
relationship as a single number. 14

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 15

Techniques for Analyzing

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to edit Master title
Statements style
(slide 2 of 2)

• Both analytical methods and ratios can be used

to compare a company’s financial performance
over time or to another company.
– Comparisons Over Time: The comparison of a
financial statement item or ratio with the same item
or ratio from a prior period often helps the user
identify trends in a company’s economic
performance, financial condition, liquidity,
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solvency, and profitability.
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 16

Techniques for Analyzing

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to edit Master title
Statements style
(slide 2 of 2)

– Comparisons Between Companies: The

comparison of a financial statement item or ratio to
another company in the same industry can provide
insight into a company’s economic performance
and financial condition relative to its competitors.

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 17

Click to edit Master

Information title style
for Analysis

1. Income Statement
2. Balance Sheet
3. Statement of
Stockholders’ Equity
4. Statement of Cash Flows
5. Notes to the Financial
Statements

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© McGraw-Hill Education17
Learning Objective C1: Explain the purpose and identify the building blocks of analysis.
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Click
Information
to edit Master
Income Statement for Analysis
title style
Balance Sheet Notes

Statement of
Changes in
Stockholders’ Equity
Statement of Cash
Flows

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Click
Standards
to editfor
Master
Comparison
title style
To help me interpret our
financial statements, I
use several standards of
comparison.

 Intracompany
 Competitor
 Industry
 Guidelines 19
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Click Tools
to editof
Master
Analysis
title style
Using key relations
among financial
statement items

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Click
Basicto Analytical
edit MasterMethods
title style
• Users analyze a company’s financial
statements using a variety of analytical
methods. Three such methods are:
– Horizontal analysis
– Vertical analysis
– Common-sized statements

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©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 22

Click Tools
to editof Analysis
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Horizontal Analysis
Comparing the financial condition and
performance across time.

Vertical Analysis
Comparing the financial condition and
performance to a base amount.

Ratio Analysis
Measurement of key relations between financial 22
statement items.
© McGraw-Hill Education22
Learning Objective C2: Describe standards for comparisons in analysis.
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ClickHorizontal
to edit Master
Analysis
title style

Now, let’s
look at
some ways
to use
horizontal
Time analysis.
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Horizontal Analysis
1

The percentage analysis of

increases and decreases in
related items in comparative
financial statements is called
horizontal analysis.

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Rules for Horizontal Analysis

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1. The amount of each item on the most recent
statement is compared with a corresponding
item on one or more earlier statements.
2. The increase or decrease in the amount of an
item is listed, together with the percent of
increase or decrease
3. When the comparison is made between two
statements, the earlier statement is used as the
base.
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Comparative Statements
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CLOVER title style
CORPORATION
Comparative Balance Sheets
December 31,
Dollar Percent
2002 2001 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000 26
Total assets $ 315,000 $ 289,700
* Percent rounded to first decimal point.
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Click
Comparative
to edit Master
Statements
title style
Calculate Change in Dollar Amount
Dollar Analysis Period Base Period
Change = Amount – Amount

Since we are measuring the amount of

the change between 2001 and 2002, the
dollar amounts for 2001 become the
“base” period amounts. 27
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CLOVER CORPORATION

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Comparative Balance Sheets
December 31,
Dollar Percent
2002 2001 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses $12,0003,000 1,200= $(11,500)
– $23,500
Total current assets $ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000 28
Total assets $ 315,000 $ 289,700
* Percent rounded to first decimal point.
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Click
Comparative
to edit Master
Statements
title style
Calculate Change as a Percent
Percent Dollar Change
Change
=
Base Period Amount × 100%

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CLOVER CORPORATION

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Comparative Balance Sheets
December 31,
Dollar Percent
2002 2001 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets
($11,500 ÷ $23,500) × 100% = 48.9%
$ 155,000 $ 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000
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Total assets $ 315,000 $ 289,700
* Percent rounded to first decimal point.
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CLOVER CORPORATION

Click to edit Master title style

Comparative Balance Sheets
December 31,
Dollar Percent
2002 2001 Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets $ 155,000 $ 164,700 $ (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment $ 160,000 $ 125,000 $ 35,000 28.0
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Total assets $ 315,000 $ 289,700 $ 25,300 8.7
* Percent rounded to first decimal point.
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Exhibit 1 Comparative Balance Sheets
Lincoln Company 1
Comparative Balance Sheet
December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Assets
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $ 42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3%
325
Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)
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Lincoln Company 1
Comparative Balance Sheet
December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Assets
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets Horizontal
50,000 Analysis:
50,000
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities Difference $17,000
Current liabilities $ 210,000 $ 243,000 $ (33,000) = 3.2%
(13.6%)
Long-term liabilities Base year
100,000(2007) $533,000
200,000 100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $ 42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3%
336
Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)
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Lincoln Company 1
Comparative Balance Sheet
December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Assets
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000
Total assets Horizontal Analysis:
$1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities Difference
$ 210,000 $(82,500)
$ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 =
100,000) (46.5%)
(50.0%)
Total liabilities Base year (2007)$ 443,000
$ 310,000 $177,500
$(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $ 42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3%
347
Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)
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Exhibit 2 Comparative Schedule of
Current Assets 1

Lincoln Company
Comparative Schedule of Current Assets
December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Cash $ 90,500 $ 64,700 $ 25,800 39.9%
Marketable securities 75,000 60,000 15,000 25.0%
Accounts receivable (net) 115,000 120,000 (5,000) (4.2%)
Inventories 264,000 283,000 (19,000) (6.7%)
Prepaid expenses 5,500 5,300 200 3.8%
Total current assets $550,000 $533,000 $17,000 3.2%

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Lincoln Company
Comparative Schedule of Current Assets
December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Cash $ 90,500 $ 64,700 $ 25,800 39.9%
Marketable securities 75,000 60,000 15,000 25.0%
Accounts receivable (net)Horizontal
115,000 Analysis:
120,000 (5,000) (4.2%)
Inventories 264,000 283,000 (19,000) (6.7%)
Prepaid expenses 5,500
Difference 5,300 $25,800
200 3.8%
Total current assets $550,000 $533,000 $17,000 = 39.9%3.2%
Base year (2007) $64,700
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Exhibit 3 Comparative Income Statement
Lincoln Company 1
Comparative Income Statement
For the Year Ended December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns and allowances 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000 97,400 6,600 6.8%
Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%
Income from operations $ 160,000 $ 135,600 $ 24,400 18.0%
Other income 8,500 11,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900 14.9%
Other expense (interest) 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax expense 71,500 58,100 13,400 23.1% 3710
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
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Lincoln Company 1
Comparative Income Statement
For the Year Ended December 31, 2008 and 2007
Increase (Decrease)
2008 2007 Amount Percent
Current assets $1,530,500 $1,234,000 $296,500 24.0%
Sales returns and allowances 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expensesHorizontal104,000
Analysis: 97,400 6,600 6,.8%
Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%
Income from operations Increase amount$ 135,600
$ 160,000 $296,500$ 24,400 18.0%
Other income 8,500 11,000 = 24.0%(22.7%)
(2,500)
Base year (2007)$$1,234,000
$ 168,500 146,600 $ 21,900 14.9%
Other expense (interest) 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax expense 71,500 58,100 13,400 23.1% 3811
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
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Exhibit 4 Comparative RE Statement
1
Lincoln Company
Comparative Retained Earnings Statement
December 31, 2008 and 2007
A percentage analysis that
Increase (Decrease)
shows the relationship
2008 2007 ofAmount
each Percent
Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5%
component
Net income for year
to the
91,000
total
76,500
within
14,500 19.0%
Total a single statement is called
$228,500 $176,500 $52,000 29.5%)
Dividends:
On preferred stock vertical analysis.
$ 9,000 $ 9,000 —
On common stock 40,000 30,000 10,000 33.3%
Total $ 49,000 $ 39,000 $10,000 25.6%
Total current assets $179,500 $137,500 $42,000 30.5%

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Exhibit 4 Comparative RE Statement
1
Lincoln Company
Comparative Retained Earnings Statement
December 31, 2008 and 2007
A percentage analysis that
Increase (Decrease)
shows the relationship
2008 2007 ofAmount
each Percent
Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5%
component
Net income for year
to the
91,000
total
76,500
within
14,500 19.0%
Total a single statement is called
$228,500 $176,500 $52,000 29.5%)
Dividends:
On preferred stock vertical analysis.
$ 9,000 $ 9,000 —
Horizontal Analysis:
On common stock 40,000 30,000 10,000 33.3%
Total $ 49,000
Increase amount$ 39,000 $10,000
$37,500 25.6%
Total current assets $179,500 $137,500 $42,000 30.5%
= 37.5%
Base year (2007) $100,000
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17-
1
Click to edit Master title style
Example Exercise 17-1

The comparative cash and accounts receivable for a

company are provided below:
2008 2007
Cash $62,500 $50,000
Accounts receivable (net) 74,400 80,000
Based on this information, what is the amount and
percentage of increase or decrease that would be shown
in a balance sheet with horizontal analysis?

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17-
1
Click to edit Master title style
Follow My Example 17-1

Cash $12,500 increase ($62,500 –

$50,000), or 25%

Accounts
Receivable $5,600 decrease ($74,400 – $80,000)
or –7%

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For Practice: PE 17-1A, PE 17-1B
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Trend Analysis
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Trend analysis is used to reveal patterns in data
across periods.

Trend
Analysis period amount
Percent (%)=
Base period amount × 100

43

© McGraw-Hill Education43
Learning Objective P1: Explain and apply methods of horizontal analysis.
 44

Trend Analysis (continued)

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Exhi
bit
17.3

Using the number reported 4 years ago as the base

year, we will get the following trend percents:

Exhi
bit
44
17.4
© McGraw-Hill Education44
Learning Objective P1: Explain and apply methods of horizontal analysis.
 45

Line
ClickGraph
to editofMaster
Trendtitle
Percents
style
Exhi
bit
17.5

We can use the trend percentages to construct a

graph so we can see the trend over time.
45

© McGraw-Hill Education45
Learning Objective P1: Explain and apply methods of horizontal analysis.
 46

VV
eeClick to edit Master title style
rr
tt Now, let’s look at some vertical
ii
cc analysis tools!
aa
ll
AA
nn
aa
ll
yy
ss 46
ii
s
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VV
Click Tools
to editof
Master
Analysis
title style ee
rr
tt
Comparing a company’s ii
financial condition and cc
performance to a base amount aa
ll
A A
nn
aa
ll
yy
ss
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ii
ss
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Click to
Vertical
edit Master
Analysis
title style

Percentage analysis may be used to show the

relationship of the component parts to the total
in a single statement. This type of analysis is
called vertical analysis.

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17-
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Vertical Analysis
1

A percentage analysis used to

show the relationship of each
component to the total within a
single statement is called
vertical analysis.

49
 50

Rules for Vertical Analysis

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1. In vertical analysis of the balance sheet,
each asset item is stated as a percent of
total assets, and each liability and
stockholders’ equity item is stated as a
percent of total liabilities and
stockholders’ equity.
2. In vertical analysis of the income
statement, each item is stated as a percent
of net sales. 50
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17-
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Vertical Analysis of Balance Sheet
1

In a vertical analysis of the balance

sheet, each asset item is stated as a
percent of the total assets. Each
liability and stockholders’ equity item
is stated as a percent of the total
liabilities and stockholders’ equity.

51
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Click to edit Master title style

Lincoln Company
Comparative Balance Sheet
17-
1
For the Years Ended December 31, 2008 and 2007
2008 2007
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total
Total assets
assets $1,139,500
$1,139,500 100.0%
100.0% $1,230,500 100.0%
$1,230,500100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
2.2% Common stock, $10 par 500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% 18
52
Totalliab.
Total liab.&&stockholders’
Stockholders’equity
equity $1,139,500
$1,139,500 100.0%
100.0% $1,230,500 100.0%
$1,230,500100.0%
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17-
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To demonstrate how vertical

analysis percentages are
calculated for the balance sheet,
let’s see how the 48.3 percent
was calculated for the 2008
current assets in the next slide.

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Lincoln Company
Comparative Balance Sheet
17-
1
For the Years Ended December 31, 2008 and 2007
2008 2007
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total
Total assets
assets $1,139,500
$1,139,500 100.0%
100.0% $1,230,500 100.0%
$1,230,500100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities $ 310,000 27.2% $ 443,000 36.0%
Vertical Analysis:
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 1
Current
2.2% assets
Common stock, $10 par $550,000500,000 43.9 500,000 40.6
Retained earnings 179,500 =15.7
48.3% 137,500 11.2
Total
Total assetsequity $1,139,500
stockholders’ $ 829,500 72.8% $ 787,500 64.0% 20
54
Totalliab.
Total liab.&&stockholders’
Stockholders’equity
equity $1,139,500
$1,139,500 100.0% $1,230,500 100.0%
100.0% $1,230,500100.0%
 55

17-
Click to edit Master title style
Vertical Analysis of Income Statement
1

In a vertical analysis of the

income statement, each item is
stated as a percent of net sales.
As an example, let’s see how the
percent of 12.8% was calculated
for 2008 selling expenses.

55
 56

17-
Click to edit Master title style
Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2008 and 2007 1
2008 2007
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns and allow. 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense (interest) 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
22
56
 57

Click to edit Master title style 17-

Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2008 and 2007 1
2008 2007
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns and allow. 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Vertical Analysis:
Other expense (interest) 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Selling expenses
Income tax expense $191,000
71,500 4.8 58,100 4.8
Net income $ 91,000 =6.1%
12.8%$ 76,500 6.4%
Net sales $1,498,000 57
23
 58

Click
Common-Size
to edit Master
Statements
title style

In Common-Size Statements all

items are expressed only in
relative terms

58
 59

Click
Common-Size
to edit Master
Statements
title style

In Common-Size Statements all

items are expressed only in
relative terms

59
 60

Click
Common-Size
to edit Master
Statements
title style
Calculate Common-size Percent
Common-size Analysis Amount
Percent
= Base Amount × 100%

Financial
Financial Statement
Statement Base
BaseAmount
Amount
Balance
BalanceSheet
Sheet Total
Total Assets
Assets
Income
IncomeStatement
Statement Revenues
Revenues 60
 61
Lincoln Company
Comparative Balance Sheets

Click
Assets
to edit Master title style
December 31, 2003 December 31, 2002
Amount Percent Amount
Common-Size Percent
Statements
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Fixed assets (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
$1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
$310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Preferred stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
Common stock, $10 par 500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
$829,500 72.8% $787,500 64.0%
61
$1,139,500 100.0% $1230,500 100.0%
 62
CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Click to edit Master title style
Common-size
Percents*
2002 2001 2002 2001
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
($12,000 ÷ $315,000)
Total current assets $ 155,000× 100% = 3.8%
$ 164,700
Property and equipment:
Land ($23,50040,000
÷ $289,700) × 100% = 8.1%
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment $ 160,000 $ 125,000 62
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 63
CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Click to edit Master title style
Common-size
Percents*
2002 2001 2002 2001
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 6343.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 CLOVER CORPORATION 64
Comparative Balance Sheets
December 31,

Click to edit Master title style

Common-size
Percents*
2002 2001 2002 2001
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities $ 70,000 $ 50,000 22.2% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities $ 145,000 $ 130,000 46.0% 44.9%
Shareholders' equity:
Preferred stock 20,000 20,000 6.3% 6.9%
Common stock 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital $ 90,000 $ 90,000 28.6% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
64
Total shareholders' equity $ 170,000 $ 159,700 54.0% 55.1%
Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
 65
CLOVER CORPORATION
Comparative Income Statements
Click to edit Master title style
For the Years Ended December 31,
Common-size
Percents*
2002 2001 2002 2001
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01 65
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
 66

Click
Common-Size
to edit Master
Graphics
title style
This is a graphical analysis of Clover
Corporation’s common-size income
statement for 2002.
Interest Income taxes Net income
expense 1% 3%
1%
Selling and
administrative
Cost of sales
25%
70%

66
 67

Why to prepare Common-Size

Click to edit Master title style
Statements
1. Common-size statements may be prepared
in order to compare percentages of a
current period with past periods.
2. Common-size statements may also be
prepared to compare individual businesses
or to compare one business with industry
percentages.
67
 68

17-
Click to edit Master title style
Common-Size Statements
1

In a common-sized statements, all

items are expressed as a percentage.
Common-sized statements are
useful in comparing the current
period with prior periods, individual
businesses, or one business with
with industry percentages.
68
 69

17-
Click
Statementto edit Master title style
Common-Size Income
1

25
69
 70

17-
1
Click to edit Master title style
Example Exercise 17-2

Income statement information for Lee Corporation is

provided below:
Lee Corporation
Sales

$100,000
Cost of goods sold
Prepare a vertical analysis of the income statement for
Lee Corporation.
65,000
Gross profit
26
70
$ 35,000
 71

17-
1
Click to edit Master title style
Follow My Example 17-2

Amount Percentage
Sales $100,000 100% ($100,000/$100,000)
Cost of goods
sold 65,000 65 ($65,000/$100,000)
Gross profit 35,000 35% ($35,000/$100,000)

27
71
For Practice: PE 17-2A, PE 17-2B
 72

17-
Click to edit Master title style 2

Objective
Objective 22
Apply financial
statement analysis to
assess the solvency
of a business.
72
 73

17-
Click to edit Master title style
Solvency Analysis
2

The ability of a business to meet

its financial obligations (debts)
is called solvency.
The ability of a business to earn
income is called profitability.

73
 74

Solvency Analysis
Click to edit Master title style
Solvency is the ability of a business to meet its
financial obligations (debts) as they are due.
Solvency analysis focuses on the ability of a
business to pay or otherwise satisfy its current
and noncurrent liabilities.
This ability is normally assessed by examining
balance sheet relationships.

74
 75

ClickAnalyzing
to edit Master
Liquidity
title style
• Liquidity analysis evaluates the ability of a
company to convert current assets into cash.
• Liquidity ratios and measures focus upon a
company’s current position (current assets and
liabilities), accounts receivable, and inventory.

75

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 76

Liquidity
Click to edit
Ratios
Master
and title
Measures
style

76

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 77

17-
Click to edit Master title style
Current Position Analysis
2

Using measures to assess a

business’s ability to pay its
current liabilities is called
current position analysis. Such
analysis is of special interest to
short-term creditors.

77
 78

Click
Current
to edit
Position
MasterAnalysis
title style
• This information helps short-term creditors
determine how quickly they will be repaid.
• This analysis includes:
– Working Capital
– Current ratio
– Quick ratio

78

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 79

17-
Click to edit Master title style
Working Capital
2

The excess of current assets of a

business over its current liabilities
is called working capital. The
working capital is often used in
evaluating a company’s ability to
meet currently maturing debts.

79
 80

17-
Click to edit Master title style 2
Lincoln Company
Current asset:
Cash $ 90,500

Marketable securities 75,000

Accounts receivable (net) 115,000

Inventories 264,000
Prepaid expenses 5,500
a. Total current
Working assets
capital (a – b) $550,000
$340,000
b. Current liabilities 210,000 32
80
 81

Solvency Measures — The Short-Term Creditor

Click to edit Master title style
Working
WorkingCapital
Capital and
andCurrent
CurrentRatio
Ratio
2008 2007
Current assets $550,000 $533,000
Current liabilities 210,000 243,000
Working capital $340,000 $290,000

Use:
Use: To
Toindicate
indicatethe
theability
abilityto
tomeet
meet
currently
currentlymaturing
maturingobligations.
obligations.

81
 82

Current Position Analysis:

Click to edit Master title
Working Capital style
(slide 3 of 3)

• The working capital is used to evaluate a

company’s ability to pay current liabilities.
• A company’s working capital is often
monitored monthly, quarterly, or yearly by
creditors and other debtors.
• However, it is difficult to use working capital
to compare companies of different sizes. 82

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 83

17-
Click to edit Master title style
Current Ratio
2

The current ratio, sometimes

called the working capital
ratio or bankers’ ratio, is
computed by dividing the total
current assets by the total
current liabilities.

83
 84

17-
Click to edit Master title style 2

Lincoln Company
2008 2007
a. Current assets $550,000 $533,000
b. Current liabilities 210,000 243,000
Working capital (a – b) $340,000 $290,000
Current ratio (a/b) 2.6 2.2

34
84
 85

Solvency Measures — The Short-Term Creditor

Click to edit Master title style
Working
WorkingCapital
Capital and
andCurrent
CurrentRatio
Ratio
2008 2007
Current assets $550,000 $533,000
Current liabilities 210,000 243,000 Divide
Divide
Working capital $340,000 $290,000 current
current
Current ratio 2.6 2.2 assets
assetsby by
current
current
Use:
Use: To
Toindicate
indicatethe
theability
abilityto
tomeet
meet liabilities
liabilities
currently
currentlymaturing
maturingobligations.
obligations.

85
 86

Current Position Analysis:

Click to Current
edit Master title
Ratio style
(slide 3 of 3)

• The current ratio is a more reliable indicator of

a company’s ability to pay its current liabilities
than is working capital, and it is much easier to
compare across companies.

86

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 87

17-
Click to edit Master title style
Quick Ratio
2

A ratio that measures the

“instant’ debt-paying ability
of a company is called the
quick ratio or acid-test ratio.

87
 88

Current Position Analysis: Quick

Click to editRatio
Master title style
(slide 1 of 2)
•The quick ratio is computed as follows:

– Quick assets are cash and other current assets that

can be easily converted to cash.
• Quick assets normally include cash, temporary
investments, and receivables but exclude inventories
and prepaid assets. 88

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 89

Quick
Quickassets
assetsare
arecash 17-
and Click to edit Master title style
andother
othercurrent
cash
currentassets
assets 2
that
thatcan
canbe
bequickly
quickly
converted cash..
convertedtotocash
Lincoln Company
2008 2007
Quick assets:
Cash $ 90,500 $ 64,700
Marketable securities 75,000 60,000
Accounts receivable (net) 115,000 120,000
a. Total quick assets $280,500 $244,700
b. Current liabilities $210,000 $243,000
Quick ratio (a/b) 1.3 1.0
36
89
 90

Solvency Measures — The Short-Term Creditor

Click to edit Master title style
Acid-Test
Acid-TestRatio
Ratio
2008 2007
Quick assets:
Cash $ 90,500 $ 64,700
Marketable securities 75,000 60,000
Accounts receivable (net) 115,000 120,000
Total $280,500 $244,700
Current liabilities $210,000 $243,000
Acid-test ratio 1.3 1.0

Use:
Use: To
Toindicate
indicateinstant
instantdebt-paying
debt-payingability.
ability.
90
 91

17-
2
Click to edit Master title style
Example Exercise 17-3
The following items are reported on a company’s
balance sheet:
Cash

$300,000
Marketable securities

100,000
Determine (a) the current ratio and (b) the quick ratio.
Accounts receivable (net)
37
91
200,000
Inventory
 92

17-
2
Click to edit
Follow My Example 17-3
Master title style
a. Current Ratio = Current Assets/Current Liabilities
Current Ratio = ($300,000 + $100,000 + $200,000 +
$200,000)/$400,000
Current Ratio = 2.0
b. Quick Ratio = Quick Assets (cash, marketable securities,
and accounts receivable)/Current Liabilities
(accounts payable)
Quick Ratio = ($300,000 + $100,000 + $200,000)/$400,000
Quick Ratio = 1.5
38
92
For Practice: PE 17-3A, PE 17-3B
 93

17-
Click to edit Master title style
Accounts Receivable Turnover
2

The relationship between sales and

accounts receivable may be stated as
the accounts receivable turnover.
The ratio is to assess the efficiency of
the firm in collecting receivables and
in the managing of credit.

93
 94

Accounts Receivable
Click to edit Master Analysis
title style
(slide 1 of 2)
• A company’s ability to collect its accounts
receivable is called accounts receivable
analysis.
• Accounts receivable analysis includes the
computation and analysis of the following:
– Accounts receivable turnover
– Number of days’ sales in receivables

94

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 95

Accounts Receivable
Click to edit Master Analysis
title style
(slide 2 of 2)
• Collecting accounts receivable as quickly as
possible does the following:
– Improves a company’s liquidity
– Provides cash to improve or expand operations
– Reduces the risk of uncollectible accounts

95

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 96

Accounts Receivable Analysis:

Click to edit Master title
Accounts Receivable Turnoverstyle
(slide 1 of 2)

• The accounts receivable turnover is

computed as follows:

96

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 97

17-
Click to edit Master title style 2
Lincoln Company
2008 2007
a. Net sales $1,498,000
$1,200,000
Accounts receivable (net):
Beginning of year $ 120,000
$ 140,000
End of year 115,500
120,000
Accounts
Total receivable
$ 235,000turnover $ 260,000
(a/b) 12.7 9.2
b. Average (Total/2) $ 117,500
$ 130,000 97
40
 98

Solvency Measures — The Short-Term Creditor

Click to edit Master title style
Accounts
AccountsReceivable
ReceivableTurnover
Turnover
2008 2007
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,500 120,000
Total $ 235,000 $ 260,000
Average $ 117,500 $ 130,000
Accts. receivable turnover 12.7 9.2

Use:
Use: To
Toassess
assessthe
theefficiency
efficiencyin
incollecting
collecting
receivables
receivablesand
andininthe
themanagement
managementof ofcredit.
credit.
98
 99

Accounts Receivable Analysis:

Click
Number
to edit
of Master
Days’ Sales
title style
in
Receivables (slide 1 of 3)
• The number of days’ sales in receivables is
computed as follows:

99

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 100

17-
Click to edit Master title style
Number of Days’ Sales in
Receivables 2

The number of days’ sales in

receivables is an estimate of the length
of time (in days) the accounts
receivable have been outstanding.
Comparing this measure with the credit
terms provides information on the
efficiency in collecting receivables.
100
 101

17-
Click to edit Master
Lincoln Companytitle style 2
2008 2007
a. Average (Total/2) $ 117,500
$ 130,000
Net sales $1,498,000
$1,200,000
b. Average daily sales on
Number of days’
account sales in
(Sales/365) $ 4,104
receivables
$ (a/b)
3,288 28.6 39.5

42
101
 102

17-
2
Click to edit Master title style
Example Exercise 17-4
A company reports the following:
Net sales

$960,000
Determine (a) the accounts receivable turnover and (b)
Averageofaccounts
the number receivable
days’ sales (net) Round to one
in receivables.
decimal place.
48,000

43
102
 103

17-
2
Click to edit
Follow My Example 17-4
Master title style
a. Accounts Receivable Turnover = Sales/Average accounts
receivable
Accounts Receivable Turnover = $960,000/$48,000
Accounts Receivable Turnover = 20.0
b. Number of Days’ Sales in Receivables = Average accounts

receivable/Average daily sales

Number of Days’ Sales in Receivables = $48,000/($960,000/
365)
Number of Days’ Sales in Receivables = $48,000/$2,630
Number of Days’ Sales in Receivables = 18.3 days 44
103

For Practice: PE 17-4A, PE 17-4B

 104

17-
Click to edit Master title style
Inventory Turnover
2

The relationship between the

volume of goods (merchandise)
sold and inventory may be stated
as the inventory turnover. The
purpose of this ratio is to assess
the efficiency of the firm in
managing its inventory.
104
 105

ClickInventory
to edit(slide
Master Analysis
1 of 2)
title style

• A company’s ability to manage its inventory

effectively is evaluated using inventory
analysis.
• Inventory analysis includes the computation
and analysis of the following:
– Inventory turnover
– Number of days’ sales in inventory
105

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 106

ClickInventory
to edit(slide
Master Analysis
2 of 2)
title style
• Excess inventory does the following:
– Decreases liquidity by tying up funds (cash) in
inventory
– Increases insurance expense, property taxes,
storage costs, and other related expenses
– Increases the risk of losses because of price
declines or obsolescence of the inventory

106

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 107

Inventory Analysis: Inventory

Click to edit Master
Turnover title style
(slide 1 of 2)

• The inventory turnover is computed as

follows:

107

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 108

17-
Click to edit Master title style 2
Lincoln Company
2008 2007
a. Cost of goods sold $1,043,000
$ 820,000
Inventories:
Beginning of year $ 283,000
$ 311,000
End of year 264,000
283,000
Inventory turnover (a/b) 3.8 2.8
Total $ 547,000
$ 594,000
108
46
b. Average (Total/2) $ 273,500
$ 297,000
 109

Inventory Analysis:
Click
Number
to edit
of Master
Days’ Salestitle style
in
Inventory (slide 1 of 3)
• The number of days’ sales in inventory is
computed as follows:

109

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 110

Inventory Analysis:
Click
Number
to edit
of Master
Days’ Salestitle style
in
Inventory (slide 3 of 3)

• The number of days’ sales in inventory is a

rough estimate of the length of time it takes to
purchase, sell, and replace the inventory.

110

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 111

17-
Click to edit Master title style
Number of Days’ Sales in Inventory
2

Lincoln Company
2008 2007
a. Average (Total/2) $ 273,500 $ 297,000
Cost of goods sold $1,043,000 $ 820,000
b. Average daily cost of goods
sold (COGS/365 days) $2,858 $2,247

Number of days’ sales in

inventory (a/b) 95.7 132.2
111
47
 112

17-
2
Click to edit Master title style
Example Exercise 17-5

A company reports the following:

Cost of goods sold

Determine (a) the inventory turnover and

$560,000
(b) the number
Average of days’ sales in inventory.
inventory
Round to one decimal place.
112,000

48
112
 113

17-
2
Click to edit Master title style
Follow My Example 17-5
a. Inventory Turnover = Cost of Goods Sold/Average
Inventory
Inventory Turnover = $560,000/$112,000
Inventory Turnover = 5.0
b. Number of Days’ Sales in Inventory = Average Inventory/
Average Daily Cost of Goods Sold
Number of Days’ Sales in Inventory = $112,000/
($560,000/365)
Number of Days’ Sales in Inventory = $112,000/$1,534
Number of Days’ Sales in Inventory = 73.0 days
49
113
For Practice: PE 17-5A, PE 17-5B
 114

ClickAnalyzing
to edit Master
Solvency
title style
• Solvency analysis evaluates a company’s
ability to pay its long-term debts.

114

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 115

Click toSolvency
edit Master
Ratios
title style

115

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 116

17-
Click to edit Master title style
Ratio of Fixed Assets to Long-Term
Liabilities 2

The ratio of fixed assets to long-

term liabilities is a solvency measure
that indicates the margin of safety of
the noteholders or bondholders. It
also indicates the ability of the
business to borrow additional funds
on a long-term basis.

116
 117

Ratio of Fixed Assets to Long-

Click toTerm
edit Liabilities
Master title style
(slide 1 of 2)

The ratio of fixed assets to long-term liabilities

provides a measure of how much fixed assets a
company has to support its long-term debt.
• This measures a company’s ability to repay the
face amount of debt at maturity and is
computed as follows:
117

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 118

17-
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Lincoln Company
2008 2007
a. Fixed assets (net) $444,500 $470,000
b. Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities (a/b) 4.4 2.4

118
51
 119

Solvency Measures — The Long-Term Creditor

Click to edit Master title style
Ratio
Ratioof
ofFixed
FixedAssets
Assetsto
toLong-Term
Long-TermLiabilities
Liabilities
2003 2002
Fixed assets (net) $444,500 $470,000
Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities 4.4 2.4

Use:
Use: To
Toindicate
indicatethe
themargin
marginof ofsafety
safety
to
tolong-term
long-termcreditors.
creditors.

119
 120

17-
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Ratio of Liabilities to Stockholders’
Equity 2

The relationship between the

total claims of the creditors and
owners—the ratio of liabilities to
stockholders’ equity—is a
solvency measure that indicates
the margin of safety for creditors.

120
 121

Ratio of Liabilities to
ClickStockholders’
to edit MasterEquity
title style
(slide 1 of 2)

• The ratio of liabilities to stockholders’

equity measures how much of the company is
financed by debt and equity. It indicates the
margin of safety for creditors.
• The ratio of liabilities to stockholders’ equity
is computed as:
121

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 122

17-
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Lincoln Company
2008 2007
a. Total liabilities $310,000 $443,000
b. Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity (a/b) 0.4 0.6

122
53
 123

17-
2
Click to edit Master title style
Example Exercise 17-6
The following information was taken from Acme
Company’s balance sheet:
Fixed assets (net)

$1,400,000
Long-term liabilities
Determine the company’s (a) ratio of fixed assets to
400,000
long-term liabilities and (b) ratio of liabilities to
Total liabilities
stockholders’ equity.
54
123
560,000
Total stockholders’ equity
 124

17-
2
Click to edit Master title style
Follow My Example 17-6
a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets/
Long-
Term Liabilities
Ratio of Fixed Assets to Long-Term Liabilities = $1,400,000/
$400,000
Ratio of Fixed Assets to Long-Term Liabilities = 3.5
b. Ratio of Liabilities to Total Stockholders’ Equity = Total
Liabilities/Total
Stockholders’ Equity
Ratio of Liabilities to Total Stockholders’ Equity = $560,000/

$1,400,000 55
124
Ratio of Liabilities to Total Stockholders’ Equity = 0.4
For Practice: PE 17-6A, PE 17-6B
 125

17-
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Number of Times Interest Charges
Earned 2

Corporations in some industries

normally have high ratios of debt to
stockholders’ equity. For such
corporations, the relative risk of the
debtholders is normally measured as the
number of times interest charges are
earned (during the year), sometimes
called the fixed charge coverage ratio.
125
 Times Interest Earned
(slide 1 of 2)

• The times interest earned, sometimes

called the coverage ratio, measures the risk
that interest payments will not be made if
earnings decrease.
• The times interest earned is computed as
follows:

• The higher the ratio, the more likely interest

payments will be paid if earnings decrease.
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 127

17-
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Lincoln Company

2008 2007
Income before income tax $162,500
$134,600
a. Add interest expense 6,000
12,000
b. Amount
Number available
of times to meet
interest
interestearned
charges charges(b/a) $168,500
28.1 12.2
$146,600

127
57
 128

Solvency Measures — The Long-Term Creditor

Click to edit Master title style
Number
Numberof
ofTimes
TimesInterest
InterestCharges
ChargesEarned
Earned
2003 2002
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000
Number of times earned 4.0 4.2

Use:
Use: To
Toassess
assessthe
therisk
riskto
todebtholders
debtholdersin
interms
terms
of
ofnumber
numberof
oftimes
timesinterest
interestcharges
chargeswere
were
earned.
earned.
128
 129

17-
2
Click to edit Master title style
Example Exercise 17-7

A company reports the following:

Income before income tax

$250,000
Determine the number of times interest charges
Interest expense
are earned.

100,000

58
129
 130

17-
2
Click to edit Master title style
Follow My Example 17-7

Number of Times Interest Charges are Earned =

(Income Before Income Tax + Interest Expense)/
Interest Expense
Number of Times Interest Charges are Earned =
($250,000 + $100,000)/$100,000
Number of Times Interest Charges are Earned = 3.5

59
130
For Practice: PE 17-7A, PE 17-7B
 131

17-
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Objective
Objective 33
Apply financial
statement analysis to
assess the profitability
of a business.
131
 132

17-
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Profitability Analysis
3
 Profitability is the ability of an entity to earn
profits.
 This ability to earn profits depends on the
effectiveness and efficiency of operations as
well as resources available as reported in the
balance sheet.
 Profitability analysis focuses primarily on
the relationship between operating results
reported in the income statement and
resources reported in the balance sheet. 132
 Analyzing Profitability

• Profitability analysis evaluates the ability

of a company to generate future earnings.
o This ability depends on the relationship
between the company’s operating results and
the assets the company has available for use
in its operations.
 Thus, the relationship between income statement
and balance sheet items are used to evaluate
profitability.

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Profitability Ratios

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 135

17-
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Ratio of Net Sales to Assets
3

The ratio of net sales to assets

is a profitability measure that
shows how effectively a firm
utilizes its assets.

135
 136

17-
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Lincoln Company
2008 2007
a. Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
b. Average (Total/2) $1,048,750 $1,031,500

Excludes
Excludes long-term
long-term investments
investments
63
136
 137

Profitability Measures — The Common Stockholder

Click to edit Master title style
Ratio
Ratioof
ofNet
NetSales
Salesto
toAssets
Assets
2008 2007
Net sales on account $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average $1,048,750 $1,031,500
Ratio of net sales to assets 1.4 1.2

Use:
Use: To
Toassess
assessthe
theeffectiveness
effectiveness
of
ofthe
theuse
useof
ofassets.
assets.
137
 138

17-
3
Click to edit Master title style
Example Exercise 17-8
A company reports the following:
Net sales

$2,250,000
Determine the ratio of net sales to assets.
Average total sales
Follow My Example 17-8
Ratio of1,500,000
Net Sales to Total Assets = Net Sales/Average Total
Assets
Ratio of Net Sales to Total Assets = $2,250,000/$1,500,000
Ratio of Net Sales to Total Assets = 1.5

65
138
For Practice: PE 17-8A, PE 17-8B
 Asset Turnover
(slide 1 of 2)

• The asset turnover measures how

effectively a company uses its assets.
• The asset turnover is computed as follows:

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Asset Turnover
(slide 2 of 2)

• To illustrate, the asset turnover for Lincoln

Company is computed as follows:

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Asset Turnover

• A company reports the following:

• Determine the asset turnover ratio. Round

to one decimal place.

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 142

17-
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Rate Earned on Total Assets
3

The rate earned on total

assets measures the
profitability of total assets,
without considering how the
assets are financed.

142
 Return on Total Assets
(slide 1 of 3)

• The return on total assets measures the

profitability of total assets, without considering how
the assets are financed.
o In other words, this rate is not affected by the portion of
assets financed by creditors or stockholders.
• The return on total assets is computed as follows:

o By adding interest expense to net income, the effect of

whether the assets are financed by creditors (debt) or
stockholders (equity) is eliminated.
o Because net income includes any income earned from long-
term investments, the average total assets includes long-term
investments as well as the net operating assets.
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 Return on Total Assets
(slide 3 of 3)

• The return on operating assets is

sometimes computed when there are large
amounts of nonoperating income and
expense.
• The return on operating assets is
computed as follows:

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 145

17-
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Lincoln Company
2008 2007
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
a. Total $ 97,000 $ 88,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
b. Average (Total/2) $1,185,000 $1,209,000
Rate earned on total
assets (a/b) 8.2% 7.3% 145
67
 146
Profitability Measures — The Common Stockholder

Click to edit Master title style

Rate
RateEarned
Earnedon
onTotal
Total Assets
Assets
2008 2007
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
Total $ 97,000 $ 88,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
Average $1,185,000 $1,209,000
Rate earned on total assets 8.2% 7.3%

Use:
Use: To
Toassess
assessthe
theprofitability
profitabilityof
ofthe
theassets.
assets. 146
 147

17-
3
Click to edit Master title style
Example Exercise 17-9
A company reports the following income statement and
balance sheet information for the current year:
Net income

$ 125,000
Interest expense
Determine the rate earned on total assets.
25,000
Average total assets

2,000,000 68
147
 148

17-
3
Click to edit Master title style
Follow My Example 17-9

Rate Earned on Total Assets = (Net Income + Interest

Expense)/Average Total Assets
Rate Earned on Total Assets = ($125,000 +
$25,000)/$2,000,000
Rate Earned on Total Assets = 7.5%

69
148
For Practice: PE 17-9A, PE 17-9B
 149

17-
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Rate Earned on Stockholders’ Equity
3

The rate earned on

stockholders’ equity measure
emphasizes the rate of income
earned on the amount invested
by the stockholders.

149
 Return on Stockholders’ Equity
(slide 1 of 4)

• The return on stockholders’ equity

measures the rate of income earned on
the amount invested by the stockholders.
• The return on stockholders’ equity is
computed as follows:

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 151

17-
Click to edit Master title style 3
Lincoln Company
2008 2007
a. Net income $ 91,000 $ 76,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year 829,500 787,500
Total $1,617,000 $1,537,500
b. Average (Total/2) $ 808,500 $ 768,750
Rate earned on stockholders’
equity (a/b) 11.3% 10.0%

71
151
 152
Profitability Measures — The Common Stockholder

Click to edit Master title style

Rate
RateEarned
Earnedon
onStockholders’
Stockholders’ Equity
Equity
2003 2002
Net income $ 91,000 $ 76,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year 829,500 787,500
Total $1,617,000 $1,537,500
Average $ 808,500 $ 768,750
Rate earned on equity 11.3% 10.0%

Use:
Use: To
Toassess
assessthe
theprofitability
profitabilityof
ofthe
the
investment
investmentby
bystockholders.
stockholders. 152
 153

17-
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Leverage
3

The difference in the rate

earned on stockholders’ equity
and the rate earned on total
assets is called leverage.

153
 Return on Stockholders’ Equity
(slide 3 of 4)

• The return on stockholders’ equity is

normally higher than the return on total
assets.
o This is because of the effect of leverage.
 Leverage involves using debt to increase the return
on an investment.

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Return on Stockholders’ Equity
(slide 4 of 4)

• For Lincoln Company, the effect of

leverage for 20Y6 and 20Y5 is computed
as follows:

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 156

17-
Click to edit Master title style
Exhibit 8 Leverage
3
11.3%
10.0%
10% Leverage
8.2% Leverage
3.1%
7.3% 2.7%

5%

0% 2008 2007

Rate earned on Rate earned on

73
156
total assets stockholders’ equity
 157

17-
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Rate Earned on Common
Stockholders’ Equity 3

The rate earned on common

stockholders’ equity focuses
only on the rate of profits
earned on the amount invested
by the common stockholders.

157
 Return on Common Stockholders’ Equity
(slide 1 of 3)

• The return on common stockholders’

equity measures the rate of profits
earned on the amount invested by the
common stockholders.
• The return on common stockholders’
equity is computed as follows:

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 159

17-
Click to edit Master
Lincoln Companytitle style 3
2008 2007
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
a. Remainder—common stock $ 82,000 $ 67,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
b. Average (Total/2) $ 658,500 $ 618,750
Rate earned on common
stockholders’ equity (a/b) 12.5% 10.9%
159
75
 160

Return on Common
ClickStockholders’
to edit MasterEquity
title style
(slide 3 of 3)

• Lincoln’s return on common stockholders’

equity differs from the returns on total assets
and stockholders’ equity because of leverage.

160

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 161

17-
3
Click to edit Master title style
Example Exercise 17-10
A company reports the following:
Net income

$ 125,000
Preferred dividends

Determine5,000
(a) the rate earned on stockholders’ equity
and Average stockholders’
(b) the rate equity stockholders’
earned on common
equity.
1,000,000
Average common stockholders’ 76
161
equity
 162

17-
3
Click to edit Master title style
Follow My Example 17-10
a. Rate Earned on Stockholders’ Equity = Net Income/Average
Stockholders’
Equity
Rate Earned on Stockholders’ Equity = $125,000/$1,000,000
Rate Earned on Stockholders’ Equity = 12.5%
b. Rate Earned on Common Stockholders’ Equity = (Net
Income – Preferred Dividends)/Average Common
Stockholders’ Equity
Rate Earned on Common Stockholders’ Equity =
($125,000 – $5,000)/$800,000
Rate Earned on Common Stockholders’ Equity = 15%
77
162
For Practice: PE 17-10A, PE 17-10B
 163

17-
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Earnings per Share on Common Stock
3

One of the profitability

measures often quoted by the
financial press is earning per
share (EPS) on common stock.
It is also normally reported in
the income statement in
corporate annual reports.

163
 Earnings per Share on Common Stock
(slide 1 of 3)

• Earnings per share (EPS) on common

stock measures the share of profits that
are earned by a share of common stock.
• Earnings per share must be reported in the
income statement.
• EPS on common stock is computed as
follows:

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 165

17-
Click to edit Master title style 3
Lincoln Company
2008 2007
Net income $ 91,000
$ 76,500
Preferred dividends 9,000
9,000
a. Remainder—identified with
Earningscommon
per sharestock
on common $ 82,000
stock$(a/b)
67,500 $1.64 $1.35
b. Shares of common stock 50,000
50,000
79
165
 Earnings per Share on Common Stock
(slide 3 of 3)

• Many corporations have complex capital

structures with various types of equity
securities outstanding, such as convertible
preferred stock, stock options, and stock
warrants.
• In such cases, the possible effects of such
securities on the shares of common stock
outstanding are reported separately as
earnings per common share assuming
dilution or diluted earnings per share.

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 167

17-
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Price-Earnings Ratio
3

Another profitability measure

quoted by the financial press
is the price-earnings (P/E)
ratio on common stock. The
price-earnings ratio is an
indicator of a firm’s future
earnings prospects.
167
 Price-Earnings Ratio
(slide 1 of 2)

• The price-earnings (P/E) ratio on

common stock measures a company’s
future earnings prospects.
• The price-earnings ratio is computed as
follows:

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 169

17-
Click to edit Master title style 3

Lincoln Company
2008 2007
Market price per share of
common stock $41.00 $27.00
Earnings per share on common
stock ÷ 1.64 ÷ 1.35
Price-earnings ratio on
common stock 25 20

81
169
 170

Profitability Measures — The Common Stockholder

Click to edit Master title style

Price-Earnings
Price-EarningsRatio
Ratio
2003 2002
Market price per share of common $20.50 $13.50
Earnings per share on common $ 1.64 $ 1.35
Price-earnings ratio on common 12.5 10.0

Use:
Use: To
Toindicate
indicatefuture
futureearnings
earningsprospects,
prospects,
based
basedononthe
therelationship
relationshipbetween
between
market
marketvalue
valueof
ofcommon
commonstock
stockand
and
earnings.
earnings.

170
 171

17-
3
Click to edit
Example Exercise 17-11
Master title style
A company reports the following:
Net income
$250,000
Preferred dividends
$15,000
Shares of common stock

outstanding
a. Determine the company’s earnings per share on
20,000
common stock.
Market price
b. Determine theper share of price-earnings ratio.
company’s
common
Round to onestock
decimal place. 82
171
$35
 172

17-
3
Click to edit Master title style
Follow My Example 17-11

(a) Earnings Per Share of Common Stock = (Net

Income – Preferred
Dividends)/Shares of Common Stock
Outstanding
Earnings per Share of Common Stock =
($250,000 – $15,000)/20,000
Earnings per Share of Common Stock =
$11.75
83
172
(Continued)
 173

17-
3
Click to edit Master title style
Follow My Example 17-11

(b) Price-Earnings Ratio = Market Price per Share of

Common Stock/Earnings per Share on Common
Stock
Price-Earnings Ratio = $35.00/$11.75
Price-Earnings Ratio = 3.0

84
173
For Practice: PE 17-11A, PE 17-11B
 174

17-
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Dividends per Share
3

Dividends per share can be reported

with earnings per share to indicate the
relationship between dividends and
earnings. Comparing these two per
share amounts indicates the extent to
which the corporation is retaining its
earnings for use in operations.

174
 Dividends per Share
(slide 1 of 3)

• Dividends per share measures the

extent to which earnings are being
distributed to common shareholders.
• Dividends per share is computed as
follows:

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Dividends per Share
(slide 2 of 3)

• To illustrate, the dividends per share for

Lincoln Company are computed as follows:

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 177

17-
Click to edit Master title style
Exhibit 9: Dividends and Earning per
Share of Common Stock 3

Lincoln Company
$2.00
$1.64
Per $1.50 $1.35
share
$1.00 $0.80
$0.60
$0.50

$0.00 2008 2007

Dividends Earnings 86
177
 178

17-
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Dividend Yield
3

The dividend yield on common

stock is a profitability measure
that shows the rate of return to
common stockholders in terms
of cash dividends.

178
 Dividend Yield
(slide 1 of 2)

• The dividend yield on common stock

measures the rate of return to common
stockholders from cash dividends.
• It is of special interest to investors whose
objective is to earn revenue (dividends)
from their investment.
• The dividend yield is computed as follows:

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 180

17-
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Lincoln Company
2008 2007
Dividends per share of
common stock $ 0.80
$ 0.60
Market price per share of
common stock ÷41.00
Dividend yield on
÷27.00
common stock 2.0% 2.2%

88
180
 181

Profitability Measures — The Common Stockholder

Click to edit Master title style

Dividend
DividendYield
Yield
2003 2002
Dividends per share of common $ 0.80 $ 0.60
Market price per share of common $20.50 $13.50
Dividend yield on common stock 3.9% 4.4%

Use:
Use: To
Toindicate
indicatethe
therate
rateof
ofreturn
returnto
tocommon
common
stockholders
stockholdersininterms
termsofofdividends.
dividends.

181
 182

17-
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Objective
Objective 44
Describe the
contents of corporate
annual reports.

182
 183

Corporate Annual Reports

Click to edit Master title style
In addition to financial statements, the
annual report includes:
1. Financial Highlights
2. President’s Letter to the Stockholders
3. Management Report
4. Independent Auditors’ Report
5. Historical Summary

183
 184

17-
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Corporate Annual Reports
4

In addition to the financial statements and

the accompanying notes, corporate annual
reports usually include the following
sections:
 Management Discussion and Analysis
 Report on adequacy of internal control
 Report on fairness of financial statements

184
 185

17-
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Management Discussion and
Analysis 4

The Management Discussion and Analysis

(MD&A) includes an analysis of the results
of operations and discusses management’s
opinion about future performance. It
compares the prior year’s income statement
with the current year’s. It also contains an
analysis of the firm’s financial condition.

185
 186

17-
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Report on Adequacy of
Internal Control 4

Management is required by the Sarbanes-

Oxley Act of 2002 to provide a report stating
their responsibility for establishing and
maintaining internal control. In addition, the
report must state management’s conclusion
concerning the effectiveness of internal
controls over financial reporting.

186
 187

17-
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Report on Fairness of Financial
Statements 4

All publicly held corporations are

required to have an independent audit
(examination) of their financial
statements. The CPAs who conduct the
audit render an opinion on the fairness
of the statements.

187
 Appendix 1: Unusual Items Affecting the Current
Period’s Income Statement—Earnings per Share

• Earnings per common share should be

reported separately in the notes to the
financial statements for discontinued
operations.

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Income Statement with Earnings per Share

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Unusual Income Statement Items

Three types of unusual items are:

1. Results of discontinued operations.
2. Extraordinary items of gain or loss.
3. A change from one generally accepted
accounting principle to another.
These items and the related tax effects are
reported separately in the income statement.
 Appendix 1: Unusual Items
on the Income Statement

• Generally accepted accounting principles

require that unusual items be reported
separately on the income statement.
o This is because such items do not occur
frequently and are typically unrelated to
current operations.
• Unusual items on the income statement
are classified as one of the following:
o Affecting the current period income statement
o Affecting a prior period income statement

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Appendix 1: Unusual Items Affecting the
Current Period’s Income Statement

• Discontinued operations are an unusual

item that affect the current period’s:
o Income statement presentation
o Earnings per share presentation
• Discontinued operations are reported
separately on the income statement for
any period in which they occur.

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Appendix 1: Unusual Items Affecting the Current Period’s
Income Statement—Income Statement Presentation

• A company may discontinue a component of

its operations by selling or abandoning the
component’s operations.
o If the discontinued component is (1) the result of a
strategic shift and (2) has a major effect on the
entity’s operations and financial results, any gain
or loss on discontinued operations is reported on
the income statement as a Gain (or loss) from
discontinued operations.
o A note to the financial statements should describe
the operations sold, including the date operations
were discontinued, and details about the assets,
liabilities, income, and expenses of the
discontinued component.
©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unusual Items in the Income Statement

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Reporting Unusual Items on the 14-
Income Statement 2

Unusual items that may add or

subtract income from continuing
operations in determining net
income are:
Discontinued operations
Extraordinary items

195
Discontinued Operations 14-
2

A gain or loss from disposing

of a business segment or
component of an entity is
reported on the income
statement as a gain or loss
from discontinued operations.

196
 Reporting of Unusual Items 14-
on the Income Statement 2

Discontinued
operations

36

197
Unusual Items in the 14-
Income Statement 2

37

198
Reporting Unusual Items on the 14-
Income Statement 2

Unusual items that adjust income

from continuing operations in
determining net income are:
Discontinued operations
Extraordinary items

199
Extraordinary Items 14-
2

Extraordinary items result from

events and transactions that—
(1) are significantly different
(unusual) from the typical or
the normal operating activities
of the business, and
(2) occur infrequently.

200
 Reporting of Unusual Items 14-
Insert Exhibit
on the 2 here also,
Income Statement p. 13 2

Extraordinar
y items

40

201
Unusual Items in the 14-
Income Statement 2

41

202
 Appendix 1: Unusual Items Affecting the
Prior Period’s Income Statement

• An unusual item may occur that affects a

prior period’s income statement.
o Two such items are as follows:
 Errors in applying generally accepted accounting
principles
 Changes from one generally accepted accounting
principle to another

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Retroactive Restatement 14-
2
In addition to unusual items impacting the
income statement, there are two major items
that require a retroactive restatement of prior
period earnings. These two items are:
1. errors in the recognition, measurement,
presentation, or disclosure of financial
statements, and
2. changes from one generally accepted
accounting principle to another
generally accepted accounting principle.

204
 14-
3

Objective
Objective 33
Prepare an income
statement
reporting earnings
per share data.

205
Earnings per Common Share 14-
3

The profitability of companies is often

expressed as earnings per share.
Earnings per common share (EPS),
sometimes called basic earnings per
share, is the net income per share of
common stock outstanding during a
period.

206
Income Statement with 14-
Earnings per Share 3

47

207
 14-
3
Example Exercise 14-3
Manning Company had net income of $250,000 during
the year. There were 580,000 common shares
outstanding during the year. There were 2,000 shares of
$100 par value, 9% preferred stock outstanding during
the year. Determine the basic earnings per share.

Follow My Example 14-3

$250,000 – $18,000* $0.40 per
Earnings per share = share
= 580,000
*2,000 shares x $100 par value x 9% = $18,000
48
For Practice: PE 14-3A, PE 14-3B
208