List four basic financial statement analysis procedures, describe how you would calculate each procedure and discuss why you would use each procedure. In your initial response, please do not use citations to convey your understanding. Based on your reading, please communicate your own understanding of the requirements. Must be at least 100 words. Please have done by 3pm today not later than 5pm, also this need to be based off the reading attached. OWN WORDS

edm10890_ch13_586-635.indd Page 586 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 CHAPTER 13 Financial Statement Analysis LEARNING OBJECTIVES W I L S O N , After you have mastered the material in this chapter you will be able to: 1 2 3 4 5 6 7 8 Q Describe factors associated with communicating useful information. U Differentiate between horizontal and vertical analysis. A S Calculate ratios for assessing a company's liquidity. H Calculate ratios for assessing a company's solvency. E Calculate ratios for assessing company management's effectiveness. Explain ratio analysis. Calculate ratios for assessing a company's position in the stock market. 1 9 9 7 B U Explain the limitations of financial statement analysis. CHAPTER OPENING Expressing financial statement information in the form of ratios enhances its usefulness. Ratios permit comparisons over time and among companies, highlighting similarities, differences, and trends. Proficiency with common financial statement analysis techniques benefits both internal and external users. Before beginning detailed explanations of numerous ratios and percentages, however, we consider factors relevant to communicating useful information. 586 edm10890_ch13_586-635.indd Page 587 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 The Curious Accountant On September 7, 2009, Kraft Foods, Inc., announced that it had made an offer to the board of directors of Cadbury PLC to purchase their company for $16.7 billion in cash and stock. The CEO of Cadbury promptly rejected the W I things, Cadbury's CEO described Kraft as an \"unfocused L conglomerate,\" with \"unappealing categories,\" and havS ing \"a management that underperforms.\" He said that Kraft's offer greatly undervalued Cadbury. Meanwhile, the O CEO of Kraft said its offer for Cadbury was \"full and fair.\" Upon making its offer to Cadbury's board, Kraft also N stipulated that if the board did not accept the offer by January 20, 2010, Kraft would make its offer to buy the , offer, and a four month war of words began. Among other company's stock directly to Cadbury's shareholders. When a company makes a bid for one of its competitors, it often causes other companies to enter the bidding Q U did not materialize, although there were rumors that Hershey was preparing to make an offer of $18.8 billion. A On the morning of January 19, 2010, the last day before Kraft planned to take its offer directly to Cadbury's S shareholders, the two companies announced they had reached an agreement. Kraft would buy Cadbury for H $19.4 billion. E process. Analysts predicted that Hershey and Nestle would soon make their own offers for Cadbury. These offers If after four months of waiting for Cadbury to accept its offer no other company was willing to make a competing bid for Cadbury, why whould Kraft agree to buy it at a price that was 16 percent higher than its original offer? 1 (Answer on page 591.) 9 9 7 B U 587 edm10890_ch13_586-635.indd Page 588 588 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 FACTORS IN COMMUNICATING USEFUL INFORMATION LO 1 Describe factors associated with communicating useful information. The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the intended users, the types of decisions users make with financial statement information, and available means of analyzing the information. The Users Users of financial statement information include managers, creditors, stockholders, potential investors, and regulatory agencies. These individuals and organizations use financial statements for different purposes and bring varying levels of sophistication to understanding business activities. For example, investors range from private individuals who know little about financial statements to large investment brokers and institutional investors capable of using complex statistical analysis techniques. At what level of user knowledge should financial statements be aimed? Condensing and W reporting complex business transactions at a level easily understood by nonprofessional investors is increasingly difficult. Current reporting standards target users that I have a reasonably informed knowledge of business, though that level of sophisticaL tion is difficult to define. S The Types of Decisions O Just as the knowledge level of potential users varies, the information needs of users varies, N depending on the decision at hand. A supplier considering whether or not to sell goods on account to a particular company, wants to evaluate the likelihood of getting paid; a potential investor in that company wants to predict the likelihood of increases in the market value of the company's common stock. Financial statements, however, are designed for Q general purposes; they are not aimed at any specific user group. Some disclosed information, therefore, may be irrelevantU some users but vital to others. Users must employ difto ferent forms of analysis to identify information most relevant to a particular decision. A Financial statements can provide only highly summarized economic information. S The costs to a company of providing excessively detailed information would be prohibitive. In addition, too much detail leads to information overload, the problem of havH ing so much data that important information becomes obscured by trivial information. Users faced with reams of data E become so frustrated attempting to use it that they may lose the value of key information that is provided. 1 9 Because of the diversity of users, their different levels of knowledge, the varying infor9 mation needs for particular decisions, and the general nature of financial statements, a variety of analysis techniques has been developed. In the following sections, we explain 7 several common methods of analysis. The choice of method depends on which techB nique appears to provide the most relevant information in a given situation. U Information Analysis METHODS OF ANALYSIS LO 2 Differentiate between horizontal and vertical analysis. Financial statement analysis should focus primarily on isolating information useful for making a particular decision. The information required can take many forms but usually involves comparisons, such as comparing changes in the same item for the same company over a number of years, comparing key relationships within the same year, or comparing the operations of several different companies in the same industry. This chapter discusses three categories of analysis methods: horizontal, vertical, and ratio. Exhibits 13.1 and 13.2 present comparative financial statements for Milavec Company. We refer to these statements in the examples of analysis techniques. edm10890_ch13_586-635.indd Page 589 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis EXHIBIT 13.1 589 EXHIBIT 13.2 MILAVEC COMPANY MILAVEC COMPANY Income Statements and Statements of Retained Earnings For the Years Ending December 31 Balance Sheets As of December 31 2012 2012 Sales Cost of goods sold Beginning inventory Purchases Goods available for sale Ending inventory Cost of goods sold Gross margin Operating expenses Income before taxes Income taxes Net income Plus: Retained earnings, beginning balance Less: Dividends Retained earnings, ending balance 2011 $900,000 $800,000 43,000 637,000 680,000 70,000 610,000 290,000 248,000 42,000 17,000 25,000 40,000 483,000 523,000 43,000 480,000 320,000 280,000 40,000 18,000 22,000 137,000 0 130,000 15,000 $162,000 $137,000 W I L S O N , Assets Cash Marketable securities Notes receivable Accounts receivable Merchandise inventory Prepaid expenses Property, plant, and equipment (net) Total assets $ 20,000 20,000 4,000 50,000 70,000 4,000 $ 17,000 22,000 3,000 56,000 43,000 4,000 340,000 $508,000 310,000 $455,000 Liabilities and Stockholders' Equity Accounts payable $ 40,000 Salaries payable 2,000 Taxes payable 4,000 Bonds payable, 8% 100,000 Preferred stock, 6%, $100 par, cumulative 50,000 Common stock, $10 par 150,000 Retained earnings 162,000 Total liabilities and stockholders' equity $508,000 Q U A Horizontal Analysis Horizontal analysis, also called trend analysis, refers toS studying the behavior of individual financial statement items over several accounting periods. These periods may be H several quarters within the same fiscal year or they may be several different years. The E analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages. For example, a user may observe that revenue increased from one period to the next by $42 million (an absolute dollar amount) or that it increased by 1 a percentage such as 15 percent. 9 2011 Absolute Amounts The absolute amounts of particular financial statement 9 items have many uses. Various national economic statistics, such as gross domestic product and the amount spent to 7 replace productive capacity, are derived by combining absolute amounts reported by B businesses. Financial statement users with expertise in particular industries might evalU uate amounts reported for research and development costs to judge whether a company is spending excessively or conservatively. Users are particularly concerned with how amounts change over time. For example, a user might compare a pharmaceutical company's revenue before and after the patent expired on one of its drugs. Comparing only absolute amounts has drawbacks, however, because materiality levels differ from company to company or even from year to year for a given company. The materiality of information refers to its relative importance. An item is considered material if knowledge of it would influence the decision of a reasonably informed user. Generally accepted accounting principles permit companies to account for immaterial items in the most convenient way, regardless of technical accounting rules. For example, companies may expense, rather than capitalize and depreciate, relatively inexpensive long-term assets like pencil sharpeners or waste baskets even if the assets have useful $ 38,000 3,000 2,000 100,000 50,000 125,000 137,000 $455,000 edm10890_ch13_586-635.indd Page 590 8/3/10 11:27 AM user-f497 590 /Volumes/203/MHSF225/foe94488_disk1of1/0777394488/foe94488_pagefiles Chapter 13 lives of many years. The concept of materiality, which has both quantitative and qualitative aspects, underlies all accounting principles. It is difficult to judge the materiality of an absolute financial statement amount without considering the size of the company reporting it. For reporting purposes, Exxon Corporation's financial statements are rounded to the nearest million dollars. For Exxon, a $400,000 increase in sales is not material. For a small company, however, $400,000 could represent total sales, a highly material amount. Meaningful comparisons between the two companies' operating performance are impossible using only absolute amounts. Users can surmount these difficulties with percentage analysis. Percentage Analysis Percentage analysis involves computing the percentage relationship between two amounts. In horizontal percentage analysis, a financial statement item is expressed as a percentage of the previous balance for the EXHIBIT 13.3 same item. Percentage analysis sidesteps the MILAVEC COMPANY materiality problems of comparing different W size companies by measuring changes in perComparative Income Statements centages rather than absolute amounts. Each I For the Years Ending December 31 change is converted to a percentage of the L Percentage base year. Exhibit 13.3 presents a condensed 2012 2011 Difference version of Milavec's income statement with S horizontal percentages for each item. Sales $900,000 $800,000 112.5%* O The percentage changes disclose that, Cost of goods sold 610,000 480,000 127.1 even though Milavec's net income increased N Gross margin 290,000 320,000 29.4 slightly more than sales, products may be Operating expenses 248,000 280,000 211.4 , underpriced. Cost of goods sold increased Income before taxes 42,000 40,000 15.0 much more than sales, resulting in a lower Income taxes 17,000 18,000 25.6 gross margin. Users would also want to Net income $ 25,000 $ 22,000 113.6 Q investigate why operating expenses decreased *($900,000 2 $800,000) 4 $800,000; all changes expressed as percentages of previous U substantially despite the increase in sales. totals. Whether basing their analyses on absoA lute amounts, percentages, or ratios, users S must avoid drawing overly simplistic conclusions about the reasons for the results. Numerical relationships flag conditions requiring further study. Recall that a change H that appears favorable on the surface may not necessarily be a good sign. Users must evaluate the underlying reasonsE the change. for 1 CHECK YOURSELF 13.1 9 9 The following information was drawn from the annual reports of two retail companies (amounts are shown in millions). One company is an upscale department store; the other is 7 a discount store. Based on this limited information, identify which company is the upscale B department store. U Jenkins Co. Sales Cost of goods sold Gross margin Horn's, Inc. $325 130 $195 $680 408 $272 Jenkins' gross margin represents 60 percent ($195 4 $325) of sales. Horn's gross margin represents 40 percent ($272 4 $680) of sales. Since an upscale department store would have higher margins than a discount store, the data suggest that Jenkins is the upscale department store. Answer edm10890_ch13_586-635.indd Page 591 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis 591 Obviously Kraft agreed to acquire Cadbury because it believed it could Answers to The Curious Accountant make a profit on the investment. Two major reasons were discussed as to why Kraft would want Cadbury. First, Cadbury was a bigger player than Kraft in important markets outside of the United States. Owning Cadbury would make it easier for Kraft to expand globally, especially in several rapidly developing markets, including Egypt, India, Mexico, and Thailand. Second, in 2008, Mars, Inc. had acquired the giant chewing gum company, Wm. Wrigley Jr. Company, making it a much larger confectionary company. By purchasing Cadbury, Kraft felt it could better compete with Mars. Kraft's optimism about its purchase of Cadbury does not guarantee that the investment will be successful. In W I that, a few years later, it sold at losses. How do companies decide what another company is worth, and how can L such successful companies as Hershey, Nestl, Kraft, and Cadbury have such different opinions about the value S of an investment? Valuing a potential investment is the result of extensive financial analysis, as discussed in this O chapter, and capital budgeting techniques, discussed in Chapter 10. As you have seen in these chapters, such N decision making is based on estimates about future events. Predicting the future is imperfect, no matter how well , the late 1980s and early 1990s Hershey's purchased several Dutch, German, and Italian confectionary companies trained the forecaster might be. Does this mean that financial analysis is useless? No. Consider someone planning to drive across the United Q U GPS, even though they know neither device is perfect. Similarly, just as five different financial analysts may reach A five different amounts they think a company is worth; five individuals planning a trip from Key West, Florida, to S Anchorage Alaska, could look at the same map and decide on five different ways to get there. Only after the trips H have been completed can we say which person made the best decision. E States. Would they prefer to take the trip with a map or without? Obviously they would prefer to have a map or Sources: \"Cadbury Sour on Kraft Bid,\" The Wall Street Journal, September 8, 2009, pp. A-1 and A-17, \"Nestl's Undercooked Deal Making,\" The Wall Street Journal, January 9 & 10, 2010, pp. B-10, \"Kraft Near Deal for Cadbury,\" The Wall Street Journal, January 19, 2010, pp. A-1 and A-6, \"Kraft Wins a Reluctant Cadbury with Help of Clock, Hedge Funds,\" The Wall Street Journal, January 20, 2010, pp. B-1 and B-6, and \"Hershey, On Its Own, Has Limited Options,\" The Wall Street Journal, January 20, 2010, p. B-6. 1 9 9 When comparing more than two periods, analysts use7 either of two basic approaches: (1) choosing one base year from which to calculate all increases or decreases or (2) calculatB ing each period's percentage change from the preceding figure. For example, assume Milavec's sales for 2009 and 2010 were $600,000 and $750,000, respectively. U 2012 Sales Increase over 2009 sales Increase over preceding year 2011 2010 2009 $900,000 50.0% 12.5% $800,000 33.3% 6.7% $750,000 25.0% 25.0% $600,000 Analysis discloses that Milavec's 2012 sales represented a 50 percent increase over 2009 sales, and a large increase (25 percent) occurred in 2010. From 2010 to 2011, sales increased only 6.7 percent but in the following year increased much more (12.5 percent). edm10890_ch13_586-635.indd Page 592 592 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 Vertical Analysis Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. Horizontal analysis compares items over many time periods; vertical analysis compares many items within the same time period. Vertical Analysis of the Income Statement Vertical analysis of an income statement (also called a common size income statement) involves converting each income statement component to a percentage of sales. Although vertical analysis suggests examining only one period, it is useful to compare common size income statements for several years. Exhibit 13.4 presents Milavec's income statements, along with vertical percentages, for 2012 and 2011. This analysis discloses that cost of goods sold increased significantly as a percentage of sales. Operating expenses and income taxes, however, decreased in relation to sales. Each of these observations indicates a need for more analysis regarding possible trends for future profits. W I EXHIBIT 13.4 L MILAVEC COMPANY S Vertical Analysis of Comparative Income Statements O 2011 N 2012 Percentage* Percentage* , Amount of Sales Amount of Sales Sales Cost of goods sold Gross margin Operating expenses Income before taxes Income taxes Net income $900,000 Q 610,000 290,000 U 248,000 A 42,000 17,000 S $ 25,000 H E 100.0% 67.8 32.2 27.6 4.7 1.9 2.8% $800,000 480,000 320,000 280,000 40,000 18,000 $ 22,000 100.0% 60.0 40.0 35.0 5.0 2.3 2.8% *Percentages may not add exactly due to rounding. Vertical Analysis of the Balance Sheet 1 Vertical analysis of the balance sheet involves converting each balance sheet compo9 nent to a percentage of total assets. The vertical analysis of Milavec's balance sheets in Exhibit 13.5 discloses few large percentage changes from the preceding year. Even 9 small individual percentage changes, however, may represent substantial dollar 7 increases. For example, inventory constituted 9.5% of total assets in 2011 and 13.8% B in 2012. While this appears to be a small increase, it actually represents a 62.8% increase in the inventory account balance [($70,000 2 $43,000) 4 $43,000] from U 2011 to 2012. Careful analysis requires considering changes in both percentages and absolute amounts. RATIO ANALYSIS LO 3 Explain ratio analysis. Ratio analysis involves studying various relationships between different items reported in a set of financial statements. For example, net earnings (net income) reported on the income statement may be compared to total assets reported on the balance sheet. Analysts calculate many different ratios for a wide variety of purposes. The remainder of this chapter is devoted to discussing some of the more commonly used ratios. edm10890_ch13_586-635.indd Page 593 8/3/10 11:27 AM user-f497 /Volumes/203/MHSF225/foe94488_disk1of1/0777394488/foe94488_pagefiles Financial Statement Analysis EXHIBIT 13.5 MILAVEC COMPANY Vertical Analysis of Comparative Balance Sheets 2012 Assets Cash Marketable securities Notes receivable Accounts receivable Merchandise inventory Prepaid expenses Total current assets Property, plant, and equipment Total assets Percentage* of Total 2011 Percentage* of Total $ 20,000 20,000 4,000 50,000 70,000 4,000 168,000 340,000 $508,000 3.9% 3.9 0.8 9.8 13.8 0.8 33.1 66.9 100.0% $ 17,000 22,000 3,000 56,000 43,000 4,000 145,000 310,000 $455,000 3.7% 4.8 0.7 12.3 9.5 0.9 31.9 68.1 100.0% $ 38,000 3,000 2,000 43,000 100,000 143,000 50,000 125,000 137,000 312,000 8.4% 0.7 0.4 9.5 22.0 31.4 11.0 27.5 30.1 68.6 $455,000 100.0% Liabilities and Stockholders' Equity Accounts payable $ 40,000 Salaries payable 2,000 Taxes payable 4,000 Total current liabilities 46,000 Bonds payable, 8% 100,000 Total liabilities 146,000 Preferred stock 6%, $100 par 50,000 Common stock, $10 par 150,000 Retained earnings 162,000 Total stockholders' equity 362,000 Total liabilities and stockholders' equity $508,000 *Percentages may not add exactly due to rounding. 7.9% 0.4 0.8 9.1 19.7 28.7 9.8 29.5 31.9 71.3 100.0% W I L S O N , Q U A S H E Objectives of Ratio Analysis As suggested earlier, various users approach financial statement analysis with many 1 different objectives. Creditors are interested in whether a company will be able to 9 repay its debts on time. Both creditors and stockholders are concerned with how the company is financed, whether through debt, equity, or earnings. Stockholders 9 and potential investors analyze past earnings performance and dividend policy for 7 clues to the future value of their investments. In addition to using internally generated data to analyze operations, company managers find much information prepared B for external purposes useful for examining past operations and planning future U policies. Although many of these objectives are interrelated, it is convenient to group ratios into categories such as measures of debt-paying ability and measures of profitability. MEASURES OF DEBT-PAYING ABILITY Liquidity Ratios Liquidity ratios indicate a company's ability to pay short-term debts. They focus on current assets and current liabilities. The examples in the following section use the financial statement information reported by Milavec Company. LO 4 Calculate ratios for assessing a company's liquidity. 593 edm10890_ch13_586-635.indd Page 594 594 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 Working Capital Working capital is current assets minus current liabilities. Current assets include assets most likely to be converted into cash in the current operating period. Current liabilities represent debts that must be satisfied in the current period. Working capital therefore measures the excess funds the company will have available for operations, excluding any new funds it generates during the year. Think of working capital as the cushion against short-term debt-paying problems. Working capital at the end of 2012 and 2011 for Milavec Company was as follows. 2012 Current assets 2 Current liabilities Working capital 2011 $168,000 46,000 $122,000 $145,000 43,000 $102,000 W Milavec's working capital increased from 2011 to 2012, but the numbers themselves I say little. Whether $122,000 is sufficient or not depends on such factors as the industry L in which Milavec operates, its size, and the maturity dates of its current obligations. We can see, however, that the increase in working capital is primarily due to the increase in S inventories. O Current Ratio N Working capital is an absolute , amount. Its usefulness is limited by the materiality dif- ficulties discussed earlier. It is hard to draw meaningful conclusions from comparing Milavec's working capital of $122,000 with another company that also has working capital of $122,000. By expressing the relationship between current assets and current Q liabilities as a ratio, however, we have a more useful measure of the company's debtpaying ability relative to otherU companies. The current ratio, also called the working capital ratio, is calculated as follows. A Current assets S Current liabilities H To illustrate using the current ratio for comparisons, consider Milavec's current posiE Current ratio 5 tion relative to Laroque's, a larger firm with current assets of $500,000 and current liabilities of $378,000. 1 9 9 Current assets (a) 2 Current liabilities (b) 7 Working capital B Current ratio (a 4 b) U Milavec Laroque $168,000 46,000 $122,000 3.65:1 $500,000 378,000 $122,000 1.32:1 The current ratio is expressed as the number of dollars of current assets for each dollar of current liabilities. In the above example, both companies have the same amount of working capital. Milavec, however, appears to have a much stronger working capital position. Any conclusions from this analysis must take into account the circumstances of the particular companies; there is no single ideal current ratio that suits all companies. In recent years the average current ratio of the nonfinancial companies that constitute the Dow Jones Industrial Average was around 1.29:1. The individual company ratios, however, ranged from .33:1 to 3.24:1. A current ratio can be too high. Money invested in factories and developing new products is usually more profitable than money held as large cash balances or invested in inventory. edm10890_ch13_586-635.indd Page 595 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis Quick Ratio The quick ratio, also known as the acid-test ratio, is a conservative variation of the current ratio. The quick ratio measures a company's immediate debt-paying ability. Only cash, receivables, and current marketable securities (quick assets) are included in the numerator. Less liquid current assets, such as inventories and prepaid expenses, are omitted. Inventories may take several months to sell; prepaid expenses reduce otherwise necessary expenditures but do not lead eventually to cash receipts. The quick ratio is computed as follows. Quick assets Quick ratio 5 Current liabilities Milavec Company's current ratios and quick ratios for 2012 and 2011 follow. 2012 2011 145,000 W 4 43,000 3.37:1 I 98,000 4 43,000 Quick ratio L 2.28:1 S The decrease in the quick ratio from 2011 to 2012 reflects both a decrease in quick O assets and an increase in current liabilities. The result indicates that the company is less N liquid (has less ability to pay its short-term debt) in 2012 than it was in 2011. , Current ratio 168,000 4 46,000 3.65:1 94,000 4 46,000 2.04:1 Accounts Receivable Ratios Offering customers credit plays an enormous role in generating revenue, but it also Q increases expenses and delays cash receipts. To minimize bad debts expense and collect cash for use in current operations, companies want to collect receivables as quickly as U possible without losing customers. Two relationships are often examined to assess a A company's collection record: accounts receivable turnover and average days to collect receivables (average collection period). S Accounts receivable turnover is calculated as follows. H Net credit sales E Accounts receivable turnover 5 Average accounts receivable Net credit sales refers to total sales on account less sales discounts and returns. 1 When most sales are credit sales or when a breakdown of total sales between cash 9 sales and credit sales is not available, the analyst must use total sales in the numerator. The denominator is based on net accounts receivable9 (receivables after subtracting the allowance for doubtful accounts). Since the numerator represents a whole 7 period, it is preferable to use average receivables in the denominator if possible. When comparative statements are available, the average can be based on the beginning B and ending balances. Milavec Company's accounts receivable turnover is computed as U follows. 2012 Net sales (assume all on account) (a) Beginning receivables (b) Ending receivables (c) Average receivables (d) 5 (b 1 c) 4 2 Accounts receivable turnover (a 4 d) 2011 $900,000 $ 56,000 50,000 $ 53,000 16.98 $800,000 $ 55,000* 56,000 $ 55,500 14.41 *The beginning receivables balance was drawn from the 2010 financial statements, which are not included in the illustration. 595 edm10890_ch13_586-635.indd Page 596 596 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 The 2012 accounts receivable turnover of 16.98 indicates Milavec collected its average receivables almost 17 times that year. The higher the turnover, the faster the collections. A company can have cash flow problems and lose substantial purchasing power if resources are tied up in receivables for long periods. Average days to collect receivables is calculated as follows. Average days to collect receivables 5 365 days Accounts receivable turnover This ratio offers another way to look at turnover by showing the number of days, on average, it takes to collect a receivable. If receivables were collected 16.98 times in 2012, the average collection period was 21 days, 365 4 16.98 (the number of days in the year divided by accounts receivable turnover). For 2011, it took an average of 25 days (365 4 14.41) to collect a receivable. Although the collection period improved, no other conclusions can be reached without considering the industry, Milavec's past performance, and the general economic environment. In recent years the average time to collect accounts receivable for the 26 nonfinancial companies thatW make up the Dow Jones Industrial Average was around 39 days. (Financial firms are excluded because, by the nature of their business, they I have very long collection periods.) L S Inventory Ratios A fine line exists between having too much and too little inventory in stock. Too little O inventory can result in lost sales and costly production delays. Too much inventory can N use needed space, increase financing and insurance costs, and become obsolete. To help analyze how efficiently a company manages inventory, we use two ratios similar to those , used in analyzing accounts receivable. Inventory turnover indicates the number of times, on average, that inventory is Q totally replaced during the year. The relationship is computed as follows. U Cost of goods sold Average inventory A The average inventory is usually based on the beginning and ending balances that S are shown in the financial statements. Inventory turnover for Milavec was as follows. H E Inventory turnover 5 2012 Cost of goods sold (a) 1 Beginning inventory (b) Ending inventory (c) 9 Average inventory (d) 5 (b 1 c) 4 2 9 Inventory turnover (a 4 d) 7 B U 2011 $610,000 $ 43,000 70,000 $ 56,500 10.80 $480,000 $ 40,000* 43,000 $ 41,500 11.57 *The beginning inventory balance was drawn from the company's 2010 financial statements, which are not included in the illustration. Generally, a higher turnover indicates that merchandise is being handled more efficiently. Trying to compare firms in different industries, however, can be misleading. Inventory turnover for grocery stores and many retail outlets is high. Because of the nature of the goods being sold, inventory turnover is much lower for appliance and jewelry stores. We look at this issue in more detail when we discuss return on investment. Average days to sell inventory is determined by dividing the number of days in the year by the inventory turnover as follows. Average days to sell inventory 5 365 days inventory turnover edm10890_ch13_586-635.indd Page 597 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis The result approximates the number of days the firm could sell inventory without purchasing more. For Milavec, this figure was 34 days in 2012 (365 10.80) and 32 days in 2011 (365 4 11.57). In recent years it took around 70 days, on average, for the companies in the Dow Jones Industrial Average that have inventory to sell their inventory. The time it took individual companies to sell their inventory varied by industry, ranging from 7 days to 198 days. Solvency Ratios Solvency ratios are used to analyze a company's long-term debt-paying ability and its financing structure. Creditors are concerned with a company's ability to satisfy outstanding obligations. The larger a company's liability percentage, the greater the risk that the company could fall behind or default on debt payments. Stockholders, too, are concerned about a company's solvency. If a company is unable to pay its debts, the owners could lose their investment. Each user group desires that company financing choices minimize its investment risk, whether the investment is in debt or stockholders' equity. W Debt Ratios I The following ratios represent two different ways to express the same relationship. Both are frequently used. L Debt to assets ratio. This ratio measures the percentage of a company's assets that are S financed by debt. O Debt to equity ratio. As used in this ratio, equity means stockholders' equity. The debt N to equity ratio compares creditor financing to owner financing. It is expressed as the dollar amount of liabilities for each dollar of stockholders' equity. , These ratios are calculated as follows. Q U Total liabilities A Debt to equity 5 Total stockholders' equity S Applying these formulas to Milavec Company's results produces the following. H E 2012 2011 Debt to assets 5 Total liabilities Total assets Total liabilities (a) Total stockholders' equity (b) Total equities (liabilities 1 stockholders' equity) (c) Debt to assets (a 4 c) Debt to equity ratio (a 4 b) $146,000 $143,000 312,000 1 362,000 $508,000 $455,000 9 29% 31% 0.46:1 9 0.40:1 7 Each year less than one-third of the company's assets were financed with debt. The B amount of liabilities per dollar of stockholders' equity declined by 0.06. It is difficult to judge whether the reduced percentage of liabilities is favorable. In general, a lower level U of liabilities provides greater security because the likelihood of bankruptcy is reduced. Perhaps, however, the company is financially strong enough to incur more liabilities and benefit from financial leverage. The 26 nonfinancial companies that make up the Dow Jones Industrial Average report around 38 percent of their assets, on average, are financed through borrowing. The debt to asset ratios of these companies ranged from 5 percent to 85 percent. Number of Times Interest Is Earned This ratio measures the burden a company's interest payments represent. Users often consider times interest is earned along with the debt ratios when evaluating financial risk. The numerator of this ratio uses earnings before interest and taxes (EBIT), rather LO 5 Calculate ratios for assessing a company's solvency. 597 edm10890_ch13_586-635.indd Page 598 598 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 than net earnings, because the amount of earnings before interest and income taxes is available for paying interest. Number of times Earnings before interest and taxes expense 5 interest is earned Interest expense Dividing EBIT by interest expense indicates how many times the company could have made its interest payments. Obviously, interest is paid only once, but the more times it could be paid, the bigger the company's safety net. Although interest is paid from cash, not accrual earnings, it is standard practice to base this ratio on accrualbased EBIT, not a cash-based amount. For Milavec, this calculation is as follows. 2012 $42,000 8,000 $50,000 6.25 times Income before taxes Interest expense (b) Income before taxes and interest (a) W Times interest earned (a 4 b) 2011 $40,000 8,000* $48,000 6 times I L Any expense or dividend payment can be analyzed this way. Another frequently S used calculation is the number of times the preferred dividend is earned. In that case, O the numerator is net income (after taxes) and the denominator is the amount of the annual preferred dividend. N , *Interest on bonds: $100,000 3 .08 5 $8,000. CHECK YOURSELF 13.2 Q Selected data for Riverside Corporation and Academy Company follow (amounts are shown U in millions). A S Total liabilities (a) H Stockholders' equity (b) E Total liabilities 1 stockholders' equity (c) Interest expense (d) Income before taxes (e) 1 Income before taxes and interest (f) Riverside Corporation Academy Company $650 300 $950 $ 65 140 $205 $450 400 $850 $ 45 130 $175 9 Based on this information alone,9 which company would likely obtain the less favorable interest rate on additional debt financing? 7 Answer Interest rates vary with risk levels. Companies with less solvency (long-term debtB paying ability) generally must pay higher interest rates to obtain financing. Two solvency U measures for the two companies follow. Recall: Total assets 5 Liabilities 1 Stockholders' equity Riverside Corporation Debt to assets ratio (a 4 c) Times interest earned (f 4 d) Academy Company 68.4% 3.15 times 52.9% 3.89 times Since Riverside has a higher percentage of debt and a lower times interest earned ratio, the data suggest that Riverside is less solvent than Academy. Riverside would therefore likely have to pay a higher interest rate to obtain additional financing. edm10890_ch13_586-635.indd Page 599 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis Plant Assets to Long-Term Liabilities Companies often pledge plant assets as collateral for long-term liabilities. Financial statement users may analyze a firm's ability to obtain long-term financing on the strength of its asset base. Effective financial management principles dictate that asset purchases should be financed over a time span about equal to the expected lives of the assets. Short-term assets should be financed with short-term liabilities; the current ratio, introduced earlier, indicates how well a company manages current debt. Long-lived assets should be financed with long-term liabilities, and the plant assets to long-term liabilities ratio suggests how well long-term debt is managed. It is calculated as follows. Plant assets to long-term liabilities 5 Net plant assets Long-term liabilities For Milavec Company, these ratios follow. 2012 2011 W Net plant assets (a) $340,000 $310,000 I Bonds payable (b) 100,000 100,000 Plant assets to long-term liabilities (a 4 b) 3.4:1 3.1:1 L S O MEASURES OF PROFITABILITY N Profitability refers to a company's ability to generate earnings. Both management and , external users employ profitability ratios to assess a company's success in generating profits and how these profits are used to reward investors. Some of the many ratios available to measure different aspects of profitability are discussed in the following two Q sections. U A Measures of Managerial Effectiveness S The most common ratios used to evaluate managerial effectiveness measure what percentage of sales results in earnings and how productive assets are in generating H those sales. As mentioned earlier, the absolute amount of sales or earnings means E little without also considering company size. Net Margin (or Return on Sales) 1 Gross margin and gross profit are alternate terms for the amount remaining after subtracting the expense cost of goods sold from sales.9 margin, sometimes called Net operating margin, profit margin, or the return on sales ratio, describes the percent 9 remaining of each sales dollar after subtracting other expenses as well as cost of 7 goods sold. Net margin can be calculated in several ways; some of the more common methods only subtract normal operating expenses or all expenses other than income B tax expense. For simplicity, our calculation uses net income (we subtract all expenses). Net income divided by net sales expresses net incomeU (earnings) as a percentage of sales, as follows. Net margin 5 Net income Net sales For Milavec Company, the net margins for 2012 and 2011 were as follows. 2012 Net income (a) Net sales (b) Net margin (a 4 b) 2011 $ 25,000 900,000 2.78% $ 22,000 800,000 2.75% LO 6 Calculate ratios for assessing company management's effectiveness. 599 edm10890_ch13_586-635.indd Page 600 600 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 Milavec has maintained approximately the same net margin. Obviously, the larger the percentage, the better; a meaningful interpretation, however, requires analyzing the company's history and comparing the net margin to other companies in the same industry. The average net margin for the 26 nonfinancial companies that make up the Dow Jones Industrial Average has been around 12 percent in recent years; some companies, such as Merck & Co. with 33 percent, have been much higher than the average. Of course, if a company has a net loss, its net margin for that year will be negative. Asset Turnover Ratio The asset turnover ratio (sometimes called turnover of assets ratio) measures how many sales dollars were generated for each dollar of assets invested. As with many ratios used in financial statement analysis, users may define the numerator and denominator of this ratio in different ways. For example, they may use total assets or only include operating W assets. Since the numerator represents a whole period, it is preferable to use average assets in the denominator if possible, especially if the amount of assets changed I significantly during the year. We use average total assets in our illustration. L Net sales Asset turnover 5 S Average total assets O For Milavec, the asset turnover ratios were as follows. N , 2012 Net sales (a) Q Beginning assets (b) Ending assets (c) U Average assets (d) 5 (b 1 c) 4 2 A Asset turnover (a 4 d) $900,000 $455,000 508,000 $481,500 1.87 2011 $800,000 $420,000* 455,000 $437,500 1.83 S H E *The beginning asset balance was drawn from the 2010 financial statements, which are not included in the illustration. As with most ratios, the implications of a given asset turnover ratio are affected by other considerations. Asset turnover will be high in an industry that requires only minimal investment to operate, such as real estate sales companies. On the other 1 hand, industries that require large investments in plant and machinery, like the auto 9 industry, are likely to have lower asset turnover ratios. The asset turnover ratios of the nonfinancial companies that make up the Dow Jones Industrial Average have aver9 aged around 0.91 in recent years. This means that annual sales have averaged 91 percent 7 of their assets. B U Return on Investment Return on investment (ROI), also called return on assets or earning power, is the ratio of wealth generated (net income) to the amount invested (average total assets) to generate the wealth. ROI can be calculated as follows.1 ROI 5 1 Net income Average total assets Detailed coverage of the return on investment ratio is provided in Chapter 9. As discussed in that chapter, companies frequently manipulate the formula to improve managerial motivation and performance. For example, instead of using net income, companies frequently use operating income because net income may be affected by items that are not controllable by management such as loss on a plant closing, storm damage, and so on. edm10890_ch13_586-635.indd Page 601 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis For Milavec, ROI was as follows. 2012 $25,000 4 $481,500* 5 5.19% 2011 $22,000 4 $437,500* 5 5.03% *The computation of average assets is shown above. In general, higher ROIs suggest better performance. The ROI of the large nonfinancial companies that make up the Dow Jones Industrial Average had averaged around 9 percent in recent years. These data suggest that Milavec is performing below average, and therefore signals a need for further evaluation that would lead to improved performance. Return on Equity W Return on equity (ROE) is often used to measure the profitability of the stockholders' I investment. ROE is usually higher than ROI because of financial leverage. Financial leverage refers to using debt financing to increase theL assets available to a business beyond the amount of assets financed by owners. As long as a company's ROI exceeds S its cost of borrowing (interest expense), the owners will earn a higher return on their O investment in the company by using borrowed money. For example, if a company borrows money at 8 percent and invests it at 10 percent, the owners will enjoy a return N that is higher than 10 percent. ROE is computed as follows. , ROE 5 Net income Average total stockholders' equity Q If the amount of stockholders' equity changes significantly during the year, it is desirable to use average equity rather than year-end equity in the denominator. The U ROE figures for Milavec Company were as follows. Net income (a) Preferred stock, 6%, $100 par, cumulative Common stock, $10 par Retained earnings Total stockholders' equity (b) ROE (a 4 b) A 2012 S $H 25,000 50,000 E 150,000 162,000 $362,000 1 6.9% 2011 $ 22,000 50,000 125,000 137,000 $312,000 7.1% 9 The slight decrease in ROE is due primarily to the increase in common stock. 9 The effect of the increase in total stockholders' equity offsets the effect of the increase 7 in earnings. This information does not disclose whether Milavec had the use of the additional stockholder investment for all or part of theB year. If the data are available, calculating a weighted average amount of stockholders' equity provides more meaningU ful results. We mentioned earlier the companies that make up the Dow Jones Industrial Average had an average ROI of 9 percent. The average ROE for the companies in the Dow was 26 percent, indicating effective use of financial leverage. Stock Market Ratios Existing and potential investors in a company's stock use many common ratios to analyze and compare the earnings and dividends of different size companies in different industries. Purchasers of stock can profit in two ways: through receiving dividends and through increases in stock value. Investors consider both dividends and overall earnings performance as indicators of the value of the stock they own. LO 7 Calculate ratios for assessing a company's position in the stock market. 601 edm10890_ch13_586-635.indd Page 602 602 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 Earnings per Share Perhaps the most frequently quoted measure of earnings performance is earnings per share (EPS). EPS calculations are among the most complex in accounting, and more advanced textbooks devote entire chapters to the subject. At this level, we use the following basic formula. Earnings per share 5 Net earnings available for common stock Average number of outstanding common shares EPS pertains to shares of common stock. Limiting the numerator to earnings available for common stock eliminates the annual preferred dividend (0.06 3 $50,000 5 $3,000) from the calculation. Exhibit 13.1 shows that Milavec did not pay the preferred dividends in 2012. Since the preferred stock is cumulative, however, the preferred dividend is in arrears and not available to the common stockholders. The number of common shares outstanding is determined by dividing the book value of the common stock by its par value per share ($150,000 4 $10 5 15,000 for 2012 and $125,000 4 $10 5 12,500 for 2011). Using these data, Milavec's 2012 EPS is calculated as follows. W $25,000 (net income) 2 $3,000 (preferred dividend) I 5 $1.60 per share (15,000 1 12,500)y2 (average outstanding common shares) L Investors attribute a great deal of importance to EPS figures. The amounts used in S calculating EPS, however, have limitations. Many accounting choices, assumptions, O and estimates underlie net income computations, including alternative depreciation methods, different inventory cost flow assumptions, and estimates of future bad debt N or warranty expenses, to name only a few. The denominator is also inexact because , various factors (discussed in advanced accounting courses) affect the number of shares to include. Numerous opportunities therefore exist to manipulate EPS figures. Prudent investors consider these variables in deciding how much weight to attach to earnings Q per share. U Book Value A Book value per share is another frequently quoted measure of a share of stock. It is S calculated as follows. H E Book value per share 5 Stockholders' equity 2 Preferred rights Outstanding common shares Instead of describing the numerator as stockholders' equity, we could have used assets minus liabilities, the algebraic computation of a company's \"net worth.\" Net 1 worth is a misnomer. A company's accounting records reflect book values, not worth. 9 Because assets are recorded at historical costs and different methods are used to transfer asset costs to expense, the book value of assets after deducting liabilities means little if 9 anything. Nevertheless, investors use the term book value per share frequently. Preferred rights represents 7 amount of money required to satisfy the claims of the preferred stockholders. If the B preferred stock has a call premium, the call premium amount is subtracted. In our example, we assume the preferred stock can be retired at U par. Book value per share for 2012 was therefore as follows. $362,000 2 $50,000 5 $20.80 per share 15,000 shares Price-earnings Ratio The price-earnings ratio, or P/E ratio, compares the earnings per share of a company to the market price for a share of the company's stock. Assume Avalanche Company and Brushfire Company each report earnings per share of $3.60. For the same year, Cyclone Company reports EPS of $4.10. Based on these data alone, Cyclone stock may seem to be the best investment. Suppose, however, that the price for one share of stock edm10890_ch13_586-635.indd Page 603 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis in each company is $43.20, $36.00, and $51.25, respectively. Which stock would you buy? Cyclone's stock price is the highest, but so is its EPS. The P/E ratio provides a common base of comparison. Price-earnings ratio 5 Market price per share Earnings per share The P/E ratios for the three companies are: Avalanche Brushfire Cyclone 12.0 10.0 12.5 Brushfire might initially seem to be the best buy for your money. Yet there must be some reason that Cyclone's stock is selling at 12 times earnings. In general, a higher P/E ratio indicates the market is more optimistic about a company's growth potential than it is about a company with a lower P/E ratio. The market price of a company's W stock reflects judgments about both the company's current results and expectations I about future results. Investors cannot make informed use of these ratios for investment decisions without examining the reasons behind the ratios. In October 2009, when the L Dow Jones Industrial Average was around 9,000 points, the average P/E ratio for the S companies in the Dow Jones Industrial Average was around 17. O Dividend Yield N There are two ways to profit from a stock investment. One, investors can sell the stock , for more than they paid to purchase it (if the stock price rises). Two, the company that issued the stock can pay cash dividends to the shareholders. Most investors view rising stock prices as the primary reward for investing in stock. The importance of receiving Q dividends, however, should not be overlooked. Evaluating dividend payments is more complex than simply comparing the dividends per share paid by one company to the U dividends per share paid by another company. Receiving a $1 dividend on a share purA chased for $10 is a much better return than receiving a $1.50 dividend on stock bought for $100. Computing the dividend yield simplifies comparing dividend payments. S Dividend yield measures dividends received as a percentage of a stock's market price. H Dividends per share Dividend yield 5 E Market price per share To illustrate, consider Dragonfly, Inc., and Elk Company. The information for calculat1 ing dividend yield follows. 9 9 7 B U Dragonfly Dividends per share (a) Market price per share (b) Dividend yield (a 4 b) Elk $ 1.80 40.00 4.5% $ 3.00 75.00 4.0% Even though the dividend per share paid by Elk Company is higher, the yield is lower (4.5 percent versus 4.0 percent) because Elk's stock price is so high. The dividend yields for the companies included in the Dow Jones Industrial Average were averaging around 1.4 percent in October of 2009. Other Ratios Investors can also use a wide array of other ratios to analyze profitability. Most profitability ratios use the same reasoning. For example, you can calculate the yield of a variety of financial investments. Yield represents the percentage the amount received is of the amount invested. The dividend yield explained above could be calculated for either common or preferred stock. Investors could measure the earnings yield by 603 edm10890_ch13_586-635.indd Page 604 604 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 calculating earnings per share as a percentage of market price. Yield on a bond can be calculated the same way: interest received divided by the price of the bond. The specific ratios presented in this chapter are summarized in Exhibit 13.6. EXHIBIT 13.6 Summary of Key Relationships Liquidity Ratios Solvency Ratios Profitability Ratios Stock Market Ratios 1. Working capital 2. Current ratio 3. Quick (acid-test) ratio 4. 5. 6. 7. 8. 9. 10. Accounts receivable turnover Average days to collect receivables Inventory turnover Average days to sell inventory Debt to assets ratio Debt to equity ratio Number of times interest is earned W I L 11. Plant assets to long-term liabilities S 12. Net margin 13. Asset turnover O 14. Return on investment (also: return on assets) N 15. Return on equity 16. Earnings per share , 17. Book value per share Q U A S H LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS E Analyzing financial statements is analogous to choosing a new car. Each car is different, 18. Price-earnings ratio 19. Dividend yield LO 8 Explain the limitations of financial statement analysis. Current assets 2 Current liabilities Current assets 4 Current liabilities (Current assets 2 Inventory 2 Prepaids) 4 Current liabilities Net credit sales 4 Average receivables 365 4 Accounts receivable turnover Cost of goods sold 4 Average inventory 365 4 Inventory turnover Total liabilities 4 Total assets Total liabilities 4 Total stockholders' equity Earnings before interest and taxes 4 Interest expense Net plant assets 4 Long-term liabilities Net income 4 Net sales Net sales 4 Average total assets Net income 4 Average total assets Net income 4 Average total stockholders' equity Net earnings available for common stock 4 Average outstanding common shares (Stockholders' equity 2 Preferred rights) 4 Outstanding common shares Market price per share 4 Earnings per share Dividends per share 4 Market price per share and prospective buyers must evaluate and weigh a myriad of features: gas mileage, engine size, manufacturer's reputation, color, accessories, and price, to name a few. Just 1 as it is difficult to compare a Toyota minivan to a Ferrari sports car, so it is difficult to compare a small textile firm to 9 giant oil company. To make a meaningful assessment, a the potential car buyer must focus on key data that can be comparably expressed for 9 each car, such as gas mileage. The superior gas mileage of the minivan may pale in comparison to the thrill of driving the sports car, but the price of buying and operating the 7 sports car may be the characteristic that determines the ultimate choice. B External users can rely on financial statement analysis only as a general guide to the U potential of a business. They should resist placing too much weight on any particular figure or trend. Many factors must be considered simultaneously before making any judgments. Furthermore, the analysis techniques discussed in this chapter are all based on historical information. Future events and unanticipated changes in conditions will also influence a company's operating results. Different Industries Different industries may be affected by unique social policies, special accounting procedures, or other individual industry attributes. Ratios of companies in different industries are not comparable without considering industry characteristics. A high debt to assets ratio is more acceptable in some industries than others. Even within an edm10890_ch13_586-635.indd Page 605 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial Statement Analysis 605 REALITY BYTES The single most important source of financial information is a company's annual report, but decision makers should also consider other sources. Interested persons can access quarterly and annual reports through the SEC's EDGAR database, and often from company websites. Many companies will provide printed versions of these reports upon request. Companies also post information on their websites that is not included in their annual reports. For example, some automobile companies provide very detailed production data through their corporate websites. Users can frequently obtain information useful in analyzing a particular company from independent W sources as well as from the company itself. For example, I the websites of popular news services, such as CNN (www.money.cnn.com) and CNBC (www.moneycentral. L msn.com) provide archived news stories and indepenS dent financial information about many companies. The websites of brokerage houses like www.schwab.com O offer free financial information about companies. Finally, libraries often subscribe to independent services that evaluate N companies as potential investments. One example worth reviewing is Value Line Investment Survey. , Q industry, a particular business may require more or less working capital than the industry average. If so, the working capital and quickU ratios would mean little compared to those of other firms, but may still be useful for trend analysis. A Because of industry-specific factors, most professional analysts specialize in one, or only a few, industries. Financial institutions such as S brokerage houses, banks, and insurance companies typically employ financial analysts who specialize in areas such H as mineral or oil extraction, chemicals, banking, retail, insurance, bond markets, or E automobile manufacturing. 1 When comparing firms, analysts must be alert to changes in general economic trends 9 from year to year. Significant changes in fuel costs and interest rates in recent years 9 make old rule-of-thumb guidelines for evaluating these factors obsolete. In addition, the presence or absence of inflation affects business prospects. 7 B Accounting Principles U Changing Economic Environment Financial statement analysis is only as reliable as the data on which it is based. Although most firms follow generally accepted accounting principles, a wide variety of acceptable accounting methods is available from which to choose, including different inventory and depreciation methods, different schedules for recognizing revenue, and different ways to account for oil and gas exploration costs. Analyzing statements of companies that seem identical may produce noncomparable ratios if the companies used different accounting methods. Analysts may seek to improve comparability by trying to recast different companies' financial statements as if the same accounting methods had been applied. Accrual accounting requires the use of many estimates; bad debt expense, warranty expense, asset lives, and salvage value are just a few. The reliability of the resulting edm10890_ch13_586-635.indd Page 606 606 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Chapter 13 financial reports depends on the expertise and integrity of the persons who make the estimates. The quality and usefulness of accounting information are influenced by underlying accounting concepts. Two particular concepts, conservatism and historical cost, have a tremendous impact on financial reporting. Conservatism dictates recognizing estimated losses as soon as they occur, but gain recognition is almost always deferred until the gains are actually realized. Conservatism produces a negative bias in financial statements. There are persuasive arguments for the conservatism principle, but users should be alert to distortions it may cause in accounting information. The pervasive use of the historical cost concept is probably the greatest single cause of distorted financial statement analysis results. The historical cost of an asset does not represent its current value. The asset purchased in 2001 for $10,000 is not comparable in value to the asset purchased in 2010 for $10,000 because of changes in the value of the dollar. Using historical cost produces financial statements that report dollars with differing purchasing power in the same statement. Combining these differing dollar values is akin to adding miles to kilometers. To get the most from analyzing financial W statements, users should be cognizant of these limitations. I L CHECK YOURSELF 13.3 S O The return on equity for Gup Company is 23.4 percent and for Hunn Company is 17 percent. Does this mean Gup Company is better managed than Hunn Company? N Answer No single ratio can adequately measure management performance. Even analyzing , a wide range of ratios provides only limited insight. Any useful interpretation requires the analyst to recognize the limitations of ratio analysis. For example, ratio norms typically differ between industries and may Q affected by temporary economic factors. In addition, be companies' use of different accounting practices and procedures produces different ratio U results even when underlying circumstances are comparable. > A Look Forward The next chapter presents a detailed explanation of the statement of cash flows. In that chapter, you will learn how to classify cash receipts and payments as financing activities, investing activities, or operating activities. The chapter explains how to use the T-account method to prepare a statement of cash flows and the difference between the direct method of presenting cash flows from operating activities and the indirect method of presenting cash flows from operating activities. The depth and timing of statement of cash flows coverage varies among colleges. Your instructor may or may not cover this chapter. edm10890_ch13_586-635.indd Page 607 8/3/10 1:59 AM user-f494 /Users/user-f494/Desktop/mhbr169:slavin:208 Financial statements for Stallings Company follow. Income Statements for the Years Ended December 31 2012 Revenues Net sales Expenses Cost of goods sold Selling, general, and administrative expenses Interest expense Income before taxes Income tax expense (40%) Net income Balance Sheets As of December 31 2011 $ 315,000 $ 259,000 (189,000) (154,000) (46,000) (4,500) 54,500 (21,800) $ 32,700 W (54,000) I (4,000) 68,000 L(27,200) $ 40,800 S O N , 2012 Assets Current assets Cash Accounts receivable Inventories Total current assets Plant and equipment (net) Total assets Liabilities and Stockholders' Equity Liabilities Current liabilities Accounts payable Other Total current liabilities Bonds payable Total liabilities Stockholders' equity Common stock (50,000 shares, $3 par) Paid-In capital in excess of par Retained earnings Total stockholders' equity Total liabilities and stockholders' equity Q $ U 6,500 51,000 A 155,000 S 212,500 187,500 H $400,000 E 1 $ 60,000 25,000 9 85,000 9 100,000 185,000 7 B 150,000 20,000 U 45,000 215,000 $400,000 2011 $ 11,500 49,000 147,500 208,000 177,000 $385,000 $ 81,500 22,500 104,000 100,000 204,000 150,000 20,000 11,000 181,000 $385,000 Required a. Use horizontal analysis to determine which expense item